Let’s think about the exam now: March 18, we will cover everything covered so far, so the role

of the
Banks in the economy, especially, the central banks role, the debt and equity markets. Think about
what should central banks do in a country where the economy is stagnating, price level stagnating
(review what Japan is doing for example) and compare/contrast with a central bank in an economy
where the price levels are rising, debts increasing, and the banks are full of nonperforming assets.
What should or can central banks do?
Review central banks / bank regulations and bank risk management

Role of central banks

(1) Implement a monetary policy that provides consistent growth and maximises employment.
Central banks can set interest rates.
(2) Promote stability of the financial system.
(3) Manage the production and distribution of the nation’s currency.
(4) Inform the public of the overall state of the economy by publishing economic statistics.

Europe – European Central Bank (ECB), European Money Union (EMU)

USA – Federal Reserve System (FED)
Singapore - Monetary Authority of Singapore (MAS)

Fiscal policy – Government use (1) Tax rates and (2) Government spending to control inflation

For example, stimulating a stagnant economy by increasing spending or lowering taxes runs the risk
of causing inflation to rise.
This is because an increase in the amount of money in the economy, followed by an increase in
consumer demand, can result in a decrease in the value of money - meaning that it would take more
money to buy something that has not changed in value.

Let's say that an economy has slowed down. Unemployment levels are up, consumer spending is
down and businesses are not making substantial profits. A government thus decides to fuel the
economy's engine by decreasing taxation, which gives consumers more spending money, while
increasing government spending in the form of buying services from the market (such as building
roads or schools). By paying for such services, the government creates jobs and wages that are in
turn pumped into the economy. Pumping money into the economy by decreasing taxation and
increasing government spending is also known as "pump priming." In the meantime, overall
unemployment levels will fall.

With more money in the economy and fewer taxes to pay, consumer demand for goods and services
increases. This, in turn, rekindles businesses and turns the cycle around from stagnant to active.
If, however, there are no reins on this process, the increase in economic productivity can cross over a
very fine line and lead to too much money in the market. This excess in supply decreases the value of
money while pushing up prices (because of the increase in demand for consumer products). Hence,
inflation exceeds the reasonable level.

For this reason, fine tuning the economy through fiscal policy alone can be a difficult, if not
improbable, means to reach economic goals. If not closely monitored, the line between a productive
economy and one that is infected by inflation can be easily blurred.

And When the Economy Needs to Be Curbed …

When inflation is too strong, the economy may need a slowdown. In such a situation, a
government can use fiscal policy to increase taxes to suck money out of the economy. Fiscal policy
could also dictate a decrease in government spending and thereby decrease the money in circulation.
Of course, the possible negative effects of such a policy in the long run could be a sluggish
economy and high unemployment levels. Nonetheless, the process continues as the government uses
its fiscal policy to fine-tune spending and taxation levels, with the goal of evening out the business
cycles.
The Bottom Line
One of the biggest obstacles facing policymakers is deciding how much involvement the government
should have in the economy. Indeed, there have been various degrees of interference by the
government over the years. But for the most part, it is accepted that a degree of government
involvement is necessary to sustain a vibrant economy, on which the economic well-being of the
population depends.

How Central Banks Use INTEREST RATES for Fiscal Policy

 Central Banks offer overnight loans to commercial banks
 Lender of last resorts, support liquidity needs
 Ensures commercial banks have sufficient cash for consumers to borrow, as the availability of
credit has a direct impact on business and consumer spending
 The rates the CB charges affects the rates that commercial banks charge their customers as
banks must recover the cost they paid plus a profit.
 If increased consumer spending is needed to stimulate the economy (like recently in US and
China), the CB can lower short term rates when loaning to banks.
 Banks will then lower the rates they charge
 This encourages spending and investments both from households and corporates
 If tightening the economy is need to slow inflation, CBs can increase interest rates to make loans
more expensive, leading to a reduction in spending.

Supply and Demand of Currency

Like a product, the value of a free-floating currency is based on supply and demand of it
To increase value of a currency, the CB can buy currency and hold it in reserves. This reduces the
money supply and can lead to an increase in valuation.
To decrease value, the CB can sell its reserves to the market. This increases the money supply and
reduces its valuation.
International trade also affects this. When a country exports more than it imports, foreign buyers
must exchange more of their currency to buy the currency of the exporting country, increasing the
demand for the currency.

