Chapter 01: A modern financial system: an overview

1.1 Financial crises and the real economy

The exchange of goods and services is made more efficient by money.

Short selling is the sale of a financial product that the seller does not own.

The term ‘medium of exchange' for money refers to its use as something that is widely
accepted as payment for goods and services.

The role of money as a store of value refers to the fact that money allows worth to be
stored readily.

Money increases economic growth by assisting transfers from savers to borrowers.

Financial markets have developed to facilitate the exchange of money between savers
and borrowers.claim to future cash flows is NOT a function of money

Buyers of financial claims lend their excess funds because they want surplus funds in
the future.

Sellers of financial claims promise to pay back borrowed funds based on their
expectation of having surplus funds in the future.

Possible explanation for the GFC

A savings-surplus unit is an entity which has an income that exceeds its spending.

The process of facilitating the flow of funds between borrowers and lenders performed
by the financial system increases the rate of economic growth of a country.

Both real and financial assets have four principal attributes that are significant factors
in the investment decision process. These are: I. liquidity II. capital gain III. risk IV.
return or yield V. time pattern of future cash flows VI. price and cash flow volatility I,
III, IV, V

Which of the following is NOT associated with characteristics of shares A fixed interest
payment

A financial institution that obtains most of its funds from deposits is a/an commercial
bank.
Institutions that specialise in off-balance-sheet advisory services are called investment
banks.

A financial intermediary that receives premium payments which are used to purchase
assets to cover future possible payments is a life insurance office.
1.2 Financial system and financial institutions

Financial institutions whose liabilities specify that, in return for the payment of periodic
funds to the institution, the institution will make payments in the future (if and when a
specified event occurs) are contractual savings institutions.

Financial institutions that raise the majority of their funds by selling securities in the
money markets are finance companies.

Financial institutions that are formed under a trust deed and attract funds by inviting
the public to buy units are unit trusts.

Contractual claim is NOT a term associated with shares

Higher ranking than bond holders on claims on assets is NOT a characteristic
commonly associated with preference shares
Long-term debt financing instruments used by companies are called debentures.

When a borrower issues a debt instrument with collateral specified in its contract this
debt instrument is called secured.

Debt instruments that can be easily sold and transferred in the financial markets are
called negotiable.

Their prices do not fluctuate as much as shares is NOT a feature of a debt instrument

The contract price is settled at the end of the contract is NOT a feature of futures
contracts

Forward contracts are closed out by trading an opposite contract is NOT a feature of
forward contracts

The right to buy is called a put option is NOT a feature of option contracts

Interest rate swaps exchange principal at the beginning and the end is NOT a feature
of swaps

The key reason for the existence of markets of financial assets is that holders of
shares generally want to f them for bonds and other financial instruments.

Financial markets: facilitate the exchange of financial assets./ provide information

about prices of financial assets. /provide a channel for funds to flow between the
providers and users of funds

The most important function of a financial market is to facilitate the flow of funds
between lenders and borrowers.

Financial markets issue claims on future cash flows of individual borrowers directly to
lenders.
A primary financial market is one tahat involves the sale of financial assets for the first
time.
1.3 Financial instruments
A secondary financial market is one that involves the sale of existing financial assets.

Purchasing shares on the Australian Securities Exchange is an example of a

secondary market transaction.

When a security is sold in the financial markets for the first time funds flow from the
saver to the issuer.

A mortgage bond is NOT an example of primary market transactions

A ‘primary market' is a market where borrowers sell new financial instruments to

buyers.

Buying bonds in the capital markets is an example of a secondary market transaction.

The market where existing securities are sold is the secondary market.

When a large company issues a financial instrument into the financial markets it sells a
financial claim.

Secondary markets allow borrowers to raise long-term funds/ facilitate capital-raising in

the primary market/do not raise new funds but offer liquidity.

The flow of funds through financial markets increases the volume of savings and
investment by providing savers with a variety of ways to lend to borrowers.

Financial markets generally deal only with the purchase and sale of government
securities.

is NOT a feature of financial markets

has a selection of financial assets with similar timings of cash flow is NOT true—a well-
functioning financial market
Financial markets involve both primary and secondary transactions.

Direct financing allows a borrower to diversify their funding sources.

Cost of the financial intermediary involved is NOT a possible disadvantage of direct

financing

An issue of debentures is an example of a direct form of funding.

An example of an indirect form of funding is a/an term loan.

Direct finance reduces search and transactions costs is NOT a major advantage of
direct finance

Financial intermediaries act as a third party by holding a portfolio of assets and issuing
claims based on them to savers.

The flow of funds between lenders and borrowers is channelled indirectly through
financial intermediaries.

‘Intermediaries, by managing the deposits they receive, are able to make long-term
loans while satisfying savers' preferences for liquid claims.' This statement is referring
to which important attribute of financial intermediation Maturity transformation

The main role of financial intermediaries is to borrow funds from surplus units and lend
them to borrowers.

Financial intermediaries pool the funds of many small savers and make loans to many
borrowers.

1.4 Financial markets

Small savers prefer to use financial intermediaries rather than lending directly to
borrowers because financial intermediaries offer the savers a wide portfolio of financial
instruments.

Financial intermediaries can engage in credit risk transformation because they develop
expertise in lending and diversifying loans.

When a financial intermediary collects together deposits and lends them out as loans
to companies, it is engaging in asset transformation.

Liquidity’ in financial terms is the ease with which an asset can be sold at the
published market price.

When an individual has immediate access to their funds from an account with a
financial intermediary, the intermediary is engaging in liquidity management.
When a financial intermediary can repeatedly use standardised documents, it is
engaging in: economies of scale.

According to the textbook, all of the following are financial intermediaries except a/an
share broking firm.
An example of a financial intermediary is an insurance company.

The main participants in the financial system are individuals, corporations and
governments. Individuals are generally suppliers of funds and corporations are net
users of funds.

The Commonwealth Government would pay the lowest interest rate on debts of equal
maturity

Generally, in the long term, a government is a net borrower of funds.

The money market is created by a financial connection between providers and users
of short-term funds.
Unsecured notes is NOT usually a short-term discount security

It only operates as a market in which new security issues are created and marketed is
NOT a feature of the money market

The market that involves the buying and selling of short-term securities is the money
market.
A large company with a temporary surplus of funds is most likely to buy bank bills.

A company that issues promissory notes into the short-term debt markets is
conducting a transaction in the commercial paper market.

A company with a high credit rating can issue commercial paper directly into the
money markets

The market that generally involves the buying and selling of discount securities is the
money market.
A source of short-term liquidity funding for banks is the issue of certificates of deposit.

The market that includes individuals, companies and governments in the buying and
selling of long term debt and equity securities is the capital market.

When a company issues a long-term debt instrument with no security attached it is

selling unsecured notes to investors.

From the viewpoint of a corporation, which source of long-term funding does not have
to be repaid Equity
For additional funding, a company decides to issue $15 million in corporate bonds. The
securities will be issued into the capital markets.
The major financial assets traded in the capital market are shares and bonds.
Compared with Treasury bonds, Treasury notes generally are discount securities.
 If you purchase an Australian government bond, that bond is an asset to you but a
liability for the Australian government.

When government borrowing reduces the amount of funds available for lending to
businesses, this is called crowding out.

All of the following are key financial services provided by the financial system except
profitability.

A government authority wanting to borrow to finance highway construction would be

most likely to use financial markets to borrow?

Generally, financial instruments are divided into three broad categories of equity, debt
and derivatives. Which of the following are usually issued by a company to raise new
funds? i. Unsecured notes ii. Ordinary shares iii. Debentures iv. Bills of exchange v.
Futures contracts vi. Preference shares (i, ii, iii, iv )

The movement of funds between the four sectors of a domestic economy and the rest
of the world is called flow of funds.

As a broad generalisation, in the sectorial flow of funds households are typically a

surplus sector.

The flow of funds between the sectors of a nation-state relates to all of the given
answers.

1.5 Flow of funds and market relationships and stability

Key Concept Misunderstanding

+ Money allows economic

+Four main attributes of an asset are return, risk, volatility
and financial transactions to and time-pattern of cash flows. - The attributes are return,
be carried out more efficiently risk, liquidity and time-pattern.
than bartering - Bartering
generally involves high search +Deficit entities purchase financial instruments that offer
the lowest interest rate -Deficit entities sell financial
costs instruments.

+Individuals may be +Monetary policy relates to actions of a central bank to

categorised as risk averse, control the amount of money for transactions in an
economy -From the early days of banking it was
risk neutral or risk takers. Risk
recognised that there needed to be control over the money
averse individuals will accept supply. A country's central bank was usually assigned this
a lower rate of return so as to task.
reduce their risk exposure
 + The government organisation responsible for the conduct
of monetary policy is the prudential supervisor of a
- An investor who prefers an country's banks -Generally, the task of monetary policy is
investment with less risk to assigned to a central bank.
another with more risk, + Investment banks are contractual organisations that
provided they offer the same make up contracts for their corporate clients and
expected return, is risk governments -Investment banks generally focus on
averse. provision of advisory services for corporate and
government clients.
+ A well-functioning financial + In recent years, depository financial institutions have
system enables participants obtained a large proportion of their funds from the financial
to readily change the markets directly -For the major financial intermediaries (the
banks) the bulk of their funds are still obtained from
composition of their financial deposits.
assets portfolio- With liquid
+A stock is a debt security that promises to make specified
markets and financial interest payments -A stock is a share that promises to pay
intermediaries, investors are dividends.
able to change their portfolios. +Margin trading is the sale of a financial product that the
seller does not own and who intends to buy back at a lower
price later -Short selling is the sale of a financial product
that the seller does not own.
Chapter 2- Commercial banks Learning objectives

2.1 Main activities of commercial banking

Deregulation of the banking sector throughout the late 1970s and the 1980s sought to
reduce the discrimination against banks owing to direct controls on them only.

The changes to the regulations for the banking industry under deregulation in the mid
1980s have resulted in increasing the growth of bank sector

The Australian Reserve Bank monitors capital adequacy requirements for banks.

concerning banks is incorrect

Unlike most other businesses, a bank's balance sheet is made up mainly of financial
assets and liabilities.

The level of banks' share of assets of all Australian financial institutions from the 1950s
onwards first _______, then in the 1980s _______ and recently has _______ owing to
banks forming consolidated corporate entities (decreased; increased; decreased )

The market structure of the banking sector has changed since deregulation of the
financial system during the 1980s. . Major banks maintain the highest percentage of
branches and share of total assets most closely reflects the current structure of the
banking sector in Australia

Facilitating the flow of funds from savers to borrowers is a role of a bank

Banks have gradually moved to liability management in the management of their

balance sheets. The deposit base and other funding sources are managed in order to
fund loan and other commitments statement best describes liability management
For banks, asset management refers to managing the loans portfolio.

For banks, liability management refers banks ensuring they have sufficient funds by
managing their deposit base.

When a bank raises funds in the international markets to fund new lending growth, it is
involved in liability management.
Off-balance-sheet business for a bank refers to a bank's contingent liabilities.

Liability management is the management of a bank's loans about a bank's activities is

incorrect

The assets on a bank's balance sheet are the uses of funds.

The liabilities on a bank's balance sheet are the sources of funds.

Each of the following balance sheet portfolio items are liabilities of a bank, except
overdrafts.
2.2 Sources of funds

Each of the following balance sheet portfolio items are sources of funds for a bank,
except overdrafts.

Certificates of deposit is a bank liability

A cheque account may pay interest about deposits is correct

Current accounts form an increasingly important type of asset for banks statements
about banks' current accounts is incorrect
They are generally negotiable instruments statements is NOT true of term deposits

As a depositor shifts funds from current deposits to term deposits in a bank, generally
the depositor’s liquidity decreases and interest income increases.

If a bank required more short-term funding, it would issue a certificate of deposit.

Both bank bills and certificates of deposit are liquid instruments is generally a highly
liquid instrument
The term ‘negotiable' in relation to a security means it can be sold easily.
The rate of interest on a CD can be adjusted quickly regarding certificates of deposit
(CDs) is correct

The advantage of a CD to a bank is/are its rate of interest may be adjusted quickly/ it
can be sold quickly in the money market for cash/ it is a negotiable instrument.

A major difference between a bank's term deposit and a certificate of deposit is a

certificate of deposit does not pay interest until maturity.

CDs are issued by large, creditworthy companies following about CDs is incorrect

With regard to bank bills, the bill is sold at a discount because the difference between
the initial price and the final sale price is the return to the holder.

With regard to bank bills, the expression ‘the issuer sells the bill at the best discount’
means the issuer is selling the bill into the market at the lowest yield.

With regard to bank bills, the actual role of the acceptor is to pay the face value of the
funds to the holder at maturity.

An issuer will seek to sell the bill in the market at the highest yield is incorrect in
relation to bill financing

2.3 Uses of funds

For a bank, an advantage of bill financing is: the bank earns income from accepting
bills/the bank doesn't necessarily have to use its own funds/interest rates on bill
funding can be adjusted rapidly
If interest rates change before a bank bill matures, the bank can change the interest
rate on it is incorrect

Commercial banks take part in the money markets as both lenders and borrowers of
funds.

Foreign currency liabilities have increased in importance as a source of funds for

Australian banks. Which of the following statements is NOT a major reason? i.
deregulation of the foreign exchange market ii. diversification of funding sources iii.
demand from multinational corporate clients iv. internationalisation of global financial
markets v. avoidance of the non-callable deposit prudential requirement vi. expansion
of banks' asset-base denominated in foreign currencies (v )

Alternatives to the usual source of long-term bank funds that have the characteristics
of both debt and equity are called subordinated notes.

The following balance sheet portfolio items are all assets of a bank, except certificates
of deposit.

A short-term discount security issued by a drawer at a discount, with the promise to

repay the face value at maturity, is called a commercial paper/ a commercial bill/a
certificate of deposit.

Australian banks occasionally issue debt securities into the international markets to
raise sums ranging from $20 million to $50 million following statements regarding the
foreign currency liabilities of a bank is incorrect

All of the following financial securities are considered ‘uses of funds' by banks except
certificates of deposit.

If you take out a mortgage from a bank, the mortgage is a/an liability to you and an
asset to the bank.

The interest rate BBSW refers to the average mid-point of the bid and offer rates in the
bank bill market.

Banks invest in government securities because they can be used as security against
banks' borrowing.

Typically, term loans are for maturities ranging from 5 to 15 years following statements
about commercial lending is incorrect

Banks invest in T notes because they provide short-term income streams following
about bank lending to government is incorrect

Off-balance-sheet business for a bank refers to transactions that are currently only a
contingent liability.

2.4 Off-balance-sheet business

All of the following are off-balance-sheet transactions of a bank except bills receivable.

In recent times, there had been a substantial expansion in fee-related income for
banks. this Increased off-sheet business (OBS) for banks is the principal reason for

Off balance-sheet business represents fee-based income is true for off-balance-sheet

business for banks

They form a small part of banks' OBS business following statements about market-
rate-related items such as forward-rate agreements is incorrect

Market-rate-related transactions following categories represents the most significant

proportion of total off balance-sheet business of the banks

(Interest rate swaps) following categories represents the most significant proportion
of total market-rate related off-balance-sheet business of the banks?

An example of an ‘off-sheet business' transaction that banks are generally involved in

is: providing a ‘standby letter of credit'/ providing a note issuance facility/ providing a
short term, self-liquidating trade contingency

The bank provides funding to a third party instead of the client providing the funding:
following statements about direct credit substitutes provided by a commercial bank is
incorrect

Off-balance-sheet business is usually divided into four major categories Direct credit
substitutes, trade and performance-related items, commitments and market-related
transactions.

A ‘commitment’ by a bank is an undertaking to advance funds or to acquire an asset in

the future.
Currency swap is not a commitment by a bank

The excess return on assets that banks have been making in recent years is NOT an
argument for some form of government regulation of the banking system

Lowering the cost of funds is NOT associated with the purpose of regulating financial
institutions

The Australian institution APRA is responsible for the regulatory supervision of

financial institutions such as banks and credit unions. APRA stands for Australian
Prudential Regulation Authority.

Following institutions are supervised by APRA: Building societies, Commercial banks,

Credit unions - All

Within the context of the Corporations Law in Australia, the supervision of financial
market integrity and consumer protection is done by ASIC
The requirement and observation of standards designed to ensure the stability and
soundness of a financial system is called prudential supervision.

2.5 Regulation and prudential supervision

The Basel capital adequacy requirements apply to all banks registered with APRA and
some other financial institutions.

Some of the elements in assessing capital adequacy requirements for banks under the
Basel II capital accord are credit risk, market risk and type of capital held.

According to the textbook, the Basel II approach to capital adequacy for banks
involves six main elements.

Cumulative irredeemable APRA-approved preference shares can be included in Tier 1

capital following does NOT apply to Tier 1 capital

Under Basel II prudential standards, an institution is required to maintain a risk-based

capital ratio of 8.00 percent of total-risk-weighted assets.

2.8 Liquidity management and other supervisory controls

Tier 2 capital includes general reserves for doubtful debts, asset revaluation reserves
of premises, other preference shares, mandatory convertible notes, cumulative
redeemable preference shares and perpetual subordinated debt following statements
about regulatory capital is false

The Pillar 1 approach of Basel II capital adequacy incorporates the following three risk
components credit risk, market risk and operational risk.
Eligible Tier 1 capital must constitute at least 70% of a bank's capital base
statements regarding capital adequacy requirements is incorrect

Under the capital adequacy requirement for banks, in order to fund a $100 000 loan for
a multinational corporate client with a Standard & Poor's rating of AA, a bank will
assign a risk-weighting of 20% for the balance.

In the Basel II standardised approach to external rating grades, the asset counterparty
weights for capital adequacy guidelines are 20%, 50%, 100% and 150%.

The Basel II risk weighting factor for a bank loan to an Australian company with a
Moody's Investors Service rating of C is 150%.

Under Pillar 1 of the Basel II framework, the risk weight for a residential housing loan is
determined by the amount borrowed./ level of mortgage insurance./house valuation

A bank provides a loan of $1 million to a company that has an A rating. Calculate the
dollar value of capital required under the capital adequacy requirements to support the
facility($40 000 )

2.6 Background to capital adequacy standards

A bank provides documentary letters of credit for a company that has a credit rating of
A+. The face value of contracts outstanding is $2 million. Calculate the dollar value of
capital required under the capital adequacy requirements to support these facilities,
given that the bank supervisor's credit conversion factor is 20%.($16 000)

A large commercial bank operating in the international markets will generally apply to
the banks' supervisor to use the risk advanced internal ratings-based approach to
credit

Definition of capital
Under Basel II capital accord, the approach to credit risk that requires a bank to assign
risk weights given by the prudential supervisor is called a standardised approach.

The risk that arises from chance of loss as a result of inadequate internal bank
processes is called operational risk.

Banks hold a fixed allocation of funds between various balance sheet assets and off-
balance-sheet business following statements about recently adopted guidelines
covering capital requirements for market risk that banks are required to perform is
false

For a commercial bank operating in foreign exchange, interest rate and equity
markets, the capital adequacy guidelines for the market risk it is exposed to fall under
Pillar 1.

For a commercial bank's normal day-to-day business, the capital adequacy guidelines
for the operational risk it is exposed to fall under: Pillar 1.

Market-related OBS transactions

 For a commercial bank's market discipline, the capital adequacy guidelines for its
disclosure and transparency requirements fall under Pillar 3.

Under Pillar 2 of Basel II, bank supervisors should review and evaluate banks' internal
capital adequacy assessments.

Part of a bank's liquidity management is to hold a portfolio of Commonwealth

government securities.

In relation to a bank, liquidity management means the bank's ability to quickly convert
deposits into loans.

A commitment by a bank is: an undertaking to advance funds or to acquire an

asset in the future.

Negotiable in relation to a security means it can be sold easily

Unlike most other businesses, a bank's balance sheet is made up mainly of financial
assets and liabilities

For a commercial bank s market discipline, the capital adequacy guidelines for its
disclosure and transparency requirements fall under: Pillar 3

The level of banks share of assets of all Australian financial institutions from the 1950s onwards
first decrease, then in the 1980s increase, and recently has decreased owing to banks forming
consolidated corporate entities
2.7 Basel II and Basel III
key Concepts Misunderstanding

+The greater the dominance of

Main elements of Basel II
commercial banks in an economy, the
less regulation required -Because of
+Commercial banks are the main type of the dominance of banks and the
financial institution in a financial system correlation between their business
because they hold the largest amounts of and a country's economy, there are
financial assets -Banks have long been the strong arguments for regulation to
dominant type of financial institution, constrain a bank's business
although in recent years managed funds
have close to having the same amount of + Call deposits are funds lodged in a
financial assets under management. bank account for a specified short-
term period
+ Banks obtain funds from many areas.
These sources of funds appear as + A bank may either issue a
liabilities on a bank's balance sheet - negotiable certificate of deposit
Deposits are a major part of a bank's directly into the money markets or
sources of funds and a bank needs to pay place it directly with another bank with
interest expenses. surplus funds.

+. Liability management is where banks + As the majority of banks' assets are

actively manage their liabilities in order to short-term loans, they are active in the
meet future loan demand. money markets in order to fund part of
their lending -A normal bank acquires
+ One of the important attributes of most of its funding from deposits.
certificates of deposit for a bank is the
ability to adjust the yields on new issues- + A bank may seek to obtain funds by
The yield on a CD cannot be adjusted until issuing unsecured notes with a
it reaches maturity and a new CD is collaterised floating charge over its
issued. deposits -Unsecured notes do not
have any security attached.
Capital adequacy standard + Foreign currency liabilities are debt
instruments issued into another
country but not denominated in the
currency of that country -Foreign
currency liabilities are typically
denominated in foreign currencies
such as US dollars, the yen and
pound sterling.

