Industry Terms (S2)

Glossary of Industry Terms & Supporting Information

ICON Securities Lending (S2)

Stock: In the investment world, a share of stock (also referred to as equity share) represents a share of ownership in a corporation (company).

In the plural, stocks is often used as a synonym for ‘shares’ especially in the United States, but it is less commonly used that way outside of North America.

In the United Kingdom, South Africa, and Australia, stock can also refer to completely different financial instruments such as government bonds or, less commonly, to all kinds of marketable securities

TYPES OF STOCK –

Authorized stocks, Shares authorized is the maximum number of shares that a company can issue. This number is specified in the company’s articles of association but can be changed by shareholder approval. A company usually authorizes a higher number of shares than required to be able to issue stock in the future.
- Shares authorized = Shares issued + Shares unissued
- Shares issued = Shares outstanding + Treasury stock

Basic formula

Buying back shares

Benefits

In an efficient market, a company buying back its stock should have no effect at all on its stock price. If the market fairly prices a company’s shares at $50/share, and the company buys back 100 shares for $5000, it now has $5000 less cash but there are 100 fewer shares outstanding; the net effect should be that the value per share is unchanged. However, buying back shares does improve certain per-share ratios, such as price/earnings (earnings per share is increased due to fewer shares outstanding), but since the market risk increases by the same amount, the share value remains unchanged.

If the market is not efficient, the company’s shares may be underpriced. In that case a company can benefit its other shareholders by buying back shares. If a company’s shares are overpriced, then a company is actually hurting its remaining shareholders by buying back stock.

Incentives

One other reason for a company to buy back its own stock is to reward holders of stock options. Call option holders are hurt by dividend payments, since, typically, they are not eligible to receive them. A share buyback program may increase the value of remaining shares (if the buyback is executed when shares are under-priced); if so, call option holders benefit. A dividend payment short term always decreases the value of shares after the payment, so, on the day shares go ex-dividend, call option holders always lose whereas put option holders benefit. Finally, if the sellers into a corporate buyback are actually the call option holders themselves, they may directly benefit from temporarily unrealistically favorable pricing.

A company does not benefit by helping call stock options holder so this is not an incentive. A company will not do it for this reason except for the case in which the decision makers for the company have the incentive of profiting which is indeed illegal.

After buyback

The company can either retire the shares (however, retired shares are not listed as treasury stock on the company’s financial statements) or hold the shares for later resale. Buying back stock reduces the number of outstanding shares. To see this, note that accompanying the decrease in the number of shares outstanding is a reduction in company assets, in particular, cash assets, which are used to buy back shares.

Accounting for treasury stock

On the balance sheet, treasury stock is listed under shareholder equity as a negative number. The accounts may be called equity reduction or contra-equity.

One way of accounting for treasury stock is with the cost method. In this method, the paid-in capital account is reduced in the balance sheet when the treasury stock is bought. When the treasury stock is sold back on the open market, the paid-in capital is either debited or credited if it is sold for more or less than the initial cost respectively.

Another common way for accounting for treasury stock is the par value method. In the par value method, when the stock is purchased back from the market, the books will reflect the action as a retirement of the shares. Therefore, common stock is debited and treasury stock is credited. However, when the treasury stock is resold back to the market the entry in the books will be the same as the cost method.

In either method, any transaction involving treasury stock cannot increase the amount of retained earnings. If the treasury stock is sold for more than cost, then the paid-in capital treasury stock is the account that is increased, not retained earnings. In auditing financial statements, it is a common practice to cheque for this error to detect possible attempts to “cook the books.”

United States regulations

In the United States, buybacks are covered by multiple laws.

According to SEC Rule 10b-18:

One Broker-dealer per Day: The company repurchasing shares may not use more than one broker or dealer to acquire the shares per each day.
Timing of Purchase: A repurchase may not be the first trade of the day. Repurchases may not be made in the last ten minutes of the trading day. These rules do not apply to over-the-counter securities.
Purchase Price: A repurchase may not be bid at a price higher than the highest independent bid or last price of the last trade.
Volume: Repurchases per day may not exceed 25% of the average daily volume of the previous 4 calendar weeks. Block purchases not effected by a broker-dealer are excluded from this restriction.

United Kingdom regulations

In the UK, the Companies Act of 1955 disallowed companies from holding their own shares. However, the Companies Act of 1993 later repealed this.

