Chapter 3

The financial context of business I

Outcome
By the end of this session you should be able to:

 explain the role of various financial assets, markets and institutions in assisting
organisations to manage their liquidity position and to provide an economic
return to providers of liquidity

 explain the role of commercial banks in the process of credit creation and in
determining the structure of interest rates and the roles of the 'central bank' in
ensuring liquidity

and answer questions relating to these areas.

The underpinning detail for this chapter in your Integrated Workbook can
be found in Chapter 3 of your Study Text

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Chapter 3

Overview

Liquidity
Financial System
surpluses/deficits

FINANCIAL CONTEXT

Financial Financial Financial

products intermediaries markets

Yields

Interest rates

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 The financial context of business I

Introduction – the financial system

1.1 The financial system

 Financial markets e.g. stock exchanges, money markets.

 Financial institutions e.g. banks, building societies,

 Financial assets and liabilities e.g. mortgages, bonds, equity shares

1.2 Financial markets

 Capital markets – stock-markets for shares and bond markets.

 Money markets – short-term (< 1 year) debt financing and investment.

 Commodity markets – e.g. oil, metals and agricultural produce.

 Derivatives markets – instruments for the management of financial risk

 Insurance markets – facilitate the redistribution of various risks.

 Foreign exchange markets – trading foreign exchange.

1.3 Financial intermediaries

Financial intermediaries have a number of important roles.

 Risk reduction

 Aggregation

 Maturity transformation

 Financial intermediation

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Liquidity surpluses and deficits

2.1 Businesses

Receipts Payments Dealing with differences

 Sales  Wages  Short term – overdraft

revenue
 Purchases  Medium term – loans, leasing

 Capital exp.  Long term – equity, loans

 Acquisitions

2.2 Governments

Receipts Payments Dealing with differences

 Tax  Wages  Short term – Central bank credit facility

 Suppliers  Medium term – loans, bonds

 Pensions  Long term – loans, bonds

 Capital exp

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Financial products

3.1 Main considerations

 Yield/cost E.g. yield on CD lower than that on equities.

 Risk (main driver of yield/cost) E.g. equities riskier than CDs

 The amounts involved/divisibility E.g. Minimum for CD is £50k

 Time periods E.g. treasury bills 91 days

 Liquidity E.g. shares in an unquoted company

 Transaction costs E.g. arrangement fees for mortgages

3.2 Capital and money markets

 Capital markets – maturities >

E.g. equities, bonds and mortgages.
1 year

 Money markets – maturities <

E.g. CDs and bills of exchange
1 year

3.3 Equity (Ordinary shares)

Operation  Investors purchase shares and become owners of the company.

They may receive dividend income and the value of the shares
may grow (or fall) in line with the fortunes of the company.

Return  Potentially very high (Includes dividends and ∆ share price)

Risk  Potentially very high (e.g. Last in line in the event of a liquidation)

Timescales  Long term

Liquidity  Good for quoted companies, poor for unquoted

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3.4 Bonds

Operation  Investors purchase the bonds, which come with legal obligations
for the company to pay interest to the bond holder during the
bond’s life. Redeemable bonds must be paid back by the
company at the end of the bond life.

Return  Low (Includes interest and redemption premium)

Risk  Low (e.g. usually secured, fixed coupon rate)

Timescales  Vary from very short term to > 25 years

Liquidity  Good if quoted companies, must wait for redemption if unquoted

3.5 Certificates of deposit (CDs)

Operation  Certificates of deposit are recognitions of a deposit made with a

bank that will be repaid with interest on a fixed future date

Return  Very low

Risk  Very low

Timescales  Typically 3 and 6 months

Liquidity  Some types of CD can be readily sold on money markets

3.6 Credit agreements (e.g. credit cards, store HP agreements)

Operation  Sellers allow customers to purchase goods or services without

having to pay for them immediately. Instead they pay down the
debt over time. Interest is earned while the debt is outstanding.

Cost  Very high – typically 25–30%

Risk  The credit card company faces the risk of default – unsecured

Timescales  Supposed to be short term

Liquidity  The debt cannot be resold by the lender but the borrower may be
able to repay early if funds permit.

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 The financial context of business I

3.7 Mortgages

Operation  Lenders offer credit secured against a property being purchased.

The debt is paid down over time and interest is earned by the
lender during the mortgage period.

Cost  Relatively low

Risk  Secured on property

Timescales  Long term – typically 10-35 years

Liquidity  Traditionally mortgages could not be resold by the lender but

now can in the form of CDOs (collateralised debt obligations).
The borrower may repay the loan early, albeit with possible
penalties.

3.8 Bills of exchange

 usually issued at a discount by companies to finance trade

Operation  Like a post-dated cheque – obligates payment of a fixed amount

at a future date.

Cost  Return = ∆ (full redemption value – discounted issue price)

Risk  Varies – some bills may be guaranteed by banks

Timescales  Short term – 3 and 6 month maturities are the most common.

