Finance and Financial Markets
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1 Finance and Financial Markets Second Edition Keith Pilbeam palgrave macmillan
2 Brief contents 1 The world of finance 1 2 Financial intermediation and financial markets 22 3 Financial institutions 39 4 Monetary policy and interest rate determination 61 5 Domestic and international money markets 96 6 The domestic and international bond market Portfolio analysis: risk and return in financial markets The capital asset pricing model Stockmarkets and equities The efficiency of financial markets The foreign exchange market Theories of exchange rate determination Financial futures Options Option pricing Swap markets Regulation of the financial sector 432 IV
3 Contents Preface The World of Finance Introduction Financial centres The role of a financial centre Money markets, capital markets and the banking system Services of a financial centre The growth of the financial services industry The globalization of financial markets Technology Deregulation Financial innovation Types of financial innovations Emerging markets Problems concerning investment in emerging markets The future Conclusions Financial Intermediation and Financial Markets 2.1 Introduction 2.2 Surplus and deficit agents 2.3 What is a financial security? 2.4 Types of financial claims: debt and equity 2.5 The role of financial intermediaries 2.6 Provision of a payments mechanism 2.7 Maturity transformation 2.8 Risk transformation xx
4 CONTENTS 2.9 Liquidity provision Reduction of contracting, search and information costs Types of financial markets The classification of financial markets The role played by financial markets Participants in financial markets Conclusions Financial Institutions Introduction The central bank The implementation of monetary policy Management of the national debt Supervisory function Types of financial intermediaries Deposit institutions The banking sector Savings institutions Insurance companies The phenomenon of Bancassurance Mutual funds or unit trusts Investment companies and investment trusts Pension funds Specialist financial institutions Venture capital companies Hedge funds Finance companies or finance houses Factoring agencies The role of financial institutions Conclusions 58 4 Monetary Policy and Interest Rate Determination Introduction The functions of money Bills and bonds The operation of monetary policy Monetary policy in practice and the announcement effect The commercial banking system and the narrow and broad money supply Formula for the money multiplier Controlling the money supply The determination of interest rates The loanable funds approach to interest rate determination 76
5 4.11 Money market or loanable funds theory? 4.12 Inflation and interest rates Fiscal policy and interest rates 4.14 Other factors influencing the interest rate 4.15 Theories of the yield curve 4.16 Expectations theory 4.17 Liquidity preference theory 4.18 Preferred habitat theory 4.19 Market segmentation theory 4.20 The importance of alternative views of the term structure 4.21 Problems with monetary policy 4.22 Conclusions Domestic and International Money Markets 5.1 Introduction 5.2 Types of domestic money market instruments 5.3 Treasury bills 5.4 Commercial paper 5.5 The interbank market 5.6 Bankers' acceptances 5.7 Repurchase agreements 5.8 Certificates of deposit 5.9 The international money market 5.10 Euromarkets 5.11 The origins and development of the Euromarkets 5.12 The characteristics of the Eurodollar market 5.13 The competitive advantage of Eurobanks 5.14 The coexistence of domestic and Eurobanking 5.15 The creation of Eurodeposits 5.16 The pros and cons of the Eurocurrency markets Syndicated loans 5.18 Euronotes 5.19 Conclusions The Domestic and International Bond Market 6.1 Introduction 6.2 Trading in government bonds 6.3 Determining the price of government bonds 6.4 Clean and dirty bond prices 6.5 The current yield 6.6 The simple yield to maturity 6.7 Yield to maturity 6.8 The par value relation 6.9 Bond price volatility CONTENTS * U VII
6 viii I i CONTENTS 6.10 Duration Modified duration The duration for a portfolio of bonds A formula to calculate duration Duration and the problem of curvature of the bond-price relationship The usefulness of the duration measure Yield curves Corporate bonds Credit ratings Risks associated with corporate bonds Financial innovation and corporate bonds junk bonds Medium-term notes The international capital market Motivations behind international capital flows The origins and development of the Eurobond market Typical features of a Eurobond Control and regulation of the Eurobond market The management of a Eurobond issue Innovations in the Eurobond market Conclusions 151 Portfolio Analysis: Risk and Return in Financial Markets Introduction Determining the price of a financial asset The rate of return on a security The variance and standard deviation of the rate of return Risk on a security Covariance and correlation of rates of return Different types of investors The indifference curves of risk-averse investors Portfolio theory Reducing risk through diversification Measuring risk on a portfolio The two-asset efficiency frontier The minimum variance portfolio in the two risky asset case The portfolio efficiency frontier Market risk and specific risk The efficient set with a riskless security The market portfolio 180
