UNITY UNIVERSITY

COLLEGE OF DISTANCE AND CONTINUING EDUCATION

DEPARTMENT OF ECONOMICS

International Economics II (Econ-2082) Module

 CHAPTER ONE

2.1 PORTFOLIO CHOICE

Suppose you suddenly struck it rich. Maybe you have just won $25 million in the lottery
and your first payment of $600,000 has arrived. Or your dear departed Aunt has
remembered you with a $200,000 bequest. There are a lot of things you might want to do
with this windfall: put a down payment on a mansion, buy a Car, or invest in gold coins,
land, Treasury bills, or AT & T stock. How will you decide what portfolio of assets you
should hold to store your newfound wealth? What criteria should you use to decide
among these various stores of wealth? Should you buy only one type of asset or several
different types? Dear distance learner, this chapter helps answer these questions by
developing an economic theory known as the theory of portfolio choice. This theory
outlines criteria that are important when deciding which assets are worth buying. In
addition, it gives us an idea why it is good to diversify and not to put all our eggs in one
basket. Accordingly, in this chapter issues like determinants of asset demand, theories of
portfolio choice, benefits of asset diversification and others will be raised and discussed
thoroughly.

Thus, after studying this chapter you will be able to:

 Identify the determinants of asset demand
 Know the criteria that are important in buying different assets
 Explain the different theory of portfolio choice
 Realize the benefits of diversification

The theory of portfolio choice plays a pivotal role in the study of money, banking, and
financial markets.
2.2 DETERMINANTS OF ASSET DEMAND

An asset is a piece of property that is a store of value. Items such as money, bonds,
stocks, art, land, houses, farm equipment, and manufacturing machinery are all assets.
Facing the question of whether to buy and hold an asset or whether to buy one asset
rather than another, an individual must consider the following factors:

1. Wealth, the total resources owned by the individual, including all assets
2. Expected return (the return expected over the next period) on one asset relative
to alternative assets
3. Risk (the degree of uncertainty associated with the return) on one asset relative to
alternative assets
4. Liquidity (the ease and speed with which an asset can he turned into cash)
relative to alternative assets

Wealth: When we find that our wealth has increased, we have more resources available
with which to purchase assets, and so, not surprisingly, the quantity of assets we demand
increases. But the demand for inferior assets might have the property that the quantity
demanded does not increase as wealth increases, such assets are rare. Hence we will
always assume that demand for an asset increases as wealth increases. The demand for
different assets responds differently to changes in wealth, however; the quantity
demanded of some assets grows more rapidly with a rise in wealth than the quantity
demanded of others. The degree of this response is measured by a concept known as the
wealth elasticity of demand (which is similar to the concept of income elasticity of
demand, which you have learned in microeconomics). The wealth elasticity of demand
measures how much, with everything else unchanged, the quantity demanded of an asset
changes in percentage terms in response to a percentage change in wealth:
 % change in quantity demanded
= Wealth elasticity of demand
% change in wealth

If, for example, the quantity of currency demanded increases only by 50 percent when
wealth increases by 100 percent, we say that currency has a wealth elasticity of demand
of ½. If, for a common stock, the quantity demanded increases by 200 percent when
wealth increases by 100 percent, the wealth elasticity of demand equals 2.

Assets can be sorted into two categories, depending on the value of their wealth elasticity
of demand. An asset is a necessity if there is only so much that people want to hold, so
that as wealth grows, the percentage increase in the quantity demand of the asset is less
than the percentage increase in wealth- in other words, its wealth elasticity is less than 1.
Because the quantity demanded of a necessity does not grow proportionally with wealth,
the amount of this asset that people want to hold relative to their wealth falls as wealth
grows. An asset is a luxury if its wealth elasticity is greater than 1; and as wealth grows,
the quantity demanded of this asset grows more than proportionally, and the amount that
people hold relative to their wealth grows. Common stocks and municipal bonds are
examples of luxury assets, and currency and checking account deposits are necessities.

The effect of changes in wealth on the quantity demanded of an asset can he summarized
in this way: Holding everything else constant, an increase in wealth raises the quantity
demanded of an asset; and the increase in the quantity demanded is greater if the asset
is a luxury than if it is a necessity.

Expected returns: the return on an asset (such as a bond) measures how much we
gain from holding that asset. When we make a decision to buy an asset, we are influenced
by what we expect the return on that asset to be. If a Mobil Oil Corporation bond, for
example, has a return of 15 percent half of the time and 5 percent the other half of the
time, its expected return (which you can think of as the average return) is 10 percent. If
the expected return on the Mobil Oil bond rises relative to expected returns on alternative
assets, holding everything else constant, then it becomes more desirable to purchase it,
and the quantity demanded increases. This can occur in either of two ways: (1) when the
expected return on the Mobil Oil bond rises while the return on an alternative asset—say,
stock in IBM—remains unchanged or (2) when the return on the alternative asset, the
IBM stock, falls while the return on the Mobil Oil bond remains unchanged. To
summarize, an increase in an asset’s expected return relative to that of an alternative
asset, holding everything else unchanged, raises the quantity demanded of the asset.

Risk: The degree of risk or uncertainty of an asset’s returns also affects the demand for
the asset. Consider two assets, stock in Fly-by-Night Airlines and stock in Feet-on- the-
Ground Bus Company. Suppose that Fly-by-Night stock has a return of 15 percent half
the time and 5 percent the other half of the time, making its expected return 10 percent,
while stock in Feet-on-the-Ground has a fixed return of 10 percent. Fly-by-Night stock
has uncertainty associated with its returns and so has greater risk than stock in Feet-on-
the-Ground, whose return is a sure thing.

A risk-averse person prefers stock in Feet-on- the-Ground (the sure thing) to Fly-by-
Night stock (the riskier asset), even though the stocks have the same expected return, 10
percent. By contrast, a person who prefers risk is a risk preferrer or risk lover. Most
people are risk-averse: Everything else being equal, they prefer to hold the less risky
asset. Hence, holding everything else constant, if an asset’s risk rises relative to that of
alternative assets, its quantity demanded will fall.

Liquidity: Another factor that affects the demand for an asset is how quickly it can be
convened into cash without incurring large costs—its liquidity. An asset is liquid if the
market in which it is traded has depth and breadth, that is, if the market has many buyers
and sellers. A house is not a very liquid asset because it may be hard to find a buyer
quickly; if a house must be sold to pay off bills, it might have to be sold for a much lower
price. And the transaction costs in selling a house (broker’s commissions, lawyer’s fees,
and so on) are substantial. A U.S. Treasury bill, by contrast, is a highly liquid asset. It can
be sold in a well-organized market where there are many buyers, so it can be sold quickly
at low cost. The more liquid an asset is relative to alternative assets, holding everything
else unchanged, more desirable it is, and the greater will be the quantity demanded.
2.3 THEORY OF PORTIFOLI CHOICE

All the determining factors we have just discussed can be assembled into the theory of
portfolio choice, which stares that, holding all of the other factors constant:

1. The quantity demanded of an asset is usually positively related to wealth, with the
response being greater if the asset is a luxury than if it is a necessity.
2. The quantity demanded of an asset is positively related to its expected return
relative to alternative assets.
3. The quantity demanded of an asset is negatively related to the risk of its returns
relative to alternative assets
4. The quantity demanded of an asset is positively related to its liquidity relative to
alternative assets.

2.4 BENEFITS OF DIVERSIFICATION

Our discussion of the theory of portfolio choice indicates that most people like to avoid
risk; that is, they are risk-averse. Why, then, do many investors hold many risky assets
rather than just one? Doesn’t holding many risky assets expose the investor to more risk?

The old warning about not putting all your eggs in one basket holds the key to the
answer: Because holding many risky assets (called diversification), reduces the overall
risk an investor faces, diversification is beneficial. To see why this is so, let’s look at
some specific examples of how an investor fares when holding two risky securities.

Consider two assets, common stock of Frivolous Luxuries, Inc., and common stock of
Bad Times Products, Unlimited. When the economy is strong, which we’ll assume is half
of the time, Frivolous Luxuries has high sales and the return on the stock is 15 percent;
when the economy is weak, the other half of the time, sales are low and the return on the
stock is 5 percent. In contrast, suppose that Bad Times Products thrives when the
economy is weak so that its stock has a return of 15 percent, but it earns less when the
economy is strong and has a return on the stock of 5 percent. Both stocks have a return of
15 percent half of the time and 5 percent the other half of the time, and both have an
expected return of 10 percent. However, both stocks carry a fair amount of risk because
there is uncertainty about their actual returns.

Suppose now that instead of buying one stock or the other, Irving the Investor puts half
his savings in Frivolous Luxuries stock and the other half in Bad Times Products stock.
When the economy is strong, Frivolous Luxuries stock has a return of 15 percent and Bad
Times Products has a return of 5 percent. The result is that Irving earns a return of 10
percent (the average of 5 percent and 15 percent) on his holdings of the two stocks. When
the economy is weak, Frivolous Luxuries has a return of only 5 percent and Bad Times
Products has a return of 15 percent, so Irving still earns a return of 10 percent. If Irving
diversifies by buying both stocks, he earns a return of 10 percent regardless of whether
the economy is strong or weak. Irving is better off from this strategy of diversification
because his expected return is 10 percent, the same as from holding either Frivolous
Luxuries or Bad Times Products alone, yet he is not exposed to any risk.

Although the case we have described demonstrates the benefits of diversification, it is

some what unrealistic. It is hard to find two securities with the characteristic that when
the return of one is low, the reruns of the other are always high (such a case is described
by saying that the returns on the two securities are perfectly negatively correlated). In the
real world, we are more likely to find at best returns on securities that are independent of
each other; that is, when one is low, the other is just as likely to be high as to be low.

Suppose that both securities have an expected return of 10 percent, with a realm of 5
percent half of the time and 15 percent the other half of the time. Sometimes both
securities will earn the higher return, and sometimes both will earn the lower return. In
this case, if Irving holds equal amounts of each security, he will on average earn the same
return as if he had just put all his savings into one of the securities. However, because the
returns on these two securities are independent, it is just as likely that when one earns the
high 15 percent return, the other earns the low 5 percent return and vice versa, giving
Irving a return of 10 percent (equal to the expected return). Because Irving is more likely
to earn what he expected to earn when he holds both securities instead of just one, we can
see that Irving has again reduced his risk through diversification.

The one case in which Irving will not benefit from diversifying occurs when the returns
on the two securities move perfectly together. In this case, when the first security has a
return of 15 percent, the other also has a return of 15 percent, and holding both securities
result in a return of 15 percent. When the first security has a return of 5 percent, the other
has a return of 5 percent, and holding both results in a return of 5 percent. The result of
diversifying by holding both securities is a return of 15 percent half of the time and 5
percent the other half of the time, which is exactly the same returns that are earned by
holding only one of the securities. Consequently, diversification in this case does not lead
to any reduction of risk.

The examples we have just examined illustrate the following important points about
diversification:
1. Diversification is almost always beneficial to the risk-averse investor because it
reduces risk except in the extremely rare case where returns on securities move
perfectly together.
2. The less the returns on two securities move together, the more benefit (risk
reduction) there is from diversification.

2.5 SYSTEMATIC RISK

Given the benefits of diversification, you might think that by holding enough different
securities in a portfolio, you could eliminate risk entirely. Unfortunately, this is not
possible because securities have systematic risk, risk that can not be eliminated through
diversification. In other words, no matter how many different securities you hold in your
portfolio, you will still be stuck with some unavoidable risk, and this is the systematic
risk. To understand systematic risk better, we need to recognize that we can divide the
risk of an asset into two components, systematic risk and nonsystematic risk, the risk
unique to an asset that can be diversified away by holding enough different securities in
your portfolio:

Asset risk = systematic risk + nonsystematic risk

Nonsystematic risk is unique to an asset because it is related to the part of an asset’s

return that does not vary with returns on other assets. With many assets in a portfolio,
nonsystematic risk becomes less important because when the non-systematic part of one
asset’s return goes up, it is likely that the nonsystematic part of another asset’s return has
gone down, movements that cancel each other out. Hence with enough diversification as
a result of a portfolio containing a large number of different assets, the nonsystematic risk
contributes nothing to the total risk of the portfolio. In other works, the risk of a well-
diversified portfolio is due solely to the systematic risk of assets in the portfolio.

This fact is very important because it tells us that if we diversify sufficiently, the only
component of an asset’s risk that we have to worry about is its systematic risk. Systematic
risk of an asset is measured by a concept called beta, a measure of the sensitivity of an
asset’s return to changes in the value of the entire market of assets. When on average a 1
percent rise in the value of the market portfolio leads to a 2 percent rise in the value of an
asset, the beta for this asset is calculated to be 2.0. If, conversely, the value of the asset on
average rises by only 0.5 percent when the market rises by 1 percent, the asset’s beta is
0.5.

The first asset, with a beta of 2.0, has much more systematic risk than the asset with a
beta of 0.5. To see this, we first recognize that the portfolio made up of the entire market
is a completely diversified portfolio and hence has only systematic risk. When the value
of the market fluctuates by a certain amount, the asset with a beta of 2.0 fluctuates twice
as much. Therefore, its return has twice as much systematic risk. By contrast, the asset
with a beta of 0.5 fluctuates less than the market and so has less systematic risk. Because
an asset with a higher beta has more systematic risk, this asset is less desirable because
the systematic risk cannot be diversified away. Thus, holding everything else constant, an
asset with a higher beta has a lower quantity demanded. We have reached the following
conclusion, which is of great importance to participants in financial markets: the greater
an asset’s beta, the greater the asset’s systematic risk and the less desirable the asset is
to hold in one’s portfolio.

QUESTIONS FOR REVIEW AND DISCUSSION

1. What are the determinants of asset demand? Discuss how each is related to the
demand of a certain asset.
2. What is diversification?
3. By using an example, show how diversification is beneficial. In what
circumstance does not diversification beneficial?
4. What is the difference between systematic risk and nonsystematic risk? Explain
by using an example.
5. Discuss the theory of portfolio choice.
6. What is wealth elasticity of demand? What are the types of assets classified based
on their wealth elasticity?
7. Discuss the impacts of change in wealth on the different types of assets.
 CHAPTER THREE

3. INTEREST RATES

The money and capital markets are one of the vast pools of funds, depleted by the
borrowing activities of households, businesses and governments and replenished by the
savings these sectors supply to the financial system. The money and capital markets make
saving possible by offering the individual saver a wide menu of choices where funds may
be placed at attractive rates of return. BY committing funds to one or more financial
instruments, the saver, in effect, becomes a lender of funds. The financial markets also
make borrowing possible by giving the borrower a channel through which securities
(IOUs) can be issued to lenders. And the money and capital markets make investment and
economic growth possible by providing the funds needed for the purchase of machinery
and equipment and the construction of buildings, highways, and other productive
facilities.

Clearly, then, the acts of saving and lending, borrowing and investing are intimately
linked through the financial system. And one factor that significantly influences and ties
all of them together is the rate of interest. The rate of interest is the price a borrower
must pay to secure scarce loanable funds from a lender for an agreed-upon period. It is
the price of credit. But unlike other prices in the economy, the rate of interest is really a
ratio of two quantities: the money cost of borrowing divided by the amount of money
actually borrowed, usually expressed as an annual percentage basis.

Interest rates send price signals to borrowers, lenders, savers, and investors. For example,
higher interest rates generally bring forth a greater volume of savings and stimulate the
lending of funds. Lower rates of interest, on the other hand, tend to dampen the flow of
savings and reduce lending activity. Higher interest rates tend to reduce the volume of
borrowing and capital investment, and lower rates stimulate borrowing and investment
spending. In this chapter, we will discuss in more detail the forces that are believed by
economists and financial analysts to determine prevailing rates of interest in the financial
system.
Thus, after studding this chapter, you will be able to:
 Define what interest rate is
 Realize the functions of interest rate in the economy
 Know the distinction between interest rate and returns
 Explain the different theories of the rate of interest as well as the limitations of
each theories

3.1 FUNCTIONS OF THE RATE OF INTEREST IN THE ECONOMY

The rate of interest performs several important roles or functions in the economy:
 It helps guarantee that current savings will flow into investment to promote
economic growth.
 It rations the available supply of credit, generally providing loanable funds to
those investment projects with the highest expected returns.
 It brings into balance the supply of money with the public’s demand for money.
 It is also an important tool of government policy through its influence on the
volume of saving and investment. If the economy is growing too slowly and
unemployment is rising, the government can use its policy tools to lower interest
rates in order to stimulate borrowing and investment. On the other hand, an
economy experiencing rapid inflation has traditionally called for a government
policy of higher interest rates to slow both borrowing and spending.

To uncover these basic rate-determining forces, however, we must make a simplifying

assumption. We assume in this chapter that there is one fundamental interest rate in the
economy known as the pure or risk-free rate of interest, which is a component of all
interest rates. The closest approximation to this pure rate in the real world is the market
yield on government bonds. It is a rate of return presenting little or no risk of financial
loss to the investor and representing the opportunity cost of holding idle cash, because the
investor can always invest in low-risk bonds and earn this minimum rate of return.

