CONTENTS

1. Chapter 1 Introduction 1Chapter 2 Financial Intermediaries and

Financial Innovations 4

2. Chapter 4 Depository Institutions: Activities& Characteristics 7

Chapter 5 Central Banks and the creationOf Money 12

3. Chapter 7 Insurance Companies 15

4. Chapter 8 Investment Companies and Exchange Traded Funds 21

Chapter 9 Pension Funds 27

5. Chapter 14 Primary Markets and Underwriting of Securities 30

Chapter 15 Secondary Markets 32

6. Chapter 16 Treasury and agency SecuritiesMarkets 34

7. Chapter 18 Common Stock Markets in theUnited States of America 39

8. Chapter 19 International Stock Markets 47

9. Chapter 23 The Mortgage Market 54

10. Chapter 26 Financial Futures Markets 60

INTRODUCTION (Chapter 1)

There are two types of Markets i.e. the ‘Product market’& the ‘Factors of production Market’; Financial Market is part of latter.

Financial Assets: Asset is a possession having value in exchange.Value of tangible assets depends on some physical properties, whereas that of intangible assets represents legal claims to some future benefit.Financial assets are intangible, having a claim to future cash. The issuer undertakes to pay future cash to the investor (the owner).

Debt versus Equity Instruments: Debt instruments have fixed amount of claims and priority over the Equity instruments (Residual Claim). The claim under the latter depends on the performance of the investment.Some securities like preferred stock & convertible bonds can fall under both the categories.

The Price of a FINANCIAL ASSET & Risk The price of a financial asset is equal to the present value of its expected future cash flow. The risks involved in the matter are the inflation risk, the default risk and the foreign Exchange risk.

Financial Assets versus Tangible AssetsIn business both, financial as well as tangible assets, generate cash flow for the owner and ownership of tangible assets is financed by issuance of financial assets.

The Role of Financial Assets. They have two roles i.e. transfer of funds from savers to investors and Risk separation and distribution.

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FINANCIAL MARKETSMarkets where financial assets are exchanged (traded)

Role of Financial MarketsIn addition to bringing together the savers & investors and separation & diversification of risk, the financial markets perform the following three economic functions:

The interaction of buyers and sellers determine the prices of assets. This is the price discovery process

It offers liquidity & even premature financial assets can be encashed

It reduces the cost of transaction by eliminating the search and information costs.

Classification of Financial Markets By nature of claim, Debt/Equity market By maturity of claim, Money /capital market Seasoning of claim, Primary/Secondary market Immediate/future delivery, cash or spot/Derivative market Organizational structure, Auction/Over-the-counter/

intermediated market

GLOBALIZATION OF FINANCIAL MARKETSFinancial markets throughout the world have integrated into an international financial market because of:

a) Deregulation and liberalization of markets & participants,b) Technological advancement in financial operations, andc) Increased institutionalization of financial markets.

From the perspective of a particular country the Global markets, can be classified into internal or national (including domestic and foreign markets) and external or international market.

Motivation for using foreign markets

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Domestic market may not be fully developed, Opportunities might exist for obtaining lower cost, Geographical diversification of funding source Publicity for the name of the corporation, and Presence of a subsidiary, parent or affiliate.

DERIVATIVE MARKETSContracts or obligations to buy/sell in future. The future price depends upon the value of the asset, its expected future value and the rate of interest.

Types of Derivative instrumentsFuture/Forward Contracts are agreements between two parties to transact a financial asset at a predetermined price at a specified future date.An Option Contract gives the owner of the contract, a right to buy (or sell) a financial asset at a specified price from (or to), another party. The buyer has to pay a price to the seller called the option price.When the right to buy is acquired, the option is called call option;and in case of option to sell it is called a put option.

The Role of Derivative InstrumentsThe use of derivative instruments mitigates financial risks; some examples being:

Protection against a future rise in interest, Protection against a decline in the prices of stocks, Protection against fluctuations in the exchange rates.

The three advantages of Derivative market over the spot market are (a) lower transaction cost, (b) Faster speed of completion of transaction, and(c) greater liquidity.

FINANCIAL INTERMEDIARIESand

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FINANCIAL INNOVATION (Chapter 2)

Financial Intermediaries help in diverting savings into investments.

Recent innovations have helped in globalization of business. A recent innovation in the financial market is sale of securities

backed by traditional assets like car loans, mortgages etc.

FINANCIAL INSTITUTIONSFinancial Institutions act as (a) financial intermediaries, (b) Brokers, Dealers & Agents, (c) Underwriters and (d) Captive Finance Companies.

Role of Financial IntermediariesFinancial intermediaries transform savings into investments. Advances of a bank are its direct investments, whereas they are indirect investments of depositors, who provide the raw material. This transformation involves, at least, one of the following economic functions: Maturity intermediation: Financial institutions accept deposits at call and various maturities; similarly they make loans of short term as well as long term maturities. They do commit longer-term investments (counting on successive deposits) at a relatively lesser rate than an individual investor. Reducing Risk via diversification: Reducing the costs of Contracting and information processing: Commercial Banks & Investment Companies etc. get acquainted with the market conditions and they have standardized forms etc. So they can achieve better results at lower costs in choosing financial assets for their constituents. Providing a Payments Mechanism.

Asset/Liability Management.

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The depository institutions endeavor to earn profit through the spread between what they pay to the depositors and what they earn from their borrowers. Insurance business is also somewhat similar. Pension funds and Investment companies are different.

Nature of Liabilities.

Type-1 Liabilities: Amount & Time of cash outlay is known e.g. payment of interest/Principal on CDs, GIC (insurance plans) etc.

Type-2 Liabilities: Amount of cash outlay is known but the time is not certain, like life insurance policy.

Type-3 Liabilities: Amount of cash outlay is not certain but the time is certain, like certificates of deposits with return on the same attached to Bank Rate etc. (instead of being fixed).

Type-4 Liabilities: Both, amount & time of cash outlays are not known, like property and liability insurance policies etc.

Each financial institution has to manage its affairs in such a manner to be able to meet its contractual obligations.

FINANCIAL INNOVATIONS. Financial innovations have been categorized differently by different agencies, some of which are: Market broadening instruments, Risk Management Instruments,

and Arbitraging instruments and processes. Price-risk transferring innovations, Credit-risk transferring

instruments, liquidity generating innovations, Credit generating instruments and Equity generating instruments.

New financial products best suited to the circumstances of time and Strategies to use these products.

Motivation for Financial Innovations: Volatile interest rates, inflation, equity prices & exchange rates; Progress in computer & telecommunication; Sophistication & training of professionals; Competition; Incentive to face existing regulation tax laws and Changing global pattern of financial wealthAsset Securitization as a Financial Innovation. Securitization is the collection or pooling of loans and the sale of securities backed by these loans. It is different from traditional banking and can

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involve more than one institution for lending capital, e.g. insurance, servicing, and collection etc.

Benefits to issuers: Diversification and reduced cost of funding Management of regulatory capital Generation of servicing fee Management of interest rate volatility

Benefits to investors: Investment is backed by a diversified pool of loans Credit enhancement Lesser mediation cost, therefore higher returns

Benefits to borrower The loan being fully securitized is more liquid and can be sold

in the market, therefore low lending rate also.

Implications of Securitization for Financial Markets. As against the traditional financial intermediaries, securitization provides direct financing between the borrowers and the investors, therefore, the mediation cost is lower. Credit enhancement reduces the risk of default and is therefore more acceptable to the investors. Offering of various maturities enables, securitization to compete with the traditional competitors shifting its risk to the lenders.

Social Benefits.

DEPOSITORY INSTITUTIONSActivities and Characteristics (Chapter 4)

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Commercial Banks, Savings & Loan Associations, Savings Banks and Credit Unions are depository institutions, which accept deposits for investment in loans and securities. Their source of income is return from loans, securities & Fees.Maintenance of checking deposits by thrift institutions is recent.The banking system plays an important role in an economy, besides implementing Government monetary policies.

Asset/Liability problem of depository institutionsThe spread income of these institutions should be sufficient enough to meet operating expenses & earn some profit on capital.But the generation of this spread involves the following risks:Credit or Default Risk, Regulatory risk and Interest rate Risk.

Liquidity ConcernsLiquidity & profitability of depository institutions has a very delicate relationship. They should be liquid enough to honor all checks drawn on them & provide additional loans. This can be done through: additional deposits, borrowings from federal agency/other financial institutions against existing securities, raising short term funds in the money market and sale of securities.(The existing portfolio of loans can also be curtailed, if needed)

COMMERCIAL BANKSThere are State Chartered & Federal Government chartered banks (national banks). All national banks must be members of the Federal Reserve System & Bank Insurance Fund (BIF), which is administered by FDIC. Joining of the Federal Reserve System by State Chartered banks is optional but their deposits must be insured by BIF. The member banks of Fed hold 75% of total US deposits. Reserve requirements of Fed apply to all banks.Bank Services Individual Banking includes services provided to individuals Institutional Banking includes services provided to financial/ non financial corporations, government entities, commercial real estate financing, leasing and factoring etc.

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Global Banking includes corporate financing, capital market & foreign Exchange products. The activities relating to underwriting, letters of credit etc fall under this category.Bank Funding Deposits consist of Demand, Savings, Time (including negotiable as well as non negotiable) liabilities.Reserve requirements of FED, which are different for different types of deposits, have to be kept in view while making loans.Temporary shortage of reserve requirements can be corrected through borrowings from the Federal Funds market. Borrowings at the Fed discount window. Temporary borrowing from this window against permissible collaterals is available at Fed’s discount rate, which is kept changing to implement monetary policies. Other non-deposit Borrowings include Repurchase Agreements in the money market and long-term floating-rate notes and bonds in the capital market.Regulation Regulation on interest rates. Regulation on payable interest rates has almost been withdrawn except the demand deposits. After 1966 the interest rates crossed the ceiling fixed by Regulation Q, which resulted in disintermediation causing outflow of funds from banks etc to other avenues with better prospects.The banks developed new matching instruments, and opened branches abroad to circumvent the restrictions of Regulation Q.By 1980 ceilings on interest rates on time deposits and CDs phased out with only a few exceptions. Geographical Restrictions. Some States do not allow opening of branches of bigger banks within their jurisdiction for the fear of elimination of the smaller banks, and thereby competition. Others allow only unit banks, with no branches. Permissible Activities for Commercial Banks. Previously the banks were forbidden from all those activities which were not ‘closely related to banking’ in the eyes of Fed. Certain Investment banking activities, like underwriting of stocks & Securities, acting

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as Dealers in securities in the secondary market (except US Government obligations and Municipal bonds etc) were not allowed. Banks could not maintain a securities firm nor affiliated with one engaged in issues, underwriting, public sale and distribution of stocks, shares and debentures etc. Certain restrictions did also encompass the insurance area.Later legislation/Court rulings help evade some restrictions, which were finally removed by Gramm-Leach Blily Act of 1999. Capital Requirements for Commercial Banks. The low ratio of equity capital to total assets of banks creates concerns about their solvency. The Contra & other such liabilities, which do not form a part of the balance sheet, enhance these concerns.Prior to 1989 capital requirements were based only on total assets. Now the risk profile is also taken into account while determining the capital requirement.Capital has been segmented into two i.e. the core capital (the actual equity) and supplementary Capital (loan loss reserves, equity contracts etc).Similarly there are two tiers of assets, the actual & the ones calculated on the basis of risk. A credit risk of 0%, 20%, 50% & 100% is attached to each asset & its actual value worked out from the book value in accordance with the weighted risk.The minimum core capital & total capital requirement is 4% and 8% of the actual assets & assets calculated on the basis of risk, respectively.Latter on attempts were made to incorporate interest rate risk also in setting capital requirements, but measurement of this risk was never worked out. Instead only guidelines were provided to banks to evaluate the adequacy & effectiveness of their interest rates.

