ICON Commercial Lending, Inc.
7086 South Highland Drive, Suite 250
Salt Lake City, UT 84121
1-866-956-5554
 ICONmd@gmail.com

Industry Terms (F)

Glossary of Industry Terms & Supporting Information

ICON Securities Lending (F)

Fair market price (FMP): The price a willing buyer would pay a willing seller for an asset, where both are acting rationally with full knowledge.

Fair market value (FMV): This is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the real estate market. An estimate of fair market value may be founded either on precedent or extrapolation. Fair market value differs from the intrinsic value that an individual may place on the same asset based on their own preferences and circumstances.

Since market transactions are often not observable for assets such as privately-held businesses and most personal and real property, FMV must be estimated. An estimate of Fair Market Value is usually subjective due to the circumstances of place, time, the existence of comparable precedents, and the evaluation principles of each involved person. Opinions on value are always based upon subjective interpretation of available information at the time of assessment. This is in contrast to an imposed value, in which a legal authority (law, tax regulation, court, etc.) sets an absolute value upon a product or a service.

A real estate sale, in lieu of an eminent domain taking, would not be considered a fair market transaction since one of the parties (i.e., the seller) was under undue pressure to enter into the transaction. Other examples of sales that would not meet the test of fair market value include a liquidation sale, deed in lieu of foreclosure, distressed sale, and similar types of transactions. There is no longer any such value in real estate appraising as Fair Market Value, the correct term is Market value.

FDIC: The Federal Deposit Insurance Corporation (FDIC) is a United States government corporation created by the Glass-Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. The FDIC insures deposits at 8,195 institutions.

New Deposit Insurance Limits – The standard insurance amount of $250,000 per depositor is in effect through December 31, 2013. On January 1, 2014, the standard insurance amount will return to $100,000 per depositor for all account categories except IRAs and other certain retirement accounts, which will remain at $250,000 per depositor. For more information visit: Deposit Insurance Simplification Fact Sheet.

Insured institutions are required to place signs at their place of business stating that “deposits are backed by the full faith and credit of the United States Government.”  Since the start of FDIC insurance on January 1, 1934, no depositor has lost a single cent of insured funds as a result of a failure.

Board of Directors

The Board of Directors of the FDIC is the governing body of the FDIC. The Board is composed of five members, three appointed by the President of the United States with the consent of the United States Senate and two ex officio members. The three appointed members each serve six year terms. No more than three members of the Board may be of the same political affiliation. The President, with the consent of the Senate, also designates one of the appointed members as Chair of the Board, to serve a five year term, and one of the appointed members as Vice Chair of the Board, to also serve a five year term.

As of 2009, the current members of the Board of Directors of the Federal Deposit Insuracance Corporation are:

History

Inception

During the 1930s, the United States and the rest of the world experienced a severe economic contraction that has now been named the Great Depression. In the United States, during the height of the Great Depression, the official unemployment rate was 25% and the stock market had declined 75% since 1929. Bank runs were common place because there wasn’t any insurance on deposits at banks, citizens ran the risk of losing all of the money that they had deposited if their bank failed.

On June 16, 1933, President Franklin D. Roosevelt signed the Banking Act of 1933. This legislation:

  • Established the FDIC as a temporary government corporation
  • Gave the FDIC authority to provide deposit insurance to banks
  • Gave the FDIC the authority to regulate and supervise state nonmember banks
  • Funded the FDIC with initial loans of $289 million through the U.S. Treasury and the Federal Reserve
  • Extended federal oversight to all commercial banks for the first time
  • Separated commercial and investment banking (Glass-Steagall Act)
  • Prohibited banks from paying interest on chequeing accounts
  • Allowed national banks to branch statewide, if allowed by state law.
  • 1934 – $2,500
  • 1935 – $5,000
  • 1950 – $10,000
  • 1966 – $15,000
  • 1969 – $20,000
  • 1974 – $40,000
  • 1980 – $100,000
  • 2008 – $250,000 (Temporary increase due to expire December 31, 2013)

Historical insurance limits

S&L and bank crisis of the 1980s

Federal deposit insurance received its first large-scale test in the late 1980s and early 1990s during the savings and loan crisis (which also affected commercial banks and savings banks).

The brunt of the crisis fell upon a parallel institution, the Federal Savings and Loan Insurance Corporation (FSLIC), created to insure savings and loan institutions (S&Ls, also called thrifts). Due to a confluence of events, much of the S&L industry was insolvent, and many large banks were in trouble as well. The FSLIC became insolvent and merged into the FDIC. Thrifts are now overseen by the Office of Thrift Supervision, an agency that works closely with the FDIC and the Comptroller of the Currency. (Credit unions are insured by the National Credit Union Administration.) The primary legislative responses to the crisis were the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), and Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA).

This crisis cost taxpayers an estimated $150 billion to resolve.

Financial Crisis of 2008 and 2009

2008

As a result of the financial crisis in 2008, twenty-five U.S. banks became insolvent and were taken over by the FDIC.[7]. However, during that year, the largest bank failure in terms of dollar value occurred on September 26, 2008 when Washington Mutual experienced a 10-day bank run on its deposits.

2009

On July 31, 2009, the FDIC launched its Legacy Loans Program (LLP). This initiative is aimed at helping banks rid their balance sheets of toxic assets so they can raise new capital and increase lending.

On August 14, 2009, Bloomberg reported that more than 150 publicly traded U.S. lenders had nonperforming loans above 5% of their total holdings. This is important because former regulators say that this is the level that can wipe out a bank’s equity and threaten its survival. While this ratio doesn’t always lead to bank failures if the banks in question have raised additional capital and have properly established reserves for the bad debt, it is an important indicator for future FDIC activity.

On August 21, 2009, the 2nd largest bank in Texas became insolvent and was taken over by BBVA of Spain. This is the first foreign company to buy a failed bank during the credit crisis of 2008 and 2009.  This transaction alone, cost the FDIC Deposit Insurance Fund $3 Billion.

On August 27, 2009, the FDIC increased the number of troubled banks to 416 in the second quarter. That number compares to 305 just three months earlier.

As of October 2, 2009, a total of 98 banks became insolvent.  This eight month tally surpasses the 50 banks that were seized in all of 1993, but is still smaller than the number of failed banking institutions in 1992, 1991, or 1990.

FDIC Funds

Former Funds

Between 1989 and 2006, there were two separate FDIC funds — the Bank Insurance Fund (BIF), and the Savings Association Insurance Fund (SAIF). The latter was established after the savings & loans crisis of the 1980s. The existence of two separate funds for the same purpose led to banks attempting to shift from one fund to another, depending on the benefits each could provide. In the 1990s, SAIF premiums were at one point five times higher than BIF premiums; several banks attempted to qualify for the BIF, with some merging with institutions qualified for the BIF to avoid the higher premiums of the SAIF. This drove up the BIF premiums as well, resulting in a situation where both funds were charging higher premiums than necessary.

Then Chairman of the Federal Reserve Alan Greenspan was a critic of the system, saying that “We are, in effect, attempting to use government to enforce two different prices for the same item – namely, government-mandated deposit insurance. Such price differences only create efforts by market participants to arbitrage the difference.” Greenspan proposed “to end this game and merge SAIF and BIF”.

Deposit Insurance Fund

In February, 2006, President George W. Bush signed into law the Federal Deposit Insurance Reform Act of 2005 (“FDIRA”) and a related conforming amendments act. The FDIRA contains technical and conforming changes to implement deposit insurance reform, as well as a number of study and survey requirements. Among the highlights of this law was merging the Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF) into a new fund, the Deposit Insurance Fund (DIF). This change was made effective March 31, 2006. The FDIC maintains the DIF by assessing depository institutions an insurance premium. The amount each institution is assessed is based both on the balance of insured deposits as well as on the degree of risk the institution poses to the insurance fund.

Bank failures typically represent a cost to the DIF because FDIC, as receiver of the failed institution, must liquidate assets that have declined substantially in value while at the same time making good on the institution’s deposit obligations.

A March 2008 memorandum to the FDIC Board of Directors shows a 2007 year-end Deposit Insurance Fund balance of about $52.4 billion, which represented a reserve ratio of 1.22% of its exposure to insured deposits totaling about $4.29 trillion. The 2008 year-end insured deposits were projected to reach about $4.42 trillion with the reserve growing to $55.2 billion, a ratio of 1.25%.  As of June 2008, the DIF had a balance of $45.2 billion.[19] However, 9 months later, in March, 2009, the DIF fell to $13 billion.  That was the lowest total since September, 1993 and represented a reserve ratio of 0.27% of its exposure to insured deposits totaling about $4.83 trillion.  In the second quarter of 2009, the FDIC imposed an emergency fee aimed at raising $5.6 billion to replenish the DIF.  However, Saxo Bank Research reported that after Aug 7th further bank failures had reduced the DIF balance to $648.1 million.  FDIC-estimated costs of assuming additional failed banks on Aug 14th exceeded that amount.  The FDIC announced its intent, on September 29, 2009 to asses the banks in advance for three years of premiums in an effort to avoid DIF insolvency. The FDIC revised its estimated costs of bank failures to about $100 billion over the next four years, an increase of $30 billion from the $70 billion estimate of earlier in 2009. The FDIC board voted to require insured banks to prepay $45 billion in premiums to replenish the fund. News media reported that the prepayment move would be inadequate to assure the financial stability of the FDIC insurance fund. The FDIC elected to request the prepayment so that the banks could recognize the expense over three years, instead of drawing down banks’ statutory capital abruptly, at the time of the assessment.  The fund is mandated by law to keep a balance equivalent to 1.15 percent of insured deposits.  As of June 30, 2008, the insured banks held approximately $7,025 billion in total deposits, though not all of those are insured.

The DIF’s reserves are not the only cash resources available to the FDIC: in addition to the $10 billion in the DIF as of August, 2009; the FDIC has $22 billion of cash and U.S. Treasury securities held as of June 30, 2009 and has the ability to borrow up to $500 billion from the Treasury. The FDIC can also demand special assessments from banks as it did in the second quarter of 2009.

“Full Faith and Credit”

In light of apparent systemic risks facing the banking system, the adequacy of FDIC’s financial backing has come into question. Beyond the funds in the Deposit Insurance Fund above and the FDIC’s power to charge insurance premia, FDIC insurance is additionally assured by the Federal government. According to the FDIC.gov website (as of January 2009), “FDIC deposit insurance is backed by the full faith and credit of the United States government”. This means that the resources of the United States government stand behind FDIC-insured depositors.”  The statutory basis for this claim is less than clear. Congress, in 1987, passed a non-binding resolution to this effect, but there appear to be no laws strictly binding the government to make good on any insurance liabilities unmet by the FDIC.

Insurance requirements

To receive this benefit, member banks must follow certain liquidity and reserve requirements. Banks are classified in five groups according to their risk-based capital ratio:

  • Well capitalized: 10% or higher
  • Adequately capitalized: 8% or higher
  • Undercapitalized: less than 8%
  • Significantly undercapitalized: less than 6%
  • Critically undercapitalized: less than 2%

When a bank becomes undercapitalized the FDIC issues a warning to the bank. When the number drops below 6% the FDIC can change management and force the bank to take other corrective action. When the bank becomes critically undercapitalized the FDIC declares the bank insolvent and can take over management of the bank.

Resolution of insolvent banks

The two most common methods employed by FDIC in cases of insolvency or illiquidity are:

  • Purchase and Assumption Method (P&A), in which all deposits (liabilities) are assumed by an open bank, which also purchases some or all of the failed bank’s loans (assets). Other failed assets are auctioned online, primarily through The Debt Exchange and First Financial Network.
  • Payout Method, in which insured deposits are paid by the FDIC, which attempts to recover its payments by liquidating the receivership estate of the failed bank. These are straight deposit payoffs and are only executed if the FDIC doesn’t receive a bid for a P&A transaction or for an insured deposit transfer transaction. In a straight deposit payoff, no liabilities are assumed and no assets are purchased by another institution. Also, the FDIC determines the insured amount for each depositor and pays that amount to him or her. In calculating each customer’s total deposit amount, the FDIC includes all the interest accrued up to the date of failure under the contractual terms of the depositor’s account.

FDIC-insured products

FDIC deposit insurance covers deposit accounts, which, by the FDIC definition, include:

Accounts at different banks are insured separately. All branches of a bank are considered to form a single bank. Also, an Internet bank that is part of a brick and mortar bank is not considered to be a separate bank, even if the name differs. Non-US citizens are also covered by FDIC insurance.

The FDIC publishes a guide entitled Your Insured Deposits, which sets forth the general contours of FDIC deposit insurance, and addresses common questions asked by bank customers about deposit insurance.

Items not insured by FDIC

Only the above types of accounts are insured. Some types of uninsured products, even if purchased through a covered financial institution, are:

Even though the word deposit appears in the name, under federal law a safe deposit box is not a deposit account – it’s a well-secured storage space rented by an institution to a customer.

  • Losses due to theft or fraud at the institution.

These situations are often covered by special insurance policies that banking institutions buy from private insurance companies.

  • Accounting errors.

In these situations, there may be remedies for consumers under state contract law, the Uniform Commercial Code, and some federal regulations, depending on the type of transaction.

Federal Reserve The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States. It was created in 1913 by the enactment of the Federal Reserve Act, largely as a response to a series of financial panics or bank runs, particularly a severe panic in 1907. Over time, the roles and responsibilities of the Federal Reserve System have expanded and its structure has evolved.  Events such as the Great Depression were some of the major factors leading to changes in the system.  Its duties today, according to official Federal Reserve documentation, fall into four general areas:

  1. Conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.
  2. Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers.
  3. Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.
  4. Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system.

Federal Reserve System is not “owned” by anyone and is not a private, profit-making institution. Instead, it is an independent entity within the government, having both public purposes and private aspects.

According to the Federal Reserve, there are presently five different parts of the Federal Reserve System:

  1. The presidentially appointed Board of Governors of the Federal Reserve System, a governmental agency in Washington, D.C.
  2. The Federal Open Market Committee (FOMC), which oversees Open Market Operations, the principal tool of national monetary policy.
  3. Twelve regional privately-owned Federal Reserve Banks located in major cities throughout the nation, which divide the nation into 12 districts, acting as fiscal agents for the U.S. Treasury, each with its own nine-member board of directors.
  4. Numerous other private U.S. member banks, which subscribe to required amounts of non-transferable stock in their regional Federal Reserve Banks.
  5. Various advisory councils.

The structure of the central banking system in the United States is unique compared to others’ in the world, in that an entity outside of the central bank creates the currency. This other entity is the United States Department of the Treasury.