3.2 THE DISTINCTION BETWEEN INTEREST RATES AND

RETURNS

Many people think that the interest rate on a bond tells them all they need to know about
how well off they are as a result of owning it. If Irving the Investor thinks he is better off
when he owns a long-term bond yielding a 10 percent interest rate and the interest rate
rises to 20 percent, he will have a rude awakening: As we will shortly see, Irving has lost
his shirt! How well a person does by holding a bond or any other security over a
particular time period is accurately measured by the return or, in more precise
terminology, the rate of return. For any security, the rate of return is defined as the
payments to the owner plus the change in its value, expressed as a fraction of its purchase
price. To make this definition clearer, let us see what the return would look like for a $
1000 face-value coupon bond with a coupon rate of 10 percent that is bought for $1000,
held for one year, and then sold for $1200. The payment to the owner are the yearly
coupon payments of $100, and the change in its value is $1200-$1000 = $200. Adding
these together and expressing them as a fraction of the purchase price of $1000 gives us
the one-year holding-period return for this bond:

$100 + $200 $300

= = 0.30 = 30%
$1000 $1000

You may have noticed something quite surprising about the return that we have just
calculated: It equals 30 percent. This demonstrates that the return on a bond will not
necessarily equal the interest rate on that bond. We now see that the distinction between
interest rate and return can be important, although for many securities the two may be
closely related.

More generally, the return on a bond held from time t to time t+1 can be written as

C + P1+1 − pt
RET=
Pt (1)
Where RET = return from holding the bond from time t to time t +1
Pt = price of the bond at time t
Pt +1 = Price of the bond at time t+1
C = coupon payment

A convenient way to rewrite the return formula in Equation 1 is to recognize that it can be
split up into two separate terms. The first is the current yield i c (the coupon payment over
the purchase price):
C
=i
Pt c
The second term is the rate of capital gain, or the change in the bond’s price relative to
the initial purchase price:

Pt +1−Pt
=g
Pt
Where g = rate of capital gain. Equation 1 can then be rewritten as

RET = ic +g (2)

which shows that the return on a bond is the current yield i c plus the rate of capital gain.
This rewritten formula illustrates the point we just discovered. Even for a bond for which
the current yield ic is an accurate measure of the yield to maturity, the return can differ
substantially from the interest rate. Returns will differ from the interest rate especially if
there are sizable fluctuations in the price of the bond that produce substantial capital
gains or losses.

To explore this point even further, let’s look at what happens to the returns on bonds of
different maturities when interest rates rise. Table 2 calculates the one-year return on
several 10 percent –coupon-rate bonds all purchased at par when interest rates on all
these bonds rise from 10 to 20 percent. Several key findings in this table are generally
true of all bonds.

 The only bond whose return equals the initial yield to maturity is one whose time
to maturity is the same as the holding period (see the last bond in Table 2).
  A rise in interest rates is associated with a fall in bond prices, resulting in capital
losses on bonds whose terms to maturity are longer than the holding period.
 The more distant a bonds maturity, the greater the size of the price change
associated with an interest-rate change.
 The more distant a bond’s maturity, the lower the rate of return that occurs as a
result of the increase in the interest rate.
 Even though a bond has a substantial initial interest rate, its return can turn out to
be negative if interest rates rise.

TABLE 3.1: One-Year Returns on Different-Maturity 10 percent Coupon Rate

Bonds When Interest Rates Rise
(1) (2) (3) (4) (5) (6) (7) (8)
Years to Initial Initial Yield to Price Initial Rate of Rate of
Maturity Yield to price Maturity Next Current Capital Return
When Maturity ($) Next Year Yield Gain (6+7)
Bonds is (%) year (%) ($) (%) (%) (%)
Purchased
30 10 1000 20 503 10 -49.7 -39.7
20 10 1000 20 516 10 -48.4 -38.4
10 10 1000 20 597 10 -40.3 -30.3
5 10 1000 20 741 10 -25.9 -15.9
2 10 1000 20 917 10 -8.3 +1.7
1 10 1000 20 1000 10 0.0 +10.0

At first it frequently puzzles students that a rise in interest rates can mean that a bond has
been a poor investment (as it puzzles poor lrving the Investor). The trick to understanding
this is to recognize that a rise in the interest rate means that the price of a bond has fallen.
A rise in interest rates therefore means that a capital loss has occurred, and if this loss is
large enough, the bond can be a poor investment indeed. For example, we see in Table 2
that the bond that has 30 years to maturity when purchased has a capital loss of 49.7
percent when the interest rate rises from 10 in 20 percent. This loss is so large that it
exceeds the current yield of 10 percent, resulting in a negative return (loss) of —39.7
percent.

3.3 THEORIES OF INTEREST RATES

3.3.1 THE CLASSICAL THEORY OF INTEREST RATES
One of the oldest theories concerning the determinants of the pure or risk-free interest
rate is the classical theory of interest rates, developed during the 18th and 19th centuries
by a number of British economists and elaborated by Irving Fisher (1930) earlier in this
century. The classical theory argues that he rate of interest is determined by two forces:
(1) the supply of savings, derived mainly from households, and (2) the demand for
investment capital, coming mainly from the business sector. Let us examine these rate-
determining forces of savings and investment demand in detail.

Saving by Households

What is the relationship between the rare of interest and the volume of savings in the
economy? Most saving in modern industrialized economies is carried out by individuals
and families. For these households, saving is simply abstinence from consumption
spending. Current saving, therefore, are equal to the difference between current income
and current consumption expenditures.

In making the decision on the timing and amount of saving to be done, households
typically consider several factors: the size of current and long-term income, the desired
savings target, and the desired proportion of income to be set aside in the form of savings
(i.e., the propensity to save). Generally, the volume of household savings rises with
income. Higher-income families and individuals tend to save more and consume less
relative to their total income than families with lower incomes.

Although income levels probably dominate saving decisions, interest rates also play an
important role. Interest rates affect an individual’s choice between current consumption
and saving for future consumption. The classical theory of interest assumes that
individuals have a definite time preference for current over future consumption. A rational
individual, it is assumed, will always prefer current enjoyment of goods and services over
future enjoyment. Therefore, the only way to encourage an individual or family to
consume less now and save more is to offer a higher rate of interest on current savings. If
more were saved in the current period at a higher rate of returns, future consumption and
future enjoyment would be increased. For example, if the current rate of interest is 10
percent and a household saves $100 instead of spending it on current consumption, it will
be able to consume $110 in goods and services a year from now.

The classical theory considers the payment of interest a reward for waiting - the
postponement of current consumption in favor of greater future consumption. Higher
interest rates increase the attractiveness of saving relative to consumption spending,
encouraging more individuals to substitute current saving (and future consumption) for
some quantity of current consumption. This so-called substitution effect calls for a
positive relationship between interest rates and the volume of savings. Higher interest
rates bring forth a greater current volume of savings.

Saving by business firms

Not only households, but also businesses, save and direct a portion of their savings in to
the financial markets to purchase securities and make loans. Most businesses hold savings
balances in the form of retained earnings (as reflected in their equity or net worth
accounts). In fact, the increase in retained earnings reported by businesses each year is a
key measure of the volume of current business saving. And these retained earnings supply
most of the money for annual investment spending by business firms.

Although the principal determinant of business saving is profits, interest rates also play a
role in the decision of what proportion of current operating costs and long-term
investment expenditures should be financed internally and what proportion externally.
Higher interest rates in the money and capital markets typically encourage firms to use
internally generated funds more heavily in financing projects. Conversely, lower interest
rates encourage greater use of external funds from the money and capital markets.

Saving by Government
Governments also save, though less frequently than households and businesses. In fact,
most government saving (i.e. a budget surplus) appears to be unintended saving that
arises when government receipts unexpectedly exceed the actual amount of expenditures.
Income flows in the economy (out of which government tax revenues arise) and the
pacing of government spending programs are the dominant factors affecting government
savings. Interest rates are probably not a key factor here.

The Demand for Investment Funds

Business, household, and government savings are important determinants of interest rates
according to the classical theory of interest, but not the only ones. The other critical rate
determining factor is investment spending by business firms.

The investment decision-Making process: The process of investment decision making

by business firms is complex and depends on a host of qualitative and quantitative
factors. The firm must compare its current level of production with the capacity of its
existing facilities and decide whether it has sufficient capacity to handle anticipated
demand for its product. If expected future demand will strain the firm’s existing facilities,
it will consider expanding its operating capacity through net investment.

Most business firms have several investment projects under consideration at any one
time. Although the investment decision-making process varies from firm to firm, each
business generally makes some estimate of net cash flows (i.e., revenues minus all
expenses including taxes) that each project will generate over its useful life. From this
information plus knowledge of each investment project’s acquisition cost, management
can calculate its expected rate of return and compare that expected return with anticipated
returns from alternative projects.

One of the more popular methods for performing this calculation is the internal rate of
return method, which equates the total cost of an investment project with the future net
cash flows (NCF) expected from that project discounted back to their present values.
Thus,
NCF 1 NCF 2 NCF n
Cost of project = 1
+ 2
+. ..+ ( 1)
( 1+r ) (1+ r ) ( 1+r )n
where each NCF represents the expected annual net cash flow from the project and r is its
expected internal rate of return. The internal rate performs two functions: (1) it measures
the annual yield the firm expects from an investment project and (2) it reduces the value
of all future cash flows expected over the economic life of the project down to their
present value to the firm. In general, if the firm must choose among several mutually
exclusive projects, it will choose the one with the highest expected internal rate of return.

Although the internal rate of return provides a yardstick for selecting potentially
profitable investment projects, how does a business executive decide how much to spend
on investment at any point in time? How many projects should be chosen? It is here that
the financial markets play a key role in the investment decision- making process.

Suppose a business firm is considering the following projects with their associated
expected internal rates of return:
Project Expected internal rate of return
(annualized)
A 15%
B 12
C 10
D 9
E 8

How many of these projects will be adopted? The firm must compare each project’s
expected internal return with the cost of raising capital- the interest rate- in the money
and capital markets to finance the project.

Assume that funds must be borrowed in the financial marketplace to complete any of the
above projects and the current cost of borrowing – the rate of interest – is 10 percent.
Which projects are acceptable from an economic standpoint? As shown in Exhibit 3.1,
projects A and B clearly are acceptable because their expected returns exceed the current
cost of borrowing capital (10 percent) to finance them. The firm would be indifferent
about project C because its expected return is no more than the cost of borrowed funds
(i.e., the current interest rate). Projects D and E, on the other hand, are unprofitable at this
time.
 It is through changes in the cost of raising funds that the financial markets can exert a
powerful influence on the investment decisions of business firms. As credit becomes
scarcer and more expensive, the cost of borrowed capital rises, eliminating some
investment projects form consideration. For example, if the cost of borrowed funds rises
from 10 to 13 percent, it is obvious that only project A in our earlier example would then
be economically viable. On the other hand, if credit becomes more abundant and less
costly, the cost of capital for the individual firm will tend to decline and more projects
will become profitable. In our example, a decline in the cost of borrowed funds forms 10
to 8 ½ percent would make all but project E economically viable and probably acceptable
to the firm.

Exhibit 3.1 The Cost of Capital and the Investment Decision

Cost of capital A
(Percent per 15%
annum) B
12%
C Cost of Capital funds = 10%
10%
D
9%
E
8%
0
Dollar cost of investment projects

Exhibit 3.2 The Investment Demand Schedule in the Classical Theory of

Interest Rates

Rate of interest
(percent per annum) I
12

10

150 200
Volume of investment spending ($billions)
 Investment Demand and the Rate of Interest: This reasoning explains, in part, why the
demand for investment capital by business firms was regarded by the classical
economists as negatively related to the rate of interest. Exhibit 3.2 depicts the business
investment demand schedule as drawn in the classical theory. This demand schedule
slopes downward and to the right. At low rates of interest, more investment projects
become economically viable and firms require more funds to finance a longer list of
projects. On the other hand, if the rate of interest rises to high levels, fewer investment
projects will be pursued and fewer funds will be required from the financial markets. For
example, at a 12 percent rate of interest, only $150 billion in funds for investment
spending might be demanded by business firms in the economy. If the rate of interest
drops to 10 percent, however, the volume of desired investment by firms might rise to
$200 billion.

The Equilibrium Rate of Interest in the Classical Theory of Interest

The classical economists believed that interest rates in the financial markets were
determined by the interplay of the supply of saving and the demand for investment.
Specifically, the equilibrium rate of interest is determined at the point where the quantity
of savings supplied to the market is exactly equal to the quantity of funds demanded for
investment. As shown in Exhibit 3.4, this occurs at point E, where the equilibrium rate of
interest is iE and the equilibrium quantity of capital funds traded in the financial markets
is QE.
Exhibit 3.3 The Equilibrium Rate of Interest in the Classical Theory

Rate of interest Demand for Inv’t

(Percent per Volume of saving
annum)
iE E

QE
Volume of saving and investment
To illustrate, suppose the total volume of savings supplied by businesses, households, and
governments in the economy at an interest rate of 10 percent is $200 billion. Moreover, at
this same 10 percent rate, businesses would also demand $200 billion in funds for
investment purposes. Then 10 percent must be the equilibrium rate of interest, and $200
billion is the equilibrium quantity of funds that would be traded in the money and capital
markets.

Limitations of the Classical Theory of Interest

The classical theory sheds considerable light on the factors affecting interest rates. How-
ever, it has serious limitations. The central problem is that the theory ignores factors other
than saving and investment that affect interest rates. For example, many financial
institutions have the power to create money today by making loans to the public. When
borrowers repay their loans, money is destroyed. The volume of money created or
destroyed affects the total amount of credit available in the financial system and therefore
must be considered in any explanation of the factors determining interest rates.

In addition, the classical theory assumes that interest rates are the principal determinant
of the quantity of savings available. Today economists recognize that income is more
important in determining the volume of saving. Finally, the classical theory contends that
the demand for borrowed funds comes principally from the business sector. Today,
however, both consumers and governments are important borrowers, significantly
affecting credit availability and cost.

3.3.2 THE LIQUIDITY PREFERENCE THEORY

The classical theory of interest has been called a long-term explanation of interest rates
because it focuses on the public’s thrift habits and the productivity of capital - factors that
tend to change slowly. During the 1930s, British economist John Maynard Keynes (1936)
developed a short-term theory of the rate of interest that, he argued, was more relevant for
policymakers and for explaining near-term changes in interest rates. This theory is known
as the liquidity preference theory of interest rates.
The Demand for Liquidity
Keynes argued that the rate of interest is really a payment for the use of a scarce resource,
money. Businesses and individuals prefer to hold money for carrying out daily
transactions and also as a precaution against future cash needs even through its yield is
low or nonexistent. Investors in fixed-income securities, such as corporate and
government bonds, frequently desire to hold money as a haven against declining security
prices. Interest rates, therefore, are the price that must be paid to induce money holders to
surrender a perfectly liquid asset and hold other assets that carry more risk. At times the
preference for liquidity grows very strong. Unless the government expands the money
supply, interest rates will rise. In the theory of liquidity preference, only two outlets for
investor funds are considered: bonds and money (including bank deposits). Money
provides perfect liquidity (instant spending power); bonds pay interest but cannot be
spent until converted into cash.

If interest rates rise, the market value of bonds paying a fixed rate of interest falls; the
investor would suffer a capital loss if those bonds were converted into cash. On the other
hand, a fall in interest rates results in higher bond prices; the bondholder will experience
a capital gain if his or her bonds are sold for cash. To the classical theorists, it was
irrational to hold money because it provided little or no return. To Keynes, however, the
holding of money could be a perfectly rational act if interest rates were expected to rise,
because rising rates can result in substantial losses for investors in bonds.

Total Demand for Money: The total demand for money in the economy is simply the
sum of transactions, precautionary, and speculative demands. Because the principal
determinant of transaction and precautionary demand is income, not interest rates, these
money demands are fixed at a certain level of national income. Let this demand be
represented by the quantity OK shown along the horizontal axis in Exhibit 3.4. Then, any
amount of money demanded in excess of OK represents speculative demand. The total
demand for money is represented along curve D T. Therefore, if the rate of interest lies at
the moment at i, Exhibit 3.4 shows that the speculative demand for money will be KJ and
the total demand for money will be OJ.
The Supply of Money
The other major element determining interest rates in liquidity preference theory is the
supply of money. In modern economies, the money supply is controlled, or at least
closely regulated, by government. Because government decisions concerning the size of
the money supply presumably are guided by the public welfare, not by the level of
interest rates, we assume that the supply of money is inelastic with respect to the rate of
interest. Such a money supply curve is represented in Exhibit 3.5 by the vertical line Ms.
Exhibit 3.4 The total demand for money in the economy

DT

AD

Total demand
for many
DT

0
K J
Quantity of money demanded ($ billions)
Exhibit 3.5 The equilibrium interest in the liquidity preference theory
DT MS
Rate of interest
(percent per Supply of Money
annum)

iE Total demand
for Money

0
Quantity of money demanded and supplied
($ billons)
The Equilibrium Rate of Interest in Liquidity Preference Theory

The interplay of the total demand for and the supply of money determines the equilibrium
rate of interest in the short run. As shown in Exhibit 3.5, the equilibrium rate is found at
point iE, where the quantity of money demanded by the public equals the quantity of
money supplied. Above this equilibrium rate, the supply of money exceeds the quantity
demanded, and some businesses, households, and units of government will try to dispose
of their unwanted money balances by purchasing bonds. The prices of bonds will rise,
driving interest rates down toward equilibrium at iE. On the other hand, at rates below
equilibrium, the quantity of money demanded exceeds the supply. Some decision makers
in the economy will sell their bonds to raise additional cash, driving bond prices down
and interest rates up toward equilibrium.

