IBS

FINANCE SPECIALIZATION FINAL EXAMINATION Q&A

Table of Contents

MANAGEMENT ACCOUNTING:...............................................................................................................4

1. Costing I: Cost classification, the problem and process of overhead absorption........................4

2. Costing II: Marginal, absorption and activity-based costing; process, advantages/disadvantages, comparison.............................................................................................4

3. Short-term decision-making: CVP analysis, relevant costs, segmental analysis, selling price decisions, limiting factors, renlacement of equipment.......................................................................4

4. Budgeting, standard costing, variance analysis: Preparation of budgets, the behavioural effects of budgeting, definition of standard cost, the process of standard costing, definition of variance analysis, calculation of variances, operating statement.......................................................9

CONTROLLING AND INTERNAL AUDITING............................................................................................16

1. Planning and the control process..............................................................................................16

2. Measuring divisional financial performance.............................................................................18

3. Controlling systems and new approaches................................................................................22

4. Planning and executing the internal audit................................................................................30

BANKING:..............................................................................................................................................30

1. Banking is a simple business. A bank issues capital, raises deposits at X% interest rate and lends the money at X+% interest rate. List the key factors of why the levels of banking profits change and why some banks make higher profits than other banks during the same financial year.

30

2. Why have some banks, unexpectedly, made such very large losses that these have either caused the liquidation of the bank or the sale to another bank to protect the depositors? How could these losses have been avoided?............................................................................................43

3. Banks can only operate if they have adequate capital. The standards for measuring capital adequacy have been agreed globally. Outline the components used in measuring capital adequacy, and the relationships required for these components.....................................................................43

4. Why is mismatching an important factor in the level of profits for a bank? Give examples of mismatching, how they can create a higher or lower level of profits, and how the bad effects of mismatching can be avoided?..........................................................................................................51

INVESTMENTS:......................................................................................................................................60

1. Explain the advantages of mutual fund investing to an individual investor. Discuss the types of investment funds and their structures. Illustrate the calculation of Net Asset Value. Mutual Fund Performance Measurement..............................................................................................................60

2. Discuss the importance of macroeconomic and industry analysis in equity valuation. Compare and contrast consensus forecasting with econometric models. List the factors that determine an industry’s sensitivity to the business cycle. Describe the macroeconomic variables that play the most important role in equity markets.............................................................................................62

3. Define call options and put options. Discuss the put-call parity relationship. Who are the participants of options markets and why do they trade options? Contrast options and futures contracts from a risk management perspective...............................................................................64

4. Describe the main characteristics of futures contracts and explain how margin accounts operate. Define swap contracts. Explain how a plain vanilla currency swap is set up and what cash flows are exchanged.........................................................................................................................70

MANAGEMENT ACCOUNTING:

1. Costing I: Cost classification, the problem and process of overhead absorption

Definitions:

Cost = a resource sacrificed or forgone to achieve a specific objective, mostly considered as monetary amounts

Costing = the process of determining the cost of doing something, the cost of manufacturing an article, rendering a service, performing a function (these are objectives of costing)

Cost objective = any activity for which a separate measurement of costs is desired.

Cost object = anything for which a separate measurement of costs is desired.

Cost centre = a collecting place for certain costs before they are analysed further.

Cost unit = unit of product or service to which costs can be related, a basic control unit for costing purposes. Costs traced to cost centres can be further analysed to establish cost per cost unit, or costs can be charged directly to cost units.

Costing systems = systems designed to provide financial accounting information for use in the P&L account and the B/S. In particular COS in the P&L account and Stock value in the B/S

Cost assignment = general term that encompasses both (1) tracing accumulated costs to a cost object (direct costs), and (2) allocating accumulated costs to a cost object (indirect costs).

Cost classification = the presentation of costs in logical groups with regard to the nature of the costs or the purpose to be fulfilled in presenting the cost.

Cost classification purposes:

1. Costs for stock valuation

Direct and indirect cost Direct costs – those costs that can be directly and exclusively identified with a particular

activity (e.g. product or service); costs that are related to the particular cost object and that can be traced to it in an economically feasible (cost-effective) way.

Indirect cost – these costs are material, labour and other expenses that cannot be directly identified as a direct cost (e.g. overheads – production and non-production); costs that are related to the particular cost object but cannot be traced to it in an economically feasible (cost effective) way. Indirect costs are allocated to the cost object using a cost allocation method.

Problem:

A cost may be direct regarding one cost object and indirect regarding other cost objects. The direct and indirect classification depends on the choice of the cost object. For example, the salary of an assembly-department supervisor may be direct cost of the assembly department at Fiat but and indirect cost of a product such as the Fiat Uno.

Elements of manufacturing/production costs (see below) Direct material costs: the acquisition costs of all materials that eventually become part of

the cost object and that can be traced to the cost object in an economically feasible way. Acquisition costs of direct materials include fright-in (inward delivery) charges, sales taxes and custom duties.

Direct manufacturing labour costs: compensation of all manufacturing labour that is specifically identified with the with the cost object, and that can be traced to the cost object in an economically feasible way. Examples are wages and fringe benefits paid to machine operators and assembly line workers.

Indirect manufacturing costs: all manufacturing costs considered to be part of the cost object, but that cannot be individually traced to that cost object in an economically feasible way. Examples: power, supplies, indirect materials, indirect manufacturing labour (wages of supervisors, sales people), plant rent, plant insurance, property taxes on plants, plant depreciation and the compensation of plant managers. Other terms for this cost category include manufacturing overhead costs and factory overhead costs.

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Direct materials X These costs can be physically or specifically traced to or identified with productsDirect labour (wages) X

Direct expenses (e.g. hiring cost of specific machinery)

X

Prime cost X

Indirect production costs or overheads (indirect material, labour, expenses)

X Cannot be charged directly to the products, can be allocated to cost centres and transferred to products

Production cost X = Total Manufacturing Costs

Administration X Non-manufacturing overhead costs (usually period cost)

Selling X

Distribution X

R&D X

Total cost X

Period and product costs Product costs – costs that are identified with goods purchased or produced for resale,

included in stock valuation (cost of goods sold) Period costs – costs that are not included in the stock valuation, treated as expenses in

the period in which they are incurred (non-manufacturing overheads: administration, distribution expenses)

Job and process costs Job = A job is a cost unit, which consists of a single order or contract. Job costing is a form

of specific order costing which applies where work is undertaken to customers’ special requirements and each order is of comparatively short duration (compared with those to which contract costing applies).

Batch = A batch is a cost unit, which consists of a separate, readily identifiable group of units, which maintains its separate identity throughout the production process. Batch costing is a form of specific order costing which applies where similar articles are manufactured in batches either for sale or for use within the undertaking.

Contract = A contract is a cost unit or cost centre, which is charged with the direct costs of production and an apportionment of head office overheads. Contract costing is a method of job costing where the job is of large magnitude.

Process = A process is a cost centre, which consists of a specific process or a continuous sequence of operations. Process costing is the costing method used where it is not possible to identify separate units of production or jobs, usually because of the continuous nature of the production processes involved.

Service = Service costing is concerned with establishing the costs, not of items of production, but of services rendered.

2. Costs for decision-making

Cost behaviour – knowledge of how costs will vary with different levels of activity (units, hours, miles, etc.) or volume Fixed cost – costs that remain constant over wide ranges of activity for a specified time

period (the shorter the time period, the greater the probability that a particular cost will be fixed)

Variable cost – costs that vary in direct proportion to the volume of activity (over a sufficiently long time period, virtually all costs are variable!)Examples:

o Manufacturing variable cost: piecework labour, direct materialo Non-manufacturing: sales commission, transportation/petrol cost

Semi-variable/mixed cost – costs that contain elements of both fixed and variable cost behaviour

Step cost – costs that change abruptly at intervals of activity because the resources and their costs come in indivisible chunks

Direct and indirect cost Relevant and irrelevant costs

Relevant costs – those future costs that will be changed by a decision

Irrelevant costs – those costs that will not be affected by the decisionExample: decision on car or public transport – relevant: petrol costs, irrelevant: car tax and insurance costs

A relevant range is the range of the cost driver in which specific relationship between cost and driver is valid.

Avoidable and unavoidable costs – synonym for ir/relevant Avoidable costs – those costs that may be saved by not adopting a given alternative Unavoidable costs cannot be savedDecision rule: revenues > avoidable costs

Sunk costs – costs that have been created by a decision made in the past and that cannot be changed by any decision that will be made in the future, irrelevant costs for decision-making (Not all irrelevant costs are sunk costs!)

Example: depreciation of purchased asset

Opportunity costs – cost that measures the opportunity that is lost or sacrificed when the choice of one course of action requires that an alternative course of action be given up (e.g. lost revenue from sacrificed production)

Marginal/incremental/differential costs – additional costs or revenues that arise from the production of a group of additional items

3. Costs for control

Controllable and uncontrollable costs – whether costs are controllable by the manager of the responsibility centre where the costs have been allocated to

Cost behaviour

Cost Classification can also be made on the basis of:1. Business Function

a. Research and developmentb. Design of products, services and processesc. Productiond. Marketinge. Distributionf. Customer service

2. Assignment to a cost objecta. Direct costsb. Indirect costs

3. Behaviour pattern in relation to changes in the level of a cost drivera. Variable costsb. Fixed costs

4. Aggregate or averagea. Total costsb. Unit costs

Overhead absorptionCost Allocation: the process by which specific, identifiable cost items are charged direct to a cost unit or cost centre.

Direct costs to direct cost centres or cost units i.e. products Production overheads: cannot charge directly to cost units, more roundabout system i.e. first

allocate to OH cost centres

Cost Apportionment: the division of an indirect or overhead cost item among two or more cost centres in proportion to the estimated benefits received (so as to reflect the relative use of that cost item by each cost centre) by using some basis of apportionment using an appropriate basis of apportionment. (E.g. rent > area occupied)

Cost Absorption: Overhead absorption is the process of adding or absorbing allocated and apportioned overhead costs into the cost of production or sales, that is assigning these to cost units (i.e. products).

Blanket overhead rates: Some companies establish a single overhead rate for the factory as a whole and this rate is assigned to all products (absorption). Appropriate where all products consume cost centre overheads in approximately the same proportions. Not appropriate where products consume cost centre overheads in different proportions.

Two stage overhead allocation process

Stage 1: Assign overheads to production departments

Stage 2: Allocate overheads to products

Following steps are used:

1. Assign overheads to production and service (support) departments (some costs can be directly assigned but others need to be apportioned).

2. Re-allocate service department costs to production departments.3. Calculate separate overhead rates for each cost centre.5. Allocate departmental overheads to products

Overall allocation process1. Select bases of apportioning OH costs

2. Prepare a factory overhead budget for the planning period (estimate overhead costs and volume of OH apportioning bases)

3. Compute OARs 4. Obtain actual data on activity levels (volume of apportionment basis)5. Apply budgeted OH to cost units by multiplying OAR, the budgeted rate with actual OH

absorption basis, activity level.6. At year end account for any differences between the amount of OH actually incurred and OH

applied to products.

Problems with cost absorption:Under or over recovery of overheads

There will be under or over recovery of OHs whenever actual activity or OH expenditure is different from the calculations used to estimate the OH rate.

Rate is based on estimates (both numerator and denominator) Estimates might not agree what actually occurs Actual overheads are different from budgeted overheads Actual activity levels are different from budgeted activity level

Over-absorption: overheads charged to cost of sales are greater than overheads actually incurred; occurs when the allocated amount of indirect costs in an accounting period exceeds the actual (incurred) amount in that period

Under-absorption: insufficient overheads have been included in cost of sales; occurs when the allocated amount of indirect costs in an accounting period is less than the actual (incurred) amount in that period.

Indirect costs allocated/budgeted

- Indirect costs incurred------------------------------------------

Over / (under)allocated indirect costs

Treatment of under or over recovery of overheads:

Treat under-recovery as period cost, write off against profit in P/L statement in current accounting period. Never allocate to products, do not include in stock valuation!

Actual costing versus Normal costing:

Actual costing system: OH would be applied only at period end, when actual OH cost is known.

Goods are produced and sold during the year, overheads might not be known until the year end

Frequent calculation of overhead absorption rates distorts costsNormal costing system: determine OAR at the beginning of the financial period to apply overhead costs as products are produced.

2. Costing II: Marginal, absorption and activity-based costing; process, advantages/disadvantages, comparison

There is no completely satisfactory way of sharing out indirect costs between many different items of production which benefit from them.

Traditional costing methods:

Absorption / Full costing

All costs incurred in the production process (all fixed manufacturing costs and manufacturing overheads) are allocated to products.

COGS = VC + fair share of manufacturing FOH

Advantages:

SSAP 9 requires that absorption costing is used for external reporting/financial statements Useful for setting sales prices, ensuring these will cover all costs of production. Absorption does not understate the importance of fixed costs: since FOHs are incurred in

production, they should be included as product costs. Analysis of fixed and variable costs are not required. Absorption costing avoids “fictitious losses” / prevents “distorted” profits being reported (e.g.

stocks accumulated in advance in seasonal business). Absorption costing is theoretically superior to variable costing. (Note cost obviation concept

favors variable costing, whereas revenue production concept favors absorption costing.)

Disadvantages:

No clear relationship between profits and sales volume, profit is also a function of production. => confusing and unsatisfactory method of monitoring profitability.

Provides misleading information for decision makingo In short-term decisions FCs do not change, therefore should not be included

o FCs should be independent of production volume

Absorption Costing

Variable / Marginal / Direct costing :

Only variable manufacturing costs are allocated to products, all other costs (fixed manufacturing costs and non-manufacturing overheads) are considered period costs (irrelevant for short term decision-making) and charged directly to the profit and loss account.

FOHs are not brought forward as part of closing stock Highlights contribution = sales revenue - VCs

Advantages:

Variable costing provides more useful information for decision-making o In short-term decisions fixed costs do not change.o FCs are unaffected by changes in production volumeso Enables contribution maximizing in decisions

Variable costing removes from profit the effect of stock changes: if sales volumes are the same from period to period, marginal costing will report the same profit each period (absorption

Production

Costs

Direct cost

DM DL DE

Indirect cost/OH

Variable / Fixed

Production cost

Total cost (P&L a/c)

Variable Fixed

Non-manufacturing

Absorbed OH Under- or

overabsorbed OH

WIP, Finished goods stock

costing will result in varying profits even when volume of sales is constant).=> FCs are treated in accordance with their nature: period, rather than product costs. Variable costing prevents “distortion” of profits due to changes in stock levels.

Variable costing avoids fixed overheads being capitalised in unsaleable stocks. Arguably absorption costing is a confusing and unsatisfactory method of monitoring profitability

whereas variable costing gives an accurate picture of how a firm’s cash flows and profits are affected by changes in sales volume.

Volatile sales and changing stock levels favor variable costing.

Disadvantages:

Costs need to be divided into their fixed and variable elements.

Variable costing

Indirect cost/OH

Variable Fixed

Production

Costs

Direct cost

DM DL DE

Production cost

Total cost (P&L a/c)

Variable Fixed

Non-manufacturing

WIP, Finished goods stock

Absorption vs. Marginal costing

Absorption Marginal

Differ in the treatment of fixed manufacturing costs:

Costs added to direct costs of production Indirect/fixed costs are treated as a lump sum cost = period cost

Profits are the same for both, then production = sales volume (no changes in stock)

PRODUCTION > SALES

(increasing stock levels)

Absorption costing system produces higher profits!

SALES > PRODUCTION

(declining stock levels)

Variable costing system produces higher profits!

Internal profit measurement favors:

SEASONAL SALES, where stocks are built up (no fictional losses)

VOLATILE SALES and CHANGING STOCK LEVELS

Differences:

Reporting to management - Profit monitoring and control:

Reported profit is likely to differ according to costing method used Marginal costing – contribution varied in direct proportion to the volume of units sold: profits

increase as sales volume rises (arguably gives an accurate picture of how a firm’s cashflows and profits are affected by sales volume changes).

Absorption costing – profits decline when sales volume increases and costs remain unchanged (e.g. period 6), no clear relationship between profit and sales volume, it is also a function of production: as sales volume rises, total profit rises by the sum of gross profit per unit plus the amount of OH absorbed per unit (arguably a confusing and unsatisfactory method of monitoring profitability).

Profits are the same for both methods when production equals sales (no change in stock levels in periods 1&4).

Where production exceeds sales (increasing stock levels) the absorption costing system produces higher profits (periods 2&5).

Where sales exceed production (declining stock levels) the variable costing system produces higher profits (periods 3&6).

External reporting – Profits and inventory values:

SSAP9: requirement to include production Overheads in inventory value in published accounts Information for planning, control and decision-making:

Using absorption costing for decision-making provides totally misleading information: absorption costing information about unit profits is irrelevant in short-term decisions in which Fixed Costs do not change (choose alternative maximizing contribution).

Conclusion

1. Choice depends on the circumstances Volatile sales and changing stock levels favour variable costing for internal monthly or

quarterly profit measurement Seasonal sales where stocks are built up in advance favours absorption costing

2. Debate only applies to internal reporting –

3. Debate only applies when historical cost accounting is used

Activity-based costing (ABC)

“A cost management approach that allows better decisions through more accurate process and product cost information. ABC assumes that there is a cause and effect relationship between activities, associated costs and output and provides a means of measuring that relationship in terms of costs.”

Activity – a defined scope of work which produces a physical or informational result, utilises a measurable set of resources and has an identifiable driver

Driver – one or more business factors or events which cause this work to be performed

Cost driver – the events or forces that are the significant determinants of the cost of the activities

Decades ago Today

Narrow range of products OHs small fraction of Total Cost

Lot of different products Direct Labour small fraction of Total Cost

Direct Labour, Direct Material are dominant costs

Errors made in OH attribution ARE NOT significant

OHs are major part of Total Cost Errors made in OH attribution ARE

significant (global competition)

Major ideas behind ABC:

Activities cause costs. Products create demand for activities Costs are assigned to products on the basis of product’s consumption of activitiesAim of ABC is to manage activities and not costs. By managing the forces that cause activities, costs will be managed in the long run.

Classification of activities

1. Unit-level activities Performed each time a unit of the product is produced. Examples: DL, DM, machine costs and energy.

2. Batch-related activities Performed each time a batch of goods is produced. Examples: set-ups, purchase ordering, first-item inspection activities.

