Types of banks and their role in the international financial market.

Banks' activities can be divided into retail banking (commercial, community, private, credit union, savings, offshore banks), dealing directly with individuals and small businesses; business banking, providing services to mid-market business; corporate banking, directed at large business entities; private banking, providing wealth management services to high net worth individuals and families; and investment banking, relating to activities on the financial markets. Most banks are profit-making, private enterprises. However, some are owned by government, or are non-profit organizations.

Central bank is an institution that manages a nation's currency, money supply, and interest rates. The primary function of a central bank is to manage the nation's money supply (monetary policy), through active duties such as managing interest rates, setting the reserve requirement, and acting as a lender of last resort to the banking sector during times of bank insolvency or financial crisis. Central banks usually also have supervisory powers, intended to prevent commercial banks and other financial institutions from reckless or fraudulent behavior.

Commercial bank (type of retail banks) is an institution which accepts deposits, makes business loans, and offers related services. These institutions are run to make a profit and owned by a group of individuals, yet some may be members of the Federal Reserve System. Commercial banks offer services such as trade finance, project finance, payroll, foreign exchange transactions and trading, lock boxes for collecting payments and general corporate finance. While commercial banks offer services to individuals, they are primarily concerned with receiving deposits and lending to businesses. Without commercial banks, the international finance and import-export industry would not exist. Commercial banks make possible the reliable transfer of funds and translation of business practices between different countries and different customs all over the world. The global nature of commercial banking also makes possible the distribution of valuable economic and business information among customers and the capital markets of all countries. Commercial banking also serves as a worldwide barometer of economic health and business trends.

Investment bank is a financial institution which acts as an underwriter or agent for corporations and municipalities issuing securities. Most also maintain broker/dealer operations, maintain markets for previously issued securities, and offer advisory services to investors. Investment banks also have a large role in facilitating mergers and acquisitions, private equity placements and corporate restructuring. Unlike traditional banks, investment banks do not accept deposits from and provide loans to individuals. Investment banking is a particular banking system that allows customers to invest their money directly or indirectly and also helps companies, government and individual raise fund by means of bond selling, security sales, mergers and acquisitions and issuing of IPO. Investment banking gives both the learned and the novice in the investment industry the opportunity to maximize better dividend of their business or property by way of mergers and acquisitions.

Universal banks are a combination of commercial and investment banks and they can offer a wide range of financial services. The concept is most relevant in the United Kingdom and the United States (f.e. Deutsche Bank,UBS and Credit Suisse).

42. The global equities market: size, indicators, principles of organization.

Equity market (stock market) is a public entity for the trading of company stock (shares) and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately. The size of the world stock market was estimated at about $36.6 trillion at the beginning of October 2008.

Market participants include individual retail investors, institutional investors such as mutual funds, banks, insurance companies and hedge funds, and also publicly traded corporations trading in their own shares.

The stocks are listed and traded on stock exchanges which are entities of a corporation or mutual organizations specialized in the business of bringing buyers and sellers of the organizations to a listing of stocks and securities together. Stock markets that have a physical location include the New York Stock Exchange, Chicago Mercantile Exchange, Tokyo Stock Exchange and London Stock Exchange. These organizations incur operating expenses, such as rent and utilities. Other securities markets lack physical substance and operate "over-the-counter," or OTC, trading platforms. An example is the National Association of Securities Dealers Automated Quotation, also known as NASDAQ. OTC markets incur fewer operating expenses, although their information-technology costs may run higher.

The stock market is one of the most important sources for companies to raise money. This allows businesses to be publicly traded, or raise additional financial capital for expansion by selling shares of ownership of the company in a public market. The liquidity that an exchange affords the investors gives them the ability to quickly and easily sell securities. This is an attractive feature of investing in stocks, compared to other less liquid investments such as real estate. Some companies actively increase liquidity by trading in their own shares

Indicators for equity markets

Traditional: Market capitalization to GDP, Tunover ratio, Stock traded to GDP

New: Access: Market capitalization, trading volume of top 10 firms. Efficiency: Liquidity, Transaction costs, private information trading; Stability: Volatility, price earnings ratios, duration, vulnerability to earning manipulation.