Monetary Policy
In UK and US, monetary policy is the most important tool for maintaining low inflation.
Government sets a low positive interest rate and the Monetary Policy Committee (MPC) of England
uses interest rates to try and achieve this target.
MPC predicts future inflation by looking at economic statistics.
Increased interest rates reduce the growth of aggregate demand of the country
Slower growth leads to lower inflation.
High interest rates reduce consumer spending
Increase the cost of borrowing, discouraging borrowing and spending
Makes it more attractive to save
Reduce the disposable income of those with loans and mortgages
Higher interest rates increase the value of the exchange rate and leads to lower exports and more
imports

Cost-push inflation
 Inflation believed to be temporary
 Rising oil prices, rising tax rates, impact of devaluation
 Economy in recession, reducing aggregate demand by increasing interest rates can worsen
recession

Goals of the Federal Reserve System (FED)

 Conduct monetary policy
 Supervise and regulate banking institutions
 Maintain stability of the financial system
 Provide financial services to depository institutions
FED’s monetary policy (Goals)
(1) Maximise sustainable output and employment
(2) Stable Prices, low stable inflation
(3) Implies MODERATE long term interest rates

Tools to conduct policy

(1) Open market operations
(2) Discount rate
(3) Reserve requirements

Open Market Operations (Buy – stimulate)

(Buy securities, increase bank money supply, reduce interest rates, encourage spending)
 Buying and selling US government securities on the open market to align the federal funds rate
 If the Federal Open Market Committee (FOMC) lowers its target for the federal funds rate
 Buy securities on the open market
 Pays for the securities by crediting the reserve accounts of the banks selling the securities
 When the FOMC buys securities, it is creating money
 Additional money in the bank reserve accounts puts downward pressure on the federal funds
rates
 Short-term interest rates directly/indirectly linked to the federal funds rates also fall
 Lower interest rates encourage consumer spending
 Stimulate economy

 If the FOMC raises its target for the federal funds rates
 Sell government securities, collecting payments from the banks selling them
 Withdraw money from the banks’ reserve accounts
 Smaller money supply
 Increase the federal funds rates and the interest rates
 Discourage spending encourage saving

Discount Rate
 Discount rate set by Federal Reserve
 The rate at which banks borrow from the central bank
 If the bank wants to stimulate economy, lower interest rates by offering commercial banks lower
rates

Reserve Requirements
All depository institutions must set a % of their deposits as reserves to be held as cash
Altering reserve requirements is a monetary policy that is rarely used
Supports monetary policy by creating a relatively predictable demand for loans in the federal funds
market
Banks sometimes borrow in the market just to meet reserve requirements
Bank regulations
Uniform Financial Institutions Rating System (UFIRS) assigns a composite rating
CAMELS based on SIX essential components
(1) Capital adequacy
(2) Asset Quality
(3) Management
(4) Earnings
(5) Liquidity
(6) Sensitivity to market risk
Rating from 1-5
1. Best – Institution sound in all aspects
2. Fundamentally sound, but modest weakness which can be easily corrected during normal business
3. Financial, operational or compliance weaknesses are present
4. Immoderate volume of financial weakness
5. Immediate or near term failure is likely

Basel I – First minimum standards for bank capital ratios

Basel II – 3 pillar framework.
(1) Capital ratios
(2) Supervisory review
(3) Market discipline through disclosure

Basel III
 Increase in minimum capital requirements at individual banks
 Improvement of quality of capital and risk coverage at individual banks
 Internationally harmonised leverage ratios at all individual banks
 Improvements to supervisory processes at national level
 Counter cyclical buffers of increasing buffers in good times

Criticisms of Basel III

One set of minimum standards for all lenders with different situations
Highly reliant on limited number of rating agencies
Complexity of metrics increased manifold
Tougher capital requirements – restricts bank lending – restricts economic growth due to the freeze
up of assets

Bank risk management

1) Interest rate risk – mismatch of maturities of assets and liabilities. When FI holds longer-term
assets (loans) than liabilities (deposits), RSL>RSA, CGAP –ve. When interest rate increase, NII
decrease as CGAP is –ve.
Use interest rate swaps to hedge risks – client wants fixed rate but bank wants floating asset.
2) Credit risk – borrower defaults
FIs need to monitor and collect information about firms whose assets are in their portfolios.
Bank’s managerial efficiency and credit risk management strategies shape the loan return distribution.
Effective credit risk management takes into account that credit risks will rise with unexpected change
in interest rate and market conditions.
3) Foreign exchange risk – undiversified foreign expansions expose FIs to foreign exchange risk in
addition to credit risk and default risk
4) Country or sovereign risk – more serious than domestic credit risk. A foreign FI may be unable
to pay even if it would like to. During times of crisis, government may prohibit cash outflow and limit
payments due to currency shortage and political reasons.
5) Off-balance sheet risk – letters of credit, loan commitments, mortgage servicing contracts,
forwards, futures, swaps, options, derivatives that are not reflected in the balance sheet.
6) Technology and operational risk – when investment in new technology is unsuccessful or
underwhelming. Mergers with the potential to improve technology synergies fail to generate success
or cost savings
Operational risk – related to people or technology risk and can arise whenever existing technology
is inefficient in supporting operations and creates new risk because of risk underestimation. Human
errors in risk calculations.

7) Liquidity risk – whenever a FI’s liability holders demand immediate cash for financial claims or
when there is an unexpected demand in new loans. FIs must be able to meet borrower’s demands.
When their supply is restricted or unavailable,
Banks have to liquidate less liquid items at a loss to finance their lending
Solvency problem and cause a bank run

Effective liquidity risk management ensures a bank’s ability to meet cash flow obligations, which are
uncertain as they are affected by external events and agent’s behaviour.