Chapter 3- Non-bank financial institutions

3.1 Describe the roles of investment banks.

The financial institution that is a specialist provider of financial and advisory services to
companies is a/an investment bank.
Money market corporations are generally referred to as investment banks.

The task of the investment bank in a public issue of new shares is to provide advice in
designing and pricing a share issue.

Investment banks are not required to comply with minimum capital adequacy
requirements like commercial banks are required to.

A company may hire a/an investment banker to advise on and underwrite its new
share issue

According to the text, the principal source of income for investment banks is off-
balance sheet business.

Money market corporations (merchant and investment banks) have significantly

increased their off-balance-sheet business on account of competition. All of the
following are off-balance sheet activities of investment banks except trading in the
short-term money market.

Most corporations will seek advice from a/an investment banker on possible mergers
and acquisitions.
The process of due diligence involves detailed analysis of a firm's financial statements.

The detailed analysis of a firm's financial statements as part of a possible takeover is

called due diligence.

Underwriting is when a/an: broker or a financial institution guarantees prices on a

security issue for a company.

When an investment bank guarantees a certain price for a company issuing new
shares, it is acting as a/an underwriter.

When an investment bank helps a company sell large parcels of shares directly to
institutional investors, this is called placement.

The takeover company is the company in a merger transaction that tries to merge with
or acquire another company
Venture capital is funding provided for a new start-up business by a group of investors.

3.2 Explain the structure, roles and operation of managed funds and identify
factors for their rapid growth
 The target company is the company in a merger transaction that is being pursued as a
takeover possibility.

If a car manufacturer were to purchase one of the companies listed below, A rival car
manufacturer would be called a horizontal takeover

If a car manufacturer were to purchase one of the companies listed below, An

electronic components supplier would be called a vertical takeover
The following factors are all reasons for mergers except reduction of debt.

The financial institution that pools funds for individuals and then invests them in both
the money and capital markets is amanaged fund.

. For Australia, recent figures show that the statutory funds of life offices have the
largest amounts of assets under management following statements about managed
funds is incorrect

A managed fund that is established under a trust deed and is managed by a

responsible entity is called a trust fund.

Superannuation funds that aim at delivering a longer term income stream and capital
appreciation by acquiring a diversified asset portfolio across a wider risk spectrum are
classified as balanced growth funds.

An investor who wishes to save for their retirement in 20 years' time and who has a
high propensity for taking risk is likely to invest in a managed fund which invests in
government securities and foreign equities.

Managed fund managers: invest funds according to their fund's trust deed./generally
reinvest income and any capital gains in the fund/ will usually maintain a diversified
portfolio of assets within the asset classes
Funds under management by managed funds in 2010 have a value of $1666 b.

3.3 Discuss purpose and operation of cash management and public unit trusts

A mutual investment fund that specialises in short-term debt instruments and managed
by a financial intermediary is called a cash management trust.

The main feature of cash management trusts is: they allow individuals to access the
money markets. / they provide liquidity and access to funds/ that many are associated
with stockbrokers and the electronic purchasing and selling of securities by investors.

The largest proportion of funds held by cash management funds in Australia is in cash
and deposits.

Unlisted unit trusts are generally highly liquid as they can accept money from investors
at any time. following statements is NOT a feature of unit trusts
Since the early 1990s, public unit trusts have seen the largest growth in assets in
equities and units in trusts.

The majority of securities owned by unlisted public unit trusts are capital market
securities.

Property trusts are generally unlisted as they need notice to sell their physical assets
following statements is NOT a feature of public unit trusts

An investor is considering different methods of investment, including a public unit trust.

Which of the following is NOT a function of a public unit trust?(Locking in a trust unit
price by listing on the Australian Securities Exchange )

A developer is promoting a large new suburban shopping centre and decides to

establish a publicly listed unit trust to attract investors. A property trust would likely be
established.

The main advantage of a listed trust over an unlisted unit trust is that a listed trust can
be sold at any time by the unit holder in the marketplace.

In Australia, listed property trusts dominate over the proportion of unlisted property unit
trusts because listed shares can be more advantageous in terms of liquidity.

The function of a superannuation fund is to provide income for employees of

corporations or governments after they retire

Essentially, superannuation assets provide retirement income for employees.

Recent figures about superannuation assets in Australia show that the largest amounts
of assets are in the self-managed superannuation fund

The introduction of the Superannuation Guarantee Charge (SGC) policy in 1992

resulted in rapid growth in Australia's superannuation industry throughout the 1990s is
true

Superannuation funds, because of the long -term nature of their liabilities, prefer to
hold long -term assets.

3.4 Describe nature and roles of superannuation funds. LO 3.5 Define life
insurance and general insurance offices and explain main types of insurance
policies

A private superannuation fund to which an individual makes recurring, predetermined

payments for a given number of years into the plan is called a/an superannuation
savings plan.

If an individual retires early but wants to retain their superannuation entitlements in a

favourable taxation environment, they can hold their eligible superannuation funds in a
rollover scheme.
A defined benefit plan may have a shortfall, but the employer will make good the
shortfall.

In an accumulation superannuation fund superannuation income varies depending on

how well the plan's investments have performed.

The superannuation fund that involves the amount of benefit paid out on retirement
being calculated by a formula based at the time when a person joined the fund is
called a defined benefit fund.

The superannuation fund where the amount of funds available at retirement consists of
past contributions plus earnings less taxes and expenses is called an accumulation
fund.

The superannuation fund where the employer must make good a shortfall in the fund
when the benefit is to be paid up is a/an defined benefit fund.

3.6 Discuss hedge funds

When an employee makes regular contributions equal to 7% of their salary and their
employer also contributes the equivalent of 14% of salary to a superannuation fund
that is an accumulation scheme: the final payout depends upon the investment
performance of the fund.

All of the following Acts or Bills are relevant to the operation of the Australian
superannuation industry except the Superannuation (Agents and Brokers) Act 1984.

The vast majority of retirement savings are invested in superannuation funds.is NOT
an important result of the compulsory guarantee charge implemented in July 1992

The amount of financial assets held by insurance companies has increased

dramatically over the past 20 years

Recent figures show the largest proportion of assets held by life insurance companies
is equities and units in trusts.

3.7 Explain principal functions of finance companies and general

In Australia, the prudential supervisor of life insurance offices is: APRA

Life insurance companies are more likely to acquire long-term assets because their
liabilities are long term in nature following statements with regard to life insurance
companies is true

Life insurance companies have large amounts of short-term liquid securities

statements about life insurance companies is false
Life insurance companies are significant investors in equities.
Life insurance offices are providers of superannuation products which make up 87 per
cent of the assets of life insurance offices' statutory funds

In Australia there has been a substantial expansion of assets in the life insurance
industry. . Growth in superannuation funds following factors is one of the primary
reasons for this? B

3.8 Outline roles and relative importance of building societies and credit unions
and analyse changes in the sector

Life insurance companies attract a large proportion of their funds through regular
premiums from policy holders. In regard to the matching principle, Money market
securities would an insurance company hold the smallest proportions of

A life insurance company that sells a large number of one-year renewable term
policies will need a large portion of liquid assets to match the liabilities

General insurance companies hold a greater number of short-term assets than life
insurance companies.

General insurance companies hold more liquid assets than life insurance companies
because events such as fires and earthquakes are difficult to predict.

A major difference between a whole-of-life insurance policy and a term-life policy is

only a whole-of-life policy has an investment part.

Premiums reduce over time owing to accumulated bonuses following does NOT apply
to a whole-of-life insurance policy

In a/an term insurance policy, there is no savings component

In relation to insurance for term-life policies with a stepped premium over time, the
policy holder pays premiums that increase gradually over time.

For motor vehicle insurance, a third party policy means the policy covers damage or
loss to a third party or property only.

A fund that aims to achieve high investment returns by using exotic financial products
is called a hedge fund.

A hedge fund that takes a long position in the Australian foreign exchange market is
forecasting Australian foreign currency will increase.

A hedge fund that takes a short position in equity markets will sell forward shares.

Finance companies generally raise funds in financial markets to lend to households

and companies.

3.9 Describe the unique role of export finance corporations

The majority of finance companies' funds are sourced from banks following
statements is NOT a feature of finance companies

Since deregulation of the financial markets in the 1980s, finance companies have seen
the largest growth in their assets in loans to businesses.

Finance companies use their funds to provide: loans to individuals/ instalment credit to
finance retail sales to retail stores/ lease financing

By the end of the 1990s, there had been a substantial contraction in the building
society sector. Conversion of building societies to banks principal reason for this
contraction in building societies

Now currently the building society sector holds 2 per cent of the total assets of the
Australian financial system following statement about building societies in Australia is
incorrect

Under deregulation, building societies lost market share to other financial institutions.
Their response included: mergers with other building societies/ expenditure on
technology / expanding their range of products

In Australia permanent building societies are supervised by APRA

A credit union differs from most other financial institutions because: it accepts deposits
mainly from members. / its assets are mainly loans to members./ there are stringent
requirements to hold prime liquid assets.
An important source of funds for credit unions is loan interest.
The uses of funds for credit unions are mainly mortgages.

Credit unions, while representing a very small proportion of total financial assets, have
strong numerical representation throughout Australia. They derive this numerical
strength from a common bond of association among society members.

Building societies holds the smallest percentage of total assets of financial institutions:
finance companies, credit unions, managed funds and permanent building societies

Export Finance and Insurance Corporation's function is to encourage export trade by

providing trade insurance and financial services.

The form of financing for large tourist resorts, property developments, heavy industry
and processing plant developments is called Project finance.

The main difference between project finance and other forms of lending is lenders
base their participation on expected future cash flows and assets of the project.

Finance is usually established on a non-recourse basis features is NOT generally true

of project finance in Australia
 A credit union is a financial intermediary that deals mainly in the flow of funds
between members. Membership is generally derived from some common bond.

A portfolio manager for a general insurance company who expects a downturn in the
market is likely to shift more of the company’s portfolio into: short-term securities.

A conglomerate takeover occurs when companies from different business areas

merge.

The financial institution that pools funds for individuals and then invests them in both

the money and capital markets is a managed fund.

By the end of the 1990s, there had been a substantial contraction in the building society sector.
Conversion of building societies to banks

If a car manufacturer were to purchase one of the companies listed below - a vertical takeover -
An electronic components supplier

3.10.changes that have impacted finance company business

Key Concepts Misunderstanding

+. In relation to Australian managed funds, +Unlike commercial banks, investment banks only
superannuation funds currently have the largest accept deposits from large corporations -Investment
amount of funds under management - Since the banks are specialist providers of financial and advisory
introduction of compulsory superannuation, services to corporations, high-net-worth individuals and
superannuation funds have achieved significant governments.
growth.
+ As investment banks have increased their
+. A managed growth fund is designed to underwriting activities in recent years, the number of
maximise the return from appreciation in the financial assets held by them has similarly increased. -
value of assets in its portfolio- The proportion of The number of financial assets held by them has
equity is generally larger than for a balanced decreased as they are focused on advisory services.
growth fund and the equity part of the fund
includes a greater range of risk securities than + In the context of a merger, the process of due
a balanced growth fund. These offer the diligence involves valuing the target company shares -
Due diligence is detailed analysis of the financial and
possibility of potentially higher returns. operational condition of the target company.
+ On average, the value of a balanced growth + In relation to Australian managed funds, cash
fund is subject to less market fluctuation than management trusts currently have the largest amount
that of a capital growth fund -The proportion of of funds under management - Superannuation trusts
equity is lower and so a balanced growth fund
have the largest amount of funds under management.
has generally lower volatility.

+ An insurance company is not a depository + A capital guaranteed fund guarantees that

financial institution -Insurance companies contributors will receive at least the value of the
receive funds in the form of premiums. contributions and future earnings of the fund -Only the
capital is guaranteed.

+ Cash management trusts are restricted under their

trust deed to hold only bank deposits and cash - Cash
management trusts are generally restricted to short-
term money market securities.

Chapter 4
4.1 The nature of a corporation

• Share market
– A formal exchange facilitating the issue, buying and selling of equity securities. •
Publicly listed corporation
– A company whose shares are quoted and traded on a formal stock exchange. •
Ordinary share
– The principal form of equity issued by a corporation, which bestows a claim to
residual cash flows and ownership and voting rights.
• The corporation differs from other business forms
– Ownership claims are widespread and easily transferable.
– Owners (shareholders) do not affect the day-to-day affairs of the company. –
Shareholders’ liability is limited to:
• the issue price of shares of a limited liability company
• any partly paid portion of shares of a no-liability company.
• Advantages of the corporate form
– Can obtain large amounts of finance at a relatively cheap cost
– The liquidity of securities facilitates investor diversification and encourages
investment in corporate securities
– Separation of ownership and control facilitates:
• appointment of specialised management
• greater effectiveness in the planning and implementation of strategic decisions
– ‘Perpetual succession’—the corporate form is unaffected by changes in
management or ownership
– The corporate form is suited to large-scale operations
• Disadvantages of the corporate form
– Factors moderating conflict of interest between owners and managers • Investors’
ability to sell shares in a corporation, causing the share price to fall
• Dismissal from the board at AGM by shareholders
• Threat of takeover and loss of employment
 • Use of performance incentives, such as share options
• More rigorous corporate governance

4.2 The stock exchange

• Origins of the modern stock exchange traceable to mid-16th century England. •
Principal functions of a modern and efficient stock exchange in a globalised market
are the provision of:
– markets for a range of financial securities
– securities trading system
– clearing and settlement system
– regulation and monitoring of market integrity
– well-informed market.
• Specifically, the following roles of a stock exchange are considered: – Primary
market role
– Secondary market role
– Managed Product role
– Derivative market role
– Interest rate market role
– Trading and settlement roles
– Information role
– Regulatory role

Primary market role

• A stock exchange facilitates the efficient and orderly sale of new financial securities –
New floats/Initial public offerings (IPOs)
– Rights issue
-rata basis – Placements
– Dividend reinvestment plans
Primary market role
Secondary market role
• The stock exchange facilitates trading in existing shares
– No new funds are raised by the issuing company
– An active, liquid, well-organised secondary market increases the appeal of buying new shares in
the primary market
– Market liquidity

– Market turnover

Managed product role

• The stock exchange provides a market for trading managed products – Equity-
based managed products are professionally managed funds. – The ‘units’ in these
funds are bought and sold on the stock exchange in the same way as shares in
corporations.
– Managed products are described as:
 Derivative market role
• The stock exchange provides a market for trading equity-related derivative
products – A derivative is a financial security that derives its price from an
underlying commodity (e.g. gold) or financial instrument (e.g. BHP shares).
– Derivative products are described as:
-traded contracts
• standardised financial contracts traded on a formal exchange
-the-counter contracts
non-standardised contracts negotiated between writer and buyer

• The stock exchange provides a market for trading equity-related derivative

products (cont.)
– Derivatives serve as a:

– Derivatives traded on a stock exchange include:

Interest rate market role

• The listing, quotation and trading of typically longer term debt instruments on a stock exchange
– Straight corporate bonds
– Floating rate notes (FRNs)
– Convertible notes
– Preference shares
• This role adds value to a debt issue owing to:
– transparency
• information about price, yield, maturity, credit rating of debt instruments – ease of entry
• electronic trading system facilitates buy and sell orders at minimum cost and time delay at
current market prices
– liquidity
• quotation on a stock exchange provides access to a wider market

Trading and settlement roles

• The Australian Securities Exchange (ASX) uses ASX Trade and ASX Trade24, which are integrated
computer-based trading systems to trade all listed securities and derivatives
– Clients’ orders are executed via computer from the broker’s office. – Orders are executed in
order of time received and the buy/sell price. • The ASX uses CHESS (Clearing House
Electronic Sub-register System) – Facilitates the settlement of transactions conducted through
ASX Trade – Settlement of transactions within three days
(T + 3)
– Provides an electronic sub-register that records the ownership of listed securities
– A CHESS sponsor is a market participant with access to CHESS, e.g. stockbroker.

Information role
• Investor confidence in the ASX relies on informational efficiency
– The current share prices should reflect all information available in the market, determined by:
• The ASX has a critical role in facilitating the flow of information to the market. • Corporations Act
2001 (Cwlth) requires information materially affecting the share price of a listed company to be
immediately given to the ASX.
• Listing rules are stock exchange rules with which a listed entity must comply. • Examples of
information disclosures required by ASX listing rules
– A change in a company’s financial forecasts
– Appointment of a liquidator
– Declaration of a dividend
– Notice of a takeover bid
– Disclosure of directors’ interests
Regulatory role
• The aim of regulation is to ensure market participants have confidence in the integrity of market
operations.
• Two main supervisors in Australia
– Australian Securities Exchange (ASX)
– Australian Securities and Investments Commission (ASIC)
• ASX
– Ensures listed companies meet specified limited levels of performance and standards of
information disclosure so investors can make informed decisions • Continuous disclosure
– Prescribes appropriate behaviour of broker participants on the exchange • Sanctions include
discipline, penalties, loss of licence
– Electronic surveillance systems to monitor trading behaviour of market participants
• Detect trades that fall outside certain limits
• Cross-references all trades against information on the relevant
company, directors and associated parties
• ASIC
– Responsible for the supervision of Corporations Law and markets in Australia (Corporations Act
2001 (Cwlth))
– Responsible for market integrity and consumer protection across the financial system, covering
investment, insurance and superannuation products – Supervises the ASX, addressing potential
conflicts of interest as a publicly listed corporation

4.3 The private equity market

• Private equity is an alternative funding source for companies unable or not wanting to access equity
capital though a public issue.
• Source of funds
Superannuation funds and life insurance offices
• Use of funds
Start-ups, business expansion, recovery finance for distressed companies, management
buyouts
Aim is generally to:
improve profitability sufficiently to realise value though an IPO
break up business to achieve return on investment.
ASX monitors market participants and ASIC supervises Corporations Law and market integrity.

4.1 The nature of corporation

- A business organisation that is a separate legal entity, can buy property in its own
name and can enter into contracts with other entities is a corporation.
- A publicly listed corporation has its shares listed on a formal exchange, is a legal
entity (as part of the Corporations law of a nation-state), has to comply with the rules of the
exchange where it is listed.
- A corporation has a widely dispersed ownership amongst its shareholders, has its
objectives and policies decided by a board of directors, has an executive management
group responsible for day-to-day management of the corporation
- The actual owners of a company is/are the shareholders.
- The executive management group is/are responsible for conducting the day-to-day
financial and operational affairs of the company.
- The board of directors is/are responsible for the objectives and policies of the
company, but not its day-to-day affairs.
- Corporation 8 forms of business organisation is characterised by limited liability
- If a sole proprietorship fails to meet its obligations to its creditors, then the creditors
have a legal right to take possession of the personal assets of the owner(s).
- If a growing organisation wanted to set itself up so it had greater access to a wider
range of capital, it would become a listed corporation.
- The owners of ole proprietorships and partnerships only face unlimited liability.
- The liability of shareholders in ‘limited liability' companies means shareholders are
only liable for any amount that is unpaid on the shares of a company.
- Because of their limited liability, corporate stockholders are more interested in
chances of success than failure
- The shareholders of a publicly listed small corporation have the right to participate in
the day-to-day management of the business about a corporation is incorrect
- When a no-liability company defaults on its loans with its creditors, this means the
shareholders do not have to meet any remaining payment on shares.
- When the owners of a company hire full-time executives to be responsible for the day-
to day decisions, this brings on the problem managers-shareholders
- Freely transferable ownership, limited liability, access to capital markets are
advantages of a corporation except low management costs.
- Since shares represent ownership in a company, ownership cannot be readily
transferred to new owners statements regarding companies is incorrect
- When a corporation continues to operate regardless of changes in ownership, this is
known as the right of perpetual succession.
- There is a separation of ownership (shareholders) and management control is NOT an
advantage of the corporate form of organisation
- A wide pool of investors can supply large amounts of corporate funding to the
corporation is an advantage of the corporate form of organisation
- Many companies use share options to align the interests of shareholders with those of
management.
- Agency theory is concerned with a conflict between owners and managers.
- The conflict of interests between the goals of the firm's owners and those of its
managers is the agency problem.
- The key aspect of the agency relationship for the corporate form of business is that
the managers have different incentives from the shareholders.
- Management reports to shareholders would NOT relate to agency costs involving
management's desire to maximize its benefits
- Agency problems are reduced by monitoring management behaviour, the
shareholders' ability to sell their shares, the threat of takeover by another firm.
- Agency problems would be less likely to exist in a sole proprietorship.
- The members of the board of directors of a corporation are elected by the
shareholders.
- A primary aim of corporate management should be to maximise the shareholders'
wealth.
- The most appropriate goal for corporate management, according to finance theory, is
to maximise the company's share price.
- A share represents a financial claim to the cash flow of a business after all other
claims have been deducted.
- The right to periodic payments is NOT a feature of a share
- Consider the following statements:
i. A corporation differs from other forms of business organisation only in that it tends to be
larger.
ii. The corporate form of business organisation is destined to fail because ‘managers', and
not the ‘owners', run the business.
iii. The corporate entity ceases on the death or bankruptcy of the individual shareholders.
iv. The stock exchange is important to the corporation only because it provides the
institutional framework through which new shares may be sold to the public.
v. Maximisation of shareholder utility is presumed when managers maximise possible
profit.
1 statement is true and 4 are false

4.2 The stock exchange

- Every time a listed company's shares are bought or sold, the company receives
funding statements about share markets is false
4.3 The primary market role of stock exchange
- The total number of equity raisings on the Australian Securities Exchange (ASX)
primary market over the past 20 years has increased.
- The greatest number of issues of equity capital on the ASX over recent years has
involved new floats.
- The number of listed companies in the ASX is approximately 2200
- The listing of new companies on an exchange such as the ASX is known as initial
public offerings.
- Commercial paper is NOT usually listed on the ASX
- An issue of new shares to the public must have a prospectus attached.
- From a company's viewpoint, the existence of an active, liquid, well-organised market
in existing shares encourages successful primary market issues.
- An initial public share offering represents the share market's primary role
- The primary market role of a stock exchange is to ensure the sale of new-issue
securities.
- A newly issued share. would you expect to buy on the primary market
- The company process that gives the shareholders the chance to change their
dividends into additional company shares is called rights issue.
- The distribution of extra shares by a company to all existing shareholders is called a
rights issue
- The selling of new shares to a selected number of institutional investors is called a/an
share placement.
- Compared with other forms of equity raisings, share placements can be quicker and
often cheaper.
- The basic role of a company underwriter about to list a new share issue on a stock
exchange is to purchase any unsold shares on issue.
- If the depth and liquidity of a share market is high, it means corporations may raise
funds at lower costs.
- The document drawn up by a company stating the terms and conditions of a public
share issue is called a prospectus.