Principles of organization

Organizations play the stock-market game by issuing stocks and bonds on securities exchanges. Stock or bond issuance enables a company to tap into a deep liquidity pool, helping the firm fund its short-term activities or long-term expansion plans. Institutional investors, such as banks and hedge funds, work in tandem with portfolio managers and traders to inject liquidity into the market. A liquid exchange allows sellers and buyers to trade assets quickly and at market prices. Individual investors also buy and sell financial products on stock market, an important process that helps people meet their retirement goals.

Government agencies monitor stock-market players' actions, ensuring that investors maintain high standards of conducts when trading. Regulatory oversight ensures a level playing field in securities exchanges, barring shrewd participants from manipulating prices and reaping ill-gotten profits. The most important U.S.-based stock-market regulators include the Securities Exchange Commission, Commodities Futures Trading Commission and Financial Industry Regulatory Authority.

 

43. The global debt securities market: composition, principles of organization.

Debt securities- any debt instrument that can be bought or sold between two parties and has basic terms defined, such as notional amount (amount borrowed), interest rate and maturity/renewal date. Debt securities include government bonds, corporate bonds, CDs, municipal bonds, preferred stock, collateralized securities (such as CDOs, CMOs, GNMAs) and zero-coupon securities.

 

The interest rate on a debt security is largely determined by the perceived repayment ability of the borrower; higher risks of payment default almost always lead to higher interest rates to borrow capital.

Most debt securities are traded over-the-counter, with much of the trading now conducted electronically. The total dollar value of trades conducted daily in the debt markets is much larger than that of stocks, as debt securities are held by many large institutional investors as well as governments and non-profit organizations.

Debt securities on the whole are safer investments than equity securities, but riskier than cash. Debt securities get their measure of safety by having a principal amount that is returned to the lender at the maturity date or upon the sale of the security. They are typically classified and grouped by their level of default risk, the type of issuer and income payment cycles.

The holder of a debt security is typically entitled to the payment of principal and interest, together with other contractual rights under the terms of the issue, such as the right to receive certain information. Debt securities are generally issued for a fixed term and redeemable by the issuer at the end of that term. Debt securities may be protected by collateral or may be unsecured, and, if they are unsecured, may be contractually "senior" to other unsecured debt meaning their holders would have a priority in a bankruptcy of the issuer

The bond market (also known as the credit, or fixed income market) is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the Secondary market, usually in the form of bonds. The primary goal of the bond market is to provide a mechanism for long term funding of public and private expenditures. Traditionally, the bond market was largely dominated by the United States, but today the US is about 44% of the market. As of 2009, the size of the worldwide bond market (total debt outstanding) is an estimated $82.2 trillion, of which $31.2 trillion refers to U.S. bond market debt. Nearly all of the $822 billion average daily trading volume in the U.S. bond market takes place between broker-dealers and large institutions in a decentralized, over-the-counter (OTC) market. However, a small number of bonds, primarily corporate, are listed on exchanges.

Types of bond markets: Corporate; Government & agency; Municipal; Mortgage backed, asset backed, and collateralized debt obligation; Funding

Bond market participants: either buyers (debt issuer) of funds or sellers (institution) of funds and often both. They include institutional investors; Governments; traders; individuals

Because of the specificity of individual bond issues, and the lack of liquidity in many smaller issues, the majority of outstanding bonds are held by institutions like pension funds, banks and mutual funds. In the United States, approximately 10% of the market is currently held by private individuals.

44. The international debt securities: types and organization.

Organizations issue debt securities to raise capital. Most debt securities pay interest at a fixed rate; debt securities are frequently called fixed income securities. Common types of debt securities include corporate bonds, municipal bonds, and treasury bonds.

