Financial institutions INstruments and markets 9e viney

This new edition, while maintaining its accessible approach and style, encourages
students to understand, anticipate and challenge the complex and global nature
of finance today.

KEY FEATURES
▶ Currency Contemporary, reliable and authoritative commentary on modern and topical financial

systems, including discussion on ethics and the global financial crisis
▶ New financial case studies With the right balance of local and international examples, students can

understand the global nature of financial institutions through real-world cases
▶ Examples Integrated worked examples and short in-chapter exercises assist student learning by

bridging the gap between theory and application
▶ Pedagogical features An easy-to-read layout includes tagged learning objectives, chapter summaries

and extended learning sections that provide additional resources for self-assessment and study

Financial
Institutions
Instruments
& Markets
9TH EDITION

9e
VINEY • PHILLIPS

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enhanced digital tools to create a personalised learning experience that provides
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Financial Institutions, Instruments & Markets

Now in its ninth edition, Financial Institutions, Instruments and Markets continues
to be one of the market leaders in financial institutions management. With a wellrespected author team at the helm, it is a comprehensive resource for all students
wanting to learn about the modern financial system, as well as those preparing for
a career in finance.

CHRISTOPHER VINEY
PETER PHILLIPS

www.mhhe.com/au/viney9e

spine: 26mm


FINANCIAL ABBREVIATIONS
ABS
ACCC
ADI
ADR
AFMA
AFR
AGPS
ANZ
AOFM
APRA

ARBL
ASIC
ASX
ATM
AWOTE
BAB
BBSW
BIS
CAR
CBA
CBOT
CD
CDI
CDS
CEDEL
CEO
CGS
CHESS
CLICK XT/ITS
CME
CMT
CP
CPI
CRA
CUFS
EBIT
ECP
EDI
EDR
EFIC

EFTPOS
EMU
EPS
ERM
ESA
ETP
EU
EUR
FDA
FEC
Fed
FRA
FRN
FTSE
FX
G-10
GDP
GDR
GICS
GNE
HPY
IBSA
IMF
IPO
IRR
IWT
L/C
LBO
LEPO

Australian Bureau of Statistics
Australian Competition and Consumer Commission
Authorised deposit-taking institution
American depositary receipt
Australian Financial Markets Association
Australian Financial Review
Australian Government Printing Service
ANZ Banking Group
Australian Office of Financial Management
Australian Prudential Regulation Authority
Assets repriced before liabilities
Australian Securities and Investments Commission
Australian Securities Exchange
Automatic teller machine
Average weekly ordinary time earnings
Bank accepted bill
Bank bill swap rate
Bank for International Settlements
Capital adequacy requirement
Commonwealth Bank of Australia
Chicago Board of Trade
Certificate of deposit
CHESS depositary interest
Credit default swap
Centrale de Livraison des Valeurs Mobilières
Chief executive officer
Commonwealth Government Securities
ASX Clearing House Electronic Sub-register System
ASX securities electronic trading system
Chicago Mercantile Exchange

Cash management trust
Commercial paper
Consumer price index
Credit rating agency
CHESS Units of Foreign Securities
Earnings before interest and tax
Eurocommercial paper
Electronic data interchange
Euro depositary receipt
Export Finance and Insurance Corporation
Electronic funds transfer at point of sale
European Monetary Union
Earnings per share
Exchange rate mechanism (European Union)
Exchange settlement account
Eligible termination payment
European Union
Euro
Fully drawn advance
Forward exchange contract
Federal Reserve Bank (USA)
Forward rate agreement
Floating rate note
Financial Times Stock Exchange
Foreign exchange
Group of ten central banks
Gross domestic product
Global depositary receipt
Global industry classification standard
Gross national expenditure

Holding period yield
International Banks and Securities Association
International Monetary Fund
Initial public offering
Internal rate of return
Interest withholding tax
Letter of credit
Leveraged buy-out
Low exercise price option

WORLD CURRENCIES
LIBID
LIBOR
LIFFE
LIMEAN
LME
LSE
M&A
MA
MBO
MSCI
MTN
NAB
NASDAQ
NBFI
NCD
NGF
NIC
NIF
NPV

NTA
NYSE
OBS
OBU
OECD
OPEC
OTC
P/E
PLC
P-note
PPP
PSBR
PV
PVCF
QIB
RBA
RBL
RBNZ
repos
RITS
ROE
ROI
RTGS
S&P
SEC
SFE
SGC
SIBOR
SIS
SMART

SME
SOMA
SPAN
SPI
SPV
SSP
SWIFT
T-bill
TLC
T-note
TWI
UK
USA
USCP
USSR
VaR
WBC

London interbank bid rate
London interbank offered rate
London International Financial Futures Exchange
London interbank mean rate
London Metals Exchange
London Stock Exchange
Merger and acquisition
Moving average
Management buy-out
Morgan Stanley Capital International index
Medium-term note
National Australia Bank

National Association of Securities Dealers Automated
Quotation System
Non-bank financial institution
Negotiable certificate of deposit
National Guarantee Fund
Newly industrialising country
Euronote issuance facility
Net present value
Net tangible assets
New York Stock Exchange
Off-balance sheet
Offshore banking unit
Organisation for Economic Cooperation and Development
Organization of Petroleum Exporting Countries
Over-the-counter
Price to earnings ratio
Publicly listed corporation
Promissory note
Purchasing power parity
Public sector borrowing requirement
Present value
Present value of cash flows
Qualified institutional buyers
Reserve Bank of Australia
Reasonable benefit limit
Reserve Bank of New Zealand
Repurchase agreements
Reserve Bank Information and Transfer System
Return on equity
Return on investment

Real-time gross settlement
Standard and Poor’s Credit Rating Agency
Securities and Exchange Commission (USA)
Sydney Futures Exchange
Superannuation guarantee charge
Singapore interbank offered rate
Superannuation Industry (Supervision) Act
Specific, measurable, achievable, realistic, timely
Small- and medium-sized enterprise
Surveillance of Market Activity system (ASX)
Standard portfolio analysis of risk
hare price index
Special-purpose vehicle
Special service provider
Society for Worldwide Interbank Financial
Telecommunications
Treasury bill
Transferable loan certificate
Treasury note
Trade-weighted index
United Kingdom
United States of America
United States commercial paper
Union of Soviet Socialist Republics
Value at risk
Westpac Banking Corporation

ARS
AUD
BRL

CAD
CLP
RMB

CZK
DKK
EUR

HKD
HUF
INR
IDR
ILS
JPY
MYR
MXN
NZD
NOK
PKR
PHP
PLN
RUB
SAR
SGD
ZAR
KRW
LKR
SEK
CHF
TWD

THB
TRY
UAE
GBP
USD
VND

spine: 26mm

Argentina
Australia
Brazil
Canada
Chile
China, People’s Republic of
• CNY (traded on-shore)
• CNH (traded off-shore)
Czech Republic
Denmark
European monetary union
• Austria
• Belgium
• Cyprus
• Estonia
• Finland
• France
• Germany
• Greece
• Ireland
• Italy