4.4 The secondary market role of a stock exchange

- Secondary market can provide liquidity but do not raise new funds, make capital
raising in the primary market more attractive, help borrowers raise long-term funds.
- A characteristic of secondary markets for shares is that companies do not get funds
from the secondary market in shares.
- A well-developed secondary market is likely to aid in raising extra finance, help
manage risk exposures of investors, help with corporate agency problems.
- In relation to a share market the ratio of the value of turnover to market capitalisation
is called market liquidity.

4.5 The managed product and derivative product roles of a stock exchange
- If a stock exchange provides a market for the trade of specific share market-related
derivative products, the derivative products remove the share price volatility of stocks listed
on the stock exchange is generally incorrect
- Compared with an exchange-traded derivative product, over-the-counter derivative
products are discussed and agreed upon by the parties involved.
- Compared with an over-the-counter derivative product, exchange-traded derivative
products are standardised, involve margin calls, are not negotiated between the buyer and
seller of the contract.
- To protect their portfolio of shares from a possible share price fall, an investor could
buy a put option.
- The strategy of lowering risk exposure by holding a number of investments in a
portfolio is called diversification.
- In options markets, option premiums are paid by option buyers to sellers.
- The units of a listed REIT purchases property are generally illiquid is incorrect
- An investor holding an investment portfolio who purchases a put option is expecting
share prices to fall in the short term.
- The writer of a put option expects the share price to increase.
- If an investor buys a put option on shares he owns and then the price of the shares
rises, the investor has no obligation to exercise the option.
- A holder of a call index warrants benefits when the underlying index price increases
- A futures contract is a contract that provides a specified commodity or instrument to
be bought at a future date at a price decided today.

4.6 The interest rate market role of a stock exchange

- Units sold in a managed investment scheme that follows the performance of a
specified share market index are called exchange traded funds.
- A contract for difference is an agreement to exchange the difference between a
contract start and close values.
- A stock exchange may also list some debt issues of companies and governments.
This provision by a stock exchange is known as a/an interest rate market.
- Its main function is to serve as a primary market for debt issues statements, in regard
to the provision of an interest rate market by a stock exchange, is NOT correct
- Floating rate notes is often quoted on the Australian Stock Exchange (ASX)
- Examples of debt instruments listed on a stock exchange do NOT include promissory
notes.
- The corporate bond that pays a variable rate of interest based on interest rate
changes for a reference rate is a/an floating rate note.
- A clearing house is NOT used by the Australian Stock Exchange (the ASX) to
promote an efficient market

4.7 The trading and settlement roles of a stock exchange

- A security that pays a fixed dividend and usually converts to ordinary shares at a
future date is called a preference share.
- The Australian Stock Exchange, the ASX now operates a system known as ASX
Trade. At opening of trade, overlapping bids and offers are shared between existing orders
is correct in relation to ASX Trade
- ASX Trade provides a fair, efficient trading system, developing latency down to the 1
second are incorrec
- The Clearing House Electronic Subregister System (CHESS) is operated by the ASX.
Shareholders can still hold traditional share certificates regarding CHESS is incorrect
- Preference shares have a number of features similar to debt that distinguish them
from ordinary shares i. Cumulative or non-cumulative; ii. Convertible or nonconvertible; iii.
Redeemable or non-redeemable; iv. Issued at different rankings; v. Participating or non-
participating

4.8 The information role of a stock exchange

- The risk that arises from the failure of parties to complete and resolve a transaction is
called settlement risk.
- The probability that a party to a buy/sell transaction will not complete it is called
settlement risk.

4.9 The regulatory role of a stock exchange

- The reason for the requirement by the ASX for companies to abide by the
Corporations Act 2001 (Cwlth) is to ensure that information which may have a material
effect on the share price is provided to the market.
- The rules that apply to listed companies about promptly advising a stock exchange of
any material changes relating to the corporation are called continuous disclosure.
- Having regard to a number of high-profile situations where improper practices resulted
in share market volatility, losses to individual shareholders, and possible breaches of
existing legislation, the Commonwealth government transferred responsibility in 1991 for
the administration of Corporations Law to the Australian Securities and Investments
Commission.
- ASIC is the regulatory body responsible for the supervision of corporations law and
markets.
- The main supervisor in the Australian market is the ASX itself is incorrect
- To try to remove potential conflicts of interest with regard to the ASX monitoring listed
 companies, ASIC has also assumed the role of supervising the ASX.
- ASIC regulatory body has responsibility for supervision of real-time trading on
Australian domestic licensed markets, including the supervision of financial services licence
holders
- The major supervisors of the Australian share market are ASIC and ASX
- Funding that is provided to higher risk companies seeking equity funding (but are
unable to access equity funding through a public issue in the share market) is generally
called equity funding.

Key points Misunderstandings

- The corporate entity means that if a major - Shareholders of a public corporation have the
shareholder is declared bankrupt it does not right to participate in the profits and receive
necessarily impact on the firm's operations annual dividends
- When a shareholder first sells their shares on a stock - The shareholders of a public corporation do not
exchange this involves the secondary role of the participate directly in the day-to-day operation of
share market a company but appoint the executive
- A common measure of market liquidity is the ratio of management group to do so at the shareholders'
turnover to market capitalisation. general meeting
- The price of an equity-related derivative is directly - For a limited liability company the liability is
related to the price of the corresponding security on restricted to the debt holders of the company and
the stock exchange not the shareholders
- A growth maximisation strategy by
management always results in wealth
maximisation for the shareholders
- An active and well-organised secondary market
in existing shares benefits a company because it
receives an additional payment from the share
market

Chapter 5
5.1 The investment decision
• The objective of financial management is to maximise shareholder value. • Four
main aspects of financial management
1. Investment decision (capital budgeting)
2. Financing decision (capital structure)
3. Liquidity (working capital) management
4. Dividend policy decision

• This chapter focuses on the investment and financing decisions. • A corporation

first determines the assets in which it will invest funds according to organisational
objectives
1. Real assets; e.g. plant and equipment
2. Financial assets; e.g. equities, bonds.
• Competing investment alternatives should be evaluated on the basis of shareholder
wealth maximisation.
• Two important measures used to quantify the contribution of an investment to
shareholder wealth
1. Net present value (NPV)
2. Internal rate of return (IRR).

Net Present Value (NPV)

• The difference between the present value of cash flows associated with an
investment and the cost of the investment.
• The NPV decision rule
– Accept an investment that has a positive NPV; i.e. reject an investment with a
negative NPV.
• NPV (and IRR) influences:
– the accuracy of the forecasted cash flows
– the discount rate (required rate of return).

Internal Rate of Return (IRR)

• The required rate of return resulting in NPV = 0.
• The IRR acceptance rule
– Accept the investment if its IRR is greater than the firm’s required rate of return.
• Limitations of IRR
– Non-conventional cash flows
– Mutually exclusive projects

not choose the project with the highest NPV.

5.2 The financing decision

• The financing decision concerns the capital structure used to fund the firm’s business
activities.
• The financial objective of a corporation is to maximise return, subject to an
acceptable level of risk.
• Returns are generated from the net cash flows of the business.
• Risk is the uncertainty or variability of expected cash flows derived from: – business
risk
– financial risk.
• Business risk
– The level of business risk depends upon the type of operations of the business, i.e.:
• industry sector that influences the level of fixed versus variable
operating costs.
– Also affected by:
• sectoral growth rates
• market share
• aggressiveness of competitors
• competence of management and workforce.
• Financial risk
– Exposure to factors that impact on the value of assets, liabilities and cash flows.
– The level of financial risk of a company is borne by the security holders (debt and
equity).
– Financial risk categories
• Interest rate risk
• Risk of adverse movements in interest rates
• Foreign exchange risk
• Risk of adverse movements in exchange rates.
• Financial risk (cont.)
– Financial risk categories
• Interest rate risk
• Risk of adverse movements in interest rates
• Foreign exchange risk
• Risk of adverse movements in exchange rates
• Liquidity risk
• Risk of insufficient cash in the short term
• Credit risk
• Risk of default or untimely payments by debtors
• Capital risk
• Risk of insufficient shareholder funds to meet capital growth
needs or absorb abnormal losses
• Country risk
• Risk of financial loss owing to currency devaluation or
inconvertibility.

– D/E is the ratio of funds contributed by shareholders (equity) to funds borrowed

(debt).
– D/E indicates the risk of being unable to meet interest due and principal repayments
associated with use of debt, i.e. risk of insolvency.
– Earnings per share (EPS) is the net return on a company’s shares expressed in
cents per share (CPS)

shareholders on account of higher EPS.

risk of insolvency.
• What is the appropriate D/E ratio?
– Although there is no agreed ideal D/E ratio, factors influencing the D/E ratio in
practice are:
 estrictions placed on a
borrower specified in a loan contract

5.3 Initial public offering

• Initial public offering (IPO) is an offer to investors of ordinary shares in a newly listed
company on a stock exchange
– New share issuer must meet ASX listing requirements.
– The promoter appoints advisers (stockbroker, merchant bank, other specialists) and
possibly underwriters.
– Underwriters
he issue

allocation of securities.
• Initial public offering (IPO) is an offer to investors of ordinary shares in a newly
listed company on a stock exchange (cont.)
– Prospectus lodged with ASIC

securities to the public

– Out-clause
agreement
– Publicly listed corporation
• Ordinary shares: limited liability companies
– Major source of equity funding
– Shareholders have voting rights at general meetings.
– Shareholders’ voting rights may be transferred to a proxy.
– Shares usually sold fully paid, or can be partly paid (contributing basis) or paid by
instalment receipt.
– Instalment receipt

share.
specified amount at a future date, a fully paid share is issued in
place of instalment receipt.
– Shareholders’ liability is limited to the price of fully paid shares.
– Partly-paid shareholders have a contractual obligation to pay the remaining amount
when it is called or due.
• Ordinary shares: no-liability companies
– Used for highly speculative ventures
– Shares issued as partly paid
– Shareholders may decide not to meet future calls, in which case they forfeit the
partly paid shares

5.4 Listing a business on a stock exchange

• A company seeking to have its securities quoted on a stock exchange (i.e. to join the
official list) must comply with listing rules, which are additional to the corporations’
legislation obligations.
• A non-complying listed company can be suspended from quotation or delisted. •
Listing rule principles embrace the interests of listed entities, maintain investor
protection, and maintain the reputation and integrity of the market. Main principles of a
stock exchange’s listing rules include the following:
• minimum standards on quality, size, operations and disclosure
• sufficient investor interest required to warrant listing
• security issues must be fair to both new and existing holders
• rights and obligations attached to securities must be fair to both new and existing
holders.
• Main principles of a stock exchange’s listing rules include the following (cont.): •
prescribed information must be provided to the exchange on a timely basis • material
information that may affect security prices or investment decisions must be disclosed
immediately to the exchange
• disclosure of relevant information of a sufficiently high standard to investors • highest
standards of behaviour on the part of company officers.

5.5 Equity funding for listed companies

• Different forms of equity finance are available to established companies – Additional

ordinary shares

– Preference shares
– Quasi-equity

Rights issue
• Issue of ordinary shares to existing shareholders
• Issued pro rata, e.g. 1:5 or 1 for 5
• Factors influencing the issue price
– Company’s cash flow requirements
– Projected earnings flows from the new investments funded by the rights issue – Cost
of alternative funding sources
• Two types
– Renounceable—shareholder may sell their right
– Non-renounceable—right may not be sold
• Rights issued at a discount to current share price

Placements
• Additional new ordinary shares issued directly to selected investors (institutions and
individuals) deemed to be clients of brokers
• Not required to register a prospectus but a memorandum of information must be
prepared
• Minimum subscription $500 000 to not more than 20 participants
• Market price discount cannot be excessive
• Allows smaller discount and shorter time frame than rights issue
• Dilutes holding of non-participating shareholder

Takeover issues
• Acquiring company issues additional ordinary shares to owners of target company in
settlement of the transaction.
• Alleviates need for owners of acquiring company to inject cash for the purchase of
the company.
Dividend reinvestment schemes
• Shareholders have the option of reinvesting dividends in additional ordinary shares. •
Usually issued at a discount between 0% and 5%
• No brokerage or stamp duty payable
• In growth periods it allows companies to pay dividends and pass on tax credits, while
increasing equity.
• Schemes may be suspended in low growth periods.

Preference shares
• Classed as hybrid securities; i.e. they have characteristics of both debt and equity •
Fixed dividend rates are set at issue date.
• Rank ahead of ordinary shareholders in the payment of dividends and liquidation •
Include combinations of the following features:
cumulative or non-cumulative
redeemable or non-redeemable
convertible or non-convertible
participating or non-participating
issued with different rankings
• Advantages of preference shares
Fixed interest borrowings but they are an equity finance instrument
Assist in maintaining debt to equity ratio
Widen a company’s equity base, which allows further debt to be raised Dividends may
be deferred on cumulative shares and not paid on non-cumulative shares, while
interest on debt must be paid

Convertible notes
• Classed as a hybrid instrument, issued for a fixed term at a stated rate of interest,
either by direct placement or pro rata to shareholders
• Holder has right to convert the note into ordinary shares at a specified future date
and at a predetermined price.
• The option to convert to equity has value.
• If share price subsequently rises, then a gain is made.
• If share price falls, holder may not exercise conversion option and take the notes’
cash value.
• Interest paid on notes is usually lower than straight debt interest.
• Interest payments are tax deductible to the company.
• Notes are often issued for longer periods than is possible with straight debt
borrowings.

Company-issued options
• Provide the right, but not the obligation, to purchase shares at a stated price and date
• Allow companies to raise further equity funds at planned future dates (providing
holders exercise the option)
• Typically offered in conjunction with a rights issue or placement
• Issued free or sold at a price
• Generally have value and may be traded
• The option will be exercised if the exercise price is less than the market price of the
share at the exercise date.

Company-issued equity warrants

• Generally attached to corporate bond issues but may be issued unattached • Holder
has option to convert warrant into ordinary shares at specified price over a given
period
• Warrants may be detachable from the bond and traded separately
• No dividends but holders benefit from capital gains if share price rises above
conversion price