Common stock is a form of corporate equity ownership, a type of security. It is called “common” to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc. On the other hand, common shares on average perform better than preferred shares or bonds over time.

Common stock is usually voting shares, though not always. Holders of common stock are able to influence the corporation through votes on establishing corporate objectives and policy, stock splits, and electing the company’s board of directors. Some holders of common stock also receive preemptive rights, which enable them to retain their proportional ownership in a company should it issue another stock offering.

Additional benefits from common stock include earning dividends and capital appreciation.

Concentrated stock is an equity making up a substantial part (usually, more than 30%) of the investor’s portfolio. The major risk associated with such a portfolio is a lack of diversification; concentrated stock makes a large portion of the investor’s wealth dependent on the performance of one particular stock. The reasons for keeping a concentrated stock may be restrictions for sale (see restricted stock), emotional attachment, donation, inheritance, stock options, and the selling of businesses.
Golden Share is a nominal share which is able to outvote all other shares in certain specified circumstances, often held by a government organization, in a government company undergoing the process of privatization and transformation into a stock-company.

Purpose

This share gives the government organization the right of decisive vote, thus to veto all other shares, in a shareholders-meeting. Usually this will be implemented through clauses in a company’s Articles of Association, and will be designed to prevent stake-building above a certain percentage ownership level, or to give a government veto powers over any major corporate action, such as the sale of a major asset or subsidiary or of the company as a whole.

This share is often retained only for some defined period of time to allow a newly privatized company to become accustomed to operating in a public environment, unless ownership of the organization concerned is deemed to be of ongoing importance to national interests, for example for reasons of national security.

History

The term arose in the 1980s when the British government retained golden shares in companies it privatized, and later in many other European countries.

It was introduced in Russia (Zolotaya Aktsiya, in Russian) by a law initiated by the President in November 16, 1992.

Legal challenges

In 2003 the UK government’s golden share in BAA, the UK airports authority, was ruled illegal by European courts, deemed contradictory to the principle of free circulation of capital within European Union. But taking in account the implications of this decision—especially the transitional state in countries which are candidates to join the Union—it allowed provisions to use Golden Shares in strategically important areas.

Other golden shares ruled illegal include the Spanish government’s golden shares in Telefonica, Repsol YPF, Endesa, Argentaria and Tabacalera.

The Golden Share structure of Volkswagen AG and the travails of the German Land (Federal State) of Niedersachsen (Lower Saxony) are discussed by Johannes Adolff, Turn of the Tide? The ‘Golden Share’ Judgments of the European Court of Justice and Liberalization of the European Capital Markets, available in the German Law Journal as well as Peer Zumbansen and Daniel Saam, The ECJ, Volkswagen and European Corporate Law: Reshaping the European Varieties of Capitalism, CLPE Research Paper 30/2007, (also published in 7 German Law Journal 1027 [2007]

Outstanding stock, also called Shares outstanding are common shares that have been authorized, issued, and purchased by investors. They have voting rights and represent ownership in the corporation by the person or institution that holds the shares. They should be distinguished from treasury shares, which is common stock held by the corporation.

Shares outstanding can be calculated as either basic or fully diluted. The fully diluted shares outstanding count includes diluting securities as options, warrants or convertibles. Shares outstanding can be obtained from quarterly filings with the SEC.

Preferred stock, also called preferred shares or preference shares, is typically a ‘higher ranking’ stock than common stock, and its terms are negotiated between the corporation and the investor.

Preferred stock usually carries no voting rights, but may carry priority over common stock in the payment of dividends and upon liquidation. Preferred stock may carry adividend that is paid out prior to any dividends being paid to common stock holders. Preferred stock may have a convertibility feature into common stock. Preferred stockholders will be paid out in assets before common stockholders and after debt holders in bankruptcy. Terms of the preferred stock are stated in a “Certificate of Designation”.