• Latvia
• Lithuania
• Luxembourg
• Malta
• The Netherlands
• Portugal
• Slovakia
• Slovenia
• Spain

Argentine peso
Australian dollar
Brazilian real
Canadian dollar
Chilean peso
Chinese renminbi (yuan)

Hong Kong
Hungary
India
Indonesia
Israel
Japan
Malaysia
Mexico
New Zealand
Norway
Pakistan
Philippines
Poland

Russia
Saudi Arabia
Singapore
South Africa
South Korea
Sri Lanka
Sweden
Switzerland
Taiwan
Thailand
Turkey
United Arab Emirates
United Kingdom
United States of America
Vietnam

Hong Kong dollar
Hungarian forint
Indian rupee
Indonesian rupiah
Israeli shekel
Japanese yen
Malaysian ringgit
Mexican peso
New Zealand dollar
Norwegian krone
Pakistani rupee
Philippine peso
Polish złoty
Russian rouble

Saudi riyal
Singapore dollar
South African rand
South Korean won
Sri Lankan rupee
Swedish krona
Swiss franc
New Taiwan dollar
Thai baht
Turkish lira
Emirati dirham
British pound
US dollar
Vietnamese dong

Czech koruna
Danish krone
Euro


FINANCIAL ABBREVIATIONS
ABS
ACCC
ADI
ADR
AFMA
AFR
AGPS
ANZ
AOFM

APRA
ARBL
ASIC
ASX
ATM
AWOTE
BAB
BBSW
BIS
CAR
CBA
CBOT
CD
CDI
CDS
CEDEL
CEO
CGS
CHESS
CLICK XT/ITS
CME
CMT
CP
CPI
CRA
CUFS
EBIT
ECP
EDI
EDR

EFIC
EFTPOS
EMU
EPS
ERM
ESA
ETP
EU
EUR
FDA
FEC
Fed
FRA
FRN
FTSE
FX
G-10
GDP
GDR
GICS
GNE
HPY
IBSA
IMF
IPO
IRR
IWT
L/C
LBO
LEPO

Australian Bureau of Statistics
Australian Competition and Consumer Commission
Authorised deposit-taking institution
American depositary receipt
Australian Financial Markets Association
Australian Financial Review
Australian Government Printing Service
ANZ Banking Group
Australian Office of Financial Management
Australian Prudential Regulation Authority
Assets repriced before liabilities
Australian Securities and Investments Commission
Australian Securities Exchange
Automatic teller machine
Average weekly ordinary time earnings
Bank accepted bill
Bank bill swap rate
Bank for International Settlements
Capital adequacy requirement
Commonwealth Bank of Australia
Chicago Board of Trade
Certificate of deposit
CHESS depositary interest
Credit default swap
Centrale de Livraison des Valeurs Mobilières
Chief executive officer
Commonwealth Government Securities
ASX Clearing House Electronic Sub-register System
ASX securities electronic trading system

Chicago Mercantile Exchange
Cash management trust
Commercial paper
Consumer price index
Credit rating agency
CHESS Units of Foreign Securities
Earnings before interest and tax
Eurocommercial paper
Electronic data interchange
Euro depositary receipt
Export Finance and Insurance Corporation
Electronic funds transfer at point of sale
European Monetary Union
Earnings per share
Exchange rate mechanism (European Union)
Exchange settlement account
Eligible termination payment
European Union
Euro
Fully drawn advance
Forward exchange contract
Federal Reserve Bank (USA)
Forward rate agreement
Floating rate note
Financial Times Stock Exchange
Foreign exchange
Group of ten central banks
Gross domestic product
Global depositary receipt
Global industry classification standard

Gross national expenditure
Holding period yield
International Banks and Securities Association
International Monetary Fund
Initial public offering
Internal rate of return
Interest withholding tax
Letter of credit
Leveraged buy-out
Low exercise price option

WORLD CURRENCIES
LIBID
LIBOR
LIFFE
LIMEAN
LME
LSE
M&A
MA
MBO
MSCI
MTN
NAB
NASDAQ
NBFI
NCD
NGF
NIC
NIF

NPV
NTA
NYSE
OBS
OBU
OECD
OPEC
OTC
P/E
PLC
P-note
PPP
PSBR
PV
PVCF
QIB
RBA
RBL
RBNZ
repos
RITS
ROE
ROI
RTGS
S&P
SEC
SFE
SGC
SIBOR
SIS

SMART
SME
SOMA
SPAN
SPI
SPV
SSP
SWIFT
T-bill
TLC
T-note
TWI
UK
USA
USCP
USSR
VaR
WBC

London interbank bid rate
London interbank offered rate
London International Financial Futures Exchange
London interbank mean rate
London Metals Exchange
London Stock Exchange
Merger and acquisition
Moving average
Management buy-out
Morgan Stanley Capital International index
Medium-term note

National Australia Bank
National Association of Securities Dealers Automated
Quotation System
Non-bank financial institution
Negotiable certificate of deposit
National Guarantee Fund
Newly industrialising country
Euronote issuance facility
Net present value
Net tangible assets
New York Stock Exchange
Off-balance sheet
Offshore banking unit
Organisation for Economic Cooperation and Development
Organization of Petroleum Exporting Countries
Over-the-counter
Price to earnings ratio
Publicly listed corporation
Promissory note
Purchasing power parity
Public sector borrowing requirement
Present value
Present value of cash flows
Qualified institutional buyers
Reserve Bank of Australia
Reasonable benefit limit
Reserve Bank of New Zealand
Repurchase agreements
Reserve Bank Information and Transfer System
Return on equity

Return on investment
Real-time gross settlement
Standard and Poor’s Credit Rating Agency
Securities and Exchange Commission (USA)
Sydney Futures Exchange
Superannuation guarantee charge
Singapore interbank offered rate
Superannuation Industry (Supervision) Act
Specific, measurable, achievable, realistic, timely
Small- and medium-sized enterprise
Surveillance of Market Activity system (ASX)
Standard portfolio analysis of risk
hare price index
Special-purpose vehicle
Special service provider
Society for Worldwide Interbank Financial
Telecommunications
Treasury bill
Transferable loan certificate
Treasury note
Trade-weighted index
United Kingdom
United States of America
United States commercial paper
Union of Soviet Socialist Republics
Value at risk
Westpac Banking Corporation