5.1 The investment decision: capital budgeting

- An investment decision differs from a financing decision in that an investment
decision first determines what assets the firm will invest in, while a financing decision
considers how the investments under consideration are to be funded.
- When a company decides to issue an unsecured note to pay for a new machine,
it has made a/an financing decision.
- The finance required by a company to fund its day-to-day operations is called
working capital.
- When a company decides to pay for an investment project using a short-term
bank loan, this is best described as a/an financing decision.
- The IRR is greater than the required rate of return is correct for an investment
proposal with a positive NPV
- Regarding project selection criteria based on IRR, a project will be considered
when IRR is lower than cost of capital.
- Problems associated with calculating an internal rate of return include negative
cash flows during the project's lifetime, choosing one project from two or more
projects, timing of cash flows.
- When a company's project results in a return and profits which exceed the cost of
its debt financing only the shareholders may share in the profits.
- For capital budgeting projects IRR can be misleading or wrong when the cash
flows change signs more than once.
- IRR is the discount rate that makes NPV equal zero best relates NPV and
IRR100.
- A firm is considering a project with an initial investment of $25 000 and cash
flows in the following three years (1–3) of $10 000, $12 000, $14 000. This sort of
project would be discounted at a 14 per cent rate. Should the project be funded. Yes
because the NPV is $2455.
5.2 The financing decision: equity, debt and risk
- Financial risk refers to the risk faced by the shareholders when debt is used.
- Increasing the financial leverage of a company will increase shareholders'
expected returns and increase their risk.
- If a corporation imports goods from overseas then an appreciation in the
exchange rate will adversely affect the company's profits is NOT correct
- When a business fails equity holders rank ahead of providers of debt due
to their higher financial risk is NOT correct
- A company's business risk depends on the risk of the company's
operations and assets.
- Industry norms, History of the ratio for the firm, Limit imposed by lenders,
The company's capacity to service debt would be determinants of the
appropriate ratio of debt to equity if a company should not take on more debt
than can be serviced under conservative economic forecasts
- Restrictions placed on borrowers by lenders in the loan agreement are
called loan covenants.
- An increase in a firm's level of debt will increase the variability in earnings
per share.
- The operating activities of companies in the banking and retail s ectors are
different. Compared with retail sector companies, banks have a high debt-to-
equity ratio.
- The claims of the equity holders on the assets of the firm have priority over
those of no other holder.
5.3 Initial public offering
- The common shareholders are sometimes referred to as the residual owners of
the corporation
- It gives them the right of a vote for each share they own is the function of a proxy
statement for a shareholder
- Dividends of ordinary shares are always tax deductible is NOT a feature of
ordinary shares
- Generally, an initial public offering (IPO) is an offer to potential investors of
ordinary shares to newly list a company on a stock exchange
- Common shareholders are not guaranteed a periodic distribution or a distribution
in the liquidation of the company.
- The party seeking the flotation of the company best describes the role or
function of the promoter of a flotation
- Potential investors learn of the information concerning the company and its new
issue through a prospectus sent by the broker.
- As part of the listing process for an unlisted organisation, a document that
provides detailed information on the past and forecast performance for it is a
prospectus.
- When a company undertakes an initial public offering (IPO) it may issue and list
shares in the primary share market.
- Compared with raising debt through a bank, the raising of equity through an initial
public offering (IPO) for a firm is generally preferred.
- The distinction between an initial public offering (IPO) and seasoned equity
offering is best described by An IPO is an offer to investors of ordinary shares in a
newly listed company on a stock exchange, A seasoned equity offering is an offer to
both existing and new investors through right issue, private placement and dividend
re-investment scheme, A seasoned equity offering is considered when an existing
publicly traded company considers raising additional capital by selling additional
shares of its securities to the public
- A financial institution involved in underwriting the sale of new securities by buying
them from the issuing firms and then reselling them to the public in the primary capital
market is an investment banker.
- To invest the funds raised in the offering is NOT a role of an underwriter in a
public offering of shares
- If, for an IPO, circumstances change and the issue becomes unattractive, the
underwriters may purchase unsubscribed shares.
- If, for an IPO, market prices have fallen, then underwriters with an out-clause that
gives a level of a specified price index that the index cannot fall below, then the
underwriters may be released from their obligations.
- Ordinary shares in limited liability companies are the major source of external
equity funding for Australian companies. No liability company can issue shares only
on a fully paid basis because of the risk is NOT correct
- Companies can raise equity capital through internal sources of capital and the
share market.
- A person who is authorised to vote on a shareholder's behalf is called a proxy.
- A no liability company may also offer shareholders an option to sell
shares back to the company if the company exploration is not successful is
NOT correct
- Financing for high-risk companies is often in the form of no-liability
shares.
- The underwriter in an initial public offering probably has the biggest risk
because of he obligation to buy up the unsold share.
5.4 : Listing a business on a stock exchange
- The company must issue a prospectus that is to be lodged with the ASX
does NOT apply to a company seeking a public listing on the Australian
Securities Exchange (ASX)
- Most publicly listed companies raise funds by selling their securities in a
public float.
- Some of the main principles that form the basis of a stock exchange's listing
rules are security holders must be consulted on matters of significance except for
agreements between the entity and related parties.
5.5 Equity-funding alternatives for listed companies
- A company may seek to raise further funds by issuing additional ordinary
shares. The terms and conditions of the new share issue are determined by
the board of directors in consultation with its financial advisers and others and
having regard to the preferences of existing shareholders and the needs of the
company. The discount to current market price that can be offered to
shareholders is LEAST likely to be a determinant of the price that is eventually
struck
- A rights offering is the issue of an option to purchase shares directly to the
shareholders.
- A company may raise additional equity capital through a rights issue, a
placement, a dividend reinvestment scheme.
- A right that can only be exercised by the shareholder and not sold is
called a non-renounceable right.
- Before making a rights issue, a company's management must consider
several important variables.The effect on the firm's profits is NOT one of these
variables
- The subscription price in a rights offering is generally below the current
share price.
- No expiration date is generally NOT a characteristic of rights
- A pro-rata share rights offer means that the offer must be made to
shareholders on the basis of the number of shares already held
- A pro-rata share rights offer of 1:5 gives existing shareholders the right to
purchase one share for every 1/5 shares held.
- For a share placement or private placement, the Australian authority ASIC
requires a memorandum of information to be sent to all participating
institutions.
- For a share placement, the Australian authority ASIC or ASX listing rules
require the discount from market price must not be above 50 per cent.
- Share placements may, subject to compliance with certain regulations, be
made to institutional investors. Under no circumstances should placements be
in excess of 10 per cent of the issued shares permitted is NOT a requirement
of the Australian authority ASIC for share placements
- If a company raises equity funds by issuing shares to a selected number
of institutional investors, this is known as a placement.
- Compared with a pro-rata issue of shares, placements usually can be
carried out much more quickly.
- The main advantage of placements or private placement to raise
additional equity funds compared to a rights issue is it reduces the proportion
of ownership by existing shareholders.
- When a takeover company issues additional shares to fund the
acquisition of the shares in a target company this is called an equity-funded
takeover.
- Companies have encouraged shareholders to use dividend reinvestment
plans does NOT apply to a dividend reinvestment plan
- The shareholders can redeem shares for dividends is NOT a feature of a
dividend reinvestment scheme for a company
- A dividend reinvestment plan generally increases the return on the
security.
- Dividend reinvestment schemes are a significant source of equity for
many Australian companies. Such schemes allow dividends to be paid while
retaining cash for future growth may, at times, also be regarded as a
disadvantage
- Preferred shareholders are promised a fixed periodic dividend, the payment of
which must be paid before that of ordinary shares.
- Any unpaid dividends that must be paid before payment of dividends to ordinary
shareholders are called cumulative preference shares.
- A company is likely to issue preference shares if it has reached its optimal
gearing level.
- Holders of participating preference shares are entitled to dividend payments
beyond the stated dividend rate.
- A preference share issue offers flexible dividend policy, fixed interest borrowings
that can count as equity, extension of the equity base of the company advantages to a
company except an indefinite maturity.
- An important source of company funding is NOT a feature of preference shares
- Preference shares have their dividend fixed at the issue date.
- Preference shares have a number of features similar to debt that distinguish
them from ordinary shares. Cumulative or non-cumulative, Convertible or non-
convertible, Redeemable or non-redeemable , Issued at different rankings,
Participating or non-participating may be incorporated in a preference share issue
- Convertible preference shares are normally converted into shares.
- Compared with ordinary shares, preference shares usually have dividends set at
issue.
- A convertible note is a/an debt instrument that the holder has the option to
convert into an initially specified number of shares.
- Maturity of convertible notes is usually shorter than straight debt instruments is
NOT a feature of convertible notes
- Convertible notes offer a higher interest rate than straight debt instruments is
NOT a feature of convertible notes
- An advantage of a convertible security for a company is that it can generally be
sold with interest rates unrelated to other non-convertible debt securities.
- The buyer of a convertible security accepts a lower rate of interest because of
the possibility of becoming a shareholder in the future.
- When a convertible security is issued, the issue price is usually close to the
current market price of the company's share.
- There is an increase in financial leverage upon conversion is NOT an advantage
for a company that issues a convertible note
- A company is advised to issue convertible notes. They are advised of the
conditions applicable to the convertible note issue. The holder of the note has the
right to convert the note into preference shares is NOT correc
- A convertible note is a hybrid fixed-interest debt security that gives the holder an
option to convert to ordinary share at specified date, A preference share is considered
a hybrid security that pays a fixed divided payment and offers the right to convert to
ordinary shares at a future date, Convertible notes and preference shares possess
characteristics of both debt and equity.are true for convertible notes and preferences
- Compared with straight debt, convertible notes may offer a company lower
borrowing costs.
- When a company wants to increase the marketability of a rights issue, it may
offer options attached.
- When warrants are converted by a holder only the number of shares increases.
- There is no certainty that the future funds from the exercise of the option will
eventuate is NOT an advantage for a company that sells a company-issued option
with a rights issue
- Dividends for warrants are usually lower than for ordinary shares is NOT correct
- It is considered a quasi-equity issue is NOT correct
- An equity warrant gives the holder an option to purchase a specified number of
shares at a predetermined price over a given period
- It has no expiration date for the exercise is NOT correct
- A warrant holder receives dividend payments over the life of the warrant is NOT
correct
- A warrant holder receives a dividend, unlike a rights holder is NOT correct
- Because company-issued equity warrants are attached to a bond they have no
value is NOT correct
- A right and a warrant both have similar maturities is NOT a similarity between a
right and a warrant
- The company must lodge a prospectus with the ASX on an annual basis does
NOT apply to a company seeking a public listing on the ASX
- The internal relationship between shareholders, the board of directors and the
managers of a company is called corporate governance.
 - The placement of ordinary shares has this advantage money can be raised in a
short time.
- Financial risk is higher when the debt-to-equity ratio is higher. Payment to
creditors is obligatory, and payment to shareholders is not obligatory.
- For listing on the ASX a firm must meet a number of criteria. Among them are
continuous disclosure, either profits test or assets test.
- Preference shares may be cumulative, which requires the payment of dividends
in the current year and unpaid dividends from prior years before ordinary shareholders
can receive a dividend in the current year.
- Criteria would be determinants of the appropriate ratio of debt to equity if a
company should not take on more debt than can be serviced under conservative
economic forecasts: ii. Industry norms; iii. History of the ratio for the firm; v. Limit
imposed by lenders; vi. The company's capacity to service debt

Key points Misunderstandings

- A placement occurs where a company offers - The investment decision for a corporation
additional shares to select institutional investors involves the types of securities it is going to issue
- Limited liability shares are generally sold to or invest in
investors on a fully paid basis - In consultation with a company, the promoter
- A pro-rata offer of rights to existing (an investment bank) will seek flotation of the
shareholders must be accompanied by a company shares
prospectus - Financial risk refers to risks arising from the
- If the calculated IRR on an investment different types of debt securities issued by a
proposal is greater than the required rate of company
return, the company should proceed with the - A low debt-to-equity ratio for a company
project means that a rise in interest rates will not affect the
- The main objective of a business variable rate debt issued by the company
corporation is the maximisation of shareholder - Business risk is determined in part by a
value corporation's choice of business activity and the
- If a listed company violates the listing rules manner in which it has financed those activities
of the stock exchange, the company is likely to - A principal objective of a business
be delisted organisation is the maximisation of its profits
- A company's debt-to-equity ratio is
determined in practice with reference to four
main criteria and not by finance theory

Chapter 6
6.1 Share-market investment

• Investors buy shares to receive returns from dividends and capital gains (losses). • Other factors
encouraging investment in securities quoted on a stock exchange (SX) – Depth of the market
ations listed on an SX
– Liquidity of the market

– Efficient price discovery

• The SX offers a wide range of security types to the investor.

• Securities listed on the SX are categorised into industry groups, allowing investors a choice from a
range of economic sectors.

• Two types of risk impact on security returns

– Systematic risk

in interest rates and exchange rates – Unsystematic risk

technology failure, board problems

• Diversified investment portfolio

– A portfolio containing a wide range of securities
–
higher returns for unnecessarily bearing unsystematic risk
–
sensitivity of the price of an asset relative to the market
– Expected portfolio return is the weighted average of expected returns of each share
– Portfolio variance (risk) is the correlation of pairs of securities within the portfolio.

• Investors may take one of two approaches

– Active investment approach
nd risk return preferences
– Passive investment approach
-market index, e.g. industrial or
telecommunications sector index
• Some managed funds are index funds
– Portfolios are structured to fully or partially replicate a specific share-market index

• Investors need to consider asset allocation within a share portfolio

international shares.
• Asset allocation may be:

6.2 Buying and selling shares

• Direct investment in shares
– Investor buys and sells shares through a stockbroker
-service advisory broker
– Consideration of liquidity, risk, return, charges, taxation, social security, etc. •
Indirect investment in shares
– Investor purchases units in a unit trust or managed fund, e.g. equity trusts 6.3

Taxation

• Pre-dividend imputation (prior to 1987)

– Dividends were taxed twice—first at company level (as profits) and then at the
investor’s marginal rate
• Dividend imputation (since 1987)
– Removed the double taxation of dividends
– Investors receive franking credit for the tax a company pays on a franked
dividend
• Capital gains tax
on shares
purchased
– Prior to 19/9/1985 tax free
– 19/9/1985–21/9/1999

ate applied to indexed capital gain if held over 12

months
– Since 21/9/1999
– 21/9/1999

6.4 Financial performance indicators

• Potential investors are concerned with the future level of a company’s

performance. • Company’s performance affects both the profitability of the company
and the variability of the cash flows.
• Indicators of company performance
– capital structure
– liquidity
– debt servicing
– profitability
– share price
– risk.

Capital structure

• Proportion of company assets (funding) obtained through debt and equity –

Usually measured by debt to equity ratio (D/E)
isk; i.e. firm may not be able to meet
interest payments.
– Also measured by proprietorship ratio, which is the ratio of shareholders’ funds to
total assets
less reliance on external funding.

Liquidity

• The ability of a company to meet its short-term financial obligations • Measured by

current ratio
– Fails to consider the not very liquid nature of certain current assets, such as
inventory
• Measured by liquid ratio
• The higher the current and liquid ratios, the better the liquidity position of a firm.
Debt servicing
• Ability to meet debt-related obligations, i.e. interest and repayment of debt •
Measured by debt to gross cash flow ratio
– Indicates number of years of cash flow required to repay total firm debt •
Measured by interest coverage ratio

Profitability
• Wide variation in the measurement of profitability
– Earnings before interest and tax (EBIT) to total funds ratio
– Earnings per share (EPS)

• Wide variation in the measurement of profitability (cont.)

– EBIT to long-term funds ratio
• Wide variation in the measurement of profitability (cont.)
– Return on equity (net income/equity)
– Higher ratios indicate greater profitability
Share price

• Represents investors’ view of the present value of future net cash flows of a firm •
Share price performance indicators
–
– Price to earnings ratio (P/E)

– Share price to net tangible assets ratio (P/NTA)

’s share price is
trading relative to its NTA

Risk

• Variability (uncertainty) of the share price

• Two components
1. Systematic risk (often referred to as beta)
domestic economy and world economy
2. Non-systematic risk
-specific factors, e.g. management competence, labour
productivity, financial and operational risks
-diversified portfolio

6.5 Pricing of shares

• Share price is mainly a function of supply and demand for a share – Supply and
demand are influenced mainly by information.
– Share price is considered to be the present value of future dividend payments to
shareholders.
– New information that changes investors’ expectations about future dividends will
result in a change in the share price.
• Cum-dividend and ex-dividend
– Dividends are payments made to shareholders, expressed as cents per share. –
Dividends are declared at one date and paid at a later, specified date. – During the
period between the two dates, the shares have the future dividend entitlement
attached, i.e. cum-dividend.
– Once the dividend is paid the shares are traded ex-dividend.
– Theoretically, the share price will fall on the ex-dividend date by the size of the
dividend

Example:
Share price cum-dividend $1.00
Dividend paid 0.07
Theoretical ex-dividend price 0.93

• Bonus share issues

– Where a company has accumulated reserves, it may distribute these to existing
shareholders by making a bonus issue of additional shares.
– As with dividends, there will be a downward adjustment in share price when
shares go ex-bonus.
– As no new capital is raised, there is no change in the assets or expected
earnings of the company

—If a bonus 1:4 issue is made:

Cum-bonus price $5.00
Market value of 4 cum-bonus shares $20.00
Theoretical value of 5 ex-bonus shares $20.00
Theoretical value of 1 ex-bonus share $4.00

• Share splits
– Involves division of the number of shares on issue
– Involves no fundamental change in the structure or asset value of the company
– Theoretically, the share price will fall in the proportion of the split
Example—5 for 1 split:
Pre-split share price $50.00
Theoretical ex-split share price $10.00

• Pro-rata rights issue

– Involves an increase in the company’s issued capital
– Typically issued at a discount to market price
– Theoretically, the market pr
of shares issued

– Example—market price cum-rights $1.00, with 1:5 rights issue priced at $0.88:
Cum-rights share price $1.00
Market value of 5 cum-rights shares 5.00
Plus new funds from 1:5 issue 0.88
Market value of 6 ex-rights shares 5.88
Theoretical ex-rights share price (5.88/6) 0.98

• Pro-rata rights issue (cont.)

–
of the right is determined by
6.6 Stock-market indices and published share information

• Stock-market indices
–
Performance benchmark index
• Measures overall share-market performance based on
capitalisation and liquidity
• A narrow index used as the basis for pricing certain derivative
products
• Measure of overall share-market performance
• Market indicator indices
– Price-weighted, e.g. Dow Jones
– Capitalisation-weighted, e.g. S&P/ASX All Ords

– Share-price index measures capital gains/losses from investing in an index

related portfolio
– Accumulation index includes share price changes and reinvestment of dividends
– Global industry classification standard (GICS) comprises 10 standard
international industry sector indices; e.g. energy, materials, industrials. • Published
share information
– Newspapers and financial journals provide share-market information to varying
degrees of detail; e.g. Australian Financial Review.

6.1 Share market investment

Fund managers often adopt either passive investment strategies, active management
strategies or the combination of both.
In the context of investment environment, passive investment means building a portfolio of
shares based on the strategy of Replicating a market index. -
Typically, a large stock exchange such as New York Stock Exchange (NYSE) and
Australian Securities Exchange (ASX) has preference shares, shares, exchange-traded
funds listed on it
Compared with fixed interest securities, shares may offer Periodic dividends and capital
gains at higher risk.
It is commonly accepted view that a portfolio is generally considered well diversified if it
includes about 10-25 stocks.
According to portfolio diversification principle, an investment portfolio that is well-diversified
contains A large range of shares, fixed-income securities and properties.
A diversification is considered most effective if it includes a pair of assets that have A
lowest correlation.
A diversified portfolio containing negatively correlated investments has a lower variance
than a portfolio containing a single asset type is true for the formation of a diversified
portfolio
Systematic risk refers to Risks that have an impact on the majority of shares in the market.
The risk that impacts specificially on the share price of a particular company is called
unsystematic risk
Introduction of new company legislation is an example of systematic risk exposures for a
company
Change in future performance forecast for a company is an example of an unsystematic
risk exposure for a company
When investors buy and sell shares based on receiving new information on shares and
markets, this is known as Active investment.
To track the S&P500, a fund manager can buy all the stocks in the S&P500, an S&P500
index fund,a percentage of stocks that essentially tracks the index. .
The correlation of pairs of securities within a portfolio is called: Covariance.
The correlation coefficient between two shares can take on positive values, can take on
negative values, is related to the covariance of a share.
For a portfolio of stocks, the diversification benefit of the portfolio risk is based on: a
weighted average of the covariance of the stocks in the portfolio.
When an investor alters the mix of their portfolio allocation to reflect market changes or
their circumstances, this is called tactical asset allocation.
For an investor, the mix of shares that satisfies their known cash-flow requirements, risk
tolerance and future life cycle positions is called Strategic asset allocation
Stockbrokers act as agents for an exchange.
A diversified portfolio: reduces unsystematic risk.
CEO scandal is NOT an example of a systematic risk
financial ratio provides information essential for assessing the long-run operation of the
company is debt
A diversified portfolio generally includes: 10-25 stocks

6.2 Buying and selling shares

Major differences between a discount stockbroker and a full-advisory stockbroker lie in the
level of fees, the amount of advice given, the quantity of share recommendations..
Full-advisory stockbrokers' fees are competitive with discount brokers does NOT apply to
full-advisory stockbrokers
There are many forms of investing. When an investor purchases unit in a unit trust, this is
considered as indirect investing.
When an investor puts an order to buy shares through their stock broker via their internet
share account, this is called Direct investment.
An investor is generally required to pay taxation on the final dividend payment statements
regarding dividends is NOT correct

6.3 Taxation
- There are two forms of tax system, a conventional and an imputation system.
Dividend imputation is best described as Encouraging investment and growth in the share
market.
- In relation to dividend imputation, a shareholder whose marginal tax is lower than the
company tax rate will pay their marginal tax on the dividend received is NOT correct
- Consider the following five statements:
i. The expected return of a portfolio of shares is the weighted average of the expected
returns for each share.
ii. All other things being equal, a cum-dividend share price should fall by the amount of a
dividend that is paid.
iii. One of the effects of dividend imputation is the removal of ‘double taxation' of company
profits that are distributed as dividends.
iv. For a shareholder with a marginal tax rate that is lower than the company tax rate, no
tax will be payable on the fully franked dividend received, and the excess credit can be
applied against other assessable income.
v. In a one-for-nine bonus issue, if the cum-bonus price was $10, then the theoretical
exbonus price would be $9.
I, ii, iii, iv statements are true and v is false
- Consider the following five statements:
i. The expected return of a portfolio of shares is the weighted average of the expected
returns for each share.
ii. All other things being equal, a cum-dividend share price should fall be the amount of a
dividend that is paid.
iii. One of the effects of dividend imputation is the removal of ‘double taxation' of company
profits that are distributed as dividends.
iv. For a shareholder with a marginal tax rate that is lower than the company tax rate, no
tax will be payable on the fully franked dividend received, and the excess credit can be
applied against other assessable income.
v. In a one-for-nine bonus issue, if the cum-bonus price was $10, then the theoretical
exbonus price would be $9.
i, ii, iii and iv are true and v is false
Australian personal income taxation exhibits: increasing marginal tax rates as income
increases and the elimination of double taxation of dividends.
- Company shares are priced at $13.45. The company announces a share split of 3 for
2. The new share price should be $8.97.
A firm has recently paid dividend per share of $1.20. The dividend is expected to grow at the
rate of 5 per cent per annum. If the minimum rate of return required by an investor for that
share is 10 per cent, the real value of the stock is $25.20.
An analyst estimates that the Seraphim Company will be able to increase its dividends at a
2.5 per cent rate indefinitely. The current annual dividend is $3, and the required rate of
return is 12 per cent. $32.37 is the value of a share using the dividend growth model

6.4 Financial performance indicators

The capital structure of a company is one of the important indicators of performance. The
capital ratios of companies, and industry groupings, are generally similar statements
regarding capital structure is NOT correct
Compared with a company's current ratio, the shareholders' interest ratio gives information
about a company's long-term viability
Inventories are current assets of companies
Bank overdraft facility are current liabilities of a company
- The major objectives of financial ratios are to evaluate the current state of the firm’s
operations, show the relative strengths and weaknesses of a company as compared to
other firms in the industry and leading firms in the industry, help to show whether the firm’s
position has been improving or deteriorating.
- The greater the proportion of debt financing compared with equity financing for a
company the greater the degree of financial risk for the company.
- A company with a higher ratio of equity to debt is less dependent on external
financing
- The indicator ratio that should be used to assess a company's ability to meet its
short-term obligations is its liquidity.
- A dividend is declared on 1 November, has a cum-dividend date of 19 November and
a record date of 26 November, shareholders will NOT receive the dividend on 29
November
- An example of a liquidity ratio for a company is the current ratio
- Liquid ratio is a measure of liquidity that excludes inventories
A company has a higher current ratio than the industry average. This implies that the
company is more likely to avoid insolvency in the short term than other companies in the
industry.
When using indicators for a company's performance all of the given are correct
If a company has a current ratio of 2, Paying off a short-term bank advance with long-term
debt measures will increase the current ratio
If a company has a current ratio of 0.9, in order to improve its current ratio it might use
more long-term debt to decrease current liabilities.
If a company has a liquid ratio of 0.9, in order to improve its liquid ratio it might increase its
large amounts of accounts receivable to improve its cash position.
The shareholders' interest ratio is an indicator of the longer term viability and stability of a
company.
Debt ratio provides information essential for assessing the long-run operation of the
company
The financial ratio that indicates the number of years required for a company to repay its
total debt is debt to gross cash flow.
The financial ratio that measures operating profit after tax to shareholders funds is Return
on equity.
Compared with a company's interest cover ratio, earnings before interest and tax
measures its profitability.
Liquidity and profitability provide information on the short-run operation of the company
Debt to equity ratio links long-term funds provided by the company's owners and those of
the creditors
Liquidity ratio is used to measure a company's ability to meet its short-term financing
Interest cover ratio measures a company's ability to service its interest commitment
The higher the value of the Liquidity ratio, the better able the firm is to meet its short-term
financial obligations.
The price/earnings ratio is an indicator of investors' evaluation of a company's future
earnings potential.
The following is a simplified financial position statement for a company: Assets $ Liabilities
$ Cash 250 000 Accounts payable 1 480 000 Trading securities 350 000 Accrued
expenses payable 420 000 Accounts receivable 1 360 000 Taxes payable 140 000
Inventory 2 470 000 Long-term debt 3 850 000 Property 3 350 000 Shareholders' funds 2
340 000 Equipment 450 000 Calculate the liquidity ratio. 0.96
The lower the interest cover ratio, the greater the company's ability to cover interest
commitments statements regarding the debt servicing capacity of a company is NOT
correct
If a share currently sells for $20 and has annual earnings per share of 2.0, the
price/earnings ratio is: 10.0
The price/earnings ratio is an indicator of the share market's evaluation of a company.
Systematic risk is also referred to as market risk.
The risk that affects the whole market is called systematic risk.
According to modern portfolio theory, investment risk is divided into two components:
systematic risk and unsystematic risk.
Increase in the corporate tax rate is an example of systematic risk
Increased competition, increased costs of labour and lawsuits are all examples of
unsystematic risk.
Changes occur in the level of company tax rates is NOT an example of unsystematic risk
for a company
Estimating systematic risk involves comparing the price history of a particular share
relative to movements on the overall market index. an average
The higher the beta of a share the greater the systematic risk.
A stock with a beta of 1.25 will move more than a stock with a beta of 1.25 about beta
coefficient is NOT correct
$31.25 should be the price of a share with a constant dividend of $2.50, if the growth rate
is zero and the required rate of return is 8 per cent per annum
$26.00 should be the price of a share if it paid $1.75 in dividends in the last financial year,
its dividend growth rate is 4 per cent, and the required rate of return is 11 per cent
Return on equity measure takes interest and taxes into account
A company whose earnings are likely to grow fast will likely have a high P/E ratio,
especially if the P/E ratio is based on historical earnings.