Japan economy (1) Stagnating economy (2) Price level stagnating

(1) Price levels rising (2) Debts rising (3) Banks full of non-performing assets

Looking at recent events: How would you rate, ECB, the Federal Reserve, Bank of
England and the Bank of Japan. Which Central bank, in your opinion is doing its best?
And why? Consider the three key roles of central banks: (1) dealing with monetary
policy, (2) financial system stability and (3) currency management.

1) Bank of England
In terms of which central banks are doing best, I would rank it in this order (Best first)
BOE, the Fed, European Central Bank (ECB) and then BOJ.

Bank of England - why I think it's doing well is because its fiscal stimuluses work. Given that Brexit was a fairly
significant event, we can see that the BOE reacted quickly to this negative event in two ways:

1. In terms of monetary policy - it made the decision to cut its benchmark interest rate, an accommodative move
that was meant to combat an expected decline in the UK economy from this event.

2. It provided immediate fiscal stimulus with bond buybacks. Buy back securities, inject commercial banks
with money, downward pressure on interest rates, increase consumer spending.

The results? The UK economy has been recovering well post Brexit and GDP growth has been
sustained at 0.7% QoQ, while consumer prices have been expanding rapidly.

In terms of currency management, it is difficult for the BoE to control the sterling given that many factors are at
large - from market sentiment to algorithmic trading machines (last year's flash crash comes to mind). However,
they have been taking fiscal measures to boost the UK economy at large, such as its bond buying programme.
Given that rates are also very accommodative at 0.25%, Britain is definitely poised for growth as its
currency makes it attractive for foreign investors to come in at this period of time. This could in
turn offset the ~20% GBP devaluation that happened last year post-Brexit.

I feel that BOE would rank the highest.

“UK business activity suffer the biggest fall ever, the Business Activity Index fell to 47.4 in July from 52.3 in
June.” However, the predictions and pessimistic sentiments of the UK economy has not moved in tandem with
the UK economy growing 1.8% in 2016, second only to Germany’s 1.9% among the world’s G7 leading
industrialized nations.

This was aptly controlled by the BOE where they launched a 170b pound stimulus package, coupled with
interest cuts, encouraging consumer and institutional expenditures. The decrease in interest cuts encouraged
companies to increase investments, allowing Britons to remain upbeat about their career prospects. Though
inflation has been inching higher - to 1.8% in January, unemployment has continued to fall, to
stand at an 11 year low of 4.8%. (BBCNews, 2017) Therefore, boosting consumer spirits whilst keeping
consumer confidence level stable, and higher than 12 months previously. (The Telegraph, 2017)
2) USA – Federal Reserve System (FED)
In my opinion Feds is performing the best. As many of my classmates has correctly pointed out, US has been
recovering from the 2008 global financial crisis and was able to maintain moderate growth along
with low inflation rates. I will like to move on to explain why US was able to outperform ECB and BOJ even
though all 3 countries used quantitative easing as means to stimulate the economy. Quantitative Easing is
the buying of government securities in order to lower interest rates and increase money supply. QE
is adopted when short term interest rates are at or approaching zero and thus the central banks
tries to affect long term interest rates in order to flatten the yield curve. I believe the main reason why
QE worked for the US is because they managed to implement their fiscal policy in tandem with their
monetary policy. When Japan and Europe increased the money supply in the economy, interest rates
decreased. However, that did not help to stimulate the economy. This was because the money remained in
the bank reserves as banks were conservative with their lending and demand for credit was low
due to the negative economic conditions. Without increased lending and investing, economic
activity continued to remain low and therefore they failed to experience any growth. What the US did
differently was that they made use of their fiscal policy to move the money supply from the bank reserves, into
the economy. The government went on to borrow money from the banks and increased their government
expenditure. This expansionary fiscal policy helped increase growth rates and reduce unemployment in the US.
I think the BoJ faces an uphill challenge in boosting the Japanese economy - it has tried to initiate many forms of
stimulus - monetary/fiscal with negative rates and lots of helicopter money; but the slump continues despite this
because of the structural problems that its economy faces.

I agree with the points posted by the others and the general consensus of the ranking of BOE, Fed, ECB and
BOJ. As many have already expounded on the successes of BOE and failures of BOJ, in this post, I would like to
talk about how ECB has failed.
3) European Central Bank
As mentioned, ECB has been rather slow and inflexible in terms of managing crisis. However, as we try to
ascertain why this is so, we first take a look at what ECB defines their primary objective to be:
“The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates
of below, but close to, 2% over the medium term.”

This can be contrasted with other central bank’s goals, for example, BOE’s:
“The Bank’s monetary policy objective is to deliver price stability – low inflation – and, subject to that, to support
the Government’s economic objectives including those for growth and employment.”

From this, we can see that ECB has placed a lot of focus on simply maintaining low inflation rates,
without much emphasis on other aspects of the economy such as growth and employment. This has
result in certain odd policy decisions, for example, increasing interest rates in 2011 even though the
European economy was entering a double dip recession, just to keep inflation low. While this has
indeed helped them keep their inflation close to their target of 2%, it did nothing to help with the falling
growth rates. If the ECB had been willing to tolerate slight cost-push inflation in the short run, they may have
been able to mitigate the fall in growth and reduced unemployment.