3. Product-sustaining activities Performed to support different products in the product line. Examples: activities related to maintaining an accurate bill of materials, preparing

engineering change notices.4. Facility-sustaining activities

Performed to sustain a facility’s general manufacturing process. Examples: plant management, maintenance of buildings, heating and lighting. Common to all products and not assigned to individual products.

Advantages and Disadvantages of ABC

Advantages

1. Relative simplicity2. Broader outlook and impact – provides multiple “views” of the business

Recognises complexity with multiple cost drivers, attention on nature of cost behaviour Meaningful analysis of costs to provide info for realistic assessment of product profitability,

product performance measurement Highlights interrelationships between areas

3. Basis for making processes more efficient and waste elimination Insight into product design, product mix, processing methods Value-added / Non-value added activities are separated based on activity analysis By understanding where the majority of OH costs go, changes are possible to minimize

expenses

4. Greater interaction between finance function and production functions – links financial and operational data

5. Encourages non-financial measures of activity and performance

Disadvantages

1. Difficult and expensive to set up, firms implementing ABC are likely to maintain two systems (monthly profit reporting / external financial accounting and ABC costing system)

2. Questionable whether ABC costs can be used directly for decision-making (ABC system is relevant for identifying managerial attention and NOT for providing decision relevant costs)

3. Some unsolved problems remain4. Activities must be quantifiable 5. Not activities but decisions or the passage of time cause costs

Comparison of ABC with Traditional Costing

Traditional product costing systems measure accurately volume-related resources that are consumed in proportion to the number of units produced, but they do not measure accurately consumption of non-volume related activities. => Traditional costing systems produce false product costs, whenever the costs of product related activities are unrelated to volume. Non-volume related activities consist of support activities such as material handling, material procurement, set-ups, production scheduling and first-item inspection activities. (Resources are consumed each time a batch of products is processed.)

Traditional product costing system

Stage 1: Overheads assigned to production departments

Stage 2: Overheads allocated to products using overhead rates

OVERCOST: high volume products – more DL, etc. => high proportion of OHs allocated!

UNDERCOST: low volume products

=> long-run: high volume products are more expensive to produce than some low volume products!

Activity-based product costing system

Stage 1: Overheads assigned to cost centres/ cost pools

Stage 2: Overheads assigned to products using cost driver rates

Outline of costing methods

Traditional costing:

1. Assigning overheads to production and service departments2. Reallocation of service centre overheads to production cost centres3. Calculation of appropriate departmental overhead rates4. Charging overheads to products

ABC

1. Identify the major activities of the organisation Volume related Non-volume related

2. Determine the cost driver for each activity (factors influencing the cost of that particular activity)3. Create a cost pool (or cost centre) for each activity4. Trace the costs of activities to products according to a product’s usage of cost drivers / product’s

demand for activities

Comparison:

Both use a two-stage allocation process:

First stage Traditional – OHs allocated to production departments, fewer cost centres, complication

of service department cost reallocation ABC – OHs assigned to each major activity, more cost pools, according to number of

major activities, problem of service department reapportionment is avoided Second stage - absorption

Traditional – usually two bases (DLH, machine hour) ABC – a lot of cost drivers

3. Short-term decision-making: CVP analysis, relevant costs, segmental analysis, selling price decisions, limiting factors, renlacement of equipment

CVP – cost-volume-profit - analysis

CVP analysis is a systematic method of examining the relationship between changes in activity and

changes in total sales revenue, expenses and net profit. It is subject to a number of underlying

assumptions and limitations, and it is a powerful tool for decision-making in certain situations. It is an

application of marginal costing techniques, and sometimes called break-even analysis. The objective

of the CVP analysis is to establish what will happen to the financial results if a specified level of

activity or volume fluctuates. This information is vital to management, since one of the most

important variables influencing total sales revenue, total costs and profits is output or volume. CVP

analysis is based on the relationship between volume and sales revenue, costs and profit in the short

run, a period of one year or less. As most of the cost and prices of a firm’s products will have already

been determined, the major area of uncertainty will be sales volume. There are two approach of CVP

analysis developed: economist’s model (theoretical), and accountant’s model.

The economist’s model

The total revenue line is assumed to be curvilinear. At first it starts to increase sharply with high

revenue but little quantity sold. To increase quantity of sales, it is necessary to reduce the unit

selling price, which results in the total revenue line rising less steeply, and eventually beginning

to decline. This is because the adverse effect of price reductions outweighs the benefits of

increased sales volume.

Fixed cost is constant. The variable cost has the most significant influence on the total costs. The

total cost line rises steeply at first as the firm operates at lower levels of the volume range (the

firm operates at a level which is lower then the efficient one), then it begins to level out and rise

less steeply (the firm operates efficiently), and finally it continues to rise steeply, bottlenecks

develop, plant breakdowns begin to occur, as the cost per unit of output increases (the firm

operates beyond the efficient activity level)- decreasing returns to scale.

The total revenue and the total cost line cross at two points, where they are equal. There are two

break-even points.

The accountants’ model

Assumes a variable cost and a selling price that are constant per unit. This results in a linear

relationship for total revenue and total cost as volume changes. The most profitable output is

therefore at maximum practical capacity.

This model is not intended to provide an accurate representation of total cost and total revenue

throughout all ranges of output. The objective is to represent the behaviour of total cost and

revenue over the range of output at which a firm expects to be operating within a short-term

planning horizon. The term “relevant range” is used to refer to that output range and broadly

represent the output levels which the firm has had experience of operating in the past and for

which cost information is available.

Total fixed cost line is constant for the relevant range.

There is only one break-even point.

Four variables determine the level of profitability:

the unit price;

the level of fixed costs;

the variable cost per unit

volume

Change any one variable and profit will also change.

Clearly, the economist’s model appears to be more realistic, since it assumes that the total cost curve

is non-linear. The accountant’s assumption about the revenue line is a realistic one in those firms that

operate in industries where selling prices tend to be fixed in the short term.

CVP tools:

a) Break-even point (BEP)

That activity or output level (in units or sales value), at which total revenue equals total cost

and there is neither profit nor loss.

In units: fixed cost/ contribution in unit

In sales value: fixed cost / Cont./Sales ratio

Contribution margin is equal to sales minus variable expenses.

b) Target Profit

If a company wishes to know the level of activity it has to achieve to obtain its target profit.

Should we apply the contribution margin approach and wish to achieve the desired profit, we

must obtain sufficient contribution to cover the fixed costs plus further contribution to cover

the target profit.

Units sold for target profit = (fixed costs + target profit) / contribution per unit

c) Margin of Safety

the difference between a given level of sales, and the break-even level of sales

indicates by how much sales may decrease before a loss occurs

percentage margin of safety = (expected sales – break-even sales) / expected sales

Most significant assumptions and limitations (just read): these should be kept in mind when

preparing or interpreting CVP information, otherwise it results in serious errors and incorrect

conclusion.

1. Volume is the only factor that will cause costs and revenues to change, all other variables (eg.

productions efficiency, sales mix, price levels) remain constant. If significant changes in these

other variables occur the CVP analysis presentation will be incorrect.

2. Single product or constant sales mix: CVP analysis assumes that sales will be in accordance

with the predetermined sales mix.

3. Assumption of linear behaviour: fixed cost line, variable cost line, sales

4. Semi-variable costs: assumes that costs can be accurately analyzed into their fixed and variable

elements. Semi-variable costs, however, include both a fixed and variable component (eg. Cost of

maintenance). Variable components are directly related to activity. The high-low method is a

technique that helps to separate fixed and variable costs. It consists of examining past costs and

activity, selecting the highest and lowest activity level and comparing the changes in costs which

result from the two levels.

5. Relevant range: analysis applies to relevant range only

6. The analysis applies only to a short term time horizon

7. Profits are calculated on a variable costing basis – not absorption-costing - .

8. Complexity related fix costs related to the RANGE of items produced do not change

Relevant costs

The relevant costs and benefits required for decision-making are only those that will be

affected by the decision. The relevant financial inputs for decision-making are future cash

flows that will differ between the various alternatives being considered.

Therefore, only relevant (incremental/differential) cash flows should be taken into account,

and cash-flows that will be the same for all alternatives are irrelevant. Irrelevant costs are for

example past costs, since decision-making is concerned with choosing between future

alternative courses of action. Typical examples for irrelevant costs: fixed costs, depreciation...

If direct labour and fixed costs will remain unchanged during the period, they are not

relevant to the decision, but in the long term the amount spent on them may be changed,

therefore, they may be relevant. Note that the stock valuation cost should not be used for

decision-making. Where capacity is scarce, opportunity costs should be included in the

analysis.

Qualitative factors: those factors that cannot be expressed in monetary terms but may have

an impact on future profitability. Management should pay attention to theses factors in case

of decision-making. Example for these factors: decline in employees’ morale, loss of

customer goodwill.

Segmental analysis

Required for strategic decisions

Involvement in more than one geographical market or business sector requires turnover,

operating profit & net assets to be analyzed between the relevant segments

Comparison of profitability of different areas of company activity

Very important to be able to allocate common costs properly among the different business units to

avoid incorrect decisions like the discontinuation of a profitable business unit.

Selling price decisions

If a firm receives an order at a price below the prevailing market price, at first glance it looks

as if the order should be rejected but if the costs are carefully estimated and only the

relevant ones are taken into consideration then it can happen that the order is to be

accepted.

In the short term, fixed cost like direct labour or manufacturing fixed overheads will be

irrelevant for the decision-making as they do not change. In order to make a decision, all the

two alternatives’ relevant costs should be compared with each other, and the difference

should be presented.

Important factors to be considered before making the decisions:

o The future selling price will not be affected by selling some of the output at a price

below the going market price. Competitors will not change the price which would

lead to a fall in profits from future sales in the long-run. The loss of future profit may

be greater than the short term gain.

o No better opportunity will present itself during the period.

o Fixed costs are unavoidable for the period; they cannot be reduced, which is

expected to occur in the long-run.

Firms should take advantage of short-term opportunities, but, at the same time, the long-

term considerations must be taken into account. Special order in the long-run may not be

profitable.

Limiting factors

When sales demand is in excess of a company’s productive capacity, the resources

responsible for limiting the output should be identified. These scarce resources are known as

limiting factors. Limiting factors are factors that restrict output.

Where limiting factors exist, profit is maximized when the greatest possible contribution to

profit is obtained each time the scarce or limiting factor is used. The objective is to

concentrate on those products that yield the largest contribution per scarce factor.

Note that qualitative factors should also be taken into consideration.

Replacement of equipment

It is a capital investment or long-term decision that requires the use of discounted cash flow

procedures.

Past or sunk costs, book value, depreciation of equipments, any profit or loss on the sale of

replaced assets are irrelevant for decision-making. Only future costs or revenues that will

differ between alternatives are relevant for replacement decisions.

4. Budgeting, standard costing, variance analysis: Preparation of budgets, the behavioural effects of budgeting, definition of standard cost, the process of standard costing, definition of variance analysis, calculation of variances, operating statement

Introduction –for the sake of general understanding – not closely related, just to be read through:

The annual budget should be set within the context of longer term plans, which are likely to exist

even if they have not been made explicit. A long-term plan is a statement of the preliminary targets

and activities required by an organization to achieve its strategic plans together with an estimate for

each year of the resources required. The long-term plans, involving „looking into the future”, tend to

be uncertain, general and subject to change. Annual budgeting is concerned with the detailed

implementation of the long term plan for the year ahead. As the year progresses the control process

involves comparing planned and actual outcomes and responding to any deviation by taking remedial

action to ensure that future results will comfort to the annual budget. (Or: the budget is to be

corrected!)

The multiple functions of budgets: (just to read since it may be asked in the exam): Budgeting is the

process of devising a financial plan for future operations. It translates strategic plans into quantitative

and monetary statements. Budgets serve a number of useful purposes:

1. Planning annual operations,

2 .Coordinating the activities of the various parts of the organization and ensuring that the parts are

in harmony with each other

3. Communicating plans to the various responsibility managers

4. Motivating managers

5. Controlling activities

6. Evaluating the performance of managers

Preparation of budgets:

Stages in the budgeting process:

Communicate details of budget policy and guidelines: The long-range plan is the starting

point for the preparation of the annual budget. Top management is to communicate the

policy effects of the long-term plan to those responsible for preparing the current year’s

budget. E.g. planned changes in sales mix

Determine the factor that restricts output: In every organization there is some factor

restricting performance for a given period. Mostly sales demand or sometimes capacity.

Preparation of the sales budget: The volume of sales determines the level of a company’s

operation, when the sales demand is the factor that restricts output. So this is the most

important plan in the annual budgeting process!

Initial preparation of budgets: The managers who are responsible for meeting the budgeted

performance should prepare the budget for those areas for which they are responsible. –

bottom-up approach-

Negotiation of budgets with the higher management: The lowest level managers submit

their budgets to their superiors for approval. Then the superior incorporate this budget with

other budgets for which he is responsible and then submits this budget for approval to his

superior…and so on

Co-ordination and review of budgets: As the individual budgets move up the hierarchy in the

negotiation process, they must be examined in relation to each other. During this process a

budgeted profit and loss account, a balance sheet and a cash flow statement is to be

prepared.

Final acceptance of budgets: If budgets are in harmony they are summarized into a master

budget.

Ongoing review of the budgets: Don’t stop the process when the budgets have been agreed!

Compare results with budgeted goals...

Constructing budgets:

Step 1: sales budget

Step 2: finished goods stock budget

Step 3: production budget

Step 4: budgets of resources of production

o materials usage budget

o machine utilization budget

o labor/wages budget

Step 5: overhead cost budgets

o production overhead budget

o selling&distribution OHs budget

o administration overhead budget

o R&D overhead budget

Step 6: raw materials stock budget

Step 7: raw materials purchase budget

Step 8: creditors and debtors budget

Cash budget

Master budget: Summary of all individual budgets

The behavioral effects of budgeting:

The use of budgets as targets:

There is substantial evidence from a large number of studies that the existence of a defined,

quantitative goal or target is likely to motivate higher levels of performance than when no such

target is stated. People perform better when they have a clearly defined goal to aim for and are

aware of the standards that will be used to interpret their performance. The chosen level of difficulty

of the targets has a significant effect on motivation and performance. Set „highly achievable” goals:

challenging but achievable at a consistently high level of effort.

Accounting controls&performance evaluation:

o Organization rewards are often linked to a manager’s budget record, but accounting

performance measures represent only approximate measures of desired outcomes

o Dysfunctional consequences arise when performance measures motivate managers

to engage in behavior that is not organizationally desirable

o Hopwood observed three different styles of managerial use of accounting

information in performance evaluation (a budget constrained style, a profit-

conscious style, a non-accounting style) A budget constraint style often results in

undesirable decision behavior, which is „profitable” for the manager but not for the

whole company – short-termism

Motivation:

Properly set, defined targets increase motivation. (See above) On top of that if the manager

has the possibility to participate in the budgeting process then his motivation significantly

increases.

o Goal congruence is vital

o Role of management accountant is to encourage motivation from managers towards

the budgetary control system

o The absence of motivation at the planning stage – poor attitude towards the

budgetary control cycle may begin at the planning stage

o The absence of motivation when putting plans into action – poor attitude might arise

when a budget is implemented

o Motivation and the use of control information – attitude of managers might reduce

the effectiveness of information received

Participation in the budget and standard setting process: participatory budgets versus

imposed budgets

o Participation in budget setting is claimed to lead to improved attitude towards the

budget system, standards becoming more relevant, improved communication, higher

motivation and higher performance

Bias in the budget process:

o Where managers are able to influence their budget standard there is a possibility

that they will bias the information to gain the greatest personal benefit

o Slack is created through a process of understanding revenues and overstating costs

Definition of standard costing:

Standard costing is most suited to an organization whose activities consist of a series of common or

repetitive operations and the input required to produce each unit can be specified. E.g.:

manufacturing companies

Standard costs: The predetermined costs. They are target costs that should be incurred under

efficient operating conditions. They are not the same as budgeted costs. A budget relates to an entire

activity or operation, a standard presents the same info on a per unit basis. A standard therefore

provides cost expectations per unit of activity and a budget provides the cost expectation for the

total activity.

Standard costing: The establishment of predetermined estimates of the costs of products or services,

the collection of actual costs and the comparison of the actual results with the predetermined

estimates.

The determination of the standard costs raises the problem of how demanding the standards should

be: (just to read)

1. Basic cost standards represent constant standards unchanged over long periods.

2. Ideal standards represent perfect performance. Unlikely to be used in practice because they

may have an adverse impact on motivation.

3. Currently attainable standard costs: costs that should be incurred under efficient operating

conditions. Most widely used!

Main purposes of standard costing: (just to read)

1. Used for decision making purposes

2. Providing a challenging target

3. Assisting in setting budgets and evaluating managerial performance

4. Acting as a control device to highlight those activities which do not conform to plan

The process of standard costing (an overview of a standard costing system):

Standard cost of actual output recorded for each responsibility centre

Actual costs traced to each responsibility centre

↓

Standard and actual costs compared and variances analyzed and reported

↓

Variances investigated and corrective action taken

↓

Standards monitored and adjusted to reflect changes in standard usage and/or prices

Definition of variance analysis

Variance: The difference between standard and actual results. It can be favorable or adverse.

Variance analysis: The process by which the total difference between standard and actual results is

analyzed. Look for the causes of the variances.

Calculation of variances:

Sales variances:

o Sales price variance: The measure of the effect on expected profit of a different

selling price to standard selling price

o Sales volume variance: The difference between the actual units sold and the

budgeted quantity, valued at the standard profit per unit

Direct material cost variances:

o Direct material price variance: The difference between the standard cost and the

actual cost for the actual quantity of material used or purchased

o Direct material usage variance: The difference between the standard quantity of

materials that should have been used for the number of units actually produced, and

the actual quantity of materials used, valued at the standard cost per unit of material

Direct labor cost variances:

o Direct labor rate variance: The difference between the standard cost and the actual

cost for the actual number of hours paid for

o Direct labor efficiency variance: The difference between the hours that should have

been worked for the number of units actually produced, and the actual number of

hours worked, valued at the standard rate per hour of labor

o Idle time variance: Adverse efficiency variance, amount of wages paid to labor force

without any working being done

Fixed production overhead expenditure variance: The difference between the budgeted

fixed production overhead expenditure and actual fixed production overhead expenditure

The causes of labour, material, overhead and sales margin variances – just read, it may be asked -:

Quantities cost variances arise because the actual quantity of resources consumed exceeds actual

usage. Examples include excess usage of materials and labour arising from the usage of inferior

materials, careless handling of materials... Price variances arise when the actual prices paid for

resources exceed the standard prices. Examples include the failure of the purchasing function to seek

the most efficient supplier…

Operating statement

Operating statements reconcile budgeted and actual profit. This comparison can be executed by

adding the favorable production and sales variances to the budgeted profit and deducting the

adverse ones.