6.5 Pricing on shares

The majority of companies pay dividends twice a year to their shareholders.
When a share goes ex-rights, assuming everything else remains the same, its price should
decrease, as the shareholder is losing an option.
After a company has made an announcement about a forthcoming dividend, then at a
specified date when the share begins to trade ex-dividend the seller of the share will
receive the next dividend payment. the seller of the share will receive the next dividend
payment.
When a share is trading for a period with a cash dividend entitlement, then the share is
said to trade: cum-dividend.
If a dividend is declared on 1 November, has a cum-dividend date of 19 November and a
record date of 26 November, a buyer of the share on 29 Novemberwill NOT receive the
dividend
On the day that a share goes ex-dividend, the price should theoretically decrease by the
extent of the dividend.
The decision to pay cash dividends to shareholders is made by the board of directors.
A company declares a dividend of 35 cents per share, which was payable on 14
September. Immediately prior to the declaration of the dividend, the share price was $4.79.
At the close of trading on the stock exchange on 13 September, the share price was $5.44.
$5.09 is the theoretical ex-dividend price of the share
A rights issue differs from a bonus issue of shares in that the purpose of a bonus issue for
 a company is not to raise more funding.
If a company offers a 1 for 4 bonus issue this means for every one share a shareholder
owns they get four extra shares statement about bonus shares is NOT correct
When shares are purchased cum-rights it means the purchaser of the share may take part
in the rights offer.
For a company, a rule of thumb for the interest cover financial ratio is in the range: 1 to 2
A company recently announced renounceable offers that give eligible shareholders the
right to purchase the shares of the company at an issue price of $10.00 per share for every
five shares they hold. If the cum-right shares are priced at $12.00, the value of right is
given as $1.667
If a company offers a one-for-five bonus issue and the current share price cum-bonus is
$7.50, the theoretical value of each share ex-bonus is $6.25
A company whose share is selling for $24 announces a stock split of four-for-three. There
will be one-third more shares on issue and they will sell for $18 is correct
A company whose shares are currently trading at $3.60 proposes to have a 25 per cent
split; that is, four new shares for one existing share. At the commencement of the next
business day, a dividend of 25 cents is paid on existing shares, followed immediately by
the share split. $0.90 is the theoretical price of the new shares
Share market participants can regard a bonus issue favourably because they take it as a
signal from the company of increased future profitability.
An investor holds 100 shares of a company that is about to make a bonus issue of five
shares for every two held. If the shares are currently trading for $2.50, $250 will be the
value of the holding after the bonus issue
The current market price of a stock is $3.00. The rights issue is one-for-ten, priced at
$2.80. Calculate the theoretical ex-rights price. $2.98
To try to improve the liquidity of shares is an aim of a stock split
There is No change in the capital structure of a company after a share split
Share market participants can regard a rights issue favourably because a rights issue
increases the equity/debt ratio, and so reduces financial risk.
When a share price of a company has increased hugely compared to the prices of most
other shares on the exchange and its liquidity has decreased, the directors may decide to
split the number of shares on issue. 6.06
The S&P/ASX All Ordinaries share price index represents: changes in aggregate share
market values of the largest 500 companies.
According to the text, a tradable benchmark: may be a performance benchmark index but
with a narrower focus upon which some derivative contracts are priced. BH Mining
declared a 70 per cent partly franked dividend of $0.70 per share. The company pays a
corporate tax rate of 30 per cent. If a shareholder holds 100 shares of BH Mining and the
shareholder’s marginal tax rate is 37 percent, the tax payable by the shareholder is $7.00
The typical sequence for dividends is: announcement, cum-dividend, ex-dividend, dividend
payment.

Key points Misunderstandings

- One of the major objectives of continuous - Efficient price discovery means that share
disclosure for listed companies under ASIC’s information is disclosed at the lowest possible
guideline is to ensure that companies take transactions cost
practical steps to improve investors’ access to - If investors alter the mix of shares in their
companies’ information. portfolios as the share market suddenly falls they
- A change in foreign exchange rates are using a strategic asset allocation approach to
is a systematic risk that affects the bulk of investing
shares listed on a stock exchange - Historically, Australian banks have
- The level of beta indicates how had low EPS ratios compared with the
sensitive a share return is to changes in retail sector because of the amount of
overall market movement. lending they do.
- If two assets are negatively - Continuous disclosure rules of a stock
correlated this means their prices move exchange mean that listed companies must
in opposite directions disclose any material information continuously
- A company's ability to meet short- every hour.
term financial obligations is an important - Passive investment involves building an
financial performance indicator for an investment portfolio based on shares that are less
investor. risky than the overall share market.
- A share that has a beta of 0.5 is half as - When a share is trading cum-dividend, this
risky as the average share listed on the share means the seller of the share will receive the
market. dividend payment.

Chapter 8
8.1 Simple interest

• Introduction
– Focus is on the mathematical techniques for calculating the cost of
borrowing and the return earned on an investment.
– Table 8.1 defines the symbols of various formulae.
– Although symbols vary between textbooks, formulae are consistent
• Simple interest is interest paid on the original principal amount borrowed or invested.
– The principal is the initial, or outstanding, amount borrowed or invested. – With
simple interest, interest is not paid on previous interest.

Simple interest accumulation

• The amount of interest paid on debt, or earned on a deposit is:

where:
• A is the principal
• d is the duration of the loan, expressed as the number of
interest payment periods (usually one year)
• i is the interest rate, expressed as a decimal

• Example 1: If $10 000 is borrowed for one year, and simple interest of 8% per annum
is charged, the total amount of interest paid on the loan would be:
I=A d i
= 10 0
 = $800
• Example 2: Had the same loan been for two years the total amount of interest paid
would be:
I
= $1600

• The market convention (common practice occurring in a particular financial market) is

for the number of days in the year to be 365 in Australia and 360 in the US and the
euromarkets.
• Example 3: If the amount is borrowed at the same rate of interest but for a 90-day
term, the total amount of interest paid would be:

I
= $197.26

• The final amount payable (S) on the borrowing is the sum of the principal plus the
interest amount.
• Alternatively, the final amount payable can be calculated in a single equation:

S=A+I
= A + (A n i)
S = A[1 + (n i)]

• The final amounts payable in the three previous examples are:

– Example 1a:
S
– Example 2a:
S = 10 000 [1 + ( 2

Present value with simple interest

• The present value is the current value of a future cash flow, or series of cash
flows, discounted by the required rate of return.
• Alternatively, the present value of an amount of money is the necessary
amount invested today to yield a particular value in the future.
– The yield is the effective rate of return received.

• Equation for calculating the present value of a future amount is a re-arrangement

of Equation 8.2
Calculation of yields

• In the previous examples, the return on the instrument or yield was given. •
However, in other situations it is necessary to calculate the yield on an instrument
(or cost of borrowing).

i = 365 x I
dA
• Example 7: What is the yield (rate of return) earned on a deposit of $50 000 with a
maturity value of $50 975 in 93 days? That is, this potential investment has a
principal (A) of $50 000, interest (I) of $975 and an interest period (d) of 93 days.

i = 365 x $975
93 $50 000

= 0.07653

= 7.65%

Holding period yield (HPY)

• HPY is the yield on securities sold in the secondary market prior to maturity –
Short-term money market securities (e.g. T-notes) may be sold prior to maturity
because:
-term management of surplus cash held by
investor

• HPY is the yield on securities sold in the secondary market prior to maturity (cont.)
– The yield to maturity is the yield obtained by holding the security to maturity. –
The HPY is likely to be different from the yield to maturity.
y pays no interest but is sold today for less than its face value,
which is payable at maturity, e.g. T-note.

• The HPY will be:

– greater than the yield to maturity when the market yield declines from the yield at
purchase, i.e. interest rates have decreased and the price of the security increases
– less than the yield to maturity when the market yield increases from the yield at
purchase, i.e. interest rates have increased and the price of the security
decreases.

8.2 Compound interest

Compound interest accumulation (future value)

• When an amount is invested for only a small number of periods it is possible to

calculate the compound interest payable in a relatively cumbersome way
(illustrated in Example 10 in the textbook).
• This method can be simplified using the general form of the compounding interest
formula:
S = A(1 + i)n
• Applying Equation 8.6 to Example 10:
S = 5000 (1 + 0.15)3 = $7604.38

• On many investments and loans, interest will accumulate more frequently than
once a year; e.g. daily, monthly, quarterly
 – Thus, it is necessary to recognise the effect of the compounding frequency on
the inputs i and n in Equation 8.6.
– If interest had accumulated monthly on the previous loan, then:
i = 0.15/12 = 0.0125 and n 12 = 36

• Example 11a: The effect of compounding can be further understood by

considering a similar deposit of $8000 paying 12% per annum, but where interest
accumulates quarterly for four years:
I = 12.00 % p.a. / 4
= 0.03
and:
n=4
so:
S = 8000(1 + 0.03)16
= 8000(1.604706)
= $12 837.65

Present value with compound interest

• The present value of a future amount is the future value divided by the interest
factor (referred to as the discount factor) and is expressed in equation form as: A =
S
(1 + i)n
A = S(1 + i)-n

Present value of an ordinary annuity

• An annuity is a series of periodic cash flows of the same amount

– Ordinary annuity—series of periodic cash flows occur at end of each period
(Equation 8.8)
A = C [ 1 – (1 + i) -n ]
i

Present value of an annuity due

• Annuity due—cash flows occur at the beginning of each period (Equation 8.9) A =
C [ 1 – (1 + i) -n ] (1 + i)
i
Present value of a Treasury bond

• Equation 8.10 is used to calculate the price (or present value) of a corporate bond A = C [ 1 – (1 +
i) -n ] + S(1 + i)-n
i

• Example 16 in the textbook illustrates the application of Equation 8.10.

Accumulated value of an annuity (future value)

• The accumulated (or future) value of an annuity is given by Equation 8.11 S = C [ (1 + i) n

-1]
i

Effective rates of interest

• The nominal rate of interest is the annual rate of interest, which does not take into account the
frequency of compounding.
• The effective rate of interest is the rate of interest after taking into account the frequency of
compounding.

• The formula for converting a nominal rate into an effective rate is: ie = (1 + i/m ) m –
1

8.1 Simple interest

- The term ‘simple', with regard to interest, refers to the fact that interest is
calculated on the initial principal only.
- When a company discounts a commercial bill to obtain funds, this means the
company issues a commercial bill.
- When a company sells a commercial bill, this means the company issues a
commercial bill.
- When a company discounts a commercial bill, this means the company borrows
funds.
- This is not possible with positive interest rates when a future value calculated
with a simple interest rate exceed a future value calculated with compound interest at
the same rate

8.2 Compound interest

- The idea of compound interest refers to the payment of interest on previously
earned interest
- A finite stream of regular cash flows over a given period is known as a/an
annuity.
- The main difference between an annuity and an annuity due lies in the time of
the first payment.
- In regard to an annuity, if the first cash flow is made immediately, it becomes an
annuity due.

Key points Misunderstandings

- When a company obtains an interest-only business - The principal of a six-month bank deposit is the
bank loan and is required to make annual interest amount you receive at the end of its term.
payments on the principal borrowed and repay the full - The euromarkets, unlike those of the US, follow
principal at the maturity date, the type of interest is the market convention that a per-annum rate
called simple interest. relates to a 365-day year
- Accumulation of final amounts under simple interest - The amount that an investor puts up initially for a
happens at a slower rate than with compounding commercial bill is called the principal.
interest - If a commercial bill is sold into a market in which
- When a company issues a commercial bill it is said to its yield works out higher than the yield that
discount it prevailed at the original purchase date, a capital
- When a holder of a commercial bill sells it before its gain would have been made.
maturity date the return to the holder is called the - If an investor purchases a commercial bill with a
holding period return. face value of $100 000 with a yield of 7.00% per
annum and then, in 60 days, sells it at a yield of
6.70% per annum, the investor will make a capital
loss on the sale of the bill
- If an investor purchases a commercial bill with a
face value of $100 000 with a yield of 7.00% per
annum and then, in 60 days, sells it at a yield of
7.50% per annum, the investor will make a capital
gain on the sale of the bill.
- The amount that an investor receives at maturity
for a commercial bill is called the principal.

Chapter 09

LO 9.1

Short-term debt is a financing arrangement for a period of less than one year with various
characteristics to suit borrowers’ particular needs – Timing of repayment, risk, interest rate
structures (variable or fixed) and the source of funds.
• Matching principle
– Short-term assets should be funded with short-term liabilities. – The importance of
this principle was highlighted by the GFC.

• A supplier provides goods or services to a purchaser with an arrangement

for payment at a later date.
• Often includes a discount for early payment (e.g. 2/10, n/30, i.e. 2% discount if paid
within 10 days, otherwise the full amount is due within 30 days).
• From provider’s perspective
– Advantages include increased sales
– Disadvantages include costs of discount and increased discount period, increased
total credit period and accounts receivable, increased collection and bad debt costs.
When a company finances its short-term assets with short-term debt, this is known as the matching
principle.

Trade credit can be regarded as short-term debt.

According to the text, short-term debt arrangements means loans and instruments with maturity up to
a year.

LO 9.2

Major source of short-term finance

• Allows a firm to place its cheque (operating) account into deficit, to an agreed limit •
Generally operated on a fully fluctuating basis
• Lender also imposes an establishment fee, monthly account service fee and a fee on the
unused overdraft limit

Interest rates negotiated with bank at a margin above an indicator rate, reflecting the
borrower’s credit risk
• Financial performance and future cash flows
• Length of mismatch between cash inflows and outflows
• Adequacy of collateral
• Indicator rate typically a floating rate based on a published market rate, e.g. BBSW • In
some countries overdraft borrower may be required to hold a credit average balance or
compensating credit balance.

When a company provides goods to a purchaser with payment at the end of the month, this is called
trade credit.

A facility offered by many suppliers of goods that provide for the purchase of goods with a specified
period before the account must be paid for is called trade credit.
A 2/15, n/30 date of invoice translates as a 2% cash discount may be taken if paid in 15 days; if no
cash discount is taken, the balance is due 30 days after the invoice date.

The annual cost of forgoing a cash discount under the terms of sale 2/30 n/90, assuming a 365- day
year is 12.4%
A company is offered credit terms of 2/10 n/40, but decides to forgo the cash discount and pay on
the 45th day 21.28% is the company's cost of forgoing the cash discount

A supplier who changes its trade credit from 3/10 n/30 to 4/15 n/40 is likely to find its
accounts receivable increase.
LO 9.3
A bill of exchange is a discount security issued with a face value payable at a future date.
• A commercial bill is a bill of exchange issued to raise funds for general business purposes.
• A bank-accepted bill is a bill that is issued by a corporation and incorporates the name of a
bank as acceptor.
Features of commercial bills—parties involved (bank-accepted bill)
– Drawer

– Acceptor

a bank or merchant bank

• Features of commercial bills—parties involved (bank-accepted bill) (cont.) – Payee

receives the funds

payee
– Discounter
value and purchases the bill

• Features of commercial bills—parties involved (bank-accepted bill) (cont.) – Endorser

Signs the reverse side of the bill when selling, or discounting, the bill
and then to endorser

The flow of funds (bank-accepted bills)

Establishing a bill financing facility

– Borrower approaches bank or merchant bank
– Assessment made of borrower’s credit risk
– Credit rating of borrower affects size of discount
– Maturity usually 30, 60, 90, 120 or 180 days
– Minimum face value usually $100 000

• Advantages of commercial bill financing

– Lower cost than other short-term borrowing forms, i.e. overdraft, fully-drawn advances
– Borrowing cost (yield) determined at issue date (not affected by subsequent changes in
interest rates)
– A bill line
where it agrees to discount bills progressively
up to an agreed amount
– Term of loan may be extended by ‘rollover’ at maturity

When a business wants to smooth out the timing of its monthly mismatch between cash inflows
and outflows and day-to-day working capital requirements, it usually arranges a bank overdraft
facility.
When a company has a deal with a bank lender that allows access to short-term funds, this is
called a credit facility.

Which of the following statements about an overdraft facility Generally, the agreed interest rate on
an overdraft is calculated by the bank on the balance at the end of the month. is NOT correct

The prime rate is the benchmark rate of interest charged on loans to a business borrower by a bank.

The benchmark or prime rate of interest for overdrafts varies directly with
varying demand and supply for funds in the short-term markets.

The basic feature of a/an compensating balance required by some banks is that it effectively raises
the interest cost to the borrower for an overdraft facility.

LO 9.4

Calculations considered
– Calculating price—yield known
– Calculating face value—issue price and yield known
– Calculating yield
– Calculating price—discount rate known
– Calculating discount rate

If a company has a good credit standing with a bank, it will be charged a lower interest rate margin
than/as a company without an established record.

The interest rate on a bank bill is generally lower than the yield on a Treasury note is NOT correct

If a company wishes to finance a printing press with a two-year life, it would be advisable to
finance it through its bill rollover facility.
A company is likely to issue a bank bill if it wants short-term financing.
LIBOR serves as a reference interest rate in the United Kingdom
A bank bill is a bill of exchange either accepted or endorsed by a bank called

The discounter is the party that borrows the funds statements about the issuing of a
commercial bill is incorrect

The discounter is the party that lends the funds in a commercial bill transaction.

The discounter is the party that repays the acceptor at maturity statements about bank bills is
incorrect

The process of discounting a commercial bill means a buyer for the bill will provide the financing.

For a commercial bill, the interest rate is quoted as a/an annual percentage rate.
With a bank as an acceptor, it makes it easier to sell the bill at a higher yield about bank bills is incorrect

In relation to a commercial bill, the acceptance fee is the fee for taking the liability for paying the holder
at maturity.
Once a bill has been discounted into the marketplace, the cost of funds will vary for the issuer.
statements about bills is incorrect?

When a party endorses a bank bill, it creates a liability for payment of the bill.

In relation to a bank bill, endorsement means the endorser has a contingent liability when the bill
matures.

Upon maturity, the final holder of the bill approaches the acceptor for payment.

360 days maturity date is NOT likely for a bank bill

With a bank-accepted bill rollover facility the borrower agrees to accept bills drawn by the bank up to an
unspecified limit

A major advantage of a bill financing facility is that it allows businesses to access financing at a lower
cost than overdrafts.

The bank agrees to discount bills up to the agreed amounts with a fixed yield over the life of the rollover
facility. about bank bill financing facility is incorrect

With regard to a rollover bill financing facility none of the given answers are correct.

Compared to other forms of business finance such as term loans, bill financing offers the advantages of
lower costs for the bank not having to fund the bill on its balance sheet.

Which of the following statements is correct A bank bill is a negotiable instrument.

A company issues a 90-day bill with a face value of $100 000, yielding 7.65% per annum. $98 148.62
would the company raise on the issue?
LO 9.5

Also called P-notes or commercial paper, they are discount securities, issued in the money
market with a face value payable at maturity but sold today by the issuer for less than
face value.
• Typically available to companies with an excellent credit reputation because: – there is no
acceptor or endorser
– they are unsecured instruments.

• Calculations—use discount securities formulae

• Issue programs
– Usually arranged by major commercial banks and money market corporations –
 Standardised documentation
– Revolving facility
Most P-notes are issued for 90 days

• Underwritten P-Note issues

– Underwriting guarantees the full issue of notes is purchased and typical fee is 0.1% per
annum.
– Underwriter is usually a commercial bank or investment bank.
– The underwritten issue can incorporate a rollover facility, effectively extending the
borrower’s line of credit beyond the short-term life of the P-note issue. – Credit rating
• Issues may also be non-underwritten
– Issuer may approach money market directly.
– Commercial bank or investment bank may be retained as lead manager and receive fees.

A holder of a 180-day bill with 60 days left to maturity and a face value of $100 000 chooses to sell it
into the market. If 60-day bills are currently yielding 6.8% per annum, $98 894.55
A company has decided to issue a 120-day bank-accepted bill to raise additional funding of $250 000 to
buy equipment. If the bank has agreed to discount the bill at a yield of 7.65% per annum, $256 287.67
will be the face value of the bill

A company wants to invest some surplus short-term funds and plans to buy a 180-day bank bill with a
face value of $100 000. 12.41% is the yield on the bill if its price is currently $94 23445.