Limitations of the Liquidity preference Theory

Like the classical theory of interest, liquidity preference theory has limitations. It is a
short term approach to interest rate determination unless modified because it assumes that
income remains stable. In the longer term, interest rates are affected by changes in the
level of income and inflationary expectations. Indeed, it is impossible to have a stable
equilibrium interest rate without also reaching an equilibrium level of income, saving,
and investment in the economy. Also, liquidity preference considers only the supply and
demand for the stock of money, whereas business, consumer, and government demands
for credit clearly have an impact on the cost of credit. A more comprehensive view of
interest rates is needed that considers the important roles played by all actors in the
financial system: businesses, households, and governments.

3.3.3 THE LOANABLE FUNDS THEORY

A view that overcomes many of the limitations of earlier theories is the loanable funds
theory of interest rates. This view argues that the risk-free interest rate is determined by
the interplay of two forces: the demand for and supply of credit (loanable funds). The
demand for loanable funds consists of credit demands from domestic businesses,
consumers, and governments and also borrowing in the domestic market by foreigners.
The supply of loanable funds stems from four sources: domestic savings, hoarding
demand for money, money creation by the banking system, and lending in the domestic
market by foreign individuals and institutions. We consider each of these demand and
supply factors in turn.

Consumer Demand for Loanable Funds

Domestic consumers demand loanable funds to purchase a wide variety of goods and
services on credit. Recent research indicates that consumers are not particularly
responsive to the rate of interest when they seek credit but focus instead principally on
the nonprice terms of a loan, such as the down payment, maturity, and size of installment
payments. This implies that consumer demand for credit is relatively inelastic with
respect to the rate of interest. Certainly a rise in interest rates leads to some reduction in
the quantity of consumer demand for loanable funds (particularly when home mortgage
credit is involved), whereas a decline in interest rates stimulates some additional
consumer borrowing. However, along the consumer’s relatively inelastic demand
schedule, a substantial change in the rate of interest must occur before the quantity of
consumer demand for funds changes significantly.

Domestic Business Demand for Loanable Funds

The credit demands of domestic businesses generally are more responsive to changes in
the rate of interest than is consumer borrowing. Most business credit is for such
investment purposes as the purchase of inventories and new plant and equipment. As
noted earlier in our discussion of the classical theory of interest, a high interest rate
eliminates some business investment projects form consideration because their expected
rate of return is lower than the cost of funds. On the other hand, at lower rates of interest,
many investment projects look profitable, with their expected returns exceeding the cost
of funds. Therefore the quantity of loanable funds demanded by the business sector
increases as the rate of interest falls.
Government Demand for Loanable Funds
Government demand for loanable funds is a growing factor in the financial markets but
does not depend significantly on the level of interest rates. This is especially true of
borrowing by the federal government. Federal decisions on spending and borrowing are
made by congress in response to social needs and the public welfare, not the rate of
interest. More over, the federal government has the power both to tax and to create
money to pay its debts. State and local government demand, on the other hand, is slightly
interest elastic because many local governments are limited in their borrowing activities
by legal interest rate ceilings. When open market rates rise above these legal ceilings,
some state and local governments are prevented form offering their securities to the
public.

Foreign Demand for Loanable Funds

In recent years, foreign banks and corporations, as well as foreign governments, have
increasingly entered the huge financial marketplace to borrow billions of dollars. This
huge foreign credit demand is sensitive to the spread between domestic lending rates and
interest rates in foreign markets. If Ethiopia’s interest rates decline relative to foreign
rates, foreign borrowers will be inclined to borrow more in Ethiopia and less abroad. At
the same time, with higher foreign interest rates, Ethiopia’s lending institutions will
increase their foreign lending and reduce the availability of loanable funds to domestic
borrowers. The net result, then, is a negative or inverse relationship between foreign
borrowing and domestic interest rates relative to foreign interest rates.

Total Demand for Loanable Funds

The total demand for loanable funds is the sum of domestic consumer, business, and
government credit demands plus foreign credit demands. This demand curve slopes
downward and to the right with respect to the rate of interest, as shown in Exhibit 3.6.
Higher rates of interest lead some businesses, consumers, and governments to curtail their
borrowing plans; lower rates bring forth more credit demand. However, the demand for
loanable funds does not determine the rate of interest by itself. The supply of loanable
funds must be added to complete the picture.
The Supply of Loanable Funds
Loanable funds flow into the money and capital markets from at leas four different
sources: (1) domestic saving by businesses, consumers, and governments; (2) dishoarding
(spending down) of excess money balances held by the public; (3) creation of money by
the domestic banking system; and (4) lending to domestic borrowers by foreigners. We
consider each of these sources of funds in turn.

Exhibit 3.6 Total Demand for Loanable Funds

Rate of interest
(Percent per annum) DLF (= D consumer + D business + D government + D foreign)

DLF

0
Total demand for loanable funds
($ billions)

Domestic Saving: The supply of domestic savings is the principal source of loanable
funds. As noted earlier, most saving is done by households and is simply the difference
between current income and current consumption. Businesses, however, also save, by
retaining a portion of current earnings and by adding to their depreciation reserves.
Government saving, while relatively rare, occurs when current revenues exceed current
expenditures.

The net effect of the income, substitution, and wealth effects leads to a relatively interest-
inelastic supply of savings curve. Substantial changes in interest rates usually are required
to bring about significant changes in the volume of aggregate saving in the economy.

Dishoarding of Money Balances: Still another source of loanable funds is centered on

the public’s demand for money relative to the available supply of money. As noted earlier,
the public’s demand for money (cash balances) varies with interest rates and income
levels. The supply of money, on the other hand, is closely controlled by the government.
Clearly the two-money demand and money supply- need not be the same. The difference
between the public’s total demand for money and the money supply is known as
hoarding. When the public’s demand for cash balances exceeds the supply, positive
hoarding of money takes place as some individuals and businesses attempt to increase
their cash balances at the expense of others. Hoarding reduces the volume of loanable
funds available in the financial markets. On the other hand, when the public’s demand for
money is less than the supply available, negative hoarding (dishoarding) occurs. Some
individuals and businesses will dispose of their excess cash holdings, increasing the
supply of loanable funds available in the financial system.

Creation of Credit by the Domestic Banking System: Commercial banks and nonbank
thrift institutions offering payments accounts have the unique ability to create credit by
lending and investing their excess reserves. Credit created by the domestic banking
system represents an additional source of loanable funds, which must be added to the
amount of savings and the dishoarding of money balances (or minus the amount of
hoarding demand) to derive the total supply of loanable funds in the economy.

Foreign Lending to the Domestic Funds Market: Finally, foreign lenders also provide
large amounts of credit to domestic borrowers. These inflowing loanable funds are
particularly sensitive to the difference between a nation’s interest rates, say Ethiopia, and
interest rates overseas. If domestic rates rise relative to interest rates offered aboard, the
supply of foreign funds to domestic markets will tend to rise. Foreign lenders will find it
more attractive to make loans to domestic borrowers. At the same time, domestic
borrowers will turn more to foreign markets for loanable funds as domestic interest rates
climb relative to foreign rates. The combined result is to make the net foreign supply of
loanable funds to the domestic credit market positively related to the spread between
domestic and foreign rates of interest.

Total Supply of Loanable Funds

 The total supply of loanable funds, including domestic saving, foreign lending,
dishoarding of money, and new credit created by the domestic banking system, is
depicted in Exhibit 3.7. The curve rises with higher rates of interest, indicating that a
grater supply of loanable funds will flow into the money and capital markets when the
returns form lending increase.

Exhibit 3.7 The supply of loanable funds

Rate of interest
(percent per annum)
SLF (=Domestic saving
+
Newly Created money
+
Foreign lending to
domestic credit markets
–
Hoarding demand)

SLF
0
Volume of loanable funds supplied

The Equilibrium Rate of Interest in the Loanable Funds Theory

The two forces of supply and demand for loanable funds determine not only the volume
of lending and borrowing going on in the economy but also the rate of interest. The
interest rate tends toward the equilibrium point at which the supply of loanable funds
equals the demand for loanable funds. This point of equilibrium is shown in Exhibit 3.8
at iE.

If the interest rate is temporarily above equilibrium, the quantity of loanable funds
supplied by domestic savers and foreign lenders, by the banking system, and from the
dishoarding of money (or minus hoarding demand) exceeds the total demand for loanable
funds, and the rate of interest will be bid down. On the other hand, if the interest rate is
temporarily below equilibrium, loanable funds demand will exceed the supply. The
interest rate will be bid up by borrowers until it settles at equilibrium once again.
Exhibit 3.8 The Equilibrium Rate of Interest in the Loanable Funds Theory
Rate of interest DLF
(percent per annum)
 Equilibrium rate of SLF
interest
iE

0
QE
Volume of loanable funds

The equilibrium depicted in Exhibit 3.8 is only a partial equilibrium position, however.
This is due to the fact that interest rates are affected by conditions in both the domestic
and world economies. For the economy to be in equilibrium, planned saving must equal
planned investment across the whole economic system. For example, if planned
investment exceeds planned saving at the equilibrium rate shown in Exhibit 3.8,
investment spending occurs, incomes will rise, generating a greater volume of savings.
Eventually, interest rates will fall. Similarly, if exchange rates between dollars, birr, and
other world currencies are not in equilibrium with each other, there will be further
opportunities for profit available to foreign and domestic lenders by moving loanable
funds form one country to another.

Only when the economy, the money market, the loanable funds market, and foreign
currency markets are simultaneously in equilibrium will interest rates remain stable.
Thus, a stable equilibrium interest rate will be characterized by the following:
1. Planned saving = Planned investment (including business, household, and
government investment) across the whole economic system (i.e. equilibrium in
the economy).
2. Money supply = Money demand (i.e. equilibrium in the money market).
3. Quantity of loanable funds supplied = Quantity of loanable funds demanded (i.e.
equilibrium in the loanable funds market).
4. The difference between foreign demand for loanable funds and the volume of
 loanable funds supplied by foreigners to the domestic economy = the difference
between current exports from and imports into the domestic economy (i.e.,
equilibrium in the balance of payment and foreign currency markets).

3.3.4 THE RATIONAL EXPECTAITONS THEORY

In recent years, a fourth major theory about the forces determining interest rates has
appeared and now appears to be gaining supporters. This is the rational expectations
theory of interest rates. It builds on a growing body of research evidence that the money
and capital markets are highly efficient institutions in digesting new information affecting
interest rates and security prices.

For example, when new information appears about investment, saving, or the money
supply, investors begin immediately to translate that new information into decisions to
borrow or lend funds. In a short space of time – perhaps in minutes or seconds- security
prices and interest rates change to reflect the new information. So rapid is this process of
the market digesting new information that security prices and interest rates presumably
impound the new data from virtually the moment they appear. In a perfectly efficient
market, it is impossible to win excess returns consistently by trading on publicly available
information.

The important assumptions and conclusions of the rational expectations theory are that
(1) the prices of securities and interest rates should reflect all available information and
the market uses all of this information to establish a probability distribution of expected
future prices and interest rates; (2) changes in rates and security prices are correlated only
with unanticipated, not anticipated, information; (3) the correlation between rates of
return in successive time periods is zero; (4) no unexploited opportunities for profit
(above a normal return) can be found in the ‘securities’ markets; (5) transactions and
storage costs for securities are negligible and information costs are small relative to the
value of securities traded; and (6) expectations concerning future security prices and
interest rates are formed rationally and efficiently.
3.4 TERM STRUCTURE OF INTEREST RATES
One factor that influences the interest rate on a bond is its term to maturity: Bonds with
identical risk, liquidity, and tax characteristics may have different interest rates because
the time remaining to maturity is different. A plot of the yields on bonds with differing
terms to maturity but the same risk, liquidity, and tax considerations is called a yield
curve, and it describes the term structure of interest rates for particular types of bonds,
such as government bonds. Yield curves can be classified as upward-sloping, flat, and
down-ward-sloping (the last sort is often referred to as a n inverted yield curve). When
yield curves slope upward, the long-term interest rates are above the sort-term interest
rates; when yield curves are flat, short- and long- term interest rates are the same; and
when yield curves are inverted, long-term interest rates are below short-term interest
rates. Yield curves can also have more complicated shapes in which they first slope up
and then down, or vice versa.

Besides explaining why yield curves take on different shapes at different times, a good
theory of the term structure of interest rates must explain the following three important
empirical facts.

1. Interest rates on bonds of different maturities move together over time.

2. When short-term interest rates are low, yield curves are more likely to have an
upward slope; when short-term interest rates are high, yield curves are more
likely to slope downward and be inverted.
3. Yield curves almost always slope upward

Three theories have been put forward to explain the term structure of interest rates, that
is, the relationship among interest rages on bonds of different maturities reflected in yield
curve patterns: (1) the expectations hypothesis, (2) the segmented markets theory, and (3)
the preferred habitat theory.
3.4.1 Expectations Hypothesis

The expectations hypothesis of the term structure states the following commonsense
proposition: The interest rate on a long-term bond will equal an average of short-term
interest rates that people expect to occur over the life of the long-term bond. For example,
if people expect that short-term interest rates will be 10 percent on average over the
coming five years, the expectations hypothesis predicts that the interest rate on bonds
with five years to maturity will be 10 percent too. If short-term interest rates were
expected to rise even higher after this five-year period so that the average short-term
interest rate over the coming 20 years is 11 percent, then the interest rate on 20-year
bonds would equal 11 percent and would be higher than the interest rate on five-year
bonds. We can see that the explanation provided by the expectations hypothesis for why
interest rates on bonds of different maturities differ is that short-term interest rates are
expected to have different values at future dates.

The key assumption behind this theory is that buyers of bonds do not prefer bonds of one
maturity over another, so they will not hold any quantity of a bond if its expected return is
less than that of another bond with a different maturity. Bonds that have this characteristic
are said to be perfect substitutes. What this means in practice is that if bonds with
different maturities are perfect substitutes, the expected return on these bonds must be
equal.

To see how the assumption that bonds with different maturities are perfect substitutes
leads to the expectations hypothesis, let us consider the following two investment
strategies:
1. Purchase a one-year bond, and when it matures in one year, purchase another
one-year bond.
2. Purchase a two-year bond and hold it until maturity.

Because both strategies must have the same expected return if people are holding one-and
two-year bonds, the interest rate on the two-year bond must equal the average of the two
one-year interest rates. For example, let’s say that the current interest rate on one-year
bond is 9 percent and you expect the interest rate on the one-year bond next year to be 11
percent. If you pursue the first strategy of buying the two one-year bonds, the expected
return over the two years will average out to be (9% + 11%)/2 = 10% per year. You will
be willing to hold both the one-and two-year bonds only if the expected return per year of
the two-year bond equals this. Therefore, the interest rate on the two-year bond must
equal 10 percent, the average interest on the two one-year bonds.

We can make this argument more general. For an investment of $1, consider the choice of
holding, for two periods, a two-period bond or two one-period bonds. Using the
definitions
i t = today ' s (time t ) int erest rate on a one− period bond
e
i t+1 = int erest rate on a one− period bond exp ected for next period (time t−1 )
i 2t = today ' s (time t ) int erest rate on the two− period bond

the expected return over the two periods from investing $1 in the two-period bond and
holding it for the two periods can be calculated as

2
( 1+i2t ) ( 1 + i2t ) − 1= 1+2 i2t + ( i2 t ) −1
After the second period, the $1 investment is worth (1 + i 2t) (1+i2t). Subtracting the $1
initial investment form this amount and dividing by the initial $1 investment gives the
rate of return calculated in the above equation. Because (i 2t)2 is extremely small – if i 2t =
10%=0.10, then (i2t)2 = 0.01-we can simplify the expected return for holding the two-
period bond for the two periods to
2i2t

With the other strategy, in which one-period b154onds are bought, the expected return on
the $1 investment over the two periods is

(1+it) (1+iet+1) – 1

After the first period, the $1 investment becomes 1+it and this is reinvested in the one-
period bond for the next period, yielding an amount (1 + i t) (1 + iet+1). Subtracting the
$1initial investment from this amount and dividing by the initial investment of $1 gives
the expected return for the strategy of holding one-period bonds for the two periods.
Because it (ie t+1 ) is also extremely small – if it = iet+1= 0.10, then it (iet+1) = 0.01- we can
simplify this to
it + iet+1

Both bonds will be held only if these expected returns are equal, that is, when
2i2t = it + iet+1

Solving for i2t in terms of the one-period rates, we have

e
i t +i t +1
i 2t =
2 (1)
which tells us that the two-period rate must equal the average of the two one-period rates.
We can conduct the same steps for bonds with a longer maturity so that we can examine
the whole term structure of interest rates. Doing so, we will find that the interest rate of i nt
on an n-period bond must equal

e e e
t +1 t +2 t +(n−1)
it + i +i +. . . +i
i nt =
n (2)

Equation 2 states that the n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the bond. This is a restatement of
the expectations hypothesis in more precise terms.

A simple numerical example might clarify what the expectations theory in equation 2 is
saying. If the one-year interest rate over the next five years is expected to be 5,6,7,8, and
9 percent, equation 2 indicates that the interest rate on the two-year bond would be

5 %+6 %
=5 .5 %
2

While for the five-year bond it would be

5 %+6 %+7 %+8 %+9 %
=7 %
5
Doing a similar calculation for the one-, three-, and four-year interest rates, you should be
able to verify that the one- to five-year interest rates are 5.0, 5.5, 6.0, 6.5, and 7.0 percent,
respectively. Thus we see that the rising trend in expected short-term interest rates
produces an upward-sloping yield curve along which interest rates rise as maturity
lengthens.