ARS
AUD

BRL
CAD
CLP
RMB

CZK
DKK
EUR

HKD
HUF
INR
IDR
ILS
JPY
MYR
MXN
NZD
NOK
PKR
PHP
PLN
RUB
SAR
SGD
ZAR
KRW
LKR
SEK
CHF

TWD
THB
TRY
UAE
GBP
USD
VND

spine: 26mm

Argentina
Australia
Brazil
Canada
Chile
China, People’s Republic of
• CNY (traded on-shore)
• CNH (traded off-shore)
Czech Republic
Denmark
European monetary union
• Austria
• Belgium
• Cyprus
• Estonia
• Finland
• France
• Germany
• Greece
• Ireland

• Italy
• Latvia
• Lithuania
• Luxembourg
• Malta
• The Netherlands
• Portugal
• Slovakia
• Slovenia
• Spain

Argentine peso
Australian dollar
Brazilian real
Canadian dollar
Chilean peso
Chinese renminbi (yuan)

Hong Kong
Hungary
India
Indonesia
Israel
Japan
Malaysia
Mexico
New Zealand
Norway
Pakistan
Philippines

Poland
Russia
Saudi Arabia
Singapore
South Africa
South Korea
Sri Lanka
Sweden
Switzerland
Taiwan
Thailand
Turkey
United Arab Emirates
United Kingdom
United States of America
Vietnam

Hong Kong dollar
Hungarian forint
Indian rupee
Indonesian rupiah
Israeli shekel
Japanese yen
Malaysian ringgit
Mexican peso
New Zealand dollar
Norwegian krone
Pakistani rupee
Philippine peso
Polish złoty

Russian rouble
Saudi riyal
Singapore dollar
South African rand
South Korean won
Sri Lankan rupee
Swedish krona
Swiss franc
New Taiwan dollar
Thai baht
Turkish lira
Emirati dirham
British pound
US dollar
Vietnamese dong

Czech koruna
Danish krone
Euro


Financial
Institutions
Instruments
& Markets

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www.freebookslides.com

ASSURANCE OF LEARNING
Many educational institutions today are focused on the notion of assurance of learning, an important element of some
accreditation standards. This ninth edition of Financial Institutions, Instruments and Markets is specifically created to support
assurance of learning initiatives designed to draw on and expand key knowledge and skill sets required by graduates such as:
communication, initiative and enterprise, self-management, life-long learning, problem solving, technology, teamwork, planning
and organising.1
Chapter learning objectives and pedagogical features throughout the text are developed to directly relate to the learning
outcomes for your course which may assist instructors in making the collection and presentation of assurance of learning data
easier.

AACSB STATEMENT
McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of
AACSB accreditation, Financial Institutions, Instruments and Markets 9e has sought to recognise the curriculum guidelines
detailed in the AACSB standards for business accreditation. A variety of pedagogical features in chapters are designed to
draw on the general knowledge and skill guidelines found in the AACSB standards: communication abilities, use of information
technology, ethical understanding, reflective thinking, critical analysis and diversity and multicultural understanding.2
The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school
and the faculty. While Financial Institutions, Instruments and Markets 9e and the teaching package make no claim of specific
AACSB qualification or evaluation, we have geared pedagogical features and online assessment tools towards some of the
general knowledge and skills areas.

1 DEST 2002, Employability skills for the future, Department of Education, Science and Training, Commonwealth of Australia,
www.employmentdirections.net.au/docs/employabilityframework.doc.
2 AACSB International 2008, Eligibility procedures and accreditation standards for business accreditation, www.aacsb.edu.

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Financial
Institutions
Instruments
& Markets
9TH EDITION

CHRISTOPHER VINEY
PETER PHILLIPS

vin22943_prelims_i-xxxiv.indd iii

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www.freebookslides.com

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd
Additional owners of copyright are acknowledged in on-page credits.
Every effort has been made to trace and acknowledge copyrighted material. The authors and publishers tender their
apologies should any infringement have occurred.
Reproduction and communication for educational purposes
The Australian Copyright Act 1968 (the Act) allows a maximum of one chapter or 10% of the pages of this work,
whichever is the greater, to be reproduced and/or communicated by any educational institution for its educational
purposes provided that the institution (or the body that administers it) has sent a Statutory Educational notice to
Copyright Agency and been granted a licence. For details of statutory educational and other copyright licences
contact: Copyright Agency, 66 Goulburn Street, Sydney NSW 2000. Telephone: (02) 9394 7600. Website: www.
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Apart from any fair dealing for the purposes of study, research, criticism or review, as permitted under the Act, no part
of this publication may be reproduced, distributed or transmitted in any form or by any means, or stored in a database
or retrieval system, without the written permission of McGraw-Hill Education (Australia) Pty Ltd, including, but not
limited to, any network or other electronic storage. Enquiries should be made to the publisher via www.mheducation.
com.au or marked for the attention of the permissions editor at the address below.
National Library of Australia Cataloguing-in-Publication Data

Authors:
Title:
ISBN:

Christopher Viney, Peter Phillips
Financial Institutions, Instruments and Markets 9e
9781760422943

Published in Australia by
McGraw-Hill Education (Australia) Pty Ltd
Level 33, 680 George Street, Sydney NSW 2000
Portfolio lead: Jillian Gibbs
Content developer: Anne Harmer
Senior production editor: Claire Linsdell
Copyeditor: Julie Wicks
Proofreader: Annabel Adair
Cover design: Simon Rattray
Internal design: David Rosemeyer
Typeset in NimbusRomDOT 10.5/13 by SPi Global
Printed in Singapore on 70 gsm matt art by Markono Print Media Pte Ltd

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BRIEF CONTENTS
PART 1

FINANCIAL INSTITUTIONS  ...............................................................................................................................

1

Chapter 1

A modern financial system: an overview..........................................................................................................3

Chapter 2

Commercial banks..................................................................................................................................................41

Chapter 3

Non-bank financial institutions............................................................................................................................87

PART 2

EQUITY MARKETS  ...............................................................................................................................................129

Chapter 4

The share market and the corporation..............................................................................................................132

Chapter 5

Corporations issuing equity in the share market............................................................................................161

Chapter 6

Investors in the share market...............................................................................................................................191

Chapter 7

Forecasting share price movements..................................................................................................................222

PART 3

THE CORPORATE DEBT MARKET  ..................................................................................................................257

Chapter 8

Mathematics of finance: an introduction to basic concepts and calculations.........................................259

Chapter 9

Short-term debt.......................................................................................................................................................287

Chapter 10

Medium- to long-term debt...................................................................................................................................315

Chapter 11

International debt markets....................................................................................................................................347

PART 4

GOVERNMENT DEBT, MONETARY POLICY, THE PAYMENTS SYSTEM AND INTEREST RATES  .......385

Chapter 12

Government debt, monetary policy and the payments system..................................................................388

Chapter 13

An introduction to interest rate determination and forecasting..................................................................417