Corporate Bonds are debt securities issued by corporations. Interest is generally paid semi-annually. The investor receives the face amount of the bond at the bond's maturity date. Interest rates depend on the creditworthiness of the issuing company and the duration of the bond. The bond's duration is the length of time until the maturity date. Longer duration bonds pay higher rates of interest, as the investor is assuming greater risk. Some corporate bonds have a call feature, where the corporation has the right to repurchase the bond at a specific date prior to the bond's maturity.

Municipal bonds are issued by states or municipalities to fund projects or borrow money to meet general obligations. Municipal bond interest is exempt from federal income taxes. Most municipal bond interest is exempt from state and local taxes for taxpayers of the state in which they are issued. Capital gain from the sale of municipal bonds is taxable income on both the federal and state levels. Interest rates are lower than corporate bonds. Municipal bonds may be revenue bonds, where revenue from a specific project, such as an airport terminal, is dedicated to making interest payments on the bond.

Treasury bonds - marketable, fixed-interest U.S. government debt security with a maturity of more than 10 years. Treasury bonds make interest payments semi-annually and the income that holders receive is only taxed at the federal level.The United States Treasury also issues Treasury Bills, Treasury Notes, and Treasury Bonds. Treasury Bills have durations of less than one year; Treasury Notes have durations between one and ten years; Treasury Bonds have durations over ten years. Treasury debt is considered amongst the safest debt in the world, correspondingly interest rates tend to be lower than interest rates of other debt securities.

Original Issue Discount Bonds

Instead of paying interest periodically original issue discount bonds pay interest only at maturity. These bonds are sold for less than their face value; the discount from face value is the interest the investor receives if they hold the bond until maturity.

Series EE savings bonds are a form of debt security. Series EE bonds accrue interest quarterly; interest is paid when the bond is redeemed. Some investors can receive tax benefits when using Series EE bonds for education funding.

Packaged Debt Securities Some debt securities are pools of individual debts. Examples are collateralized mortgage obligations and collateralized debt obligations. These pools of debt securities are packaged together and sold to investors as a single debt security.

Commercial Paper Corporations issue commercial paper to fund their short term obligations. Commercial paper is generally purchased by other corporations; it is not generally sold on exchanges.

45. The government bond markets: size, composition, significance.

A government bond is a bond issued by a national government denominated in the country's own currency. The first ever government bond was issued by the English government in 1693 to raise money to fund a war against France.

A well-functioning government bond market – more pertinently a Treasury securities market – can play a critical role in developing domestic bond markets. It can increase investor confidence in overall bond and financial markets. It can also provide a risk-free benchmark yield curve, which is crucial for revaluating portfolios and pricing corporate bond issues. Banks hold a very large proportion of their assets in government bonds, which mean that stable debt management becomes critical for financial stability. A government debt market does this first by putting in place a basic financial infrastructure including laws, institutions, products, services, repo and derivatives markets, and second by playing a role as an informational benchmark. A single private issuer of securities would never be of sufficient size to generate a complete yield curve, and his securities would not be nominally riskless because only the government has the power to print domestic currency. The government, through the government debt market, can therefore provide a public good to financial markets, but only under two further conditions. First, macroeconomic volatility, especially inflation volatility, must be low so that a nominal yield curve is informative about the real cost of borrowing. And second, the government must issue a sufficient volume of debt.

The government bonds play an important role in the monetary policy too:

When people purchase U.S. bonds, it injects money into the U.S. economy with the goal of economic stimulation and it helps offset the costs of various government projects and expenses.
U.S. bond investors are not just U.S. citizens and businesses, but can consist of a wide range of domestic and foreign individuals as well as foreign governments.

Role in Decreasing/Increasing Money Supply

The Federal Reserve Board (the Fed) decreases the economic money supply by selling bonds it already owns. By doing so, the Fed is attempting to decrease upward price pressure, curb inflation and increase the value of the Dollar. In the case of slow economic growth or recession, the Fed buys government bonds to increase the economic money supply. By doing so, the Fed is attempting to increase demand for goods and services, avoid job losses and prevent the economy from slowing even further.