The expectations hypothesis is an elegant theory that provides an explanation of why the
term structure of interest rates (as represented by yield curves) changes at different times.
When the yield curve is upward-sloping, the expectations hypothesis suggests that short-
term interest rates are expected to rise in the future, as we have seen in our numerical
example. In this situation, in which the long-term rate is currently above the short-term
rate, the average of future short-term rates is expected to be higher than the current short-
term rate, which can occur only if short term interest rates are expected to rise. This is
what we see in our numerical example. When the yield curve slopes downward and is
inverted, the average of future short-term interest rates is expected to be below the current
short-term rate, implying that short-term interest rates are expected to fall, on average, in
the future. Only when the yield curve is flat does the expectations hypothesis suggest that
short-term interest rates are not expected to change, on average, in the future.

The expectations hypothesis also explains fact 1 that interest rates on bonds with different
maturities move together over time. Historically, short-term interest rates have had the
characteristic that if they increase today, they will tend to be higher in the future. Hence a
rise in short-term rates will raise people’s expectations of future short-term rates. Because
long-term rates are the average of expected future short-term rates, a rise in short –terms
rates will also raise long-term rates, causing short-and long-term rates to move together.

The expectations hypothesis also explains fact 2 that yield curves tend to have an upward
slope when short-term interest rates are low and are inverted when short-term rates are
high. When short-term rates are low, people generally expect them to rise to some normal
level in the future, and the average of future expected short-term rates is high relative to
the current short-term rate. Therefore, long-term interest rates will be substantially above
current short-term rates, and the yield curve would then have an upward slope.
Conversely, if short-term rates are high, people usually expect them to come back down.
Long-term rates would then drop below short-term rates because the average of expected
future short-term rates would be below current short-term rates and the yield curve would
slope downward and become inverted.

The expectations hypothesis is an attractive theory because it provides a simple

explanation of the behavior of the term structure, but unfortunately it has a major
shortcoming: it can not explain fact 3 that yield curves usually slope upward. The typical
upward slope of yield curves implies that short-term interest rates are usually expected to
rise in the future. In practice, short-term interest rates are just as likely to fall as they are
to rise, and so the expectations hypothesis suggests that the typical yield curve should be
flat rather than upward-sloping.

3.4.2 Segmented Markets Theory

As the name suggests, the segmented markets theory of the term structure sees markets
for different-maturity bonds as completely separate and segmented. The interest rate for
each bond with a different maturity is then determined by the supply of and demand for
that bond with no effects form expected returns on other bonds with other maturities.

The key assumption in the segmented markets theory is that bonds of different maturities
are not substitutes at all, so the expected return from holding a bond of one maturity has
no effect on the demand for a bond of another maturity. This theory of the term structure
is at the opposite extreme to the expectations hypothesis, which assumes that bonds of
different maturities are perfect substitutes.

The argument for why bonds of different maturities are not substitutes is that investors
have strong preferences for bonds of one maturity but not for another, so they will be
concerned with the expected returns only for bonds of the maturity they prefer. This
might occur because they have a particular holding period in mind, and if they match the
maturity of the bond to the desired holding period, they can obtain a certain return with
no risk at all. For example, people who have a short holding period would prefer to hold
short-term bonds. Conversely, if you were putting funds a way for your young child to go
to college, your desired holding period might be much longer, and you would want to
hold longer-term bonds.

In the segmented markets theory, differing yield curve patterns are accounted for by
supply and demand differences associated with bonds of different maturities. If, as seems
sensible, investors have short desired holding periods and generally prefer bonds with
shorter maturities that have less interest-rate risk, the segmented markets theory can
explain fact3 that yield curves typically slope upward. Because the demand for long-term
bonds is relatively lower than that for short-term bonds in the typical situation, long-term
bonds will have lower prices and higher interest rates, and hence the yield curve will
typically slope upward.

Although the segmented markets theory can explain why yield curves usually tend to
slope upward, it has a major flaw in that it cannot explain facts 1 and 2. Because it views
the market for bonds of different maturities as completely segmented, there is no reason
for a rise in interest rates on a bond of one maturity to affect the interest rate on a bond of
another maturity. Therefore, it cannot explain why interest rates on bonds of different
maturities tend to move together (fact 1). Second, because it is not clear how demand and
supply for short- versus long-term bonds changes with the level of short-term interest
rates, the theory cannot explain why yield curves tend to slope upward when short-term
interest rates are low and to be inverted when short-term interest rates are high (fact 2).

Because each of our two theories explains empirical facts that the other cannot, a logical
step is to combine the theories, which leads us to the preferred habitat theory and closely
related liquidity premium theory.

3.4.3 Preferred Habitat and Liquidity Premium Theories

The preferred habitat theory of term structure states that the interest rate on a long-term
bond will equal an average of short-term interest rates expected to occur over the life of
the long-term bond plus a term (liquidity) premium that responds to supply and demand
conditions for that bond.

The preferred habitat theory’s key assumption is that bonds of different maturities are
substitutes, which means that the expected return on one bond does influence the
expected return on a bond of a different maturity, but it allows investors to prefer one
bond maturity over another. In other words, bonds of different maturities are assumed to
be substitutes but not perfect substitutes. We might think of investors as having a
preference for bonds of one maturity over another, a particular bond maturity where they
are most comfortable to stay; we might then say that they have a preferred habitat.
Investors still care about the expected returns on bonds with a maturity other than their
preferred maturity, and so they will not allow expected returns on one bond to get too far
out of line with that on another bond with a maturity other than their preferred maturity,
and so they will not allow expected returns on one bond to get too far out of line with that
on another bond with a different maturity. Because they prefer bonds of one maturity over
another, they will be willing to buy bonds that do not have the preferred maturity only if
they earn a somewhat higher expected return. If investors prefer the habitat of short-term
bonds over longer-term bonds, for example, they might be willing to hold short-term
bonds even though they have a lower expected return. This means that investors would
have to be paid a positive term premium to be willing to hold a long-term bond. Such an
outcome would modify the expectations hypothesis by adding a positive term premium to
the equation that describes the relationship between long-and short-term interest rates.
The preferred habitat theory is thus written as

e e e
t +1 t+2 t + (n−1)
i t +i +i +. .. .+i
i nt = + K nt (3 )
n
Where Knt = the term premium for the n-period bond at time t.
Closely related to the preferred habitat theory is the liquidity premium theory, which
takes a somewhat more direct approach to modifying the expectations hypothesis. It
reasons that a positive term (liquidity) premium must be offered to buyers of longer-term
bonds to compensate them for their increased interest-rate risk. This reasoning leads to
the same Equation 3 implied by the preferred habitat theory, with the proviso that the
term premium Knt is always positive and rises with the term to maturity of the bond.

A simple numerical example similar to the one we used for the expectations hypothesis
further clarifies what the preferred habitat and liquidity premium theories in Equation 3
are saying. Again suppose that the one-year interest rate over the next five years is
expected to be 5,6,7,8, and 9 percent, while investors’ preferences for holding short-term
bonds mean that the term premiums for one – to five-year bonds are 0, 0.25, 0.5, 0.75,
and 1.0 percent, respectively. Equation 3 then indicates that the interest rate on the two-
year bond would be
5 %+6 %
+0. 25 %=5 .75 %
2
While for the five-year bond it would be
5 % +6 %+7 %+ 8 %+9 %
+1 %=8 %
5
Doing a similar calculation for the one-, three-, and four-year interest rates, you should be
able to verify that the one- to five- year interest rates are 5.0, 5.75, 6.5, 7.25, and 8.0
percent, respectively. Comparing these findings with those for the expectations
hypothesis, we see that the preferred habitat and liquidity premium theories produce yield
curves that slope more steeply upward because of investors’ preferences for short-term
bonds.

Let’s see if the preferred habitat and liquidity premium theories are consistent with all
three empirical facts we have discussed. They explain fact 1 that interest rates on
different- maturity bonds move together overtime: a rise in short-term interest rates
indicates that short-term interest rates will, on average, be higher in the future, and the
first term in Equation 3 then implies that long-term interest rates will rise along with
them.

They also explain why yield curves tend to have an especially steep upward slope when
short-term interest rates are low and to be inverted when short-term rates are high (fact
2). Because investors generally expect short-term interest rates to rise to some normal
level when they are low, the average of future expected short-term rates will be high
relative to the current short-term rates, and the yield curve would then have a steep
upward slope. Conversely, if short-term rates are high, people usually expect them to
come back down. Long-term rates would then drop below short-term rates because the
average of expected future short-term rates would be so far below current short-term rates
that despite positive term premiums, the yield curve would slope downward.

The preferred habitat and liquidity premium theories explain fact 3 that yield curves
typically slope upward by recognizing that the term premium rises with a bond’s maturity
because of investors’ preferences for short-term bonds. Even if short-term interest rates
are expected to stay the same on average in the future, long-term interest rates will be
above short-term interest rates, and yield curves will typically slope upward.

How can the preferred habitat and liquidity premium theories explain the occasional
appearance of inverted yield curves if the term premium is positive? It must be that at
times short-term interest rates are expected to fall so much in the future that the average
of the expected short-term rates is well below the current short-term rate. Even when the
positive term premium is added to this average, the resulting long-term rate will still be
below the current short-term interest rate.

As our discussion indicates, a particularly attractive feature of the preferred habitat and
liquidity premium theories is that they tell you what the market is predicting about future
short-term interest rates just by looking at the slope of the yield curve. A steeply rising
yield curve, as in panel (a) of Exhibit 3.9, indicates that short-term interest rates are
expected to rise in the future. A moderately steep yield curve, as in panel (b), indicates the
short-term interest rates are not expected to rise or fall much in the future. A flat yield
curve, as in panel (c), indicates that short-term rates are expected to fall moderately in the
future. Finally, an inverted yield curve, as in panel (d), indicates that short-term interest
rates are expected to fall sharply in the future.
Exhibit 3.9 Yield Curves and the Market’s Expectations of Future Short-Term interest
Rates
 QUESTIONS FOR REVIEW AND DISCUSSION

1. What is interest rate?

2. Explain the functions of the rate of interest in the economy.
3. What is the difference between the classical theory of interest rates and that of the
theory of interest rate developed by John Maynard Keynes?
4. In the classical theory of the rate of interest, how is investment decision made.
5. According to the loanable funds theory of interest rates, the risk free interest rate
is determined by the interplay of two forces: the demand for and supply of credit
(loanable funds). Discuss.
6. The liquidity preference theory of the interest rates is considered as a short run
theory of the rate of interest. Why?
7. Discuss the rational expectations theory of interest rates.
8. What is the term structure of interest rates?
9. List the empirical facts that a good theory of the term structure of interest rates
should explain.
10. What is/are the major source of discrepancy between the expectations hypothesis
and the segmented markets theories of the term structure of interest rates?
11. The preferred habitat theory of term structure of interest rates is considered as the
combination of the other two theories: the expectations hypothesis and the
segmented market theories. Why?
 CHAPTER FIVE

5.1 Financial Futures and options Contracts

Among the most innovative markets to be developed in recent years and also among the
most rapidly growing are the markets for financial futures and options. Futures and
options trading is designed to protect the investor against interest rate risk. In the
financial futures and options markets, the risk of future changes in the market prices or
yields of securities is transferred to someone - an individual or an institution – willing to
bear that risk. Financial futures and options are used in both the short-term money market
and the long-term capital market to protect both borrowers and lenders against changing
interest rates.

Although relatively new in the field of finance, risk protection through futures and
options trading is an old concept in marketing commodities. As far back as the Middle
Ages, traders in farm commodities developed contracts calling for the future delivery of
farm products at a guaranteed price. Trading in rice futures began in Japan in 1697. In the
United States, the Chicago Board of Trade established a futures market in grains in 1848.
In this chapter, issues like futures trading, principles of hedging, financial futures and
their markets, option contracts and the like will be discussed and analyzed thoroughly.

Thus, after studding this chapter you will be able to:

 Define future and options contracts
 Explain the general principles of hedging
 To realize the purpose of trading in financial futures
 Identify problems in financial futures markets
 Calculate the profits and losses on options and futures contracts
5.2 The Nature of Futures Trading

In the futures market, buyers and sellers enter into contracts for the delivery of
commodities or securities at a specific location and time and at a price that is set when the
contract is made. The principal reason for the existence of a futures market is hedging,
the act of coordinating buying and selling of a commodity or financial claim to protect
against the risk of future price fluctuations. In the futures market, investors interested in
hedging trade futures contracts with investors interested in speculating (i.e., profiting
from favorable market movements).

Adverse movements in prices can result in increased costs and lower profits and, in the
case of financial instruments, reduced value and yield. Many investors today find that
even modest changes in prices or interest rates can lead to magnified changes in their net
earnings. Some investors see the futures market as a means to ensure that their profits
depend more on planning and design rather than dictates of a treacherous and volatile
marketplace.

Adverse movements in prices can result in increased costs and lower profits and, in the
case of financial instruments, reduced value and yield. Many investors today find that
even modest changes in prices or interest rates can lead to magnified changes in their net
earnings. Some investors see the futures market as a means to ensure that their profits
depend more on planning and design rather than the dictates of a treacherous and volatile
marketplace.

Hedging may be compared to insurance. Insurance protects an individual or business firm

against risks to life and property. Hedging protects against the risk of fluctuations in
market price. However, there is an important difference between insurance and hedging.
Insurance rests on the principle of sharing or distributing risk over a large group of policy
holders. Through an insurance policy, the risk to any one individual or institution is
reduced.

In contrast, hedging does not reduce risk. It is a relatively low-cost method of transferring
the risk of unanticipated changes in prices or interest rates from one investor or institution
to another. Ultimately, some investor must bear the risk of fluctuations in the prices and
yields of commodities or securities. Moreover, that risk is generally less predictable than
would be true of most insurance claims. The hedger who successfully transfers risk
through a futures contract can protect an acceptable selling price for a commodity or a
desired yield on a security weeks or months a head of the sale or purchase of that item. In
the financial futures market, the length of such contracts normally ranges from three
months to two years.

5.3 General Principles of Hedging

The basic principles of hedging may be described most easily through the use of a model.
In this section, we examine the model of a complete, or perfect, hedge. Such a hedge
contracts away all risk associated with fluctuations in the price of an asset. The hedger
creates a situation in which any change in the market price of a commodity or security is
exactly offset by a profit or loss on the futures contract. This enables the hedger to lock in
the price or yield he wishes to obtain.

5.3.1 Opening and Closing a Hedge

Suppose an agricultural firm harvests a commodity such as wheat and is anticipating a

decline in wheat prices. This unfavorable price movement can be hedged by selling
futures contracts equal to the current value of the wheat. Sale of these contracts, which
promise the future delivery of wheat in days, weeks, or months from now, is called
“opening a hedge.” When the firm does sell its wheat, it can buy back the same number
of futures contracts it sold originally and “close the hedge.”

Of course, the firm could deliver the wheat as specified in the original futures contract.
However, this is not usually done. If the price of wheat does decline as expected, it costs
the firm less to repurchase the futures contracts than the price for which it originally sold
those contracts. Thus, the profit on the repurchase of wheat futures offsets the decrease in
the price of wheat itself. The firm would have perfectly hedged itself against any adverse
change in wheat prices over the life of the futures contracts.

What would happen if wheat rose in price instead of declined? A perfect hedge would
result in a profit on the sale of the wheat itself but a loss on the futures contracts. This
happens because the firm must repurchase its futures contracts at a higher price than its
original cost due to the higher price for wheat. Exhibit 5.1 illustrates how a profit (or
loss) on a futures contract can be used to offset a decrease (or increase) in the market
price of an asset, helping the hedger achieve a desired price level.

Exhibit 5.1 Price Changes on Assets can be offset by profits or losses

on Futures Contracts
Market price
Market
price

5.3.2 Why Hedging can be Effective

The hedging process can be effective in transferring risk because prices in the spot (or
cash) market for commodities and securities are generally correlated with prices in the
futures (or forward) market. Indeed, the price of a futures contract in today’s market
represents an estimate of what the spot (or cash) market price will be on the contract’s
delivery date (less any storage, insurance, and financing costs). Hedging essentially
means adopting equal and opposite positions in the spot and futures markets for the same
assets.

The relationship between the price of a commodity or security in the cash or spot market
and its price in the futures market is captured in the concept of basis. Specifically,

Spread between the cash (spot ) price of a commod ity

Basis for a
= or security and the futures (forward ) price for that
futures contract
same com mod ity or sec urity at the same po int in time .

For example, if long-term Treasury bonds are selling in today’s cash market for
immediate delivery at a price of $98 per bond (assuming a $100 par value) but are selling
in the futures market today for forward delivery in three months at $88 per bond, the
basis for this T-bond futures contract purchased today is $98-$88, or $10. We can also
define basis in terms of interest rates; it is the difference between the interest rate attached
to a security in the cash market and the interest rate on that same security in the futures
market.