Rights of Preferred stock

Unlike common stock, preferred stock usually has several rights attached to it:

The core right is that of preference in the payment of dividends and upon liquidation of the company. Before a dividend can be declared on the common shares, any dividend obligation to the preferred shares must be satisfied.
The dividend rights are often cumulative, such that if the dividend is not paid it accumulates from year to year. However, the directors must declare a dividend before the preferred shareholder has any right to it. In case of non-cumulative, the dividend right for the year is extinguished if it is not declared for that year.
Preferred stock may or may not have a fixed liquidation value, or par value, associated with it. This represents the amount of capital that was contributed to the corporation when the shares were first issued.
Preferred stock has a claim on liquidation proceeds of a stock corporation, equivalent to its par or liquidation value unless otherwise negotiated. This claim is senior to that of common stock, which has only a residual claim.
Almost all preferred shares have a negotiated fixed dividend amount. The dividend is usually specified as a percentage of the par value or as a fixed amount. For example Pacific Gas & Electric 6% Series A preferred. Sometimes, dividends on preferred shares may be negotiated as floating i.e. may change according to a benchmark interest rate index such as LIBOR.
Some preferred shares have special voting rights to approve certain extraordinary events (such as the issuance of new shares or the approval of the acquisition of the company) or to elect directors, but most preferred shares provide no voting rights associated with them. Some preferred shares only gain voting rights when the preferred dividends are in arrears for a substantial time.
Usually preferred shares contain protective provisions which prevent the issuance of new preferred shares with a senior claim. Individual series of preferred shares may have a senior, pari-passu or junior relationship with other series issued by the same corporation.
Occasionally companies use preferred shares as means of preventing hostile takeovers, creating preferred shares with a poison pill or forced exchange/conversion features that exercise upon a change in control.

The above list, although including several customary rights, is far from comprehensive. Preferred shares, like other legal arrangements, may specify nearly any right conceivable. Preferred shares in the U.S. normally carry a call provision, enabling the issuing corporation to repurchase the share at its (usually limited) discretion.

Some corporations contain provisions in their charters authorizing the issuance of preferred stock whose terms and conditions may be determined by the board of directors when issued. These “blank cheque” preferred shares are often used as takeover defense (see also poison pill). These shares may be assigned very high liquidation value that must be redeemed in the event of a change of control or may have enormous super-voting powers.

Types of Preferred Stock

In addition to the straight preferred, as just described, there is great diversity in the preferred stock market. Additional types of preferred stock include:

Prior Preferred Stock: Many companies have different issues of preferred stock outstanding at the same time and one of them is usually designated to be the one with the highest priority. If the company has only enough money to meet the dividend schedule on one of the preferred issues, it makes the dividend payments on the prior preferred. Therefore, prior preferred have less credit risk than the other preferred stocks but it usually offers a lower yield than the others.
Preference Preferred Stock: Ranked behind the company’s prior preferred stock (on a seniority basis), are the company’s preference preferred issues. These issues receive preference over all other classes of the company’s preferred except for the prior preferred. If the company issues more than one issue of preference preferred, then the various issues are ranked by their relative seniority. One issue is designated first preference, the next senior issue is the second and so on.
Convertible Preferred Stock: These are preferred issues that the holders can exchange for a predetermined number of the company’s common stock. This exchange can occur at any time the investor chooses regardless of the current market price of the common stock. It is a one way deal so you cannot convert the common stock back to preferred stock.
Participating Preferred Stock: These preferred issues offer the holders the opportunity to receive extra dividends if the company achieves some predetermined financial goals. The investors who purchased these stocks receive their regular dividend regardless of how well or how poorly the company performs, assuming of course, the company does well enough to make the annual dividend payments. If the company achieves predetermined sales, earnings or profitability goals, the investors receive an additional dividend.

Users of Preferred stock

Preferred shares are more common in private or pre-public companies, where it is more useful to distinguish between the control of and the economic interest in the company. Government regulations and the rules of stock exchanges may discourage or encourage the issuance of publicly traded preferred shares. In many countries banks are encouraged to issue preferred stock as a source of Tier 1 capital. On the other hand, the Tel Aviv Stock Exchange prohibits listed companies from having more than one class of capital stock.

A single company may issue several classes of preferred stock. For example, a company may undergo several rounds of financing, with each round receiving separate rights and having a separate class of preferred stock; such a company might have “Series A Preferred,” “Series B Preferred,” “Series C Preferred” and common stock.