Chapter 14

Interest rate risk measurement............................................................................................................................453

PART 5

THE FOREIGN EXCHANGE MARKET  .............................................................................................................483

Chapter 15

Foreign exchange: the structure and operation of the FX market.............................................................485

Chapter 16

Foreign exchange: factors that influence the exchange rate......................................................................513

Chapter 17

Foreign exchange: risk identification and management...............................................................................538

PART 6

DERIVATIVE MARKETS AND RISK MANAGEMENT  ..................................................................................563

Chapter 18

An introduction to risk management and derivatives....................................................................................565

Chapter 19

Futures contracts and forward rate agreements............................................................................................594

Chapter 20

Options......................................................................................................................................................................626

Chapter 21

Interest rate swaps, cross-currency swaps and credit default swaps.......................................................663

v

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CONTENTS
Preface�������������������������������������������������������������������������������� xx

Text at a glance��������������������������������������������������������������� xxv

About the authors������������������������������������������������������������ xxi

Connect�������������������������������������������������������������������������� xxviii

Acknowledgments������������������������������������������������������������ xxi

Exploring finance on the web���������������������������������������� xxx

Highlights of the ninth edition��������������������������������������� xxii

Careers in finance��������������������������������������������������������� xxxii

PART 1
CHAPTER 1

1FINANCIAL INSTITUTIONS

1

A MODERN FINANCIAL SYSTEM: AN OVERVIEW 
1.1

3

Theory and facts in finance  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

1.2

The financial system and financial institutions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

1.3

Financial instruments  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1.3.1 Equity  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1.3.2 Debt  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
1.3.3 Derivatives  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

1.4

Financial markets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1.4.1 Matching principle  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.4.2 Primary and secondary market transactions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.4.3 Direct finance and intermediated finance  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
1.4.4 Wholesale and retail markets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1.4.5 Money markets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1.4.6 Capital markets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

1.5



CHAPTER 2

Flow of funds, market relationships and stability  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

Case study: The next global financial crisis?  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Extended learning A: The global financial crisis of 2008  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Extended learning B: The impact of the Asian financial crisis on the financial system  . . . . . . . . . . .
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30
32
35
38
39

COMMERCIAL BANKS

41

2.1

The main activities of commercial banking  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

2.2

Sources of funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
2.2.1 Current account deposits  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
2.2.2 Call or demand deposits  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
2.2.3 Term deposits  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
2.2.4 Negotiable certificates of deposit  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

2.2.5 Bill acceptance liabilities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
2.2.6 Debt liabilities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
2.2.7 Foreign currency liabilities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
2.2.8 Loan capital and shareholders’ equity  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

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2.3

Uses of funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
2.3.1 Personal and housing finance  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
2.3.2 Commercial lending  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
2.3.3 Lending to government  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
2.3.4 Other bank assets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

2.4

Off-balance-sheet business  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
2.4.1 Direct credit substitutes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
2.4.2 Trade- and performance-related items  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
2.4.3 Commitments  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
2.4.4 Foreign exchange contracts, interest rate contracts and other
market-rate-related contracts  ����������������������������������������������������������������������������������������������54
2.4.5 Volume of off-balance-sheet business  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

2.5

Regulation and prudential supervision of commercial banks  . . . . . . . . . . . . . . . . . . . . . . . . 56

2.6

A background to the capital adequacy standards  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

2.7

The Basel accords: evolution from Basel I to Basel III  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
2.7.1 Minimum capital adequacy requirement  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
2.7.2 The definition of capital  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
2.7.3 Basel III structural framework  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
2.7.4 Basel III and bank liquidity  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

2.8

Liquidity management and other supervisory controls  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
2.8.1 Other regulatory and supervisory controls  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70



CHAPTER 3

Case study: Basel III reforms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Summary  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Extended learning A: The standardised approach to credit risk  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Extended learning B: Business continuity risk management  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Extended learning C: Corporate governance and ethics  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

72
74
77
82
84
85

NON-BANK FINANCIAL INSTITUTIONS

87

3.1

Investment banks  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
3.1.1 Sources of funds and uses of funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
3.1.2 Off-balance-sheet business  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

3.2

Managed funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
3.2.1 Structure of the managed funds sector  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
3.2.2 Sources and uses of funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
3.2.3 Capital guaranteed funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
3.2.4 Capital stable funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
3.2.5 Balanced growth funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
3.2.6 Managed growth or capital growth funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

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3.3

Cash management trusts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98

3.4

Public unit trusts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

3.5

Superannuation funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
3.5.1 Sources of funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
3.5.2 Defined benefit funds and accumulation funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
3.5.3 Regulation  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

3.6

Life insurance offices  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
3.6.1 Life insurance policies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

3.7

General insurance offices  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

3.8

Hedge funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112

3.9

Finance companies and general financiers  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

3.7.1 General insurance policies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

3.9.1 Sources of funds and uses of funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
3.9.2 Sector structure  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
3.10

Building societies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

3.11

Credit unions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

3.12

Export finance corporations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116



Case study: The hedge fund sector  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117

Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Extended learning: Project finance and structured finance  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

PART 2
CHAPTER 4

EQUITY MARKETS
THE SHARE MARKET AND THE CORPORATION

4.1

129
132

The nature of a corporation  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
4.1.1 Advantages of the corporate form of business organisation  . . . . . . . . . . . . . . . . . . . . 135
4.1.2 Disadvantages of the corporate form of business organisation  . . . . . . . . . . . . . . . . . 135

4.2

The stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

4.3

The primary market role of a stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138

4.4

The secondary market role of a stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140

4.5

The managed product and derivative product roles of a stock exchange  . . . . . . . . . . . 141
4.5.1 Exchange traded funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
4.5.2 Contracts for difference  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
4.5.3 Real estate investment trusts (REIT)  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
4.5.4 Infrastructure funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
4.5.5 Options  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
4.5.6 Warrants  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
4.5.7 Futures contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145

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4.6

The interest rate market role of a stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

4.7

The trading and settlement roles of a stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

4.8

The information role of a stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150

4.9

The regulatory role of a stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152

4.10

The private equity market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153



Case study: Development of industrial scale blockchain in Australia  . . . . . . . . . . . . . . . . . . . . . . . 154
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

CHAPTER 5

CORPORATIONS ISSUING EQUITY IN THE SHARE MARKET

5.1

161

The investment decision: capital budgeting  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
5.1.1 Net present value  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
5.1.2 Internal rate of return  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

5.2

The financing decision: equity, debt and risk  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
5.2.1 Financial risk and the debt-to-equity ratio  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
5.2.2 What is the appropriate debt-to-equity ratio?  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168