CONTROLLING AND INTERNAL AUDITING

1. Planning and the control process

Managerial decisions, coordination, various aspects

In the best interest of org.

Planning process, budgeting

Short term (budget), long term – strategic, corporate

Planning is the design of a desired future and of effective ways of bringing it about

Budgeting should accept the environment of today (physical, financial, human resources available)

Stages of the planning process (how budgeting fits the overall planning process)

1. Establish objectives– employees must have good understanding on the company’s aims. Objectives may be:

mission (visionary projection/overriding concept), corporate objectives (objective: more specific), unit objectives (divisional aims). (measurability, motivation)

– see: BPS2. Identify potential strategies / courses of action

- strategic analysis (environment, SWOT, etc)- strategy formulation, generic strategy (Porter: cost leadership,

differentiation, focus/niche)3. Evaluation of strategic options (also covered in depth during BPS):

- Suitability- Acceptability- Feasibility

4. Select course of action- Develop long-term plan: “a statement of the preliminary targets and

activities required by an organization to achieve its strategic plans together with a broad estimate for each year of the resources required.”

5. Implementation of long-term plan in form of annual budget- Budget: implement long-term plan in the coming year- More precise and detailed- Must be considered as an integrated part of the long-term planning

process6. Monitor actual results

- Compare actual figures with the planned ones7. Respond to divergences

Functions of budgets:

Planning

Coordinating

Communicating

Motivating

Controlling

Evaluating

Preparation of budgets:

Process of top-down statement of objectives and strategies, bottom-up budget preparation and top-down approval by senior management.

Activity-based budgeting (vs. conventional budgets)

For those indirect cost and support activities where there are no clearly-defined input-output relationships and the consumption of resources does not vary with the final output of products/services.

(Disadvantage of incremental approach: majority of expenditure, associated with the base-level of activity, remains unchanged. Thus, the cost of non-unit level activities becomes fixed and past inefficiencies and waste inherent in the current way of doing things is perpetuated.)

--- managing the costs of support activities

- Those companies that implemented ABC, also implemented ABB- Aim: to authorize the supply of only those resources that are needed to

perform activities required to meet the budgeted production and sales volume

- As being the reversed process to ABC, cost objects are the starting point (their budgeted output determines the necessary activities which are then used to estimate the resources required)

-

Stages of ABB:

- Estimate production and sales volume by individual products and customers (also the costs of ordering, receiving, scheduling and order processing are included), (identical with the first stage of conventional budgeting)

- Estimate demand for organizational activities (extend conventional budgeting to support activities such as ordering, receiving, scheduling production and processing customers’ orders), (basic information is needed!)

- Determine required resources- Estimate the quantity of each resource to meet demand (pay attention to cost

behavior)- Take action to adjust capacity of resources to match the projected supply

VariancesVariance analysis is one of the four methods of removing the distorting effects of uncontrollable factors from the results measures (after the measurement period and before the rewards are assigned).

Variance analysis seeks to analyze the factors that cause the actual results to differ from pre-determined budgeted targets. It helps to distinguish between controllable and uncontrollable items and identify those individuals who are accountable for the variances.

Total Material variance:

- the difference between the standard material cost (SC) for the actual production and the actual cost: SC-AC

Mat. Price variance: (SP-AP)x AQ (actual quantity)

- possible reasons: 1. failure of procurement2. may be beyond the control of the purchasing department3. inferior quality materials (favorable)4. machines are disfunctioning, thus the increased consumption

Mat. Usage variance: (SQ-AQ)xSP

- reasons:1. careless handling2. inferior quality

Labor variance consists of 2 factors:

1. Wage rate variance Is equal to the difference between standard wage rate per hour and actual wage rate

times the actual hours worked: (SR-AR)xAH Possible causes:

o wages might have been renegotiated that is not reflected in standard wage rate

o overtime – increased wages

2. Labor efficiency variance Equal to the difference between the standard labour hours for actual production and

the actual labour hours worked, times standard wage rate: (SH-AH)xSR

Profit variance

Selling and distribution

cost variances

Total production

cost variance

Total sales margin

variance

Sales margin price variance

Sales margin profit variance

Total direct materials variance

Total direct wages variance

Total variable overhead variance

Fixed overhead expenditure

variance

Materials price variance

Materials usage variance

Wage rate variance

Labor efficiency variance

Variable expenditure

variance

Variable efficiency variance

Possible causes:o Different grades of labouro Inferior quality materialso Failure to maintain machinery in proper condition

Sales variance

Variances should be computed in terms of profit (absorption costing) or contribution margins (variable costing) rather than sales revenues. (profit margin = selling price – total unit manufacturing cost; contribution margin = selling price – variable unit manufacturing cost)

Sales variance also consists of 2 parts:

1. Sales margin price variance Difference between actual contribution margin and standard contribution margin,

times actual sales volume: (AM-SM)*AV Possible causes: maybe we managed to increase prices through negotiations

2. Sales margin volume variance Difference between actual sales volume and budgeted volume, times standard

contribution margin: (AV-BV)*SM Possible causes: maybe, we acquired a new, not budgeted customer

3. Sales variance is the difference between actual contribution and budgeted contribution: AC-BC

Reconciliation

To reconcile actual profit with budget profit, the favorable variances are added to the budgeted profit, and adverse variances are deducted. The end result should be the actual profit.

2. Measuring divisional financial performance

o Divisionalization (reasons, results, independence, responsibility)

o Best interest of corporation?

o Financial and non-financial measures, measurement of critical success factors, reporting

o Division=investment/profit centre

o Functional vs. divisionalized organizational structures

ROI (Return on Investment)

Rather focusing on absolute profit figure of a division, ROI shows the divisional profit as a percentage of the assets employed in the division.

Advantages:

- relative figure, easy to compare- summary measure for ex-post return on capital invested- basis of accurate estimates for future cash flows- draws attention of managers to levels of working capital (because the profit is percentage of

the capital employed)- working with percentages is more convenient for people- outsiders usually see ROI as the company’s overall performance (which is not a good

attitude)

Disadvantages:

- may lead to decisions that finally make the company worse off- may motivate for incorrect asset disposal decisions

ROI is useful where managers cannot influence investment decisions (and the capital employed is fixed).

RI (Residual Income)

For purpose of evaluating divisional managers’ performance, residual income is defined as controllable contribution less a cost of capital (also controllable by the manager) charge on the investment

Advantages:

- greater probability for managers, when acting in their own best interest (meaning increasing their division’s RI), also to act in line with the company’s best interest

- Leads to correct asset disposal decisions- Flexible, because different cost of capital rates can be used for projects reflecting different

risk levels

Disadvantage:

- absolute measure; it is difficult to compare divisions’ performance- If RI is used it should be compared with budgeted/target levels which reflect the size of the

divisional investment.

RI is better where managers are able to influence the investment decisions.

EVA (Economic Value Added)

RI was extended by incorporating adjustments for the divisional profit measures that eliminate distortions generally accepted by the major accounting systems.

EVA = Conventional divisional profit based on GAAP or IAS

± Accounting adjustments (approximately 160 types, but only 10 is widely used)

– Cost of capital charge on divisional assets

Replace historical data with a measure that attempts to approximate economic profit and asset values.

Costs are spread during the time period when benefits are received (R&D).

Encourages goal congruence in terms of asset acquisition and asset disposal (managers realize that capital has a cost and thus underutilized assets are to be disposed of).

Adjustments typically include capitalization of discretionary expenses.

Transfer pricing

Goods are transferred within the company, between divisions, and the price on which the intermediate product is sold to the other division needs to be set. (For sake of simplicity, these “scenarios” are for domestic transfers, assuming that all divisions are in the same country.)

Market-based transfer prices:

Where there is a market for the intermediate product, it is optimal for the decision-making and performance evaluation purposes to set transfer prices at competitive market price. Thus divisional performance will reflect the real economic contribution. We can also see, how the 2 departments would perform if they were 2 separate companies.

Marginal cost transfer prices:

If there is no market for the intermediate product, the supplying division and the receiving division will be motivated to operate at output levels that will maximize overall company profits.

Short-term perspective: assume that marginal cost is constant and equal to short-term variable cost, thus transfer price should be the variable cost of the supplying division.

Disadvantages: - poor performance measurement

- the supplying division will record losses

Full cost transfer price:

Transfer price is the sum of all resources committed to a product or service in the long-run. An arbitrary mark-up is usually added to cover fixed cost, but similarly to costing systems, these also lead to inaccurate estimate of full costs.

Cost-plus a mark-up:

This method tries to meet the performance evaluation purpose by adding a mark-up to the costs that would allow for profit in the supplying division. Because of the mark-up the inter-divisional transfers will be less-than-optimal level for the company on the whole, because it restricts output between OQ1, when optimal would be OQ2 (see graph).

Negotiated transfer price:

When there is an external market for the intermediate product and the market has some imperfections or many selling prices, it might be an optimal solution for the company in overall to let the managers of the supplying and receiving divisions to negotiate the price. For this we have to make sure that they are competent and have the same information, and both have equal bargaining power. If no resolution is done, the HQ may arbitrate in the dispute, but then the managers are no longer fully accountable for the performance of the divisions. Limitations:

- may lead to conflict between divisions

- the final price is subject to bargaining skills as well, so result may not be optimal for the company on the whole

- time-consuming for managers involved

International transfer pricing

- Products are transferred between divisions in different countries- There may be different tax rates in these counties- The company’s best interest is to achieve the highest price in that country in which there is

the lowest tax rate, so that the company to realize high profit. In practice, if the supplying division is in the lower tax rate, the organization will implement the highest possible transfer price – to realize most profit on the supplying division’s activities.

- Where the tax is high, the company will show high costs (receiving division) and lower profits.Problems: tax authorities

OECD regulation is to check: what would be the price of the product in case of unrelated parties? The methods to be used to compare in-house price with one of these:

- comparable uncontrolled price method (externally verified prices in similar transactions)- resale price method (deduct % from selling price that allows for profit)- cost-plus method

Companies tend to use the same transfer pricing system for domestic and international transfers in order to avoid tax authorities’ attention

Transfer pricing may be also used for duties avoidance and dividend repatriation, but these may have similar consequences.

3. Controlling systems and new approaches

Action, social and results controlsControl is the process of ensuring that a firm’s activities conform to its plans and that its objectives

are achieved. Companies use many different control mechanisms to cope with the problem of

organizational control. To make sense of the vast number of controls used we shall classify them into

three categories using approaches that have been adopted by Ouchi (1979) and Merchant (1998).

They are:

1. Action (or behavioral) controls

Involve observing the actions of individuals as they go about their work

The actions themselves are the focus of control

Appropriate where cause and effect relationships are well understood, so that if the correct

means are followed, the desired outcomes will occur

Managers know what actions are desirable and have the ability to make sure that the desirable

actions occur

Forms of action control:

Behavioral constraints: preventing people from doing things that should not be done.

Include physical (password) or administrative (ceilings on capital expenditure)

constraints.

Preaction reviews: scrutiny and approval of action plans before undertaking the

course of action (e.g. approval by a tutor of a dissertation plan).

Action accountability: defining actions that are acceptable or unacceptable,

observing the actions and rewarding/punishing. (Examples are: work rules and

procedures, company codes of conduct, line item budgets, etc.) (Observation: direct

observation or e.g. internal audits)

The application of action controls is limited where the work of employees is complex and

uncertain

2. Personnel and cultural (or clan and social) controls

Based on the belief that by fostering a strong sense of solidarity and commitment towards

organizational goals people can become immersed in the interests of the organization (extreme

example: Japanese kamikaze pilots during WWII)

Main feature: high degree of employee discipline attained through the dedication of each

individual to the interests of the whole

Build on employees’ natural tendencies to control themselves

Represent a set of values, social norms and beliefs that are shared by members of the

organization and that influence their actions

Exercised by individuals over one another

Three major methods of implementing personnel controls: selection and placement, training

and job design, and the provision of the necessary resources

Number of other methods: codes of conduct, group based rewards, interorganizational

transfers

A strong internal firm culture can decrease the need for other control mechanisms since

employee beliefs and norms are more likely to coincidence with firm goals.

Latest management approach (trend): employee empowerment

3. Results (or output) controls

Involve collecting and reporting information about the outcomes of work effort

The major advantage is that senior managers merely rely on output reports. (Management

accounting control systems can be described as a form of output controls.)

Monetary terms , such as: revenues, costs, profits and ratios (e.g. ROI). Non-accounting

measures, such as: the number of units of defective production, number of customer deliveries

on time as a percentage of total deliveries, etc.

Involve the following stages:

1. establishing results (i.e. performance) measures that minimize undesirable

behavior

2. establishing performance targets

3. measuring performance

4. providing rewards (intrinsic/extrinsic) or punishment

“What you measure is what you get” – employees concentrating on improving the performance

measures even if they know that their actions are not in the firm’s best interest

However: without targets employees do not know what to aim for. “Do your best” is not

enough.

Measuring performance is not always obvious! E.g. measuring the performance of support

departments.

Measures must be: sufficiently precise, objective, free from bias, and understandable by the

individuals whose behaviors are being controlled. (Timeliness is also important!)

If uncontrollable factors cannot be separated from controllable factors, results controls

measures are unlikely to provide useful information for evaluating the actions taken.

(Controllability principle: refers to the extent that individuals whose behaviors are controlled

can influence the results controls measures.)

Responsibility accountingThe complex environment in which most businesses operate today makes it virtually impossible for

most firms to be controlled centrally. This is because it is not possible for central management to

have all the relevant information and time to determine the detailed plans for all the organization.

Some degree of decentralization is essential for all but the smallest firms. Organizations decentralize

by creating responsibility centers. A responsibility centre may be defined by as a unit of a firm where

an individual manager is held responsible for the unit’s performance. There are four types of

responsibility centers:

1. Cost or expense centers

R. centers whose managers are normally accountable for only those costs that are

under their control

Standard cost centre

Output can be measured and input can be specified

Difference between standard and actual costs: variance

Best suited to units within manufacturing firms, but also in service industries

Quality and timeliness are also required besides financial measures!

Discretionary expense center

Output cannot be measured in financial terms

No clearly observable relationships between inputs and outputs

Control: ensuring that actual expenditure adheres to budgeted expenditure for each

expense category; ensuring that the tasks assigned have been successfully

accomplished

Examples: advertising, R&D

Note: under-spending against budget may not necessarily be a good thing!

Major problem: measuring the effectiveness of expenditures

2. Revenue centers

Managers are accountable only for financial outputs in the form of generating sales

revenues (Typical example: regional sales manager accountable for sales within his

region)

Danger of concentrating solely on maximizing sales revenues at the expense of

profitability

Revenue center managers may also be held accountable for selling expenses

3. Profit centers

Managers are accountable for both revenues and costs (vs. Cost and revenue centers

where managers have limited decision making authority)

Significant increase in managerial autonomy: unit managers are given responsibility for

both production and sales

Managers are normally free to set selling prices, choose which markets to sell in, make

product mix and output decisions and select suppliers

In practice: many profit centers that do not conform to the above requirements

(pseudo-profit centers)

4. Investment centers

Represent the highest level of managerial autonomy: managers are responsible for both sales

revenues and costs and, in addition, have responsibility and authority to make working

capital and capital investment decisions.

Typical investment center performance measures: ROI, EVA

The creation of responsibility centers is a fundamental part of management accounting control

systems.

Cost managementTraditional cost control systems tend to be based on the preservation of the status quo and the ways

of performing existing activities are not reviewed. The emphasis is on cost containment rather than

cost reduction. Cost management focuses on cost reduction and continuous improvement and

change rather than cost containment. Whereas traditional cost control systems are routinely applied

on a continuous basis, cost management tends to be applied on an ad hoc basis when an opportunity

for cost reduction is identified. Also many of the approaches that are incorporated within the area of

cost management do not necessarily involve the use of accounting techniques. Cost management

consists of those actions that are taken by managers to reduce costs, some of which are prioritized

on the basis of information extracted from the accounting system. Other actions, however, are

undertaken without the use of accounting information. They involve process improvements, where

an opportunity has been identified to perform processes more effectively and efficiently, and which

have obvious cost reduction outcomes. Ideally, the aim is to take actions that will both reduce costs

and enhance customer satisfaction.

Approaches to cost management:

Life-cycle costing

Target costing

Kaizen costing

Activity-based management

Business process re-engineering

Cost of quality

To compete successfully in today’s global competitive environment companies are becoming

‘customer-driven’ and making customer satisfaction an overriding priority. Customers are

demanding ever-improving levels of service regarding cost, quality, reliability, delivery and the

choice of innovative new products. Total Quality Management (TQM), a term used to describe a

situation where all business functions are involved in a process of continuous quality

improvement, has been adopted by many companies. The emphasis of TQM is to design and

build quality in, rather than trying to inspect it in, by focusing on the causes rather than the

symptoms of poor quality.

Management accounting systems can help organizations achieve their quality goals by providing

a variety of reports and measures that motivate and evaluate managerial efforts to improve

quality. These will include financial and non-financial measures. Managers need to know the

costs of quality and how they are changing over time. A cost of quality report should be

prepared to indicate the total cost to the organization of producing products or services that do

not conform with quality requirements. Four categories of costs should be reported:

1. Prevention costs : costs incurred in preventing the production of products that do not

conform to specification. Cost of preventive maintenance, quality planning and training

and the extra costs of acquiring higher quality raw materials.

2. Appraisal costs : costs incurred to ensure that materials and products meet quality

conformance standards. Costs of inspecting purchased parts, work in process and

finished goods, quality audits and field tests.

3. Internal failure costs : costs associated with materials and products that fail to meet

quality standards. Costs incurred before the product is despatched to the customer,

such as the costs of scrap, repair, downtime and work stoppages caused by defects.

4. External failure costs : costs incurred when products or services fail to conform to

requirements or satisfy customer needs after they have been delivered. Costs of

handling customer complaints, warranty replacement, repairs of returned products and

the costs arising from a damaged company reputation. Costs within this category can

have a dramatic impact on future sales.