One important principle of futures trading is the principle of convergence. As the delivery
date specified in a futures contract draws nearer, the gap (basis) between the futures and
spot prices for the same security or commodity narrows. At the moment of delivery, the
futures price and spot price on the same security or commodity must be identical (expect
for transactions costs), so that the basis of the futures contract becomes zero. Whether a
futures trade ultimately turns out to be profitable depends on what happens to its basis
now and when the contract ends. It is changes in basis that create risk in the trading of
futures contracts.
Hedging through futures converts price or interest rate risk into basis risk. One useful
measure of basis risk in financial futures is the volatility ratio:

Volatility ratio Percentage change in cash (spot ) price of a

for a com mod ity or security
=
futures contract Percentage change in the price of the futures
(basis risk measure) instrument used for hedging the commod ity
or security
The more stable the basis associated with a given futures trade – that is, the closer the
volatility ratio is to 1- the greater the reduction of risk achieved by the futures trader.
When cash and futures prices or interest rates move in parallel, basis risk is zero. The
futures markets “work” to reduce risk, because the risk of changes in basis is generally
less than the risk of changes in the price or yield from a commodity or security. However,
as we will soon see, there are both risks and costs to futures trading, and losses can mount
rapidly, especially for the uninformed investor.

5.3.3 Risk Selection through Hedging

In the wheat example discussed earlier, we described a complete (perfect) hedge. In a

perfect hedge, the basis remains constant throughout the contract period. Profits (loses) in
the cash market exactly offset losses (profits) in the futures market. Such a hedge is
essentially a profitless hedging position and is rare; in most futures trades, the basis
fluctuates, introducing at least some degree of risk. Many investors, however, are willing
to take on added risk by not fully closing a hedge, believing they can guess correctly
which way prices are going. Through the futures market, the investor can literally “dial”
the degree of risk he/she wishes to accept. If the investor wishes to take on all the risk of
price fluctuations in the hope of achieving the maximum return, no hedging will take
place at all.

5.4 Financial Futures

The development of futures markets for the financial instruments in the U.S. was
motivated by the extremely volatile interest rate movements that have characterized the
financial markets for the past two decades. Repeatedly, interest rates have risen to record
levels under the pressure of tight money policies and inflation, shutting out important
groups of borrowers from access to credit. These high and volatile rates reduce the value
of securities held by financial institutions, threatening them with a liquidity crisis and
failure. Some members of the regulatory community have favored the growth of financial
futures as a way to reduce the risks associated with security investments. However, as we
will soon see, other regulatory authorities believe that the development of the futures
markets may have encouraged speculation and increased the riskiness of those financial
institutions participating in futures trading. These regulatory agencies have placed tight
restrictions on the use of the futures markets, especially by the banking industry.

5.5 The Purpose of Trading in Financial Futures

The basic principle behind trading in financial futures is the same as in the commodity
markets. A securities dealer, bank, or other investor may sell futures contracts on selected
securities in order to protect against the risk of falling security prices (rising interest
rates) and, therefore, a decline in the rate of return or yield from an investment. If the
price of the security in question does fall, the investor can lock in the desired yield,
because a profit on the futures contract may offset the capital loss incurred when selling
the security itself. On the other hand, a rise in the market price of a security (fall in
interest rates) may be offset by a loss in the futures market. Either way, the investor is
able to maintain his or her desired holding period yield. (These points are illustrated in
Exhibit 5.2). Many financial institutions prefer to use the futures market to hedge against
interest rate fluctuations rather than passing interest rate risk on to their customers
through floating-rate loans, deposits, and other financial assets.

Exhibit 5.2 Changes in the Yield on Securities can be offset by Profits or

Losses on Futures Contracts
Yield (percent)
Yield (percent)

5.6 FINANCIAL FUTURES MARKETS

Given the default risk and liquidity problems in the interest rate forward market, another
solution to hedging interest rate was needed. This solution was provided by the
development of financial futures contracts.

5.6.1 Financial futures contracts

A financial futures contract is similar to an interest-rate forward contract in that it
specifies that a debt instrument must be delivered by one party to another on a stated
future date. However, it differs from an interest-rate forward contract in several ways that
overcome some of the liquidity and default problems of forward markets.
To understand what financial futures contracts are all about, let’s look at one of the most
widely traded futures contracts, that for Treasury bonds, which are traded on the Chicago
Board of Trade. The contract value is for $100,000 face value of bonds. Prices are quoted
in points, with each point equal to $1000, and the smallest change in price is one thirty-
second of a point ($31.25). This contract specifies that the bonds to be delivered must
have at least 15 years to maturity at the delivery date (and must also not be callable, that
is, redeemable by the Treasury at its option, in less than 15 years). If the Treasury bonds
delivered to settle the futures contract have a coupon rate different from the 8 percent
specified in the futures contract, the amount of bonds to be delivered is adjusted to reflect
the difference in value between the delivered bonds and the 8 percent coupon bond. In
line with the terminology used for forward contracts, parties who have bought a futures
contract and thereby agreed to buy (take delivery of) the bonds are said to have taken a
long position, and parties who have sold a futures contract and thereby agreed to sell
(deliver) the bonds have taken a short position.

To make our understanding of this contract more concrete, let’s consider what happens
when you buy or sell one of these Treasury bond futures contracts. Let’s say that on
February 1, you sell one $100,000 June contract at a price of 115 (that is, $115,000). By
selling this contract, you agree to deliver $100,000 face value of the long-term Treasury
bonds to the contract’s counterparty at the end of June for $115.000. By buying the
contract at a price of 115, the buyer has agreed to pay $115,000 for the $100,000 face
value of bonds when you deliver them at the end of June. If interest rates on long-term
bonds rise so that when the contract matures at the end of June the price of these bonds
has fallen to 110 ($110,000 per $100,000 of face value), the buyer of the contract will
have lost $5000 because he or she paid $115,000 for the bonds but can sell them only for
the market price of $110,000. But you, the seller of the contract, will have gained $5000
because you can now sell the bonds to the buyer for $115,000 but have to pay only
$110,000 for them in the market.
It is even easier to describe what happens to the parties who have purchased futures
contracts and those who have sold futures contracts if we recognize the following fact: At
the expiration date of a futures contract, the price of the contract is the same as the price
of the underlying asset to be delivered. To see why this is the case, consider what happens
on the expiration date of the June contract at the end of June when the price of the
underlying $100,000-face-value Treasury bond is 110 ($110,000). If the futures contract
is selling below 110, say, at 109, a trader can buy the contract for $109,000, take delivery
of the bond, and immediately sell it for $110,000, there by earning a quick profit of
$1000. Because earning this profit involves no risk, it is a great deal that everyone would
like to get in on. That means that everyone will try to buy the contract, and as a result, its
price will rise. Only when the price rises to 110 will the profit opportunity cease to exist
and the buying pressure disappear. Conversely, if the price of the futures contract is above
110, say, at 111, everyone will want to sell the contract. Now the sellers get $111,000
from selling the futures contract but have to pay only $110,000 for the Treasury bonds
that they must deliver to the buyer of the contract, and the $1000 difference is their profit.
Because this profit involves no risk, traders will continue to sell the futures contract until
its price falls back down to 110, at which price there are no longer any profits to be made.
The elimination of riskless profit opportunities in the futures market is referred to as
arbitrage, and it guarantees that the price of a futures contract at expiration equals the
price of the underlying asset to be delivered.

Armed with the fact that a futures contract at expiration equals the price of the underlying
asset makes it even easier to see who profits and loses from such a contract when interest
rates change. When interest rates have risen so that the price of the Treasury bond is 110
on the expiration day at the end of June, the June Treasury bond futures contract will also
have a price of 110. Thus if you bought the contract for 115 in February, you have a loss
of 5 points, or $5000 (5 percent of $100,000). But if you sold the futures contract at 115
in February, the decline in price to 110 means that you have a profit of 5 points, or $5000.

5.6.2 Some problems with Financial Futures Markets

Although financial futures markets can help financial institutions reduce interest rate risk,
managers of these institutions can run into two basic problems when they try to hedge
with financial futures.

BASIS RISK: The first problem is associated with basis risk, the risk associated with the
possibility that the prices of the hedged asset and the asset underlying the futures contract
do not move together over time. The interest rates on the long-term bonds deliverable in
the Treasury bond futures contract may not move completely in tandem with the interest
rates on the security that a financial institution might want to hedge. Basis risk is often
not large because interest rates on most bonds do move fairly closely together, but
sometimes it can be. For example, suppose that the First National Bank was attempting to
hedge its holdings of long-term municipal bonds by taking a short position in the
Treasury bond futures contract and that sometime before the delivery date, a major
default occurred in this market. Such a default might cause a sharp upward movement in
interest rates on municipal bonds because perceptions of higher default risk would shrink
demand for them, while demand for default-free Treasury bonds would increase, possibly
lowering their interest rates. The result could then be that interest rates on municipal
bonds and on the Treasury bond futures contract would move in opposite directions. The
rise in municipal bonds would produce a loss on the municipal bonds the bank is holding,
but the fall in interest rates on the Treasury bonds would result in and additional loss on
the bank’s short position in the futures contract. In this case, the futures hedge could
make the situation even worse for the bank. The example here is quite extreme, but it
does show that the dangers of basis risk are real.

ACCOUNTING PROBLEMS: A second problem with futures hedges arises from the
system of accounting that financial institutions use. Under generally accepted accounting
principles, when a macro hedge is made that hedges not a specific financial asset but a
financial institution’s entire portfolio, profits or losses the institution makes on the hedge
cannot be offset by the unrealized gains or losses on the institution’s portfolio (so-called
paper gains or losses that are not realized because sales of the items in the portfolio have
not yet occurred). To see what this could mean, suppose that a bank manager’s hedge
words out perfectly, so when interest rates rise and this results in a decrease in the value
of the bank by, say, $1 million, the hedge with futures contracts shows an exactly
offsetting profit of $1 million. Although the bank has been completely immunized against
the change in interest rates, the bank is required to show an increase in profits of the $1
million it makes on the hedge but is not allowed to offset this profit with the losses it
suffered on the rest of its portfolio. This example illustrates that hedging with financial
futures might result in apparent (but not real) fluctuations in income that could be
misinterpreted by the markets or have adverse tax consequences.

5.7 OPTIONS

Another vehicle for hedging interest-rate and stock market risk involves the use of
options on financial instruments .Options are contracts that give the purchaser the option,
or right, to buy or sell the underlying financial instrument at a specified price called the
exercise price or strike price, with in a specific period of time (the term expiration). The
seller (some times called the writer) of the option is obligated to buy or sell the financial
instrument to the purchaser if the owner of the option exercises the right to sell or buy.
These option contract features are important enough to be emphasized: The owner or
buyer of an option does not have to exercise the option; he or she can let the option expire
with out using it. Hence the owner of an options is not obligated to take any action but
rather has the right to exercise the contract if he or she so chooses. The seller of an
option, by contrast, has no choice in the matter; he or she must buy or sell the financial
instrument if the owner exercises the option.

Because the right to buy or sell a financial instrument at a specified price has value, the
owner of an option is willing to pay an amount for it called a premium. There are two
types of options contracts: American options can be exercised at any time up to the
expiration date of the contract, and European options can be exercised only on the
expiration date.

Options contracts are written on a number of financial instruments. Options on individual

stocks are called stock options, and such options have existed for a long time. Options
contracts on financial futures called financial futures options or, mote commonly, future
options, were developed in 1982 and have become the most widely traded option
contracts.

You might wonder why option contracts are more likely to be written on financial futures
than on underlying debt instruments such as bonds or certificated of deposit .As you saw
earlier in the chapter, at the expiration date, the price of the futures contract and of the
deliverable debt instruments will be the same because of arbitrage. So it would seem that
investors should be indifferent about having the option written on the debt instrument or
on the futures contract. However, financial futures contracts have been so well designed
that their markets are often more liquid than the markets in the underlying debt
instruments. So investors would rather have the option contract written on the more liquid
instrument, in this case the futures contract.

The regulation of option markets is split between the Securities and Exchange
Commission (SEC), which regulates stock options and the commodity Futures Trading
Commission (CFTC), which regulates futures options. Regulation focuses on ensuring
that writers of options have enough capital to make good on their contractual obligations
and on overseeing traders and exchanges to prevent fraud and ensure that the market is
not being manipulated.

5.8 Option Contracts

A call option is a contract that gives the owner the right to buy a financial instrument at
the exercise price with in a specific period of time. A put option is a contract that gives
the owner the right to sell a financial instrument at the exercise price within a specific
period of time.

5.9 Profit and losses on option and futures contracts

To understand option contracts more fully, let’s first examine the option on the June
Treasury bond futures contract. Suppose, if you buy this future contract at a prices of 115
(that is %115,000), you have agreed to pay $115,000 for $100,000 face value of long–
term Treasury bonds when they are delivered to you at the end of June. If you sold this
futures contract at a price of 115, you agreed, in exchange for $115,000, to deliver
$100,000 face value of the long term Treasury bonds at the end of June. An option
contract on the Treasury bond futures contract has several key features: (1) it has the
same expiration date as the underlying futures contract, (2) it is an American option and
so can be exercised at any time before the expiration date, and (3) the premium (price) of
the option is quoted in points that are the same as in the futures contract, so each point
corresponds to $1000. If, the for a premium of $2000, you buy one call option contract on
the June Treasury bond contract with an exercise price of 115, you have purchased the
right to buy (call in) the June Treasury bond futures contract for a price of 115 ($115,000
per contract) at any time through the expiration date of this contract at the end of June.
Similarly, when for $2000 you buy a put option on the June Treasury bond contract with
an exercise price of 115, you have the right to sell (put up) the June Treasury bond futures
contract for a price of 115 ($115,000 per contract ) at any time until the end of June .

Futures option contracts are somewhat complicated, so to explore how they work and
how they can be used to hedge risk, let’s first examine how profits and losses on the call
option on the June Treasury bond futures contract occur. In February, our old friend
Irving the investor buys, for a $2000 premium, a call option on the $100,000 June
Treasury bond futures contract with a strike price of 115. (We assume that if Irving
exercises the option, it is on the expiration date at the end of June and not before.) On the
expiration date at the end of June, suppose that the underlying Treasury bond for the
futures contract has a price of 110. Recall that on the expiration date, arbitrage forces the
price of the futures contract to be the same as the price of the underlying bond, so it too
has a price of 110 on the expiration date at the end of June. If Irving exercises the call
option and buy the futures contract at an exercise price of 115, he will lose money by
buying at 115 and selling at the lower market price of 110. Because Irving is smart, he
will not exercise the option, but he will be out the $2000 premium he paid. In such a
situation, in which the price of the underlying financial instrument is below the exercise
price, a call option is said to be “out of the money.” At the price of 110 (less than the
exercise price), Irving thus suffers a loss on the option contract of the $2000 premium he
paid.

5.10 Potential Benefits from the Futures and Options Markets

Trading in futures and options offers several potential advantages to financial institutions
and individual investors. The prospect of hedging against changes in security prices and
interest rates offers the potential for reducing risk and offsetting losses, particularly for
security dealers, banks, insurance companies, and other financial institutions that
experience marked fluctuations in income due to changes in the differential between
interest rates on borrowed funds and interest returns on assets. Moreover, if the futures
and options markets do lead to a reduction of risk, this will enable many financial
institutions to extend greater amounts of credit to their customers. The results could be a
more efficient allocation of scarce funds within each financial institution and within the
financial system as a whole.

Not all observers agree that futures and options markets result in a net gain for society by
helping financial institutions reduce risk and use scarce resources more efficiently. Some
analysts believe that the futures and options markets are largely speculative and not really
geared for the hedging of risks per se. They see these markets as aimed principally at
providing wealthy investors with a speculative outlet for their funds and as resulting in
unnecessary risks due to excessive speculation. Some have argued that futures and
options market increase the price volatility of those securities whose contracts are
actively traded and have played a major role in recent stock market downturns.

On balance, futures and options markets probably have resulted in a net benefit to the
financial system and to the economy. They have separated the risk of changing security
prices and interest rates from the lending of funds, at least for those institutions actively
participating in these markets. The risk of price and yield changes is transferred to
investors willing to assume such risks. The futures and options markets have helped to
reduce search costs and expand the flow of information on market opportunities for those
who seek risk reduction through hedging. Moreover, this developing institution has
tended to unify local markets into an international forward market, overcoming
geographic and institutional rigidities that tend to separate one market from another.

But futures and options trading is not with out its own special risks. The risk of price and
yield fluctuations is reduced through negotiating these contracts, but the investor faces
the risk of changing interest rates and security prices between futures and spot markets
(basis risk). It is rate that gains and losses from simultaneous trading in spot, futures, or
options markets exactly offset each other, resulting in a perfect hedge. There is also the
risk of broker cash margin calls on the trader due to adverse price changes (margin risk)
and possible problems in liquidating an open position in futures or options (liquidity
risk). Moreover, there are substantial brokerage fees for executing futures contracts and
required minimum deposits for margin accounts that tie up cash in non interest-bearing
assets.

QUESTIONS FOR REVIEW AND DISCUSSION

1. What are the similarities and differences between hedging and insurance?
2. What is hedging?
3. Hedging is considered as the principal reason for the existence of futures markets.
Discuss how.
4. Explain opening and closing a hedge.
5. In what circumstances does hedging considered as effective?
6. What are financial futures and what is the purpose of trading in financial futures?
7. Account for the main problems of treading in financial futures markets.
8. What are options?
9. Explain the difference between American options and European options.
10. By taking your own example, discuss how options and futures contracts will lead
to profits and/or losses.
 11. List for the potential benefits from the futures and options markets.
CAHPTER SEVEN

7. FOREIGN EXCHANGE MARKETS

When studying open economies that trade with one another, there is a major difference in
the transactions between domestic and foreign residents as compared to those between
residents of the same country, namely, that differing national currencies are usually
involved. A US importer will generally have to pay a Japanese exporter in yen, a German
exporter in deutschmarks and a British exporter in pounds. For this reason, the US
importer will have to buy these currencies with dollars in what is known as the foreign
exchange market. The foreign exchange market is not a single physical place, rather it is
defined as a market where the various national currencies are bought and sold. Exactly
what factors determine how much domestic currency has to be given in exchange to
obtain a unit of foreign currency, the behavior of exchange rates and the impact of
exchange-rate changes, are one of the major fields of study in international economics.