5.3

Initial public offering  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
5.3.1 Ordinary shares: limited liability companies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
5.3.2 Ordinary shares: no liability companies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171

5.4

Listing a business on a stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172

5.5

Equity-funding alternatives for listed companies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
5.5.1 Rights issue or share purchase plan  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
5.5.2 Placements  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
5.5.3 Takeover issues  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
5.5.4 Dividend reinvestment schemes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
5.5.5 Preference shares  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
5.5.6 Convertible notes and other quasi-equity securities  . . . . . . . . . . . . . . . . . . . . . . . . . . . 178



Case study: Covenant-lite loans—risk implications  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180

Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181
Extended learning: Australian Securities Exchange (ASX) listing rule requirements  . . . . . . . . . . . 183
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190

CHAPTER 6

INVESTORS IN THE SHARE MARKET

191

6.1

Share-market investment  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

6.2

Buying and selling shares  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196

6.3Taxation 
6.4

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198

Financial performance indicators  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
6.4.1 Capital structure  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
6.4.2 Liquidity  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201

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6.4.3 Debt servicing  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
6.4.4 Profitability  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
6.4.5 Share price  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
6.4.6 Risk  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
6.5

Pricing of shares  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
6.5.1 Estimating the price of a share  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
6.5.2 Cum-dividend and ex-dividend share prices  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
6.5.3 Bonus share issues  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
6.5.4 Share splits  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
6.5.5 Pro-rata rights issues  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

6.6



Stock-market indices and published share information  . . . . . . . . . . . . . . . . . . . . . . . . . . . 211

Case study: Private equity firms, angel investors and exit strategies  . . . . . . . . . . . . . . . . . . . . . . . 215
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221

CHAPTER 7

FORECASTING SHARE PRICE MOVEMENTS

7.1

222

Fundamental analysis: the top-down approach  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
7.1.1 International economies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
7.1.2 The rate of growth of an economy  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
7.1.3 Exchange rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
7.1.4 Interest rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
7.1.5 The balance of payments current account  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
7.1.6 Inflationary pressures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
7.1.7 Wages growth  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
7.1.8 Understanding the interrelationships of economic fundamentals  . . . . . . . . . . . . . . . 229

7.2

Fundamental analysis: the bottom-up approach  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230

7.3

Technical analysis  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
7.3.1 Moving-averages models  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
7.3.2 Charting  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235

7.4

Electronic trading  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240

7.5

The random walk, efficient market and behavioural finance hypotheses  . . . . . . . . . . . . 242
7.5.1 The random walk hypothesis  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
7.5.2 The efficient market hypothesis  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
7.5.3 The behavioural finance hypothesis  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245



Case study: The effects of scandals on the market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255

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PART 3

THE CORPORATE DEBT MARKET

CHAPTER 8

MATHEMATICS OF FINANCE: AN INTRODUCTION TO BASIC
CONCEPTS AND CALCULATIONS

8.1

257
259

Simple interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
8.1.1 Simple interest accumulation  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
8.1.2 Present value with simple interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
8.1.3 Calculation of yields  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
8.1.4 Holding period yield  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267

8.2

Compound interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
8.2.1 Compound interest accumulation (future value)  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
8.2.2 Present value with compound interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
8.2.3 Present value of an annuity  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272
8.2.4 Accumulated value of an annuity (future value)  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
8.2.5 Effective rates of interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277



Case study: The retirement dream  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283

Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286

CHAPTER 9

SHORT-TERM DEBT 

287

9.1

Trade credit  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289

9.2

Bank overdrafts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290

9.3

Commercial bills  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
9.3.1 Features of commercial bills  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
9.3.2 The flow of funds and bill financing  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
9.3.3 Establishing a bill financing facility  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
9.3.4 Advantages of commercial bill financing  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296

9.4

Calculations: discount securities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
9.4.1 Calculating the price where the yield is known  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
9.4.2 Calculating the face value where the issue price and yield are known  . . . . . . . . . . . 299
9.4.3 Calculating the yield  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299

9.4.4 Calculating the price where the discount rate is known  . . . . . . . . . . . . . . . . . . . . . . . . 300
9.4.5 Calculating the discount rate  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301

9.5

Promissory notes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
9.5.1 Establishing a P-note issue program  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
9.5.2 Underwritten P-note issues  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
9.5.3 Non-underwritten issues  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304

9.6

Negotiable certificates of deposit  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

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9.7

Inventory finance, accounts receivable financing and factoring  . . . . . . . . . . . . . . . . . . . . 306
9.7.1 Inventory finance  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
9.7.2 Accounts receivable financing and factoring  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306

Case study: The demise of LIBOR?  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314

CHAPTER 10

MEDIUM- TO LONG-TERM DEBT 

10.1

315

Term loans or fully drawn advances  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
10.1.1 Term loan structures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
10.1.2 Loan covenants  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
10.1.3 Calculating the instalment on a term loan  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320

10.2

Mortgage finance  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
10.2.1 Calculating the instalment on a mortgage loan  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
10.2.2 Securitisation and mortgage finance  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324

10.3

The bond market: debentures, unsecured notes and subordinated debt  . . . . . . . . . . . . 325

10.3.1 Debentures and unsecured notes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
10.3.2 Issuing debentures and notes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
10.3.3 Subordinated debt  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329

10.4

Calculations: fixed-interest securities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
10.4.1 Bond price/yield relationship  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
10.4.2 Price of a fixed-interest bond at a coupon date  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
10.4.3 Price of a fixed-interest bond between coupon dates  . . . . . . . . . . . . . . . . . . . . . . . . 332

10.5Leasing 

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333

10.5.1 Types of leases  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
10.5.2 Lease structures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336


Case study: The Kangaroo bonds and blockchain bond-i’s  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
Extended learning: Securitisation  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346

CHAPTER 11

INTERNATIONAL DEBT MARKETS

347

11.1

The euromarkets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349

11.2

Eurocurrency market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
11.2.1 Short-term bank advances  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
11.2.2 Eurocurrency standby facilities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
11.2.3 Medium- to long-term eurocurrency bank loans  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353

11.3

Euronote market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
11.3.1 Euronote issuance facility  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354

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11.3.2 Eurocommercial paper  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356
11.3.3 Calculating the price of an NIF and an ECP  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356
11.4

Eurobond market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
11.4.1 Euro medium-term notes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
11.4.2 Eurobonds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
11.4.3 Issue and trading of eurobonds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
11.4.4 Types of eurobonds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
11.4.5 Calculating the price of fixed-interest euromarket securities  . . . . . . . . . . . . . . . . . . 362

11.5

Markets in the USA  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
11.5.1 Commercial paper  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
11.5.2 US foreign bonds (Yankee bonds)  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
11.5.3 American depositary receipts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366