History

Central banking in the United States

Main article: History of central banking in the United States

In early 1781 the Articles of Confederation & Perpetual Union were ratified so that Congress had the power to emit bills of credit. It passed later that year an ordinance to incorporate a privately subscribed national bank following in the footsteps of the Bank of England. However, it was thwarted in fulfilling its intended role as a nationwide central bank due to objections of “alarming foreign influence and fictitious credit,” favoritism to foreigners and unfair competition against less corrupt state banks issuing their own notes, such that Pennsylvania’s legislature repealed its charter to operate within the Commonwealth in 1785.

Four years after the U.S. constitution was ratified, the government adopted another central bank, the First Bank of the United States, but it would ultimately be shut down by President Madison. The Second Bank of the United States, i.e. the second central bank, met a similar fate when its charter expired under President Jackson. Both banks were, again, based upon the Bank of England, but the increased Federal power, due to the constitution, gave them more control over currency. Political opposition to central banking was the primary reason for shutting down the banks, but there was also a considerable amount of corruption in the second central bank. Ultimately, the third national bank was established in 1913 and still exists to this day. The time line of central banking in the United States is as follows:

  • 1791–1811

First Bank of the United States

  • 1811–1816

No central bank

  • 1816–1836

Second Bank of the United States

  • 1837–1862

Free Bank Era

  • 1846-1921

Independent Treasury System

  • 1863–1913

National Banks

  • 1913–Present

Federal Reserve System.

Creation of First and Second Central Bank

The first U.S. institution with central banking responsibilities was the First Bank of the United States, chartered by Congress and signed into law by President George Washington on February 25, 1791 at the urging of Alexander Hamilton. This was done despite strong opposition from Thomas Jefferson and James Madison, among numerous others. The charter was for twenty years and expired in 1811 under President James Madison.

In 1816, however, Madison revived it in the form of the Second Bank of the United States. Early renewal of the bank’s charter became the primary issue in the reelection of President Andrew Jackson. After Jackson, who was opposed to the central bank, was reelected, he pulled the government’s funds out of the bank. Nicholas Biddle, President of the Second Bank of the United States, responded by contracting the money supply to pressure Jackson to renew the bank’s charter forcing the country into a recession, which the bank blamed on Jackson’s policies. The bank’s charter was not renewed in 1836. From 1837 to 1862, in the Free Banking Era there was no formal central bank. From 1862 to 1913, a system of national banks was instituted by the 1863 National Banking Act. A series of bank panics, in 1873, 1893, and 1907, provided strong demand for the creation of a centralized banking system.

Creation of Third Central Bank

Main article: History of the Federal Reserve System

The main motivation for the third central banking system came from the Panic of 1907, which renewed demands for banking and currency reform.  During the last quarter of the 19th century and the beginning of the 20th century the United States economy went through a series of financial panics. According to proponents of the Federal Reserve System and many economists, the previous national banking system had two main weaknesses: an “inelastic” currency, and a lack of liquidity.  The following year Congress enacted the Aldrich-Vreeland Act which provided for an emergency currency and established theNational Monetary Commission to study banking and currency reform.  The American public believed that the Federal Reserve System would bring about financial stability, so that a panic like the one in 1907 could never happen again; but just 22 years later in 1929, the stock market crashed again, and the United States entered the worst depression in its history, the Great Depression. Some economists including Milton Friedman, Ben Bernanke, Robert Latham Owen and Murray Rothbard believe that the Federal Reserve System helped to cause the Great Depression.

Federal Reserve Act

Main article: Federal Reserve Act

The chief of the bipartisan National Monetary Commission was financial expert and Senate Republican leader Nelson Aldrich. Aldrich set up two commissions—one to study the American monetary system in depth and the other, headed by Aldrich himself, to study the European central-banking systems and report on them.  Aldrich went to Europe opposed to centralized banking, but after viewing Germany’s monetary system he came away believing that a centralized bank was better than the government-issued bond system that he had previously supported.

Centralized banking was met with much opposition from politicians, who were suspicious of a central bank and who charged that Aldrich was biased due to his close ties to wealthy bankers such as J.P. Morgan and his daughter’s marriage to John D. Rockefeller, Jr. Aldrich fought for a private bank with little government influence, but conceded that the government should be represented on the Board of Directors. Most Republicans favored the Aldrich Plan, but it lacked enough support in the bipartisan Congress to pass because rural and western states viewed it as favoring the “eastern establishment”.  Progressive Democrats instead favored a reserve system owned and operated by the government and out of control of the “money trust,” ending Wall Street’s control of the American currency supply. Conservative Democrats fought for a privately owned, yet decentralized, reserve system, which would still be free of Wall Street’s control.  The Federal Reserve Act passed Congress in late 1913 on a mostly partisan basis, with most all Democrats in support and most Republicans against it.  The plan that was adopted as the Federal Reserve Act had similarities to the Aldrich plan, but the balance of public and private control was modified.

1944-1971: Bretton Woods Era

Main article: Bretton Woods system

In July 1944, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States, to build a new international monetary system, which was in serious threat due to damage incurred during the Great Depression and the mounting debt of the Second World War. Their main objective was the cultivation of trade which relied on the easy convertibility of currencies. Negotiators at the Bretton Woods conference, fresh from what they perceived as a disastrous experience with floating rates in the 1930s, concluded that major monetary fluctuations could stall the free flow of trade. Planners fundamentally supported a capitalistic approach, but favored tight control on currency values.

The agreement established the rules for commercial and financial relations among the world’s major industrial states. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states. Its chief feature was to require that each country adopt a monetary policy which maintained its exchange rate with gold to within plus or minus one percent of a specified value. To do this, they set up a system of fixed exchange rates using the U.S. dollar (which was on the gold standard itself) as a reserve currency. The planners established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD) to regulate the newly devised system.

In the face of increasing financial strain, however, the Bretton Woods system collapsed in 1971, after the United States unilaterally terminated convertibility of the dollars to gold. This action caused considerable financial stress in the world economy and created the unique situation whereby the United States dollar became the “reserve currency” in the states that had signed the agreement.

1971-Present: Dollar Reserve Standard

Under the dollar reserve standard, the U.S. dollar was the most favored currency for nations of the world to use as reserves, which continued as a trend for over 30 years.  At the beginning of the dollar reserve standard, the 1970s became a period of high inflation.   As a result, in July 1979 Paul Volcker was nominated by President Carter as Chairman of the Federal Reserve Board. He tightened the money supply, and by 1986 inflation had fallen sharply.  In October 1979 the Federal Reserve announced a policy of “targeting” money aggregates and bank reserves in its struggle with double-digit inflation.

In January 1987, with retail inflation at only 1%, the Federal Reserve announced it was no longer going to use money-supply aggregates, such as M2, as guidelines for controlling inflation, even though this method had been in use from 1979, apparently with great success. Before 1980, interest rates were used as guidelines; inflation was severe. The Fed complained that the aggregates were confusing. Volcker was chairman until August 1987, whereupon Alan Greenspan assumed the mantle, seven months after monetary aggregate policy had changed.

Key laws

Key laws affecting the Federal Reserve have been:

Purpose

The primary motivation for creating the Federal Reserve System was to address banking panics.  Other purposes are stated in the Federal Reserve Act, such as “to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”  Before the founding of the Federal Reserve, the United States underwent several financial crises. A particularly severe crisis in 1907 led Congress to enact the Federal Reserve Act in 1913. Today the Fed has broader responsibilities than only ensuring the stability of the financial system.

Current functions of the Federal Reserve System include:

  • To address the problem of banking panics
  • To serve as the central bank for the United States
  • To strike a balance between private interests of banks and the centralized responsibility of government
    • To supervise and regulate banking institutions
    • To protect the credit rights of consumers
  • To manage the nation’s money supply through monetary policy to achieve the sometimes-conflicting goals of
    • maximum employment
    • stable prices, including prevention of either inflation or deflation
    • moderate long-term interest rates
  • To maintain the stability of the financial system and contain systemic risk in financial markets
  • To provide financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system
    • To facilitate the exchange of payments among regions
    • To respond to local liquidity needs
  • To strengthen U.S. standing in the world economy

Addressing the problem of bank panics

Further information: bank run and fractional-reserve banking

Bank runs occur because banking institutions in the United States are only required to hold a fraction of their depositors’ money in reserve. This practice is called fractional-reserve banking. As a result, most banks invest the majority of their depositors money. On rare occasion, too many of the bank’s customers will withdraw their savings and the bank will need help from another institution to continue operating. Bank runs can lead to a multitude of social and economic problems. The Federal Reserve was designed as an attempt to prevent or minimize the occurrence of bank runs, and possibly act as a lender of last resort if a bank run does occur. Many economists, following Milton Friedman, believe that the Federal reserve inappropriately refused to lend money to small banks during the bank runs of 1929.

Elastic currency

One way to prevent bank runs is to have a money supply that can expand when money is needed. The term “elastic currency” in the Federal Reserve Act does not just mean the ability to expand the money supply, but also to contract it. Some economic theories have been developed that support the idea of expanding or shrinking a money supply as economic conditions warrant. Elastic currency is defined by the Federal Reserve as:

Currency that can, by the actions of the central monetary authority, expand or contract in amount warranted by economic conditions.

Monetary policy of the Federal Reserve System is based partially on the theory that it is best overall to expand or contract the money supply as economic conditions change.

Cheque Clearing System

Because some banks refused to clear cheques from certain others during times of economic uncertainty, a cheque-clearing system was created in the Federal Reserve system. It is briefly described in The Federal Reserve System—Purposes and Functions as follows:

By creating the Federal Reserve System, Congress intended to eliminate the severe financial crises that had periodically swept the nation, especially the sort of financial panic that occurred in 1907. During that episode, payments were disrupted throughout the country because many banks and clearinghouses refused to clear cheques drawn on certain other banks, a practice that contributed to the failure of otherwise solvent banks. To address these problems, Congress gave the Federal Reserve System the authority to establish a nationwide cheque-clearing system. The System, then, was to provide not only an elastic currency—that is, a currency that would expand or shrink in amount as economic conditions warranted—but also an efficient and equitable cheque-collection system.

Lender of last resort

Further information: Lender of last resort

Emergencies

The Federal Reserve has the authority to act as “lender of last resort” by extending credit to depository institutions or to other entities in unusual circumstances involving a national or regional emergency, where failure to obtain credit would have a severe adverse impact on the economy.

Fluctuations

Through its discount and credit operations, Reserve Banks provide liquidity to banks to meet short-term needs stemming from seasonal fluctuations in deposits or unexpected withdrawals. Longer term liquidity may also be provided in exceptional circumstances. The rate the Fed charges banks for these loans is the discount rate (officially the primary credit rate).

By making these loans, the Fed serves as a buffer against unexpected day-to-day fluctuations in reserve demand and supply. This contributes to the effective functioning of the banking system, alleviates pressure in the reserves market and reduces the extent of unexpected movements in the interest rates. For example, on September 16, 2008, the Federal Reserve Board authorized an $85 billion loan to stave off the bankruptcy of international insurance giant American International Group (AIG). The Federal Reserve System’s role as lender of last resort is criticized for shifting risk and responsibility away from lenders and borrowers and placing them on others in the form of taxes and/or inflation.

Central bank

Further information: Central bank

In its role as the central bank of the United States, the Fed serves as a banker’s bank and as the government’s bank. As the banker’s bank, it helps to assure the safety and efficiency of the payments system. As the government’s bank, or fiscal agent, the Fed processes a variety of financial transactions involving trillions of dollars. Just as an individual might keep an account at a bank, the U.S. Treasury keeps a chequing account with the Federal Reserve through which incoming federal tax deposits and outgoing government payments are handled. As part of this service relationship, the Fed sells and redeems U.S. government securities such as savings bonds and Treasury bills, notes and bonds. It also issues the nation’s coin and paper currency. The U.S. Treasury, through its Bureau of the Mint and Bureau of Engraving and Printing, actually produces the nation’s cash supply and, in effect, sells it to the Federal Reserve Banks at manufacturing cost, currently about 4 cents per bill for paper currency. The Federal Reserve Banks then distribute it to other financial institutions in various ways.

Federal funds

Main article: Federal funds

Federal funds are the reserve balances that private banks keep at their local Federal Reserve Bank. These balances are the namesake reserves of the Federal Reserve System. The purpose of keeping funds at a Federal Reserve Bank is to have a mechanism through which private banks can lend funds to one another. This market for funds plays an important role in the Federal Reserve System as it is what inspired the name of the system and it is what is used as the basis for monetary policy. Monetary policy works by influencing how much money the private banks charge each other for the lending of these funds.

Balance between private banks and responsibility of governments

The system was designed out of a compromise between the competing philosophies of privatization and government regulation. In 2006 Donald L. Kohn, vice chairman of the Board of Governors, summarized the history of this compromise:

Agrarian and progressive interests, led by William Jennings Bryan, favored a central bank under public, rather than banker, control. But the vast majority of the nation’s bankers, concerned about government intervention in the banking business, opposed a central bank structure directed by political appointees.

The legislation that Congress ultimately adopted in 1913 reflected a hard-fought battle to balance these two competing views and created the hybrid public-private, centralized-decentralized structure that we have today.

In the current system, private banks are for-profit businesses but government regulation places restrictions on what they can do. The Federal Reserve System is a part of government that regulates the private banks. The balance between privatization and government involvement is also seen in the structure of the system. Private banks elect members of the board of directors at their regional Federal Reserve Bank while the members of the Board of Governors are selected by the President of the United States and confirmed by the Senate. The private banks give input to the government officials about their economic situation and these government officials use this input in Federal Reserve policy decisions. In the end, private banking businesses are able to run a profitable business while the U.S. government, through the Federal Reserve System, oversees and regulates the activities of the private banks.

Government regulation and supervision

The Board of Governors in the Federal Reserve System has a number of supervisory and regulatory responsibilities in the U.S. banking system, but not complete responsibility. A general description of the types of regulation and supervision involved in the U.S. banking system is given by the Federal Reserve:

The Board also plays a major role in the supervision and regulation of the U.S. banking system. It has supervisory responsibilities for state-chartered banks that are members of the Federal Reserve System, bank holding companies (companies that control banks), the foreign activities of member banks, the U.S. activities of foreign banks, and Edge Act and agreement corporations (limited-purpose institutions that engage in a foreign banking business). The Board and, under delegated authority, the Federal Reserve Banks, supervise approximately 900 state member banks and 5,000 bank holding companies. Other federal agencies also serve as the primary federal supervisors of commercial banks; the Office of the Comptroller of the Currency supervises national banks, and the Federal Deposit Insurance Corporation supervises state banks that are not members of the Federal Reserve System.