In this chapter, we look at some preliminary issues. We examine the various participants
in the foreign exchange market and the basic forces that operate in the market. We then
examine the basic determinants of exchange-rate behavior. The chapter proceeds to
examine various exchange-rate definitions and their economic significance, and we then
look at the basic operational differences between fixed and floating exchange rate
regimes. The chapter finishes by examining the relationship between the spot and forward
exchange rate.

Thus, after studding this chapter, you will be able to:

 Define exchange rate and foreign exchange market
 Know the characteristics and participants of foreign exchange market
 Explain the nominal, real and effective exchange rates
 Realize the different alternatives of exchange rate regimes
 State the result of the interaction of hedgers, arbitragers and speculators
7.1 Exchange-Rate Definitions

The exchange rate is simply the price of one currency in terms of another, and there are
two methods of expressing it:

1. Domestic currency units per unit of foreign currency — for example, taking the
pound sterling as the domestic currency, on 16 August 1997 there was
approximately £0.625 required to purchase one US dollar.
2. Foreign currency units per unit of the domestic currency — again taking the
pound sterling as the domestic currency, on 16 August 1997 approximately $1.60
were required to obtain one pound.

The reader will note that second method is merely the reciprocal of the former. While it is
not important which method of expressing the exchange rate is employed, it is necessary
to be careful when talking about a rise or fall in the exchange rate because the meaning
will be very different depending upon which definition is used. A rise in the pounds per
dollar exchange rate from say £0.625/$1 to £0.70/$1 means that more pounds have to be
given to obtain a dollar, this means that the pound has depreciated in value or
equivalently the dollar has appreciated in value. If the second definition is employed, a
rise in the exchange rate from $1.60/£1 to say $1.80/£l would mean that more dollars are
obtained per pound, so that the pound has appreciated or equivalently the dollar has
depreciated. For the purposes of this chapter we shall define the exchange rate as foreign
currency units per unit of domestic currency.

7.2 Characteristics and Participants of the Foreign Exchange Market

The foreign exchange market is a worldwide market and is made up primarily of

commercial banks, foreign exchange brokers and other authorized agents trading in most
of the currencies of the world. These groups are kept in close and continuous contact with
one another and with developments in the market via telephone, computer terminals,
telex and fax. Among the most important foreign exchange centers are London, New
York, Tokyo, Singapore and Frankfurt. The net volume of foreign exchange dealing
globally was in April 1995 estimated to be in excess of $1250 billion per day, the most
active centers being London with a daily turnover averaging $464 billion, followed by
New York with $244 billion and Tokyo with $161 billion, Singapore $105 billion with
Paris $58 billion and Frankfurt $76 billion.

Easily the most heavily traded currency is the US dollar which is known as a vehicle
currency — because it is widely used to denominate international transactions. Oil and
many other important primary products such as tin, coffee and gold all tend to be priced
in dollars. Indeed, because the dollar is so heavily traded it is usually cheaper for a British
foreign exchange dealer wanting Mexican pesos, to firstly purchase US dollars and then
sell the dollars to purchase pesos rather than directly purchase the pesos with pounds.

The main participants in the foreign exchange market can be categorized as follows and
are shown in Figure 7.1.

Retail clients — these are made up of businesses, international investors, multinational

corporations and the like who need foreign exchange for the purposes of operating their
businesses. Normally, they do not directly purchase or sell foreign currencies themselves,
rather they operate by placing buy/sell orders with the commercial banks.

Commercial banks — the commercial banks carry out buy/sell orders from their retail
clients and buy/sell currencies on their own account (known as proprietary trading) so as
to alter the structure of their assets and liabilities in different currencies. The banks deal
either directly with other banks or through foreign exchange brokers. In addition to the
commercial banks other financial institutions such as merchant banks are engaged in
buying and selling of currencies both for proprietary purposes and on behalf of their
customers in finance-related transactions.

Foreign exchange brokers — often banks do not trade directly with one another, rather
they offer to buy and sell currencies via foreign exchange brokers. Operating through
such brokers is advantageous because they collect buy and sell quotations for most
currencies from many banks, so that the most favorable quotation is obtained quickly and
at very low cost. One disadvantage of dealing though a broker is that a small brokerage
fee is payable which is not incurred in a straight bank-to-bank deal. Each financial centre
normally has just a handful of authorized brokers through which commercial banks
conduct their exchanges.

Figure 7.1 The organization of the foreign exchange market

Central banks — normally the monetary authorities of a country are not indifferent to
changes in the external value of their currency, and even though exchange rates of the
major industrialized nations have been left to fluctuate freely since 1973, central banks
frequently intervene to buy and sell their currencies in a bid to influence the rate at which
their currency is traded. Under a fixed exchange-rate system the authorities are obliged to
purchase their currencies when there is excess supply and sell the currency when there is
excess demand.

Box 7.1 Bulls and bears in the foreign exchange market

Speculators are usually classified as bulls and bears according to their view on a
particular currency. If a speculator expects a currency, for example, the pound (spot or
forward), to appreciate in the future he is said to be ‘bullish’ about the currency. It pays
the speculator to take a long position on the pound, that is to buy the pound spot or
forward at a cheap price today in the hope that he can sell it at a higher price in the
future.

If as speculator expects the pound (spot or forward) to depreciate in the future he is said
to be ‘bearish’ about the currency. It will pay the speculator to take a short position on
the currency that is to sell the pound at what he considers to be a relatively high price
today in the hope of buying it back at a cheaper rate sometime in the future.

7.3 Arbitrage in the Foreign Exchange Market

One of the most important implications deriving from the close communication of buyers
and sellers in the foreign exchange market is that there is almost instantaneous arbitrage
across currencies and financial centers. Arbitrage is the exploitation of price differentials
for risk less guaranteed profits. To illustrate what is meant by these two types of arbitrage
we shall assume that transaction costs are negligible and that there is only a single
exchange-rate quotation ignoring the bid—offer spread.

Financial centre arbitrage — this type of arbitrage ensures that the dollar— pound
exchange rate quoted in New York will be the same as that quoted in London and other
financial centers. This is because if the exchange rate is $1.61/£l in New York but only
$1.59/£l in London, it would be profitable for banks to buy pounds in London and
simultaneously sell them in New York and make a guaranteed 2 cents on every pound
bought and sold. The act of buying pounds in London will lead to a depreciation of the
dollar in London, while selling pounds in New York will lead to an appreciation of dollar
in New York. Such a process continues until the rate quoted in the two centers coincides
at say $1.60/£l.

Cross-currency arbitrage — to illustrate what is meant by cross currency arbitrage let

us suppose that the exchange rate of the dollar is $1.60/£1, and the exchange rate of the
dollar against the deutschmark is $0.55/1DM. Currency arbitrage implies that the
exchange rate of the DM against the pound will be 2.9091 DM per pound. If this were not
the case and the actual rate was 3 DM per pound, then a UK dealer waiting dollars would
do better to first obtain 3 DM which will then buy $1.65, making nonsense of a $1.60/£l
quotation. The increased demand for deutschmarks would quickly appreciate its rate
against the pound to the 2.9091 DM level, at which level the advantage to the UK dealer
in buying deutschmarks first to then convert into dollars disappears.
7.4 The Spot and Forward Exchange Rates

Foreign exchange dealers not only deal with a wide variety of currencies but they also
have a set of dealing rates for each currency which are known as the spot and forward
rates.

The Spot Exchange Rate

The spot exchange rate is the quotation between two currencies for immediate delivery.
In other words, the spot exchange rate is the current exchange rates of two currencies vis-
à-vis each other. In practice, there is normally a two-day lag between a spot purchase or
sale, and the actual exchange of currencies to allow for verification, paperwork and
clearing of payments.

The Forward Exchange Rate

In addition to the spot exchange rate it is possible for economic agents to agree today to
exchange currencies at some specified time in the future, most commonly for 1 month (30
days), 3 months (90 days), 6 months (180 days), 9 months (270 days) and 1 year (360
days). The rate of exchange at which such a purchase or sale can be made is known as the
forward exchange rate. Exactly why economic agents may engage in forward exchange
transactions and how the forward exchange rate quotation is determined is a subject we
shall look at later in this chapter.

7.5 Nominal, Real and Effective Exchange Rates

Policy-makers and economists are very much concerned about analyzing the implications
of exchange-rate changes for the economy and the balance of payments. The exchange
rate itself does not convey much information, and to analyze the effects and implications
of its changes economists compile indices of the nominal, real and effective exchange
rates. Since most national and international authorities quote such rates as foreign
currency per unit of domestic currency, we shall compile some hypothetical nominal, real
and effective exchange rates using this definition. This means that a rise in any of these
indices represents an appreciation of the currency.

Nominal Exchange Rate

The exchange rate that prevails at a given date is known as the nominal exchange rate; it
is the amount of US dollars that will be obtained for one pound in the foreign exchange
market. Similarly, if the deutschmark—pound quotation is 2.50DM/£l, this is again a
nominal exchange-rate quotation. The nominal exchange rate is merely the price of one
currency in terms of another with no reference made to what this means in terms of
purchasing power of goods/services. It is usually presented in index form; if at the base
period the exchange rate is $1.60/£l and one period later the exchange rate is $1.80/£l the
nominal exchange-rate index of the pound against the dollar will change from the base
period value of 100 to 112.5. A depreciation or appreciation of the nominal exchange rate
does not necessarily imply that the country has become more or less competitive on
international markets, for such a measure we have to look at the real exchange rate.

Real Exchange Rate

The real exchange rate is the nominal exchange rate adjusted for relative prices between
the countries under consideration. It is normally expressed in index form algebraically as:
SP
S r= ¿
P∗¿
Where Sr is the index of the real exchange rate, S is the nominal exchange rate (foreign
currency units per unit of domestic currency) in index form, P the index of the domestic
price level, and P* is the index of the foreign price level.

Table 7.1 depicts the compilation of hypothetical nominal and real exchange-rate indices
for the pound. The table illustrates how the nominal and real exchange-rate indices are
compiled and what exactly changes in the real exchange-rate measure. In the first period
the real exchange-rate index is set equal to 100. A basket of UK goods priced at £100 will
cost a US resident $200, while a basket of US goods priced at $100 would cost a UK
resident £50. Between period 1 and period 2 there is no change in the nominal exchange
rate which remains at $2/£l; however, the UK price index rises while the US index
remains the same. This means that there has been a real appreciation of the pound, UK
goods now become relatively more expensive for US residents as they now have to use
$240 dollars to purchase the original bundle of UK goods which now cost £120, the
bundle of US goods costs a British citizen £50. This decreased competitiveness is picked
up by the real exchange-rate appreciation from 100 to 120. Clearly, since the nominal
exchange rate has remained at 100 it has failed to pick up the change in competitiveness.
Between periods 2 and 3, UK prices remain unchanged while US prices increase,
however the pound appreciates sufficiently that the UK gains no competitive advantage.
Between periods 3 and 4 the UK prices rise and US prices fall, but the competitive
disadvantage to the UK is offset by a substantial depreciation of the pound leading to an
improvement in UK competitiveness as the real exchange rate index shows. Finally,
between periods 4 and 5 although UK prices rise much more than US prices, making the
UK less competitive, this is offset by a large nominal depreciation of the pound leading to
a real depreciation of the pound as the real exchange-rate index again shows. From this
example it is clear that the real exchange rate monitors changes in a country’s
competitiveness. Real exchange-rate indices unlike nominal exchange-rate indices are not
available on a daily basis because the price indices used are normally only published
monthly.

Table 7.1 Construction of nominal and real exchange -rate indices

Nominal Nominal Real
Period Exchange Exchange UK Price US Price Exchange
Rate Rate Index Index Index Rate Index
1 $2.00 100 100 100 100
2 $2.00 100 120 100 120
3 $2.40 120 120 120 120
4 $1.80 90 130 117 100
5 $1.50 75 150 125 90
Note: The real exchange-rate index is constructed by multiplying the nominal exchange-
rate index by the UK price index and dividing this by the US price index.
Effective Exchange Rate

Since most countries of the world do not conduct all their trade with a single foreign
country, policy-makers are not so much concerned with what is happening to their
exchange rate against a single foreign currency but rather what is happening to it against
a basket of foreign currencies with whom the country trades. The effective exchange rate
is a measure of whether or not the currency is appreciating or depreciating against a
weighted basket of foreign currencies. In order to illustrate how an effective exchange
rate is compiled consider the hypothetical case of the UK conducting 30 per cent of its
foreign trade with the US and 70 per cent of its trade with Germany. This means that a
weight of 0.3 will be attached to the bilateral exchange-rate index with the dollar, and 0.7
with the deutschmark.

Table 7.2 shows the construction of a hypothetical effective sterling exchange rate based
upon movements in the bilateral nominal exchange- rate indices against the dollar and
deutschmark.

Table 7.3 shows movements of a hypothetical effective exchange-rate index for the
pound. The US dollar has a 30 per cent weight and the German deutschmark a 70 per cent
weight. Between periods 1 and 2 the pound is unchanged against the dollar but
depreciates 10 per cent against the deutschmark. Since the deutschmark has a greater
weight than the dollar the effective exchange-rate index indicates an overall depreciation
of 7 per cent. Period 3 leads to an appreciation against the US dollar and no change
against the deutschmark; the resulting appreciation of the effective exchange rate is
consequently less marked than the appreciation against the dollar. In period 4, the pound
depreciates against both the dollar and deutschmark, and consequently there is a
depreciation of the effective exchange rate. Finally, in period 5 the pound depreciates
against the US dollar and appreciates to a lesser extent against the deutschmark; however,
the effective exchange rate depreciates only marginally because more weight is attached
to the appreciation against the deutschmark then to the depreciation against the dollar.
 Table 7.2 Construction of a nominal effective exchange-rate index
Period Nominal Exchange Nominal Exchange Effective Exchange
Rate Index of $/£ Rate Index of DM/£ Rate index of £
1 100 100 100
2 100 90 93
3 120 90 99
4 90 80 83
5 75 85 82
Note: The effective exchange-rate index is constructed by multiplying the $/£ index by
0.3 and the DM/£ index by 0.7.

Table 7.3 Nominal effective exchange-rate indices, 1980-96

United Canada Japan United Germany Italy France
states Kingdom
1980 100.0 100.0 100.0 100.0 100.0 100.0 100.0
1981 109.5 99.7 112.0 102.8 96.1 90.6 93.9
1982 121.3 99.2 104.8 99.0 101.8 85.0 87.0
1983 125.6 100.3 114.7 92.9 106.8 83.0 82.0
1984 134.3 96.8 121.0 89.5 106.3 79.5 79.3
1985 138.9 92.3 123.6 89.4 106.8 75.5 80.4
1986 113.0 86.4 158.0 81.5 116.0 76.6 82.6
1987 99.8 88.2 171.6 79.8 122.7 76.4 82.6
1988 93.0 94.0 190.1 84.7 122.0 73.8 80.9
1989 97.1 98.9 181.8 82.2 121.1 74.4 80.1
1990 92.6 99.2 163.9 80.3 126.3 75.6 83.5
1991 91.1 100.8 177.7 81.0 125.1 74.5 82.1
1992 89.4 95.0 186.4 77.9 128.9 72.2 84.7
1993 92.1 89.5 223.7 71.5 134.0 60.8 87.7
1994 90.4 84.0 241.1 71.7 134.3 58.1 88.5
1995 85.0 82.3 253.2 68.2 141.2 52.4 91.2
1996 89.5 83.8 219.8 69.3 137.5 57.2 91.1
Source: IMF, International Financial Statistics.
Notes: The above are the nominal effective exchange rates derived from the international
monetary fund multilateral exchange rate model.

While the nominal effective exchange rate is easy to compile on a daily basis and
normally provides a reasonable measure of changes in a country’s competitive position
for periods of several months, it does not take account of the effect of price movements.
In order to get a better idea of changes in a country’s competitive position over time we
would need to compile real effective exchange-rate indices. For this, we would first of all
 compile the real exchange rate against each of the trading partners’ currencies in index
form, and then use the same procedure as for compiling the nominal effective exchange
rates. Table 7.3 shows the nominal effective exchange-rate indices for the major
industrialized countries since 1980 which are derived from the International Monetary
Fund’s Multilateral Exchange Rate Model (MERM), while Table 7.4 shows the real
effective exchange-rate indices for the major industrialized countries using consumer
price indices for calculation purposes.