Another point would be their inertia in dealing with crisis. In the European Debt crisis, the ECB waited 2 years
before deciding to undergo whatever measures necessary to save the Euro. This led to unnecessary interest rate
burden for governments and Eurozone economies facing pressure to instigate harsh austerity measures that
reduced demand and economic growth. Hence, while ECB’s policies can in fact be effective (as compared to
BOJ’s), the problem lies with poor policy decision in inertia in implementing policies.
4) Bank of Japan
I agree with most of my classmates' ranking of the central banks - BoE first, followed by the Fed, ECB, and lastly
BoJ. With a general consensus of the inability of BoJ to deliver results being the main reason why BoJ is
consistently ranked last by many of us, I would like to provide for a discussion on why BoJ is not getting
anywhere with its monetary policies, and give BoJ credit where its due.

Japan has been battling deflation for 20 years, and even with Prime Minister Shinzo Abe and Central Bank
Governor Haruhiko Kuroda pledging to do "whatever it takes", Japan's economy is still lagging. BoJ is limited in
what policies it can implement and how effective it can be. Expansionary monetary policies worked for a while
but as deflation sets back in again, this shows that the effect of this monetary policy has faded. I believe that the
core issue lies with Japan's ageing population. According to an article by the World Economic Forum, "By 2020
the country will be losing around 600,000 people a year. Getting growth from an ageing, shrinking society is
difficult." The last line speaks for itself.

Another substantial issue that Japan faces, and is out of BoJ's control, would be Japan's enormous national debt,
where Japan’s gross government debt is 226% of GDP. However, without fiscal stimulus from the government to
go hand-in-hand with BoJ's expansionary monetary stimulus to keep the battle against deflation going, BoJ's
effectiveness is once again limited.

Nonetheless, in spite of these issues that are out of BoJ's control, BoJ must continue to fulfill its responsibility as
a central bank in ensuring the stability of prices and the financial system in a whole. BoJ's unwavering stance in
keeping monetary policies aggressive, leaving low interest rates unchanged might be ineffective in keeping
deflation in check and perhaps, BoJ could switch it up and surprise the market in a move to raise interest rates.
Let’s think about the exam now: March 18, we will cover everything covered so far, so for example be
prepared to do mortgage valuation and calculate the impact of interest rate changes on the mortgage
value (price), bond value (price), and understand the interest rate change implications (interest rate
risk) on the balance sheet of the banks. Think about the questions: How can banks manage the
interest rate risk, what rates are banks’ lending in Europe, US, Singapore. For example in Singapore
with the exception of HDB loans, most loans are adjustable rate mortgages (ARMs) or hybrid-ARMS,
so the banks try to pass on the exchange rate risk. But they price their mortgages based on SIBOR,
SOR, Deposit mortgage rate (or so called Fixed Deposit Home Rate at DBS), or Board rates. Why are
there so many different rates, which are relevant, how can banks, versus borrowers hedge their
risk...?

Real interest rate is the interest rate that would exist if there were no inflation.

LIBOR – London Interbank Exchange Rate

 Average interest rate that London banks charge when lending to OTHER BANKS
 Adjusted every 6 months

T-Bills
Debt obligation with maturity of less than one year

Federal funds rate

Interest rates at which FIs trade with the FED
Overnight rates
Controls money supply

High grade corporate bonds

Best quality corporate bonds determined by Moody’s, S&P

Loanable fund theory (Supply)

1) Wealth – increase and supply
2) Risk – As risk of loans decrease, supply increases
3) Near term spending need – If population ages, and elderly population has increasing near term
spending needs, supply of loans decreases
4) Economic conditions – crisis reduces supply loans

Loanable fund theory (Demand)

1) Utility derived from assets purchased with borrowed funds
2) Restrictiveness on non-price conditions on borrowed funds

Factors affecting interest rates

1) Inflation – (1+real) = (1+nominal)/(1+inflation)
Volatility in inflation causes risk to both lender and borrower
2) Default risk
3) Liquidity risk – when security cannot trade quickly enough in the market to prevent a loss
Yield Curve – measure of the market’s expectations of future interest rates given the current market
conditions.

When the yield curve changes shape, the outlook of the economy changes.
Upward sloping = long term yields are higher than short term yields.

Fisher with tax

[1+(1-T)real] = [1+(1-T)nominal] / (1+ inflation)

Flat rate calculation – the rate given is EFFECTIVE RATE

1) Determine total amount to be paid interest + principal.
2) Total amount / n = periods
3) Compute for i/r per period
4) Times number of period for APR

Fixed Rate Mortgage

Fully amortizing where the i/r remains the same

Adjustable rate mortgage ARM

20% downpayment in SG

Hybrid ARMs
Fixed for the initial period.
After initial period the rate is adjustable.