Some regulations issued by the Board apply to the entire banking industry, whereas others apply only to member banks, that is, state banks that have chosen to join the Federal Reserve System and national banks, which by law must be members of the System. The Board also issues regulations to carry out major federal laws governing consumer credit protection, such as the Truth in Lending, Equal Credit Opportunity, and Home Mortgage Disclosure Acts. Many of these consumer protection regulations apply to various lenders outside the banking industry as well as to banks.

Members of the Board of Governors are in continual contact with other policy makers in government. They frequently testify before congressional committees on the economy, monetary policy, banking supervision and regulation, consumer credit protection, financial markets, and other matters.

The Board has regular contact with members of the President’s Council of Economic Advisers and other key economic officials. The Chairman also meets from time to time with the President of the United States and has regular meetings with the Secretary of the Treasury. The Chairman has formal responsibilities in the international arena as well.

Preventing asset bubbles

The board of directors of each Federal Reserve Bank District also have regulatory and supervisory responsibilities. For example, a member bank (private bank) is not permitted to give out too many loans to people who cannot pay them back. This is because too many defaults on loans will lead to a bank run. If the board of directors has judged that a member bank is performing or behaving poorly, it will report this to the Board of Governors. This policy is described in United States Code:

Each Federal reserve bank shall keep itself informed of the general character and amount of the loans and investments of its member banks with a view to ascertaining whether undue use is being made of bank credit for the speculative carrying of or trading in securities, real estate, or commodities, or for any other purpose inconsistent with the maintenance of sound credit conditions; and, in determining whether to grant or refuse advances, rediscounts, or other credit accommodations, the Federal reserve bank shall give consideration to such information. The chairman of the Federal reserve bank shall report to the Board of Governors of the Federal Reserve System any such undue use of bank credit by any member bank, together with his recommendation. Whenever, in the judgment of the Board of Governors of the Federal Reserve System, any member bank is making such undue use of bank credit, the Board may, in its discretion, after reasonable notice and an opportunity for a hearing, suspend such bank from the use of the credit facilities of the Federal Reserve System and may terminate such suspension or may renew it from time to time.

The punishment for making false statements or reports which overvalue an asset is also stated in the U.S. Code:

Whoever knowingly makes any false statement or report, or willfully overvalues any land, property or security, for the purpose of influencing in any way…shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both.

These aspects of the Federal Reserve System are the parts intended to prevent or minimize speculative asset bubbles which ultimately lead to severe market corrections. The recent bubbles and corrections in energies, grains, equity and debt products and real estate cast doubt on the efficacy of these controls.

National payments system

The Federal Reserve plays an important role in the U.S. payments system. The twelve Federal Reserve Banks provide banking services to depository institutions and to the federal government. For depository institutions, they maintain accounts and provide various payment services, including collecting cheques, electronically transferring funds, and distributing and receiving currency and coin. For the federal government, the Reserve Banks act as fiscal agents, paying Treasury cheques; processing electronic payments; and issuing, transferring, and redeeming U.S. government securities.

In passing the Depository Institutions Deregulation and Monetary Control Act of 1980, Congress reaffirmed its intention that the Federal Reserve should promote an efficient nationwide payments system. The act subjects all depository institutions, not just member commercial banks, to reserve requirements and grants them equal access to Reserve Bank payment services. It also encourages competition between the Reserve Banks and private-sector providers of payment services by requiring the Reserve Banks to charge fees for certain payments services listed in the act and to recover the costs of providing these services over the long run.

The Federal Reserve plays a vital role in both the nation’s retail and wholesale payments systems, providing a variety of financial services to depository institutions. Retail payments are generally for relatively small-dollar amounts and often involve a depository institution’s retail clients—individuals and smaller businesses. The Reserve Banks’ retail services include distributing currency and coin, collecting cheques, and electronically transferring funds through the automated clearinghouse system. By contrast, wholesale payments are generally for large-dollar amounts and often involve a depository institution’s large corporate customers or counterparties, including other financial institutions. The Reserve Banks’ wholesale services include electronically transferring funds through the Fedwire Funds Service and transferring securities issued by the U.S. government, its agencies, and certain other entities through the Fedwire Securities Service. Because of the large amounts of funds that move through the Reserve Banks every day, the System has policies and procedures to limit the risk to the Reserve Banks from a depository institution’s failure to make or settle its payments.

The Federal Reserve Banks began a multi-year restructuring of their cheque operations in 2003 as part of a long-term strategy to respond to the declining use of cheques by consumers and businesses and the greater use of electronics in cheque processing. The Reserve Banks will have reduced the number of full-service cheque processing locations from 45 in 2003 to 4 by early 2011.

Structure

Independent within government

Further information: Central Bank Independence, List of United States independent agencies, and Independent agencies of the United States government

The Federal Reserve System is an independent government institution that has private aspects. The System is not a private organization and does not operate for the purpose of making a profit.  The stocks of the regional federal reserve banks are owned by the banks operating within that region and which are part of the system.  The System derives its authority and public purpose from the Federal Reserve Act passed by Congress in 1913. As an independent institution, the Federal Reserve System has the authority to act on its own without prior approval from Congress or the President.  The members of its Board of Governors are appointed for long, staggered terms, limiting the influence of day-to-day political considerations.  The Federal Reserve System’s unique structure also provides internal cheques and balances, ensuring that its decisions and operations are not dominated by any one part of the system. It also generates revenue independently without need for Congressional funding. Congressional oversight and statutes, which can alter the Fed’s responsibilities and control, allow the government to keep the Federal Reserve System in cheque. Since the System was designed to be independent whilst also remaining within the government of the United States, it is often said to be “independent within the government.”

The twelve Federal Reserve banks provide the financial means to operate the Federal Reserve System. Each reserve bank is organized much like a private corporation so that it can provide the necessary revenue to cover operational expenses and implement the demands of the board. Member banks are privately owned banks that must buy a certain amount of stock in the Reserve Bank within its region to be a member of the Federal Reserve System. This stock “may not be sold, traded, or pledged as security for a loan” and all member banks receive a 6% annual dividend.  No stock in any Federal Reserve Bank has ever been sold to the public, to foreigners, or to any non-bank U.S. firm.  These member banks must maintain fractional reserves either as vault currency or on account at its Reserve Bank; member banks earn no interest on either of these. The dividends paid by the Federal Reserve Banks to member banks are considered partial compensation for the lack of interest paid on the required reserves. All profit after expenses is returned to the U.S. Treasury or contributed to the surplus capital of the Federal Reserve Banks (and since shares in ownership of the Federal Reserve Banks are redeemable only at par, the nominal “owners” do not benefit from this surplus capital); the Federal Reserve system contributed over $31.7 billion to the Treasury in 2008.

Outline

Whole

  • The nation’s central bank
  • A regional structure with 12 districts
  • Subject to general Congressional authority and oversight
  • Operates on its own earnings

Board of Governors

  • 7 members serving staggered 14-year terms
  • Appointed by the U.S. President and confirmed by the Senate
  • Oversees System operations, makes regulatory decisions, and sets reserve requirements

Federal Open Market Committee

  • The System’s key monetary policymaking body
  • Decisions seek to foster economic growth with price stability by influencing the flow of money and credit
  • Composed of the 7 members of the Board of Governors and the Reserve Bank presidents, 5 of whom serve as voting members on a rotating basis

Federal Reserve Banks;

  • 12 regional banks with 25 branches
  • Each independently incorporated with a 9-member board of directors, with 6 of them elected by the member banks while the remaining 3 are designated by the Board of Governors.
  • Set discount rate, subject to approval by Board of Governors.
  • Monitor economy and financial institutions in their districts and provide financial services to the U.S. government and depository institutions.

Member banks

  • Private banks
  • Hold stock in their local Federal Reserve Bank
  • Elect six of the nine members of Reserve Banks’ boards of directors.

Advisory Committees

  • Carry out varied responsibilities

Board of Governors

The seven-member Board of Governors is the main governing body of the Federal Reserve System. It is charged with overseeing the 12 District Reserve Banks and with helping implement national monetary policy. Governors are appointed by the President of the United States and confirmed by the Senate for staggered, 14-year terms.  By law, the appointments must yield a “fair representation of the financial, agricultural, industrial, and commercial interests and geographical divisions of the country,” and as stipulated in the Banking Act of 1935, the Chairman and Vice Chairman of the Board are two of seven members of the Board of Governors who are appointed by the President from among the sitting Governors. As an independent federal government agency, the Board of Governors does not receive funding from Congress, and the terms of the seven members of the Board span multiple presidential and congressional terms. Once a member of the Board of Governors is appointed by the president, he or she functions mostly independently. The Board is required to make an annual report of operations to the Speaker of the U.S. House of Representatives. It also supervises and regulates the operations of the Federal Reserve Banks, and the US banking system in general.

Membership is generally limited to one term. However, if someone is appointed to serve the remainder of another member’s uncompleted term, he or she may be reappointed to serve an additional 14-year term. Conversely, a governor may serve the remainder of another governor’s term even after he or she has completed a full term. The law provides for the removal of a member of the Board by the President “for cause”.

The current members of the Board of Governors are

A list of every member since 1914 is also available.

Federal Open Market Committee

The Federal Open Market Committee (FOMC) created under 12 U.S.C. § 263 comprises the seven members of the board of governors and five representatives selected from the regional Federal Reserve Banks. The FOMC is charged under law with overseeing open market operations, the principal tool of national monetary policy. These operations affect the amount of Federal Reserve balances available to depository institutions, thereby influencing overall monetary and credit conditions. The FOMC also directs operations undertaken by the Federal Reserve in foreign exchange markets. The representative from the Second District, New York, is a permanent member, while the rest of the banks rotate at two- and three-year intervals. All the presidents participate in FOMC discussions, contributing to the committee’s assessment of the economy and of policy options, but only the five presidents who are committee members vote on policy decisions. The FOMC, under law, determines its own internal organization and by tradition elects the Chairman of the Board of Governors as its chairman and the president of the Federal Reserve Bank of New York as its vice chairman. Formal meetings typically are held eight times each year in Washington, D.C. Nonvoting Reserve Bank presidents also participate in Committee deliberations and discussion. The FOMC generally meets eight times a year in Telephone consultations and other meetings are held when needed.

Federal Reserve Banks

There are 12 regional Federal Reserve Banks (not to be confused with the “member banks”) with 25 branches, which serve as the operating arms of the system. Each Federal Reserve Bank is subject to oversight by the Board of Governors.  Each Federal Reserve Bank has a board of directors, whose members work closely with their Reserve Bank president to provide grassroots economic information and input on management and monetary policy decisions. These boards are drawn from the general public and the banking community and oversee the activities of the organization. They also appoint the presidents of the Reserve Banks, subject to the approval of the Board of Governors. Reserve Bank boards consist of nine members: six serving as representatives of nonbanking enterprises and the public (nonbankers) and three as representatives of banking. Each Federal Reserve branch office has its own board of directors, composed of three to seven members, that provides vital information concerning the regional economy.

The Reserve Banks opened for business on November 16, 1914. Federal Reserve Notes were created as part of the legislation to provide a supply of currency. The notes were to be issued to the Reserve Banks for subsequent transmittal to banking institutions. The various components of the Federal Reserve System have differing legal statuses.

Legal status

The Federal Reserve Banks have an intermediate legal status, with some features of private corporations and some features of public federal agencies. Each member bank owns nonnegotiable shares of stock in its regional Federal Reserve Bank. However, holding Fed stock is not like owning publicly traded stock. Fed stock cannot be sold or traded, and they do not control the Fed as a result of owning this stock. They do, however, elect six of the nine members of Reserve Banks’ boards of directors. Furthermore, the charter of each Federal Reserve Bank is established by law and cannot be altered by the member banks.  In Lewis v. United States, the United States Court of Appeals for the Ninth Circuit stated that:

The Reserve Banks are not federal instrumentalities for purposes of the FTCA [the Federal Tort Claims Act], but are independent, privately owned and locally controlled corporations.

The opinion also stated that:

The Reserve Banks have properly been held to be federal instrumentalities for some purposes.

Another decision is Scott v. Federal Reserve Bank of Kansas City in which the distinction between the Federal Reserve Banks and the Board of Governors is made.

Board of Directors

The nine member board of directors of each district is made up of 3 classes, designated as classes A, B, and C. The directors serve a term of 3 years. The makeup of the boards of directors is outlined in U.S. Code, Title 12, Chapter 3, Subchapter 7:

Class A
  • three members
  • chosen by and representative of the stockholding banks.
  • member banks are divided into 3 groups based on size—large, medium, and small banks. Each group elects one member of Class A.
  • three members
  • No director of class B shall be an officer, director, or employee of any bank
  • represent the public with due but not exclusive consideration to the interests of agriculture, commerce, industry, services, labor, and consumers.
  • member banks are divided into 3 groups based on size—large, medium, and small banks. Each group elects one member of Class B.
  • three members
  • No director of class C shall be an officer, director, employee, or stockholder of any bank
  • designated by the Board of Governors of the Federal Reserve System. They shall be elected to represent the public, and with due but not exclusive consideration to the interests of agriculture, commerce, industry, services, labor, and consumers.
  • Shall have been for at least two years residents of the district for which they are appointed, one of whom shall be designated by said board as chairman of the board of directors of the Federal reserve bank and as Federal reserve agent.
Class B
Class C

A list of all of the members of the Reserve Banks’ boards of directors is published by the Federal Reserve.

President

The Federal Reserve Act provides that the president of a Federal Reserve Bank shall be the chief executive officer of the Bank, appointed by the board of directors of the Bank, with the approval of the Board of Governors of the Federal Reserve System, for a term of five years.

The terms of all the presidents of the twelve District Banks run concurrently, ending on the last day of February of years numbered 6 and 1 (for example, 2001, 2006, and 2011). The appointment of a president who takes office after a term has begun ends upon the completion of that term. A president of a Reserve Bank may be reappointed after serving a full term or an incomplete term.

Reserve Bank presidents are subject to mandatory retirement upon becoming 65 years of age. However, presidents initially appointed after age 55 can, at the option of the board of directors, be permitted to serve until attaining ten years of service in the office or age 70, whichever comes first.

Fee: A fee is the price one pays as remuneration for services, especially the honorarium paid to a doctor, lawyer, consultant, or other member of a learned profession. Fees usually allow for overhead, wages, costs, and markup.

Traditionally, professionals in Great Britain received a fee in contradistinction to a payment, salary, or wage, and would often use guineas rather than pounds as units of account.

A contingent fee is an attorney’s fee which is reduced or not charged at all if the court case is lost by the attorney.