Liquidity  Can be resold on money markets

Illustrations and further practice

Now try TYUs 1 to 4 from Chapter 3

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Chapter 3

Calculating yields on financial products

4.1 Equity

 The total return to shareholders = dividends + growth in the share price

 Dividend yield = [dividend/share price] × 100%

– Only looks at current/most recent dividend so does not incorporate future

growth expectations.

4.2 Bonds

 The total return to bondholders = interest + gain on redemption

 Bill rate = coupon rate

 Running yield = [interest/bond price] × 100%

– Only looks at current/most recent interest so does not incorporate future

gain on redemption

 Gross redemption yield incorporates gain on redemption (calculation off

syllabus)

4.3 Risk

 Required return = risk-free return + risk premium

 An increase in risk  required return increases  fall in share (bond) price

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 The financial context of business I

Question 1
By calculating the dividend yield, you are demonstrating the maths skill of
expressing amounts as percentages of another.

Yields on shares

Consider a share with a nominal value of $1 and a current market price of $1.14

If a dividend of $0.08 is paid out calculate the dividend yield.

Dividend yield = dividend/market value × 100

Dividend yield = $0.08/$1.14 × 100 = 7.0%

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Question 2
Yields on bonds

Consider a bond with characteristics as follows:

Nominal value $100

Coupon rate 6%

Current market value $105.79

Calculate the running yield (interest yield) on the bond.

Interest yield = annual interest/market value × 100

Annual interest is calculated by multiplying the nominal value of the debt by the
coupon rate.

Annual interest = $100 × 6% = $6

Interest yield = $6/$105.79 × 100 = 5.67%

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 The financial context of business I

Interest rates

5.1 A central rate of interest

 The rate at which the central bank lends to the money market.

 Lenders would then adapt this to incorporate risk and maturity.

 Lenders in the financial markets normally demand higher interest rates on loans
as the term (i.e. length of time) to maturity increases

5.2 Real and nominal interest rates

 The interest rate used to calculate cash flows is known as a “money rate” or
“nominal rate”. This is effectively the lender’s required return and incorporates
risk, maturity and inflation.

 The “real” interest rate is the return/cost after inflation has been taken out.

 1 + m = (1 + r)(1 + i)

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Chapter 3

Financial Intermediaries

6.1 Introduction

Financial intermediaries

Deposit-taking (DTIs) Non-deposit-taking (NDTIs)

 Banks  Insurance companies

 Building societies  Pension funds, unit trusts, etc.

6.2 Banks

Banks

Commercial Investment
 Traditional banking  Financial markets, M&A,
activities underwriting

Retail Wholesale
 High volume, low value  Low volume, high value
 Individuals/small Co.s  Larger Co.s

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 The financial context of business I

6.3 Credit creation

 Banks have discovered that at most 10 per cent of the deposited cash will be
withdrawn, thereby leaving the remainder for loans and/or investment.

 This percentage is known as the cash ratio

 Furthermore, when a bank lends money to a borrower, some of that money may
ultimately be deposited back in another bank, providing more cash reserves

 Change in total deposits = multiplier × initial deposit

 Multiplier = 1/cash ratio

6.4 Role of central Banks

 Banker to other banks

 Banker to the government

– Bank accounts for Government departments

– Raising/redeeming funds and managing the national debt

– Operates monetary policy

– Manages reserves of foreign currency

 Supervises banking system

– Manages capital adequacy and liquidity

– Lender of last resort

Rule of law. Central banks ensure that banks adhere to regulations to

keep customers safe.

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Chapter 3

Question 3
By determining the change in total deposits, you are demonstrating the
maths skill of solving mathematical problems and decision making.

Credit multiplier

A bank has a cash ratio of 8%.

Calculate the change in total deposits possible if an initial cash deposit of

$5,000 is made.

Change in total deposits = multiplier × initial cash deposit

Multiplier = 1/cash ratio

Change in total deposits = 1/0.08 × $5,000 = $62,500

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 The financial context of business I

Financial Markets

7.1 Money markets

 Treasury bills, commercial bills, CDs and other short term debt

 Used by banks, companies, local authorities and the government

7.2 Stock markets

 Full equities market

– Primary and secondary market in ordinary shares, preference shares and
debentures

 AIM
– For smaller companies

 Government bond/gilts market

– short (up to 5 years) medium (5–15 years), long (over 15 years) and
undated stock
– Tender rather than fixed price

Illustrations and further practice

Now try TYUs 5 to 13 from Chapter 3

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Chapter 3

You should now be able to answers all the questions from chapter 3
of the Study Text and questions 65 – 81 from the Exam Practice Kit.

For further reading, visit Chapter 3 from the Study Text.

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 The financial context of business I

Answers

Question 1
Dividend yield = dividend/market value × 100

Dividend yield = $0.08/$1.14 × 100 = 7.0%

Question 2
Interest yield = annual interest/market value × 100

Annual interest is calculated by multiplying the nominal value of the debt by the
coupon rate.

Annual interest = $100 × 6% = $6

Interest yield = $6/$105.79 × 100 = 5.67%

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Chapter 3

Question 3
Change in total deposits = multiplier × initial cash deposit

Multiplier = 1/cash ratio

Change in total deposits = 1/0.08 × $5,000 = $62,500

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