Interest only loan

1) N=360, I/Y = 2/12, PV=500k, FV=0, PMT = -1848.097

2) Calculate remaining loan amount.
Remaining term after 1 year = 360-12 = 348. I/Y = 2/12 (the same), PMT = 1848.097
PV = 487710.4892
3) Calculate new payment
New I/Y = 3.25/12, N=348, PV = 487710.4892, FV = 0
How can banks manage the interest rate risk, what rates are banks’ lending in Europe, US, Singapore.
For example in Singapore with the exception of HDB loans, most loans are adjustable rate mortgages
(ARMs) or hybrid-ARMS, so the banks try to pass on the interest/exchange rate risk. But they price
their mortgages based on SIBOR, SOR, Deposit mortgage rate (or so called Fixed Deposit Home Rate
at DBS), or Board rates. Why are there so many different rates, which are relevant, how can banks,
versus borrowers hedge their risk...?

How Banks and Borrowers can Hedge their Interest Rate Risks
1) Forwards – determinant of gain/loss is an interest rate. One party pays a fixed interest rate and
receives a floating interest rate equal to a reference date.
2) Futures – provides the counterparties with less risk than a forward contract, namely a lessening of
default and liquidity risk due to the inclusion of an intermediary.
3) Swap – Interest rate swap involves an agreement between counterparties to exchange sets of
future cash flows. One party pays a fixed interest rate and receives a floating rate, with the other
party paying a floating rate and receiving a fixed rate.
4) Options – option contract where the underlying asset is a debt obligation. Protects parties involved
in a floating rate loan, such as ARMs.
Cap = call option on an interest rate. Borrower uses this to protect against rising interest rates. If
the actual interest rate exceeds the strike rate.
Floor = put. A lender uses this to protect against falling rates on a loan.

Singapore Interbank Offered Rate

SOR – Swap Offer Rate
 Benchmark rates for property loans in Singapore that are most popular amongst consumers due
to its open and transparent concept.
 SIBOR and SOR are shared across all banks and hence offer the concept of shared risk.
 No bank can go astray from the pack.

SIBOR is generally determined by the demand and supply of funds in the Singapore interbank
market.
SIBOR tends to be more stable than the SOR

SOR is determined by external factors such as the USD interest and exchange rates.
SOR tends to fluctuate more.
Consumers who take up SOR packages are consumers with
HIGHER RISK profiles and wish to take advantage of the SOR’s ability to drop to levels way below the
SIBOR
And can confidently tide over the period where the SOR is way above the SIBOR

While they are affected by different factors, they trend in the same general direction.
Let’s think about the exam now: March 18, we will cover everything covered so far, debt markets
instruments. Firms can secure new funds through various channels and various assets. The market
liquidity and the risk sharing are important consideration for investors in deciding whether to invest
with a specific firm or project or not. Bond investors are keenly aware of the low market liquidity and
this liquidity risk is priced in the bonds in most cases. While corporations normally carry high credit risk
(or higher than the government in their home country) there are sometimes cases when investors
(perhaps behave swayed by sentiment) and invest in companies (for example Apple) and demanding
very low returns, much lower than the returns on government bonds. So companies may be able to
exploit market sentiment and raise funds cheaply either in the debt market or in the Equity market.
What do you think about the recent IPO of SnapInc. Do you think that there is perhaps a tech bubble
in the equity market?

Bond investors must be aware of the low market liquidity and liquidity risk is priced in bonds in most
cases.
Cases where companies like Apple have raised debt with very low returns, less than government bonds,
which is evidence that they can exploit market sentiment and raise funds cheaply.

Governance:
 SnapIncs shares being sold to public are Class A shares which have NO voting rights
 Investors will have no say in the company
 Founders retain 89% of the voting rights
 Could turn institutional investors away

Network:
Although userbase has been growing rapidly in past few years
Growth of users may not significantly add revenue to Snap

Lack of Profit:
Snap cannot justify their high valuation with growth.
Though revenue has been increasing rapidly, the growth in users has slowed.
Expenses are also increasing rapidly, and could outpace revenue growth for a long time.

Rising Competition:
Whatsapp, Instagram, Facebook pulling out their own “My Story” functions on their applications. Pose
a rising threat to the exclusivity of Snap.

Highest Price-to-Sales ratio on record

Exploiting positive market sentiment – IPO market was recently very dry and investors are looking
for something new

Lock-up period:
Snap recently amended their filing, requesting for a 1 year lock up period instead of the 150 day period
initially asked for, which may indicate a lack of confidence for the stock price once the lock up period
ends. The lock up periods are intended to guard the company shares against a short selling onslaught
that can destroy its valuation if investors predict that share prices will drop. Selling by insiders are
viewed by the investing public as a lack of faith in the company’s prospects
To draw a parallel, the first day after Facebook’s lock-up period, Facebook shares dropped by 50%
from its listing price. This is further evidence of a tech bubble.