A service fee, service charge, or surcharge is a fee added to a customer’s bill. The purpose of a service charge often depends on the nature of the product and corresponding service provided. Examples of why this fee is charged are: travel time expenses, truck rental fees, liability and workers’ compensation insurance fees, and planning fees. UPS and FedEx have recently begun surcharges for fuel.

Restaurants and banquet halls charging service charges in lieu of tips must distribute them to their wait staff in some U.S. states (e.g., Massachusetts, New York, Montana), but in the State of Kentucky may keep them.

A fee may be a flat fee or a variable one, or part of a two-part tariff.

It is now very common in the United States for fees to be used to hide the real price of a service or product, in a widely used form of deceptive taxation and advertising.

Advance-fee fraud is a scam, although some contractors and other businesses may legitimately go bankrupt after accepting a fee in advance.

A membership fee is charged as part of a subscription business model.

Telecom

For telecommunications services such as high-speed Internet and mobile phones, an activation fee is commonly assessed, although most companies fail to include it in the advertised price, and activation means only typing some customer information into a computer. For example, as of 2008, Verizon Wireless has begun charging 20 dollars for activation of its phones, even for existing customers who want to upgrade. Customers are told that the phones can be returned or exchanged within 15 days, but are not told that the extra fee (which has been disclosed only in fine print) will not be returned, and that yet another fee will assessed against him or her for getting a different new phone, or even going back to their old one.

Another fee is the early-termination fee applied nearly-universally to cellphone contracts, supposedly to cover the remaining part of the subsidy that the provider prices the phones with. If the user terminates before the end of the term, he or she will be charged, often well over 100 dollars. In the U.S., mobile phone companies have come under heavy criticism for this anti-competitive practice, and the FCC is considering limits to prevent price gouging, such as requiring the fees to be prorated.

Many cable TV and telephone companies, including AT&T, include a regulatory-cost recovery fee in the bill each month of around three U.S. dollars, passing the blame onto government regulation, and essentially charging their customers for complying with U.S. law.

Banking

Further information: bank charge

Bank fees are assessed to customers for various services and as penalties. There are unauthorized overdraft fees, ATM usage fees, fees for having an account balance under a required amount. Some banks charge a fee for using tellers in an effort to encourage customers to use automated services instead.[1], The fees have come in for criticism as excessive from consumer advocates. They have also targeted banks practices the maximize the assessment of fees and fees that can add up to many times the amount of small transactions.

U.S. banks extract fees from automatic teller machine transactions that are made at rival banks, even if the customer’s home bank has no branch in a particular area (such as when the customer is on vacation). Customers are sometimes charged twice, both by the bank that owns the ATM, and again by their bank. Bank of America charges a denial fee, literally a fee for refusing service to the customer (if there are insufficient funds or a daily limit), and a fee to simply check the account balance at a “foreign” (other bank’s) ATM.

Following the 2008 financial crisis and legislation passed by Congress, banks have modified many credit card agreements with customers sometimes increasing interest rates or reducing credit limits.

Renting

Like an activation fee, a setup fee is often charged by places that rent space or other things. In the case of self-storage businesses, this negates claims of “only one dollar for the first month” made by Public Storage and others. Apartment complexes often charge fees for pets (mainly dogs and cats). Some complexes euphemistically call these a non-refundable deposit, ignoring the definition of a deposit as inherently being refundable.

Real estate

A title company or attorney collects a variety of fees in the course of handling the purchase of a house. These may include fees for tax service, flood certification, underwriting, appraisal, credit report, record deed, record deed trust, loan signing and processing.

Event tickets

With respect to events tickets, online reservations and payments, and other transactions, there is sometimes a service charge (often called a convenience fee) that serves as additional compensation for the company facilitating the transaction. Ticketmaster and others charge this, and have made a business model of it. However, such groups have a monopoly on particular events or even entire concert venues.

Air travel

Airlines have long charged fees for changing flights, and for excess luggage. However, with the oil price increases since 2003, many are increasing fees. In May 2008, it was announced that some would be charging even for just one checked bag, making it nearly impossible to avoid. Airlines have also invented fees for nearly every “service” that has always previously been included in the ticket price. While the extra income may be necessary to prevent bankruptcy, the practice of not including mandatory fees in the stated price is deceptive.

Airports also charge landing fees to airlines in order to cover costs, particularly airport security.

Customer service

Some businesses charge fees just for talking to a customer service representative. DirecTV charges this when ordering a pay-per-view movie via telephone instead of through the set-top box. Some companies charge for technical support, either prepaid or by using a premium-rate telephone number (such as the 1-900 numbers in North America). In the 2000s, some banks in the U.S. began charging a fee just to visit a teller, prompting such customer anger that the banks were forced to back down.[citation needed]

Speaking

Main article: Speaking fee

A speaking fee is a payment awarded to an individual for speaking at a public event. Sometimes it is used as a way to pass money to individuals which would otherwise be prohibited.

Late fees

Late fees are charged when payment is not received by a deadline. These are supposedly intended to get people to pay rent or other charges on time, but these are sometimes exorbitant, or extremely out of proportion to the amount of money which is late. They can also add insult to injury for people who have hit hard financial times, making their situation worse. When added to credit card bills or check cardstatements, it may also cause an overlimit or NSF fee, creating an endless and inescapable cycle of fees that trigger other fees for people aleady stretched to their financial limit.

Retail

Some retail stores add fees, mainly for “guest passes” at membership warehouses like Costco and Sam’s Club, where membership dues have not been paid.

There are a few other “cost-plus” stores, however, that add ten percent or so at checkout, using the lower shelf price to trick consumers into erroneous comparison shopping. At Food Depot and other smaller low-end chain stores like this, the shelf price may be 1.95, when the shopper will actually be charged 2.15 in the end, in a sort of legalized bait and switch. (Furthermore, a disclaimer indicates the shelf price is not even the actual cost to the store.)

Early termination

An early-termination fee is charged by a company when a customer wants or needs to be released from a contract before it expires. One example is when a renter leaves an apartment before a year-long contract is over. If tenants rent for a shorter period, or month-to-month, they are instead charged significantly more per month, and are often denied any promotional deals. Mobile phone companies in the U.S. are notorious for huge early-termination fees, typically starting at 175 dollars, and falling by only a few dollars per month, no matter the actual cost of or subsidy to the phone.

Some mortgage companies also charge early payment penalties if the homeowner pays more than is due in order to reduce the interest owed and to shorten the remaining term of the loan. The fees typically negate this advantage at least in part.

There are also fees charged for any type of termination. In the suburban Atlanta county of Gwinnett for example, customers were hit with termination fees of over 23 dollars when the county commission chose not to renew the contracts of the county trash collectors in November 2008. The two companies charged this both in violation of county law and in breach of contract.

Infrastructure and environment

An impact fee is a charge which a developer must pay to local government, in order to raise money for capital improvements to roads, libraries, and other services upon which the new land development places a burden. This prevents existing residents from being forced to pay in taxes, in addition to already having to put-up with the traffic, noise, and environmental damage of the new development.

Government

Public resources

A user fee is a fee paid for the use of a public resource, like a park. This is most common for national parks, and often also state parks or provincial parks, and for privately-owned areas.

Licenses and permits

Fees are usually charged for various government services, including license plates and annual motor vehicle registration, as well as driver licenses and professional licensing. Fees are also charged for various permits, like demolition and building permits, rezoning, and land grading (which causes silt); and sometimes for increasing stormwater runoff, destroying native vegetation, and cutting-down healthy trees.

Deceptive use

Sometimes fee is used to whitewash what are actually penalties or taxes. For example, Virginia’s now-repealed Civil Remedial Fees were actually a tax on drivers with certain kinds of traffic law violations.

Schooling

At public universities and community colleges, students are charged tuition and matriculation, when can themselves be considered fees charged per credit hour. However, the term student fees typically refers to additional charges which the student is required to pay, typically no matter how many hours the student is taking in the academic term.

Commonly this is a student activity fee, which helps to fund student organizations, particularly those which are academic in nature; and those which serve all students equally, like student government and student media. A newer fee is the technology fee, which is often charged to students by schools when state government funding fails to meet needs for computers and other classroom technology. Students may also be charged a health fee which usually covers the campus nurse, and possibly a visit to a local clinic if the student is ill.

Parking fees are normally optional, because students may not have their own automobiles. However, many U.S. schools are now forcing meal plans on their students, particularly those that stay in dorms, and some force freshmen to stay in the dorms. Generally, all fees except parking are covered under scholarships, whether they are from private, government, or lottery funds. However, at least one U.S. state (Georgia) began denying HOPE Scholarship money for any new fees added, even by its own state schools.

Finance: Finance studies and addresses the ways in which individuals, businesses and organizations raise, allocate and use monetary resources over time, taking into account the risks entailed in their projects.

Essence of finance

The term finance may incorporate any of the following:

Branches of finance

Fundamental financial concepts

History of finance

Financial analysis: Financial analysis refers to an assessment of the viability, stability and profitability of a business, sub-business or project.

It is performed by professionals who prepare reports using ratios that make use of information taken from financial statements and other reports. These reports are usually presented to top management as one of their bases in making business decisions. Based on these reports, management may:

  • Continue or discontinue its main operation or part of its business;
  • Make or purchase certain materials in the manufacture of its product;
  • Acquire or rent/lease certain machineries and equipment in the production of its goods;
  • Issue stocks or negotiate for a bank loan to increase its working capital;
  • Make decisions regarding investing or lending capital;
  • Other decisions that allow management to make an informed selection on various alternatives in the conduct of its business.

Goals

Financial analysts often assess the firm’s:

1. Profitability – its ability to earn income and sustain growth in both short-term and long-term. A company’s degree of profitability is usually based on the income statement, which reports on the company’s results of operations;

2. Solvency – its ability to pay its obligation to creditors and other third parties in the long-term;
3. Liquidity – its ability to maintain positive cash flow, while satisfying immediate obligations;

Both 2 and 3 are based on the company’s balance sheet, which indicates the financial condition of a business as of a given point in time.

4. Stability- the firm’s ability to remain in business in the long run, without having to sustain significant losses in the conduct of its business. Assessing a company’s stability requires the use of both the income statement and the balance sheet, as well as other financial and non-financial indicators.

Methods

Financial analysts often compare financial ratios (of solvency, profitability, growth, etc.):

  • Past Performance – Across historical time periods for the same firm (the last 5 years for example),
  • Future Performance – Using historical figures and certain mathematical and statistical techniques, including present and future values, This extrapolation method is the main source of errors in financial analysis as past statistics can be poor predictors of future prospects.
  • Comparative Performance – Comparison between similar firms.

These ratios are calculated by dividing a (group of) account balance(s), taken from the balance sheet and / or the income statement, by another, for example :

n / equity = return on equity

Net income / total assets = return on assets

Stock price / earnings per share = P/E-ratio

Comparing financial ratios are merely one way of conducting financial analysis. Financial ratios face several theoretical challenges:

  • They say little about the firm’s prospects in an absolute sense. Their insights about relative performance require a reference point from other time periods or similar firms.
  • One ratio holds little meaning. As indicators, ratios can be logically interpreted in at least two ways. One can partially overcome this problem by combining several related ratios to paint a more comprehensive picture of the firm’s performance.
  • Seasonal factors may prevent year-end values from being representative. A ratio’s values may be distorted as account balances change from the beginning to the end of an accounting period. Use average values for such accounts whenever possible.
  • Financial ratios are no more objective than the accounting methods employed. Changes in accounting policies or choices can yield drastically different ratio values.
  • They fail to account for exogenous factors like investor behavior that are not based upon economic fundamentals of the firm or the general economy (fundamental analysis).

Financial instrument: Financial instruments are cash, evidence of an ownership interest in an entity, or a contractual right to receive, or deliver, cash or another financial instrument.

Categorization

Financial instruments can be categorized by form depending on whether they are cash instruments or derivative instruments:

Alternatively, financial instruments can be categorized by “asset class” depending on whether they are equity based (reflecting ownership of the issuing entity) or debt based (reflecting a loan the investor has made to the issuing entity). If it is debt, it can be further categorized into short term (less than one year) or long term.

Foreign Exchange instruments and transactions are neither debt nor equity based and belong in their own category.

Financial market: In economics, a financial market is a mechanism that allows people to easily buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect the efficient-market hypothesis.

Financial markets have evolved significantly over several hundred years and are undergoing constant innovation to improve liquidity.

Both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded) exist. Markets work by placing many interested buyers and sellers in one “place”, thus making it easier for them to find each other. An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy in contrast either to a command economy or to a non-market economy such as a gift economy.

In finance, financial markets facilitate –

– and are used to match those who want capital to those who have it.

Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of interest or dividends.

In mathematical finance, the concept of a financial market is defined in terms of a continuous-time Brownian motion stochastic process.

Definition

In economics, typically, the term market means the aggregate of possible buyers and sellers of a thing and the transactions between them.

The term “market” is sometimes used for what are more strictly exchanges, organizations that facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (like the NYSE) or an electronic system (like NASDAQ). Much trading of stocks takes place on an exchange; still, corporate actions(merger, spinoff) are outside an exchange, while any two companies or people, for whatever reason, may agree to sell stock from the one to the other without using an exchange.

Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a stock exchange, and people are building electronic systems for these as well, similar to stock exchanges.

Financial markets can be domestic or they can be international.

Types of financial markets

The financial markets can be divided into different subtypes:

The capital markets consist of primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or buy existing securities.

Raising capital

To understand financial markets, let us look at what they are used for, i.e. what is their purpose?

Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks help in this process. Banks take deposits from those who have money to save. They can then lend money from this pool of deposited money to those who seek to borrow. Banks popularly lend money in the form of loans and mortgages.

More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties. A good example of a financial market is a stock exchange. A company can raise money by selling shares to investors and its existing shares can be bought or sold.

Lenders

Individuals

Many individuals are not aware that they are lenders, but almost everybody does lend money in many ways. A person lends money when he or she:

  • puts money in a savings account at a bank;
  • contributes to a pension plan;
  • pays premiums to an insurance company;
  • invests in government bonds; or
  • invests in company shares.

Companies

Companies tend to be borrowers of capital. When companies have surplus cash that is not needed for a short period of time, they may seek to make money from their cash surplus by lending it via short term markets called money markets.

There are a few companies that have very strong cash flows. These companies tend to be lenders rather than borrowers. Such companies may decide to return cash to lenders (e.g. via a share buyback.) Alternatively, they may seek to make more money on their cash by lending it (e.g. investing in bonds and stocks.)

Borrowers

Individuals

Individuals borrow money via bankers’ loans for short term needs or longer term mortgages to help finance a house purchase.