SAVINGS AND LOAN ASSOCIATIONSS&Ls came into being for financing homes. They are either mutually owned or have a corporate stock ownership.

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S&Ls can be chartered under State or federal government statutes. At the federal level they were previously regulated by FHLBB but after creation of the Office of Thrift Supervision (OTS), its Director is the primary regulator. Now S&Ls are also subject to reserve requirements of Fed. The Savings Association Insurance Fund (SAIF), which is administered by FDIC, provides deposit insurance.AssetsTraditionally investments were allowed only in mortgages and Govt. backed securities. Maturity mismatch & volatile interest rates caused widespread disaster; therefore the list of permissible investments was revised to include consumer/non consumer loans and Municipal Bonds. Despite their edge in mortgage loans, the S&Ls lacked expertise in commercial & corporate loans; therefore they started investing in corporate bonds, specially the Junk Bonds (or go go funds) with high yield. This was prohibited latter on.For operational liquidity and regulatory requirements of FDIC, S&Ls invest in short term assets like short term govt. & corporate securities, federal funds, CDs etc.FundingBefore 1981 Pass-Book & Time deposits were the main source. S&Ls had permission to offer even higher interest to depositors.They had to expand their sphere of activity in deposits after deregulation of interest rates & introduce new products like NOW.RegulationFederal S&Ls are chartered under the Home Owners Loan Act of 1933 & supervised by OTS. Respective states supervise the state chartered S&Ls. The Savings Association Insurance Fund provides insurance cover to depositors up to $ 1,00,000.00Regulation of S&Ls relates to the maximum payable interest, geographical operations, permissible accounts & Investments, capital adequacy requirements and liquidity requirements. The concept of maximum payable interest has been phased out.

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Fed’s deposit reserve requirements now apply to S&Ls, in return for permission to offer NOW accounts.

They can now raise funds from even the money market. After 1981 S&Ls can acquire thrifts in other states. Capital adequacy standard for S&Ls has a third additional tier

of tangible capital in addition to core & supplementary capitals.The S & L CrisesThe reason was short borrowing and long lending. Surge in the interest rates in 70s & 80s caused the debacle. Funds drifted out of S & Ls because they could not compete with the prevailing market rates. In an effort to save S&Ls from collapse the managers offered competitive rates, which were not viable and therefore further deteriorated the situation.

SAVINGS BANKS (Previously known as MSBs)They are similar to S&Ls, but are older and concentrated in the North Eastern States of USA. Their total deposits are less than S&Ls but the individual units are larger.Their main investment is in mortgages, which is proportionately less than that of S&Ls but more than the commercial banks.

CREDIT UNIONSCUs can be state or federally chartered. Members have a common bond. They accept deposit from & make loans only to members. CUs are self-help bodies where only ‘Treasurer’ is a paid employee.The share of members is insured by the National Credit Union Share Insurance Fund up to $1,00,000.00. The state chartered Unions can opt joining NCSIF or some state agency.National Credit Union Administration administers federal unions. Central Liquidity Union provides short term loans for liquidity.CENTRAL BANKS and THE CREATION OF MONEY (Chapter 5)

Central Bank and the Money Creation in United StatesThe Federal Reserve System, created in 1913, is responsible for management of the US monetary and banking system. It is

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managed by a seven member Board of Governors & is an absolutely independent entity.Instruments of Monetary Policy: How the Fed influences the Supply of Money Reserve Requirements: All bank deposits cannot be converted into loans. The portion not available for advances is the required reserve ratio, which can be kept as cash or deposit in Fed. In 1980 Congress assumed this responsibility through an Act and fixed a ratio of 12% for transactional accounts & 3% for Time Deposits. The same Act authorized Fed to change the ratio on checking accounts between 8% & 14%, and raise it to even 18% under special conditions. In 1992 the Fed reduced reserve ratio to 10% for banks with balance of checkable accounts at $46.8(M) or above & 3% for the smaller units.Banks short of reserves can borrow excess reserves from banks. Open Market Operations: The sale/purchase of govt. securities by the Fed in open market. The Federal Open Market Committee decides about the required volume of money supply in its monthly meetings. The policy is implemented through the trading desk of Federal Reserve Bank of New York. Open Market Repurchase agreements: In repurchase agreements the Fed buys certain securities from a security dealer, who agrees to repurchase the same at higher price at a future date. The difference in price is the return to Fed & cost to the dealer. In reverse repo the Fed sells & agrees to repurchase. The Purpose of repo & reverse repo is an alteration of Banks’ reserves. Discount Rate: The rate of interest at which the Fed makes loans to the member banks is the discount rate. An increase in discount rate discourages loans and vice versa.Different Kinds of MoneyMoney is a measure of wealth i.e. $, Rupee etc; it is a medium of exchange i.e. currency & checks drawn on demand deposits: some assets, though not immediate medium of exchange, can be so converted promptly & at negligible cost i.e. Time deposits etc.

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Money and Monetary AggregatesMonetary aggregates measure the amount of money available to the economy at any time. Monetary Base: It is the currency in circulation plus reserves in the banks, M-1: The narrow measure of money supply. It includes all instruments that serve as medium of exchange like, currency & Demand deposits, M-11: It takes into account all instruments that substitute for money as a store of value. It includes M-1 plus savings deposits and smaller time deposits of medium maturity, M-111: M-11 plus long term time deposits, commercial papers and bankers acceptance etc. Velocity of money is the relation of money supply to the GNP, the average transactions carried out by a $.

The Money Multiplier: The Expansion of Money SupplyFour players are involved in creation and changing of money supply i.e. the Fed, Banks, Savers and borrowers. The Fed determines the reserve, which the banks observe. The borrowers deposit their borrowings in their accounts with banks, which creates further cushion for banks to make fresh loans equal to the permissible extent (which is deposit minus reserve requirement)

The Impact of Interest Rates on the Money SupplyDuring the period of high interest rates, normally the banks do not hold more than the required reserves, because if not invested these funds loose higher opportunity cost. Similarly in an effort to earn interest the depositors keep all their funds with banks, which increase their reserves and therefore lending ability.The Money Supply Process in an open EconomyAn open economy, like the US, means one where foreign firms can hold and deal in the local currency. This can and does influence the exchange rate of dollar.Frequent changes in the exchange rate are never desirable; therefore, Fed intervenes in the market through sale and purchase

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of foreign currencies. At times it pumps-in dollar against foreign currencies and at others it withdraws dollars in exchange for foreign currencies.

INTERNATIONAL CENTRAL BANKS European Central Bank. It was created in 1999, replacing Central Banks of 11 countries participating in the European Economic and Monetary Union.

ECB has a transparent policy. Its activities are made public through monthly reports & press conferences.The earliest issue confronted by ECU was the weakness of Euro.Its monetary policies are centered on inflation in the Euroland & besides its own measures; ECB is trying to persuade National governments for deregulation, tax, pension and labor reforms. Bank of England: Two primary functions are setting and executing monetary policy & stability of financial system, domestic & International. In 90s it acquired rights for setting interest rates & the Treasury started managing government debts.The BoE’s Monetary Policy checks inflation through interest rates & supports govt. policy of growth & employment.12 agencies of BoE assess the economy. Bank of Japan: It became independent in 1998 & composition of its Policy Board (PB) was changed. An economic report, based on business survey, is provided before PB’s monthly meeting.The new law is designed to ensure independence of BoJ & adequate communication between it & the Government. The purpose of Monetary Policy is “development” through price stability. The main instruments of the policy are official discount rate, open market operations and reserve requirements.

INSURANCE COMPANIES (Chapter 7)

Insurance is a contract to pay sums, contingent upon future events. It involves acceptance of risks by insurance companies in return for insurance premium. A major decision in the process is, whether the premium commensurate the risk?

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Premiums are collected before payments become due, and, therefore, invested. Ins. Cos. have two sets of income, premiums and the return from investments. Their expenditure consists of payments on insurance policies & operating expenses.

Types of Insurance Life Insurance: The risk of death is insured. Health Insurance: The risk insured is cost of medical treatment. Earlier only indemnity insurance was available, which involved reimbursement of medical expenses to the health care providers, co-payments & minimum reimbursable limit etc.Absence of constraints, made this insurance expensive, therefore, many forms of “managed health care” were developed, imposing restrictions on the choice of health providers by the insured. But no generally acceptable method has yet been evolved. Property and causality Insurance: The risk insured is damage to property. Liability Insurance: The risk insured is litigation/lawsuits. Disability Insurance: The risk insured is inability to earn. ‘own occ” for white collared professional & ‘any occ’ for blue-collar workers. This type can either be guaranteed renewable or non-cancelable. It can also be short-term or long-term. Long-term Care Insurance: Provision of custodial care to the aged, who cannot take care of themselves Structured Settlements: Fixed guaranteed periodic payments, resulting from a settlement on disability insurance or other policy. Investment oriented Products: The risk of guaranteeing payable interest on investments with a company from 1 to 20 years e.g. ‘Guaranteed Investment Contract’. Annuity: It is a mutual fund in an ‘insurance wrapper’. Usually a guarantee from the insurance company that the investor will get back nothing less than what he invests. Because of premium, annuity is slightly more expensive, but the income from it, if not withdrawn, is not taxable, as against the taxable income from

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mutual funds. Annuities can either be fixed or variable based on the earnings & performance of the portfolio.