Tech Bubble:
Eight of the 10 biggest technology IPOs fell by between 25% and 71% in their first 12 months on the
public market, according to a Reuters analysis of market performance. On Feb 13, Snap announced
changes to its lock-up expiration rule to allow employees to sell shares after 150 days (versus 180
days, which was initially listed in its IPO Prospectus). Employees holding standard stock awards are
now able to sell shares after 150 days, the same holding period as co-founders and investors. There
will be two enormous lockup expirations for Snapchat in the coming months, which may offer better
buying opportunities as insider and employee sales hit the tape.

Twitter currently trades at half its value since IPO. The issue for Twitter was monetization, active user
growth and user engagement. Snapchat will likely face these same problems, as its 18-24 user base
matures with time. The likelihood of sustained value creation is low.

Recent Performance:

Since opening at $24.48 on March 2, the share price is currently 19.22 as of yesterday.
3) Review the various financial assets and instruments we learnt about (short term debt assets: short
term loans, commercial papers, long term (or capital market) debt assets, equity....)
You can organize the debt market and the equity market under private and public assets (instead of
maturity):
3A: Private debt assets: informal lending, loans
3B: Private debt assets : bonds, commercial papers, MBS, notes,
3C: Private equity: (equity through private placement, generally used during the start-up phase of the
company)
3D: Public Equity : preferred share, common share..

1) Private debt market

 Bank loans
 Private equity financing
 Venture capitalist
 Crowd funding
 Informal lending
 Government entities (development banks)
 EDB in Singapore
2) Public debt market
Short-term - Commercial papers
Long-term - Bonds

1A) Private debt - Informal Lending – Informal credit market (ICMs)

 China and less developed countries
 Used by SMEs to secure funds
 In China, official banks that dominate the market prefer to lend to Guan Xi firms
 Chinese entrepreneurs turn to shadow banks, informal money lenders, and private connections
for loans
 PROBLEM – many of these informal loans are not legally enforceable
 Informal lending is migrating online in China because (1) internet extends the lenders/borrowers
reach (2) credit from state banks remain scarce for small firms without Guan Xi (3) TCs for this
kind of lending is very high – 3-10%
 Suppliers function outside the purview of regulations imposed in the formal sector in respect of
capital, reserve and liquidity requirements, ceilings on lending and deposit rates, mandatory
credit targets, audit and reporting requirements and so on.
 If the features of ICMs mentioned above are taken into account, then an informal credit operation
can be operationally defined as one that is not regulated/audited by the Federal or Central Bank,
has flexible repayment schedules (in terms of periods and amounts), flexible interest rates, and
demand little or no collateral.
Wenzhou example:
 Informal money lending institutions will be encouraged to register as private lending institutions
free to operate
 Private citizens in Wenzhou will be allowed to invest up to 3M directly to non-bank entities
abroad, without the need for a formal government intermediary

1B) Private Debt - Crowd Funding

 Used by small companies to fund start-ups by selling small amounts of equities to many investors
 Participants (1) Start-up founders, people who need the money (2) Crowd of investors who
purchase the equity (3) Organisation or PLATFORM that brings the project and crowd together
 Star Citizen – video game – collected 36M USD in 2014
1C) Private Debt - Microfinance
 Source of financial services for entrepreneurs and small businesses lacking access to banking and
related services
 Participants (1) Banks (2) PE (3) Non-profit organisations (4) Development banks (5) Religious
institutions
 Debt / equity / deposits
 Debt comprised over one-third of the total funding of Micro Finance Institutions (MFIs)
 The Grameen Bank (Bengali: গ্রামীণ বাাংক) is a Nobel Peace Prize-
winning microfinance organisation and community development bank founded in Bangladesh. It
makes small loans (known as microcredit or "grameencredit") to the impoverished without
requiring collateral.

1D) Private Debt – Bank Loans

 Efficient monitoring
 Reduce adverse selection – occurs when bad credit risks become more probable to acquire credit
than good credit risks
 Information asymmetry – asymmetric distribution of material information between the borrower
and lender

1E) Private Debt – Private Equity

 Pooled investment vehicle for investing in equity and to a lesser extent debt securities
 Limited partnerships with a short fixed term of 10 years or less
 The goal from day one is to sell the company at a profit so it has to get good results fast
 Leveraged buyout – financial sponsor raises acquisition debt. As the debt usually has a lower cost
of capital than the cost of capital, the returns on equity increasing with increasing debt. The debt
acts as a lever to increase returns.

1F) Private Debt – Venture Capital

 Provide capital to start-ups
 Expected to realise returns in 3-5 years when the company goes through IPO
 Investments made in cash in return for equity

2) Public debt market

2A) Short term debt – commercial papers, repos, T-bills, banker’s acceptance
2B) Long term debt - bonds
2A) Public debt, short-term – Commercial Papers
 Short-term 30-270 day maturity
 Issued by large corporations or banks to fund SHORT TERM liquidity needs
 Not required to register with the US Securities and Exchange Commission (SEC)
 Unsecured debt obligations

 Cover inventory costs

 Provide the capital to finance operating expenses

 Companies without AA or AAA ratings, use

 Asset-backed CP – high quality collateral
 Credit-backed CP – guaranteed by organisation with good credit such as a bank

 Typically issued by big companies while small companies get their credit from a bank loan

 Similar to zero coupon bonds – do not pay coupons

 Bond equivalent yield. Pf is the face value, t is the term length in days.