Companies

Companies borrow money to aid short term or long term cash flows. They also borrow to fund modernization or future business expansion.

Governments

Governments often find their spending requirements exceed their tax revenues. To make up this difference, they need to borrow. Governments also borrow on behalf of nationalized industries, municipalities, local authorities and other public sector bodies. In the UK, the total borrowing requirement is often referred to as the Public sector net cash requirement (PSNCR).

Governments borrow by issuing bonds. In the UK, the government also borrows from individuals by offering bank accounts and Premium Bonds. Government debt seems to be permanent. Indeed the debt seemingly expands rather than being paid off. One strategy used by governments to reduce the value of the debt is to influence inflation.

Municipalities and local authorities may borrow in their own name as well as receiving funding from national governments. In the UK, this would cover an authority like Hampshire County Council.

Public Corporations typically include nationalized industries. These may include the postal services, railway companies and utility companies.

Many borrowers have difficulty raising money locally. They need to borrow internationally with the aid of Foreign exchange markets.

Derivative products

During the 1980s and 1990s, a major growth sector in financial markets is the trade in so called derivative products, or derivatives for short.

In the financial markets, stock prices, bond prices, currency rates, interest rates and dividends go up and down, creating risk. Derivative products are financial products which are used to control risk or paradoxically exploit risk. It is also called financial economics.

Currency markets

Main article: Foreign exchange market

Seemingly, the most obvious buyers and sellers of currency are importers and exporters of goods. While this may have been true in the distant past, when international trade created the demand for currency markets, importers and exporters now represent only 1/32 of foreign exchange dealing, according to the Bank for International Settlements.

The picture of foreign currency transactions today shows:

  • Banks/Institutions
  • Speculators
  • Government spending (for example, military bases abroad)
  • Importers/Exporters
  • Tourists

Analysis of financial markets

See Statistical analysis of financial markets, statistical finance

Much effort has gone into the study of financial markets and how prices vary with time. Charles Dow, one of the founders of Dow Jones & Company and The Wall Street Journal, enunciated a set of ideas on the subject which are now called Dow Theory. This is the basis of the so-called technical analysis method of attempting to predict future changes. One of the tenets of “technical analysis” is that market trends give an indication of the future, at least in the short term. The claims of the technical analysts are disputed by many academics, who claim that the evidence points rather to the random walk hypothesis, which states that the next change is not correlated to the last change.

The scale of changes in price over some unit of time is called the volatility. It was discovered by Benoît Mandelbrot that changes in prices do not follow a Gaussian distribution, but are rather modeled better by Lévy stable distributions. The scale of change, or volatility, depends on the length of the time unit to a power a bit more than 1/2. Large changes up or down are more likely than what one would calculate using a Gaussian distribution with an estimated standard deviation.

A new area of concern is the proper analysis of international market effects. As connected as today’s global financial markets are, it is important to realize the there are both benefits and consequences to a global financial network. As new opportunities appear due to integration, so do the possibilities of contagion. This presents unique issues when attempting to analyze markets, as a problem can ripple through the entire connected global network very quickly. For example, a bank failure in one country can spread quickly to others, which proper analysis more difficult.

Financial market slang

  • Geek, a Quant
  • Grim, an ageless person known for his/her whistle and tendency to relate current events to financial market
  • Nerd, a Quant
  • Quant, a quantitative analyst skilled in the black arts of PhD level (and above) mathematics and statistical methods
  • Rocket scientist, a financial consultant at the zenith of mathematical and computer programming skill. They are able to invent derivatives of frightening complexity and construct sophisticated pricing models. They generally handle the most advanced computing techniques adopted by the financial markets since the early 1980s. Typically, they are physicists and engineers by training; rocket scientists do not necessarily build rockets for a living.
  • White Knight, a friendly party in a takeover bid. Used to describe a party that buys the shares of an organization to help prevent the takeover of that organization by another party (that is making a hostile bid).
  • Poison pill, measures taken by a company to prevent being bought out by another company by issuing a more number of shares, thereby increasing the no. of outstanding shares to be bought by the hostile company making the bid to establish majority.

Financial ratio: In finance, a financial ratio or accounting ratio is a ratio of two selected numerical values taken from an enterprise’s financial statements. There are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm’s creditors. Security analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

Ratios may be expressed as a decimal value, such as 0.10, or given as an equivalent percent value, such as 10%. Some ratios are usually quoted as percentages, especially ratios that are usually or always less than 1, such as earnings yield, while others are usually quoted as decimal numbers, especially ratios that are usually more than 1, such as P/E ratio; these latter are also called multiples. Given any ratio, one can take its reciprocal; if the ratio was above 1, the reciprocal will be below 1, and conversely. The reciprocal expresses the same information, but may be more understandable: for instance, the earnings yield can be compared with bond yields, while the P/E ratio cannot be: for example, a P/E ratio of 20 corresponds to an earnings yield of 5%.

Sources of data for financial ratios

Values used in calculating financial ratios are taken from the balance sheet, income statement, statement of cash flows or (sometimes) the statement of retained earnings. These comprise the firm’s “accounting statements” or financial statements. The statements’ data is based on the accounting method and accounting standards used by the organization.

Purpose and types of ratios

Financial ratios quantify many aspects of a business and are an integral part of financial statement analysis. Financial ratios are categorized according to the financial aspect of the business which the ratio measures. Liquidity ratios measure the availability of cash to pay debt.  Activity ratios measure how quickly a firm converts non-cash assets to cash assets.  Debt ratios measure the firm’s ability to repay long-term debt.  Profitability ratios measure the firm’s use of its assets and control of its expenses to generate an acceptable rate of return.  Market ratios measure investor response to owning a company’s stock and also the cost of issuing stock.

Financial ratios allow for comparisons

  • between companies
  • between industries
  • between different time periods for one company
  • between a single company and its industry average

Ratios generally hold no meaning unless they are benchmarked against something else, like past performance or another company. Thus, the ratios of firms in different industries, which face different risks, capital requirements, and competition are usually hard to compare.

Accounting methods and principles

Financial ratios may not be directly comparable between companies that use different accounting methods or follow various standard accounting practices. Most public companies are required by law to use generally accepted accounting principles for their home countries, but private companies, partnerships and sole proprietorships may not use accrual basis accounting. Large multi-national corporations may use International Financial Reporting Standards to produce their financial statements, or they may use the generally accepted accounting principles of their home country.

There is no international standard for calculating the summary data presented in all financial statements, and the terminology is not always consistent between companies, industries, countries and time periods.

Abbreviations and terminology

Various abbreviations may be used in financial statements, especially financial statements summarized on the Internet. Sales reported by a firm are usually net sales, which deduct returns, allowances, and early payment discounts from the charge on an invoice. Net income is always the amount after taxes, depreciation, amortization, and interest, unless otherwise stated. Otherwise, the amount would be EBIT, or EBITDA (see below).

Companies that are primarily involved in providing services with labor do not generally report “Sales” based on hours. These companies tend to report “revenue” based on the monetary value of income that the services provide.

Note that Shareholder’s Equity and Owner’s Equity are not the same thing, Shareholder’s Equity represents the total number of shares in the company multiplied by each share’s book value; Owner’s Equity represents the total number of shares that an individual shareholder owns (usually the owner with controlling interest), multiplied by each share’s book value. It is important to make this distinction when calculating ratios.

Other abbreviations

(Note: These are not ratios, but values in currency.)

Financial statements: Financial statements (or financial reports) are formal records of the financial activities of a business, person, or other entity. In British English, including United Kingdom company law, financial statements are often referred to as accounts, although the term financial statements is also used, particularly by accountants.

Financial statements provide an overview of a business or person’s financial condition in both short and long term. All the relevant financial information of a business enterprise, presented in a structured manner and in a form easy to understand, are called the financial statements. There are four basic financial statements:

  1. Balance sheet: also referred to as statement of financial position or condition, reports on a company’s assets, liabilities, and Ownership equity at a given point in time.
  2. Income statement: also referred to as Profit and Loss statement (or a “P&L”), reports on a company’s income, expenses, and profits over a period of time.  Profit & Loss account provide information on the operation of the enterprise. These include sale and the various expenses incurred during the processing state.
  3. Statement of retained earnings: explains the changes in a company’s retained earnings over the reporting period.
  4. Statement of cash flows: reports on a company’s cash flow activities, particularly its operating, investing and financing activities.

For large corporations, these statements are often complex and may include an extensive set of notes to the financial statements and management discussion and analysis. The notes typically describe each item on the balance sheet, income statement and cash flow statement in further detail. Notes to financial statements are considered an integral part of the financial statements.

Purpose of financial statements

“The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.”  Financial statements should be understandable, relevant, reliable and comparable. Reported assets, liabilities and equity are directly related to an organization’s financial position. Reported income and expenses are directly related to an organization’s financial performance.

Financial statements are intended to be understandable by readers who have “a reasonable knowledge of business and economic activities and accounting and who are willing to study the information diligently.”  Financial statements may be used by users for different purposes:

  • Owners and managers require financial statements to make important business decisions that affect its continued operations. Financial analysis is then performed on these statements to provide management with a more detailed understanding of the figures. These statements are also used as part of management’s annual report to the stockholders.
  • Employees also need these reports in making collective bargaining agreements (CBA) with the management, in the case of labor unions or for individuals in discussing their compensation, promotion and rankings.
  • Prospective investors make use of financial statements to assess the viability of investing in a business. Financial analyses are often used by investors and are prepared by professionals (financial analysts), thus providing them with the basis for making investment decisions.
  • Financial institutions (banks and other lending companies) use them to decide whether to grant a company with fresh working capital or extend debt securities(such as a long-term bank loan or debentures) to finance expansion and other significant expenditures.
  • Government entities (tax authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company.
  • Vendors who extend credit to a business require financial statements to assess the creditworthiness of the business.
  • Media and the general public are also interested in financial statements for a variety of reasons.

Government financial statements

See also: Fund accounting

The rules for the recording, measurement and presentation of government financial statements may be different from those required for business and even for non-profit organizations. They may use either of two accounting methods: accrual accounting, or cash accounting, or a combination of the two (OCBOA). A complete set of chart of accounts is also used that is substantially different from the chart of a profit-oriented business.

Audit and legal implications

Although laws differ from country to country, an audit of the financial statements of a public company is usually required for investment, financing, and tax purposes. These are usually performed by independent accountants or auditing firms. Results of the audit are summarized in an audit report that either provide an unqualified opinion on the financial statements or qualifications as to its fairness and accuracy. The audit opinion on the financial statements is usually included in the annual report.

There has been much legal debate over who an auditor is liable to. Since audit reports tend to be addressed to the current shareholders, it is commonly thought that they owe a legal duty of care to them. But this may not be the case as determined by common law precedent. In Canada, auditors are liable only to investors using a prospectus to buy shares in the primary market. In the United Kingdom, they have been held liable to potential investors when the auditor was aware of the potential investor and how they would use the information in the financial statements. Nowadays auditors tend to include in their report liability restricting language, discouraging anyone other than the addressees of their report from relying on it. Liability is an important issue: in the UK, for example, auditors have unlimited liability.

In the United States, especially in the post-Enron era there has been substantial concern about the accuracy of financial statements. Corporate officers (the chief executive officer (CEO) and chief financial officer(CFO)) are personally liable for attesting that financial statements “do not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by th[e] report.” Making or certifying misleading financial statements exposes the people involved to substantial civil and criminal liability. For example Bernie Ebbers (former CEO of WorldCom) was sentenced to 25 years in federal prison for allowing WorldCom’s revenues to be overstated by $11 billion over five years.

Standards and regulations

Different countries have developed their own accounting principles over time, making international comparisons of companies difficult. To ensure uniformity and comparability between financial statements prepared by different companies, a set of guidelines and rules are used. Commonly referred to as Generally Accepted Accounting Principles (GAAP), these set of guidelines provide the basis in the preparation of financial statements.

Recently there has been a push towards standardizing accounting rules made by the International Accounting Standards Board (“IASB”). IASB develops International Financial Reporting Standards that have been adopted by Australia, Canada and the European Union (for publicly quoted companies only), are under consideration in South Africa and other countries. The United States Financial Accounting Standards Board has made a commitment to converge the U.S. GAAP and IFRS over time.

Inclusion in annual reports

To entice new investors, most public companies assemble their financial statements on fine paper with pleasing graphics and photos in an annual report to shareholders, attempting to capture the excitement and culture of the organization in a “marketing brochure” of sorts. Usually the company’s chief executive will write a letter to shareholders, describing management’s performance and the company’s financial highlights.

In the United States, prior to the advent of the internet, the annual report was considered the most effective way for corporations to communicate with individual shareholders. Blue chip companies went to great expense to produce and mail out attractive annual reports to every shareholder. The annual report was often prepared in the style of a coffee table book.

FICO score: FICO (NYSE: FICO), founded in 1956 as Fair Isaac by engineer Bill Fair and mathematician Earl Isaac, provides consulting services and enterprise decision management systems. They developed the FICO scores, a measure of credit risk, which are the most used credit scores in the world. FICO scores are available through all of the major consumer reporting agencies in the United States and Canada: Equifax; Experian; TransUnion; and PRBC. FICO is a registered trademark of Fair Isaac Corporation.

FICO is based in Minneapolis, Minnesota, United States. The company has offices in North America, South America, Europe, Australia and Asia. The company employs about 2,200 people (as of 2009) and earned revenue of about US$745 million in 2008.

FICO’s client list covers more than 1,400 financial-service providers, including 99 of the top 100 US banks and 49 of the top 50 global banks.  More than 200 retailers, including nine of the top 10 retail card issuers in the US use FICO retail management software. FICO serves more than 100 telecommunications providers worldwide, including the top 10 US wireless providers and six of the world’s top 10 telecommunications service providers.

Company milestones

  • 1958: Fair Isaac starts building credit scoring systems.
  • 1970: First credit card scoring system delivered.
  • 1975: First behavior scoring system to predict credit risk related to existing customers.
  • 1981: Introduction of Fair Isaac credit bureau try to scores.
  • 1986: IPO, stock listed at NASDAQ.
  • 1991: Introduction of TRIAD, a credit card management system.
  • 1996: Stock moves from NASDAQ to NYSE.
  • 1997: The American Bankers Association honors Bill Fair and Earl Isaac with Distinguished Service Award for their pioneering work in credit scoring.
  • 2002: Merger with HNC Software, Inc., adding fraud detection to their arsenal with the $100 million Falcon product line and strengthening their analytics offerings in the insurance and telecommunications markets.
  • 2003: Fair, Isaac and Company is renamed Fair Isaac Corporation.
  • 2004: Acquisition of London Bridge Software, expanding services to credit collections and recovery software. Opens a new analytic consulting and product development center in Bangalore, India targeted primarily at Asia Pacific markets.
  • 2005: Acquisition of RulesPower, bringing Rete III algorithm to Blaze Advisor.
  • 2006: Celebrates 50th anniversary.
  • 2008: Fair Isaac released Debt Manager 7
  • 2009: Company name changed from Fair Isaac, to FICO (FICO means Fair Isaac Corporation). Website changed to fico.com

Financial accountancy: Financial accountancy (or financial accounting) is the field of accountancy concerned with the preparation of financial statements for decision makers, such as stockholders, suppliers, banks, employees, government agencies, owners, and other stakeholders. The fundamental need for financial accounting is to reduce principal-agent problem by measuring and monitoring agents’ performance and reporting the results to interested users.