Insurance Companies versus Types of ProductsTraditionally, Life & Health Insurance Companies have been separate & distinct from Property & Causality Insurance Companies. A few ‘multiline Ins Cos’ operate in both the areas.A recent trend is towards separation of Life, Health & Disability Insurance business & specialization by different companies in each of these fields.

Fundamentals of Insurance IndustryReceipt of premium on insurance are certain, but payments, being contingent upon potential future events, are highly uncertain.On account of time lag & uncertainty, purchasers of policies prefer viable companies; hence the importance of performance of investment portfolio for profitability.

Regulation of the Insurance IndustryInsurance business is state regulated. Companies, with publicly traded stocks, are also regulated by SEC.The National Association of Insurance Commissioners developed some regulations which, though not binding, are used as a model.The soundness of an insurance company depends upon a positive relationship between its receipts & contingent payments, which are not certain. They are, therefore, required to maintain a surplus, or reserves, which is defined differently by different agencies.It is obvious that the quantum of reserves, being indicators of reliability of a company, attract more business.

Structure of Insurance CompaniesAn insurance Company has three components, which have been segmented with specialization & passage of time.

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Design & Financial guarantee. Some companies have started using external actuaries for product development; and reinsurance for financial backing. Distribution. Brokers & Internet etc are replacing agents. Investment. It is also being outsourced to professionals.

Forms of Insurance Companies: Stock & Mutual In Stock Cos, owners keep eye on dividend & escalation of capital only, therefore, short-term strategies (which make them more efficient & thrifty). Mutual Cos have reduced their expenses after demutualization & going public. In Mutual Cos., the owners care for the Co’s ability to pay on maturity of policies, therefore, long-term strategies. Profits can be passed on to policyholders via reduced premiums. Long-term investments generate higher profits.On the other hand, lack of short-term strategies, which suit the shareholders, can even result in long-term ill health. Their ability to generate additional capital is restricted to limited public debt. A recent development is the mutual holding co., which, itself, is not an insurance company. It forms a Stock Insurance Co. & keeps 51% of its shares. It has some of the advantages of both the types.

Individual versus Group InsuranceGroup Insurance Policies pertain to employees or educational, medical or professional associations. They include term-life, whole-life, medical, disability, and investment products etc.There are different distribution systems for the two.

Types of Life Insurance Term Insurance: It is for a specific term & if the insured dies during that term, the beneficiary receives the amount; otherwise it has no cash value. No borrowing is permissible. The premium can either be level or annual renewable. Cash Value or Permanent Life Insurance: It builds up a cash value within the policy, which can be withdrawn or borrowed. The policy holder overpays during early life & under pays thereafter.

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- Guaranteed Cash Value Life Insurance: A minimum cash value is guaranteed each year. In non-participating policies, the guaranteed cash value is generated whereas in participating policies it can go beyond this amount, depending upon the performance of the investment portfolio.- Variable Life Insurance: The policy owners can allocate their premiums & cash value to various investment portfolios of the Co. Thus no guarantee of cash value & death benefits, which depend upon performance of selected portfolios.- Flexible premium policies------Universal Life: The hallmark of Universal life is the flexibility of premium. There must be some initial premium to build up cash value, which is set up as cash value fund. Investment income is credited to this fund & premium debited to it. The cash value fund should also be sufficient enough to generate the required premium.- Variable universal life Insurance: It combines the features of variable life & universal life policies, i.e. choice of investment & flexible premium.

Survivorship (Second to Die) Insurance: Joint insurance of two people, usually couples, where the death benefits become due after the death of the second or surviving insured. Normally premiums are lesser on this type of insurance.

General Account & separate account productsGeneral Account Products are based upon the overall investment portfolio of an insurance company. Products written by the Co. itself have the general account guarantee & are liability of the Co.Separate account products are based upon selection of the policy holder & do not have Company’s guarantee.

Participating Policies.Performance of separate account products is restricted to performance of the selected investment portfolio. Similarly the

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performance of certain general account products is also not related to the performance of general account portfolio e.g. Disability Income Insurance Policies.A participating product can pay even higher dividends than guaranteed, depending upon the performance of the general account investment portfolio.

Insurance Company Investment Strategies: Time & amount of claims are not certain, especially in the case of Property & Causality insurance. Portfolios of Life Ins. Cos. have more yield generating securities like private placements, commercial mortgage, and less common stock, municipal bonds & longer maturity bonds. Common Stock Cos. hold relatively more ‘bonds’ for regular income instead of volatile capital growth of ‘stocks’.

Life Insurance Cos. have many tax benefits.

Changes in the Insurance Industry The Deregulation of the Financial System. The 50 year old ‘anti-affiliation restrictions’ on commercial banks, investment banks & insurance companies were removed in1999, which accelerated their affiliations & mergers. Internationalization of Insurance Industry. Us Ins. Cos. have acquired & entered into agreements with international Ins. Cos. & vice versa. The US financial market is more attractive to the international Ins Cos because of its rapid growth, attractive income potential & less regulated environment. Demutualization. Conversion of Mutual Ins. Cos. to Stock Cos. The changes have to be approved by the State Insurance Regulatory Department.

Evolution of Insurance, Investment and Retirement Products

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Previously Insurance, Investment and Pension plans had distinct products, which are becoming increasingly overlapped & hybrid.The 401 (k) and IRA are hybrids of retirement & Investment, often distributed by Ins. Cos. The qualified plans are tax deferred plans. 401 (k) Plans. These plans are primarily offered by financial institution (or others) to employers. The employers offer it to the employees for investment in a specific or diversified portfolio. The contributions of the employees & matching contribution by the employers being tax free have certain limitations. IRAs (Individual Retirement Accounts). They are usually employee/investor sponsored with a few exceptions. Assets accumulate free of taxes with certain limits on the amounts that can be invested. When contributions are tax deductible, distributions are taxable; when contributions are after tax, distributions are not taxable.Withdrawals from IRAs prior to attaining the age of 59 1/2 are subject to a 10% IRS penalty.In rollover or conduit IRAs (which are employer sponsored) the accumulated contribution can be shifted from one employer to another employer on leaving a job.SEP (Simplified Employee Pension) is an IRA most suited to self employed or small business owners. O to 15% of earned income can be contributed in this program up to a maximum of $30,000.00. Contributions are tax deductible to business.SIMPLE (Saving Incentive Matching Program for Employees). The employer should either match contribution of the employee of 1% to 3% or make a non-elective contribution of 2%.

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INVESTMENT COMPANIES & EXCHANGE-TRADED FUNDSTypes of Investment Companies. a)Open–end Funds: The Investors own a pro rata share of portfolio, the investment manager actively manages it, price of each share (net asset value) is equal to total market value of the portfolio (-) liabilities (-:-) number of shares, the published NAVs are the closing ones & all transactions into/out of fund are priced at the day’s closing NAV. b)Closed-end Funds: Shares are floated only once. Latter on they are transacted via normal channels. The prices of shares depend upon supply & demand. But, at times, there are provisions in the charter of these funds suggesting measures (like buying back the shares or conversion of the fund into open-ended) to improve the situation if the price slips below the NAV. The sale of shares to public involves costs of issuance (including sale commission of 7%); therefore, the amount invested by these funds is lesser than shares’ sale proceeds.c)Unit Trusts: They specialize in bonds & have a fixed number of certificates. After assembly unit is entrusted to a trustee, who does not trade in the bonds, but holds them till redemption. Bonds are sold only in the event of a dramatic decline in issuer’s credit. It has a fixed termination date. The trust investor is aware of the specific portfolio of bonds which the trustee cannot alter. All unit trusts charge a sale commission of 3.5 to 5.5% in addition to purchase charges of the bonds by the sponsor.

Growth of Mutual Funds

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In 90s investors started preferring ownership of financial assets instead of real estate/tangible ones, with emphasis on indirect ownership & expert management. This resulted in a boost to mutual funds, in numbers & assets. Tax deferred investments like IRAs etc was another reason.Fund Sales Charges & Annual operating ExpensesSales Charge: There used to be two types i.e. through an intermediary involving a load, (initially a front-end-load, reducing the initial investment) & direct offer no-load funds.The apprehensions of no-load funds overtaking load funds were falsified by dependence of investors on advice & opinion of the agents, innovations like back-end-loads; level loads & contingent deferred sales charge. Many mutual fund families offer their funds with three types of loads depending upon the types of shares. The maximum allowable load is 8.5%, which can be reduced with volume.Annual Operating Expenses: (The expense ratio) Management Fee or investment advisory fee for management of fund. If advisor is separate from sponsor it is passed on to him. It varies with the requisite input. Distribution costs called 12b-1 fee, cannot exceed 1% of the assets of the fund. It includes some compensation for the agent, manufacturer, marketing & advertisement. Other expenses include costs of custody, distribution of cash/securities etc, public accountant fee & directors’ fees.

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All cost information is included in prospectus of the fund.

Economic Motivation for FundsMutual funds reduce, risk through diversification of portfolio, cost related to investment & management of portfolio & also provide liquidity by being able to be sold at any day.

Types of funds by investment objectiveMutual funds satisfy the varying needs of investors through their category of assets, management style & the market segment that they deal in. Some funds specialize in stocks, bonds, money market instruments & others; with many sub-divisions. There are passive & active funds, depending upon whether they perform as per the index or try to out perform it. There are index funds and funds of funds etc.The Concept of a family of fundsA group of funds offering a choice of many funds with different investment objectives. Movement of funds by an investor from one fund to another is free or at nominal cost. Load etc policies might be similar, but the management company can devise different fee structures for such transfer of funds from one to another.In addition to internal advisors, the families can also utilize the services of external professionals

Mutual Fund Industry ConcentrationTop 5 fund families have 42% of total assets & top ten 56%. Significant growth was witnessed in 90s but change in proportional assets of the big 5, 10 or 25 was insignificant despite numerous mergers & acquisitions; the number of fund complexes

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increased from 464 to 629 & industry’s total investment in equities from 20% to 50%.