Note that some of the items in the report will have to be estimated (e.g. foregone contribution

from lost sales arising from poor quality). By expressing each category of costs as a percentage

of sales revenues comparisons can be made with previous periods, other organizations and

divisions within the same group. Such comparisons can highlight problem areas. The cost of

quality report can be used as an attention-directing device to make the top management of a

company aware of how much is being spent on quality-related costs. It also can draw the

attention to the possibility of reducing total quality costs by a wiser allocation of costs among

the four quality categories. Prevention and appraisal costs are sometimes referred to as the

costs of quality conformance or compliance and internal and external failure costs are also

known as the costs of non-conformance or non-compliance.

Benchmarking

Environmental cost management

Just-in-time systems

The balanced scorecardTo encourage behavior that is consistent with an organization’s strategy, attention is now being given

to developing an integrated framework of performance measurement that can be used to clarify,

communicate and manage strategy implementation. These approaches attempt to integrate both

financial and non-financial measures and incorporate performance measurement within the strategic

management process.

Prior to the 1980s management accounting control systems tended to focus mainly on financial

measures of performance. The inclusion of only those items that could be expressed in monetary

terms motivated managers to focus excessively on cost reduction and ignore other important

variables which were necessary to compete in the global competitive environment that emerged

during the 1980s. Product quality, delivery, reliability, after-sales service and customer satisfaction

became key competitive variables but none of these were given much importance measured by the

traditional management accounting performance measurement system. During the 1980s much

greater emphasis was given to incorporating into the management reporting system those non-

financial performance measures that provided feedback on the key variables that are required to

compete successfully in a global economic environment. However, a proliferation of performance

measures emerged. This resulted in confusion when some of the measures conflicted with each other

and it was possible to enhance one measure at the expense of another. It was also not clear to

managers how the non-financial measures they were evaluated on contributed to the whole picture

of achieving success in financial terms.

The need to integrate financial and non-financial measures of performance and identify key

performance measures that link measurements to strategy led to the emergence of the balanced

scorecard – an integrated set of performance measures derived from the company’s strategy that

gives top management a fast but comprehensive view of the organizational unit (i.e. a

division/strategic business unit). The balanced scorecard was devised by Kaplan and Norton (1992)

and refined in later publications.

The balanced scorecard philosophy assumes that an organization’s vision and strategy is best

achieved when the organization is viewed from the following four perspectives:

1. customer perspective (How do customers see us?)

2. internal business process perspective (what must we excel at?)

3. learning and growth perspective (Can we continue to improve and create value?)

4. financial perspective (How do we look to shareholders?)

The balanced scorecard is a strategic management technique for communicating and evaluating the

achievement of the mission and strategy of the organization. To implement the balanced scorecard

the major objectives for each of the four perspectives should be articulated. These objectives should

then be translated into specific performance measures. Kaplan and Norton recommended that in the

scorecard forms should identify and describe the major initiatives for achieving each objective and

also establish targets for each performance measure. The aim of the scorecard is to provide a

comprehensive framework for translating a company’s strategic objectives into a coherent set of

performance measures. In order to minimize information overload and avoid proliferation of

performance measures only the critical measures are incorporated in the scorecard.

The balanced scorecard consists of two types of performance measures:

Lagging measures: These are the financial (outcome) measures within the financial

perspective that are the results of past actions. Mostly these measures do not incorporate

the effect of decisions when they are made. Instead, they show the financial impact of the

decisions as their impact materializes and this can be long after the decisions were made.

Leading measures: Drivers of future financial performance. These are the non-financial

measures relating to the customer, internal business process and learning and growth

perspectives.

The distinguishing features of the balanced scorecard approach compared with other approaches to

performance measurement are the linkage between strategy and performance measurement and

the cause-and-effect logic to link financial and non-financial performance measures.

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4. Planning and executing the internal audit

Definition – Internal Audit

• An independent, objective assurance

• Consulting activity

• Designed to add value and improve an organization’s operations

• Helps to accomplish the objectives of the entity

• By bringing systematic, disciplined approach

• To evaluate and improve the effectiveness of risk management, control, and governance

processes

Who execute?

Management

– Develop the system of internal audit

– Responsibility to cover the resources to operate the internal audit system

Employees

– Tasks involved in their work

Independent internal audit

• It should be done periodically

Objectives

Keep the legal regulations, internal and external rules, management instructions

Realize and improve the processes and activities of the entity

Aspects: Ethical, Economic, Efficiency

Protection of resources, net assets

Treating risks connected to the processes

Accountability

Obligation of presentation

Benefits of IA

• Tells you the health of a quality system

• Identify the root of a problem and plan for corrective and preventive actions with timeline

• Achieve better allocation of resources

• Able to avoid potentially big problem

• Learn what an auditors look for

• Continuous improvement

Forms of IA

Risk management: identify, evaluate, treat the risks

1. Control activity of management

2. Controls in the processes

3. Independent internal audit

Difficult to separate

Close relationship

Based on to each other

Supplement each other

1. Management control

At different level of management: define duties and powers

Continuous control on subordinate departments

Check the instructions

are fulfilled

Insure the objectives of the entity: revision, modification

By control adequacy of risk management procedures

Should be documented

Methods of management control

1. Evaluation of information flow and apply information system

Analysing internal and external information to control the achievement of objectives,

position of the processes, possible new risks

2. Reporting

3. Right to sign:

Check the content and form of the documents

4. Direct investigation on the spot

Check the sphere of operations of en employee

2. Control in the processes

Most typical form of risk management

Regulated control system for persistent processes and activities

– Gives possibility or obligation of control at risky points of the given process

– Control: Compliance with regulations or performance-requirements

Discrepancy, mistakes: brake the process to enforce correction

Precondition:

– Well-regulated operating activities

– Regulate the system of control in the processes

– Include the control in the operations, activities

Objectives of controls in the processes

Continuous and complete control of the processes

Realization of mistakes and risks in time

Quick actions to correct the mistakes

Identification of the responsibility

Questions of control on the processes

Identification of control points

Control: What, where, how, when, with what kind of method, how often

Base of comparison and requirements (legal regulations, laws, acts, internal rules,

technological rules)

Discrepancy: feed-back

Types of control in processes

Self-control, self-checking

Control among work phases

Automated controls

– Information systems, machineries make the control

– In case of numerous processes

Independent professional controls done by separate person, team

– For a given function to control regularity

– Checking the invoices

– Cash audit

– Quality audit

– Audit of accounting of wages

– „Gate” control

3. Independent internal audit

Independent:

• Functional: in duties and organizational. Functional report to the Board

• Subordinated directly to top management, organizational report to the management

• The auditor can not be involved in any other activities

• Audit plan, prepared independently, based on risk analysis and extraordinary

controls

• Implementation, methods, establishments, reports prepared without any influence

on the auditor

The Internal Audit Process

I. PLANNING

• Entrance Conference: Meet with client management to discuss and agree on audit objectives

• Preliminary Survey: Develop overview of unit or system to be reviewed

• Planning Memorandum

II. FIELD WORK

• Systems Analysis: Review documentation and system capabilities

• Transaction Testing

• Advice and Informal Communications

III. REPORTING PROCESS

• Informal Discussion Draft: Review findings with client

• Exit Conference: Meet with department management;

revise draft as required

• Client's Response: Present implementation plan

IV. AUDIT FOLLOW-UP

I. Planning process

• Determine

• the goals of the unit or system being reviewed,

• the objective of the audit, and

• The approach the auditor will use to meet these objectives.

• Entrance conference

• the client describes the unit or system to be reviewed, the structure of the

organization,

• the available resources, including personnel, facilities, equipment, funds, and other

relevant information.

• Preliminary survey

• Auditor gathers relevant information about the unit

• Makes interviews, reviews reports, files, and other sources of information.

• Risk assessment

• A work plan is developed, revised quarterly

• The audit plan should be sent to auditee prior to audit activity

• findings from the last audit should be also mentioned

• Competency and availability of auditors

• Available time for auditing

• Planning memorandum.

• Work plan is finalized and accepted

• Presents the auditor's understanding of the objectives

• Outlines what the audit team will do to meet the objectives

• Included are data about the goals of the unit, and the size and scope of the unit or

system, as well as related information, such as an organization chart.

Field work

System analysis

the system's documentation and capabilities are reviewed,

time-consuming process (50% of fiel-work time)

the auditor uses a variety of tools and techniques: flow charts, interviews, data gathering and

analysis, and techniques for documenting findings.

Preparing work documents: audit checklists, forms for recording information; questionnaires

Transaction testing

testing the important controls, but only the critical aspects

for example, authorization or documentation

The purpose of testing is to determine if:

the control is reliable, and

transactions comply with rules and regulations.

Advice and informal communications

the auditor discusses any significant findings with the client.

provide drafts of organization charts,

proposed forms or modifications to forms, financial data or other statistics,

drafts of findings and recommendations that later may be incorporated into the formal audit

report.

the purpose is to promote constructive communication and avoid misunderstandings. Goal:

No surprises.

Audit reports

Informal discussion draft

After Internal Audit management reviews the outline, the auditor uses the outline to write a

first draft of the report.

This informal discussion draft is prepared only for the unit's operating management

Exit conference

For larger, complex project

meeting, when the client comments on the informal draft,

and any inaccuracies or impractical recommendations noted by the client are resolved to the

extent possible.

Formal Draft

takes into account any revisions resulting from the exit conference and other discussions.

If appropriate, the formal draft may be shown to the next level of management at this point.

Not recommended circulating this more widely (draft)

should include an audit questionnaire and all records and comments during the audit

The client has to respond to the formal draft (within 45 days)

Final Report includes:

the formal draft,

client management's written comments: findings and management's plans for implementing

the recommendations or otherwise dealing with a particular recommendation, and

any additional comments considered necessary by the Director of Internal Audit.

Content of Audit report

Objectives

Audit scope

Name and location of auditee

Identification of audit team leader and members

Dates and places of audit, control activities

Audit criteria and findings

Recommendations for improvement are made

The client's plans for implementation

Conclusion

– Focus on deficient conditions and not people

– Include any positive observations

– Keep the audit report simple and clear

Typical audit findings

Conformity, compliance

– Satisfactory /Adequate

– Outstanding

Non-conformity, non-compliance:

– Critical deficiency

– Major deficiency

– Minor deficiency

Isolated deficiency:

– Tends to happen randomly; no meaningful pattern; rarely happens

Systemic deficiency:

– Could be connected to a particular process, product, material, person or

organisation; shows pattern; happens more than once

Audit follow-up

Internal Audit will follow up with client management to ascertain that the recommended

improvements are made.

Office's self-evaluation program: ask clients to "audit the auditors," that is to comment on

Internal Audit's performance during a project.

BANKING:

1. Banking is a simple business. A bank issues capital, raises deposits at X% interest rate and lends the money at X+% interest rate. List the key factors of why the levels of banking profits change and why some banks make higher profits than other banks during the same financial year.

DIFFICULTIES IN MEASUREMENT: not physical output

a. Production Approach (output as flow: the amount of output produced per unit of time, and inflation bias is absent)

Treats banks as firms which use capital and labor to produce deposit & loan accounts

b.Intermediation Approach (output as stock: showing the given amount of output ata one point in time)

Core activity: intermediation; value of loans & investments are measured

Operating Profit

Income

The major components that create a profit for a bank are:

Interest margin: gap between interests & discounts received & paid Fees: earned from banking & other financial services (charged for arranging loans, deposits,

investment, providing financial advice, making payments, allowing customer access to cash from their accounts held at the bank, converting foreign currency)

Trading income: profits (+) or losses (-) from trading in foreign currency, market interest products, interest arbitrage, trading in derivatives

Costs (To be deducted from above mentioned income)

i. Operating Costs: costs of providing customer services and other costs of operations. This item includes staff costs, management costs, property costs, IT costs, branch costs etc.

In order to maintain a satisfactory level of profit a bank must maintain an interest margin that is either constant or rising percentage of the shareholder’s funds of the bank.

Low cost-efficiency ratio should be maintained, thereby

Profitability can be increased and/or Prices can be decreased enabling a serious competitive advantage

Other Income, from trading and fees should represent a high percentage of the total operating costs. By maintaining a high percentage the profits of the bank will not be adversely affected by changes in interest rates.

The outline structure of a bank’s profitability statement is set out below.

Calculation of Profits Earnings/ Average Assets/ %

Costs Liabilities

Interest Earned:

Loans x x z

Bank Deposits x x z

Reserve Deposits x x z

Total Interest Income A B C

Interest Costs

Current Accounts y y z

Time Deposits y y z

Bank Deposits y y z

Long Term Debt y y z

Total Interest Cost D E F

Interest Margin A-D B-E C-F

Fees Received and

Trading Profits G

Fees Paid H

Net Fees +/- G-H

Gross Operating Profits (A-D + (G-H)

Operating Costs J

NET OPERATING PROFIT K

In making the calculation of the average balance for each type of product the daily balances are totalled and divided by the number of days to give a weighted average of assets. The interest earned or paid on the product is divided by the average balance of the asset and multiplied by 100 to provide the average interest rate for the product.

The calculated average should be compared with the expected rate to ensure that the calculation has produced a reasonable result. In making this calculation of income and making a similar calculation for the type of share of the liabilities used to fund the assets (adjusted for capital) the interest margin for each product can be established and reviewed for each product.

Key Performance Measures

Marginal Income gross income (interest+fees) – gross costs (interest costs) Return on capital average balance of the product * risk weightening * capital adequacy ROA, ROE

Performance measures are made by comparing the gross income (interest + fees) less the gross costs (interest cost of funding the product + any fees payable to brokers etc) to give the marginal income from the product. Against the marginal income is allocated a proportion of the operating cost that has been incurred by that product. This allocation is often dependant on bargaining power of the owners of the products.

The balance is the overall net profit from the product. This profit should then be compared to the capital allocated (average balance of the product * risk weighting * 8% (or the internal target of capital adequacy). The resulting answer will give the return on capital from the product.

An additional or alternative method of measuring performance is to compare the profits (measured on a product or total balance basis) for each branch or distribution point e.g. an ATM, a merchant accepting plastic cards. In this case the allocated costs will be those costs clearly incurred by the unit (staff costs, heating, lighting, depreciation etc) plus part of the central cost. This will identify the cost per unit.

The problem of measuring profits and performance by allocating central costs is that these costs may not disappear if the product or distribution point disappears. This type of problem is not unique to banking but common to any organisation with more than one operating group or more than one type of product. To summarise, profits can be viewed as follows:

Product Profitability: may be measured as 1(a) less 2(a), and/or 1(b) less 2(b) where

1 Gross Trading Income divided into:(a) Product Type Income v Funding Allocated to Product

(b) Delivery Point income, from each type of product v Funding Allocated to Product, or Value of work undertaken

2 Operating Costs divided into:

(a) Costs Allocated to product types

(b) Costs Allocated to delivery points

Departmental or Business Unit Profitability: (a) less (b) where

(a) Products identified as being generated by a department or branch e.g. Treasury, Private Customers

(b) Costs related to the department

Overall Profitability

Total of all Product Profits + Total of all Departmental Profits – (total unallocated interest costs + total unallocated overhead costs).

The balance should equal the balance on the Profit and Loss Account of the Bank

Comparison: Earnings per share, earnings on total shareholders’ funds versus market interest rate

II. Determinants of differences in profitability

1. Banks in countries with a more competitive banking sector—where banking assets constitute a larger share of GDP—have smaller margins and are less profitable. The bank concentration ratio also affects bank profitability; larger banks tend to have higher margins.

2. Well-capitalized banks have higher net interest margins and are more profitable. This is consistent with the fact that banks with higher capital ratios have a lower cost of funding because of lower prospective bankruptcy costs.

3. Differences in a bank’s activity mix affect spread and profitability. Banks with relatively high non-interest-earning assets are less profitable. Also, banks that rely largely on deposits for their funding are less profitable, as deposits require more branching and other expenses. Similarly, variations in overhead and other operating costs are reflected in variations in bank interest margins, as banks pass their operating costs (including the corporate tax burden) on to their depositors and lenders.

4. In developing countries foreign banks have greater margins and profits than domestic banks. In industrial countries, the opposite is true.

5. Macroeconomic factors also explain variation in interest margins. Inflation is associated with higher realized interest margins and greater profitability. Inflation brings higher costs—more transactions and generally more extensive branch networks—and also more income from bank float. Bank income increases more with inflation than bank costs do.-Base interest rate

-Corporate tax (affects both banks and their clients profitability)

-Trends of stock exchanges, bond market (which financing facility firms choose)

-Currency fluctuation (see at mismatching)

6. There is evidence that the corporate tax burden is fully passed on to bank customers in poor and rich countries alike.

7. Legal and institutional differences matter. Indicators of better contract enforcement, efficiency in the legal system, and lack of corruption are associated with lower realized interest margins and lower profitability.

Empirical analysis finds that both bank-specific as well as macroeconomic factors are important determinants in the profitability of banks. With regard to macroeconomic factors, real GDP growth, inflation and real interest rates have a positive impact. Among bank-specific variables, operational efficiency and business diversification contribute to higher returns on assets, after controlling for differences in the credit quality of loans.

In terms of bank-specific factors, operational efficiency is the most important factor in explaining differences in profitability across the banks, implying that cost control remains a key task for bank management. In recent years, the pressures on banks’ profitability from their more traditional lending business have intensified, causing them to diversify into non-interest income generating business to remain competitive.

III. Factors influencing profitability

Sources of financeFinance is the same as any other commodity – it is subject to supply and demand.

Supply represents savings. Demand is borrowing and the issue of securities.

Banks are in competition with other financial markets and are also, normally, in competition with each other.

Theory would suggest that larger banks would be able to obtain funds at lower costs than smaller banks in a competitive market.

o HU: source of finance for OTP is the large depositors’ base, while other banks in Hungary and forced to borrow from OTP directly at a higher cost set by OTP.

The total cost of funds comprises the interest paid on deposit accounts (NOW accounts, savings deposits, large CDs, and small CDs), and on borrowings.

Operating incomeBanks provide customers with many services, including intermediation, low risk assets, credit and payment services, and non-monetary services such as management of investment portfolios, accounting services, and protection of valuables. In some banking systems, direct payment for these services is the exception rather than the rule.