14.50% is the discount rate of a 120-day bank bill with a face value of $100 000 and currently selling for
$95 234, with a full 120 days to run

A bill of exchange differs from a promissory note in that there is generally an issuer and an acceptor for
a bill of exchange, whereas there is no acceptor involved for a promissory note.
LO 9.6

• Short-term discount security issued by banks to manage their liabilities and liquidity •
Maturities range up to 180 days
• Issued to institutional investors in the wholesale money market
• The short-term money market has an active secondary market in CDs • Calculations—use
discount securities formulae

Promissory notes have a decided advantage over bills in that an issuer of a promissory note does not
incur a contingent liability.
Commercial paper is a short-term, unsecured discount note issued by corporate borrowers of high
credit standing. The major banks generally issue these notes on their behalf.
P-notes have no acceptor, only an endorser statements about promissory notes is incorrect

Promissory notes financial security is known as one-name paper?

Commercial paper is usually issued in multiples of $100 000 or more
Commercial paper is generally sold at a discount from its face value.
Commercial bills are sold with contingent liability in the secondary market, whereas promissory notes
are sold without contingent liability following statements is true
Typically, a promissory note will be issued for 90 days of the following statements is true?
A company may pay an additional fee to the underwriter for endorsing the issue as well. following
statements is NOT a feature of promissory notes

Compared with bill financing, commercial paper financing offers a large creditworthy company lower
costs owing to no contingent liability when sold on.

When compared with bank bills, commercial paper has the advantagethat a holder of commercial paper
has no contingent liability when selling in the money markets.

The term 'discount security' in relation to a bank bill means when the bank bill is issued, it is less than
the principal amount to be repaid at maturity . the interest on a bank bill is less than other money market
securities.

When issuing commercial paper, it is important for a company to have a well-established reputation in
the markets.

When underwriting a commercial paper issue, an investment bank's fee will usually be 0.1% per annum.

A commercial paper issue where dealers bid competitively for the paper is a/an tender.

The typical P-note issue program is a revolving facility with the dealer having the right to cancel, subject
to providing the issuer with the required notice following about a P-note issue program is incorrect

Where a company wants to guarantee all of its issue of commercial paper, it can arrange for it to be
underwritten.

The most important function of an underwriter for a promissory note issue is tobuy the issue of
securities from the corporation and resell it to investors.

One of the advantages to the corporation of an underwriting syndicate for the issue of promissory notes
is the underwriting commitment gives the corporation access to a line of credit extending beyond the life
of the promissory note.

A company has directly placed an issue of commercial paper that has a maturity of 90 days, with a face
value of $100 000 yielding 8.25% per annum. $98 006.31 would the company raise on the issue

As an alternative to issuing a commercial bill for short-term financing, corporations with an excellent
credit standing may issue commercial paper.
A revolving facility for a promissory note issue usually has a lead manager to organise the issuance.
A P-note issuer to guarantee all the funds may arrange for all of the given choices/an underwriter/ a
supporting guarantee/collateral fỏ the issue.
 The role of a lead manager for a promissory note issuance program is to act as an arranger of the debt
issue.

The interest rate charged on an unsecured short-term P-note to a company is generally higher than
the interest rate on a secured loan.

When an issuer of commercial paper issue fails to raise the funds, this most likely means the under writer
must purchase unsold notes.

The credit rating of a P-note issuer needs to be investment grade following about P-notes is incorrect

As part of their liability management, banks sell Certificate of deposit

financial instrument

When a bank needs funds for day-to-day operational liquidity requirements it may issue
CDs.

As an alternative to issuing a commercial bill for short-term funds, a corporation may use the
overdraft facility of investment bank.

The major banks lend unsecured short-term funds in the following basic ways overdraft and bill
financing.

LO 9.7

• Inventory finance f
– Most common form is ‘floor plan finance’.
– Particularly designed for the needs of motor vehicle dealers to finance their inventory of vehicles
—finance company holds title to dealership’s stock. – Dealer is expected to
promote financier’s financial products.

• Accounts receivable financing

– A loan to a business secured against its accounts receivable (debtors) – Mainly supplied by
finance companies
– Lending company takes charge of a company’s accounts receivable; however, the borrowing
company is still responsible for the debtor book and bad debts.

• Factoring
– Company sells its accounts receivable to a factoring company
– Factoring provides
immediate cash to the vendor; plus it removes administration costs of accounts receivable.
– Main providers of factor finance are the finance companies.
– Factor is responsible for collection of receivables.

• Factoring (cont.)
– Notification basis: vendor is required to notify its (accounts receivables) customers that payment
is to be made to the factor.
Negotiable certificates of deposit are short-term securities, issued by banks for financing purposes.

A negotiable certificate of deposit is all of the given answers/ is a term deposit because it has a specified
maturity date/ can be issued by banks to meet their operational liquidity/ is a short-term discount security.

If a company wished to invest funds in the short term, it could buy a promissory note.

A source of short-term funds available to smaller firms (for example, finance provided to a car dealership for
car funding) is floor plan finance.

Most agreements involving factoring of accounts receivable are made on a notification basis.
The cost of financing is relatively high is NOT an advantage of factoring

Some banks and bank subsidiaries may provide factoring following statements regarding factoring is correct

Under a non-recourse arrangement the factoring company has no claim against the seller of the accounts.

When the factoring company can make a claim against the firm that sold them the accounts this is called a
recourse factoring arrangement

When a finance company provides a loan to a business against the security of the business's accounts
receivable this is called accounts receivable financing.
When a financier provides a business with finance by buying its business's accounts receivable this is called
factoring.

Key concept Misunderstandings

One of the advantages of an overdraft facility,

from the viewpoint of a borrower, is it can be A bank that provides an overdraft facility to business
used to smooth out any seasonal mismatch customers expects the overdraft to have a fluctuating
between its cash inflows and outflows balance and doesn't require the customer to have the
The return on a commercial bill for a holder at its account in credit at any stage
maturity is the difference between its discounted Commercial bills are a category of bills of exchange that
purchase price and the face value of the bill are issued by commercial banks.
With a bank-accepted bill the drawer has a
secondary liability after the acceptor to pay the The initial discounter of a commercial bill is the issuer of
holder of the bill the face value of the bill at the the bill who receives the funds
maturity date. The market for bank-accepted bills is an illiquid one as
The acceptor of a commercial bill undertakes to banks tend to hold them until maturity
pay the face value of the bill to the holder at
maturity.
A major advantage of bill financing over other
forms of short-term debt such as overdrafts is that
the cost is usually lower.
Commercial paper securities are unsecured
promissory notes, issued by corporations, which
generally mature within 180 days
 Chapter 10
LO 10.1

Term loan
– A loan advanced for a specific period (three to 15 years), usually for a known purpose; e.g.
purchasing land, premises, plant and equipment.
– Securd by mortgage over asset purchased or other assets of the firm. • Fully drawn
advance
nthly or quarterly) and form of the repayment (e.g. amortised or interest-only
loan)

• Other fees include:

– establishment fee
– service fee
– commitment fee
– line fee
– bill option clause fee.

Loan covenants

• Restrict the business and financial activities of the borrowing firm

– Positive covenant

– Negative covenant
tructure of borrower; e.g.
maximum D/E ratio, minimum working-capital ratio, unaudited periodic financial statements
• Breach of covenant results in default of the loan contract, entitling lender to act Calculating the

loan instalment—ordinary annuity

• Calculating the loan instalment—ordinary annuity

In relation to long-term financing, a fully drawn advance is a A term loan where the full amount is provided at
the start of the loan, usually for a specified purpose.

If a company wishes to finance a printing press with a five-year life, it would be advisable to finance it with
a/an fully drawn advance.

If a company wished to structure its financing so it repaid funds borrowed only when a project begins to have
positive cash flows, it would choose a/an deferred payment loan.
Long-term debt can be categorised as financing with an initial maturity over 1 year.

In relation to long-term financing, an amortised loan involves periodic equal repayments of interest and
principal throughout the term.
A fully amortised term loan has periodic repayments, including interest and principal reduction following
statements best describes a fully amortised term loan
Term loans where each periodic loan payment consists of interest payments and then the principal is repaid in
full at maturity are interest-only loans.

The fees that represent bank costs in considering loan applications and document preparation are called
establishment fees.
The fees charged by banks onto the total amount of the loan facility and are normally payable in
advance are line fees.

Compared with an amortised loan, a deferred repayment loan involves periodic interest and
principal repayments when positive cash flows begin.

The main longer-term finance provided by financial intermediaries is/are term loans.

Term loans granted by banks generally have maturities of three to 15 years and are often made to
finance capital expenditure such as building construction and the purchase of real estate.

A term loan is when funds are borrowed for a set period.

Banks usually charge a/an commitment fee for any portion of a term loan that has not been drawn
down.

A bank charge on any part of a loan that has not been fully drawn down by a company is called
a/an commitment fee.

All of the following affect interest rates charged on term loans except refinancing risk.

BBSW rates serves as a reference interest rate in Australia

If the interest rates on shorter term-to-maturity deposits are higher than those of longer term
deposits, it is likely that the costs for the longer term financing for a company are lower

One of the advantages of a prime rate set by a financial institution is that it is less likely to be
affected by short-term credit fluctuations.

A company can borrow from a bank at a margin to the bank's base rate. According to the text, all of
the following factors affect this margin except the term structure of interest rates.

Compared with a company with a strong financial rating, a company with a weaker rating is likely
to be charged LIBOR plus 50 basis points.

When a lender includes conditions in a loan agreement to protect its loan, these are known as loan
covenants.

When a loan agreement contains actions for a borrowing company to comply with, such as
supplying financial statements, these are called positive covenants.

Supplying the creditors with annual, audited financial statements is NOT usually an example of
restrictive debt covenants

Supplying creditors with annual audited reports is NOT an example of negative debt covenants

The company is restricted from doing mergers and acquisitions. is NOT an example of a positive
debt covenant

The purpose of debt covenants that require the firm to rank any subsequent borrowing below the
original loan is to protect the lender in their claim over pledged assets in the event of failure.
The purpose of debt covenants that ban borrowers from entering into certain types of leases is to
limit the amount of fixed-interest payments.
A breach of any specified loan covenant by the borrower generally gives the lender the right to do
all of the following, except insist the company hand over its assets.

A key difference between a positive covenant and a negative covenant is, for a positive covenant, a
company must maintain a minimum debt to gross cash flow ratio.
A minimum working capital ratio is a positive loan covenant

A term loan is provided to a business by a financial institution and has a maturity of more than one
year.
LO 10.2

A mortgage is a form of security for a loan.

– The borrower (mortgagor) conveys an interest in the land and property to the lender
(mortgagee).
• The mortgage is discharged when the loan is repaid.
• If the mortgagor defaults on the loan the mortgagee is entitled to foreclose on the
property, i.e. take possession of assets and realise any amount owing on the loan.

• Use of mortgage finance

– Mainly retail home loans
 -year terms
– To a lesser degree commercial property loans
o 10 years as businesses generate cash flows enabling earlier repayment
• Providers (lenders) of mortgage finance
– Commercial banks, building societies, life insurance offices, superannuation funds,
trustee institutions, finance companies and mortgage originators

• Interest rates
–
interest loans, interest rates reset every five years or less – With interest-only mortgage
loans, interest-only period is normally a maximum of five years
• Mortgagee (lender) may reduce their risk exposure to borrower default by: – requiring the
mortgagor to take out mortgage insurance up to 100% of the mortgage value.

The type of loan where a company pays periodic interest payments over its term and the principal at
maturity to a lender is called amortised.

All of the following financial institutions arrange mortgage finance for companies except
investment banks.
The lender who registers a mortgage as a security for a loan is the mortgagee.
The borrower who issues a mortgage with real property as collateral to the bank is the mortgagor.

A company borrows $75 000 from a bank, to be amortised over five years at 8.5% per annum. The
annual instalment is $19 032.43
A company borrows $125 000 from a bank at 7.2% per annum to be amortised over six years. The
monthly instalment is $2143.15
In Australia which of the following long-term debt markets are the largest? A. The corporate bond
market
The mortgage market
When illiquid assets are transformed into new asset-backed securities, the process is called
securitisation.
Many years ago, banks held most loans on their books until they were paid off.
LO 10.3

These securities are issued in the corporate bond market

– Markets for the direct issue of longer-term debt securities
– Lenders attract higher:

intermediaries.

• Debentures and unsecured notes

– Are corporate bonds
– Specify that the lender will receive regular interest payments (coupon) during the term
of the bond and receive repayment of the face value at maturity – Unsecured notes are
bonds with no underlying security attached
– Debentures:
unpledged assets
 ote
holders

The value of a bond is the present value of the coupon payments and maturity value.

The coupon interest of a bond is calculated based on its _______, and is paid periodically face
value
Which of the following types of bond generally has the lowest interest rate Treasury bonds

Corporations and governments use long-term debt financing called bonds.

Bonds are long-term debt instruments.
Compared with unsecured notes, a debenture can offer a floating charge over the issuer's unpledged
assets.
An unsecured note differs from a debenture in that it has no supporting security.
A debt security supported or secured by mortgage assets held by a bank is a/an mortgage bond.

All of the following are examples of long-term debt instruments except promissory notes.
In relation to an issue of bonds, the method where the bond offer is made only to institutions that
deal regularly in securities is called private placement.
A debenture is a/an bond secured by a charge over the assets of the issuer.
A company issues a long-term debt security with specified interest payments and fixed charges
over unpledged assets. What type of security has been issued Debenture

When a company defaults on interest payments for a debenture, the floating charge is said to
crystallise into a fixed charge.

In the event of failure for a company that has issued a bond, the highest claims on the company's
assets generally comes from fixed-charge debenture holders.

A holder of an unsecured note has generally no charge over the issuing company's unpledged
assets.

Many securities contain an option that is included as part of a bond or preferred share, which
allows the holder to convert the security into a predetermined number of shares. This feature is
called a conversion feature.

Subordinated debentures type of financial claim is not satisfied until those of the creditors
holding certain senior debts have been fully satisfied
LO 10.4
If a bond investor pays $1030 for an annual coupon bond with a face value of $1000, it follows that
the coupon rate is higher than the current market yield.

Bond prices vary inversely with interest rates statements about bonds is correct?
The face value of a bond is also called its par value. Bonds with a current price greater than their
par value sell at a premium while bonds with a current price less than their par value sell at a
discount
What happens to the coupon rate of a $100 face value bond that pays $7 coupon annually, if market
interest rates change from 8 to 9%? The coupon rate remains at 7%.
The market price of previously issued bonds is often different from face value because the
market rate of interest has altered.
The price of a bond with a fixed coupon has a/an inverse relationship with the market interest
rates

When the coupon rate of a bond is above the current market interest rates, a bond will sell at
premium.
When the coupon rate of a bond is below the current market interest rates, a bond will sell at
discount.
When the coupon rate of a bond is equal to the current market interest rates, a bond will sell at its
original value.
A company has two outstanding bonds with the same features, apart from the maturity date. Bond
A matures in five years, while bond B matures in 10 years. If the market interest rate changes by
5%: bond B will have the greater change in price.

A company has two outstanding bonds with the same features, apart from their coupon. Bond A has
a coupon of 5%, while bond B has a coupon of 8%. If the market interest rate changes by 10%:
bond A will have the greater change in price.

Coupon rates are generally fixed when the bond is issued statements is correct.

A $1000 face value bond, with coupon rate of 8% paid annually, has five years to maturity. If bonds
of similar risk are currently earning 6%, $1084.25 is the current price of the bond

A $1000 face value bond, with coupon rate of 9% paid annually, has six years to maturity. If bonds
of similar risk are currently earning 11%, $915.39 is the current price of the bond

All of the following features of a bond are fixed except the price

A $1000 face value bond, with a 7.5% coupon rate paid semi-annually and maturing in five years,
is currently yielding 6.4% in the market. $1046.44 is the current price of the bond?
When the market interest rates decline after a bond is issued, the market value of the bond increases.

When market interest rates increase after a bond is issued, the market value of the bond decreases.

If a bond's price is at a premium to face value, it has a yield below its coupon rate of interest.

If a bond's price is at a discount to face value, it has a yield above its coupon rate.

A bond's price will beat a premium when the coupon rate is higher than current market interest
rates; equal to the face valuewhen the coupon rate is equal to the current market interest rates; and
at a discount when the coupon rate is less than the current market interest rates.

$410 644.78 is the current price of a debenture with a $500 000 face value, a coupon rate of 9.5% pai d
semi annually, six years remaining to maturity and market interest rates increased to 14%
LO 10.5
 The lessor will be responsible for the periodic maintenance of the asset statements about ‘net' finance
leases is incorrect

A/An operating lease lease is a short-term arrangement where the lessee agrees to make periodic
payments to the lessor for the right to use the asset. This arrangement usually contains only minor or no
penalties for cancellation of the lease.

The type of lease where the costs of ownership and operation are borne by the lessee, who agrees to
make a residual payment at the end of the lease period, is a/an financial lease.

When a finance company purchases assets with its own funds and leases them to a lessee for a
negotiated long-term period this is called a/an direct lease.

For A leveraged lease type of lease does the lessee borrow a large part of the funds, typically in a
multi million dollar arrangement, often with a lease manager, while one or more financial
institutions provide the remainder
A direct finance lease is best described as a/an sale and leaseback arrangement.
Compared with missing an interest payment on debt, the penalties for missing a financial lease
payment are the same.

With a net lease, costs of ownership remain with the lessee is NOT an advantage of
leasing from the lessee's viewpoint

The lessor may use the funds for other investment opportunities is NOT an advantage of leasing
from the lessor's perspective (compared with offering a straight loan)?
For An equity lease type of lease does the lessee provide a significant part of the funds to purchase
the asset, often losing the advantage of leveraged leasing, while a financial institution provides the
remainder

Key concepts Misunderstandings

A term loan is referred to as a fully drawn advance The terms subordinated debt and unsecured note are
when the borrower obtains the full amount at the interchanged as they are both corporate bonds that
start of the loan have identical features.
A term loan with interest and principal repayments
that are amortised over the term are sometimes Banks often calculate a prime rate lending as they
called credit foncier loans. can adjust it more quickly than other reference
A long-term loan will generally attract a higher rate money market rates.
of interest than a short-term loan. Apart from an interest charge on funds advanced to
a borrower, a bank will charge a service fee for
A positive loan covenant can state that a company considering the loan application and loan
must maintain a minimum level of working capital. preparation
A bond is a long-term debt instrument issued The inclusion of covenants in a term loan is
directly into the capital markets. designed to protect the borrower from taking on too
much debt.

Under mortgage financing, the mortgagor is the

lender of the mortgage funds.

omises to pay its holder regular coupon payments

and principal is repaid at maturity.

Chapter 15

LO 15.1

Exchange rate regimes

• Each country or monetary union responsible for determining own exchange rate regime.
• Exchange rate is value of one currency relative to that of another currency. • Major
currencies like USD, GBP, JPY, EUR and AUD adopt floating exchange rate (free float)
regime
– Where exchange rate determined by supply and demand factors in the FX markets.

• Other types of exchange rate regimes include:

– managed float
– crawling peg
– linked exchange rate
currencies.

The value of FX daily transactions in the global FX markets is estimated to be USD 5400 billion.
Most foreign exchange transactions are conducted in the FX over-the-counter markets.
The foreign exchange market is where different currencies are bought and sold.
The institutions that transact between the foreign exchange (FX) dealers in banks and act as
principals in the FX market are called the foreign-exchange brokers.

A large international organisation representing the central banks of the major developed countries
is called Bank for International Settlements.
Financial institutions active in the FX markets include all of the given answers/ commercial
banks/commodity traders/ insurance companies.
.
Currently, the largest FX centre is in:
London.
All of the following are primary centres of foreign exchange trading except Munich.

New York is the largest FX market about global FX markets is NOT correct?
l OM oARc PSD|12 70 5 29 4

If the value of a currency is determined by market forces, this is regarded as a floating rate regime.

If the value of a currency moves within a defined band, relative to another major currency this is a
managed floating regime.

An exchange rate regime that allows the currency to appreciate gradually over time but within a
specified limited band set by government is a crawling peg regime.

The exchange rate where the value of the pegged currency is tied into the value of another currency
or basket of currencies is a inked exchange rate regime

A managed float exchange rate regime is one which limits exchange rate movements within a band
that is set by the central bank.
LO 15.2

FX markets
– Comprise all financial transactions denominated in foreign currency, currently estimated
to be over USD54 trillion per day.
– Facilitate exchange of value from one currency to another.
– Internationally adopted FX market conventions to improve market functionality.

• FX market participants can be classified as:

– FX dealers and brokers
– central banks
– firms conducting international trade transactions
– investors and borrowers in the international money markets and capital markets
– foreign currency speculators

A floating exchange rate regime is one exchange rate for a currency is allowed to move as factors
of supply and demand dictate.

Foreign exchange brokers seek out the best exchange rates and deal mostly with FX dealers.

The foreign exchange participant who quotes prices at which they are prepared to buy and sell
foreign currencies is a foreign exchange dealer.

Foreign exchange market participants who seek out the best FX rates in the markets and match the
buy and sell orders for a fee are called FX brokers.
 The financial institutions that quote buy and sell prices and act as principals in the FX markets are
called FX dealers.

Foreign exchange dealers quote two-way prices at which they are prepared to deal in foreign
currency.
The dealer quotes of a buy and a sell price on an FX currency are called two-way prices.

Arbitrageurs market participants tend to keep exchange rates the same in all the world markets

The FX party that conducts buy and sell transactions in two or more markets simultaneously to
take advantage of price differentials is called a/an FX arbitrageur.

The central bank resources made up of foreign currencies, gold and international drawing rights
are called official reserve assets.

If the value of a currency is influenced by a central bank that intervenes from time to time in the foreign
exchange market, this is regarded as a dirty float.
If a FX dealer buys USD from a client and holds USD on its own account on the expectation of the USD
rising in value in the near future, it is taking a long position in the USD.

If a FX speculator sells USD that the speculator currently does not hold the speculator has entered
into a short position in the USD.

The holding of foreign currency in the hope of a future sale is called a/an long
position.

An Australian company has received USD in payment for goods exported. At the time of receiving the
USD, the exchange rate is quoted as AUD/USD 0.5650. Rather than immediately converting the USD
into AUD, the company decides to ‘speculate' on a favourable movement in the exchange rate. In ‘today
+ n days' the exchange rate is AUD/USD 0.5750. All of the given answers are correct/ The company has
taken a ‘long' position in the USD./ The exporter company has made a loss on its FX position/ The
opportunity cost of interest forgone will affect the profitability of the FX position.

For a floating exchange rate, if a central bank does not intervene to influence the currency this is
called a clean float.

Most foreign-exchange trading takes place in London. following statements about the foreign exchange
markets is incorrect

If the Australian central bank wished to cause the AUD to appreciate, it would buy AUD and sell
foreign currency.

If the Australian central bank wished to cause the AUD to depreciate, it would sell AUD and buy foreign
currency

A/An short position is when an FX dealer enters into a forward contract to sell FX that is not held at that
time.
If differences occur for FX rates between three or more currencies, FX dealers may perform triangular
arbitrage.
LO 15.3

The FX market:
– is a global market, operating 24 hours a day according to business hours across the time
zones

– consists of a vast and highly sophisticated global network of

telecommunications systems that provide the current buy and sell rates for various currencies
in dealing rooms located around the globe

– involves larger FX dealers like commercial and investment banks providing the FX function as
part of their overall Treasury operations within which they establish an FX dealing room.

Given the following rates, 5.882 cents arbitrage profit may be made with respect to the Australian dollar

USD 1 = AUD 1.70

USD 1 = SGD 1.70
AUD 1 = SGD 0.96

Foreign exchange dealers are regarded as forming a/an over-the-counter market

It takes place at any hour of the night or day is correct for FX market trading

The main trading floor of the Australian FX market is located in Sydney, with subsidiary branches in other
main cities statements in relation to the operation of the FX market is NOT correct
LO 15.4

• FX market instruments are typically: – spot transactions

Have maturity date two business days after the FX contract is entered into
Used, for example, if an Australian importer has an account in
USD to pay within the next few days
forward transactions

entered into •
Used, for example, if Australian importer has to pay a USD
liability in two months, and covers or hedges against an
appreciation of the USD.
 • Dealers may also provide short-dated transactions if necessary
– ‘Tod’ value transactions—same-day settlement
– ‘Tom’ value transactions—settlement tomorrow

The exchange rate between AUD and a foreign currency is the price at which Australian dollars can be
converted into another currency

For currency transactions, the spot exchange rate is the rate on that date, and the forward
exchange rate is the rate at some specified future date
In the FX markets, the spot exchange rate can be defined as the exchange rate that is settled within two
business days
In the FX markets a forward transaction refers to the exchange rate that is specified now, but with
delivery and payment at some predetermined future date.

It is Tuesday, 27 March 201X, and an Australian importing company has to pay a US exporter USD 75
000 within thenext six weeks. The company enters into a forward exchange contract with an FX dealer
for ‘one month forward delivery' of USD. On 30 April 201X date will value settlement occur

LO 15.5

Transposing spot quotations

– Example: Given a quotation of EUR/AUD1.3755–1.3765, the AUD/EUR
quotation can be determined by transposing the quotation, i.e. ‘reverse and invert’

Reverse the bid and offer prices: 1.3765–1.3755

Then take the inverse (divide both numbers into 1)

1.000 1.000
1.3765 1.3755

AUD/EUR0.7265–0.7270

• Calculating cross-rates
– All currencies are quoted against the USD.
– There are two ways currencies can be quoted against the USD:
—the USD is the base currency
—the USD is the terms currency and the other currency is
the base currency.
– When FX transactions occur between two currencies, usually where neither currency is the
USD, the cross-rate needs to be calculated
-rate calculation depends on whether the quote is direct
or indirect.
 • Calculating cross-rates

The first currency mentioned in an FX quote is called the base currency

The second currency named in an FX quote is called the terms currency

Foreign exchange market participants who seek out the best FX rates in the markets and match the buy
and sell orders for a fee are called FX brokers

A difference arises between the bid and offer rates of foreign currency because foreign exchange dealers
need to earn income

In general, high value transactions narrow the foreign exchange dealer's bid-offer spread.

In general, the foreign exchange dealer's bid ask spread narrows as liquidity in dealers market
improves

In general, the spread for retail transactions is in excess of 50 points

In general, the foreign exchange dealer's bid-offer spread widens with increased volatility of FX.

For a FX quote of AUD/GBP0.6250-53 has a spread of 53 points.

If a British car sells for £20 000 and the British pound is worth A$2.75, the Australian dollar price of
the car is $55 000.

For spot transactions, the FX contract value date is two business days from the day of the transaction.

The convention in the FX markets is that the second-named currency in a FX quote that is used to
express the value is terms currency

The convention in the FX markets is the first-named currency in a FX quote is unit of the quotation.

The convention in the FX markets is the currency on the left-hand side of a quote is base currency.
The convention in the FX markets is for the first currency mentioned in a FX quote is unit of the
quotation

An Australian export company wishes to sell its euro receipts, EUR 500 000, through an FX dealer and
receives the following quote: ‘Aussie mark spot is one-twenty-two fifty-five to sixty- five'. $407 664.09
is the value of the export receipt

A company treasurer has received the following foreign exchange quote from an FX dealer: AUD/USD
0.5655-60. For the financial report to the board of directors, the treasurer is required to ensure the USD
is the unit of the quotation. USD/AUD 1.7668-83 exchange rate quotation will the treasurer include in
the report

The bid quote is the number of units of foreign currency an Australian FX dealer is willing to
give, in order to buy the unit of the quotation, that of AUD 1.

The offer quote is the number of units of foreign currency an Australian FX dealer is willing to
take, in order to buy the unit of the quotation, that of AUD 1

In the FX markets a/an direct quote is where the USD is the base currency.

Generally foreign currencies are quoted against USD. In relation to direct, indirect and cross-
quotation quotations,For an indirect quote, the foreign currency is the term currency and the USD is
the base currency statements is NOT correct

The ask or offer is the price at which a dealer will sell another currency statement is correct for a bid and
ask quote

In the FX markets a/an indirect quote is where the USD is the terms currency and the other
currency is the unit of the quotation.

An indirect exchange rate can be converted to a direct exchange rate by transposing the indirect rate.

If it takes 1.25 euros to buy 1 US dollar, the direct quote for the exchange rate is USD/EURO 1.25

A student researching the AUD/USD exchange rate on a particular day is confused to replace the
following two quotations:
i. AUD/USD 0.5825-30
USD/AUD 1.7152-67
Quote i is the convention adopted in Australia and is an indirect quote statements is correct
For the Aussie/euro spot rate (AUD/EUR 1.8088-1.8098), the percentage spread is 5.5

When a smaller amount of a foreign currency is required to buy the Australian dollar, the currency
is said to have appreciated with respect to the dollar.

LO 15.6

• Forward points and forward exchange rates

– The forward exchange rate is the FX bid/offer rates applicable at a specified date
beyond the spot value date.
– The forward exchange rate varies from the spot rate owing to interest rate parity.

rate differentials between countries.

• Forward points and forward exchange rates

– Forward exchange rates are quoted as forward points, either above or below the spot
rate.

The difference between the spot rate and the forward rate quotation is the forward points

The theory that the annual percentage differential in the forward market for a currency quoted in
terms of another currency is equal to the approximate difference in the interest rates between two
countries is known as
interest rate parity

The principle of interest rate parity asserts that the relativity between spot and forward exchange rates
reflects the interest rate differentials between countries.

If interest rate parity holds, the currency of the country with the relatively low interest rates will
trade at a forward premium to the country with the relatively high interest rate.

If interest rate parity holds, the currency of the country with the relatively high interest rates will
trade at a forward discount to the country with the relatively low interest rate.

An importer will be required to purchase USD in approximately six months to pay for a consignment
of goods. The company is concerned that the AUD may depreciate before the due date and therefore
decides to enter into a forward exchange contract to protect its position. The company receives the
following quote: ‘the Aussie is fifty-eight forty-five to fifty-three, sixty- two to sixty-six'.
Calculate the forward exchange rate: AUD/USD 0.5907-19

If the spot rate is AUD/USD 0.5510-0.5515, and the six-month forward points are 48 to 53, the six-
month outright forward rate would be AUD/USD 0.5558-0.5568

If the spot rate is AUD/USD 0.5526-0.5531 and the 90-day forward rate is AUD/USD 0.5578-
0.5588, the AUD is trading at a/an premium.

An Australian company has received USD in payment for goods exported. At the time of
receiving the USD, the exchange rate is quoted as AUD/USD 0.5650. Rather than immediately
converting the USD into AUD, the company decides to 'speculate' on a favourable movement
in the exchange rate. In today + n days' the exchange rate is AUD/USD 0.5750. All are correct

The foreign exchange participant who quotes prices at which they are prepared to buy and sell
foreign currencies is a: foreign exchange dealer

If the forward exchange rate is priced higher than the spot rate the currency is said to be trading
at a premium.

If the forward points are falling at a specific date, the base currency is at a forward discount

Given the 3-month forward rate exchange between the USA and Switzerland is USD/CHF 1.1589
this suggests that interest rates in the USA are lower than in Switzerland.

A currency with a higher interest rate will sell at a forward discount statements is correct

Interest rate parity principles refers to the circumstance that interest rates in different countries provide
equal returns, taking into account the spot and forward exchange rates between the two countries

A bank has been asked to provide a three-month forward AUD/USD ‘buy' quote for a
corporate client. The following information is available to the FX dealer at the bank: Spot rate:
AUD/USD 0.7654–0.7659 US interest rates: 7.73% per annum Australian interest rates: 8.64%
per annum Estimate the three-month forward ‘buy' rate. 0.7637

All of the following are considered ‘hard' or major currencies, except the Mexican peso.

The financial institution responsible for monetary policy in the European Union is called the European
Central Bank
The foreign exchange quotation, EUR/AUD1.4112–20, means that a bank is willing to pay
AUD1.4112 for one euro and to sell a euro for AUD1.4120.

With a bank quotation of AUD/NZD1.1832–42, 24–20, the bank is willing to

pay NZD1.1808 for one AUD forward.

The forward rate is only determined by volatility of spot rates. statements about forward exchange rates
is NOT correct

From the quotation AUD/USD.7458–68, 25–30 we know that the AUD is selling at a forward
premium to the USD and that the forward rate is AUD/USD.7483–98

An importer who must pay in three months would hedge by buying the foreign currency forward.
The importer is concerned with an appreciation of the foreign currency

With a forward contract the parties enter into a contract today and pay or receive the foreign currency
at the forward date.

The spread in foreign exchange markets for commonly traded currenciestends to be smaller

For a FX quote of AUD/GBP0.6250-53 has a spread of 3 points

Suppose the interest rate in Inland is higher than the interest rate in Outland. The Inland currency
will be at a forward discount . This relationship occurs because of arbitrage

Key Misunderstanding

The largest FX market is based in New York.

The FX market is organised as an over-the-
counter market in which deposits denominated
in foreign currencies are bought and sold When two parties agree to exchange currency
and execute a deal at a specific date in the
future, this is described as a forward rate
A triangular arbitrage opportunity arises in the FX agreement
market when three or more currencies are The FX brokers quote two-way prices at
misquoted or mispriced which they are prepared both to buy and sell
foreign currencies and act as principals in the
FX markets
A USD/YEN quote means the price of USD1 in
terms of YEN.
If an Australian importer has a contract for
Japanese goods denominated in yen payable
When a currency is quoted against the USD and in three months' time and is concerned that
the USD is the base currency, this is direct the AUD may appreciate, the importer may
quoting. enter into a forward contract to sell the yen
for delivery in three months' time

A rule for working out a bid-ask cross rate Given USD/EURO0.6450-0.6455 an FX

for direct and indirect FX quotations is to dealer would buy USD1 from you and give
multiply the two bid rates and multiply you EURO0.6455
the two ask rates
When an FX dealer calculates a forward
Given that AUD/USD (spot) is 0.6830-40 and exchange rate for NZD/JPY they must adjust
the six-month forward rate is 0.6798-0.6813, the both interest rates to allow for the different
six-month forward points must have been falling quotation rates between Japan and New
Zealand
Chapter 18: Main points to remember
A. Call Option

- It is argued that effective risk management is vital to the survival of an organisation

because all are correct; most business organisations are exposed to a wide variety of
risks/ many business failures can be attributed to inadequate policies/ most
organisations are exposed to interest rate risk.

- Derivatives are the financial instruments that are financial assets that derive their value
from underlying assets.

- Risk management objectives and policies should be established by the board of

directors.

+ Derivative markets exist in order to reduce the risk of exposure to price

fluctuations in cash markets.

+ Risk exposures that may impact on the normal day-to-day running of a business
are called operational.

+ When an oil company suffers severe damage to one of its oil drilling platforms,
this is an example of operational risk.
 - Major financial risk exposures for corporations include all of the given choices; a change
in interest rates, foreign currency appreciating, company with insufficient funds to pay
wages.

- An investment company with an investment portfolio that matches its investment horizon
are most exposed to interest rate risk

- A local currency decreases for an exporter is NOT an example of financial risk exposure
for a company.

+ The risk exposure when a corporation appears to have insufficient funds to meet
day-to day commitments as they fall due is known as liquidity risk.

+ For a company the process of risk management needs to be a structured

process.

- One of the important first steps in a risk management strategy for a company is to
analyse the impact of the risk exposure.

B. Put Option

The analysis that documents each risk exposure and then tries to measure what will be the
operational and financial effect should the risk event occur is called cost-benefit analysis.
The correct order should be iii. identify operational and financial risk exposures; ii. Analyse the
impact of the risk exposures; i. Assess the attitude of the organisation to each identified risk
exposure

After identification of all of its risk exposure an organisation must seek to remove all these risks
is incorrect

A futures contract is an agreement that specifies the delivery of a commodity or financial

security at a predetermined future date, with a currently agreed-on price.

A standardised agreement traded on an organised exchange for delivery of a specified security

or commodity at a specified price on a predetermined date is a/an futures contract.

In relation to futures markets, the following regarding initial margins is false the initial margin will
be higher for low market volatility.

If a client investor is holding a large number of listed shares on the ASX, intends to sell in three
months' time and wishes to protect the value of the share portfolio, they may sell a futures
contract based on the S&P/ASX.

C. Risk Management Strategy

In Australia futures contracts are traded electronically by the ASX Trade 24.

The following statement relating to the use of futures contracts is incorrect: futures contracts are
generally closed out by delivery of the physical market product.
In the futures markets, if a futures contract is marked-to-market, this refers to the settlement of
gains and losses on futures contracts on a daily basis.

In the futures markets, a maintenance margin call refers to funds paid to the clearing house by
each trader to cover losses.

In the futures markets, when the initial margin of a futures account is topped up daily to cover
adverse futures price movements, this is called maintenance margin call.

The market ASX Trade 24 trades in futures contracts.

In the futures markets, the funds that represent 2 to 10 per cent of the futures contract that a
client pays to the futures exchange clearing house are called initial margin.

A company, worried that the cost of funds might rise during the term of their short-term
borrowing, can hedge this rise by selling futures contracts on bank-accepted bills.

In the futures markets, the price of a derivative contract for gold is based on price of gold in the
spot markets.

If a company intends to borrow in three months' time, it can lock in its borrowing costs by selling
futures contracts.

A forward rate agreement (FRA) is an interest rate risk-management product, generally

provided by banks over the-counter. FRAs are not standardised with regard to contract period
and amount is correct

If an FRA dealer quotes ‘6Mv9M 7.25 to 20', this means that the dealer is prepared to lend
three-month money at 7.25% per annum.
The advantage of using a forward rate agreement FRA over a futures contract is The terms and
conditions of a FRA can be negotiated.

When a company contacts a bank and asks for a 3-month forward rate and is quoted by the
bank's FX dealer AUD/USD0.9560-65 14.20, then the three month forward rate is
AUD/USD0.9574-85

An option buyer has a greater insurance benefit than the purchaser of a futures contract.

An option that gives the option buyer the right to buy the commodity or financial instrument
specified in the contact at the exercise price is called a call option.

An option that gives the option buyer the right to sell the commodity or financial instrument
specified in the contact at the exercise price is called a put option.

For a call option, the writer is committed to handing over the specified asset if the holder of the
call exercises the option.

In a put option, the buyer has the option to sell the specified asset at a specified time.

The holder of an American call option has the right to buy the underlying asset at the exercise
price on or before the expiration date.

The European call option gives the option buyer the right to exercise the option only on the
expiration date.

In the option markets, the price specified in the contract at which the buyer of the option can
buy or sell the specified commodity or financial instrument is called the exercise price.

For the writer of a put option, if the underlying share price moves above the strike price, the
potential profits are limited to the premium.
In the derivative markets a swap is an agreement between two or more persons to exchange
cash flows over some future period.

When two parties exchange the respective interest payments associated with existing debt
borrowed in the capital markets, this is called a/an swap.

An agreement between two parties to exchange a series of cash flows similar to those resulting
from an exchange of different types of bonds is called a/an interest rate swap.

The growth of the swaps market has been due to firms wanting to do all of the given choices;
lower the cost of funds., hedge interest rate risk, lock in profit margins.

D. Note

Key Concepts Misunderstanding

A government introducing legislation The board of directors of a company is

requiring carbon-emitting companies to responsible for the implementation and
lower their carbon emissions is an example monitoring of risk management strategies.
of operational risk.
For a corporation, external risk management
A commercial bank has to consider in its strategies include leading and lagging FX
risk management procedures not only transactions.
interest rate risk but also credit risk and
liquidity risk An analysis of the costs associated with
establishing and maintaining a particular risk
As risks for a company vary over time a management strategy versus the risk
flexible and robust risk management management benefits to be obtained is
strategy is essential for an organisation no called a SMART analysis
matter how large or small
The prime function of a futures clearing
An American put option is worth more than house is to bring together the buyer and
a European put option as it can be seller in each futures contract
advantageous to exercise an American put
option before expiry The maintenance margin call refers to the
difference between the futures market price
and the futures contract

A FRA expressed as 3Mv5M means the

settlement date is in three months and the
interest cover is for a five-month period
Chapter 19: Key areas

- The interest rate futures contracts, the FRA, are traded on the larger exchanges is
incorrect.

- Futures is a derivative product

+ The Chicago Board of trade (CBOT) established an organised market in grain

futures contracts in 1848

+ The Chicago Board of trade (CBOT) introduced the world's first financial (interest
rate) futures contract in 1975

- In Australia the Sydney Futures Exchange (SFE) that is now merged with the ASX
introduced the 90- day bank-accepted bills futures contract in 1979

- At the end of six months for a wheat farmer who sold previously a 6 month wheat futures
contract, he may: can sell the wheat via the spot grain market and at the same time buy
a futures contract identical to the contract originally taken

- Future contract holders will either buy or sell an opposite contract on or before expiry
date to close out the contract is correct
 + An orange grower who is concerned that the price of oranges will fall before
harvest and sale can sell an orange futures contract today.

+ At the present time the convention for quoting the prices of futures contracts
varies between exchanges around the world.

+ Only a small percentage of financial futures contracts results in actual delivery is

correct

- The following statements is characteristic of futures trading on the Australian Futures

Exchange (ASX Trade 24): all given answers; Pricing of bond contracts is on the basis of
their yield to maturity, Transactions in the ‘trading pits' are conducted by ‘open outcry',
The ASX Trade 24 clearing house enforces full payment of the initial contract amount.

- In the futures markets the buyer of a financial futures contract takes the long position.

+ In the futures markets, the buyer of a financial futures contract has the obligation
to receive the underlying financial asset at the specified future date.

+ In the futures markets, the seller of a futures contract has the obligation to deliver
the underlying financial asset at the specified future date.

+ In the futures markets, the seller of a futures contract takes the short position.

+ In the futures markets, the price of a futures contract is determined by demand

and supply between market participants in the futures market.

- In futures markets, the terms of a futures contract, for instance the quality and quantity of
the commodity and the delivery date, are specified by the futures exchange.

- The orders are put into the trading system on the basis of size details and any price
restrictions. is incorrect

- Any Australian Treasury bond futures contract for a yield of 7.50 per cent per annum is
quoted on the futures exchange as: 92.500

- If a dealer buys a futures bond contract at 92.750 and sells at 93.500, she makes a profit
is not correct
- If an investor buys a three-year Commonwealth Treasury bond futures contract at 7 per
cent and on the delivery date the interest rate of Treasury bonds is lower than they
expected at 6 per cent, they will have gained money on their long position.

+ If an investor buys a three-year Commonwealth Treasury bond futures contract

at 6 per cent and on the delivery date the interest rate of Treasury bonds is lower
than they expected at 7 per cent, they will have lost money on their long position.

+ If a bond investor sells a three-year Commonwealth Treasury bond futures

contract at 7 per cent and on delivery date the interest rate of Treasury bonds is
higher than they expected at 8 per cent, they will have gained money on their
short position.

+ If a bond investor sells a three-year Commonwealth Treasury bond futures

contract at 7 per cent and on delivery date the interest rate of Treasury bonds is
higher than they expected at 6 per cent, they will have lost money on their short
position.

- A company has sold a three-year Commonwealth Treasury bond futures contract, and
now wishes to close out its open position on maturity date. Statements relating to the
closing out of a futures position is incorrect The company may choose to deliver the
physical market Treasury bonds in settlement.

- In the futures market, the instruction to a futures broker to buy or sell at the current
market price is a market order.

- In the futures market, an instruction to a futures broker to buy or sell up to a specified

price and within a specified time is a limit order.

+ An investor holds a long oil futures contract that expires in June. To close out her
position in oil futures before the delivery date, she must sell one July oil futures
contract.
 + The maintenance margin is the value of the margin account below which the
holder receives a margin call is correct

- A futures exchange imposes an initial margin to ensure brokers and traders are able to
pay for any losses incurred over the life of the futures contract.

+ As part of futures trading, exchanges have traders place an initial margin with its clearing
house because as it acts like a performance bond to support the value of the futures
contract.

+ When Australian financial futures still in existence at trading close are settled with the
clearing house, final settlement in the form of standard delivery means the contract is
settled by delivery of the actual underlying financial asset.
+ They are quoted on the basis of their clean price relating to Commonwealth Treasury
bond futures is incorrect

- On the ASX Trade 24, financial futures contracts are currently traded on all the following
securities, except corporate bonds.

- The price of a short-term interest rate risk contract is generally derived from: the money
market instruments

- In futures markets investors who expect to purchase future bonds can reduce the risk of
price fluctuations by taking a/an: long position on futures contracts.

- In futures markets investors who expect to purchase future bonds may hedge against
the effects of falling interest rates by buying bond futures contracts.

- An orange grower who wishes to protect his future orange crop from price fluctuations
can hedge by taking a/an short position on an orange futures contract.
 + A wheat grower who wishes to protect his future wheat crop from price
fluctuations can sell a wheat futures contract.
+ In futures markets investors who expect to purchase future bonds may hedge
against the effects of falling interest rates by: buying bond futures contracts

- A company who intends to borrow in 3 months can hedge and lock in the cost of
borrowing by selling an interest rate futures contract.

- A futures trader who has a short position in oil futures wants the price of oil fall in the
future.

- A futures trader who has a long position in oil futures wants the price of oil to increase in
the future.

- A steel manufacturing company that expects a future iron price rise can hedge and take
a/an long position on iron futures contracts.

- An Australian importer with FX payable in 3 months can hedge and lock in the price of
the required foreign currency by selling AUD futures.

- An Australian exporter with FX receivable in 3 months can hedge and lock in the price of
the required foreign currency by buying AUD futures.

- In the futures markets, hedgers are mainly interested in reducing their exposure to risk of
price changes.
- In the futures markets speculators are mainly interested in attempting to make a profit by
betting on expected price changes.
- In the futures markets, arbitrageurs are mainly interested in attempting to make a profit
by taking advantage of price differentials between different markets.

- In the futures markets, speculators take on extra risk in futures markets as a result of the
actions of hedgers.

- Arbitrageurs try to make a profit by taking advantage of price differentials between the
futures markets or different markets.

- In the futures markets, price differences between the futures and the underlying assets
are reduced by the actions of arbitrageurs.

- In the futures markets, profits from speculation primarily arise because of the difference
in expectations among market participants about future prices of a commodity or
financial asset.

- They aid hedgers by adding to the liquidity in the markets is the following statements
about speculators in futures markets is correct

+ In the futures markets, speculators who strongly believe that interest rates will
rise are likely to sell futures contracts on Treasury bonds.

+ In the futures markets, speculators who strongly believe that prices of treasury
bonds will fall are likely to sell futures contracts on Treasury bonds.

+ In the futures markets, speculators who strongly believe that interest rates will fall
are likely to go long and buy futures contracts on Treasury bonds.

+ Buying a futures contract for one delivery date and selling an identical futures
contract with a different delivery date is called a straddle.
- Buying a September bank bill futures contract and simultaneously selling a June bank
bill futures contract is a/an example of a straddle

- Buying a September bank bill futures contract and simultaneously selling a June
Commonwealth Treasury bond futures contract is a/an example of a spread.

- A lender, worried that the value of their loan might fall during the term of the loan, can
hedge this fall by buying futures contracts on Treasury bonds

- An Australian bank must pay US$10 million in 90 days. It wishes to hedge the risk in the
futures market. To do so, the bank should: buy USD 10 million in US dollar futures.

- A company has identified an exposure to movements in interest rates on its existing debt
facilities. The company is considering selling futures contracts to manage that risk and is
unsure S&P/ASX 200 Index not be used for managing interest rate risk exposures.

- The market value of a bank bill futures contract with a face value of $1 000 000, a
reported price of $93.75 and 90 days to maturity $984 822.93

- A futures trader who enters into a 90-day bank bill futures contract on 20 September with
a reported price of $93.25 will need to pay on settlement date (30 September), if the face
value of the underlying bill is $1 000 000. $983 628.65

- A company has an existing $900 000 promissory note facility, which it will roll over in 90
days. It is concerned that interest rates will rise before the roll-over date and enters into
a 90-day bank-accepted bill futures contract at 92.50. Three months later, the company
 closed out its futures position at 91.75. Using the following data, calculate the profit or
loss position of the futures transactions. (Disregard margin calls and transaction costs.)
$1 779.54 profit

+ A funds manager manages a diversified Australian share portfolio, but is

concerned that stock prices in the market will fall over the next three months. The
manager decides to hedge the risk by selling 100 S&P/ASX All Ordinaries Share
Price Index futures contracts at 23.55. Three months later, when the manager
closes out the position, the contract is trading at 24.10. $137 500 loss

+ Basis risk refers to the risk from a change in the spread between the price on the
commodity or financial security in the physical market and the price of the related
futures contract.

+ One of the problems of hedging with a futures contract compared with a forward
contract is basis risk.

- A company is considering using futures contracts to hedge an identified interest rate

exposure on its debt facilities. However, it is concerned about the impact of basis risk.
Initial basis will be evident while the market is of the view that physical market prices will
remain stable is incorrect

- The variability of changing prices and costs associated with buying and selling futures
contracts best describes the risks associated with futures contracts?

- When prices of 3-year Treasury bond futures vary over time with the prices of long-term
debentures this is called spread-commodity hedging the following about hedging is
incorrect.

- In using futures contracts for hedging, All of the given choices is an important
consideration; The standard contract size, The margin payment, The basis risk

- In comparing forwards and futures, futures are typically All of the given choices; riskier
than forwards, more liquid than forwards, traded on an organised exchange.

- Futures contracts are traded on a formal, organised exchange, and forward contracts
are not traded on a formal, organised exchange.
 - The terms of futures contracts are standardised and the terms of forward contracts
Are not standardised.

- Forward contracts are not generally marked-to-market is a key difference between

forwards and futures?

+ A key characteristic of forward contracts that recommends their use over futures
contracts is all of the given answers; forwards are not traded on exchanges and
marked-to-market, forward contracts allow flexibility with respect to contract
period, forwards are not standardised instruments with regard to the amount of
each contract.

+ The over-the-counter derivative product used to manage interest rate risk is a/an
forward rate agreement.

- If a FRA covers six-month interest rates but will begin its cover in three months it will be
written 3Mv9M.

- If a borrower has entered into a FRA and its interest cover is specified as 3Mv9M, this
means six-month interest rates beginning in three-months.

- A key characteristic of futures contracts that recommends their use over forwards
contracts is all of the given answers; futures are traded on exchanges and marked-to-
market, futures contracts allow flexibility in delivery dates, futures are traded in liquid
markets and allow netting of positions.
 - For hedging interest rates the advantages of a FRA are all of the given choices; it is not
standardised like a futures contract, it does not have associated margin payments, it is
flexible with regard to contract period and amount

- A company will need to ‘roll over' its existing $500 000 funding arrangement in two
months' time for a further 90 days. It is concerned that interest rates in the short-term
debt market may rise in the meantime, and decides to manage the risk exposure by
entering into a forward rate agreement with its bank. The bank quotes a price (2Mv5M)
of 9.45 to 30. In two months' time the reference rate (BBSW) is 10.20% per annum.
$881.43.

- A company has entered into a forward rate agreement with a corporate borrower. The
following terms and conditions apply to the contract:
Notional principal: $350 000 Contract rate: 12.65% per annum Reference rate: 13.10% per
annum FRA period: 180 days
The bank will be responsible for payment of the settlement amount

Key Concepts Misunderstanding

A bond trader who buys a Treasury bond A futures contract can be defined as a
futures contract at a yield of 6.25% per contract which provides something to be
annum and then sells it at 5.5% per annum bought or sold at a future date at a price
makes a profit on the contract decided upon at the expiry of the contract

. If a futures contract holder fails to meet a The process of marking to market is when
margin call, the futures exchange clearing the clearing house demands funds from
house will routinely close out the open every futures trader that incurs a loss
position
If you buy a bank-accepted futures contract
If someone enters into a futures contract and on delivery date the interest rate on
with the intention of taking delivery of a bank- accepted bills is lower than you
commodity or financial instrument specified expected you will have gained money on
in the futures contract for a price that was your long position
determined before delivery, they are likely to
be a hedger. In the futures markets a speculator who
believes strongly that interest rates will fall
Large companies often prefer futures to in the near future would be likely to buy
FRAs because they are generally easy to futures contracts on Treasury bonds.
close out compared with a forward contract.
When a lender uses a 10-year Treasury
bond futures contract to hedge an issue of
an unsecured note, this type of hedging is
called intersection-commodity hedging.

Basis risk refers to the risk associated with

 unanticipated price movements

The process of marking to market is when

the clearing house demands funds from
every futures trader that incurs a loss

Chapter 20: Most important

- An options contract gives the right to buy or sell an underlying asset at a predetermined
price by a specified time.

- In the option markets, the option that gives the buyer the right to buy the specified
commodity or financial instrument is a/an call option.

- In the options market the option that gives the buyer the right to sell the specified
commodity or financial instrument is put option.

- In the options market, the right to buy an underlying asset lies with call buyers.

+ In the options markets for a call option, the seller is committed to handing over
the specified asset at a specified time.

+ In the options markets, for a call option, the seller is committed to deliver the
specified asset at a specified time.
 + In the options markets for a put option, the seller is committed to receiving the
underlying asset at a specified time.

+ In a put option, the buyer will exercise the option if the price of the underlying
asset has fallen below the exercise price.

- In options markets an American call option lets the buyer buy the underlying asset at the
exercise price on or before the expiration date.

- In options markets, an American put option lets the buyer sell the underlying asset at the
exercise price on or before the expiration date.

- In the options markets, an American call option should have a higher premium than the
comparable European call option because it gives more flexibility to the holder.

- For the buyer of an option, the premium paid for the contract represents the largest
potential loss.

- In the options markets, an American put option can be exercised at any time up to the
expiration date.

- A European call option can be exercised only on the expiration date.

- In options markets, options that give the option buyer the right to exercise the option only
on the maturity date are European-type options.

+ In options markets, options that give the option buyer the right to exercise the
option at any time up to the maturity date are American-type options.
 + If an option buyer wanted to decide only at the expiration date whether or not to
exercise the option then and the price locked into that date, they would buy
European-type options

- The advantages of using an American type option compared to a European type option
can be exercised at any time up to maturity.

- In option markets the price specified in the option contracts for calls and puts is called
the strike price

- In options markets the strike price is the price specified in an options contract at which
the buyer can buy or sell the underlying asset.

- In an options contract, the strike price is also known as the exercise price.

+ In options markets, the price paid by an option buyer to the writer of the option is
the premium

+ A call option is an option to purchase a specified number of shares on or before

some future date at a specified price, whereas a put option is an option to sell a
specified number of shares on or before some future date at a specified price.
Calls are bought if the share is expected to rise.

- Options are generally issued by companies is the statements about calls and puts is
incorrect

- They both result in new equity capital for the company is not true of calls and puts

- In options markets the fee charged by a seller of an option is called the option premium.

- The decision between selecting a future or an option reflects a trade-off between the
higher cost of using options and the extra insurance benefits that options provide.

- In options markets, the maximum loss a buyer of a share call option can undergo is
equal to the call premium.

- In options markets, the maximum loss a buyer of a share put option can undergo
is equal to the put premium.

+ Call option will an option buyer purchase if they believe a share price will rise

- Put option will an option buyer buy if they believe a share price will fall
- On the expiration date for a call option with strike price of $10.00, premium $1.50 and
the current spot price of $9.00, the holder will let the option contract lapse.

- On the expiration date for a call option with strike price of $10.00, premium $1.50 and
the current spot price of $14.00, the holder will let the option contract lapse.

+ On the expiration date for a put option with strike price of $10.00, premium $1.50
and the current spot price of $14.00, the holder will let the option contract lapse.

+ On the expiration date for a put option with strike price of $10.00, premium $1.50
and the current spot price of $8.00, the holder will exercise the option

- The seller of a call option loses if the spot price, plus the premium, is below the exercise
price when the option is exercised is statements about option contracts is incorrect

- An investor purchases a call option at a premium of $1.25, with an exercise price of

$7.50 within three months. The holder of the option will exercise the option at any price
above $7.50, if necessary

- The profile depicts the short call position of the option seller is the following statements
best reflects the following profit profile of an option contract

+ The profile depicts the long call position of the buyer of the option best reflects
the following profit profile of an option contract
 + The profile depicts the short put position of the option seller statements best
reflects the following profit profile of an option contract.

- The profile depicts the long put position of the buyer of the option.

- The profile depicts the long put position of the buyer of the option statements best
reflects the following profit profile of an option contract
- Buyers of put options expect the value of the underlying asset to decrease, and the
sellers of call options expect the value of the underlying asset to decrease.

- An investor holds long call options that may be exercised at any time over the next
month. The spot price of the underlying asset is $12.75; the strike price of the option is
$15.10; and the premium paid was $2.35. -$2.35 is the value of the option to the holder

- The value of a long call if the exercise price is $10.00, the premium is $1.50 and the spot
price is $8.00, given V = max(S-X, 0) – P, -$1.50

- The value of a short call if the strike price is $10.00, the premium is $1.50 and the spot
price is $8.00, given V = P - max(S-X, 0). $1.50

- The value of a long put if the exercise price is $10.00, the premium is $1.50 and the spot
price is $8.00, given V=max(X-S, 0) – P. $0.50
- The value of a short put if the exercise price is $10.00, the premium is $1.50 and the
spot price is $8.00, given V = P - max(X-S, 0). -$0.50
 - In the futures markets, price differences between the futures and the underlying assets
are reduced by the actions of arbitrageurs

- The main feature of the potential profit and loss profile for a long put party may be best
described as profits are made from exercising an option when the spot price falls below
the exercise price adjusted for the premium

+ The most important benefit of an options contract strategy for a hedger is Risk of
loss from unfavourable price movements is limited.

+ The following best reflects the exposure position of a writer of a put option are All
of the given answers; A loss is made when the spot price is below the exercise
price adjusted by the premium, The extent of the loss potential is limited to a zero
spot price less the premium paid, The maximum profit to the writer is limited to
the extent of the premium paid.

+ A covered call position is the purchase of a share at the same time as selling a
call on that share.

- A hedge fund has written a call option on shares of a company with an exercise price of
$17.45, and simultaneously also buys a call option on the same share with an exercise price of
$16.95. The hedge fund is considered to have written a/an covered call option
- In options markets, where a call writer holds the underlying assets, this is called a
covered call.

- The loss for a writer of a naked call option on a share is potentially and so currently
short-selling is banned in Australia unlimited
- When we contrast futures with options contracts, we can say that in a futures contract
the buyer and seller have symmetric rights, whereas in an options contract the buyer
and writer have asymmetric rights.

- A long call option buyer must meet the deposit and margin calls of the clearing house
whereas the writer does not have to is not a condition applied to call options listed on the
Australian Securities Exchange (ASX Trade) on leading ordinary shares
- The highly geared option contract on individual stocks on the ASX with an exercise price
of between one and ten cents is a/an LEPO

- In the Australian options markets a LEPO is low-exercise price option.

- In the Australian options markets the warrant that has an upper limit applied to the
upside profit available for the holder is a/an capped warrant.

- The option that is a highly leveraged option on individual stocks, with an exercise price
of between one and ten cents, traded on the ASX Trade, with a European-type expiry, is
a LEPO.

+ In the Australian options markets, a warrant that is made up of a selection of

shares from the mining industry is an example of a/an basket warrant.

+ Equity warrant security gives the holder an option to purchase a specified

number of shares at a predetermined price within a certain period of time

+ A lender, concerned that its cost of funds might rise during the term of a loan it
has made, can hedge this rise without forgoing the chance to profit by a decline
in the cost of funds. This is done by buying put options on Treasury bills.

- When interest rates are forecasted to rise, a company approaches its bank before the
next roll- over date of its current debt facilities, and buys an interest rate cap option.
However, the company is concerned at the cost of the cap premium and decides to
simultaneously sell an interest rate floor option of the same maturity. The company has
obtained cover with a collar option strategy is correct

- A shares are selling for $10 per share and you own a call option to buy Maxima shares
at $7.50. The intrinsic value of your option is $2.50

- The intrinsic value of an option is the amount the option is actually worth if it is
immediately exercised.

+ A call option is regarded as being in-the-money if the price of the underlying

asset is currently greater than the strike price.

+ In the options markets a put option is said to be in-the-money if the exercise price
is greater than the share price.

+ In the options markets a put option is said to be out-of-the money if the exercise
price is less than the share price.
- In the options markets for a covered option, the seller owns the underlying asset.

- In the options markets a put option is regarded as being in-the-money if The price of the
underlying asset is currently less than the strike price.

- The option is far off its expiration date is the following factors would tend to increase the
size of the premium on an options contract

- The value of a put option rises when the underlying asset experiences price falls.

- Following variables affect the value of options: i. Difficulty of interest rates ii. Time to
maturity of the option iii. Share price volatility iv. Dividend yield on the underlying share
+ The elapsed time since the start of the option is following factors is not generally
regarded as a major determinant of the price of an option

- All of the following factors affect the price of a share option except the expected rate of
return on the share.

- In relation to options when interest rates increase, the price of put options generally falls.
- In relation to options when interest rates decrease, the price of put options generally
increases.

+ The strategy whereby a company buys an interest rate option that puts a
maximum level on the interest rate for its borrowing is a cap option.

+ In option language, a ‘cap' is a ceiling option.

- The strategy whereby a company sells an interest rate option that puts a minimum level
on how low an interest rate may fall is a floor option

- The option that is a combination of a cap option and a floor option is a collar option

- If a risk manager wants to put on an upper limit on an interest rate payable on a future
borrowing by buying an option and at the same time he wants an option that puts a
minimum limit on how low interest rate payable may fall, this combination is called a
collar

- An investor purchased a call option and wrote a put option at an exercise price lower
than that of the long call option. The strategy is known as a: vertical bull spread

- An investor purchased a call option and wrote a call option at an exercise price higher
than that of the long call option. The strategy is known as a call bull spread
 - An investor purchased a put option and wrote a call option at an exercise price higher
than that of the long put option. The strategy is known as a: vertical bear spread.

- An investor purchased a put option and at the same time wrote a put option at an
exercise price lower than that of the long put option. The strategy is known as a: put
bear spread

- If a share investor with quite a bearish outlook but also wants to hedge against a price
rise, then they could undertake a: put a bear straddle.

- An investor with a very bearish attitude can limit their attitude by vertical bull spread.

- In expectation of increased price volatility, an investor purchased a call option and at the
same time bought a put option with common exercise prices. The strategy is known as a
long straddle.

- If an investor with a somewhat bearish attitude owns some shares but does not as yet
want to sell, then they can limit their downside exposure to a price fall by writing a call
option on the shares

- In expectation of increased price volatility, an investor purchased a call option and at the
same time bought a put option, both with out-of-the-money exercise prices on the same
underlying asset. The strategy is known as a long strangle.

- In expectation of increased price stability, an investor sells a call option and at the same
time sells a put option with common exercise prices on the same underlying asset. The
strategy is known as a short straddle.

Key Concepts Misunderstanding

• The seller of an option has the • Options are contracts that give the
obligation to buy or sell the underlying asset purchaser the obligation to buy or sell an
underlying asset.
• If a buyer of a particular share • A put option gives the owner the
purchased a call option on it at a strike price obligation to sell the underlying security.
of $15 and the share is selling for $12 on • In the options market the short-call
the expiration date, the call option is worth party has the right to sell shares at a
$0 specified price.
• A long-call party would exercise a call
• The value of a put option rises when option with an exercise price of $9.00 and a
the underlying asset experiences price premium of $1.50 if the current price of the
declines. underlying physical market asset is $8.00.

• If interest rates increase the value of a • A short-call party to a call option with
put option declines an exercise price of $10.00 and a premium
of $1.00, if the current price of the
underlying asset is $8.00 on the exercise
date, would make a loss of $1.00

• The intrinsic value of an option is the

amount the option is expected to be worth
on its expiration date.