Regulation of Funds Securities Act of 1933 regulates the new issues, by providing information about the issuers to avoid fraud The Securities Act of 1934 deals with trading of securities in the secondary market, after their issuance. Investment Cos. with 100 or more share holders must get registered with SEC under the provisions of Investment Co. Act of 1940. It checks their selling abuses & ensures provision of accurate information to the investors, along with some tax advantages for the registered investment advisors. Investment advisors Act of 1940 specifies registration requirements of firms or individuals dealing with investment, There are laws restricting insider dealings, inaccurate & misleading advertisements, Fees & expenses of funds, rules about readability of prospectus, etc

Taxation of Mutual FundsMutual funds distributing 90% of their investment income to share holders are exempt from corporate tax. Share holders have to pay normal tax on their receipts from these funds.Capital gain tax liability is created even for new investors.

Structure of a fund Board of Directors, representing the share holders, consisting of inside & independent persons,

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The Mutual Fund, under Investment Company Act 1940, An investment advisor, for managing the fund, A distributor or broker dealer registered under Securities Act of 1934 Other service providers, both internal & external for accounting, custodianship, transfer, marketing & legal etc.

Recent Changes in the Mutual Fund Industry Distribution Channels. During 90s sales through third parties like Employer pension plans, Banks & Life Insurance Companies were successfully implemented, in addition to the traditional channels of direct sales & sales through brokers.- Supermarkets. 1992 onwards fee based Supermarkets have started providing one source access to many fund families on no-load basis.- Wrap Programs. Fee-based, no-load managed accounts, wrapped in a service package of advice & assistance on mix.- Fee-Based Financial Advisors. Independent financial planners who charge annual fee based on volume of assets.- Variable Annuities. “Mutual funds in an Insurance wrapper” with slightly more costs but tax advantages. Changes in the Costs of purchasing Mutual Funds. In 90s competition reduced costs, both load and distribution cost, for the share-holders. Mix and Match. In view of choice of investors & competition of Supermarkets, distributors now do not restrict themselves to single or limited funds.

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Domestic Acquisitions in the US Fund Market. There has been a lot of activity to increase the scale or consolidate. Internationalization of US Funds Business. It has been in both directions, but acquisitions of US funds by foreigners have been greater in view of better prospects.

Alternatives to Mutual Funds.Exchange-Traded Funds. Exchange traded Investment Cos. are an answer to criticism over pricing of shares & capital gains. The fund advisor endeavors to maintain such a portfolio which should replicate the return of index through limit on orders, stop orders, orders to sell short and buy on margin etc. But some deviation from NAV is possible. Segregated (Separately Managed) Accounts. Initially available for large investments, but now this facility is available even for relatively smaller amounts at higher costs. Folios. A recent Internet based facility for investment into pre-selected portfolios, which can also be altered

Commercial Banks and Mutual FundsCommercial banks manage their own funds as well as deal in other funds. Their performance in the former has been dismal, but they have done well in distribution.

International Investment Companies United Kingdom. - Unit Trusts & Open ended Investment Companies. (Collective Investment Cos). Both are open ended funds, former involving beneficial interest in the Trust & the latter shares. They pool

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funds together for economies of scale; are managed by professionals; assets being held by independent Trustee Cos, who also monitor transactions & management. Unit Trusts have different prices for sales & purchases with built-in charges whereas OEICs have same price for sales & purchases with charges being shown separately.Only a registered fund can advertise to the public. The Financial Services Authority has laid certain conditions for authorization of collective investment schemes. Both types are popular, their main investment being in equity funds. - Investment Trusts. Closed-ended companies listed on the London Stock Exchange, with a board of directors etc. They have a spread between sale/purchase prices.

Germany. German mutual funds are public (retail, being Equity/Bond funds) or non-public (institutional, large volume). Adoption of Euro created many opportunities for foreign experts’ collaboration, but without much progress. The growth of industry is substantial, but is still far behind USA, France UK etc, concentrated in a few large companies.German banks & Insurance Companies do participate in the activity but mostly as partners with the managing firms.The German Mutual Funds have a distinctive structure. The Management Company, a limited liability company, manages the pool of funds of investors, through a contract, under the supervision of a German Bank. The board of this company also monitors the management of funds.

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The funds need be registered & accept the government guidelines about contract between the firm & investors. The Federal Supervisory Agency for Banking must approve the contract & select a bank to act as custodian to safeguard the interests of investors, book-keeping and accounting. The German supervisory authorities monitor marketing aspect.

PENSION FUNDS (Chapter 9)

Pension plans endeavor to provide a solution to the problem of living beyond ones income-producing years. Private business entities, Federal/State/Local Governments, unions or private individuals can sponsor pension plans. Certain requirements qualify these Plans for tax exemptions & the growth of these funds despite limitations can be attributed to employers’ contribution, being tax deductible, followed by that of employees & the fund’s earnings being tax exempt.

Types of Pension Plans. Defined Benefit Plan. Pension benefits are pre-decided with certain conditions. The sponsor guarantees retirement benefits, makes investment choices & bears the investment risks. He can also purchase an annuity. The Pension Guaranty Corporation ensures vested benefits. Defined Contribution Plan. Contributions are defined as a percentage of salary or employers’ profits. Employees select the investment options

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(mutual funds) & performance of plan plus contributions determine the payable amount.It is growing at a fast pace because of its simplicity. Cash Balance Pension Plan. A hybrid of the two, being basically defined benefits with some features of defined contribution. It is based on fixed annual employer contribution and guaranteed minimum annual investment return. An account of each participant is maintained where the employer contributes an amount as a percentage of pay plus a fixed amount of interest. The promised benefits are fixed & balances in the account can be monitored.Cash balances are portable from job to job, with uniformity of benefits each year (unlike defined benefits plan with bulk benefits at the end); therefore they are popular with youngsters who do not stick to one job. Even older workers have been given a choice to choose between the two.InvestmentsAbout 75% of assets of public & corporate defined benefit plans are in US stocks & Bonds & 15% in international Equities & Bonds. The Union Plans have only 5% in international equities & Bonds. Exemption of qualified pension plans form taxes, curtails diversion of their funds to tax exempt bonds etc.

Regulation. (Employees Retirement Income Security Act) The plans must be properly funded through contribution. Everybody associated with management of funds must act like prudent men in deciding investment portfolios

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It has established vesting standards like entitlement to 25% pension after 5 years & 100% after 10 years etc The pension Benefit Guaranty Corporation (Penny Benny) was established to ensure vested pension benefits.Periodic reporting & Stts. are required to be submitted.

Managers of Pension FundsThey can be managed through in-house staff, some money management firm or both. The Participants themselves select portfolio in defined Contribution Plans.Insurance companies, Trust departments of Commercial Banks, Investment Banks, Dealers, Brokers, private money management firms, foreign financial institutions & even consultants manage these plans. Management fee can vary from 0.75% to 0.01%

Social Security. Total contribution is 12.4%, per employee on a 50/50 basis with a limit on maximum income. The scheme is under-funded & works on go-as-you-go-system. Investments are made only in Treasury Securities. Presently receipts are greater, but position will be reversed by 2015 & assets would become Zero by 2037. Several proposals have been put forward to modify the Social Security system.Over view of Retirement PlanningLack of confidence in Social Security, and preference of employers to defined contribution plans have given a boost to the latter plus IRAs & personal savings.

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Pension funds around the World.Almost all countries have pension plans which keep changing with time. The most important reason for these changes is an increase in the number of dependents of these programs. Germany. The German pension plan is in the public sector run on pay-as-you-go system. A decline in German population is expected but longevity is projected to increase faster. The present system, running with 76% contributions & 24% Federal Budget will become highly insufficient.Hence many proposals for pension reforms including private pension funds, company pension funds etc. Japan. It has public as well as corporate plans. The problem of aging of population is greater. Defined benefits plans are in vogue in the private sector. Low investment returns of a corporation coupled with increase in number of recipients, due to aging, has left many corporations with under-funded plans.Defined contribution plans like 401(k) are being contemplated.

PRIMARY MARKETS AND THE UNDERWRITING OF SECURITIES. (Chapter 14)

The traditional process for issuing new securities

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Advising the issuer on terms & timings of issue (also called origination). Underwriting involves buying of securities or their guaranteed sale, either as firm commitment (Stand-by) or best efforts.The gross price spread is the fee of the underwriter.Syndicates formed to underwrite because of issues’ size/risk. Distribution involves sale of shares to the public. In addition to the Syndicate, a selling group is formed who can purchase securities at concessional rates. The spread is shared by underwriter, the syndicate and the selling group.

Investment BankersRestrictions on investment activities of commercial banks were withdrawn in 1999. Presently investment banking is done by Commercial Banks & Security Houses.Laws with regard to investment banking are different in different countries.

Regulation of the Primary MarketSecurities Act of 1933 governs issuance of Securities & SEC regulates underwriting activities. The Act requires filing of a registration statement with the SEC, containing two parts i.e. the Prospectus & information about nature of securities & the issuers. Preliminary prospectus can be distributed during waiting period, but the issue cannot be sold before approval. Misrepresentations can expose the issuers & underwriters to punishments including imprisonments.

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Under Rule 415 of SEC certain securities can be offered to public once or more within two years under a single registration document.Variations in the Underwriting Process Bought Deal. It is an offer to a potential issuer of debt securities for purchase of the whole, or a part of intended issue at a certain rate of interest & maturity, a day or a few hours before the issue. The deal is bought on acceptance of bid. It can in turn be offered to other investors, investment bankers or own customers.The underwriting firms with sufficient funds can avail the opportunities of varying interest rates under Rule 415 of SEC Auction Process. (Also called Competitive bidding) The issuer announces the terms of issue & interested parties submit their bid for the entire issue. The one with lowest cost to issuer wins the deal. Partial bids are also accepted in order of suitability to the issuer. Where cost is the same & only parts of two or more bids make the total/balance amount, they are accepted proportionally. There can be single-price or multiple-price-auctions.Competitive bidding & electronic bidding is more popular with Municipal bonds than corporate issues.The investment bankers argue that issuers do not get best price through this process because of limited competition, whereas they provide better return despite their fees. Preemptive Rights Offering. Issuance of new share to existing share holders in proportion to their shares at a price below market price. These shares are underwritten under standby arrangements.

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Private placement of SecuritiesSecurities Act 1934 has been interpreted to allow private placements of funds to some institutional investors like insurance Co., pension funds etc. The investment bankers help design such securities. Initially resale of these securities was not allowed for 2 years; however SEC Rule 144A of 1990 eliminated this condition.SECONDARY MARKETS (Chapter 15)

Functions of Secondary MarketsA secondary market reveals the standing of securities to the investors & the issuers & therefore keeps them alert. It offers liquidity.

Trading LocationsOrganized Stock Exchanges, Over-the-counter market. London Stock Exchange is like an over-the counter market where the members are at various locations & they communicate through electronic & computer facilities. NASDAQ & Tokyo Stock Exchanges are other such examples.