Demand deposits may not earn interest, in exchange for some “free” services. “Free retail banking” may be offered to all customers in credit, but those with an overdraft are

charged very high fees and interest, effectively subsidising customers in credit. Corporate clients normally receive a package of banking services to accompany a loan or

overdraft facility.

Operating costs The use of electronic banking may significantly decrease the costs of a bank. Using cash

dispensing machines instead of a cashier at a bank branch is an improvement in the quality of payment services, because it increases the speed of transactions. ATM technology is also known to reduce bank operating costs, but if customers access the machine more frequently than they would otherwise visit the branch, the cost savings may be lower than expected.

Lower operating expenses including rationalisation of employee costs have improved the profitability of banks.

Costs are influenced by the technology as well as the know how in the mitigation of risks. Both issues can contribute to the reduction of costs versus less experienced banks.

Economies of scaleThere is extensive literature on the degree to which scale economies exist in banking. The term, economies of scale is a long run concept, applicable when all the factor inputs which contribute to a firm’s production process can be varied. Thus, if a firm is burdened with capital, property, or labour which are fixed, then economies of scale do not apply. Assuming all factor inputs are variable, a firm is said to exhibit scale economies when equi-proportionate increases in factor inputs yield a greater than equi-proportionate increase in outputs. Firms are operating on the falling part of their average cost curves.

This theory explains why some producer firms may achieve higher profits than others in the same line of business.

Theory applicable to banking:Imagine a simple bank, with three factor inputs: capital from deposits, labour and property in the form of branch network. Economies of scale are said to exist if, as a result of doubling each of the three factor inputs, the bank is able to more than double its loan portfolio. The concept is fraught with difficulties when applied to a financial institution:

Not all of the bank’s inputs are completely variable. It is difficult to imagine a bank being able to say, double the number of depositors at a short notice.

Issue of risk: If indeed the bank can more than double its loan portfolio, the risk profile is bound to change, a critically important consideration for any bank.

The question of what constitutes output: Some authors argue that deposits, in addition to loans, must be treated as bank products, because deposits provide customers with a liquidity and saving service. Banks also produce multiple outputs, a fairly broad range of financial services.

These observations mean it is difficult to apply the term economies of scale in the financial sector.

Despite the above stated observations, ‘economies of scale’ is stated as one of the key reasons why a merger between financial institutions will be a profitable one for shareholders.

Evidence of economies of scale will mean larger banks have a cost advantage over smaller ones.

Economies of scopeEconomies of scope exists if the joint production cost of producing two or more outputs is lower than if the products are produced separately.

Suppose a bank offers three services to its customers: deposit, loans, and a payments service. Then if the bank can supply these services more cheaply through a joint production process than producing

and supplying them independently, it is said to enjoy economies of scope. The core banking business is, where the bank intermediates between borrowers and lenders by lending out a percentage of its deposits, is an obvious example of economies of scope. Through the payments service offered by banks is a by-product of intermediation, it is obvious that lower costs result from the joint production of this service with intermediation.

If cost complementaries are present, multi-product banks will be more efficient than the financial boutique.

Other theories for supernormal profits Firms with greater monopoly power can charge more for the good or service they supply. Some firms earn supernormal profits because they are more efficient than others. This firm-

specific efficiency is exogenous and reflected in high market share.

Summary – By Mr. Windsor

There are 2 factors about profits:

1. Return on capital

If a bank has a large capital (much more than the *% minimum requirement) then it pays no interest on the capital and therefore interest cost will be lower than if capital is at the minimum level. Profits will be higher but return on capital may not be.

2. Profit Level if not boosted by "higher than needed" capital

Net profit consists of Interest Margin (interest income less interest costs) and fees.

The interest margin may be higher:

a) because lower cost of interest due to more retail customer deposits, long term fixed rate of deposits taken when interest rates were low, higher level of balances on low interest accounts (such as current accounts),

b) owing to higher interest income due to higher interest paid on loans (therefore higher risk and probably higher cost of bad debts), better products, better customers.

Another component of income is fees which may be earned from:

o Electronic banking, including cards,

o Making payments on behalf of customers, foreign exchange transactions, account keeping etc

o Trading income - in foreign exchange, bonds and other securities.

Costs, to be deducted from the above income, will be

o staff cost, o branch costs,o IT costso etc

Obviously the more efficient the operations then the lower the costs and higher the profits

To summarize - higher profits may arise due to excess capital funds, cheaper deposits, more fee income. Costs may differ due to efficiency and prices paid.

2. Why have some banks, unexpectedly, made such very large losses that these have either caused the liquidation of the bank or the sale to another bank to protect the depositors? How could these losses have been avoided?

The failure of a profit maximizing firm is defined as the point of insolvency, where the company’s liabilities exceed its assets, and its net worth turns negative.

A broader definition of bank failure would be: a bank is deemed to have “failed” if it is liquidated, merged with a healthy bank (or purchased and acquired) under central government supervision / pressure, or rescued with state financial support.

There are debates on how to deal with bank failures, though there are 3 basic ways regulators can deal with this problem:

1. Put the bank in receivership and liquidate it (insured depositors are paid off, and assets are sold)

2. Merge a failing bank with a healthy bank (the most common form is for the healthy bank to purchase the failing bank without the bad assets – it often involves an agency acquiring the bad assets and attempting to sell those. A similar type of takeover is P&A – purchase and acquire -, when assets are purchased and liabilities are assumed by the acquirer. Often a state or state-run resolution pays the difference between assets or liabilities.)

3. Government intervention (can mean lending assistance, guarantees for claims on bad assets or nationalization of the bank, etc)

Major Causes of Failures:

Management

Unprofessional (substandard asset management reflected in a poor quality loan portfolio, excessive loan exposure)

Dishonest (hide losses until they are paid – if paid at all; illegal activities; fraud; law-breaking) Inept (poor management; copying untested financial innovations by other banks – herd

instinct; lack of experience / no understanding of the markets)Financial

Incorrect strategy for asset and/or liability management Losses on trading, investments, lending, currency, interest rates, mismatched asset/liabilities

(unbalanced deposit base) Theft or misappropriation of bank assets (falling capital adequacy)

Control – external and internal

Lack of control over transactions (Communication difficulties between the auditor and the bank; confusion over which regulator is in charge,

Incorrect recording and reporting of exposures (regulatory authorities who know that rules on exposure are exceeded but take no action; signing off a bank in good health when, in fact it isn’t)

Inappropriate accounting for losses at the correct time (auditors failure to detect any problem; running fictitious accounts)

Asymmetric information

Managers of a bank have more info about its financial health than depositors, regulators, shareholders or auditors. The principal-agent problem arises because of the info gap between managers and shareholders. Once shareholders delegate the running of a firm to managers, they have some temptation to act in their own interest rather than the owners’. This can lead to various types of inefficiency and even tempt managers to take on too much risky business.

Lack of competition

It arises in highly concentrated banking sectors and can also be a source of market failure. Depositors are paid less interest and borrowers are charged more than marginal operating costs could justify.

Liquidity ratio (the ratio of liquid assets to total assets, meaning that only a fraction of deposits is available to be paid out to customers at any point in time)

There is a gap between socially optimal liquidity from a safety standpoint ant the ration a profit-maximizing bank will choose. Because only a fraction of the bank’s deposits is available at any one time, an unexpected sudden surge in the withdrawal of deposits will mean they soon run out of money in the branches. Due to asymmetric info there will be rumors resulting in uninsured depositors withdrawing their deposits. A contagion arises when healthy banks become a target of runs, because depositors and investors, in the absence of info to distinguish between healthy and week banks, rush to liquidity.

If the central bank does not intervene to solve the banks liquidity problem the bank may become insolvent or generate negative net worth. If the central bank and other regulators believe that the bank is healthy but for the liquidity problem and provide it with the necessary liquidity, the panic subsides and the bank run is stopped. Yet, if regulators decide the bank is insolvent and do net help, the run on the bank continues forcing it to close down.

If authorities intervene but fail to convince depositors the problem is confined to one bank only, contagion results in systematic problems affecting other banks.

“Looting”

Close supervision by regulators combined with intervention contributes to managerial incentives to gamble.

Concerning the fact that senior management is normally the first to recognize their bank is or will be, in serious trouble. Yet, if they are the only ones with info on the true state of the bank, downside risk is truncated. If a gamble fails, the marginal effect on management is zero. If gamble succeeds, the bank and their jobs are saved. Returns are convexified, encouraging gambling to increase their survival probability and resurrect the bank. Thus, they will undertake highly risky investments, even with negative expected returns.

Moral hazard

It is a downside to the regulation of banks. It arises in the presence of deposit insurance and / or if a central bank provides liquidity to a bank in difficulties. If a deposit is backed by insurance, then the depositor is unlikely to withdraw the deposit if there is some question raised about the health of the bank. Hence bank runs are less likely.

Blanket (100 %) coverage of depositors is often deemed necessary to stop bank runs. However, deposit insurance is costly, and normally governments limit its coverage to the retail depositor. Restricted forms of deposit insurance do not eliminate the possibility of bank runs.

On the other hand, the more extensive the deposit insurance coverage and / or central bank intervention, the more threatening the moral hazard problem because if agents know a bank will be supported in the event of problems, they have little incentive to monitor the banks, making it easier for senior management to undertake risks greater than they might have in the absence of closer scrutiny by their customers.

Nonetheless, some argue that the presence of deposit insurance does not alter senior management’s incentives to such a dramatic degree that they undertake riskier investments. In addition, normally it is the banks which pay the insurance premia to fund the deposit insurance. In most countries, all banks pay the same premium but in the US, regulators rank banks according to their risk profile, which is kept confidential. The riskier the bank, the higher the premium paid. Being answerable to shareholders, linking the deposit insurance premium to banks’ risk profiles and loss of employment will help to reduce the problem of moral hazard on the part of bank management.

Banks play a critical role in the economy and therefore need to be singled out for more intense regulation than other sectors.

The banking system needs to be more closely regulated than other markets in the economy because of market failure, which can be caused by asymmetric information and negative externalities (principal-agent problems, moral hazard). The especial regulation can take a number of forms, including deposit insurance (funded by bank premiums being set aside in an insurance fund), capital requirements (e.g. Basel 1&2), the licensing and regular examination of banks, intervention by the authorities at an early stage of a problem bank (“lender of last resort” – involving the central bank, as regulator or via the regulator, to provide a very large proportion of the capital required to shore up a bank), and lifeboat rescues (where regulators pressure healthy banks for capital injections before agreeing to organize and contribute to the bailout – “too big to fail”).

Case Study: Penn Square and Continental Illinois

Penn Square Bank

The bank opened in 1960 and collapsed in 1982. It had an aggressive lending policy to the oil and gas sector (assets grew more than eightfold

within 5 years). It sold the majority interest in these loans to other banks, but remained responsible for their servicing.

Poor loan documentation, no assessment on the borrower’s ability to repay Main regulatory authority expressed concern about a number of problems from 1977

onward: poorly trained staff, low capital, lack of liquidity, weak loans and ever more problems with the loan portfolio.

Only 44 % of deposits were insured; uninsured deposits were mainly funds from other banks At the time of collapse, FDIC (Federal Deposit Insurance Corporation) paid off insured

depositors, while Charter National Bank purchased the remaining deposits.

Continental Illinois

CI had developed a big reputation as a lender in the oil and gas industry as well as a large trader in the money markets.

At the time of the collapse CI was 7th largest US bank During 1984 some customers had problems repaying their loan due to drop in oil prices. This

decline in oil prices also decreased the value of collateral securing these loans. Penn Square and CI had a close connection: Penn Square was one of the 5 banks in the US

purchasing participations in oil and gas loans; therefore, its failure made CI’s position worse Non-performing loans increase at CI CI increasingly relied on overseas markets to fund its domestic loan portfolio (60 % of its

loans were raised in the form of uninsured short-term overseas loans) Rumors about the bank’s insolvency resulted in run on the bank which made it impossible to

cover losses from emergency support from other banks FDIC and the Federal Reserve Bank announced a financial assistance programme for CI. In

return for the package all CI directors were asked to resign and FDIC took direct management control of the bank. Effectively, the bank was nationalized at a cost of $ 1.1 billion.

By 1991 CI was back in private hands, and in 1994 it was taken over by Bank America Corporation

Reasons for failure

The collapse of the 2 banks was connected

CI got into trouble due to a number of reasons: It lacked a rigorous procedure for vetting new loans, resulting in poor-quality loans to the US

corporate sector, the energy sector and the real estate sector Participation in low-quality loans to the energy sector bought from Penn Square Failure to classify bad loans as non-performing quickly causing customers to become

suspicious Much of CI’s funding was from overseas with a timing mismatched giving a liquidity exposure

Inept management in not keeping appropriate asset/liability matching and concentration on beating the local opposition (First National Bank of Chicago)

The restricted deposit base of a single branch system forced the bank to rely on wholesale funds as it fought to expand

Supervisors not paying enough attention to liability management, in addition to internal credit control procedures (failure to recognise bad asset/liability management)

Regulators were concerned too much about CI’s dependence on global funding. As a result the FED and FDIC felt it imperative to act as lenders of last resort in order to prevent the run on other US banks by foreign depositors

Regulators used the “too big to fail” policy. They though that letting CI go down would lead to a national or even to a global financial crisis since CI’s correspondent bank relationships left it highly exposed on the interbank and Federal funds market.

2. Why have some banks, unexpectedly, made such very large losses that these have either caused the liquidation of the bank or the sale to another bank to protect the depositors? How could these losses have been avoided?

3. Banks can only operate if they have adequate capital. The standards for measuring capital adequacy have been agreed globally. Outline the components used in measuring capital adequacy, and the relationships required for these components.

Capital Adequacy

The efficient functioning of markets requires participants to have confidence in each other’s stability

and ability to transact business. Capital rules require each member of the financial community to

have adequate capital. This capital must be sufficient to protect a financial organisation’s depositors

and counterparties from the risks of the financial institution. At financial institutions the credit and

market risks are the two significant risks that have to be dealt with and handled.

Capital adequacy is a measure of financial strenghts of a bank, expressed as a ratio of its capital to its

risk assets. For banks, there is a world wide capital adequacy standard, determined by the Basle

Committee (supported by Bank of International Settlements – BIS, the seat of which is in Basle,

Switzerland, so the name comes from there). It requires banks to have a capital equal to 8% of their

risk assets.

Basle Committee

The Basle Committee was formed in response to the liquidation of a Frankfurt bank (Bank Herstatt) in

1974. ( Bank Herstatt was closed down on the last business day of its insolvent operations before the

US business day began. As a result, many of the US creditors holding unsecured claims against the

bank were left with unrecoverable debts. These related to currency trades for which Herstatt had

already taken receipt of payment by European banks but had not yet made corresponding US dollar

payments to the counterparties in the United States. Since this case, Settlement risk is also known as

Herstatt risk, it is the risk that a counterparty does not deliver a security or its value in cash as per

agreement when the security was traded after the other counterparty or counterparties have already

delivered security or cash value as per the trade agreement. )

Peter Cooke is a former executive director of the Bank of England (he was it during the BCCI – case as

well), and chairman of the Basle Committee on Banking Supervision. He was among the founders of

the Basle Committee. The committee started life as the Cooke Committee, named after him.

Actually, Basle Committee on Banking Supervision was formed by the Group of Ten (G10), under the

support of the Bank of International Settlements (BIS). The Basle Committee is made up of 24 senior

officials from the central banks and financial regulatory agencies of the G10 leading economies, plus

Spain and Luxembourg.

The Basle Committee came into being to manage the problems posed for G10 financial regulators by

the increasingly global scale of the operations of the big banks based in their countries. The

regulators wanted to ensure the safety of international banking by agreeing solvency rules that

would apply internationally.

In 1988 the Basle Committee published a set of minimal capital requirements for banks, known as

Basle I or Basle Accord. It was enforced by law in G10 in 1992.

Basle Accord/Basle I

At the beginning the Basle I focused only on credit risk, that is the risk that people and firms who

have borrowed from a bank will not be able to pay it back, with interest, on time if at all . Banks

earn a living by lending money and so a commercial bank's loans are a large part of its assets.

Solvency rules for banks therefore tend to concentrate on so-called capital-to-asset ratios, or rules

requiring banks to set aside a proportion of their assets, via so-called capital charges, to take the

financial strain of unexpected shocks such as a major debtor country defaulting on its loans.

The central stipulation of Basle I is that banks should keep a minimum protective capital reserve to

asset ratio of 8%. The 8% ratio is not a scientific quantity. It was simply the number that all could

agree on. In practice, banks are generally required by their local regulators to keep significantly

higher safety ratios.

At the beginning the risks on loans were put into 4 categories relating to their weightings (the

percentages represent the weighting, based on the risk of default of the given type of credit):

0% - Deposits with Central Banks of OECD countries and banks, OECD government debt and Sovereign Loans, cash, gold

20% - Loans to banks registered in OECD

50% - Residential Mortgages within OECD or domestic

Up to 100% - loans to private sector, government debt outside OECD, most corporate debt, debt over 1 year maturity

The Basle I accord has been amended a number of times since inception (életbe lépés), including the

1996 amendment that incorporated market risk into the pact. Market risk is the risk that the value of

an investment will decrease due to moves in market factors. The four standard market risk factors

are:

Equity risk - the risk that stock prices will change. Interest rate risk - the risk that interest rates will change.

Currency risk - the risk that foreign exchange rates will change.

Commodity risk - the risk that commodity prices (i.e. grains, metals, etc.) will change.

So since 1996, the calculation of the adequate capital on the basis of the Basle I takes into

consideration the credit risk and the market risk.

Problems, Reasons for the Need for Changes

- Basle I risk weightings are not always good indicators of financial condition

- Risk weightings do not differentiate properly borrower’s real default risk

- Banks arbitrage the regulatory capital requirement – exploit differences between true

economic risk and measured risk.

Introduction of Basle II./The New Accord

The aim, why the New Accord or Basle II was formed, was to improve the way regulatory capital

reflects underlying risk. The deliberations of it began in 2001. The final version was issued in June

2004 with a small change in November, 2005.