 Note the difference in denominator for CP yield.

 During US financial crisis in 2008, total CP outstanding dropped by 370B, while asset backed CP
accounted for 267B of this decline.

 Asset backed CP, 1/3 of it was backed by US real estate assets, which was particularly vulnerable.

Structured investment vehicles (SIVs)

 Issues asset backed CP
 Administered by large commercial banks
 Fund purchases of investment grade securities and earn the spread
 Created by IBs to achieve off-balance sheet finance
 A structured investment vehicle (SIV) is a non-bank financial institution established to earn
a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities
it issues with high leverage. They are simple credit spread lenders, frequently "lending" by
investing in securitizations, but also by investing in corporate bonds and funding by
issuing commercial paper and medium term notes, which were usually rated AAA until the onset
of the financial crisis. They did not expose themselves to either interest rate or currency risk and
typically held asset to maturity. SIVs differ from asset-backed securities and collateralized debt
obligations (CDOs) in that they are permanently capitalized and have an active management
team. They do not wind-down at the end of their financing term, but roll liabilities in the same
way that traditional banks do.
 They are generally established as offshore companies and so avoid paying tax and escape the
regulation that banks and finance companies are normally subject to. In addition, until changes in
regulations around 2008, they could often be kept off the balance-sheet of the banks that set
them up, escaping even indirect restraints through regulation. Due to their structure, the assets
and liabilities of the SIV was more transparent than traditional banks for investors. SIVs were
given the label by Standard & Poors -- Moody's called them "Limited Purpose Investment
Companies" or "LiPICs". They are considered to be part of the non-bank financial system, which
has two parts, the shadow banking system comprising the "bank sponsored" SIVs (which
operated in the shadows of the bank sponsors balance sheets) and the parallel banking system,
made up from independent (i.e. non bank aligned) sponsors.
 Invented by Citigroup in 1988, SIVs were large investors in securitisations. Some SIVs had
significant concentrations in US subprime mortgages, while other SIV had no exposure to these
products that are so linked to the financial crisis in 2008. After a slow start (there were only 7
SIVs before 2000) the SIV sector tripled in assets between 2004 and 2007 and at their peak just
 before the financial crisis in mid 2007, there were about 36 SIVs[1][3] with assets under
management in excess of $400 billion.[4] By October 2008, no SIVs remained active.[5]
 The strategy of SIVs is the same as traditional credit spread banking. They raise capital and then
lever that capital by issuing short-term securities, such as commercial paper and medium term
notes and public bonds, at lower rates and then use that money to buy longer term securities at
higher margins, earning the net credit spread for their investors. Long term assets could include,
among other things, residential mortgage-backed security (RMBS), collateralized bond obligation,
auto loans, student loans, credit cards securitizations, and bank and corporate bonds.

Issue SHORT TERM CPs at LOWER RATES to raise money.

Use that money to buy LONG TERM securities at higher rates to earn a CREDIT SPREAD.

2A) Public Debt – Mortgage Backed Securities

 Asset backed security that is backed by a collection of mortgages
 Mortgages are the loans which are packages by banks and sold to investors
 Low priority, high interest slices/tranches were repackaged and resold as collateralized debt
obligations (CDOs) – played a major part in the 2008 US subprime crisis
 Once a lender sold a mortgage, it no longer had a part to play in whether the borrower could
meet his payments

2A) Public Debt – T-Bills

2A) Public Debt – Banker’s acceptance – deposit to a bank, bank borrow money from a person who is
due payment at expiration date (liability for bank)

2B) Public Debt – Long term – Treasury Bonds/ Notes

 Promissory note issued by a borrower that requires the issuer to make specified payments to the
holder over a specific period.
 Issuers (1) Corporate (2) Government (3) Municipalities
 Terms (1) Short-term 1-5 years (2) Intermediate term 5-12 years (3) Long term >12 years

 Call option – gives the issuer (bank) the right to buy back the debt
 Put option – gives the buyer the right to sell back the debt

 Convertible – gives bondholder right to change the bond to a specified number of shares

 Bond prices and market i/r are negatively related

 A bond with longer maturity is MORE price sensitive than

 Bond with shorter maturity when i/r changes

 A bond with LOWER coupon rate is MORE price sensitive than

 Bond with HIGHER coupon rate

 For all bonds, a given INCREASE in i/r will cause a SMALLER price change than a decrease in i/r
of the SAME magnitude.
3) Private Equity
Private placement - A private placement is the sale of securities to a relatively small number of select
investors as a way of raising capital. Investors involved in private placements are usually large
banks, mutual funds, insurance companies and pension funds. A private placement is different from a
public issue, in which securities are made available for sale on the open market to any type of
investor.