Market StructuresIn continuous markets prices are determined as an interaction of supply & demand continuously. In call markets orders are batched & grouped together for simultaneous execution at same price. Orders are held back & then executed in bulk like auction. Till recently the Paris stock market was a call market.Currently some markets are a mix of the two.

Perfect markets

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Large number of buyers & seller with no one in a position to alter price, commodity traded is homogenous, with no transaction costs (frictions). Financial markets do have some frictions & special features like short selling etc.

Role of Brokers and Dealers in Real MarketsBrokers are agents of investors; they provide technical assistance to investors in sale/ purchase of securities against commission. They do not themselves take positions like dealers. Dealers as Market Makers.The dealers themselves deal in financial assets and take positions. They buy assets to add to their inventory & sell the same to capitalize on an available price spread. Their activities correct temporary imbalances in the number of buy/sell orders & supply immediacy/ short-run price stability.The dealers, in some market structures have access to information about the flow of orders or limit orders, which enable them to provide price information to investors.Similarly in some market structures the dealers also act as auctioneers. The market makers on organized Stock Exchanges in the US organize trading, and play the role of auctioneer in call markets where they do not take positions.The charges of dealers for their services depend upon their costs and the risks involved in their trade.

Market Efficiency. Operational Efficiency. Costs of transaction services represent the degree of efficiency. Initially costs used to be high & fixed with poor efficiency.

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Latter on costs were liberalized on account of competitive & negotiated commission. Similarly the spread was also rationalized. Pricing Efficiency. Information about securities determines their price. Investors either pursue active policy of capitalizing on mispricing, involving transaction costs and risks; or the policy of holding a cross section of securities.

Electronic Trading.Bonds’ is a principal business; larger capital requirements & volatility of business with consequent greater risks and lesser profitability have changed the trend. The traditional dealers have retreated to leave room for electronic trading. It provides liquidity, price discovery & efficiency.

TREASURY AND AGENCY SECURITY MARKETS (Chapter 16)

Treasury Securities are considered to have no credit risk & their interest rate as the benchmark. The issuance of these securities has been curtailed because of declining deficit of US govt., which has started buying back the longer-term securities. The Securities of Govt. sponsored enterprises (Agency Securities) are replacing the former as new bench-mark interest rates.

Treasury SecuritiesIt is the largest single debt in the world, being most active & liquid with very narrow spread. The Fed issues only receipts instead of certificates. Interest is subject to Federal Income tax but exempt from State & Local taxes.

Types of Treasury Securities.

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They have two categories of discount & coupon securities. Treasury bills’ maturity is below one year; Treasury notes’ 2 to 10 years & Treasury bonds’ more than 10 years.Treasury inflation-protection securities (TIPs) are notes & bonds. The principal amount is linked to Consumer Price Index for All Urban Consumers (CPI-U) & calculated biannually. The predefined interest rate of coupon is applied on the new principal. The adjustment is taxed each year. Disinflation can reduce the principal amount, but the Treasury has so devised TIPs that in such an eventuality, the higher of the adjusted or par value is to be paid.

Primary MarketsThe Treasury determines the amount, time & maturity etc. Auction Cycles. Bills are auctioned weekly, quarterly and bi-annually; coupon securities comprising 2 year & 5 year notes monthly; 10 year notes & 30 year bonds quarterly.Occasionally even the outstanding issues are reopened with an increased outstanding amount. Determination of the result of an auction. Auction is conducted on competitive bidding basis after deducting the non-competitive bids & bids of Fed. The last, i.e. the highest accepted bid is the stop yield. Primary Dealers. The Fed deals only with its designated primary dealers or recognized dealers in open market operations, because they have adequate capital with reasonable volume of dealings in Treasury Securities. On application for primary dealership, the position & volume of a firm is ascertained by the Fed. On

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satisfaction it is placed on Fed’s reporting list with the status of a reporting firm. After satisfactory service as a reporting firm for some time it is designated as Primary Dealer. Submission of bids. Till recently primary dealers & large commercial banks would submit bids for themselves & their customers. Others could bid only for themselves against large cash deposits as guarantee. But 1991 onwards only qualified broker-dealers are allowed to bid for their customers. The process of submission of bids has been computerized & is accessible only to the qualified dealers. The Secondary Market.The secondary market for a vast majority of Treasury securities is over-the–counter. Normal settlement period is the next business day. The most recent auction of a given maturity is called on-the-run or current issue. The issue replaced by on-the-run is off-the-run. When-Issued Market. It is trading in Treasury securities between the dates of announcement of auction until the issue date. Government Brokers. When the dealers trade with each other it is through the interdealer brokers or the government brokers who display highest bids & lowest offers on their screens, keeping names of dealers confidential. Bid and Offer quotes on Treasury Bills.Instead of price they are quoted on a bank discount basis & the yield on the same basis is computed as per the following formula: Y=D/F*360/t, whereY=Annualized yield on a bank discount basis

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D= dollar discount= diff between face value and priceF= Face valuet= number of days remaining to maturity. Bid & Offer Quotes on Treasury coupon Securities. They are traded on a dollar price basis in price units of 1/32 0f 1%. A price quote of 92-14 refers to 92 and 14/32. A plus sign following 32nd

means that a 64th is added to the price.

Regulation of the Secondary Market.As against the stock market an elaborate system of trading in the Treasury market does not exist. There is no system of a reliable display of bids and quotations for the general public. The sale of US government Securities being exempt from SEC jurisdiction has further aggravated the matter. The NASD has set guidelines for a reasonable bid-ask spread, but lack of disclosures to customers’ leaves them helpless.

Dealer Use of the Repurchase Agreement Market Repo is availment of a loan from the Repo market against pledge of Treasury Securities with an agreement to repurchase them within a specified period of time at an express rate of interest. It can be an overnight, term or open repo. Reverse repo is a mirror image of repo, where securities are obtained against a loan on similar terms.Parties to repo are exposed to credit risk, which has resulted in cautiousness about credit worthiness of counterparties.Repo rate is not uniform. Basically Federal fund rate determines it, but it can vary from transaction to

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transaction depending upon the nature of collateral (hot or special).A note on terminology in the Repo marketIt is quite confusing in the matter of transactions of Fed. Reverse repo is called system repo. The same on behalf of foreign central banks is called customer repo. An actual repo is called matched sale. Some more examples of Wall Street jargon in repo are:Lending securities against cash is reversing out; lending cash against securities is reversing in; financing securities using them as collaterals is repo securities; Investment in repo is to do repo; lending on the basis of security is buying collateral & financing a security with repo is selling security.

Stripped Treasury Securities.Purchase of Treasury bonds; their deposit in a bank for safe custody; issuance of receipts representing interest in each coupon of the same and a receipt for amount of the bond itself. This is coupon stripping. These receipts were issued under various trade marks, lacked liquidity on account of competition of issuers. The risk in the matter was limited to insolvency of custodian bank.Latter, a group of dealers joined hands in issuing such receipts named as Treasury Receipts without trademarks.Ultimately the Treasury started issuing such securities called Separate Trading of Registered Interest and Principal of Securities (STRIPS). Those representing coupon payments & principal are coupon strips and principal strips respectively.

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This distinction has been necessitated due to different treatment to returns from the two types in calculating taxes.

Federal Agency SecuritiesTwo type of issues i.e. federally related institutions & Government sponsored enterprises (GSEs). Federally related institutions. (Govt.-0wned agencies) They are exempt from SEC registration. Normally they do not issue securities directly, except Tennessee Valley Authority and Govt. National Mortgage Association. All securities except that of TVA and Private Export Funding Corporation are backed by the US Govt. Government Sponsored enterprises. Privately owned, publicly chartered entities created for assistance in some important sectors of economy. They issue securities direct in the market. Five GSEs issue Securities i.e. Federal Farm Credit System, Federal Home Loan Bank System, Federal National Mortgage Association, Federal Home Loan Bank Corporation & Student Loan Marketing Association. Only the securities of Farm Credit Financial Assistance Corp. have the backing of govt., others involve credit risk.GSEs’ securities are of two type i.e. debentures & asset backed securities. They can be callable or non-callable. Non-US Government Bond Markets

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Besides Japan many European countries issue Bonds, the Yield on German bonds is the benchmark. They are mostly fixed interest bonds. The British Gilts are either convertible or linked to the general index of retail price, their maturities varying from short-term to 2024. Similarly Canadian & Australian govts. have issued bonds linked to inflation.Methods of Distribution. Regular Auction: Winning bidders allocated at bid-yield Regular Auction Calendar: Award at stop yield. Ad hoc Auction System: Amount & Maturity disclosed at auction. Tap System: Auction of outstanding from a previous issue.

Common Stock Markets in the United States (Chapter 18)

Stock Markets indicate the standing of companies & their prospects. They have globalized due to institutionalization, changes in govt. regulation & innovations.Characteristics of Common Stock.They represent an ownership interest in a corporation; a right to its earnings and a pro rata share of the remaining equity in liquidation. There are two types of shares i.e. ordinary and preferred.Where Stock Trading Occurs Organized exchanges through the auction system & Over-the-Counter through negotiated system. The former is also called central auction specialist system & the latter multiple market-maker system. A third system called the electric communication system has also emerged & is growing.

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NYSE & American Stock Exchange (AMEX) are two national exchanges which trade stocks of US as well as non-US Cos.Regional Stock Exchanges deal in shares of US based Cos.The major OTC market is NASDAQ owned & operated by NASD. It is a national market. NASDAQ & AMEX merged in 1998. There are four types of markets for trading of stocks:

1. Trading of listed stocks on exchanges.2. Trading in the OTC market of stocks not listed

on an exchange,3. Trading in the OTC market of stocks listed on an

exchange4. Private transactions between institutional

investors who deal directly without intermediary broker-dealer.

EXCHANGESThey are formal organizations, approved by SEC, who deal in listed stocks. Only members can trade through purchase of a seat. Two kinds of stock are listed on regional stock exchanges i.e. I) stocks of Cos which could not qualify for listing on a national Exchange or those which could qualify but chose not to get listed and II) stocks enlisted on one of national exchanges. THE NYSE. Trading is a continuous auction process at a designated location (post) on the floor, where brokers buy & sell orders. Designated specialists are market makers for each stock. Orders (bids & offers) arrive at each post through brokers & SuperDot, an electronic delivery system. In addition to specialists, other member firms also deal for themselves & their customers through brokers.