The aims of the introduction of Basle II would be:

1. Ensuring more risk-sensitive capital allocation

2. Separating operational risk from credit risk (quantify both)

3. Align (egyenget) economic and regulatory capital more closely to reduce regulatory arbitrage

Basle II uses a "three pillars" concept to promote greater stability in the financial system. These

pillars are:

1. minimum capital requirement:

- develop and expand the standardized 1988 rules

- replacement of risk-weighting system by external credit rating (eg.: countries: AAA – 0%, A –

20%; corporates: AA – 20%, A – 100%, the list varies from segment to segment)

- for low quality exposure – higher than 100% weight

2. supervisory review of capital adequacy:

- ensures that bank’s position is equal to its overall risk provision

- ability to require banks with greater degree of risk to excess the minimum capital

requirement

3. market discipline:

- encourage high disclosure standards

- role of market participants in encouraging banks to hold adequate capital

Three approaches for calculating credit risk and operational risk in Basle 2

There are 3 approaches for calculating both market risk and operational risk. When a bank can fulfill

the first level, then it can use the second method, if it is fulfilled as well, then they can use the third

approach. If the bank has already reached level 3, it can not return to the previous approaches. From

technical point of view, to be able to reach the third level costs more for banks, that why usually just

bigger banks can afford it. But from the point of view of capital adequacy requirement, the third level

would provide for banks the most favourable solution (from the point of view of the amount of

capital required). The level of calculating credit risk has to correspond with the level of calculating

operational risk.

Credit Risk Operational RiskLevel 1 Standard Basic IndicatorLevel 2 Foundation IRB StandardisedLevel 3 Advanced IRB Advanced Measurement (AMA)IRB = internal rating based

Criticism on Basle II:

- because of the technical requirements, it gives advantage to larger banks (technical

requirements needed to be allowed to calculate risks on a more sophisticated level,

mentioned above)

- elements of truths – banks move towards pricing of risk, banks land to higher risk borrowers

on higher prices

- will lead to more typical business cycle

Future

The committee is working on improvements

- refine definition of bank capital;

- quantify further classes of risk;

- improve sensitivity of risk measures.

The Standard & Poor’s credit rating agency would like to develop own tools to measure strengths of

banks’ balance sheet, as Basle II is too complicated to make comparisons among banks. Basle II is too

complex, because it allows banks to use internal risk-modeling techniques when measuring risk (that

is different banks use different methods – result are not comparable).

Calculating Capital Adequacy on the basis of Basle I:

1. Market risk (it was already mentioned earlier)

- risk of loss on on-balance sheet or off-balance sheet positions, arising from fluctuations in

market prices. E.g.: risks on interest rate-related instruments and equity positions in the

trading book, foreign exchange risk and commodities risk arising from all on- and off-balance

sheet activities

Capital requirements for market risk apply on a consolidated basis in the same way as for credit risk.

There are 2 methods for banks to measure market risk:

- standardized method;

- “internal models” approach - subject to certain conditions and requires approval (from

supervisory body), permits banks to rely on risk measures from their own internal risk

management models, provided the bank satisfies qualitative and quantitative conditions

2. Credit Risk

In the capital adequacy calculation, first we have to calculate the weighted risk assets (WRA). That is

to take the value of the assets (e.g. corporate loans, loans to government, mortgage loans, other

loans to individuals) and multiply their value with the weighting. Then we have to add up the

weighted amounts and take 8 % of it (if the requirement is to determine whether the bank has

enough tier 1,2 and 3 capital according to the Basle 1 regulation). Later on, this amount should be

compared to the sum of tier 1,2 and 3 capital less the investments. If the 8% of the WRA is higher,

then the bank can not fulfill the capital requirement under the current conditions.

3. Overall minimum capital requirement

1. requirements for credit risk set forth in the 1988 Basle Accord

Plus

2. requirements for market risk – 1. arithmetic sum of the capital requirements for market risk OR

2. the capital requirements from internal models approach OR

3. combination of the above two summed arithmetically

Forms of Capital to Cover Risks

The balance sheet of a bank is given. The balance sheet of banks differs from that of the commercial

companies. Most of a bank’s assets consists of loans given to its clients. Furthermore, similarly to

other companies, there are for instance real estate, goodwill or investments on the asset side of a

bank’s balance sheet. In order to ensure the safety of the money of the banks’ depositors, the bank’s

has to have adequate capital (coming from 3 different categories, described later as Tier 1,2,3).

According to Basle 1 this adequate capital should be 8% of its weighted risk assets. Lets see first what

weighted risk assets mean. According to Basle 1, different loans provided by the bank has different

risk factors, that is the possibility that the debtor will not able to repay them to the bank is different.

The different risk factors

The main forms of capital accepted for covering market risk are core capital (Tier 1 capital) and

supplementary capital (Tier 2 and Tier 3 capital).

The capital ratio represents the capital available to cover both credit risk and market risk.

Basic Elements of Core Capital (“Tier 1”)

+ shareholders equity (issued and fully paid ordinary shares/common stock and non-cumulative preference shares) (add);

+ undistributed profit (add)

+ disclosed reserves (share premium, retained profits,general reserves, legal reserves) (add);

- intangible assets, goodwill (deduct). - current year's losses (deduct);

- future tax benefits (deduct);

Shareholder’s fund

Basic Elements of Tier 2 Capital = Pseudo Capital (it is like capital) + undisclosed and revaluation reserves, general provisions for bad debts; + cumulative perpetual preference shares

+ long-term subordinated debt (i.e. debt with no maturity date which ranks in priority behind all creditors except shareholders).

It is limited to a maximum of 100% of Tier 1 capital. Subordinated debt is limited to 50% of Tier 1 capital.

Tier 3 Capital

Short-term subordinated debt with a minimum maturity of 2 yearsTier 3 capital can be used only to cover market risk and limited to 250% of Tier 1 capital.

The followings has to be deducted from Total Capital (Sum of Tier 1, 2, 3)

Investments (at the asset side of the balance sheet), in unconsolidated banking and financial subsidiaries is deducted from total capital.

Goodwill - deducted from Tier 1 capital

Allowed Proportions of the different type of capitals to cover market risk and credit risk:

The amount required to cover Market Risk can come only from Tier 1 and Tier 3 capital. The

proportion of the total amount for market risk is:

Tier 1 : Tier 3 = 1 : 2,5

E.g.: let’s say the calculated market risk is 700, it has to be covered from Tier 1 and Tier 3 in the

following way:

From Tier 1: 700/(1+2,5) × 1 = 200

From Tier 3: 700/(1+2,5) × 2,5 = 500

The amount required to cover Credit Risk can come from Tier 1 and Tier 2 capital. Covering Credit

Risk is divided into two sources within Tier 1 and Tier 2 capital.

In case of subordinated debt, the ration of Tier 1 : Tier 2 = 1:1

In case of the other type of sources for credit risk, the proportion of Tier 1 : Tier 2 = 1: 0,5

Definitions:

G10 – Group of 10: group of countries agreed to participate in the General Arrangements to Borrow

(GAB) in 1962. G10 is in fact a group of 11: Canada, Belgium, France, Germany, Italy, Japan, the

Netherlands, Sweden, Switzerland, the UK and the US.

General Arrangements to Borrow (GAB):

OECD - Organisation for Economic Co-operation and Development: it is an international

organisation of those developed countries that accept the principles of representative democracy

and a free market economy. It originated in 1948 as the Organisation for European Economic Co-

operation (OEEC), to help administer the Marshall Plan for the re-construction of Europe after World

War II. Later its membership was extended to non-European states, and in 1960 it was reformed into

the Organisation for Economic Co-operation and Development.

BCCI – case: The bankrupt of the Bank of Credit and Commerce International (BCCI should have been

monitored/supervised by the Bank of England, it went into bankrupt because of fraud, they were a

kind of money laundry in South-America for the money from drug businesses).

4. Why is mismatching an important factor in the level of profits for a bank? Give examples of mismatching, how they can create a higher or lower level of profits, and how the bad effects of mismatching can be avoided?

Mismatches in banking:

Banks take deposits from savers, paying interest on some of these accounts. They pass these funds on to borrowers, receiving interest on the loans. Their profits are derived from the spread between the rate they pay for funds and the rate they receive from borrowers. This ability to pool deposits from many sources that can be lent to many different borrowers creates the flow of funds inherent in the banking system. By managing this flow of funds, banks generate profits, acting as the intermediary of interest paid and interest received and taking on the risks of offering credit.

The reason for the existence of banks as intermediaries is twofold. First, the presence of information costs undermines the ability of a potential lender to find the most appropriate borrower; second, borrowers and lenders have different liquidity preferences.

For all banks, the objective is to maximize profits and shareholder value added. Management or risks and mismatches are central in the achievement of this goal. Risk is defined as the volatility of or standard deviation (square root of the variance) of net cash flows. In the extreme, inadequate risk management may threaten the solvency of the bank, where insolvency is defined as a negative worth, that is, liabilities in excess of assets.

Banks are risk traders. They live off the mismatch between assets (loans to customers, bonds or real estate) and liabilities (deposit products, life insurance policies or annuities). To the best of their ability, they try to second guess the markets and reduce such a mismatch by assuming part of the risks and by engaging in proper portfolio management. For this they charge fees and commissions, interest and profits – which constitute their sources of income. If any expertise is attributed to the banking system, it is risk management.

Economic effects may also lead to mismatching. If market interest rates rise: banks suffer losses, as deposit costs grow faster than interest payments on assets. An equivalent intuition is that rising interest rates reduce the value of banks' assets more than the value of its liabilities, reducing bank's net worth. Conversely, banks profits and net worth will rise if market rates fall.

To protect itself: bank can sell long-term T-bond futures. If interest rates rise, then long-term bond prices will fall, and bank will earn profits on its futures contract. These profits can offset the losses due to maturity mismatch. Conversely, if interest rates fall, then long term bond prices will rise, and bank will lose money on its futures contract. However, this can be offset by gains due to maturity mismatch.

Credit risk:

It is the risk that an asset or a loan becomes irrecoverable in the case of outright default, or the risk of delay in the servicing of the loan. In either case, the present value of the asset declines, thereby undermining the solvency of the bank.

Liquidity and Funding risk:

This is the risk of insufficient liquidity for normal operating requirements, the ability of the bank to meet its liabilities when they fall due. Funding risk is the risk that a bank is unable to fund its day-to-day operations.

Liquidity is an important service offered by a bank (e.g. depositors willing to withdraw their deposit whenever they wish). If the ability of the bank to pay put on demand is questioned, all its business may be lost overnight.

Maturity matching will guarantee liquidity and eliminate funding risk because all deposits are invested into assets of identical maturities. But such policy will never be adopted because intermediation in the form of asset transformation is a key source of of bank profit. The maturity profile of a bank’s liabilities understates actual liquidity; usually only a small percentage of a bank’s deposits will be withdrawn at maturity. Maturity matching to reduce liquidity risk to zero will reduce shareholder value added. Objective: maintain some acceptable degree of maturity mismatch.

Interest rate risk

Interest rate risk arises from interest rate mismatches in both volume and maturity of interest-sensitive assets, liabilities and off-balance sheet items. An unanticipated movement in interest rates can seriously affect the profitability of the bank.

Banks can lend at either fixed or variable rates. They will always have some interest mismatch, such as a mismatch between fixed and variable rate assets and liabilities:

Excess fixed rate liabilities = vulnerable to falling rates

Excess fixed rate assets = vulnerable to rising interest rates

Asset sensitive = interest rate sensitive assets reprice faster than their interest sensitive liabilities

Liabilities sensitive = interest rate sensitive liabilities reprice faster than their interest sensitive assets

Typically the former is the norm, meaning a fall in interest rates will reduce net interest income by increasing the bank’s cost of funds relative to its yield on assets. If a bank is liability sensitive, a rise in rates will reduce net income.

Foreign exchange or currency risk:

Under flexible exchange rates, any net short or long open position in a given currency will expose the bank to foreign exchange risk. Mismatch by currency or by maturity is an essential feature of the business.

Other risks resulting in mismatches:

Settlement/payments risk: created if one party to a deal pays money or delivers assets before receiving its own cash or assets, thereby exposing it to potential loss.

E.g. Herstatt Bank: Due to the existence of different time zones, the settlement of foreign exchange transactions was delayed. When Herstatt closed down in the morning (German time), dollar payments to American banks which had been agreed over the previous two days were not delivered. The exposed US banks were faced with liquidity crisis.

Market or Price risk: Exposure means that the price of an instrument (e.g. equities, bonds) will be volatile. General or systematic market risk is caused by a movement in the prices of all market instruments because of for example a change in economic policy. Unsystematic or specific market risk arises in situations where the price of one instrument moves out of the line with other similar instruments because of an event related to the issuer of the instrument. A bank can be exposed to a market risk in relation to:

o debt securities (e.g. bonds),

o debt derivatives (forward rate agreements, futures and options on debt instruments, interest rate and cross currency swaps, and forward foreign exchange positions),

o equities,

o equity derivatives (equity swaps, futures and options on equity indices, options on futures, warrants),

o currency transactions.

Sovereign and political risk: Sovereign risk refers to the risk that a government will default on debt owed to a private bank (special form of credit risk, no collateral can be taken as possession by the bank). Political risk is the risk of political interference in the operations of a private sector bank (interest rate or exchange rate regulations).

Operating risk: risk associated with losses arising from fraud or unexpected expenses such as for litigation.

Pre-payment risk arises with fixed rate mortgages for example. A prepayment option will result in different outcomes:

o if interest rates rise, mortgage prepayments decline and the expected average life of the portfolio increases

o if interest rates fall, prepayment increases (because the fixed payments are less attractive) and the average life of the portfolio declines.

II. Management of mismatches:

Traditional focus of risk management, or “asset-liability” management is proactive management of both sides of the balance sheet, with a special emphasis on the management of interest rate and

liquidity risk. Thereby the traditional risk management focused on a bank’s banking book (balance sheet assets and liabilities), while modern risk management is concerned with the trading book as well, which consist mainly of off-balance sheet financial instruments. A bank and trading books can be affected differently for a given change, e.g. in interest rates. A rise in interest rates may cause a reduction in the market value of off-balance sheet items, but a gain (in terms of economic value) in the banking book. The market value loss on the trading book has an immediate effect on profits and capital.

Credit Risk Analysis

Increases in credit risk will raise the marginal cost of debt and equity, which in turn increases the cost of funds. Loan quality problems are an important cause of bank failure.

Ways to minimize credit risk:

1. Accurate loan pricing: loan rate should consist of the market rate (e.g. base or prime lending rate), risk premium, and administration costs.

2. Credit rationing: credit lines and availability of credit restricted by credit constraints to well-defined groups of borrowers.

3. Collateral or security: may reduce credit risk. However, if the price of the collateral becomes more volatile, then for an unchanged loan rate, banks will have to demand more collateral to offset the increased probability of loss on credit.

4. Loan diversification: additional volatility created from an increase in the number of risky loans can be offset either by new injections of capital or by diversification (seek assets which yield returns that are negatively correlated).

Interest rate risk and asset-liability management

Once the bank decided on the maturity of a fixed rate deposit, it incurs interest rate risk. The only time there will be no risk is if the volumes of liabilities and assets are roughly equal, and the bank matches the maturity of the loans with the deposits.

Gap analysis

Gap analysis is the most well known ALM technique, normally used to manage interest rates risk, though it can be used in liquidity risk management. The gap is the difference between interest sensitive assets and liabilities for a given time interval. In gap analysis each of the bank’s assets and liability categories is classified according to the date the asset and the liability is reprised, and “time-buckets”: groupings of assets or liabilities are placed in the buckets.

Analysts compute incremental and cumulative gap results. An incremental gap is defined as earning assets – funding sources in each time bucket; cumulative gaps are the cumulative subtotals of the incremental gaps. If total earning assets must equal total funding sources, then by definition, the incremental gaps must always total zero and therefore, the last cumulative gap must be zero. Analysts focus on the cumulative gaps fot the different time frames.

A gap analysis in practice separates the assets and liabilities of a bank’s balance sheet into groups of with cash flows that are either sensitive or insensitive to changes in interest rates. An asset or liability is said to be interest rate sensitive if cash flows from the asset or liability change in the same direction as a change in interest rates. The gap is the sterling amount by which sensitive assets > sensitive liabilities. Negative gap means sensitive liabilities > sensitive assets; a positive gap is the opposite. Suppose the gap is positive, then a rise in interest rates will cause the bank to have asset returns rising faster than liabilities costs. If interest rates fall, liabilities costs will rise faster than asset returns.

Gap analysis provides with a picture of overall balance sheet mismatches.

Problem:

It ignores mismatches that fall within each time bucket. Occurs when equity is in the “not stated” time bucket because it has no stated maturity. E.g. maturity of 3.5 months put into the bucket of “>3-6” months.

Some bank products, such as non-maturity accounts, non-market rate accounts, and off-balance sheet items cannot be handled in a gap analysis framework. (Though part of this problem has been overcome through duration gap analysis.)

Duration analysis

Duration analysis measures the impact on shareholder’s equity if a risk-free rate, for all maturities, rises or falls. Duration analysis allows for the possibility that the average life (duration) of an asset or liability differs from their respective maturities. If part of the loan is repaid each month, then the duration of the loan will differ from its maturity. Duration will equal maturity if depositors are paid a lump sum at the end of the maturity. A duration gap is created exposing the bank to interest rate risk.

Duration is the present value weighted average term to repricing, and was originally applied to bonds with coupons, correcting the impurity of a bond: true duration is less than the bond’s term to maturity.

All cash flows are included in the computation, and there is no need to choose a time frame as in gap analysis.

The computed duration of equity is used to analyse the effect of a change in interest rates on the value of the bank, because it will approximate a zero coupon bond with the given duration. The greater a bank’s duration mismatch, the greater the exposure of the bank to unexpected changes in interest rates.

Duration gap analysis

This is a form of analysis mixes both gap and duration analysis. The duration of assets and liabilities are matched, instead of matching time until repricing, as in standard gap analysis. The on- and off-balance sheet interest sensitive positions of the bank are placed in time bands, based on the maturity of the instrument. The position in each time band is netted, and the net position is weighted by an estimate of its duration, where duration measures the price sensitivity of fixed rate instruments with

different maturities to changes in interest rates. If the duration of designated liabilities and assets are matched, then the duration gap on that part of the balance sheet is zero. This part of the B/S is said to be immunised against unexpected changes in the interest rate. In this way immunisation can be used to obtain a fixed yield for a period of time because both sides of the B/S are protected from interest rate risk.

Problems:

Market yields can change in the middle of an investment period.

Other risks are still present, such as credit risk.