7 CONTENTS IX 7.18 The market price of risk Measuring the market index Conclusions The Capital Asset Pricing Model Introduction The market model Portfolio risk and return using the market model The capital asset pricing model Assumptions of the CAPM The theory behind the CAPM Expressing the CAPM in risk premium form The securities market line The CAPM in action: measuring the beta coefficient Empirical testing of the CAPM The empirical evidence on the CAPM The multifactor CAPM The arbitrage pricing theory critique of the CAPM Conclusions Stockmarkets and Equities Introduction The major international stockmarkets Stockmarket participants The primary arid secondary market Different types of equity The buying and selling of shares A rights issue A simple model of the pricing of a rights issue Does the performance of the stockmarket matter? The pricing of equities The dividend pricing approach The Cordon growth model A non-constant growth version of the dividend discount model The dividend irrelevance theorem Measurement of the required rate of return The subjectivity of share pricing Forecasting future dividends: business risk and the effects of gearing Debt or equity finance? Other approaches to equity valuation: financial ratio analysis The usefulness of financial ratios Conclusions 243
8 p :j CONTENTS 10 The Efficiency of Financial Markets Introduction Three levels of efficiency The efficient market hypothesis and a random walk Implications of various forms of efficiency tests Active versus passive fund management Testing for weak market efficiency ' Tests of the random-walk hypothesis Filter rule tests Other statistical tests The day of the week effects The January effect The winner-loser problem Testing for semi-strong market efficiency The results of event studies The size effect The price-earnings effect The earnings-announcement effect Stockmarket crashes Testing the strong form of market efficiency Directors'/managers'share purchases Information content of analysts forecasts Conclusions < The Foreign Exchange Market Introduction Exchange rate definitions Characteristics of and participants in the foreign exchange market Arbitrage in the foreign exchange market The spot and forward exchange rates A simple model for determining the spot exchange rate Alternative exchange rate regimes Determination of the forward exchange rate Nominal, real and effective exchange rates Conclusions Theories of Exchange Rate Determination Introduction Purchasing power parity theory Absolute PPP Relative PPP Measurement problems in testing for PPP Empirical evidence on PPP 305
9 CONTENTS I XI M 12.7 Summary of the empirical evidence on PPP Explaining the poor performance of purchasing power parity Modern theories of exchange rate determination Uncovered interest rate parity Monetary models of exchange rate determination The flexible-price monetary model The Dornbusch sticky-price monetarist model A simple explanation of the Dornbusch model A formal explanation of the Dornbusch model A money supply expansion and exchange rate overshooting Importance of the Dornbusch overshooting model The Frankel real interest rate differential model Conclusions Financial Futures Introduction The growth of futures exchanges Comparison between futures and forward contracts The symmetry of profits/losses on futures/forward positions Exchange-traded derivative contracts versus the over-the-counter market Trading in exchange futures contracts The role of the clearing house Open-interest and reversing trades Stock-index futures The pricing of a stock futures index Short-term interest rate futures The pricing of sterling futures Using interest rate futures Bond futures contracts Currency futures The pricing of currency futures Conclusions Options Introduction The growth of options markets Options contracts A call option contract A put option contract Stock-index options Interest rate options 371
10 n xii I I CONTENTS Li 14.8 Currency options The uses of option contracts Differences between options and futures contracts A currency option versus a forward contract for hedging A currency option versus a forward for speculating Option strategies Exotic options Conclusions Option Pricing Introduction Principles of option pricing Intrinsic value and time value The distribution of the option premium between time and intrinsic value The Black-Scholes option pricing formula Different measures of volatility The calculation of historical volatility Problems with the Black-Scholes option pricing formula The sensitivity of options prices Put-call parity Conclusions Swap Markets Introduction Potential swap scenarios An interest rate swap A currency swap agreement The role of the intermediary in the swap The secondary market in swaps Distinguishing characteristics of the swap market from the forward and futures markets Reasons for the existence of the swap market Innovations in the swap market Conclusions Regulation of the Financial Sector Introduction The rationale for government intervention The objectives of government regulation Types of government regulation Regulation of the banking sector Statutory versus self-regulation 439
11 CONTENTS ^ xill 17.7 Regulation in the United Kingdom Big Bang, The Financial Services Act The Banking Act European regulation The First Banking Directive The Second Banking Directive International regulation: the Basle Accord The Basle II Accord Conclusions 454 Solutions to Multiple Choice Questions 455 Glossary 457 References 468 Further Reading 472 Index 475
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