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Commission brokers, who are employees of security houses, also deal for their firms & its customers. Other transactors include independent floor brokers and registered traders. NYSE Specialist. A dealer or market-maker assigned by NYSE to conduct auction process & maintain orderly market in one or more designated stocks. He can act as a broker/ dealer. Orders for designated stocks arrive at their posts electronically or through brokers & are executed. They themselves trade in designated stocks for maintaining an orderly market (with price continuity & reasonable depth). Orders which are not routed through specialists are traded on the floor. The ‘limit’ orders, if not executable immediately, are referred to specialists who record them for execution at appropriate time. This process is confidential. Diversity of participants at NYSE has helped provide variety & depth to it.NYSE-assigned specialists have four major roles: They trade for themselves only when buyers & sellers are temporarily absent or their orders have been satisfied As agents they execute orders of brokers & limit orders As catalysts they help to bring buyers & sellers together. As auctioneers they quote current bid-ask prices.Specialists cannot transact in securities in which they are registered unless it is for a fair & orderly market. But being responsible for balancing buy & sell orders, they can participate in the opening session.When imbalance between buy & sell orders occurs & a fair & orderly market cannot be maintained, the

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specialist can close the market for that stock until the determination of balanced price. NYSE trading officials oversee their activities & their approval is necessary for delays or discontinuation of trading etc.Capital requirements for the specialists do exist. Of late they have started consolidating; some have been acquired by public companies & others have themselves gone public. Commissions. Prior to 1975 commissions were fixed, but afterwards they became negotiable under pressure from institutional buyers.

The OTC Market.It is the market for unlisted stocks. NASDAQ Stock Market. A telecommunication network. It is a virtual trading floor, which provides price quotations to participants on NASDAQ listed stocks.NASDAQ market Tires: NASDAQ National Market & NASDAQ small capitalization market, the former being the dominant OTC market in USA. Securities must meet stringent listing requirements. Financial criteria for the two are different.Occasionally cos. shift from NASDAQ to NYSE, but some Cos. have stayed back despite qualifying for NYSE.NASD is a non-profit organization; NASDAQ is for-profit but does not shift its profit upstream. NASD sold its main shares to broker-dealers & companies whose shares are traded on NASDAQ. NASD is planning sale of all its shares to NASDAQ. Other OTC Markets. Securities not listed on NYSE or NASDAQ are traded on the following two markets:

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I. OTC Bulletin. It is owned & operated by NASDAQ & regulated by NASD. It includes securities not traded on NYSE, AMEX or NASDAQ.

II. Pink Sheets. Prior to NASDAQ dealer quotations were disseminated on pink papers, therefore the OTC securities were called Pink Sheet Stocks. Weekly publishing of these sheets is still in vogue in addition to an electronic version.

The Third Market. Trading of NYSE listed stocks in the OTC market, basically for avoiding fixed fees prior to 1975. The orders are executed through the market participants but booked by non-member dealers. Alternative Trading System—The Fourth Market.Direct trading of stocks between two customers without the broker. These systems are operated by “brokers’ brokers” via the NASD members through two types of systems:

1. Electronic Communication Networks (ECNs). They are privately owned broker-dealers who operate within the NASDAQ system. The limit-book like orders, containing bids & offers, are disseminated for continuous trading at reduced prices to the subscribers & participants.

2. Crossing Networks. These networks process batches to aggregate orders for execution typically via computers.

Rule 144 A Securities. It permits the issue of non-registered securities & their trade in the secondary market by qualified institutions.

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American Depository Receipts. Negotiable receipts issued in US by US banks certifying deposit of specific number of foreign shares with an overseas branch of the bank or another bank for safe custody in country of origin.

The Role and Regulation of Dealers in Exchange and OTC markets.The specialist is the sole market maker in an exchange; whereas the number of market-makers in OTC market is greater with greater competition. A study in the matter regarding efficiency & economy in costs disclosed negative & positive points of both the types.

Trading Mechanics Types of orders and Trading Priority Rules. A market order is executed at the best available price. When prices are similar precedence is given to time & in case of simultaneous time, better price gets precedence. Similarly public orders are given priority over orders of members.A limit order designates a price; execution of these orders can be delayed for availability of asked price.A stop order can be executed only when the market moves to a designated price. Here it becomes a market order. A stop-limit-order is a hybrid of limit & stop orders.Market if touched order. It becomes a market order on reaching the designated market price. A fill or kill order must be executed as soon as it reaches the trading floor otherwise it is cancelled.An open order is valid till its cancellation.

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A round order is typically for a lot of 100; an odd one lesser.A block trade at NYSE is for 10,000 shares of a particular stock or total market value of $ 200,000 or above. The exchanges have systems for routing orders of specified sizes through computers to the specialists.Short Selling. Sale of securities by investor, not owned at the time of sale. Stock Exchanges permit short sales if the short sale price is higher than the last sale; or if it is equal to the last sale price, then the last sale price should be higher than the one preceding it.Margin Transactions.A transaction in which an investor borrows to buy shares, using the shares as collateral. The broker provides the funds & his charges include interest plus service charges. Setting initial Margin Requirements. Legally the brokers can lend only a specified percentage of the market value of securities. Maintenance Margin. The investor is required to maintain a specified minimum margin (equity) in his account in proportion to the market value of the shares against which a loan has been availed.Margin practices also exist for short selling.

Transaction Costs. Explicit Costs. The commission of the broker, custodial costs & transfer fees. Implicit Costs. They include: - Impact Costs. Larger sale/purchases can affect costs.

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- Timing Costs. Time taken during the completion of a transaction. - Opportunity Cost. It is the cost of securities not traded or missed or partially completed trades.

Trading Arrangements for Retail andInstitutional Investors.Institutions transact comparatively larger orders, at lower commissions and their orders are executed swiftly. Holdings of institutions increased during last 50 years & household declined, perhaps due to their holdings through intermediaries. Retail Stock Trading. 1975 onwards commissions on stock trading have declined; and introduction & utilization of new technologies has made the trade more efficient. Institutional Trading. Increased institutional trading in stocks has resulted in increased facilities for them including block trades & Program trades (en-block purchase of shares of many companies). A so-called upstairs market has been developed by the major institutional investors & major securities firms where they can communicate with each other through electronic display system etc.- Block Trades. NYSE trades about 50% of its business through block-trades. New techniques have been developed to cope with this situation. The block execution departments of major brokerage firms operate through the upstairs offices, & also contact other firms in case of need.- Program Trades. (Also called a basket trades) It has been defined as a trade in at least 15 companies’ shares with a minimum volume of $1 million.

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A major application of the program trade is allocation/ reallocation/balancing of assets, through deployment of new cash or reallocation from one sector to another.The second application pertains to stock index futures. When price of an index in futures contracts increases beyond certain limits & despite cost of transactions, an opportunity is created for making profit, the entire kitty is sold in future contract & replaced with fresh stocks against cash.The best alternate arrangements for commission should be chosen, & steps taken to avoid frontrun by brokerage firms.The dealer can conduct the program trade either on agency basis or as a principal. The former involves commission and uncertain price along with the danger of frontrunning. A modified model of this deal, agency incentive arrangement, specifies the benchmark price of the group of stocks. Execution on principal basis involves deployment of own capital by the brokerage firm in the entire sale & purchase. On account of market risk it involves higher commission.Price Limits and CollarsThe minimum price limit below which trading is not conducted in a stock exchange. This temporary pause is also intended to “give the market a breather”.Stock Market IndicatorsThey include Dow Jones Industrial Average, S&P 500, NYSE Composite Index, NASDAQ Composite Index etc. Normally they rise & fall in similar patterns, & can be classified in three groups. 1) Produced by stock exchanges based on the traded stocks, 2) produced by organizations based on subjective

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selection & 3) objective selection based on market capitalization.Pricing Efficiency of the Stock MarketSecurity prices must reflect all available information relevant to their valuation. There are three forms of pricing efficiency The weak form. Price reflects the past price & trading history of a security. It is said that those who select securities on this basis cannot do better than the market. The semi-strong form. The price of a security fully reflects all public information, price history & trading pattern. Selection of securities on the basis of analysis of financial statements, quality of management & economic environment of a company. Studies have produced conflicting reports. The Strong form. It reflects all information about a security both the apparent & that of the insiders’. Historically money managers & financial experts have performed in accordance with market whereas insiders have done well.Implications of investing in Common Stock.Active strategies try to out-perform the market whereas passive strategies do not. The market portfolio captures the pricing efficiency. The chosen portfolio should be an appropriate fraction of the market portfolio, weighing each security on the basis of relative market capitalization.International Stock Markets (Chapter 19)

Purpose of investing abroad includes diversification besides profits. Some American securities are listed on foreign stock exchanges; New American securities have also been issued for financing overseas

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subsidiaries. Simultaneous offer of securities in several countries is Euroequity. Overview of Major International Stock Markets and Indexes. Morgan Stanley Capital International Indexes are most widely used which indicate that worldwide market capitalization of USA is the highest, whereas that of Japan in Europe & Far East is the highest. Multiple Listing on National market. Listing of shares of companies in several overseas exchanges is on the increase, despite varying policies of foreign countries in the matter. Diversity, fear of takeover by a domestic concern & boosting sales, name/fame are the main driving forces. On account of arbitrage it is not possible to have different prices of shares in different exchanges. Trading costs in International Stock Markets. Trading costs are different in different countries, which affect the investment returns accordingly. Global Diversification: Correlation of World Equity Markets. Returns from international capital markets do not always increase & decrease in unison. The largest influence on the prices of local stocks is local conditions. Hence the need for diversification. Studies have revealed that international stock markets behave differently from one another; geography & political alliance influence their correlations and their movements are still, fairly integrated. But two factors increase correlation first being the overall behavior of investors in crises and second the uniform behavior of the global sectors of various economies. Major International Stock Markets.

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After the 1975 reforms of US Stock market, there have been numerous reforms in the stock markets of the world. United Kingdom. All exchanges of GB merged into one in 1973 & the Dublin Stock Exchange separated in 1995. The remaining portion is now known as London Stock Exchange, one of the leading equity markets of the world. LSE deals in shares of local & foreign companies, private fixed-interest securities as well acts as a primary & secondary market for British Government securities.- Operations: The Big Bang significantly changed the operations of LSE. Floor trading system was replaced by screen trading. Another change facilitated automatic execution of orders when bid & offer prices match. Registered market makers are also required to display their bid & offer prices to the market along with corresponding maximum sizes through out the trading day.- Reforms: Decline in the status of British securities market, its delayed response to internationalization & technological developments called for financial reforms in 1986. Commissions were liberalized and the rule of prohibiting non-stock exchange members from investing in the companies of stock exchange members was abolished. The erstwhile rigid division between agents & jobbers gave way to the concept of dual capacity.