Financial accountancy is used to prepare accounting information for people outside the organization or not involved in the day to day running of the company. Managerial accounting provides accounting information to help managers make decisions to manage the business.

In short, Financial Accounting is the process of summarizing financial data taken from an organization’s accounting records and publishing in the form of annual (or more frequent) reports for the benefit of people outside the organization.

Financial accountancy is governed by both local and international accounting standards.

Basic accounting concepts

Financial accountants produce financial statements based on Generally Accepted Accounting Principles of a respective country.

Financial accounting serves following purposes:

  • producing general purpose financial statements
  • provision of information used by management of a business entity for decision making, planning and performance evaluation
  • for meeting regulatory requirements

Financial distress: Financial distress is a term in Corporate Finance used to indicate a condition when promises to creditors of a company are broken or honored with difficulty. Sometimes financial distress can lead to bankruptcy. Financial distress is usually associated with some costs to the company; these are known as costs of financial distress.

Cost of financial distress

A common example of a cost of financial distress is bankruptcy costs. These direct costs include auditors’ fees, legal fees, management fees and other payments. Cost of financial distress can occur even if bankruptcy is avoided (indirect costs):

Financial distress in companies can lead to problems that can reduce the efficiency of management. As maximizing firm value and maximizing shareholder value cease to be equivalent managers who are responsible to shareholders might try to transfer value from creditors to shareholders.

The result is a conflict of interest between bondholders (creditors) and shareholders. As a firm’s liquidation value slips below its debt, it is the shareholder’s interest for the company to invest in risky projects which increase the probability of the firm’s value to rise over debt. Risky projects are not in the interest of creditors, since they also increase the probability of the firms value to decrease further, leaving them with even less. Since these projects do not necessarily have a positive net present value, costs may arise from lost profits.

Equally, management might chose to prolong bankruptcy, which has the same effect on probabilities of a change in the firm’s value. Management might also distribute high dividends to “save” money from the creditors.

Another source of indirect costs of financial distress are higher costs of capital: Short-term loans by contractors and banks are expensive and difficult to obtain.

Valuation

Companies in financial distress undergo corporate restructuring where valuations are used as negotiating tools. This distinction between negotiation and process is a difference between financial restructuring and corporate finance.

Additional modifications to a valuation approach, whether it is market-, income- or asset-based, may be necessary in some instances. There are other adjustments to the financial statements that have to be made when valuing a distressed company.

Options for Relieving Financial Distress

Debt restructuring is a process that allows a private or public company or a sovereign entity facing cash flow problems and financial distress, to reduce and renegotiate its delinquent debts in order to improve or restore liquidity and rehabilitate so that it can continue its operations.

If promises to creditors cannot be kept, bankruptcy is an option for both companies and individuals. In the United Kingdom, the Individual Voluntary Arrangement is a formal alternative to bankruptcy for individuals.

Financial instrument: Financial instruments are cash, evidence of an ownership interest in an entity, or a contractual right to receive, or deliver, cash or another financial instrument.

Categorization

Financial instruments can be categorized by form depending on whether they are cash instruments or derivative instruments:

Alternatively, financial instruments can be categorized by “asset class” depending on whether they are equity based (reflecting ownership of the issuing entity) or debt based (reflecting a loan the investor has made to the issuing entity). If it is debt, it can be further categorized into short term (less than one year) or long term.

Foreign Exchange instruments and transactions are neither debt nor equity based and belong in their own category.

Financial statement: Financial statements (or financial reports) are formal records of the financial activities of a business, person, or other entity. In British English, including United Kingdom company law, financial statements are often referred to as accounts, although the term financial statements is also used, particularly by accountants.

Financial statements provide an overview of a business or person’s financial condition in both short and long term. All the relevant financial information of a business enterprise, presented in a structured manner and in a form easy to understand, are called the financial statements. There are four basic financial statements.

  1. Balance sheet: also referred to as statement of financial position or condition, reports on a company’s assets, liabilities, and Ownership equity at a given point in time.
  2. Income statement: also referred to as Profit and Loss statement (or a “P&L”), reports on a company’s income, expenses, and profits over a period of time.  Profit & Loss account provide information on the operation of the enterprise. These include sale and the various expenses incurred during the processing state.
  3. Statement of retained earnings: explains the changes in a company’s retained earnings over the reporting period.
  4. Statement of cash flows: reports on a company’s cash flow activities, particularly its operating, investing and financing activities.

For large corporations, these statements are often complex and may include an extensive set of notes to the financial statements and management discussion and analysis. The notes typically describe each item on the balance sheet, income statement and cash flow statement in further detail. Notes to financial statements are considered an integral part of the financial statements.

Financial transactions: A financial transaction is an event or condition under the contract between a buyer and a seller to exchange an asset for payment. In accounting, it is recognized by an entry in the books of account. It involves a change in the status of the finances of two or more businesses or individuals.

Purchase

This is the most common type of financial transaction. An item or good is exchanged for money. This transaction results in a decrease in the finances of the purchaser and an increase in the benefits of the sellers. An example is a real estate transaction.

The Loan

This is a slightly more complicated transaction in which the lender gives a single large amount of money to the borrower now in return for many smaller repayments of the borrower to the lender over time, usually on a fixed schedule. The smaller delayed repayments usually add up to more than the first large amount. The difference in payments is called interest. Here, money is given for not any specific reason.

Mortgage

This is a combined loan and purchase in which a lender gives a large amount of money to a borrower for the specific purpose of purchasing a very expensive item (most often a house). As part of the transaction, the borrower usually agrees to give the item (or some other high value item) to the lender if the loan is not paid back on time. This guarantee of repayment is known as collateral.

Bank account

Main article: Bank account

A bank is a business that is based almost entirely on financial transactions. In addition to acting as a lender for loans and mortgages, banks act as a borrower in a special type of loan called an account. The lender is known as a customer and gives unspecified amounts of money to the bank for unspecified amounts of time. The bank agrees to repay any amount in the account at any time and will pay small amounts of interest on the amount of money that the customer leaves in the account for a certain period of time. In addition, the bank guarantees that the money will not be stolen while it is in the account and will reimburse the customer if it is. In return, the bank gets to use the money for other financial transactions as long as they hold it.

Credit-card purchase

This is a special combination of a purchase and a loan. The seller gives the buyer the good or item as normal, but the buyer pays the seller using a credit card. In this way, the buyer is paying with a loan from the credit card company, usually a bank. The bank or other financial institution issues credit cards to buyers that allow any number of loans up to a certain cumulative amount. Repayment terms for credit card loans, or debts vary, but the interest is often extremely high. An example of common repayment terms would be a minimum payment of the greater of $10 or 3% every month and a 15-20% interest charge for any unpaid loan amount. In addition to interest, buyers are sometimes charged a yearly fee to use the credit card.

In order to collect the money for their item, the seller must apply to the credit card company with a signed receipt. Sellers usually apply for many payments at regular intervals. The seller is also charged a fee of normally 1-3% of the purchase price by the credit card company for the privilege of accepting that brand of credit card for purchases.  Thus, in a credit card purchase, the transfer of the item is immediate, but all payments are delayed.

Debit-card purchase

This is a special type of purchase. The item or good is transferred as normal, but the purchaser uses a debit card instead of money to pay. A debit card contains an electronic record of the purchaser’s account with a bank. Using this card, the seller is able to send an electronic signal to the buyer’s bank for the amount of the purchase, and that amount of money is simultaneously debited from the customer’s account and credited to the account of the seller. This is possible even if the buyer or seller use different financial institutions. Currently, fees to both the buyer and seller for the use of debit cards are fairly low because the banks want to encourage the use of debit cards. The seller must have a card reader set up in order for such purchases to be made. Debit cards allow a buyer to have access to all the funds in his account without having to carry the money around. It is more difficult to steal such funds than cash, but it is still done. See also skimming and shoulder surfing.

Five percent policy: NASD policy to limit commissions, markups, and markdowns to five percent. This is a guideline rather than a rule because a number of other factors must also be considered.

Fixed income: Fixed income refers to any type of investment that yields a regular (or fixed) return.

For example, if you lend money to a borrower and the borrower has to pay interest once a month, you have been issued a fixed-income security. When a company does this, it is often called a bond or corporate bank debt (although “preferred stock” is also sometimes considered to be fixed income). Sometimes people misspeak when they talk about fixed income. Bonds actually have higher risk, while notes and bills have less risk because these are issued by government agencies.

The term fixed income is also applied to a person’s income that does not vary with each period. This can include income derived from fixed-income investments such as bonds and preferred stocks or pensions that guarantee a fixed income. When pensioners or retirees are dependent on their pension as their dominant source of income, the term “fixed income” can also carry the implication that they have relatively limited discretionary income or have little financial freedom to make large expenditures.

Fixed-income securities can be contrasted with variable return securities such as stocks. In order for a company to grow as a business, it often must raise money; to finance an acquisition, buy equipment or land or invest in new product development. Investors will only give money to the company if they believe that they will be given something in return commensurate with the risk profile of the company. The company can either pledge a part of itself, by giving equity in the company (stock), or the company can give a promise to pay regular interest and repay principal on the loan (bond or bank loan) or (preferred stock).

While a bond is simply a promise to pay interest on borrowed money, there is some important terminology used by the fixed-income industry:

  • The issuer is the entity (company or govt.) who borrows an amount of money (issuing the bond) and pays the interest.
  • The principal (of a bond) is the amount that the issuer borrows.
  • The coupon (of a bond) is the interest that the issuer must pay.
  • The maturity is the end of the bond, the date that the issuer must return the principal.
  • The issue is another term for the bond itself.
  • The indenture is the contract that states all of the terms of the bond.

People who invest in fixed-income securities are typically looking for a constant and secure return on their investment. For example, a retired person might like to receive a regular dependable payment to live on, but not consume principal. This person can buy a bond with their money, and use the coupon payment (the interest) as that regular dependable payment. When the bond matures or is refinanced, the person will have their money returned to them.

Interest rates change over time, based on a variety of factors, particularly rates set by the Federal Reserve. For example, if a company wants to raise $1 million and not a lot of people in the market have free cash to lend, the company will have to offer a high rate of interest (coupon) to get people to buy their bond. If there are a lot of people in the market trying to get a return on their money, the company can offer a lower coupon.

To complicate matters further, fixed income securities are actually traded on the open market, just like stocks. To understand this, first realize that bonds are usually created in round face values, for example $100,000. If the current yield (interest rate) of newly issued similar bonds is 6% per year, and you are buying a bond with a coupon rate below 6%, then you can get the bond at a discount (below face value of $100,000), which brings your rate of return on that bond to 6%. Similarly, if the coupon rate of the bond you are buying is greater than 6% you will have to pay a premium for the bond to bring the rate of return down to 6%.

There are also index-linked, fixed-income securities. The most common and an example of the highest rated variety of this kind could include Treasury Inflation Protected Securities (TIPS). This type of fixed income is adjusted to the Consumer Price Index for all urban consumers (CPI-U), and then a real yield is applied to the adjusted principal. This means that the US Treasury issues fixed income that is backed by the full faith and credit of the US government to outperform the CPI (e.g. to outperform the inflation rate). This allows investors of all sizes to not lose the purchasing power of their money due to inflation, which can be very uncertain at times. For example, assuming 3.88% inflation over the course of 1 year (just about the 56 year average inflation rate, through most of 2006), and a real yield of 2.61% (the fixed US Treasury real yield on October 19, 2006, for a 5 yr TIPS), the adjusted principal of the fixed income would rise from 100 to 103.88 and then the real yield would be applied to the adjusted principal, meaning 103.88 x 1.0261, which equals 106.5913; giving a total return of 6.5913%. TIPS moderately outperform conventional US Treasuries, which yield just 5.05% for a 1 yr bill on October 19, 2006. By investing in such fixed income, index linked fixed income securities, consumers can exceed the pace of inflation, and gain value in real terms.

All fixed income securities from any entity have risks including but not limited to:

  • inflationary risk
  • interest rate risk
  • currency risk
  • default risk
  • repayment of principal risk
  • reinvestment risk
  • liquidity risk
  • maturity risk
  • streaming income payment risk
  • duration risk
  • convexity risk
  • credit quality risk
  • political risk
  • tax adjustment risk
  • market risk
  • climate risk
  • event risk

Forward contract: A forward contract or simply a forward is an agreement between two parties to buy or sell an asset at a certain future time for a certain price agreed today.  This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged.

The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party.

Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.

A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not marked to market, exchange traded, or defined on standardized assets.  Forwards also typically have no interim partial settlements or “true-ups” in margin requirements like futures – such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. A forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain.

How a forward contract works

Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year’s time of $104,000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract.

At the end of one year, suppose that the current market valuation of Andy’s house is $110,000. Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one needs only to recognize that Bob can buy from Andy for $104,000 and immediately sell to the market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000.

The similar situation works among currency forwards, where one party opens a forward contract to buy or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time. As the exchange rate between U.S. dollars and Canadian dollars fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one party gains and the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward is opened as the investor will actually need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward does so even though they may not truly need Canadian dollars and are simply hedging currency risk, but they are speculating on the currency, expecting the exchange rate to move favorably in order to generate a gain on closing the contract.

In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy $100 million Canadian dollars equivalent to, say $114.4 million USD at the current rate—these two amounts are called the notional amount(s)). While the notional amount or reference amount may be a large number, the cost or margin requirement to command or open such a contract is considerably less that that amount, which refers to the leverage created, which is typical in derivative (finance) contracts.

Example of how forward prices should be agreed upon

Continuing on the example above, suppose now that the initial price of Andy’s house is $100,000 and that Bob enters into a forward contract to buy the house one year from today. But since Andy knows that he can immediately sell for $100,000 and place the proceeds in the bank, he wants to be compensated for the delayed sale. Suppose that the risk free rate of return R (the bank rate) for one year is 4%. Then the money in the bank would grow to $104,000, risk free. So Andy would want at least $104,000 one year from now for the contract to be worthwhile for him – the opportunity cost will be covered.