In the United States there are two types of preferred stocks: straight preferreds and convertible preferreds. Straight preferreds are issued in perpetuity (although some are subject to call by the issuer under certain conditions) and pay the stipulated rate of interest to the holder. Convertible preferreds – in addition to the foregoing features of a straight preferred—contain a provision by which the holder may convert the preferred into the common stock of the company (or, sometimes, into the common stock of an affiliated company) under certain conditions, among which may be the specification of a future date when conversion may begin, a certain number of common shares per preferred share, or a certain price per share for the common.

There are income tax advantages generally available to corporations that invest in preferred stocks in the United States that are not available to individuals.

Some argue that a straight preferred stock, being a hybrid between a bond and a stock, bears the disadvantages of each of those types of securities without enjoying the advantages of either. Like a bond, a straight preferred does not participate in any future earnings and dividend growth of the company and any resulting growth of the price of the common. But the bond has greater security than the preferred and has a maturity date at which the principal is to be repaid. Like the common, the preferred has less security protection than the bond. But the potential of increases of market price of the common and its dividends paid from future growth of the company is lacking for the preferred. One big advantage that the preferred provides its issuer is that the preferred gets better equity credit at rating agencies than straight debt, since it is usually perpetual. Also, as pointed out above, certain types of preferred stock qualifies as Tier 1 capital. This allows financial institutions to satisfy regulatory requirements without diluting common shareholders. Said another way, through preferred stock, financial institutions are able to put on leverage while getting Tier 1 equity credit.

Suppose that an investor paid par ($100) today for a typical straight preferred. Such an investment would give a current yield of just over 6%. Now suppose that in a few years 10-year Treasuries were to yield 13+% to maturity, as they did in 1981; these preferreds would yield at least 13%, which would knock their market price down to $46, for a 54% loss. (In all probability, they would yield some 2% more than the Treasuries—or something like 15%, which would take the market price down to $40, for a 60% loss.)

The important difference between straight preferreds and Treasuries (or any investment-grade Federal agency or corporate bond) is that the bonds would move up to par as their maturity date is approached, whereas the straight preferred, having no maturity date, might remain at these $40 levels (or lower) for a very long time.

Advantages of straight preferreds posited by some advisers include higher yields and tax advantages (currently yield some 2% more than 10-year Treasuries, rank ahead of common stock in the case of bankruptcy, dividends are taxable at a maximum 15% rather than at ordinary income rates, as in the case of bond interest).

Restricted stock, also known as letter stock or restricted securities, refers to stock of a company that is not fully transferable until certain conditions have been met. Upon satisfaction of those conditions, the stock becomes transferable by the person holding the award.

Another type of restricted stock is a form of compensation granted by a company. Typically, the conditions that allow the shares to be transferred are a period of time, when they vest. However, those restrictions can also be some sort of performance condition, such as the company reaching earnings per share goals or financial targets. Restricted stock is becoming a more prominent form of employee compensation, particularly to executives. It has come to prominence as stock options have fallen out of favor after the perceived excesses of the stock market in the early 21st century.

Treasury stock, also called a reacquired stock is stock which is bought back by the issuing company, reducing the amount of outstanding stock on the open market (“open market” including insiders’ holdings).

Stock repurchases are often used as a tax-efficient method to put cash into shareholders’ hands, rather than pay dividends. Sometimes, companies do this when they feel that their stock is undervalued on the open market. Other times, companies do this to provide a “bonus” to incentive compensation plans for employees. Rather than receive cash, recipients receive an asset that might appreciate in value faster than cash saved in a bank account. Another motive for stock repurchase is to protect the company against a takeover threat.

The United Kingdom equivalent of treasury stock as used in the United States is treasury share. Treasury stocks in the UK refers to government bonds or gilts.

Limitations of treasury stock

Treasury stock does not pay a dividend
Treasury stock has no voting rights
Total treasury stock can not exceed the maximum proportion of total capitalization specified by law in the relevant country

When shares are repurchased, they may either be canceled or held for reissue. If not canceled, such shares are referred to as treasury shares. Technically, a repurchased share is a company’s own share that has been bought back after having been issued and fully paid.

The possession of treasury shares does not give the company the right to vote, to exercise pre-emptive rights as a shareholder, to receive cash dividends, or to receive assets on company liquidation. Treasury shares are essentially the same as unissued capital and no one advocates classifying unissued share capital as an asset on the balance sheet, as an asset should have probable future economic benefits. Treasury shares simply reduce ordinary share capital.