GermanyFrankfurt Stock Exchange, the first to become operational after World War II, was renamed as Deutsche Borse AG in 1992. It is owned by German

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International Banks, official ledger brokers and other regional stock exchanges.There are eight independent stock exchanges, which cooperate closely for uniform pricing mechanism. Equity trading is concentrated in Frankfurt where floor trading & electronic trading co-exist.In 1990 Deutche TerminBorse (DTB), a fully computerized exchange was formed for trading equity options & Futures. DTB & the Swiss derivatives exchange merged in 1998 to form Eurex, the world’s derivatives exchange.In German banking laws sale/purchase of securities for others can only be done by banks.In 1997 Exchange Electronic Trading (Xetra), a modern, cost efficient & order driven trading system with automatic matching was introduced. All orders are recorded with full conditions & they can be kept pending up to one year.

JapanTSE was established in 1878. 1980s onwards many steps have been taken for deregulation & globalization. Depending upon size, turnover and share ownership the listed shares have been divided into first section & second section. - Operations: TSE is a continuous auction market. Based on orders placed by regular members before the start of session, prices are established. Latter on, the ‘Saitori members’, who only act as intermediaries between regular members & maintain record of orders, match the same.The trading floor was closed in 1999 & transactions take place on Computer-Assisted Order Routing & Execution System only through authorized security

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dealers who are members of Japan Security Dealers Association.- Reforms: Financial markets were highly regulated till 70s. Reforms at the pattern of British Big Bang were initiated in 1996 because of internationalization of financial markets & Japan’s inability to compete. The purpose of these reforms was to make Japan’s financial market ‘fair, free, global & less susceptible to domestic political pressures.China.Till 2001 Chinese stock market had two types of shares, ‘A’ restricted to Chinese investors & ‘B’ reserved for foreign investors. ‘A’ was the larger market but limited to state- owned companies, with limited access to private companies.‘B’ was started in 1991 to attract foreign capital, despite government listing requirements. But it did not develop as expected by the government because of involvement of Chinese in trading in ‘B’ market instead of foreigners, their relative lower prices. Moreover, inadequate accounting standards led to quoting of these shares in the Hong Kong market. The ‘Red Chips i.e. shares of Hong Kong companies with strong Chinese ties, were also traded in Hong Kong.Ultimately Chinese ownership of ‘B’ shares was allowed in 2001, with permission to Chinese investors to transfer foreign currencies into a trading account for this purpose. All the Chinese companies, whether public or private, were also allowed to sell ‘A’ or ‘B’ shares.

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This resulted in increased access to Chinese investors to ‘B’ shares & Chinese companies to ‘A’ Shares.

Recent European Stock Market Reorganizations.In addition to globalization of stock markets, the creation of European Monetary Union & the emergence of Euro have made the stock market more competitive within Europe. London Stock Exchange. Once most active in Europe. The Stock Exchange Automated Quotation system was launched in 1985 for pan-European stocks. Similarly the order-driven Stock Exchange Trading Service was developed for the largest 100 stocks in 1997, which was later on expanded to 200 stocks. It wanted to merge with Deutche Boerse but the talks failed.OM Gruppen who had acquired the Stockholm Stock Exchange wanted to acquire LSE, which was not agreed to. Deutch Borse. After failure of its attempts to merge, the FSE transformed itself & emerged as a system provider in addition to becoming Europe’s 2nd

largest exchange. It introduced the Xetra trading system in addition to sponsoring two other exchanges i.e. it owns 50% shares in Eurex, the largest derivative exchange and DB’s Neuer Mart, which trades high technology companies.DB offered 27% of its shares to public in its IPO raising an amount of $ 1 Billion. Euronext. Created with merger of Paris, Brussels & Amsterdam exchanges to form a pan-European market. Though the three markets are legally

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different, with slightly different trading rules but they have a common trading system. Volume & market capitalization wise, it is No. 1 & 2 respectively in Europe. Paris stock exchange has also sold its advanced trading technology to many foreign markets. Technologically DB & Paris Bourse are known to be the best exchanges of Europe. Other European Stock Market Activities. In 2001 NASDAQ took-over 58% shares of EASDAQ, a pan-European electronic market place for small but fast growing young companies. Renamed as NASDAQ Europe it was to be linked to trading systems of NASDAQ in US & Japan, for dealings in pan-European stocks.NASDAQ also announced a partnership with London International Financial Futures & Options Exchange in 2001 to introduce single stock futures in US. Though US investors have been barred from such trading, regulations permitting the same are expected.NASDAQ, NYSE & Euronext are planning to go public. New European Exchanges. In 90s smaller markets on the pattern of NASDAQ started emerging in Europe. Neuer Market & EASDAQ are examples of such developments. New Japanese Exchanges. Out of the three very small markets for emerging companies, NASDAQ Japan is the most important. All issues are traded via auction process, but later on they will be divided into two; based on trading volume, market capitalization etc. Smaller will be traded via market-making system and larger through either of the two. All the current issues have been classified as small.

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The OTC market adopted market-making system in 1998. There are 28 market-makers trading 30% of listed issues.

Ownership and Control of National Stock Exchanges.In US Stock exchanges are SEC regulated but privately owned & competitive. They set membership & listing criteria & commissions are negotiable. The exchanges in Japan, UK, Canada, Hong Kong and Australia are similar except that in Japan the Ministry of Finance approves listed securities, though the exchange sets a limit on the number of member.Some stock exchanges have traditionally been public or quasi-public institutions, with govt control over appointment of brokers, commission etc. France, Belgium, Spain etc are examples, where significant changes occurred after 1980s, replacing individual brokers with corporations, making commission negotiable etc. But the govt approval is still required in many areas.In some other countries transactions can take place only through the banks.

Trading Procedures and ComputerizationMany markets use call auction procedure to set an opening price & then allow prices to be determined on a continuous basis. The advent of computer & its associated advantages have brought many changes in the world’s equity market. Many call markets have been converted into continuous markets.Dealers in Major MarketsIn continuous US markets there are two forms of dealings, i.e. through the specialist or the competitive dealer system like OTC NASDAQ market where there can be several dealers for one stock.

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The specialist system also appears in Montréal, Toronto & to some extent in Amsterdam.The rest of the continuous trading exchanges employ competitive dealer system whereas Japan has a saitori.Block Trades have the upstairs market.

Stock Market IndexesEach stock market has an index which measures the movement of prices of the listed shares. Some indexes are produced by the stock exchanges themselves; others are produced by outsiders. Some indexes show movements in the prices of all the listed shares on a stock exchange, while others show movements of selected stocks. There are many indexes for the US stock exchanges, the London Stock Exchange, the Tokyo Stock exchange etc, prepared from different angles. Some indexes even cover the equity market around the world. Free Float. That portion of stocks of a company or corporation which are available for transactions. Those stocks which are not available for transaction i.e. stocks held by the government or stocks of other corporations owned & held by other corporations (Cross holding) are not available for transactions.Global Depository Receipts.GDRs are issued by banks as evidence of ownership of the underlying stock of a foreign corporation that the bank holds in trust. Generally the corporations themselves sponsor such GDRs to enable trade of their stock in a foreign country without complying with its regulatory issuing requirements.

The Mortgage Market (Chapter 23)

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What is Mortgage? It is the pledge of immovable property to secure payment of a debt. Non-payment, as per agreement, can result in seizure of property. In addition to conventional mortgages, the concept of insured mortgages also exist, where insurance is provided either by private insurers or government agencies like Federal Housing Administration (FHA), Veterans Administration (VA) and Rural Housing Service (RHS). Mortgage Origination. Original lenders like Thrifts, Commercial banks, Mortgage bankers, Insurance companies & Pension Funds are the originators. Income of the originators consists of origination fee, application fee, processing fee plus the profit, if any, in sale of mortgage in the secondary market. Other sources of income include the service fee or retention of mortgage as investment. Mismatching maturities of assets & liabilities coupled with reduced tax benefits have induced thrifts & banks to be contented with fees etc only, instead of investment. The Mortgage Origination Process. It starts with an application containing details of the applicant, the property & choice of the type of mortgage. Approval is considered on the basis of Payment-to-income (PTI) ratio and the Loan-to-value (LTV) ratio.Concurrence follows a commitment letter containing details & asking the applicant to pay the commitment fee.The originator can keep the mortgage in its portfolio, sell it or use it for securitization. If it wants to sell it, commitments would be obtained from potential

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purchasers (the conduits) including two federally sponsored agencies. The federal agencies have set standards for conforming mortgages in the areas of PTI, LTV & maximum loan amount.The originator sets rate of interest as desired by purchaser. The Risks Associated with Mortgage Origination. Pipeline risks refer to the risks associated with originating a mortgage. It has two components: Price risk & fallout risk.Price risk refers to adverse changes in rate of interest during origination. Fallout risks refer to risk associated with the applicants’ not completing mortgage after issuance of letter of commitment. Main reasons could be adverse change in rates of interest, unfavorable property inspection report etc.Price risk can be protected against through a commitment in the form of a forward contract with the intending purchaser.Fallout risk can be protected against through an optional contract with one of the conduits.

Types of Mortgage Designs Fixed-Rate, Level-Payments, Fully amortized Mortgages. Traditional repayment of principal & interest amount in equal monthly installments over a period of 15 to 30 years. The interest rate includes service costs & risk. - Cash Flow Characteristics of the Traditional Mortgages. The repayment schedule is so designed that on payment of last installment, both, the principal as well as the agreed inertest get adjusted. Major portion of initial monthly installments goes

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towards interest with nominal reduction in the principal; but the position gets reversed later on. - Prepayments. They represent payments made in excess of the scheduled principal repayments. The reasons can include sale of the mortgaged property; a comparative reduction in the market interest rate; re-possession of mortgaged property due to default and destruction of mortgaged property which is insured.Normally the borrower repays only the outstanding amount & he is not penalized for prepayment with the exception of the prepayment penalty mortgages. - Deficiencies of Traditional Mortgages. The mismatch problem arises out of varying maturities of assets & liabilities and the changes in short-term rates of interest. It can be resolved through acquiring long term deposits or designing different sorts of mortgages.The tilt problem relates to the higher burden of repayment installments in the beginning & a reduction in the same during the latter years due to inflation. This discourages purchases of houses in early earning years. Adjustable-Rate Mortgages. The returns of this asset match the short-term market rates. - Characteristics of the Adjustable-rate Mortgage. It involves periodic resetting of interest rate in accordance with some index reflecting short term market rates e.g. one year Treasury rate or the 11th

Home Loan Bank Board District. It suits the lenders; but borrowers can opt for prepayment.Period caps & lifetime caps, which are expressed in percentages, impose limits on resetting of interest.