11.6



Credit rating agencies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367

Case study: Supervision of rating agencies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
Extended learning A: Novation, subparticipation and transferable loan certificates  . . . . . . . . . . . 375
Extended learning B: Convertible bonds and warrants  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
Extended learning C: US medium-term notes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
Extended learning D: Standard & Poor’s credit rating definitions  . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383

PART 4

CHAPTER 12

GOVERNMENT DEBT, MONETARY POLICY, THE PAYMENTS
SYSTEM AND INTEREST RATES
GOVERNMENT DEBT, MONETARY POLICY AND THE PAYMENTS SYSTEM

12.1

385
388

The Commonwealth Government borrowing requirement  . . . . . . . . . . . . . . . . . . . . . . . . . 390
12.1.1 The borrowing requirement: full financial year  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
12.1.2 The borrowing requirement: within the financial year  . . . . . . . . . . . . . . . . . . . . . . . . 391

12.2

Commonwealth Government securities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
12.2.1 Treasury bonds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
12.2.2 Treasury notes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396

12.3

State government securities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399

12.4

Monetary policy  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
12.4.1 Open market operations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403
12.4.2 Impacts on financial system liquidity  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404

12.5

The payments system  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 406
12.5.1 Exchange settlement accounts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
12.5.2 Real-time gross settlement  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408
12.5.3 Repurchase agreements (repos)  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409



Case study: The new payments platform (NPP) in Australia and the risk of fraud  . . . . . . . . . . . . . 410
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411

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Extended learning: Fixed-coupon Treasury bonds: price calculation using the
Australian Office of Financial Management (AOFM) formula  . . . . . . . . . . . . . . . . . . . . . . . . . 413
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416
CHAPTER 13

AN INTRODUCTION TO INTEREST RATE DETERMINATION AND FORECASTING

417

13.1

The macroeconomic context of interest rate determination  . . . . . . . . . . . . . . . . . . . . . . . 419

13.2

The loanable funds approach to interest rate determination  . . . . . . . . . . . . . . . . . . . . . . . 423
13.2.1 The demand for loanable funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425
13.2.2 The supply of loanable funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426
13.2.3 Equilibrium in the loanable funds market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 427
13.2.4 Loanable funds—an expected increase in the level of economic activity  . . . . . . . . 428
13.2.5 Inflationary expectations in the loanable funds approach  . . . . . . . . . . . . . . . . . . . . . 429

13.3

The term structure of interest rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431
13.3.1 The expectations theory  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433
13.3.2 The segmented markets theory  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435
13.3.3 The expectations approach versus the segmented markets approach  . . . . . . . . . 437
13.3.4 The liquidity premium theory  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438

13.4



The risk structure of interest rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441

Case study: The Reserve Bank’s balancing act  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443

Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445
Extended learning: The yield curve and expectations theory calculations  . . . . . . . . . . . . . . . . . . . 447
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 452

CHAPTER 14

INTEREST RATE RISK MEASUREMENT

453

14.1

Interest rate risk  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455

14.2

Exposure management systems  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456
14.2.1 Forecasting  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457
14.2.2 Strategies and techniques  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457
14.2.3 Management reporting  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458

14.3

Assets re-priced before liabilities principle  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459

14.4

Pricing financial securities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460
14.4.1 Discount security pricing  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460

14.4.2 Fixed-interest security pricing  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 461

14.5

Re-pricing gap analysis  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 462

14.6Duration 

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 464

14.7Convexity 
14.8

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 470

Interest rate risk management techniques  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473
14.8.1 Internal techniques  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474
14.8.2 External techniques  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475

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Case study: APRA and bear as risk management regimes in Australia  . . . . . . . . . . . . . . . . . . . . . . 476
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482

PART 5
CHAPTER 15

THE FOREIGN EXCHANGE MARKET
FOREIGN EXCHANGE: THE STRUCTURE AND OPERATION OF THE FX MARKET

483
485

15.1

Exchange rate regimes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487

15.2

Foreign exchange market participants  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 488
15.2.1 Foreign exchange dealers and brokers  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
15.2.2 Central banks  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
15.2.3 Firms conducting international trade transactions  . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
15.2.4 Investors and borrowers in the international money markets
and capital markets  ��������������������������������������������������������������������������������������������������������� 490
15.2.5 Speculative transactions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490
15.2.6 Arbitrage transactions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 491

15.3

The operation of the FX market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492

15.4

Spot and forward transactions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 493

15.5

Spot market quotations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494
15.5.1 Asking for a quotation  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494
15.5.2 Two-way quotations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495
15.5.3 Transposing spot quotations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497
15.5.4 Calculating cross-rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497

15.6

Forward market quotations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
15.6.1 Forward points and forward exchange contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
15.6.2 Some real-world complications  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502

15.7



Economic and Monetary Union of the EU and the FX markets  . . . . . . . . . . . . . . . . . . . . . 505

Case study: Fixed exchange rates and currency misalignments  . . . . . . . . . . . . . . . . . . . . . . . . . . . 506
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510

Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511

CHAPTER 16

FOREIGN EXCHANGE: FACTORS THAT INFLUENCE THE EXCHANGE RATE

16.1

513

The FX markets and an equilibrium exchange rate  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
16.1.1 Demand for a currency  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
16.1.2 Supply of a currency  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
16.1.3 Equilibrium exchange rate  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517

16.2

Factors that influence exchange rate movements  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
16.2.1 Relative inflation rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
16.2.2 Relative national income growth rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

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16.2.3 Relative interest rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
16.2.4 Exchange rate expectations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524
16.2.5 Central bank or government intervention  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
16.3



Measuring exchange rate sensitivity to changes in economic variables  . . . . . . . . . . . . . 528

Case study: Terrorist attacks and FX movements  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 530
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531
Extended learning: Purchasing power parity   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 536
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537

CHAPTER 17

FOREIGN EXCHANGE: RISK IDENTIFICATION AND MANAGEMENT

538

17.1

Foreign exchange risk policy formulation  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 540
17.1.1 Foreign exchange objectives  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541
17.1.2 Management structure  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541
17.1.3 Authorisations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 542
17.1.4 Exposure reporting systems  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 543
17.1.5 Communications  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 543
17.1.6 Performance evaluation  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 543

17.1.7 Audit and review procedures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 544

17.2

Measuring transaction exposure  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 545
17.2.1 Net cash flows  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 546
17.2.2 Transaction exposures: currency variability  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 548
17.2.3 Transaction exposures: currency correlations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 549

17.3

Risk management: market-based hedging techniques  . . . . . . . . . . . . . . . . . . . . . . . . . . . . 551
17.3.1 Forward exchange contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 551
17.3.2 Money-market hedge to cover FX risk  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 553