Duration measure assumes a linear relationship between interest rates and asset value. In fact the relationship is normally convex. The greater the convexity of interest rate-asset relationship, the less useful is the simple duration measure. Hence, the use of duration to measure interest rate sensitivity should be limited to small changes in the interest rate.

Liquidity risk and asset-liability management

Management of liquidity risk is the other traditional focus of ALM. Assuming the liquidity preferences of a bank’s customers are roughly constant, the problem usually arises if there is a run on the bank as depositors try and withdraw their cash. A bank liquidity crisis is normally triggered either by loss of confidence in the bank or because of poor management practices, or the bank is a victim of a loss of confidence in the financial system.

The objective of liquidity risk management should be to avoid a situation where the net liquid assets are negative. Gap analysis can be used to manage this type of risk. The gap is defined in terms of net liquid assets: the difference between net liquid assets and volatile liabilities. Liquidity gap analysis is similar to the maturity ladder for interest rate risk but items from the balance sheet are placed on a ladder according to the expected time the cash flow is generated. Net mismatched positions are accumulated through time to produce a cumulative net mismatch position. The bank can monitor the amount of cash which will become available over time, without having to liquidate assets early, at penal rates.

Currency risk management

Foreign exchange risk or currency risk arises from exposure in foreign currencies. In the foreign exchange markets, duration analysis is used to compute the change in the value of a foreign currency bond in relation to foreign currency interest rates, or domestic currency interest rates, or the spot exchange rate. Gap analysis may also be employed in the foreign exchange markets, where gaps that exist in individual currencies are identified.

Some global banks reduce currency risk through multicurrency based share capital, that is, denominating their share capital in multiple currencies. Is share capital is denominated in a mixture of currencies to match the volume of business assets and liabilities, then capital ratios will not change by much during exchange rate fluctuations and currency risk is reduced without using hedging instruments.

III. Tools to mitigate mismatches:

Credit risk

Suppose a bank has long-term assets and short-term liabilities, and wants to protect itself against interest rate risk.

We've already seen one strategy: selling futures on long-term bonds.

Another strategy is to buy a put option on long term-bonds. If interest rates rise, then bond prices will fall. The put option will be in the money, and the bank can exercise it, realizing a profit. This profit can offset some of the losses the bank realizes due to maturity mismatch when interest rates rise.

Under futures, profits are completely insulated from interest rate risk: if rates rise, profits from futures offset balance sheet losses due to maturity mismatch, while if rates rise, losses on futures offset balance sheet gains due to maturity mismatch. Under options, profits are largely shielded from interest rate increases, although not as effectively as under futures, because having to pay the option price reduces the bank's profits relative to futures.

Asset securitization

This involves turning traditional, non-marketed balance sheet assets into marketable securities, and moving them off-balance sheet. E.g. residential mortgages, credit card receivables, student loans, commercial loans, trade receivables.

Asset securitization is attractive to banks for several reasons:

Unbundling: Volatile interest rates forced bankers to manage interest rate risk effectively. Securitization allows the interest rate risk to be unbundled from credit risk, and the originating bank, which is good at assessing the credit risk, can pass on the interest rate risk to another institution. Thus securitization can be used to pass on maturity mismatch to investors.

Securitization can also be used to reduce exposure to a given sector, where its lending is too concentrated.

Banks may resort to securitization to raise funds to improve liquidity. E.g. sell the credit card portfolio.

By moving assets off the balance sheet, capital regulatory requirements (Basle) can be more easily satisfied, reducing regulatory costs.

Derivatives

A derivative is a contract which gives one party claim on an underlying asset, or cash value of the asset, at some fixed date in the future. The other party is bound by the contract to meet the corresponding liability.

For banks, derivatives are off-balance sheet commitments (reducing capital requirements). Banks can use derivatives to generate business related to transferring various risks between different parties.

They can be used to hedge against interest rate, currency rate mismatches. Nonetheless the instrument used to hedge out one position, may expose the party to new risks.

Futures: Standardized contract traded on an exchange and is delivered at some future, specified date.

Forwards: A non-standardized agreement to buy or sell an asset, at a future date for a price determined at the time of the agreement. These are customized to suit the risk management objectives of the counterparties.

Forward rate agreements: Contract in which two parties agree on the exchange rate or interest rate to be paid on the notional deposit or specified maturity at the settlement date. Parties agree that they will indemnify each other against the impact if any change in exchange rates or interest rates – the seller of the contract thereby hedges against a future fall in interest rates, whereas the buyer gets protection from a future rise in interest rates. Currency forwards permit the buyer to hedge against the risk of future fluctuations in currencies.

Options: Unilateral contracts which are only binding on the seller of the option. Purchasers of option see them as insurance against adverse interest or exchange rate movements. (Options can be bundled together to create option-based contracts such as caps, floors and collars.)

Swaps: Bilateral agreement/contract to exchange a cash flow related to the debt obligation of two counterparties. They are bilateral agreements. Currency swaps are often motivated by the objective to obtain low-cost financing.

From the case studies:

“One of the errors was dramatically increasing Continental’s loan-to-assets ration from 57.9% in 1977 to 68.8% (see table 2) by year-end 1981(FDIC, 1997). This of course is not a big error if the loans are relatively secured (E.g. house mortgage loans), however, Continental was investing in a very risky business which could backfire, and so it did. Along with taking this high risk, the bank has adopted “below-market” pricing strategy for its loans. The average loan for Continental earned less by this time than in the books in 1978 given the large increase in interest rates over the period on the market. Below market pricing strategy is always aimed at gaining more market share. Why would a bank with the increasing loan-to-asset ratio try to generate even more loans by charging low interest rates on them? And if so is it a crucial point for us to think that this can lead to the failure? This aggressive policy at that time was really common among the largest commercial banks in US due to high competition among them. The managers took a risk, which could have been well-taken if not the problem of “mismatching”, which was a consequence of the bank putting more effort on making new and long term investments. Apart from this, the only fact that the greater proportion of the bank’s portfolio it holds in loans also suggests that the more exposed the firm is to a default risk. Although it is hard to state that had Continental maintained its previous percentage of assets in loans it wouldn’t have failed, it is mostly sure that the new loans did not help either.

On the contrary, new loans have led to one additional problem, which bank had to face, the mismatch in assets and liabilities. Continental had little retail banking business and therefore relatively small amounts of core deposits. In 1977 they made up 30% of total deposits; by 1981 they had declined to just under 20% (see table 3). Instead, the bank relied on fed funds and large core

deposits. In addition, management favored issuing short-term, more volatile but less-expensive instruments rather than long term ones that were both more stable and more expensive. (fdic.gov) As a result, the bank turned out having short-term deposits and long term loans and investments. Continental faced the problem of funding. The bank had to repay its deposits in short terms, while the main source of funding the liabilities (the assets) was on long term basics. Therefore, Continental had not enough cash to meet its liabilities on time.

At the same time, there was a decrease in the Continental’s interest margin (interest earned les interest costs), which could not be previously predicted by the banks management. The interest that was earned is the interest earned on the Continental’s loans. Due to the aggressive pricing strategy and the competitive environment, the bank charged those interests at the below-market prices. So, the bank took a risk, relying first of all on the decrease in interest costs, which they tried to maintain with the help of low cost short term deposits giving up the opportunity to avoid the risk of mismatching via concentrating on long term liabilities. Unfortunately, the “doom” hung over the Continental Illinois Bank. The loss of confidence due to Penn Square meant the bank had to pay higher than the average on the market rates on its core deposits. The interest margin has significantly dropped, which made the situation even worse for Continental.”

INVESTMENTS:

1. Explain the advantages of mutual fund investing to an individual investor.  Discuss the types of investment funds and their structures.  Illustrate the calculation of Net Asset Value. Mutual Fund Performance Measurement.

Introduction

A mutual fund is the common name for an open-end investment company that pools money from many investors and invests it in a variety of stocks, bonds, short-term money-market instruments, commodities, other securities or assets, or in some combination of these investments. The combined holdings the mutual fund owns are known as its portfolio. Mutual funds issue redeemable shares that investors purchase directly from the fund or through a broker instead of purchasing from investors on a secondary market. Each share represents an investor's proportionate ownership of the fund's holdings and the income those holdings generate

I. ADVANTAGES OF MUTUAL FUNDS

Liquidity : Mutual fund investors can readily redeem their shares at the current NAV — plus any fees and charges assessed on redemption — at any time. Mutual fund is as liquid as regular stock.

Diversification : Diversification is an investing strategy that can be neatly summed up as "Don't put all your eggs in one basket." Spreading your investments across a wide range of companies and industry sectors can help lower your risk if a company or sector fails. Some investors find it easier to achieve diversification through ownership of mutual funds rather than through ownership of individual stocks or bonds.

Professional Management : Professional money managers research, select, and monitor the performance of the securities the fund purchases. Mutual fund management tries to ‘beat-the-market’, to generate superior performance by buying and selling securities with better-than-average returns based on a careful research.

Lower transaction cost (Economies of Scale): Mutual funds are able to make transactions on a much larger scale, so they can achieve substantial savings on brokerage fees and commissions.

Affordability : Some mutual funds accommodate investors who don't have a lot of money to invest by setting relatively low dollar amounts for initial purchases, subsequent monthly purchases, or both.

Divisibility: investors can purchase mutual funds in smaller denominations

On the other hand, funds are assessed management fees and incur other expenses, with reduce the

investor’s rate of return. (Front- or Back-end loads/Annual expense fees/Penalties for early

withdrawal)

II. TYPES OF INVESTMENT FUNDS AND THEIR STURCTURE

In the US, investment companies are either classified as unit investment trusts or managed investment companies.

Unit Investment Trust(UIT) is a US investment company offering a fixed (unmanaged) portfolio of securities having a definite life. UIT is created for a specific length of time and is a fixed portfolio, meaning that the UIT’s securities will not be sold or new ones bought, except in certain limited situations

Management Investment Co.(two types)

Open-End(=mutual fund): see in intro

Closed-End Fund: issues a fixed number of shares usually listed on a major stock exchange. Unlike open-end mutual funds, closed end funds do not stand ready to issue and redeem shares on a continuous basis. Closed-end fund shares often sell at a discount from net asset value.

Other Investment Organizations (intermediaries not formally organised)

Commingled funds (partnership of investors for special purpose e.g. retirement account) Real Estate Investment Funds ( similar to closed-end fund invest in real estate)

It is important to understand that each investment fund has different risks and rewards. In general, the higher the potential return, the higher the risk of loss.

Mutual funds are broadly classified according to three types of investment objectives: growth of capital, stability of capital, or current income. Mutual funds are often categorized by investment policy (which is described in the fund’s prospectus). Major policy groups include money market funds; equity funds; bond funds; international funds; balanced and income funds; asset allocation and flexible funds and index funds

Main types of mutual fund

Money market funds: invest money market securities,low-risk, low-return, very liquid, short-term investments

Equity funds: invest primarily in stock, classification of fund according to their emphasis on capital appreciation vs. current income:

a. Income funds tend to hold shares of firms with consistently high dividend yieldsb. Growth funds focusing instead of current income on prospects for capital gainsc. Sector funds invests in a particular industry, e.g. biotechnology

Fixed income funds (Bond funds): specialise in the fixed-income sector by location, maturity and credit risk

Balanced and income funds: invest in both equities and fixed-income securities in stable proportion

a. Income funds safety of principal &current incomeb. Balanced funds minimize investment risks without sacrificing long-term growth

International funds: invest in securities of firms located outside the United States Asset allocation and flexible funds: invests both stocks and bonds in different proportion,

market timing is important, not designed to be low-risk investment vehicles

Index funds: buys shares in securities included in a particular index, tries to match the

performance of a broad market index, low cost passive investment strategy

Other types:

Fund of funds: invest in other underlying mutual funds

Hedge Fund: uses high-risk techniques, such as borrowing money and selling short, in an

effort to make extraordinary capital gains, enters into futures, swaps and other derivative

contracts

Exchange Traded Funds: new innovation, traded like stocks on the exchanges, combine

characteristics of both mutual funds and closed-end funds

III. CALCULATION OF NET ASSET VALUE.

The value of each share is called net asset value. Calculated as the following:

$ per shares

IV. MUTUAL FUND PERFORMANCE MEASUREMENT

Sharpe ratio is a measure of the mean excess return per unit of risk in an investment asset or a trading strategy (using total risk).

Treynor ratio gives excess return per unit of risk, but it uses systematic risk (beta) instead of total risk.

Jensen’s alpha: the average return on the portfolio over and above that predicted by the CAPM, given the portfolio’s beta and the average market return

2. Discuss the importance of macroeconomic and industry analysis in equity valuation.  Compare and contrast consensus forecasting with econometric models.  List the factors that determine an industry’s sensitivity to the business cycle.  Describe the macroeconomic variables that play the most important role in equity markets.

I. THE IMPORTANCE OF MACROECONOMIC AND INDUSTRY ANALYSIS IN EQUITY VALUATION.

Fundamental Analysis (=macroeconomic and industry analysis) helps to determine the value of company’s equity. The business success of a firm determines the dividends it can pay to the shareholders and the price it will command in the stock market. Because the prospects of the firm are tied to those of the broader economy, however, fundamental analysis must consider the business environment in which the firm operates.

Top-down analysis: examines broad economic environment, state of the aggregate and international economy

II. COMPARE AND CONTRAST CONSENSUS FORECASTING WITH ECONOMETRIC MODELS.

Consensus forecasting and econometric models are tools used to forecast future developments based on past events. Forecast how changes in some variables will affect the future course of others.

Consensus forecast is the mean of all financial analysts' forecasts for a company.The aggregation

of information in groups can result in better decisions than could have been made by any single member of the group.

An econometric model is one of the tools that economists use to forecast future developments in the economy. In the simplest terms, econometricians measure past relationships between variables such as consumer spending and gross national product, and then try to forecast how changes in some variables will affect the future course of others.

Econometricians make these calculation based on an economic model, which shows how different factors in the economy interact with one another. Using real data to determine or estimate all the parameter values in the model is the critically important step that turns the abstract mathematical economic model into an econometric model. Actually, no econometric model is ever truly complete. All models contain variables that the model cannot predict because they are determined by forces "outside" the model.

An econometric forecast can be wrong for several reasons:

a. Input errors incorrect assumptions about the ‘outside’ variables (monetary policy)b.Model errors econometric equations that are only approximations to the truth c. Combination of both input & model error

III. LIST THE FACTORS THAT DETERMINE AN INDUSTRY’S SENSITIVITY TO THE BUSINESS CYCLE

Not all industries are equally sensitive to business cycle. E.g. cigarette demand does not seem affected by the state of macroeconomy in any meaningful way (habit). On the other hand, auto production is highly volatile.

Three factors determine the sensitivity to the business cycle:

Sensitivity of sales: Necessities will show little sensitivity to business conditions (e.g. food industry). In contrast, firms in industries such as machine tools are highly sensitive to the state of economy.(whether it belongs to cyclical or defensive industry)

Operating leverage: it refers to the division between fixed and variable costs. Firms with greater amounts of variable as opposed to fixed costs will be less sensitive to business conditions. This is because in economic downturns these firms can reduce costs as output falls in response to falling sales.

Financial leverage: interest payments on debt must be paid regardless to sales. They are fixed costs that also increase the sensitivity of profits to the business conditions.

Investors should not always prefer industries with lower sensitivity to the business cycles. Firms in sensitive industries will have high-beta stocks and are riskier. But while they swing lower in downturns, they also swings higher in upturns.

IV. DESCRIBE THE MACROECONOMIC VARIABLES THAT PLAY THE MOST IMPORTANT ROLE IN EQUITY MARKETS.

GDP: measure of the economy’s total production and services. Rapidly growing GDP indicates an expanding economy with great opportunities for firms to increase sales.

Employment / Unemployment rate: The unemployment rate is the % of the total working force yet to find work. It measures the extent to which the economy is operating at full

capacity. Another measure of utility is the „factory capitalization rate” which is the ratio of actual output from factories to potential output.

Inflation: The rate at which the general level of prices is rising. High rates are associated with overheated economies meaning that the demand for goods and services is outstripping productive capacity, which leads to upward pressure on prices.

Interest rate: High interest rates reduce the PV of future cash flows, thereby reducing the attractiveness of investment opportunities. So real interest rates are key determinants of business investment expenditure.

Budget deficit: Difference between government spending and revenues. Any budgetary shortfall results in government borrowing which force up interest rates by increasing the total demand for credit.

Sentiment: Consumers’ and producers’ optimism or pessimism concerning the economy. Exchange rate: A currency will tend to lose value, relative to other currencies, if the country's

level of inflation is relatively higher, if the country's level of output is expected to decline, or if a country is troubled by political uncertainty. In choosing what type of asset to hold, people are also concerned that the asset will retain its value in the future. Most people will not be interested in a currency if they think it will devalue.

Money supply: is the quantity of currency and checkable deposits in the hands of the non-bank public available within the economy to purchase goods, services, and securities. The money supply affects the interest rates.

Industrial capacity utilization: refers to the extent to which a nation actually uses its productive capacity. Thus, it refers to the relationship between actual output produced and potential output that could be produced with installed equipment, if capacity was fully used. Economists and bankers closely watch capacity utilization indicators for signs of inflation pressures.

Consumer price index: A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. Changes in CPI are used to assess price changes associated with the cost of living.

3. Define call options and put options.  Discuss the put-call parity relationship.  Who are the participants of options markets and why do they trade options?  Contrast options and futures contracts from a risk management perspective.

Call Options

A call option gives its holder the right to purchase an asset for a specified price, called the exercise or strike price, on or before some specified expiration date.

The holder of the option is not required to exercise the option. The holder will choose to exercise only if the market value of the asset to be purchased exceeds the exercise price. When the market price does exceed the exercise price, the option holder will “call away” the asset for the exercise price. Otherwise the option may be left unexercised. If it is not exercised before the expiration date of the contract, a call option simply expires and no longer has value. Therefore, if the stock price is greater than the exercise price on the expiration date, the value of the call option equals the difference between the stock price and the exercise price; but if the stock price is less than the exercise price at expiration, the call will be worthless. The net profit on the call is the value of the option minus the price originally paid to purchase it.

The purchase price on the option is called the premium. It represents the compensation the purchaser of the call must pay for the right to exercise the option if exercise becomes profitable.