Table 7.4 Real effective exchange-rate indices, 1980-95

United Canada Japan United Germany Italy France
states Kingdom
1980 100.0 100.0 100.0 100.0 100.0 100.0 100.0
1981 109.5 105.0 106.3 102.9 91.3 97.6 95.4
1982 123.0 112.1 93.6 99.3 92.9 98.8 91.1
1983 128.6 117.0 99.8 91.2 93.5 104.1 87.7
1984 136.1 114.8 102.1 87.2 89.4 104.8 86.1
1985 140.9 110.8 100.9 88.9 86.9 104.5 88.3
1986 118.4 100.2 126.7 82.7 92.0 111.8 91.5
1987 106.7 100.4 132.1 82.6 95.0 115.2 92.6
1988 100.3 105.8 138.4 89.2 92.7 114.0 90.5
1989 103.8 113.3 130.1 89.6 9.04 116.7 88.6
1990 99.5 112.1 116.7 92.6 93.2 122.2 91.7
1991 98.4 115.4 123.6 94.4 91.3 122.5 88.5
1992 96.2 106.0 127.7 91.3 94.8 121.0 90.1
1993 99.5 99.3 153.7 81.9 98.0 102.4 91.3
1994 98.0 90.2 763.0 82.0 98.1 100.1 91.0
1995 92.7 86.8 172.0 78.6 106.0 108.7 91.4
Source: IMF, International Financial Statistics.
Note: A rise represents a real effective exchange rate appreciation of the country’s
currency. The above indices are based on wholesale prices. The weights used for
compiling the indices are based on disaggregated trade data for manufactured goods and
primary products covering the three year period 1980—2.

7.6 A Simple Model of the Determination of the Spot Exchange Rate

Since the adoption of floating exchange rates in 1973, there has developed an exciting
new set of theories attempting to explain exchange-rate behavior, generally known as the
 modern asset market approach to exchange-rate determination. For the time being, we
shall look at a simple model of exchange-rate determination which was widely used prior
to the development of these new theories. Despite its shortcomings the model serves as a
useful introduction to exchange-rate determination. The basic tenet of the model is that
the exchange rate (the price) of a currency can be analyzed like any other price by a resort
to the tools of supply and demand. The exchange rate of the pound will be determined by
the intersection of the supply and demand for pounds on the foreign exchange market.

The Demand for Foreign Exchange

The demand for pounds in the foreign exchange market is a derived demand; that is, the
pounds are not demanded because they have an intrinsic value in themselves, but rather
because of what they can buy. Table 7.5 depicts the derivation of a hypothetical demand
for pounds schedule with respect to changes in the exchange rate. As the pound
appreciates against the dollar, that is moves from $1.40 towards $2, the price of the UK
export to US importers increases and this leads to a lower quantity of exports and with it
a reduced demand for pounds. Hence, the demand curve for pounds which is depicted in
Figure 7.2 slopes down from left to right.

Table 7.5 The derivation of the demand for pounds

Price of UK Exchange Price of UK Quantity of Demand
export good in £s rate $/£ export good in $s UK exports for pounds
10 $1.40 14 1400 14000
10 $1.50 15 1200 12000
10 $1.60 16 1000 10000
10 $1.70 17 900 9000
10 $1.80 18 800 8000
10 $1.90 19 700 7000
10 $2.00 20 600 6000

In this simple model, the demand for pounds depends upon the demand for UK exports.
Any factor which results in an increase in the demand for UK exports, that is column 4 in
Table 7.5, will result in an increased demand for pounds and a shift to the right of the
demand curve for pounds. Among the factors that result in such a rightward shift are a
rise in US income, a change in US tastes in favor of UK goods, and a rise in the price of
US goods. All these factors result in an increased demand for UK exports and hence
pounds and a shift of the demand schedule to the right.

$/£
Rate

2.00

1.60
1.40

D
0 6000 10 000 14 000
Quantity of £S
Figure 7.2 The demand for pounds

The supply of Foreign Exchange

The supply of pounds is in essence the UK demand for dollars, and Table 7.6 sets out the
derivation of a hypothetical supply of pounds schedule. As the pound appreciates the cost
of US exports becomes cheaper for UK residents. As such, they demand more US exports
and this results in an increased demand for dollars which are purchased by increasing the
amount of pounds supplied in the foreign exchange market, this yields an upward sloping
supply of pounds curve (Figure 7.3).

Table 7.6 The supply of Pounds

Price of US Exchange Price of US Quantity of Demand for Supply of
export good rate $/£ export in £s US exports Dollars Pounds
in dollars
20 $1.40 14.29 600 12000 8571
20 $1.50 13.33 700 14000 9333
20 $1.60 12.50 800 16000 10000
20 $1.70 11.76 950 19000 11176
20 $1.80 11.11 1100 22000 12222
20 $1.90 10.53 1225 24500 12895
20 $2.00 10.00 1350 27000 13500
 2.00
1.60
1.40

0 8571 10000 13500 Quantity of £s

Figure 7.3 the supply of pounds

The supply of pounds schedule depends upon the UK demand for US exports. The
position of the schedule will shift to the right if there is an increase in UK income, a
change in British tastes in favor of US goods, or a rise in UK prices. All these factors
imply an increased demand for US goods and dollars which is reflected in an increased
supply of pounds.

Since the exchange market merely brings together those people that wish to buy a
currency (which represents the demand) with those that wish to sell the currency (which
represents the supply), then the spot exchange rate can most easily be thought of as being
determined by the interaction of the supply and demand for the currency.

Figure 7.4 depicts the determination of the dollar—pound exchange rate in the context of
such a supply and demand framework in the foreign exchange market. The equilibrium
exchange rate is determined by the intersection of the supply and demand curves to yield
a dollar—pound exchange of $1.60/£l. When the exchange rate is left to float freely, it is
determined by the interaction of the supply and demand curves.

7.7 Alternative Exchange-Rate Regimes

At the Bretton Woods conference of 1948 the major nations of the Western world agreed
to a pegged exchange rate system, each country fixing its exchange rate against the US
dollar with a small margin of fluctuation around the par value. In 1973 the Bretton Woods
system broke down and the major currencies were left to be determined by market forces
in a floating exchange-rate world. The basic differences between the two regimes can be
highlighted using the supply and demand framework.

$/£
rate S

1.60

0
10000 Quantity of £s
Figure 7.4 Determination of the dollar-pound exchange rate

Floating Exchange-Rate Regime

Under a floating exchange-rate regime the authorities do not intervene to buy or sell their
currency in the foreign exchange market. Rather, they allow the value of their currency to
change due to fluctuations in the supply and demand of their currency to change due to
fluctuations in the supply and demand of the currency, and this is illustrated in Figure 7.5

(a) S
$/£
rate
1.80

1.60
D2

D1

0
Q1 Q2 Quantity of £s
 $/£ (b)
rate S1
S2

1.60
1.40

0
Q1 Q2 Quantity of £s

Figure 7.5 Floating exchange-rates regime: (a) increase in demand (b) increase in
supply

In Figure 7.5(a) the exchange rate is initially determined by the interaction of the demand
(D1) and supply (S1) of pounds at the exchange rate of $1.60/£1. There is an increase in
the demand for UK exports which shifts the demand curve from D l to D2. This increase in
the demand for pounds leads to an appreciation of the pound from $1.60/£1 to $1.80/£1.
Figure 7.5(b) examines the impact of an increase in the supply of pounds due to an
increased demand for US exports and therefore dollars. The increased supply of pounds
shifts the S1 schedule to the right, to S2, resulting in a depreciation of the pound from
$1.60/£1 to $1.40/£1. The essence of a floating exchange rate is that the exchange rate
adjusts in response to changes in the supply and demand for a currency.

Fixed Exchange-Rate Regime

In Figure 7.6(a) the exchange rate is assumed to be fixed by the authorities at the point
where the demand schedule (Dl) intersects the supply schedule (S1) at $1.60/£1. If there is
an increase in the demand for pounds which shifts the schedule from D l to D2, there is a
resulting pressure for the pound to be revalued. To avert an appreciation it is necessary
for the Bank of England to sell Q1Q2 pounds to purchase dollars with pounds in the
foreign exchange market; these purchases shift the supply of pounds from S1 to S2. Such
intervention eliminates the excess demand for pounds so that the exchange rate remains
fixed at $1.60/£1. The intervention increases the Bank of England’s reserves of US
dollars while increasing the amount of pounds in circulation.

Figure 7.6(b) depicts an initial situation where the exchange rate is pegged by the
authorities at the point where the demand schedule (Dl) intersects the supply schedule (S1)
at $1.60/£l. An increase in the supply of pounds (increased demand for US dollars) shifts
the supply schedule from S1 to S2. The result is an excess supply of pounds at the
prevailing exchange rate, which means that there will be pressure for the pound to be
devalued. To avoid this, the Bank of England has to intervene in the foreign exchange
market to purchase Q3Q4 pounds to peg the exchange rate. This intervention is
represented by a rightward shift of the demand schedule from D l to D2. Such intervention
removes the excess supply of pounds so that the exchange rate remains pegged at
$1.60/£1, and it leads to a fall in the Bank of England’s reserves of US dollars and a fall
in the amount of sterling in circulation.

7.8 The Determination of the Forward Exchange Rate

The forward exchange market is where buyers and sellers agree to exchange currencies at
some specified date in the future. For example, a UK trader who has to pay $15500 to his
US supplier at the end of August may decide on 1 June to buy 15500 dollars for delivery
on 31 August of the same year at a forward exchange rate of $1.55/£1. The question that
naturally arises is why should anyone wish to agree today to exchange currencies at some
specified time in the future? To answer this question we need to look at the various
participants in the forward exchange market. Traditionally, economic agents involved in
the forward exchange market are divided into three groups where classifications are
distinguished by their motives for participation in the foreign exchange market.
 (a)
$/£ Intervention
rate
1.60

0
Q1 Q2 Quantity of £s

S1
(b)
$/£ S2
rate

1.60
Intervention

D2

D1

0
Q3 Q4 Quantity of £s
Figure 7.6 Fixed exchanges –rate regime: (a) increase in demand (b) increase in
supply
1. Hedgers — these are agents (usually firms) that enter the forward exchange
market to protect themselves against exchange-rate fluctuations which entail
exchange-rate risk. By exchange risk we mean the risk of loss due to adverse
exchange-rate movements. To illustrate why a firm may engage in a forward
exchange-rate transaction consider the example of a UK importer who is due to
pay for goods from the US to the value of $15000 in one year’s time. Let us
suppose that the spot exchange rate is $1.60/£l while the one-year forward
exchange rate is $1.55/£l. By buying dollars forward at this rate the trader can be
sure that he only has to pay £10 000. If he does not buy forward today, he runs the
 risk that in one year’s time the spot exchange rate may be worse than $1.55/£l,
such as $1.30/£l which would mean him having to pay £11923 ($15 500/1.30). Of
course, the spot exchange rate in one year’s time may be more favorable than
$1.55/£l, such as $2/£l in which case he would only have had to pay £7750 ($15
500/2) which would ex post have been better than engaging in a forward exchange
contract. But by engaging in a forward exchange contract the trader can be sure of
the amount of sterling he will have to pay for the imports, and therefore can
protect himself against the risk entailed by exchange-rate fluctuations.

It may be asked why the importer does not immediately buy US $15500 spot at
$1.60/£l and hold the dollars for 1 year. One reason is that he may not at present
have the necessary funds for such a spot purchase and is reluctant to borrow the
money, knowing that he will have the funds in one year’s time because of money
from sales of goods. By engaging in a forward contract he can be sure of getting
the dollars he requires at a known exchange rate even though he does not yet have
the necessary sterling.

In effect, hedgers avoid exchange risk by matching their assets and liabilities in
the foreign currency. In the above example, the UK importer buys $15500
forward (his asset) and will have to pay $15500 for the imported goods (his
liability).

2. Arbitrageurs — these are agents (usually banks) that aim to make a riskless
profit out of discrepancies between interest-rate differentials and what is known as
the forward discount or forward premium. A currency is said to be at a forward
premium if the forward exchange-rate quotation for that currency represents an
appreciation of that currency compared to the spot quotation. On the other hand a
currency is said to be at a forward discount if the forward exchange-rate quotation
for that currency represents a depreciation of that currency compared to the spot
quotation.

The forward discount or premium is usually expressed as a percentage of the spot

 exchange rate. That is:
F−S
x 100
Forward discount/premium = S
where F is the forward exchange-rate quotation and S is the spot exchange- rate
quotation.

The presence of arbitrageurs ensures that what is known as the covered interest parity
(CIP) condition holds continually — this is the formula used by banks to calculate their
forward exchange quotation and is given by the following formula:

( r∗− r ) S
F= +S (7 . 1)
(1+ r )

where F is the one-year forward exchange-rate quotation in foreign currency per unit of
domestic currency, S is the spot exchange-rate quotation in foreign currency per unit of
domestic currency, r is the one- year domestic interest rate, and r* is the one-year foreign
interest rate.

The above formula has to be amended by dividing the three-month interest rates by 4 to
calculate the three-month forward exchange-rate quotation, and dividing the six-month
interest rates by 2 to calculate the six-month forward exchange rate. Table 7.7 shows how
the calculation works in practice using the deutschmark—sterling exchange rate and data
from the Financial Times.

Example calculation of the forward exchange rate:

Suppose that the one-year dollar interest rate is 5 per cent, and the sterling interest rate is
8 per cent, and the spot rate of the dollar against the pound is $1.60/£l. Then the one-year
forward exchange rate of the pound is:
(0 . 05−0. 08 )
F= 1 . 60+1. 60=$ 1 . 5555/£1
1. 08
Since
F-S 1. 5555−1 . 60
= x100=−2. 78
S 1. 60
The one-year forward rate of sterling is at an annual forward discount of 2.78 per cent.
To understand why CIP must be used to calculate the forward exchange rate consider
what would happen if the forward rate was different from that calculated in the example,
for example $1.70/£l. In this instance, a US investor with $100 could earn the US interest
rate and at the end of the year have $105, but by buying pounds spot at $1.60/£l and
simultaneously selling pounds forward at $1.70, he would have £62.50 earning the UK
interest rate of 8 per cent, giving him £67.50 (£62.50 x 1.08) at the end of one year,
which he would sell at a forward price of $1.70 giving $114.75. Clearly, it pays a US
investor to buy pounds spot and sell pounds forward. With sufficient numbers of
investors doing this, the forward rate of the pound would depreciate until such arbitrage
possibilities were eliminated. With a spot rate of $1.60/£1, only if the forward rate is at
$1.5555/£1 will the guaranteed yields in US and UK time deposits be identical, since
£67.50 multiplied by $1.5555 equals $105. Only at this forward exchange rate is there no
riskless arbitrage profits to be made.

Since the denominator in equation (7.1) is typically very close to unity, the equation can
be simplified to yield an approximate expression for the forward premium/discount:

F−S
≈ r∗− r ( 7 . 2)
S
This approximate version of CIP says that if the domestic interest rate is higher than the
foreign interest rate, then the domestic currency will be at a forward discount by an
equivalent percentage; while if the domestic interest rate is lower than the foreign interest
rate, the currency will be at a forward premium by an equivalent percentage. In our
example, the US interest rate of 5 per cent less the UK interest rate of 8 per cent indicates
an annual forward discount on the pound of 3 per cent, which is an approximation to the
actual 2.78 per cent discount obtained using the full CIP formula.

3. Speculators — speculators are agents that hope to make a profit by accepting

exchange-rate risk. They engage in the forward exchange market because they
believe that the future spot rate corresponding to the date of the quoted forward
exchange rate will be different from the quoted forward rate. Consider the
situation where the one-year forward rate is quoted at $1.55/£l, and a speculator
feels that the pound will be $1.40/£l in one year’s time. In this instance he may
 sell £1000 forward at $1.55/£l so as to obtain $1550 one year hence and hope to
change them back into pounds in one year’s time at $1.40/£l, and so obtain
£1107.14 making £107.14 profit. Of course the speculator may be wrong and find
that in one year’s time the spot exchange rate is above $1.55/£l, say $1.70/£l, in
which case his $1550 are worth £911.76 implying a loss of £88.24. A speculator
hopes to make money by taking an ‘open position’ in the foreign currency. In our
example, he has a forward asset in dollars which is not matched by a
corresponding liability of equal value.

7.9 The Interaction of Hedgers, Arbitrageurs and Speculators

The forward exchange rate is determined by the interaction of traders, hedgers and
speculators. One of the conditions that must hold in the forward exchange market is that
for every forward purchase there must be a forward sale of the currency so that the net
demand for the currency sums to zero:

NDH+NDA+NDS=0

where NDH is the net demand of hedgers, NDA is the net demand of arbitrageurs, and
NDS is the net demand of speculators.

The forward exchange rate and volume of forward transactions is determined by the
actions of arbitrageurs traders and speculators and is jointly determined with the spot
exchange rate. This is illustrated in Figure 7.7 which depicts the simultaneous
determination of the spot and forward exchange rate. Figure 7.7 (a) shows the supply and
demand situation in the spot market, and Figure 7.7(b) the net demand schedules in the
forward market. The AA schedule reflects the forward exchange rate consistent with CIP.
In effect, this is the supply and demand of forward exchange of arbitrageurs for a given
interest differential. Since the pound is at a forward discount the interest rate in the UK is
above that in the US. The DH schedule is the net demand for pounds of hedgers in the
forward exchange market; as the pound depreciates in the forward market then hedgers’
net demand for pounds rises.
The DS schedule is the net demand schedule for forward exchange of speculators, and it
cuts the vertical axis at $1.50 per pound. This means that $1.50 represents the average
forecast of speculators since at this rate speculators would be neither net purchasers or
sellers of forward pounds. However, because speculators on average expect the pound to
depreciate more than is indicated by the forward exchange rate, they are net sellers of
pounds forward if the rate is above $1.50/£1 (because they then expect to be able to buy
pounds in the future at a better rate than they sold them), and net purchasers of pounds
forward if the rate is below $1.50/£1 (because they then expect to be able to sell in the
future at a better rate than they purchased them).