17.4

Risk management: internal hedging techniques  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555
17.4.1 Invoicing in the home currency  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555
17.4.2 Creating a natural hedge  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555
17.4.3 Currency diversification  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556
17.4.4 Leading and lagging FX transactions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556
17.4.5 Mark-ups  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557
17.4.6 Counter-trade and currency offsets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557



Case study: FX risk management: Do companies hedge or speculate?  . . . . . . . . . . . . . . . . . . . . . 558
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 561

Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 562

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PART 6
CHAPTER 18

DERIVATIVE MARKETS AND RISK MANAGEMENT
AN INTRODUCTION TO RISK MANAGEMENT AND DERIVATIVES

563
565

18.1

Understanding risk  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 567
18.1.1 Operational risks  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 567
18.1.2 Financial risks  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 568

18.2

The risk management process  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570
18.2.1 Identify operational and financial risk exposures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570

18.2.2 Analyse the impact of the risk exposures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 571
18.2.3 Assess the attitude of the organisation to each identified risk exposure  . . . . . . . . 571
18.2.4 Select appropriate risk management strategies and products  . . . . . . . . . . . . . . . . 572
18.2.5 Establish related risk and product controls  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 572
18.2.6 Implement the risk management strategy  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 572
18.2.7 Monitor, report, review and audit  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 573

18.3

Futures contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574

18.4

Forward contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 576
18.4.1 Forward rate agreements  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 576
18.4.2 Forward foreign exchange contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578

18.5

Option contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 579
18.5.1 Call option profit and loss payoff profiles  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 580
18.5.2 Put option profit and loss payoff profiles  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 581

18.6

Swap contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 582
18.6.1 Interest rate swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 583
18.6.2 Cross-currency swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 584

Case study: Regulatory reforms and the ‘clearing’ of derivatives  . . . . . . . . . . . . . . . . . . . . . . . . . . . 586
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 588
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 590
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 593

CHAPTER 19

FUTURES CONTRACTS AND FORWARD RATE AGREEMENTS

594

19.1

Hedging using futures contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 596

19.2

Main features of a futures transaction  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 597
19.2.1 Orders and agreement to trade  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 598
19.2.2 Margin requirements  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 599
19.2.3 Closing out of a contract  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600
19.2.4 Contract delivery  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

19.3

Futures market instruments  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 601

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19.4

Futures market participants  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603
19.4.1 Hedgers  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603
19.4.2 Speculators  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603
19.4.3 Traders  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 604
19.4.4 Arbitrageurs  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 604

19.5

Hedging: risk management using futures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 605
19.5.1 Hedging the cost of funds (borrowing hedge)  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 605
19.5.2 Hedging the yield on funds (investment hedge)  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 607
19.5.3 Hedging a foreign currency transaction  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 608
19.5.4 Hedging the value of a share portfolio  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609
19.5.5 Hedging against volatility  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 610

19.6

Risks in using futures contracts for hedging  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 612
19.6.1 Standard contract size  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 612
19.6.2 Margin payments  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 613
19.6.3 Basis risk  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 614

19.6.4 Cross-commodity hedging  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 614

19.7

Forward rate agreements  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615
19.7.1 Using an FRA for a borrowing hedge  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617



Case study: SPI futures market acts as a market-maker facilitating price discovery
in the S&P/ASX 200 Index  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 619
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 620
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 623
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625

CHAPTER 20

OPTIONS

626

20.1

The nature of options  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 628

20.2

Option profit and loss payoff profiles  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629
20.2.1 Call option profit and loss payoff profiles  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629
20.2.2 Put option profit and loss payoff profiles  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 632

20.2.3 Covered and naked options  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 634

20.3

The organisation of the market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 636
20.3.1 International options markets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 636
20.3.2 The Australian options markets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 637

20.4

Factors affecting an option contract premium  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641
20.4.1 Intrinsic value  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641
20.4.2 Time value  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 642
20.4.3 Price volatility  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 642
20.4.4 Interest rate levels  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 644
20.4.5 Cap, floor and collar: an options cost-minimisation strategy  . . . . . . . . . . . . . . . . . . . 644

20.5

Option risk management strategies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645
20.5.1 Single-option strategies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645
20.5.2 Combined-options strategies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 648

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Contents



Case study: The Black–Scholes option pricing model: The equation that can end
the world?  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 657
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 659
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 661
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 662

CHAPTER 21

INTEREST RATE SWAPS, CROSS-CURRENCY SWAPS AND CREDIT DEFAULT SWAPS

663

21.1

Interest rate swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 666

21.2

Rationale for the existence of interest rate swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 670
21.2.1 Lowering the net cost of funds (comparative advantage)  . . . . . . . . . . . . . . . . . . . . . 670
21.2.2 Gaining access to otherwise inaccessible debt markets  . . . . . . . . . . . . . . . . . . . . . . 671
21.2.3 Hedging interest rate risk exposures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 671
21.2.4 Lock in profit margins on business transactions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 672

21.3

Cross-currency swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 673

21.4

Rationale for the existence of currency swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 676

21.5

Credit default swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 678

21.6

Credit and settlements risk associated with swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 681



Case study: Naked credit default swaps: Two perspectives  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 683
Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 684
Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687
Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 690
Glossary  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 691
Index  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 712

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PREFACE
This book has achieved remarkable acceptance by academics and their students in a significant number of tertiary
institutions throughout Australia, New Zealand and Asia, and by professionals within the financial services industry. In this
ninth edition, we present once more a finance text for you that is authoritative and scholarly, and which at the same time
highlights the dynamic, exciting and global nature of financial institutions, instruments and markets.
As the global financial crisis and its aftermath fades into history, attention has turned to the financial services industry
itself, its culture and its values. In 2018, the Royal Commission into Misconduct in the Banking, Superannuation and
Financial Services Industry in Australia highlighted many areas of concern and highlighted the importance of strong
governance, codes of conduct and ethics within financial services firms. The findings of the Royal Commission will
continue to shape public opinion and trust in financial institutions for many years to come. New graduates in finance, as
well as their professors, are not powerless to ensure that this trust is restored sooner rather than later.
As the ninth edition was being finalised, financial markets in the United States were tentatively testing and retreating
from new highs against a backdrop of stronger economic activity and rising interest rates. In Australia, the challenge
of returning interest rates to more ‘normal’ levels without causing a major disruption to the housing market remained
perhaps the most significant challenge confronting the Reserve Bank of Australia.
Although political uncertainty has swept through Europe and the United States, it is important to recognise that
innovation, technological and otherwise, continues at pace. New companies with new products and new ideas are
forever emerging and will seek capital from the world’s debt and equity markets to fund their first (or next) steps. In the
financial markets, as for most aspects of life, we can never wait for the clouds of uncertainty to lift before trying to make
our way.
One thing is certain, change will occur. As students of the financial system you must keep yourself informed about
the structure and operation of financial institutions, instruments and markets. Importantly, you must think about and
anticipate future directions and change. Despite the continuous change that financial markets undergo, there are a set of
stable, underlying principles that govern decision-making across all markets and instruments. It is worth keeping in mind,
then, that a sound knowledge of the basics can take you much further than you might think.
With that said, we encourage you to accept every opportunity that comes your way and we wish you the best of
success.
Christopher Viney and Peter J Phillips