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- Balloon/Reset Mortgages. A long term financing but the rate is renegotiated at specified future dates. Or a short term lending, which can extend up to an agreed longer term on revised rates. The maximum change can be up to 50 points per year; & the period of renegotiation can vary from 3 to 7 years as determined at origination. - Assessment of Adjustable-Rate Mortgages. They provide a solution to the problem of mismatch of maturities. It is said that instead of tying caps to certain indexes they should be left to private bargaining. It is also said that ARMs do not address the tilt problem. Mortgage Designs to Deal with Inflation. Inflation & associated problems helped creation of the following designs to cope with the problems of apparent difference in interest rates, the value of property & the tilt effect. - Graduated-Payment Mortgage. The nominal monthly payments grow for a few initial years at a constant rate & remain level afterwards. The interest rate remains same. Since rate of inflation cannot be determined; & interest rate on mortgage is fixed, this type does not suggest a proper solution to the problems of tilt as well as mismatch maturities. It also does not deal properly with inflation. - Price-Level-Adjusted Mortgage. (PLAM)It is like a traditional mortgage except that the rate is real instead of the nominal one, specifying the index to be used. The real value of the monthly installments due each year & the outstanding balance are computed in accordance with the movement of the

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index. This method has been used in many countries with high degree of inflation but not in USA. - Dual-Rate Mortgage. (DRM-Inflation-proof mortgage). Initial payments start lower than the normal amortized amount & then gradually rise (normally annually) in accordance with changes in purchasing power. Thus the annual payments are level in terms of purchasing power. The amount owed by borrower is computed on the basis some floating short-term rate like Treasury Bills etc., which eliminates the interest & prepayment risks. It has very limited application in USA. Other Mortgage Designs. - Pre-payment penalty Mortgages. It is a recent development, based on Federal & State Laws. Some States permit this on fixed rate mortgages others do not. The Federal laws overrule the State legislation. Typically prepayments beyond 20% of original loan are not permitted during first 3 to 5 years’ lockout period. In a 3 years lockout period, penalty equals lesser of 2% of prepayment beyond 20% or six months interest on this amount. In 5 years it is 6 months interest on this amount. - Growing-Equity Mortgage. The monthly repayments increase over time, to pay down the principal faster & shorten the term of mortgage. The rate remains the same.- Reverse Mortgages. Conversion of equity into cash; borrowing against a fully owned home or the one with very low repayable balance. It also involves purchase of house with a combination of own funds & calculated amount of reverse mortgage. The amount

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depends upon age of borrower, value of property & rate of interest.- High-LTV Loans. They have been designed for borrowers in conventional non-conforming loans with less than the required, or no down payments.- Alt-A Loans. It allows alternate/reduced documentation in the absence of conforming criteria. The credit quality of the borrower must compensate the lack of documentation. Borrowers willingly pay a premium in rate for the privilege.- Sub prime Loans. Loans to people with blemished credit history. They comprise various credit risk grades, starting from fallen angels at the top & ending with habitual mismanagement of debts, with appropriate pricing criteria.

Commercial Mortgage-Backed Securities. Loans for income-producing properties, with recourse only against the property & not the borrower, both, for interest and principal.- Measures used in evaluating the Credit Risk of Commercial Mortgage Loans. The two ratios are Debt-to-Value & Debt-to-service-coverage.- Pre-payment protection to lenders.

1. Prepayment lockout. 2. Defeasance. Provision of sufficient funds for

investment in Treasury securities to replicate the expected cash flows in the absence of prepayments.

3. Prepayment penalty points.4. Yield maintenance charge.

Investment Risks. There are four types of risks:

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- Credit Risk. The risk of default. Insurance provides a solution. LTV can measure the risk.- Liquidity Risk. Mortgage loans, being large & indivisible, are quite illiquid.- Price Risk. A rise in interest rate decreases the price of a mortgage loan.- Prepayments and Cash Flow Uncertainty. Prepayments affect the certainty of cash flows.

FINANCIAL FUTURES MARKET (Chapter 26)

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Futures Contracts help in hedging adverse price movements. There can be commodity futures and financial futures; the latter comprising stock-index/interest rate/currency futures. Futures Contracts. Contracts to buy or sell specific amount of a specific item at a specific future date & price.The key elements in futures contracts are futures price, settlement date, underlying, long position and short position. Liquidating a Position. It involves, either taking an offsetting position before due date, or delivery of underlying on due date at agreed price. The role of the Clearinghouse. A corporation associated with an exchange that guarantees performance by two parties to a transaction. Whenever someone takes a position in the futures market, the clearinghouse takes the opposite position. It buys every sale & sells every purchase. Margin Requirements. Exchange set minimum margin requirements for futures contracts (the investor’s equity); each individual firm can set its own margin above this amount. It can also be an interest bearing security.Settlement price i.e. the price considered to be representative for futures contracts is determined daily which reflects the investor’s equity also. Maintenance margin. The minimum margin level for equity of an investor. Any reduction below this margin calls for variation margin, only in cash. While investing in securities this margin can be borrowed from the broker, but not in futures contracts. The maintenance margin is less than the equity margin,

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but when equity falls even below this level, it is required to be raised to the equity level. Leveraging Aspect of Futures. A position can be taken on provision of the required margin only; even in the absence of the total amount for a futures transaction. Market Structure. Futures contract are traded at the designated location of Futures Exchanges called Pit; price is determined through open outcry of bids or hand signals. Trading is restricted to members, who are of two types; locals and floor brokers. The former trade for themselves & the later trade for themselves as well as act as brokers.Meeting of members at the pit for trading is still the dominant way of determination of price, despite introduction of round the clock electronic system. Daily Price Limits. Exchanges can impose limits on variation of prices of future contracts over the closing prices of previous day. These limits cannot be violated. There are reasons for and against this controversial discretion.

Futures Vs Forward Contract.Both are similar with variations in following areas:Standardization, dealings through organized exchanges, availability of Clearing House & the resultant reduced credit risk, existence of secondary market, mode of settlement, interim cash flows on account of margin fluctuations etc. The Role of Futures in Financial Markets. In the absence of futures market, investors could alter their investment portfolio through cash only. The level of efficiency of the two determines the choice between them.

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The futures market is the easier & less costly market for altering a portfolio position; therefore it is the one where price discovery takes place on receipt of some information, which is later on transmitted to the cash market.Speculative dealings in the futures market have sparked criticism and conflicting arguments from the two sides of the divide. Though confirmed that price volatility of the financial assets dealt in futures market has increased; it is being justified by one quarter & criticized by the other.U.S. Financial Futures Market Stock Index Futures Market. 1982 onwards broad based & specialized stock index futures contracts have been introduced, the most active being S & P 500. $ value of a stock index futures contract=price of the futures contract X the notified multiple. They are settled in cash. Interest Rate Futures Markets. - Treasury Bill Futures. These futures contracts involve delivery of Treasury Bills of the face value of one million with 13 weeks remaining to maturity on agreed futures price, at the settlement date.- Eurodollar CD Futures. The underlying is three months’ Eurodollar CD of face value of $ one million. Their settlement is through cash & they are a more popular mode of short-term investment than Treasury Bill Futures.- Treasury Bond Futures. The underlying is a hypothetical $ 100,000, 20 year, 6% coupon bond. Rates are quoted in terms of this hypothetical bond, but the seller has choice between several actual bonds acceptable for delivery with at least 15 years

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to maturity. Since the underlying does not exist, problems crop up at delivery in determining its actual value at the date of settlement. Variations in rate of 6% might not provide equitable return to one of the two parties. Conversion factors take care of this problem. The delivery options are also the discretion of the seller.- Treasury Note Futures. There are three futures options: 10, 5 and 2 year. The underlying for the 1st is a $ 100,000, 6%, 10 year hypothetical Note with maturity not less than 6.5 years or greater than 10 years from the first day of delivery month. The maturity of 2nd not to be more than 5 yr 3 months, remaining not greater than 5 yr 3 months & less than 4 yrs 2 months. The 3rd pertains to a note of 200,000, remaining maturity not above 2 yrs & below 1 yr 9 months.- Agency Future Contract. Since agency securities are gaining ground & replacing Treasury securities as interest bench mark, future contracts have started taking place in the same. The underlying is a 10 year Agency Note with a face value of $ 100,000 & a notional coupon of 6%. The note must be uncallable, with original maturity of not more than 10.25 years & remaining maturity of at least 6.5 years; the original issue should be $ 3 billion or above; fixed coupons should be payable semi-annually. The delivery months are March, June, Sept and December.- Bond Buyer’s Municipal Index Futures. The underlying is a basket of 40 Municipal Bonds. The Bond Buyer, a trade publication of municipal bonds industry manages the index. On receipt of prices from brokers average price referred to as appraisal

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value is determined. It is a cash settlement contract, with value based upon the value of the basket on the delivery date.

Financial Futures Markets in Other CountriesOther countries have also developed futures contracts, mostly designed at the pattern of the US futures market.

The GAO Study on Financial DerivativesSome derivative instruments are exchange traded & others are OTC, created by commercial banks without having any risk management system. The General Accounting Officer prepared a report, which recognized the importance of derivatives, highlighted the possible threats they pose to the entire financial system and suggested certain measures for improvement. The boards of directors & senior management were advised to set basic standards to manage risks; frame comprehensive accounting rules, improve regulations in coordination with foreign regulators & regulate derivative activity instead of suppressing it.Forward Rate Agreements.It is an OTC counterpart of exchange traded futures contracts on short-term rates, typically short-term LIBOR. Its elements are: The Contract rate. It is the rate specified in the contract at which the buyer & seller agree to pay for & receive respectively for investing funds. Reference rate. It is the interest rate used. It could be three months’ or six months’ LIBOR. Notional amount. It is the notional principal amount, which is not exchanged between parties.

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Settlement rate. The value of the reference rate at the settlement date. It is the market rate of the reference rate. Settlement date. The date at which actual transaction is to take place.They are cash settlement contracts & in the case of difference between contract & settlement rates:Buyer receives compensation if settlement rate is > contract rate & vice versa.

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