Role in Interest Rates

When the Fed decreases the money supply by selling bond it already owns, it increases interest rates. This increases the amount of money that banks are required to keep on hand to cover their liabilities, called a "reserve requirement." Increased reserve requirements leave banks with less money to lend to consumers. This discourages borrowing and slows an economy that is growing too rapidly. When the Fed increases the money supply by purchasing government bonds, it decreases interest rates, which decreases the reserve requirements for banks. This leaves banks with more money to lend to consumers, encouraging borrowing and stimulating economic growth.

Role in Local Economies

State and local governments also issue bonds, called municipal bonds. The proceeds from the sale of these bonds fund statewide and local projects. These projects include the maintenance and repair of public utility infrastructures. By funding these projects through the sale of bonds, state and local governments can avoid raising income, sales or property taxes to pay for project costs. Increased taxes can be potentially damaging to state and local economies by inducing residents to move to an area with lower taxes. Higher taxes also discourage new business growth with business owners choosing to operate in areas with lower taxes.

As of 2009, the size of the worldwide bond market (total debt outstanding) is an estimated $82,2 trillion, of which the size of the outstanding U.S. bond market debt was $31,2 trillion accordingly to BIS (or alternatively $34,2 trillion accordingly to SIFMA – The Security and Financial Markets Association)

46. Mortgage-backed securities: mechanism of issuance, the role in the international financial crisis of 2007-2009.

Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization.

While a residential mortgage-backed security (RMBS) is secured by single-family or two to four family real estate, a commercial mortgage-backed security (CMBS) is secured by commercial and multifamily properties, such as apartment buildings, retail or office properties, hotels, schools, industrial properties and other commercial sites. A CMBS is usually structured as a different type of security than an RMBS

There are a variety of underlying mortgage classifications in the pool:

· Prime mortgages are conforming mortgages with prime borrowers, full documentation (such as verification of income and assets), strong credit scores, etc.

· Alt-A mortgages are an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.)^[15]

· Subprime mortgages have weaker credit scores, no verification of income or assets, etc.

· Jumbo mortgages when the size of the loan is bigger than the "conforming loan amount" as set by Fannie Mae.

Most MBSs are issued by the Government National Mortgage Association (Ginnie Mae), a U.S. government agency, or the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U.S. government-sponsored enterprises. Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments. Fannie Mae and Freddie Mac also provide certain guarantees and, while not backed by the full faith and credit of the U.S. government, have special authority to borrow from the U.S. Treasury. Some private institutions, such as brokerage firms, banks, and homebuilders, also securitize mortgages, known as "private-label" mortgage securities.

Mechanism of issuance of mortgage-back securities (on example of Fannie Mae). Fannie Mae buys loans from approved mortgage sellers, either for cash or in exchange for a mortgage-backed security that comprises those loans and that, for a fee, carries Fannie Mae's guarantee of timely payment of interest and principal. The mortgage seller may hold that security or sell it. Fannie Mae may also securitize mortgages from its own loan portfolio and sell the resultant mortgage-backed security to investors in the secondary mortgage market, again with a guarantee that the stated principal and interest payments will be timely passed through to the investor. By purchasing the mortgages, Fannie Mae and Freddie Mac provide banks and other financial institutions with fresh money to make new loans. This gives the United States housing and credit markets flexibility and liquidity.

In order for Fannie Mae to provide its guarantee to mortgage-backed securities it issues, it sets the guidelines for the loans that it will accept for purchase, called "conforming" loans. Mortgages that don't meet the guidelines are called "nonconforming". Fannie Mae produced an automated underwriting system (AUS) tool called Desktop Underwriter (DU) which lenders can use to automatically determine if a loan is conforming; Fannie Mae followed this program up in 2004 with Custom DU, which allows lenders to set custom underwriting rules to handle nonconforming loans as well.^[35] The secondary market for nonconforming loans includes jumbo loans, which are mortgages larger than the maximum mortgage that Fannie Mae and Freddie Mac will purchase. In early 2008, the decision was made to allow TBA (To-be-announced)-eligible mortgage-backed securities to include up to 10% "jumbo" mortgages.