Stamp duty reserve tax: Stamp duty reserve tax (SDRT) was introduced under the Finance Act 1986 to ensure that a form of tax equivalent to stamp duty would continue to be payable on the transfer of uncertificated shares. At that time, it was expected that the TAURUS share trading system would come into operation. In the event, SDRT was adapted for the change to trading in uncertificated shares in CREST, and is charged on agreements to transfer shares and other securities. SDRT is not a stamp tax, but a self-assessed transfer tax which is usually collected automatically by stock market participants (such as brokers) when a transaction takes place.

Stamp duty remains in force for shares and securities that are held in certificated form which can only be transferred by using a physical stock transfer form, and runs in parallel to SDRT on agreements to transfer shares. Since 1986, both stamp duty and SDRT have been charged at a rate of 0.5% of the consideration for the transfer of shares (in the case of stamp duty, rounded up to the nearest £5). The same transaction may include an agreement to transfer shares which may trigger a liability to SDRT, and the agreement may later be completed by a transfer of the shares which is liable to stamp duty. Provided that the transfer is stamped within 6 years, the charge to SDRT is cancelled to avoid a double charge. Stamp duty on transfers of shares with a value of less than £1000 was abolished from 13 March 2008.

A higher rate of SDRT at 1.5% is charged for the issue or transfer of shares to a person who operates a depositary receipt scheme or a clearance service (other than CREST, which is exempted). The higher charge compensates for the fact that later transfers of depositary interests or through the clearance services will not attract SDRT. This type of SDRT is by nature paid almost exclusively by offshore (i.e. non-UK) investors, primarily US fund managers and amounts to approx. 25% of the total SDRT collected annually.

A unique feature of SDRT, compared to other purely domestic taxes in the United Kingdom, is that more than 40% of the annual intake is collected from outside the UK, thus creating an annual inflow of approx. £1.5 billion pounds from foreign investors to the UK government.

Stock dividend: A dividend in the form of stock. Shareholders are given additional shares of stock, rather than being paid cash. Stock dividends are stated as a percentage. For example, if a 10% stock dividend is paid, the owner of 100 shares receives an additional 10 shares.
Stock Market: A stock market is a public market for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.

The size of the world stock market was estimated at about $36.6 trillion US at the beginning of October 2008. The total world derivatives market has been estimated at about $791 trillion face or nominal value, 11 times the size of the entire world economy. ^[3] The value of the derivatives market, because it is stated in terms of notional values, cannot be directly compared to a stock or a fixed income security, which traditionally refers to an actual value. Moreover, the vast majority of derivatives ‘cancel’ each other out (i.e., a derivative ‘bet’ on an event occurring is offset by a comparable derivative ‘bet’ on the event not occurring.). Many such relatively illiquid securities are valued as marked to model, rather than an actual market price.

The stocks are listed and traded on stock exchanges which are entities of a corporation or mutual organization specialized in the business of bringing buyers and sellers of the organizations to a listing of stocks and securities together. The stock market in the United States includes the trading of all securities listed on the NYSE Euronext, the NASDAQ, the Amex, as well as on the many regional exchanges, e.g. OTCBB and Pink Sheets. European examples of stock exchanges include the London Stock Exchange, the Deutsche Börse.

Trading

Participants in the stock market range from small individual stock investors to large hedge fund traders, who can be based anywhere. Their orders usually end up with a professional at a stock exchange, who executes the order.

Some exchanges are physical locations where transactions are carried out on a trading floor, by a method known as open outcry. This type of auction is used in stock exchanges and commodity exchanges where traders may enter “verbal” bids and offers simultaneously. The other type of stock exchange is a virtual kind, composed of a network of computers where trades are made electronically via traders.

Actual trades are based on an auction market model where a potential buyer bids a specific price for a stock and a potential seller asks a specific price for the stock. (Buying or selling at market means you will accept any ask price or bid price for the stock, respectively.) When the bid and ask prices match, a sale takes place, on a first-come-first-served basis if there are multiple bidders or askers at a given price.

The purpose of a stock exchange is to facilitate the exchange of securities between buyers and sellers, thus providing a marketplace (virtual or real). The exchanges provide real-time trading information on the listed securities, facilitating price discovery.