At the end of the day the arbitrage formula as given by CIP is crucial to the forward rate
which is determined along the arbitrage schedule AA at $1.5555/£1. At this rate, hedgers
happen to be net purchasers of pounds given by DH1, while speculators happen to be net
sellers of pounds given by DS1. Since the net purchases of hedgers exceed the net sales of
speculators, then there is pressure for the forward rate to rise above $15555 and this
induces arbitrageurs to be net sellers of pounds forward (constituting net sales equal to
DH1 — DS1) so as to clear the forward exchange market.

Speculators are at work in both the spot and forward exchange markets; if they decide
that the current spot rate is overvalued they may sell spot so that the currency depreciates,
and if interest rates do not change then both the spot and forward exchange rates
depreciate. Similarly, if speculators feel that the currency is overvalued forward then they
will sell forward and both the forward and spot exchange quotations will depreciate.
Hence, arbitrage ties the spot and forward exchange market quotations together via the
CIP condition. Speculation and hedging may be thought of as determining the level of the
spot and forward exchange quotations.

$/£
rate
D
 S
$/£
rate

$1.60
A A

D
DH
Ds

0
Q1 Quantity Net forward D
Net
S1 forward DH1
of £’s sales of £’s purchases of £’s
Figure 7.7 The joint determination of the spot and forward exchange rate

QUESTIONS FOR REVIEW AND DISCUSSION

1. What is foreign exchange market? How about foreign exchange rates?

2. What is the difference between the spot and forward exchange rates and illustrate
how they are determined? Use examples in your illustration.
3. Define the nominal, real and effective exchange rates and discuss their
importance.
4. Discuss how the exchange rate is determined under the different alternative
exchange rate regimes.
5. Who are the participants of the foreign exchange market and state their role/s
within the market.
6. What is arbitrage and discuss its types.

CHAPTER EIGHT
8.1 THE REGUALTION OF FINANCIAL INSTITUTIONS

Financial institutions are the most heavily regulated of all businesses in the world.
Around the globe these financial service firms face stringent government rules limiting
the services they can offer, territories they can enter, the makeup of their portfolios of
assets, liabilities, and capital, and even how they price and deliver their services to the
public. As we will see in this chapter, over the centuries a variety of reasons have been
offered for heavy government intrusion into the financial institutions’ sector, including
protecting the public’s savings and ensuring that consumers receive an adequate quantity
and quality of financial services that are reasonably priced.

Many economists, financial analysts, and financial institutions have argued over the years
that government regulation has done more harm than good for both financial institutions
themselves and for the public they serve. In particular, government restrictions allegedly
have allowed nonregulated or less regulated financial service firms to invade the markets
and capture many of less regulated financial services, who are not sufficiently free to
compete effectively. Moreover, regulations are often backward looking, addressing
problems which have long since disappeared, and they may compound this problem of
“relevancy” by changing much more slowly than the free marketplace, inhibiting the
ability of the regulated financial institutions to stay abreast of new technologies and
changing customer tastes. Other observes, however, argue that government regulations
have achieved some positive results in the financial institutions’ sector, reducing the
number of failed financial service firms, promoting more stable financial markets, and
reducing the incidence of racial, age, and sex discrimination in public access to financial
services.

In this chapter we explore these and many other issues as we examine the variety of
government regulations and regulatory agencies that oversee financial institutions, assess
the reasons for and the effectiveness of existing regulations, and explore recent attempts
to deregulate the financial institutions’ sector.
Thus, after studding this chapter, you will be able to:
 Identify the main justifications behind the regulation of financial institutions
  Explain whether the regulation of financial institutions is beneficial or harmful
 Realize how regulation is made over commercial banks, pension funds, insurance
companies, and finance companies.

8.2 THE REASONS BEHIND THE REGUALTION OF FINANCIAL

INSTITUTIONS

Elaborate government rules controlling what financial institutions can and cannot do arise
from multiple causes. One is concern about the safety of the public’s fund, especially the
savings of millions of individuals and families. The reckless management and ultimate
loss of personal savings can have devastating consequences for a family’s future
economic wellbeing and life style, particularly at retirement. While savers have a
responsibility to carefully evaluate the quality and stability of financial institutions before
committing their funds to it, governments have long expressed a special concern for small
savers who may lack the financial expertise and access to quality information necessary
to be able to correctly judge the true conditions of a financial institution. Moreover, many
of the reasons that cause financial institutions to fail-such as fraud, embezzlement,
deteriorating loans, or manipulation of the books by insiders-are often concealed from the
public.

Related to the desire for safety is a government’s goal of promoting public confidence in
the financial system. Unless the public is confident enough in the safety and security of
their funds places under the management of financial institutions, they will withdraw
their savings and thereby reduce the volume of funds available for productive investment
to construct new buildings, purchase new equipment, set up new business, and create new
jobs. The economy’s grow will slow and, over time, the public’s standard of loving will
fall.

Government rules are also aimed at ensuring equal opportunity and fairness in the
public’s access to financial services. For example, in an earlier era many groups of
customers- women, members of racial minority groups, the elderly, and those of foreign
birth- found that their ability to borrow money on convenient terms was often severely
restricted. Consumers of financial services were not well organized then, and the
discriminatory policies of lending institutions seemed to change very slowly, particularly
in markets where competition was less intense. While many economists believed that the
potent force of competition generated by both domestic and Foreign Service suppliers
would eventually kill off the vestiges of discrimination, other observers argued that such
an event might take a very long time, particularly in those markets where financial firms
colluded with each other and agreed not to compete.

Many regulations in the financial sector spring from the ability of some financial
institutions to create money in the form of credit cards, checkable deposits, and other
accounts that can be used to make payments for the purchase of goods and services.
History has shown that creation of money is closely associated with inflation. If
uncontrolled money growth outstrips growth in the economy’s production of goods and
services, prices will begin to rise, damaging specially those consumers on fixed incomes,
as their money balances can buy fewer and fewer goods and services. Thus, the regulation
of money creation has become a key objective of government activity in the financial
sector.

Regulation is justified as the most direct way to aid so-called “disadvantaged” sectors in
the economy- those groups that appear to need special help in the competition for scarce
funds. Examples include new home buyers, farmers, small businesses, and low income
families. Governments often place high social value on subsidizing or guaranteeing loans
made to these sectors of the economy.

Finally the enforcement of government rules for financial institutions has arisen because
governments depend upon these institutions for many important services. Governments
borrow money and depend upon financial institutions to buy substantial proportion of
government IUOs. Financial institutions also aid governments in the collection and
disposal of tax revenues and in the pursuit of economic policy through the manipulation
of interest rates and money supply. Thus, governments frequently regulate financial
institutions simply to insure that these important financial services will continue to be
provided at a reasonable cost and in a reliable manner.

What are we to make of these reasons so often posed for the extensive government
regulations applied to many financial institutions? Few of them can go unchallenged. For
example, while safety is important for many savers, no government can completely
remove risk for savers. Indeed, in the long run, it may be more efficient and far less
costly for governments to promote full disclosure of the financial conditions of individual
financial institutions and let competition in a free marketplace discipline poorly managed,
excessively risky financial service firms. Similarly, there is no question that
discrimination on the basis of sex, race, religious affiliation, or other irrelevant factors is
repugnant, but can we be more effective by eliminating discriminating by some method
other than by writing and struggling to enforce complicated rule books and by requiring
endless compliance reports? Perhaps the same ends could be achieved by lowering the
regulatory barriers to competition and by making it easier for customers hurt by
discrimination to recover their damages in court.

Certainly the ability of financial institutions to create money needs to be monitored

carefully, because excessive money growth can easily generate inflation and weaken the
economy. But, aren’t there already enough tools available to control money growth? For
example, when money grows too fast, a central bank like the Federal Reserve System can
use its powerful tools (like deposit reserve requirements or open market operations) to
slow money growth. And wouldn’t it be more efficient to pay direct money subsidies to
disadvantaged groups (such as new home buyers) rather than to directly reach these
groups by regulating financial institutions and interfering with the free operation of the
financial services markets? As for providing a reliable stream of financial services to
governments, wouldn’t profit motivated financial institutions be likely to provide these
services if it were profitable to do so?
In brief, there are no absolutely irrefutable arguments justifying the regulation of
financial institutions. Much depends on your personal political philosophy regarding
society’s goals and whether these goals are each more likely to be achieved by an
unfettered marketplace or by collective action through government laws and regulations.
As we shall see shortly, there is a trend today toward gradually allowing private markets
to discipline risk taking by financial institutions and minimize the role of government.
Progress toward deregulation of the financial sector is slow, however, and can easily be
derailed if financial institutions abuse the new liberties that may soon come their way.

8.3 DOES REGLATION BENEFIT OR HARM FINANCIAL

INSTITUTIONS?

For many years a controversy has been brewing as to whether government regulations
help or hurt financial institutions. One of the earliest arguments on the positive side was
propounded by economist George Stigler (1971), who suggested that regulated industries,
far from dreading regulation, actually invite government intrusion, expecting to benefit
from it. In the early history of the United States, for example, the railroads often
prospered because government subsidized their growth and protected them from
competition. Because regulators may prevent or restrict entry into an industry, the firms
involved may earn excess profit (“monopoly rents”) due to the absence of strong
competitors. Therefore, the lifting of regulatory rules (deregulation) may bring about
decreased profits for financial institutions.

A more balanced view on the benefits and costs of regulation has been offered by Edward
Kane (1983). He suggests that, on the positive side, regulation tends to increase public
confidence in the regulated industry. Thus, customers may trust their banks’ stability and
reliability more because they are regulated, increasing customer loyalty to regulated firms
and helping to shelter them from risk. Moreover regulation may lead to a curious form of
“innovation” which Kane labels as the regulatory dialectic. He believes that regulated
firms are constantly searching for ways around government rules in order to increase the
market value of their business. Once they find a regulatory loophole that attracts the
regualtors’ attention, new rules are imposed to close the gap. But this leads to still more
“innovation” by regulated business in order to escape the new restrictions. The result is a
continuing chain reaction: regulators spawn innovative escapes that, in turn, give rise to
new rules in a never ending struggle between the regulators and the regulated. Many
observers of the banking industry in recent years see clear evidence of this dialectic
process-bankers finding ways to offer prohibited services, like security underwriting and
sales of insurance, spawning still more restrictive rules.

Notice, too, that the so-called “innovation” brought on by the regulatory dialectic is not
the most productive and efficient form of innovation from society’s point of view. Instead
of developing ways to lower costs and deliver financial services more efficiently to the
public, financial institutions are spending their time and energy looking regulatory
loopholes-something they wouldn’t do if the regulations weren’t there in the first place.
This “wasted time and energy, Kane believes, places regulated firms at a disadvantage
vis-a–vis their unregulated competitors. Other factors held equal, the market share of the
regulated firms begins to fall. Many economists believe that this has happened to banks
and other depository institutions in recent years, as security dealers and mutual funds,
facing fewer regulations, have captured many of the banking industry’s biggest and most
profitable customers, reducing the share of the financial services marketplace controlled
by depository institutions.

On balance, then, regulations of financial institutions may be a “tale of two cities,”

delivering both the best of times and the worst of times. Regulation may increase the
profit of regulated institutions’ profitability and shelter them from risk, resulting in fewer
failures, but perhaps at the price of costlier services and less efficient financial firms. In
return for greater stability and greater public confidence in financial institutions,
customers must expect to be less well served in terms of prices charged and quality of
services delivered.

8.4 THE REGULATION OF COMMERCIAL BANKS

Due to their importance in the financial system, commercial banks are typically the most
regulated of all financial institutions. One of the areas where the state and federal
regulators have exercised the most influence over banking is controlling what new
geographic markets banks can enter with their offices.

Another method of the regulation of commercial banks is through the regulation of the
services that banks can offer. Even as banks have sought greater freedom to expand
geographically, they have also fought for, but only occasionally won, new service powers
in order to retain their existing customers and attract new ones. Unfortunately, regulations
have been tight and sometimes unyielding in this area out of concern for bank safety (as
service innovation can be highly risky) and because of a desire to protect certain nonbank
financial institutions, such as credit unions, savings and loans, and insurance companies,
from tough bank competition.

For example, probably the most influential law in American history in defining bank
service powers was the Glass-Steagall Act (or Banking Act) of 1933. This sweeping law
confined bank service powers essentially to the making of loans and the taking of
deposits, while insurance services were largely relegated to insurance companies, and
home lending was centered in savings and loan associations and savings banks. U.S.
bankers also lost an important service power they possessed in the decades before Glass-
Steagall- the power to assist their largest corporate customers by purchasing corporate
stock and then reselling it in the open market. Foreign banks have continued to offer
corporate bond and stock underwriting services to American companies, and U.S. banks
are active in the security underwriting business overseas through a variety of affiliated
organizations, but they have clearly lost customers to security dealers and foreign banks
(principally from Canada and Western Europe) in domestic underwriting, except for
underwriting those types of securities where exceptions have been granted from federal
restrictions. Bankers have avidly sought security underwriting powers because this
business can be highly profitable and it complements traditional lending services.
One of the most rapidly expanding areas of banking regulation today centers around
disclosure rules— regulations requiring financial institutions to reveal certain information
to customers (in an effort to encourage shopping around and avoid deception) and to
regulators (to improve supervision of the banking industry). For example, banks could be
required to disclosure of all the interest and fees associated with selling loans and
deposits to individuals who are bank customers. Similarly, in case of home mortgage,
banks could be required to report to the public and to regulators the locations of both their
approved and rejected applications for loans to purchase or improve homes as a check on
possible discrimination in lending. Another could be a requirement on banks and other
depositories to notify customers and regulators in advance when branch offices are to be
closed.

In addition to the spread of interstate banking and the explosion in branching activity by
banks, another major trend reshaping the regulation of banks and other financial
institutions today centers upon their capital —the long-term funds invested in a financial
institution, mainly by its owners. For example, when stockholders buy ownership shares
in a bank, they have a claim against the hank’s earnings and assets. However, a bank’s
stockholders bear all the risks of ownership. If the bank fails to generate sufficient
earnings, the stockholders may receive no dividend income and, if the bank fails, they
close everything. When a bank chooses to take on more risk, its owners should be asked
to increase their financial commitment to the bank by supplying more capital. Because
stockholders capital is expensive to raise and could be lost completely if the bank fail, the
owners of the bank are likely to monitor the bank’s risk taking more closely, pressuring
management to be more prudent in taking on additional risk.

The tremendous changes in banking regulation in recent years- including the adoption of
nationwide banking and the spreading internationalization of bank regulation as
evidenced by the Basel Agreement on bank capital- might lead us to think that there is
little left to do in reshaping the future structure of bank regulation. Nothing could be
further from the truth! Banking in the United States (and in most other countries of the
world) remains heavily burdened by constraining government rules. Slowly and along a
zigzag path, banking is experiencing an era of deregulation, as legal constraints are being
lifted on a few banking activities.
8.5 THE REGULATION OF INSURANCE COMPANIES

While not quite as heavily regulated as commercial banks, insurance intermediaries face
tough rules that are imposed primarily by state governments, which create insurance
commissions to regulate the industry. The fundamental purpose of insurance company
regulation is to ensure that the public is not overcharged or poorly served and to
guarantee adequate compensation to insurance companies themselves. A new company
must be chartered under the rules of a particular home state. Once chartered, each
company must submit periodic reports to state commissions, its agents must be licensed
by the states, and the terms of its policies (including the premium rates it charges
policyholders) must be approved by state insurance commissions. Both the courts and
state commissions insist that any investments of incoming policyholder premiums must
conform to the common law standard of a ‘prudent person.”

8.6 THE REGULATION OF PENSION FUNDS

Because pension funds have risen rapidly to hold the bulk of the retirement savings of
millions of workers, they have been subject to much heavier regulation by the courts and
government agencies. Because employers- the principal creators and managers of pension
plans- have an incentive to take on considerable risk in an effort to minimize the cost
burden they must carry, many pension plans even today remain only partially funded —
that is, the market value of their assets plus expected investment income does not fully
cover all the benefits promised to pension plan members. While English common law
requires pension plans to be “prudent” managers of their members’ retirement savings,
many pensions have branched out into riskier investments, including real estate
development projects and derivative securities contracts.

8.7 THE REGULATION OF FINANCE COMPANIES

Finance companies are among the most important lenders and businesses in recent years.
The bulk of regulation of this industry is at the state level and focuses principally on the
making of consumer loans. Several states impose maximum loan rates so that finance
companies are limited in the amount of interest they can charge consumers, which tends
to limit the volume of credit extended to riskier households. The states, trying to protect
consumers, also usually spell out the rules for installment loan contracts and the
conditions under which automobiles, furniture, home appliances, or other household
assets can be repossessed for nonpayment of a loan extended by a finance company.

QUESTIONS FOR REVIEW AND DISCUSSION

1. What are the main justifications for regulating the financial institutions?
2. Discuss whether the regulation of financial institutions is harmful or beneficial.
3. It is said that due to their importance in the financial system, commercial banks
are typically the most regulated of all financial institutions. Discuss how
commercial banks are regulated.
4. Explain how regulations can be taken over:
 Insurance companies
 Pension funds, and
 Finance companies