The role in the international financial crisis of 2007-2009. The growth of private-label securitization and lack of regulation in this part of the market resulted in the oversupply of underpriced housing finance that led, in 2006, to an increasing number of borrowers, often with poor credit, who were unable to pay their mortgages - particularly with adjustable rate mortgages (ARM), caused a precipitous increase in home foreclosures. As a result, home prices declined as increasing foreclosures added to the already large inventory of homes and stricter lending standards made it more and more difficult for borrowers to get mortgages. This depreciation in home prices led to growing losses for the government-sponsored enterprise (such as Fannie Mae and Freddie Mac), which back the majority of US mortgages. In July 2008, the government attempted to ease market fears by reiterating their view that "Fannie Mae and Freddie Mac play a central role in the US housing finance system". The Treasury Department and the Federal Reserve took steps to bolster confidence in the corporations, including granting both corporations access to Federal Reserve low-interest loans (at similar rates as commercial banks) and removing the prohibition on the Treasury Department to purchase the GSEs' stock. Despite these efforts, by August 2008, shares of both Fannie Mae and Freddie Mac had tumbled more than 90% from their one-year prior levels.

On Oct 21, 2010 Federal Housing Finance Agency estimates revealed that the bailout of Fredie Mac and Fannie Mae will likely cost taxpayers $224–360 billion in total, with over $150 billion already provided.

47. Exchange-traded derivatives: types, functions, mechanism of trading.

Exchange-traded derivatives is a type of financial derivative that is traded through an exchange, such as the Chicago Board of Trade or Chicago Mercantile Exchange.

Derivative is an agreement between counterparties to buy/sell certain asset (commodity, currency, equity, index, bond, interest rate, etc.) or to buy/sell a right to buy/sell certain asset in a certain date (or period) in future.

An asset that derives its value from another asset. For example, a call option on the stock of Coca-Cola is a derivative security that obtains value from the shares of Coca-Cola that can be purchased with the call option. Call options, put options, convertible bonds, futures contracts, and convertible preferred stock are examples of derivatives. A derivative can be either a risky or low-risk investment, depending upon the type of derivative and how it is used.

Types of derivatives: Futures, Forwards, Options, Swaps, Credit Derivatives

Futures contract is a standardized contract between two parties to buy or sell a specified asset (eg.oranges, oil, gold) of standardized quantity and quality at a specified future date at a price agreed today (the futures price). The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They are still securities, however, though they are a type of derivative contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position.

A futures contract gives the holder the obligation to make or take delivery under the terms of the contract, whereas an option grants the buyer the right, but not the obligation, to establish a position previously held by the seller of the option. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position, effectively closing out the futures position and its contract obligations.

Forward contract is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed upon today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

Options

A call option gives its owner the right, but not the obligation, to buy something at a specified price (the exercise or strike price) on or before a specified date (the maturity or expiration date).

A put option gives its owner the right, but not the obligation, to sell something at a specified price on or before a specified date.

The party that receives the right to buy/sell in the future buys the option and has a long position. The party that gives the right to buy/sell in the future writes the option and has a short position.

Unlike with forward and futures contracts, the buyer of an option is not obligated to buy or sell.

The owner of a European-style option can exercise only on the expiration date. The owner of an American-style option can exercise at any time up to and including the expiration date.

Swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. A swap is an instrument in which both sides have obligations to perform in the future. That is, if the underlying rate moves against either party, that party will have to pay up, much like a future or forward contract. This is in contrast to an option from the perspective of its holder. An option grants the right, not the obligation, to the option holder to buy a particular asset and creates an obligation on the part of the option writer to sell that asset. We can sell a right and assume an obligation but we cannot sell an obligation.