Spot – Forward parity

Main article: Forward price

See also: Cost of carry and convenience yield

Spot-forward parity provides the link between the spot market and the forward market. It describes the relationship between the spot and forward price of the underlying asset in a forward contract. While the overall effect can be described as the cost of carry, this effect can be broken down into different components, specifically whether the asset:

  • pays income, and if so whether this is on a discrete or continuous basis
  • incurs storage costs
  • is regarded as an investment asset, that is an asset held primarily for investment purposes (eg gold, financial securities); or a consumption asset, that is an asset held primarily for consumption (eg oil, iron ore etc)

Relationship between the forward price and the expected future spot price

Main articles: Normal backwardation and Contango

The market’s opinion about what the spot price of an asset will be in the future is the expected future spot price.  Hence, a key question is whether or not the current forward price actually predicts the respective spot price in the future. There are a number of different hypotheses which try to explain the relationship between the current forward price, F0 and the expected future spot price, E(ST).

The economists John Maynard Keynes and John Hicks argued that in general, the natural hedgers of a commodity are those who wish to sell the commodity at a future point in time.  Thus, hedgers will collectively hold a net short position in the forward market. The other side of these contracts are held by speculators, who must therefore hold a net long position. Hedgers are interested in reducing risk, and thus will accept losing money on their forward contracts. Speculators on the other hand, are interested in making a profit, and will hence only enter the contracts if they expectto make money. Thus, if speculators are holding a net long position, it must be the case that the expected future spot price is greater than the forward price.

This market situation, where E(ST) > F0, is referred to as normal backwardation. Since, forward/futures prices converge with the spot price at maturity (see Basis), normal backwardation implies that futures prices for a certain maturity are increasing over time. The opposite situation, where E(ST) < F0, is referred to as contango. Likewise, contango implies that futures prices for a certain maturity are falling over time.

Rational pricing

If St is the spot price of an asset at time t, and r is the continuously compounded rate, then the forward price at a future time T must satisfy Ft,T = Ster(T ? t).

To prove this, suppose not. Then we have two possible cases.

Case 1: Suppose that Ft,T > Ster(T ? t). Then an investor can execute the following trades at time t:

  1. go to the bank and get a loan with amount St at the continuously compounded rate r;
  2. with this money from the bank, buy one unit of stock for St;
  3. enter into one short forward contract costing 0. A short forward contract means that the investor owes the counterparty the stock at time T.

The initial cost of the trades at the initial time sum to zero.

At time T the investor can reverse the trades that were executed at time t. Specifically, and mirroring the trades 1., 2. and 3. the investor

  1. ‘ repays the loan to the bank. The inflow to the investor is ? Ster(T ? t);
  2. ‘ settles the short forward contract by selling the stock for Ft,T. The cash inflow to the investor is now Ft,T because the investor receives ST from the buyer; there is an inflow of funds to the investor ofFt,T ? Ster(T ? t).

The sum of the inflows in 1.’, 2.’ and 3.’ equals Ft,T ? Ster(T ? t), which by hypothesis, is positive. This is an arbitrage profit. Consequently, and assuming that the non-arbitrage condition holds, we have a contradiction. This is called a cash and carry arbitrage because you “carry” the stock until maturity.

Case 2: Suppose that Ft,T < Ster(T ? t). Then an investor can do the reverse of what he has done above in case 1. But if you look at the convenience yield page, you will see that if there are finite stocks/inventory, the reverse cash and carry arbitrage is not always possible. It would depend on the elasticity of demand for forward contracts and such like.

Extensions to the forward pricing formula

Suppose that FVT(X) is the time value of cash flows X at the contract expiration time T. The forward price is then given by the formula:

The cash flows can be in the form of dividends from the asset, or costs of maintaining the asset.

If these price relationships do not hold, there is an arbitrage opportunity for a riskless profit similar to that discussed above. One implication of this is that the presence of a forward market will force spot prices to reflect current expectations of future prices. As a result, the forward price for nonperishable commodities, securities or currency is no more a predictor of future price than the spot price is – the relationship between forward and spot prices is driven by interest rates. For perishable commodities, arbitrage does not have this

The above forward pricing formula can also be written as:

Ft,T = (St ? It)er(T ? t)

Where It is the time t value of all cash flows over the life of the contract.

For more details about pricing, see forward price.

Theories of why a forward contract exists

Allaz and Vila (1993) suggest that there is also a strategic reason (in an imperfect competitive environment) for the existence of forward trading, that is, forward trading can be used even in a world without uncertainty. This is due to firms having Stackelberg incentives to anticipate their production through forward contracts.

Floor broker: A floor broker is a member of an exchange who is an employee of a member firm and executes orders, as agent, on the floor of the exchange for clients. The floor broker receives an order via teletype machine from his firm’s trading department and then proceeds to the appropriate trading post on the exchange floor. There he joins other brokers and the specialist in the security being bought or sold and executes the trade at the best competitive price available. On completion of the transaction the customer is notified through his registered representative back at the firm and the trade is printed on the consolidated ticker tape which is displayed electronically around the country. A floor broker should not be confused with a Floor Trader who trades as a principal for his or her own account, rather than as a broker.

Floor trader: A floor trader is a member of a stock or commodities exchange who trades on the floor of that exchange for his or her own account. The floor trader must abide by trading rules similar to those of the exchange specialists who trade on behalf of others. The term should not be confused with Floor broker. Floor Traders are occasionally referred to as Registered Competitive Traders, Individual Liquidity Providers or locals.

Fraud: In the broadest sense, a fraud is an intentional deception made for personal gain or to damage another individual. The specific legal definition varies by legal jurisdiction. Fraud is a crime, and is also a civil law violation. Many hoaxes are fraudulent, although those not made for personal gain are not technically frauds. Defrauding people of money is presumably the most common type of fraud, but there have also been many fraudulent “discoveries” in art, archaeology, and science.

Types of fraudulent acts

Fraud can be committed through many methods, including mail, wire, phone, and the internet (computer crime and internet fraud). The difficulty of chequing identity and legitimacy online, and the ease with which hackers can divert browsers to dishonest sites and steal credit card details, the international dimensions of the web and ease with which users can hide their location, all contribute to making internet fraud the fastest growing area of fraud.

Acts which may constitute criminal fraud include:

Elements of fraud

Common law fraud has nine elements:

  1. a representation of an existing fact;
  2. its materiality;
  3. its falsity;
  4. the speaker’s knowledge of its falsity;
  5. the speaker’s intent that it shall be acted upon by the plaintiff;
  6. plaintiff’s ignorance of its falsity;
  7. plaintiff’s reliance on the truth of the representation;
  8. plaintiff’s right to rely upon it; and
  9. consequent damages suffered by plaintiff.

Most jurisdictions in the United States require that each element be pled with particularity and be proved with clear, cogent, and convincing evidence (very probable evidence) to establish a claim of fraud. The measure of damages in fraud cases is to be computed by the “benefit of bargain” rule, which is the difference between the value of the property had it been as represented, and its actual value. Special damages may be allowed if shown proximately caused by defendant’s fraud and the damage amounts are proved with specificity.

Notable fraudsters

  • Buddy Adkins & Johnny Bonanno, US: Spector Freight Systems owner(s) falsely represented as a legitimate trucking firm to swindle tens of thousands from transportation firms by false pretenses. Also used cheque fraud as well as wire and mail fraud.
  • Frank Abagnale Jr., US impostor who wrote bad cheques and falsely represented himself as a qualified member of professions such as airline pilot, doctor, and attorney. The film Catch Me If You Can is based on his life.
  • Eddie Antar, founder of Crazy Eddie, who has about $1 billion worth of judgments against him stemming from fraudulent accounting practices at that company.
  • Cassie Chadwick, who pretended to be Andrew Carnegie‘s daughter to get loans.
  • Charles Dawson, an amateur British archeologist who claimed to have found the Piltdown man.
  • Marc Dreier, Managing founder of Attorney firm Dreir LLP. Prosecutors allege that from 2004 through December 2008, He sold approximately $700 million worth of fictitious promissory notes.
  • Richard Eaton, an English businessman who was business partners with mobster Paul Vario and Jimmy Burke and was involved in the Lufthansa heist. An associate of the Lucchese crime family
  • Bernard Ebbers, founder of WorldCom, which inflated its asset statements by about $11 billion.
  • Ramón Báez Figueroa, banker from the Dominican Republic and former president of Banco Intercontinental. Sentenced on October 21, 2007 to ten years in prison for a US$2.2 billion fraud case that drove the Caribbean nation into an economic crisis in 2003.
  • Martin Frankel is a former U.S. financier, convicted in 2002 of insurance fraud worth $208 million, racketeering and money laundering.
  • Samuel Israel III (1959)- Former hedge fund manager that ran the former fraudulent Bayou Hedge Fund Group. He had pretended to faked suicide.
  • Konrad Kujau, German fraudster and forger responsible for the “Hitler Diaries“.
  • Kenneth Lay, the American businessman who built energy company Enron. He was one of the highest paid CEOs in America until he was ousted as Chairman and was convicted of fraud and conspiracy, although as a result of his death, his conviction was vacated.
  • Nick Leeson, English trader whose unsupervised speculative trading caused the collapse of Barings Bank.
  • James Paul Lewis, Jr., ran one of the biggest ($311 million) and longest running Ponzi Schemes (20 years) in US history.
  • Gregor MacGregor, Scottish conman who tried to attract investment and settlers for the non-existent country of Poyais.
  • Bernard L. Madoff, creator of a $65 billion Ponzi scheme – the largest investor fraud ever attributed to a single individual.
  • Colleen McCabe, British headmistress who stole £½ million from her school.
  • Gaston Means, a professional conman during U.S. President Warren G. Harding‘s administration.
  • Matt the Knife, American born con artist, card cheat and pickpocket who, from the ages of approximately 14 through 21, bilked dozens of casinos, corporations and at least one Mafia crime family out of untold sums.
  • Michael Milken, “The Junk Bond King”.
  • Barry Minkow and the ZZZZ Best scam.
  • Michael Monus, founder of Phar-Mor, which ultimately cost its investors more than $1 billion.
  • F. Bam Morrison, who conned the town of Wetumka, Oklahoma by promoting a circus that never came.
  • Lou Pearlman, former boy-band manager indicted by a federal grand jury in Orlando on charges that he schemed to bilk banks out of more than $100 million.
  • Frederick Emerson Peters, US impersonator who wrote bad cheques.
  • Charles Ponzi and the Ponzi scheme.
  • Alves Reis, who forged documents to print 100,000,000 PTE in official escudo banknotes (adjusted for inflation, it would be worth about US$150 million today).
  • Christopher Rocancourt, a Rockefeller impersonator who defrauded Hollywood celebrities.
  • John Spano, a struggling businessman who faked massive success in an attempt to buy out the New York Islanders of the NHL.
  • Robert Allen Stanford (1950)- American businessman head of Stanford Financial Group accused of running a huge $8 billion dollar Ponzi scheme.
  • John Stonehouse, the last Postmaster-General of the UK and MP who faked his death.
  • Kevin Trudeau (1963) – US writer and billiards promoter, convicted of fraud and larceny in 1991, known for a series of late-night infomercials and his series of books about “Natural Cures “They” Don’t Want You to Know About”.
  • Richard Whitney, who stole from the New York Stock Exchange Gratuity Fund in the 1930s.
  • In the UK a report concluded that the total costs of fraud and dealing with fraud in the year 2005-2006 was at least 13.9 Billion GBP.

Fraudulent trading: Fraudulent trading is an insolvency law concept, and in particular a UK insolvency law concept. It refers to a company that has carried on business with intent to defraud creditors.

Law

Where during the course of a winding-up it appears to the liquidator that fraudulent trading has occurred, the liquidator may apply to the court for an order any persons who were knowingly parties to the carrying on of such business are to be made liable to make such contributions (if any) to the company’s assets as the court thinks proper.

Conceptually, fraudulent trading is similar to a fraudulent conveyance, but the key distinction is that an application to have a transaction set aside as a fraudulent conveyance usually requires to the third party beneficiary to disgorge the benefit of the conveyance to undo the loss to the company’s assets, whereas a court order in relation to fraudulent trading it is the responsible parties (usually the directors) who must make up the loss and the third party beneficiaries will usually retain the benefit. However, it is perfectly possible for a single transaction to be simultaneously fraudulent trading and a fraudulent conveyance, and to be the subject on concurrent applications. Some legal systems permit a director who makes a contribution to the company’s assets pursuant to an order for fraudulent trading to subrogated to any claim that the company might have with respect to a fraudulent conveyance.

In practice, applications for orders in respect of fraudulent trading are rare because of the high burden of proof associated with fraud. Usually, even where fraudulent trading is suspected, an application is made with respect to an allegation of “wrongful trading” (or “insolvent trading”) where the burden of proof is lower. Where applications are brought for fraudulent trading it is usually because when the trading occurred, the company was not insolvent at that time (insolvency at the time of the trading is normally a requirement to establish wrongful trading, but not fraudulent trading).

The effect of a successful application for fraudulent trading varies between different legal systems. In some countries the assets contributed by the directors are treated as general assets which may be taken by any secured creditors who may have a security interest which attaches to all the company’s assets (characteristically, a floating charge). However, some countries have “ring-fenced” payments made for fraudulent trading so that they are made available to the pool of assets for unsecured creditors.

Fraudulent trading is entirely separate and distinct from “insider trading“, which focuses purely upon the abuse of inside information in relation to financial markets for personal financial gain, and is wholly unrelated to creditor’s rights or insolvency law.

Cases

Fully paid securities: Securities held in a cash account for which full payment has been made.

Futures contract: Futures contract, in finance, refers to a standardized contract to buy or sell a specified commodity of standardized quality at a certain date in the future, at a market determined price (the futures price). The contracts are traded on a futures exchange. Futures contracts are not “direct” securities like stocks, bonds, rights or warrants. They are still securities, however, though they are a type of derivative contract.

The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract.

In many cases, the underlying asset to a futures contract may not be traditional “commodities” at all – that is, for financial futures, the underlying asset or item can be currencies, securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates.

The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day’s trading session on the exchange is called the settlement price for that day of business on the exchange at a price specified today.

A futures contract gives the holder the obligation to make or take delivery under the terms of the contract, whereas an option grants the buyer the right, but not the obligation, to establish a position previously held by the seller of the option. In other words, the owner of an options contract may exercise the contract, but both parties of a “futures contract” must fulfill the contract on the settlement date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position, effectively closing out the futures position and its contract obligations.