Leveraged buyouts
A leveraged buyout (LBO) is the acquisition of another company using a significant amount of
borrowed money to meet the cost of acquisition. The assets of the company being acquired are often
used as collateral for the loans, along with the assets of the acquiring company. The purpose of
leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of
capital.
As the debt usually has a lower cost of capital than the cost of capital, the returns on
equity increasing with increasing debt. The debt acts as a lever to increase returns.
BREAKING DOWN 'Leveraged Buyout - LBO'
In an LBO, there is usually a ratio of 90% debt to 10% equity. Because of this high debt/equity ratio,
the bonds issued in the buyout are usually are not investment grade and are referred to as junk
bonds. Further, many people regard LBOs as an especially ruthless, predatory tactic. This is because
it isn't usually sanctioned by the target company. Further, it's seen as ironic in that a company's
success, in terms of assets on the balance sheet, can be used against it as collateral by a hostile
company.
Reasons for LBOs
LBOs are conducted for three main reasons. The first is to take a public company private; the second
is to spin-off a portion of an existing business by selling it; and the third is to transfer private
property, as is the case with a change in small business ownership. However, it is usually a
requirement that the acquired company or entity, in each scenario, is profitable and growing.
Venture capital

Mezzanine capital
Mezzanine financing is a hybrid of debt and equity financing that gives the lender the rights to
convert to an ownership or equity interest in the company in case of default, after venture
capital companies and other senior lenders are paid.

Distressed investments

3) Public equity
IPO
IPO Firm Commitment (for high quality companies):
 Underwriter GUARANTEES the sales
 Shares that are not sold are bought by the underwriter
 For high quality companies

IPO Best Efforts (for newer and unseasoned companies):

 Underwriter agrees to do his best to sell
 Sets a MINIMUM LEVEL of sales
 If minimum level is not reached the sale is cancelled

SEO
Subscription rights – shareholders receive subscription rights. One to one or one to two. For every
share they own, they can subscribe to one new share or two new shares at a preset price
Pre-emptive rights – 10k shares in 500k a share company. 2% ownership. When new shares are
traded, the company has to give the owner a chance to buy new shares to maintain 2% ownership.
Ordinary shares
 Ownership right
 Residual cash flow

Preferred shares
 Hybrid asset, mix of bond and equity
 No voting rights
 Higher priority to claim than ordinary
 Cumulative or non-cumulative

Warrant (Transferable subscription right TSR)

 Similar to option
 Fixed life, if not exercised becomes worthless at expiry date
 Call = right to buy
 Put = right to sell

Ordinary warrant Option Structured warrant

Issued by FIRM Issued by outsiders Issued by a third party FI
When an ordinary warrant is No chance in number of shares
exercised, the firm must issue outstanding
NEW SHARES
Exercising the warrant brings Does not bring cash into the
cash INTO THE FIRM firm

Depository receipts
 Broker buys shares in home country and deposits shares in bank, bank issues DRs
 Traded in foreign exchanges
 Dividends paid in local currencies
 Exposed to political and forex risk
 Price of ADRs closely tracks stock in home market

Mutual funds
 Collective investment vehicle
 Open end – issue NEW shares to investors
 Closed end – fixed number of shares

Unit Trusts
 Passive
 Buy and hold
 Lower transaction costs
 Holds a fixed portfolio

ETFs
 Open-ended investment funds which track indices
 Provide access to a wide range of asset classes

REITS
 Raise capital to purchase real estate assets
 Generate income for unit holders of the fund
 Allows individual investors to indirectly invest in property and share the benefits and risks
 Distribute income at regular intervals
 Less volatile than equities
 Less correlation with other financial assets
 More dividends than ordinary stocks
1) Central Bank
2) Bank regulations / bank risk management
3) Mortgage valuations
4) Bond valuations
5) In general, financial asset valuation
-Understanding that financial asset value is the present value of future CFs, where the discount
rate captures market conditions, an opportunity costs political uncertainty etc. (different types
of stocks, different types of bonds, different types of loans)
6) Debt market / equity market / stock market
Private Public assets Private Public assets
Loans Bonds Private placements on Public placement, IPO,
equity market SEO etc
Informal Commercial papers
In both markets companies aim to minimise cost of raising funds via debt or equity instruments while
investors are aiming to maximise return / yield.

For the Midterm review my advice was to:

1) review central banks / bank regulations and bank risk management
2) review calculation examples: mortgage calculations and bond calculations (do not forget we made
assumptions, we use APR for quotation, for mortgage full amortization etc)
-- understand that the value of a financial asset is always the present value of the future cash
flows, where the discount rate depends on risk aversion, risk in the system and risk related to the
specific asset (firm risk, or default risk, liquidity risk, market risk, currency risk, operation risk etc).
Some of the these risks can be managed at the company by using collateral, or hedging tools.
3) Review the various financial assets and instruments we learnt about (short term debt assets: short
term loans, commercial papers, long term (or capital market) debt assets, equity....)
You can organize the debt market and the equity market under private and public assets (instead of
maturity):
3A: Private debt assets: informal lending, loans
3B: Private debt assets : bonds, commercial papers, MBS, notes,
3C: Private equity: (equity through private placement, generally used during the start-up phase of the
company)
3D: Public Equity : preferred share, common share..