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ABOUT THE AUTHORS
CHRISTOPHER VINEY brings to this book a wealth of industry experience and academic
knowledge associated with the international financial markets. His appreciation of the nature
of both the theoretic and the applied functions and operations of the global financial system
is reflected in the clear and interesting presentation of issues in such a way that the reader is
motivated to learn.
Prior to moving into academia Chris spent 27 years in the commercial banking industry
including retail banking, corporate lending, risk management, personnel, property, policy and
administration. His academic career included appointments at Monash University and Deakin
University, Melbourne, Australia. He has taught in the areas of financial markets, financial
institutions management, corporate finance, treasury management and personal financial
planning. Chris has also taught in Singapore, Malaysia, Thailand, Indonesia and New Zealand.
He has received university awards for contributions to the internationalisation of teaching and
learning programs. As the director of the finance international study programs at Monash and Deakin Universities, Chris
has taken select groups of students overseas as part of their tertiary studies. He has also published research papers on
the capital markets, operational risk management, bureau de change, money laundering and education and training.
Following the passing of Michael McGrath with the first edition of the text, Chris has guided the evolution of future
editions of the book and it has now become a principal learning and reference source for undergraduate students,
postgraduate students and industry practitioners alike. Peter Phillips joined Chris ahead of the seventh edition and has
been Chris’s co-author since 2011.

PETER PHILLIPS has been teaching economics and finance at the University of Southern
Queensland (USQ) in Toowoomba, Australia, since 1998. Presently, he is an Associate
Professor in Finance at USQ. He has taught in the areas of financial markets and institutions,

portfolio management and corporate finance as well as several economics courses, including
macroeconomics and econometrics.
In 2003 Peter completed a PhD at USQ in financial economics. Since then he has
published a number of papers on the topic of Self Managed Superannuation Funds (SMSFs)
in which he and his co-authors explore various aspects of the portfolios chosen by SMSF
investors.

Acknowledgments
The challenge of maintaining the currency and relevancy of a book with the scope of financial institutions, instruments and
markets is enormous. This daunting task is tackled at many levels. At one level we are most appreciative of those users
of the book, including academics, practitioners and students, who provide ongoing feedback in the form of comment,
suggestion and discussion. We value your contributions immensely.
The quality of the production of the book is also dependent on the expertise and hard work of the people at McGrawHill Education (Australia). As authors, we have been very fortunate to have the dedicated editorial support of Jillian Gibbs.
We would also like to acknowledge and thank the team at McGraw-Hill, including Anne Harmer, Claire Linsdell, Marisa
Rey Bulen and Bethany Ng.
We would like to thank our case study contributor, Jaison Parackel Johnny (University of Southern QueenslandToowoomba). We would also like to thank Michael Baker (Flinders University), Sisira Colombage (Federation University
Australia) and David Spiers (Federation University Australia) for their detailed reviews of the material during development.

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HIGHLIGHTS OF THE NINTH EDITION
C HAPTER 1  A modern financial system: an overview
introduces the financial institutions, financial instruments
and financial markets that comprise domestic and global
financial systems and explains why a stable financial

system is important for economic growth
provides a concise context that assists the reader to
understand the relationships of the material in the
following chapters
discussion moves away from the global financial crisis and
broadens to describe how theories and ideas operate in
the discipline of finance. The framework is simple: risk and
reward, supply and demand
extended learning—the global financial crisis
extended learning—the impact of the Asian financial crisis
on the financial system
case study—the current possibilities of future financial
crises

C HAPTER 2  Commercial banks
contains a detailed discussion on the commercial bank,
including its role, products, off-balance-sheet business,
regulation and supervision
provides a concise explanation of the capital adequacy
and liquidity standards that apply to banks under Basel III
shifts the focus to Basel III, which was finalised in 2017,
but which will take several more years to fully implement.
Basel II is out, Basel III is in
outlines aspects of the regulatory response to the global
financial crisis
extended learning—the standardised approach to credit
risk
extended learning—business continuity risk management
extended learning—corporate governance and ethics
case study—Australian banking’s prompt response to the

new Basel requirements

C HAPTER 3  Non-bank financial institutions
a current examination of investment banks, managed
funds, superannuation funds, cash management trusts,
public unit trusts, life and general insurance offices, hedge
funds, finance companies, building societies, credit unions
and export finance corporations
extended learning—project finance and structured finance
case study—hedge fund managers, regulation, and
current hedge fund trends

C HAPTER 4  The share market and the corporation
new approach focusing on Basel III
considers the management structure of a publicly listed
corporation
discusses the important roles of a stock exchange in
facilitating the listing of a corporation’s shares on the
exchange (primary market role) and the ongoing trading

of existing shares (secondary market role) on the share
market
examines the managed products and derivative products
offered by a stock exchange, including exchange traded
funds, contracts for difference, real estate investment
trusts, infrastructure funds, options, warrants and futures
contracts
examines the interest rate market role, the trading and
settlements roles, the information role and the regulatory
roles of a stock exchange

case study—industrial-scale blockchain in Australia

C HAPTER 5  Corporations issuing equity in the share
market
introduces the capital budgeting investment decision
process; funding issues related to debt and equity;
initial public offerings, stock exchange listing rules and
alternative forms of equity issues
extended learning—current Australian Securities
Exchange (ASX) listing requirements
case study—covenant-lite loans and their risk implications

C HAPTER 6  Investors in the share market
considers the role of the investor in the share market;
risks associated with buying and selling shares
discusses taxation; financial performance indicators and
the pricing of shares
introduces share market indices and the interpretation of
share market information
case study—private equity firms, angel investors and exit
strategies

C HAPTER 7  Forecasting share price movements
examines fundamental analysis and technical analysis
approaches to share price forecasting
updated consideration of the impact of electronic trading
and technology on share prices
introduces the random walk hypothesis and the
efficient markets hypothesis (EMH) within the context of
forecasting share price movements

introduces behavioural finance as an alternative
theoretical framework to the EMH for understanding share
price movements
case study—the effects of scandal on the market

C HAPTER 8  Mathematics of finance: an introduction to
basic concepts and calculations
introduces the principles of mathematical calculations that
underpin financial market instruments, including simple
interest, compound interest, present value, future value,
yield, annuities and effective rates of interest
case study—the 4% rule and considering the feasibility of
early retirement

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