Futures contracts, or simply futures, (but not future or future contract) are exchange traded derivatives. The exchange’s clearinghouse acts as counterparty on all contracts, sets margin requirements, and crucially also provides a mechanism for settlement.

Origin

Aristotle described the story of Thales, a poor philosopher from Miletus who developed a “financial device, which involves a principle of universal application.” Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with local olive-press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or poor and because the olive-press owners were willing to hedge against the possibility of a poor yield. When the harvest-time came, and many presses were wanted all at once and of a sudden, he let them out at any rate he pleased, and made a large quantity of money.

The first futures exchange market was the D?jima Rice Exchange in Japan in the 1730s, to meet the needs of samurai who – being paid in rice, and after a series of bad harvests – needed a stable conversion to coin.

Futures versus forwards

While futures and forward contracts are both contracts to deliver an asset on a future date at a prearranged price, they are different in two main respects:

Thus futures are standardized and face an exchange, while forwards are customized and face a non-exchange counterparty.

  • Futures are margined, while forwards are not.

Thus futures have significantly less credit risk, and have different funding.

Exchange versus OTC

Futures are always traded on an exchange, whereas forwards always trade over-the-counter, or can simply be a signed contract between two parties.

Thus:

  • Futures are highly standardized, being exchange-traded, whereas forwards can be unique, being over-the-counter.
  • In the case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty for delivery on a futures contract is chosen by the clearing house.

Margining

For more details on Margin, see Margin (finance).

Forwards transact only when purchased and on the settlement date. Futures, on the other hand, are margined daily, every day to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset (based on mark to market).

The result is that forwards have higher credit risk than futures, and that funding is charged differently.

The fact that forwards are not margined daily means that, due to movements in the price of the underlying asset, a large differential can build up between the forward’s delivery price and the settlement price, and in any event, the unrealized gain (loss) over the entire life of the contract is open or not settled up until settlement. Again, this differs from futures which get ‘trued-up’ typically daily by a comparison of the market value of the future to the collateral securing the contract to keep it in line with the brokerage margin requirements. This true-ing up occurs by the “loss” party providing additional collateral; so if the buyer of the contract incurs a drop in value, the shortfall or variation margin would typically be shored up by the investor wiring or depositing additional cash in the brokerage account.

In a forward though, the spread in exchange rates is not trued up regularly but, rather, it builds up as unrealized gain (loss) depending on which side of the trade being discussed. This means that entire unrealized gain (loss) becomes realized at the time of delivery (or as what typically occurs, the time the contract is closed prior to expiration) – assuming the parties must transact at the underlying currency’s spot price to facilitate receipt/delivery.

In most cases involving institutional investors, the daily variation margin settlement guidelines for futures call for actual money movement only above some insignificant amount to avoid wiring back and forth small sums of cash. The threshold amount for daily futures variation margin for institutional investors is often $1,000.

The situation for forwards, however, where no daily true-up takes place in turn creates credit risk for forwards, but not so much for futures. Simply put, the risk of a forward contract is that the supplier will be unable to deliver the referenced asset, or that the buyer will be unable to pay for it on the delivery date or the date at which the opening party closes the contract.

The margining of futures eliminates much of this credit risk by forcing the holders to update daily to the price of an equivalent forward purchased that day. This means that there will usually be very little additional money due on the final day to settle the futures contract: only the final day’s gain or loss, not the gain or loss over the life of the contract.

In addition, the daily futures-settlement failure risk is borne by an exchange, rather than an individual party, further limiting credit risk in futures.
Example: Consider a futures contract with a $100 price: Let’s say that on day 50, a futures contract with a $100 delivery price (on the same underlying asset as the future) costs $88. On day 51, that futures contract costs $90. This means that the “mark-to-market” calculation would require the holder of one side of the future to pay $2 on day 51 to track the changes of the forward price (“post $2 of margin”). This money goes, via margin accounts, to the holder of the other side of the future. That is, the loss party wires cash to the other party.

A forward-holder, however, would pay nothing until settlement on the final day, potentially building up a large balance; this may be reflected in the mark by an allowance for credit risk. So, except for tiny effects of convexity bias (due to earning or paying interest on margin), futures and forwards with equal delivery prices result in the same total loss or gain, but holders of futures experience that loss/gain in daily increments which track the forward’s daily price changes, while the forward’s spot price converges to the settlement price. Thus, while under mark to market accounting, for both assets the gain or loss accrues over the holding period; for a futures this gain or loss is realized daily, while for a forward contract the gain or loss remains unrealized until expiry.

Note that, due to the path dependence of funding, a futures contract is not, strictly speaking, a European derivative: the total gain or loss of the trade depends not only on the value of the underlying asset at expiry, but also on the path of prices on the way. This difference is generally quite small though.

Nonconvergence

Some exchanges tolerate ‘nonconvergence’, the failure of futures contracts and the value of the physical commodities they represent to reach the same value on ‘contract settlement’ day at the designated delivery points. An example of this is the CBOT (Chicago Board of Trade) Soft Red Winter wheat (SRW) futures. SRW futures have settled more than 20¢ apart on settlement day and as much as $1.00 difference between settlement days. Only a few participants holding CBOT SRW futures contracts are qualified by the CBOT to make or receive delivery of commodities to settle futures contracts. Therefore, it’s impossible for almost any individual producer to ‘hedge’ efficiently when relying on the final settlement of a futures contract for SRW. The trend is for the CBOT continuing to restrict those entities that can actually participate in settling contracts with commodity to those that can ship or receive large quantities of railroad cars and multiple barges at a few selected sites. The Commodity Futures Trading Commission, which has oversight of the futures market in the United States, has made no comment as to why this trend is allowed to continue since economic theory and CBOT publications maintain that convergence of contracts with the price of the underlying commodity they represent is the basis of integrity for a futures market. It follows that the function of ‘price discovery’, the ability of the markets to discern the appropriate value of a commodity reflecting current conditions, is degraded in relation to the discrepancy in price and the inability of producers to enforce contracts with the commodities they represent.

Standardization

Futures contracts ensure their liquidity by being highly standardized, usually by specifying:

  • The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate.
  • The type of settlement, either cash settlement or physical settlement.
  • The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.
  • The currency in which the futures contract is quoted.
  • The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content and API specific gravity, as well as the pricing point — the location where delivery must be made.
  • The delivery month.
  • The last trading date.
  • Other details such as the commodity tick, the minimum permissible price fluctuation.

Margin

To minimize credit risk to the exchange, traders must post a margin or a performance bond, typically 5%-15% of the contract’s value.

To minimize counterparty risk to traders, trades executed on regulated future exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders to transact without performing due diligence on their counterparty.

Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position.

Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers’ open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers.

Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Also referred to as performance bond margin.

Initial margin is the equity required to initiate a futures position. This is a type of performance bond. The maximum exposure is not limited to the amount of the initial margin, however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. Initial margin is set by the exchange.
If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned.

In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Often referred to as “variation margin”, margin called for this reason is usually done on a daily basis, however, in times of high volatility a broker can make a margin call or calls intra-day.

Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. After the position is closed-out the client is liable for any resulting deficit in the client’s account.

Some U.S. exchanges also use the term “maintenance margin”, which in effect defines by how much the value of the initial margin can reduce before a margin call is made. However, most non-US brokers only use the term “initial margin” and “variation margin”.

The Initial Margin requirement is established by the Futures exchange, in contrast to other securities Initial Margin (which is set by the Federal Reserve in the U.S. Markets).

A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level.

Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in his margin account.

Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he doesn’t want to be subject to margin calls.

Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit.

Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. For example if a trader earns 10% on margin in two months, that would be about 77% annualized.

Settlement – physical versus cash-settled futures

Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:

  • Physical delivery – the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position – that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long). The Nymex crude futures contract uses this method of settlement upon expiration.
  • Cash settlement – a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires. Cash settled futures are those that, as a practical matter, could not be settled by delivery of the referenced item – ie how would one deliver an index? A futures contract might also opt to settle against an index based on trade in a related spot market. Ice Brent futures use this method.

Expiry (or Expiration in the U.S.) is the time and the day that a particular delivery month of a futures contract stops trading and the final settlement price for that contract month and year obtains. For many equity index and interest rate futures contracts (as well as for most equity options), this happens on the third Friday of certain trading month. On this day the t+1 futures contract becomes the t futures contract. For example, for most CME and CBOT contracts, at the expiration of the December contract, the March futures become the nearest contract. This is an exciting time for arbitrage desks, which try to make quick profits during the short period (perhaps 30 minutes) during which the underlying cash price and the futures price sometimes struggle to converge. At this moment the futures and the underlying assets are extremely liquid and any disparity between an index and an underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions. On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour.

Pricing

When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a future is determined via arbitrage arguments. This is typical for stock index futures, treasury bond futures, and futures on physical commodities when they are in supply (e.g. corn after the harvest). However, when the deliverable commodity is not in plentiful supply or when it does not yet exist – for example on wheat before the harvest or on Eurodollar Futures or Federal funds rate futures (in which the supposed underlying instrument is to be created upon the delivery date) – the futures price cannot be fixed by arbitrage. In this scenario there is only one force setting the price, which is simple supply and demand for the asset in the future, as expressed by supply and demand for the futures contract.

Arbitrage arguments

Arbitrage arguments (“Rational pricing“) apply when the deliverable asset exists in plentiful supply, or may be freely created. Here, the forward price represents the expected future value of the underlying discounted at the risk free rate—as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away; see rational pricing of futures.

This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields.

In a perfect market the relationship between futures and spot prices depends only on the above variables; in practice there are various market imperfections (transaction costs, differential borrowing and lending rates, restrictions on short selling) that prevent complete arbitrage. Thus, the futures price in fact varies within arbitrage boundaries around the theoretical price.

Pricing via expectation

When the deliverable commodity is not in plentiful supply (or when it does not yet exist) rational pricing cannot be applied, as the arbitrage mechanism is not applicable. Here the price of the future is determined by today’s supply and demand for the asset in the future.

In a deep and liquid market, supply and demand would be expected to balance out at a price which represents an unbiased expectation of the future price of the actual asset and so be given by the simple relationship.

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By contrast, in a shallow and illiquid market, or in a market in which large quantities of the deliverable asset have been deliberately withheld from market participants (an illegal action known as cornering the market), the market clearing price for the future may still represent the balance between supply and demand but the relationship between this price and the expected future price of the asset can break down.

Relationship between arbitrage arguments and expectation

The expectation based relationship will also hold in a no-arbitrage setting when we take expectations with respect to the risk-neutral probability. In other words: a futures price is martingale with respect to the risk-neutral probability. With this pricing rule, a speculator is expected to break even when the futures market fairly prices the deliverable commodity.

Contango and backwardation

The situation where the price of a commodity for future delivery is higher than the spot price, or where a far future delivery price is higher than a nearer future delivery, is known as contango. The reverse, where the price of a commodity for future delivery is lower than the spot price, or where a far future delivery price is lower than a nearer future delivery, is known as backwardation.

Futures contracts and exchanges

Contracts

There are many different kinds of futures contracts, reflecting the many different kinds of “tradable” assets about which the contract may be based such as commodities, securities (such as single-stock futures), currencies or intangibles such as interest rates and indexes. For information on futures markets in specific underlying commodity markets, follow the links. For a list of tradable commodities futures contracts, see List of traded commodities. See also the futures exchange article.

Trading on commodities began in Japan in the 18th century with the trading of rice and silk, and similarly in Holland with tulip bulbs. Trading in the US began in the mid 19th century, when central grain markets were established and a marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (also called spot or cash market) or for forward delivery. These forward contracts were private contracts between buyers and sellers and became the forerunner to today’s exchange-traded futures contracts. Although contract trading began with traditional commodities such as grains, meat and livestock, exchange trading has expanded to include metals, energy, currency and currency indexes, equities and equity indexes, government interest rates and private interest rates.

Exchanges

Contracts on financial instruments were introduced in the 1970s by the Chicago Mercantile Exchange (CME) and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. This innovation led to the introduction of many new futures exchanges worldwide, such as the London International Financial Futures Exchange in 1982 (now Euronext.liffe), Deutsche Terminbörse (now Eurex) and the Tokyo Commodity Exchange (TOCOM). Today, there are more than 90 futures and futures options exchanges worldwide trading to include:

Who trades futures?

Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying asset (which could include an intangible such as an index or interest rate) and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and opening a derivative (finance) contract related to the asset “on paper”, while they have no practical use for or intent to actually take or make delivery of the underlying asset. In other words, the investor is seeking exposure to the asset in a long future or the opposite effect via a short future contract.

Hedgers typically include producers and consumers of a commodity or the owner of an asset or assets subject to certain influences such as an interest rate.

For example, in traditional commodity markets, farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, “producers” of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap.

An example that has both hedge and speculative notions involves a mutual fund or separately managed account whose investment objective is to track the performance of a stock index such as the S&P 500 stock index. The Portfolio manager often “equitizes” cash inflows in an easy and cost effective manner by investing in (opening long) S&P 500 stock index futures. This gains the portfolio exposure to the index which is consistent with the fund or account investment objective without having to buy an appropriate proportion of each of the individual 500 stocks just yet. This also preserves balanced diversification, maintains a higher degree of the percent of assets invested in the market and helps reduce tracking error in the performance of the fund/account. When it is economically feasible (an efficient amount of shares of every individual position within the fund or account can be purchased), the portfolio manager can close the contract and make purchases of each individual stock.

The social utility of futures markets is considered to be mainly in the transfer of risk, and increased liquidity between traders with different risk and time preferences, from a hedger to a speculator, for example.

Options on futures

In many cases, options are traded on futures, sometimes called simply “futures options”. A put is the option to sell a futures contract, and a call is the option to buy a futures contract. For both, the option strike price is the specified futures price at which the future is traded if the option is exercised. See the Black-Scholes model, which is the most popular method for pricing these option contracts.

Futures contract regulations

All futures transactions in the United States are regulated by the Commodity Futures Trading Commission (CFTC), an independent agency of the United States government. The Commission has the right to hand out fines and other punishments for an individual or company who breaks any rules. Although by law the commission regulates all transactions, each exchange can have its own rule, and under contract can fine companies for different things or extend the fine that the CFTC hands out.

The CFTC publishes weekly reports containing details of the open interest of market participants for each market-segment that has more than 20 participants. These reports are released every Friday (including data from the previous Tuesday) and contain data on open interest split by reportable and non-reportable open interest as well as commercial and non-commercial open interest. This type of report is referred to as the ‘Commitments of Traders Report‘, COT-Report or simply COTR.

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