Sellers of call options, who are said to “write” calls, receive premium income now as payment against the possibility they will be required at some later date to deliver the asset in return for an exercise price lower then the market value of the asset. If the option is left to expire worthless because the exercise price remains above the market price of the asset, then the writer of the call clears a profit equal to the premium income derived from the sale of the option. But if the call is exercised, the profit to the option writer is the premium income derived when the option was initially sold minus the difference between the value of the stock that must be delivered and the exercise price that is paid for those shares. If that difference is larger than the initial premium, the writer will incur a loss.

Put Options

A put option gives its holder the right to sell an asset for a specified exercise or strike price on or before some expiration date.

While profits on call options increase when the asset increases in value, profits on put options increase when the value falls. A put will be exercised only if the exercise price is greater than the price of the underlying asset, that is, only if its holder can deliver for the exercise price an asset with market value less than the exercise price. The owner of the put profits by the difference between the exercise price and market price.

*An American option can be exercised before and up to its expiration date

*A European option can be exercised only on the expiration date.

An option is describe as in the money when its exercise would produce profits for its holder. An option is out of the money when exercise would be unprofitable. Therefore, a call option is in the money when the exercise price is below the asset’s value. It is out of the money when the exercise price exceeds the asset value. Put options are in the money when the exercise price exceeds the asset’s value, because delivery of the lower-valued asset in exchange for the exercise price is profitable for the holder. Options are at the money when the exercise price and asset price are equal.

Put-Call Parity Relationship

The put-call parity theorem is equation representing the proper relationship between put and call prices. Violation of parity allows arbitrage opportunities.

The put-call parity is a principle referring to the static price relationship, given a stock's price, between the prices of European put and call options of the same class (i.e. same underlying, strike price and expiration date). This relationship is shown from the fact that combinations of options can create positions that are the same as holding the stock itself. These option and stock positions must all have the same return or an arbitrage opportunity would be available to traders. Any option pricing model that produces put and call prices that don't satisfy put-call parity should be rejected as unsound because arbitrage opportunities exist.

The above illustration demonstrates a simple put-call parity relationship. Looking at the graph, we see that a long-stock/long-put position (red line) has the same risk/return profile as a long call (blue line) with the same expiration and strike price. The only difference between the two lines is the assumed dividend that is paid during the time to expiration. The owner of the stock (red line) would receive the additional amount, while the owner of the call (blue line) would not. However, if we assume no dividend would be paid to stockholders during the holding period, then both lines would overlap.

Consider the strategy of buying a call option, and in addition, buying Treasury bills with face value equal to the exercise price of the call, and with maturity date equal to the expiration date of the option. For example, if the exercise price of the call option is $100, then each option contract (written on 100 shares) would require payment of $10,000 upon exercise. Therefore, you would purchase one T-bill, which also has a maturity value of $10,000. More generally, for each option that you hold for exercise price X, you would purchase a risk-free zero-coupon bond with face value X.

Examine the value of this position at time T, when the options expire and the zero-coupon bond matures:

ST <=X ST > X

Value of call option 0 ST – X

Value of riskless bond X X

Total X ST

If the stock price is below the exercise price, the call is worthless, but the riskless bond matures to its face value, X. The bond therefore provides a floor value to the portfolio. If the stock price exceeds X,

then the payoff to the call, ST – X, is added to the face value of the bond to provide a total payoff of ST

. The payoff of this portfolio is precisely identical to the payoff of the protective put.

As we can see in the last row of the tables, the value of the two portfolios are equal. If two portfolios provide equal values, then they must cost the same amount to establish. That is to create a protective put portfolio (stock plus put) has to cost the same as a call plus bills portfolio.

In the call plus bills portfolio the call option costs C, that is the paid option premium. The treasury bill

(riskless, zero-coupon) costs

X

(1+rf)T

.

That is the amount that we have to pay for the Treasury bill when we buy it. We know that the future value of the Treasury bill - that is the face value paid at maturity - equals to the exercise price of the bond. We calculate it by discounting the future value by the risk-free interest rate. We calculate it this way because we do not get interest on the Treasury bill, we buy it at a lower price than the face value and than at maturity we receive the face value, the difference between the purchase price and the face value is our profit on the bill.

In the protective put portfolio, the stock costs S0 at the time of the purchase (at time zero), furthermore the price of the put option, that is the optimum premium paid for the put option is P.

Therefore:

X

(1+rf)T S0 + PC + =

This equation is called the put-call parity theorem/relationship. It represents the proper relationship between put and call prices.

If the two sides of the above equation are not equal, in indicates mispricing and an arbitrage opportunity arises. For instance if it is cheaper to establish a protective put portfolio (right side of the equation) than to establish a call plus bills portfolio, the investor who wants to earn an arbitrage profit will buy the cheaper portfolio and sell the more expensive one (in this case he would write a call option and borrow from the bank). The immediate cash flow of the investment (arbitrage profit) is the difference between the two sides of the equation, the cash flow at maturity will be zero regardless of the share price.

The above equation of the put-call parity is true only for stocks that do not pay dividend before the maturity of the option. If the options are European type and the stock is dividend paying (before the option expires), than the above equation will change to the following:

P = C - S0 + PV (X) + PV (dividend)

In this equation PV(X) represents present value of the exercise price at maturity (same as

X

(1+rf)T

above) and PV (dividend) represents the present value of the dividend received during the life of the option, calculated on the basis of the same methodology as PV(X).

If a call and a put may be optimally exercised at different times before their common expiration date, then the equality of payoffs cannot be assured, or even expected, and the portfolios will have different values.

If we know the cost of purchase of a call option (and all other data needed, that is amount of dividend payment if any, risk-free rate, stock price at the date of issuing the option and the exercise price), we can calculate, what would be the cost of a put option, if it is priced fairly (no mispricing) for the same stock, same exercise price under the same market conditions with the same maturity.

Participants of Options Markets

Holder (buyer) – is not required to exercise the option if it is unprofitable (the long position)

Writer (seller) – has obligation to carry out the deal when the holder requires (always short position)

Speculator: speculating price movements of underlying security

Institutional Investor (mutual or pension fund) or sophisticated investor with large portfolio: decrease the risk of a portfolio and minimize losses to a certain degree. Save on transaction costs and tax, avoid stock market restrictions, and achieve the same risk exposure with less capital.

Business Firms (especially in commodity industries): hedge to reduce risks of fluctuation in commodity prices, interests or exchange rates.

Options and Futures Contracts

Similarities: specified purchase or sale of some underlying security at some future date at an agreed price.

Differences: the holder of the option is not obliged to exercise, while future contracts make obligations to fulfill the agreed transaction.

Risk management perspective: in case of a fall in the price of the underlying asset, the only loss on option is the premium paid for it, while futures can cause much more serious losses (an issuer of an option takes similar risk exposure as a participant of a futures contract).

Appendix to Put-call Parity

In the previous section there was introduced that both protective put portfolio and a call plus bills portfolio provides for the investor limited downside risk with unlimited upside potential. The tables below show the total value of the investment in this two cases.

S0 = stock price when the option is sold/bought

ST = stock price at maturity (T = time)

X = strike price, exercise price

P = option premium paid for the put option (right to sell)

C = option premium paid for the call option (right to buy)

rf = risk free interest rate

if ST <= X if ST > X

Stock ST ST

Value of put option (long put = right to sell ) X-ST 0

Total value of the investment X ST

Protective Put Strategy

If we buy stock and a put option for the same stock (protective put portfolio), the value of the investment can be the following:

1., If the stock price at the date of maturity (ST) is below or equals to the exercise price (strike price) (X), the value of the investment equals to the exercise price. In practice it means, that if the exercise price is $100 and the share price falls to $90 per share, thanked to the put option we still have the right to sell it for $100, so the right to sell it for $100 is worth $10 per share ($ 100-$90=$10). The total value of the investment in this case is the share price at maturity ($90) plus the value of the put option ($10). (ST + (X-ST) = X)

2., If the stock price at the date of maturity is over the exercise price, the value of the put option is worthless (0). So the value of the investment is the higher stock price. In practice it means, that if the exercise price is $ 100 and the price of the stock at maturity is $120, we will not exercise our right to sell the option for $100, because we can sell it to the market for a higher price ($120). The total amount that we receive at maturity is $120 per share (ST + 0 = ST)

if ST <= X if ST > X

Call option (long call = right to buy) 0 ST-X

Value of treasury bill/bond (riskless) X XTotal value of the investment X ST

Call plus bills/bonds

In case of the call plus bills portfolio, that is when we buy call option and buying Treasury bills with face value equal to the exercise price of the call, the value of the investment is the following:

1., If the stock price is below the exercise price of the option at the date of maturity, than our call option is worthless and the value of the investment equals with the value of the treasury bill, that is the exercise price of the option (X). In practice it means, that if the exercise price is $100 and the actual price of the share at maturity is $90, we will not exercise our right to buy it for $100 if we can buy the same share from the market at a cheaper price. But we still receive the face value of the treasury bill, that equals to the exercise price of the option.

2., If the stock price is above the exercise price of the option at the date of maturity, the value of the call option is the difference between the exercise price and the market price of the stock (S T-X). The value of the treasury bill is independent from the stock price, so it remains the same as in the previous case, so it is still equal to the exercise price of the option (X). So in this case the value of the investment is ST (ST-X+X = ST). In practice it means, that if the exercise is $100 and the actual price of the stock at maturity is $120, we will earn $20. In addition to this we receive the face value of the treasury bill as well.

4. Describe the main characteristics of futures contracts and explain how margin accounts operate.  Define swap contracts.  Explain how a plain vanilla currency swap is set up and what cash flows are exchanged.

I. Main characteristics of futures contracts

The futures contract

Futures contract ~ forward contract protects each party from future price fluctuations

BUT futures contract obligates the holder to buy or sell an asset at a predetermined delivery price during a specified future time period and which is settled daily, meaning simply a deferred-delivery sale of some asset with the sales price agreed on now. They call for a daily settling up of any gains or losses on the contract

forward contract olbigates the holder to buy or sell an asset for a predetermined delivery price at a predetermined future time, where no money changes hands until the delivery date

Futures markets: formalize and standardize forward contracting, where buyers and sellers trade in a centralized futures exchange

– exchange standardizes: types of contracts, contract size, the acceptable grade of commodity, contract delivery dates, and so forth

– although standardization eliminates much of the flexibility available in forward contracting, it has the offsetting advantage of liquidity because many traders will concentrate on the same small set of contracts

– the centralized market, standardization of contracts, and depth of trading in each contract allows futures positions to be liquidated easily through a broker rather than personally renegotiated with the other party to the contract. Because the exchange guarantees the performance of each party to the contract, costly credit checks on other traders are not necessary. Instead, each trader simply posts a good-faith deposit, called the margin, in order to guarantee contract performance.

Characteristics

Futures contracts have standard delivery dates, trading units, terms and conditions.

Futurse price – a specified agreed-upon price to be paid at contract maturity

– the contract specifies precise requirements for the commodity

Futures can be based on individual shares, stock market indices, bonds, interest rates and different kinds of commodities as well.

Equity futures: let the investor to focus on specific shares

Index futures: follows the performance of certain indexes, which include several companies; delivery may be accomplished by a cash settlement procedure such as those for index options

Opening a futures position means buying or selling a future, closing means the opposite.

long position (buy): the trader commits to purchasing the commodity on the delivery date

Profit to long = Spot price at maturity – Original futures price

short position (sell): the trader commits to delivering the commodity at contract maturity

Profit to short = Original futures price – Spot price at maturity

2 types of deliveries can be differentiated:

physical delivery: the underlying product will actually be delivered (e.g.: commodities)

financial delivery: a financial settlement happens between the buyer and the seller, at the settlement price at maturity.

Futures (or futures contracts) can be classified into the group of derivative financial instruments, the name derivative refers to the fact that the price of these products can be derived from the price of the underlying assets. Options are also part of the derivative financial instruments, however the main difference between options and futures is that the holder of the option is not obliged to buy or sell if the trade seems unprofitable, it gives the option to do so.

Futures contract are usually used for hedging. Short hedgers take short positions in contracts to offset any gains or losses on the value of an asset already held in inventory. Long hedgers take long positions to offset gains or losses in the purchase price of a good.

On the other hand, they may be used for speculating, as well. Speculators use the contracts to take a stand on the ultimate price of an asset.

Benefits of trading futures

The direction of the prices of the underlying asset is not sure, the price of the futures is not known in advance. That is why futures carry the risk that prices will go the opposite way as the desired. However, investors can profit in a falling market and also in a rising market. When investing in shares the rule of buy low and sell high is used to profit from market prices. In case of futures markets the opportunity is provided to sell futures when the share price is thought to fall. If the point of view was right and the price of the future falls together with the underlying share price, the position can be closed by buying back the future for less in order to make a profit.

Futures can be used to hedge the existing underlying assets if the price seems to fall. A futures position could be opened to protect the existing assets in the event of a down turn in prices. Selling the futures against the equity portfolio is good means to avoid making a loss without having to pay the costs associated with selling the assets. This futures position can be closed by buying the same amount of futures in the market. So the losses incurred in the underlying asset can be compensated by the profit made on futures.

Another benefit of trading futures is the lower commission structure. Futures trading commissions typically represent a third of the costs for those to trade the underlying market and cash-settled futures contracts.

Futures also can be used to profit from volatile market conditions. In other words the opportunity is provided to profit from the upward and downward turns in the prices of the underlying assets, as mentioned earlier. Futures is an effective means of controlling risk.

Futures exchanges

2 largest in the US:

- Chicago Board of Trade (CBOT)- Chicago Mercantile Exchange (CME)

Largests in Europe:

- London International Financial Futures and Options Exchange (LIFFE)- EUREX- EURONEXT

Others:

- Bolsa de Mercadorias y Futuros in Sao Paolo (CMF)- Tokyo International Financial Futures Exchange (TIFFE)- Singapore International Monetary Exchange (SIMEX)- Sydney Futures Exchange (SFE)

Hungary:

- Budapest Stock Exchange (BSE), established in 1864II. Operation of margin accounts

1. Marking to market: the process by which profits or losses accrue to traders It ensures that, as futures prices change, the proceeds accrue to trader’s margin account

immediately.

Marking to market is the major way in which futures and forward contracts differ, besides contract standardization. Futures follow the pay- (or receive-) as-you-go method.

Margin account: a security account consisting of a cash or near-cash securities, that ensures the trader is able to satisfy the obligations of the futures contract. Because both parties to a futures contract are exposed to losses, both must post margin.

The initial margin is usually set between 5% and 15% of the total value of the contract, but contracts written on assets with more volatile prices require higher margins.

Maintenance margin: an established value below which a trader’s margin cannot fall. Reaching the maintenance margin triggers a margin call. new funds must be transferred into the margin account, or the broker will close out enough of the trader’s position to meet the required margin for that position

The futures price on the delivery date will equal the spot price of the commodity on that date. The delivery of the commodity may be obtained either by purchasing it directly in the spot market or by entering the long side of a futures contract.

Convergence property: the futures price and the spot preice must converge at maturity, or else investors will rush to purchase it from the cheap source in order to sell it in the high-priced market.

Profits on a futures contract held to maturity perfectly track changes in the value of the underlying asset.

2. Clearinghouse: established by exchanges to facilitate transfer of securities resulting from trades. For options and futures contracts, the clearinghouse may interpose itself as a middleman between two traders.

The clearinghouse requires all positions to recognize profits as they accrue daily, instead of waiting until the maturity date for traders to realize all gains and losses.

III. Swap contracts

Swap is arrangement whereby two companies lend to each other on different terms, e.g., in different currencies, or on one at a fixed rate and the other at a floating rate. The application of swaps allows the parties to change their risk and therefore hedge against risks.

Types of swaps:

- Interest rate swaps: a method to manage interest rate risk where parties trade the cash flows corresponding to different securities without actually exchanging securities directly

- Currency swap: an agreement to exchange stipulated amounts of one currency for another at one or more future dates

- Intermarket spread swap: switching from one segment of the bond market to another- Substitution swap: exchange of one bond for a bond with similar attributes but more

attractively priced- Tax swap: swapping two similar bonds to receive a tax benefit

IV. The set up plain vanilla currency swap and the cash flows exchanged

Swaps

Objective: to hedge the risk the firm buys one asset and sells an equal amount of another asset

Currency swap an agreement to exchange stipulated amounts of one currency for another at one or more future dates

The most popular version of currency swap is the `plain vanilla swap', also known as a `generic swap'

Plain vanilla currency swap

The term `currency swap' can sometimes cause confusion because it can refer to an arrangement in either the foreign exchange markets or the capital markets. In the foreign exchange markets a currency swap is a simultaneous spot sale and forward purchase of one currency for another. In the capital markets a currency swap is an agreement to exchange a loan in one currency for one denominated in another currency.

The concept is the same as an interest rate swap but the introduction of different currencies means that there are many different versions of currency swaps. The swap might be an exchange of interest only or could involve both principals and interest. The interest swapped might be fixed-to-fixed or fixed-to-floating or floating-to-floating.

Same as interest rate swap but the cash flow streams are in different currency

Equivalent to a strip of currency forwards

In contrast to a plain-vanilla interest rate swap, a currency swap typically not only involves an exchange of coupon payments but also an exchange of principal.

Example:- American Firm A would like to borrow pounds- British Firm B wants to borrow dollars- Because it is better known in the US, Firm A can borrow dollars at a lower interest

rate than Firm B, while Firm B, because it is better known in the UK, can borrow pounds at a lower interest rate than Firm A

- So if Firm A borrows dollars in the US and Firm B borrows pounds in the UK, but then they swap their obligations, each firm can benefit from the other firm’s superior borrowing rate in its domestic currency

- Typically, the swap is set up so that its value, based on the current exchange rate is zero.

- Nonetheless, both counterparties benefit from the swap because they end up borrowing at lower foreign interest rates than they could have on their own.

- In many cases in practice, one of the firms does not have an absolute advantage over the other firm in borrowing in its own domestic market, and yet the swap can be mutually beneficial. All that is necessary is that each firm have a comparative advantage in its domestic market. For example, firm A (which has a comparative advantage in dollars) can on its own borrow dollars at 8% and pounds at 11%, while

Firm B (which has a comparative advantage in pounds) can on its own borrow dollars at 10% and pounds at 11.5%.

- The sequence of events is as follows: Original loan and exchange of principals

Exchange of interest

Re-exchange of principals and repayment of loans

- The arrangement can be illustrated diagrammatically as follows: