Showing posts with label Finance. Show all posts
Showing posts with label Finance. Show all posts
Commercial banks are involved in futures, options, and other derivative instruments in two important ways. First, they design or price these derivative instruments for their clients. Second, they also use derivative instruments in managing interest rate and currency risks specifically and asset-liabilities in general. Introduction of the international dimension to bank management transforms various risk facets and their management. For instance, domestic interest rate risk of a bank may be mitigated or magnified in the presence of the currency risk it faces. Further, the economics of benefit-cost analysis regarding risk management on behalf of the bank’s clients as well as on its own account significantly changes in the presence of a bewildering array of derivative instruments available on international dimension (swaps, belong to this category). Thus, an understanding of these instruments is vital for managing operations of multinational banks.
Primarily on currency and interest rates related derivative instruments because they are widely used by multinational banks. First, differences and similarities between forward and futures contracts are discussed. Then, salient characteristics of both currency and interest rate futures contracts are described. Options and options on futures are finally explained. One major purpose is highlight linkages among futures, options, and their underlying assets. This discussion serves as a foundation for discussion of some intricate derivative instruments such as interest rate and currency swaps, where these complex instruments will be shown as a combination of the basic (option and futures) instruments.
Primarily on currency and interest rates related derivative instruments because they are widely used by multinational banks. First, differences and similarities between forward and futures contracts are discussed. Then, salient characteristics of both currency and interest rate futures contracts are described. Options and options on futures are finally explained. One major purpose is highlight linkages among futures, options, and their underlying assets. This discussion serves as a foundation for discussion of some intricate derivative instruments such as interest rate and currency swaps, where these complex instruments will be shown as a combination of the basic (option and futures) instruments.
For a non-financial firm, the MM theory provides at least a starting point for the resource allocation process: the firm should find the net present value of the prospective real asset first as if it is being financed exclusively by stockholders; and if it is positive, then the appropriate asset financing should take advantage of existing financial market imperfections. For a financial firm or bank, such a dichotomy of investment and financing decisions creates one major problem.The bank’s assets are as much financial as its liabilities. The basic premise for the existence of banks is rooted in financial market inefficiencies, and this premise is at odds with the MM theory. Indeed, such inefficiencies signify a joint consideration of investment and financing decisions, and the computation of the cost of capital (as suggested by, for instance, MM) as a cutoff rate becomes less meaningful for a bank than for the non-financial firm.1 Furthermore, any investment project cannot be considered in isolation or by itself. Instead, its impact on the owners must be analyzed in the context of other investments of the firm.
Bank management practice that focuses on joint consideration of (a) investment-financing decisions, and (b) an investment proposal with existing investments (rather than the proposal in itself ) is consistent with the above conceptual implications. Hence, concentrates on bank management practice that emphasizes asset-liability management, rather than consideration of a single project. In turn, the asset-liability management practice has highlighted the risk (rather than return) dimension.2 Its objective has been to optimize three components of risk: liquidity risk, credit risk, and interest rate risk. Liquidity risk is typically monitored by liability and liquidity managers. Similarly, most banks delegate the management of credit risk to the bank’s loan and investment centers; credit risk, specifically pertaining to the international dimension. Hence we concentrate here on the interest rate risk dimension as it relates to asset-liability management.3 One risk typically ignored in the domestic, single-currency dimension is the foreign exchange risk. Currency risk is intimately interrelated to the interest rate risk.Therefore, for expository ease, we will first focus on a single-currency scenario, and later modify the analysis to include the multi-currency consideration.
Bank management practice that focuses on joint consideration of (a) investment-financing decisions, and (b) an investment proposal with existing investments (rather than the proposal in itself ) is consistent with the above conceptual implications. Hence, concentrates on bank management practice that emphasizes asset-liability management, rather than consideration of a single project. In turn, the asset-liability management practice has highlighted the risk (rather than return) dimension.2 Its objective has been to optimize three components of risk: liquidity risk, credit risk, and interest rate risk. Liquidity risk is typically monitored by liability and liquidity managers. Similarly, most banks delegate the management of credit risk to the bank’s loan and investment centers; credit risk, specifically pertaining to the international dimension. Hence we concentrate here on the interest rate risk dimension as it relates to asset-liability management.3 One risk typically ignored in the domestic, single-currency dimension is the foreign exchange risk. Currency risk is intimately interrelated to the interest rate risk.Therefore, for expository ease, we will first focus on a single-currency scenario, and later modify the analysis to include the multi-currency consideration.
The international monetary policies of the New Deal may be divided into two decisive and determining actions, one at the beginning of the New Deal and the other at end. The first was the decision, in early 1933, to opt for domestic inflation and monetary nationalism, a course that helped steer the entire world onto a similar path during the remainder of the decade. The second was the thrust, during World War to reconstitute an international monetary order, this time built on the dollar as the world’s “key” and crucial currency. If we wished to use lurid terminology, we might call these a decision for dollar nationalism and dollar imperialism respectively.
The gold standard in the prewar era was never “pure,” no more than was laissez-faire in general. Every major country, except the United States, had central banks which tried their best to inflate and manipulate the currency. But the system was such that this intervention could only operate within narrow limits. If one country inflated its currency, the inflation in that country would cause the banks to lose gold to other nations, and consequently the banks, private and central, would before long be brought to heel.
The advent of the World War disrupted and rended this economic idyll, and it was never to return. In the first place, all of the major countries financed the massive war effort through an equally massive inflation, which meant that every country except the United States, even including Great Britain, was forced to go off the gold standard, since they could no longer hope to redeem their currency obligations in gold. The international order not only was sundered by the war, but also split into numerous separate, competing, and warring currencies, whose inflation was no longer subject to the gold restraint. In addition, the various governments engaged in rigorous exchange control, fixing exchange rates and prohibiting outflows of gold; monetary warfare paralleled the broader economic and military conflict.
The gold standard in the prewar era was never “pure,” no more than was laissez-faire in general. Every major country, except the United States, had central banks which tried their best to inflate and manipulate the currency. But the system was such that this intervention could only operate within narrow limits. If one country inflated its currency, the inflation in that country would cause the banks to lose gold to other nations, and consequently the banks, private and central, would before long be brought to heel.
The advent of the World War disrupted and rended this economic idyll, and it was never to return. In the first place, all of the major countries financed the massive war effort through an equally massive inflation, which meant that every country except the United States, even including Great Britain, was forced to go off the gold standard, since they could no longer hope to redeem their currency obligations in gold. The international order not only was sundered by the war, but also split into numerous separate, competing, and warring currencies, whose inflation was no longer subject to the gold restraint. In addition, the various governments engaged in rigorous exchange control, fixing exchange rates and prohibiting outflows of gold; monetary warfare paralleled the broader economic and military conflict.
Foreign trade financing is one major activity pursued by banks, small and large.Various forms of guarantees, including the letter of credit, facilitate foreign trade for enabling exporters to minimize the risk of payment and importers to minimize the risk of performance. Although financing is not a necessary condition for providing these guarantees, financing is usually a part of the package.
In addition to trade financing, banks also provide or convert foreign exchange for trade participants. Participants may also require arrangements for “local” borrowing or hedging the currency exposure of the trade transactions. Firms with foreign operations would require these services on an ongoing basis and on a larger scale.
The term “local” here connotes not only the foreign location where the participant has the business interest and is subject to government regulations but also the unregulated, offshore markets. Offshore markets are commonly called “Euro”-markets. One segment of the Euro markets is the Euro currencies market where spot currency transactions as well as trading in short- and medium-term funds and instruments are undertaken.The “interbank” market, where banks conduct business among themselves, significantly overlaps the Euro markets; hence, the term “interbank” is often used interchangeably with “Euro-” or “Euro currencies” markets.13 Euro currencies markets are notable in two respects: (a) over 80 percent of foreign exchange trading takes place in these markets; and (b) given their informational and cost efficiencies, these markets greatly facilitate banks’ asset-liability management to attain targets of liquidity and interest rate exposures.
In addition to trade financing, banks also provide or convert foreign exchange for trade participants. Participants may also require arrangements for “local” borrowing or hedging the currency exposure of the trade transactions. Firms with foreign operations would require these services on an ongoing basis and on a larger scale.
The term “local” here connotes not only the foreign location where the participant has the business interest and is subject to government regulations but also the unregulated, offshore markets. Offshore markets are commonly called “Euro”-markets. One segment of the Euro markets is the Euro currencies market where spot currency transactions as well as trading in short- and medium-term funds and instruments are undertaken.The “interbank” market, where banks conduct business among themselves, significantly overlaps the Euro markets; hence, the term “interbank” is often used interchangeably with “Euro-” or “Euro currencies” markets.13 Euro currencies markets are notable in two respects: (a) over 80 percent of foreign exchange trading takes place in these markets; and (b) given their informational and cost efficiencies, these markets greatly facilitate banks’ asset-liability management to attain targets of liquidity and interest rate exposures.
Competitive financial markets, irrespective of competitiveness of goods markets but ensuring nonetheless competitive foreign exchange markets, make banks’ intermediary role less relevant, if not redundant. Due to equal access to relevant information and absence of any roadblocks1 in entering or exiting financial markets, market participants can engage in a tradeoff between current and future consumption patterns without help from banks. Similarly, it is doubtful whether banks per se are essential to provide an effective conduit for the government in carrying out the monetary policy measures. Although competitive financial markets in the ideal form are nowhere near reality currently (or, for that matter, in the foreseeable future), imperfections in financial markets are not static in nature. In fact, many of them tend to atrophy over time and are replaced by new ones, as the last quarter of the twentieth century has witnessed in the USA and elsewhere in the world. A gradual birth or removal of and transformation in imperfections in financial markets has thus changed the distance between perfect and imperfect financial markets, affecting thereby the role of banks in these markets.
This is the essence of sound strategy formulation and implementation. Students of strategy have debated whether the focus should be on analysis of external environment or core strength of the firm. In the case of a commercial bank, this debate will have to take a back seat since both these aspects are equally crucial for strategy formulation in a global context.
This is the essence of sound strategy formulation and implementation. Students of strategy have debated whether the focus should be on analysis of external environment or core strength of the firm. In the case of a commercial bank, this debate will have to take a back seat since both these aspects are equally crucial for strategy formulation in a global context.
Financial institutions in an economy pool the savings of investors and invest them in enterprises or assets that generate uncertain returns. In this section,we consider the pivotal role of financial institutions in an economy. In a basic sense, the existence of financial institutions is justifiable only if they can improve the risk-return trade off for participants in the financial markets.
The CAPM theory described above assumes that an asset is infinitely divisible; hence, an investor having a small endowment can still construct a portfolio that mirrors the market portfolio. In reality, such a possibility does not exist. This divergence underscores the critical relevance of the notion of actuarial risk and the pivotal role played by financial institutions in making it achievable by investors. Suppose an investor has $1,000 to invest and she seeks to invest it in a company whose shares are selling at $1,000 apiece and this company faces a 10 percent chance of failure. If a failure occurs, the investor will lose all her money.Thus the likelihood of 10 percent is meaningless for our investor.
Edge Act Corporation
An Edge Act corporation, or “edgie,” is a specialized banking organization in international trade-related transactions or investments open to US domestic banks since 1919 and to foreign banks since 1978. Edge Act corporations are restricted to handle foreign customers and to handle the international business activities of domestic customers.These activities include trade-financing arrangements, deposit taking from outside the USA, lending money to international businesses and making equity investments in foreign operations.
An edgie allows a bank to undertake the above-mentioned activities especially in a port city, which may be in a different state from the state of the bank’s domicile.Thus it enables a bank to circumvent prohibition of interstate operations, a feature that was much more appealing prior to 1978 when the deregulation movement started.12 By its very nature, the edgie undertakes activities peripheral to the mainstream business; hence competent employees have not been enthusiastic about assignment to the edgie business, unless it is understood as interim.
An edgie allows a bank to undertake the above-mentioned activities especially in a port city, which may be in a different state from the state of the bank’s domicile.Thus it enables a bank to circumvent prohibition of interstate operations, a feature that was much more appealing prior to 1978 when the deregulation movement started.12 By its very nature, the edgie undertakes activities peripheral to the mainstream business; hence competent employees have not been enthusiastic about assignment to the edgie business, unless it is understood as interim.
The commercial bank plays three primary roles in the financial market:
1. information processing;
2. risk sharing; and
3. money creation.
First, the bank collects and processes information.The bank collects information on both its depositors who provide funds and borrowers who represent investment opportunities for the deposit funds. The bank allows the depositors and the prospective borrowers to avoid the search cost of directly finding each other. Further, the bank’s specialized resources for screening loan candidates reduce the likelihood of default faced by the depositors on their own. Since the bank undertakes investments in specialized resources on its own account, depositors are able to share the default risk not only with one another but also with the shareholders of the bank. As a result, depositors are only concerned with the viability of the bank, and not of individual borrowing entities. Through this process, the bank fulfills its second role of risk sharing. Finally, a bank loan to a business reduces the information asymmetry for other investors through a signal regarding credit worthiness of this entity.
In order to sharpen the focus on the role played by a commercial bank, it is useful to consider two other financial intermediaries, investment banks and insurance companies. The investment bank engineers specific financial products that are tailored to suit the needs of their customers.To accomplish this task, it focuses on gathering and analyzing information pertaining to its customers’ needs. Because the prototype investment bank does not undertake investment activities on its own account, its customers bear the risk of investments on their own.Thus, the investment bank supplies its customers the information, but does not offer them an actuarial risk sharing function.
An insurance company, on the other hand, specializes in risk sharing. Unlike the investment bank, an insurance company (another major financial intermediary) does not gather information on customers’ investment needs; instead, it attracts a large number of customers who fund each other in the eventuality of a specific adversity such as a fire or a death. By collectively sharing each other’s risk, the insurance company’s customers minimize their individual loss in the event that the insured risk materializes.
First, the bank collects and processes information.The bank collects information on both its depositors who provide funds and borrowers who represent investment opportunities for the deposit funds. The bank allows the depositors and the prospective borrowers to avoid the search cost of directly finding each other. Further, the bank’s specialized resources for screening loan candidates reduce the likelihood of default faced by the depositors on their own. Since the bank undertakes investments in specialized resources on its own account, depositors are able to share the default risk not only with one another but also with the shareholders of the bank. As a result, depositors are only concerned with the viability of the bank, and not of individual borrowing entities. Through this process, the bank fulfills its second role of risk sharing. Finally, a bank loan to a business reduces the information asymmetry for other investors through a signal regarding credit worthiness of this entity.
In order to sharpen the focus on the role played by a commercial bank, it is useful to consider two other financial intermediaries, investment banks and insurance companies. The investment bank engineers specific financial products that are tailored to suit the needs of their customers.To accomplish this task, it focuses on gathering and analyzing information pertaining to its customers’ needs. Because the prototype investment bank does not undertake investment activities on its own account, its customers bear the risk of investments on their own.Thus, the investment bank supplies its customers the information, but does not offer them an actuarial risk sharing function.
An insurance company, on the other hand, specializes in risk sharing. Unlike the investment bank, an insurance company (another major financial intermediary) does not gather information on customers’ investment needs; instead, it attracts a large number of customers who fund each other in the eventuality of a specific adversity such as a fire or a death. By collectively sharing each other’s risk, the insurance company’s customers minimize their individual loss in the event that the insured risk materializes.
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