The New York Stock Exchange is a physical exchange, also referred to as a listed exchange — only stocks listed with the exchange may be traded. Orders enter by way of exchange members and flow down to a floor broker, who goes to the floor trading post specialist for that stock to trade the order. The specialist’s job is to match buy and sell orders using open outcry. If a spread exists, no trade immediately takes place–in this case the specialist should use his/her own resources (money or stock) to close the difference after his/her judged time. Once a trade has been made the details are reported on the “tape” and sent back to the brokerage firm, which then notifies the investor who placed the order. Although there is a significant amount of human contact in this process, computers play an important role, especially for so-called “program trading“.

The NASDAQ is a virtual listed exchange, where all of the trading is done over a computer network. The process is similar to the New York Stock Exchange. However, buyers and sellers are electronically matched. One or more NASDAQ market makers will always provide a bid and ask price at which they will always purchase or sell ‘their’ stock.

The Paris Bourse, now part of Euronext, is an order-driven, electronic stock exchange. It was automated in the late 1980s. Prior to the 1980s, it consisted of an open outcry exchange. Stockbrokers met on the trading floor or the Palais Brongniart. In 1986, the CATS trading system was introduced, and the order matching process was fully automated.

From time to time, active trading (especially in large blocks of securities) have moved away from the ‘active’ exchanges. Securities firms, led by UBS AG, Goldman Sachs Group Inc. and Credit Suisse Group, already steer 12 percent of U.S. security trades away from the exchanges to their internal systems. That share probably will increase to 18 percent by 2010 as more investment banks bypass the NYSE and NASDAQ and pair buyers and sellers of securities themselves, according to data compiled by Boston-based Aite Group LLC, a brokerage-industry consultant.

Now that computers have eliminated the need for trading floors like the Big Board‘s, the balance of power in equity markets is shifting. By bringing more orders in-house, where clients can move big blocks of stock anonymously, brokers pay the exchanges less in fees and capture a bigger share of the $11 billion a year that institutional investors pay in trading commissions as well as the surplus of the century had taken place.

Market participants

A few decades ago, worldwide, buyers and sellers were individual investors, such as wealthy businessmen, with long family histories (and emotional ties) to particular corporations. Over time, markets have become more “institutionalized”; buyers and sellers are largely institutions (e.g., pension funds, insurance companies, mutual funds, index funds, exchange-traded funds, hedge funds, investor groups, banks and various other financial institutions). The rise of the institutional investor has brought with it some improvements in market operations. Thus, the government was responsible for “fixed” (and exorbitant) fees being markedly reduced for the ‘small’ investor, but only after the large institutions had managed to break the brokers’ solid front on fees. (They then went to ‘negotiated’ fees, but only for large institutions)

However, corporate governance (at least in the West) has been very much adversely affected by the rise of (largely ‘absentee’) institutional ‘owners’.

History

In 12th century France the courratiers de change were concerned with managing and regulating the debts of agricultural communities on behalf of the banks. Because these men also traded with debts, they could be called the first brokers. A common misbelieve is that in late 13th century Bruges commodity traders gathered inside the house of a man called Van der Beurze, and in 1309 they became the “Brugse Beurse”, institutionalizing what had been, until then, an informal meeting, but actually, the family Van der Beurze had a building in Antwerp where those gatherings occurred ; the Van der Beurze had Antwerp, as most of the merchants of that period, as their primary place for trading. The idea quickly spread around Flanders and neighboring counties and “Beurzen” soon opened in Ghent and Amsterdam.

In the middle of the 13th century, Venetian bankers began to trade in government securities. In 1351 the Venetian government outlawed spreading rumors intended to lower the price of government funds. Bankers in Pisa, Verona, Genoa and Florence also began trading in government securities during the 14th century. This was only possible because these were independent city states not ruled by a duke but a council of influential citizens. The Dutch later started joint stock companies, which let shareholders invest in business ventures and get a share of their profits – or losses. In 1602, the Dutch East India Company issued the first share on the Amsterdam Stock Exchange. It was the first company to issue stocks and bonds.

The Amsterdam Stock Exchange (or Amsterdam Beurs) is also said to have been the first stock exchange to introduce continuous trade in the early 17th century. The Dutch “pioneered short selling, option trading, debt-equity swaps, merchant banking, unit trusts and other speculative instruments, much as we know them”^[4]. There are now stock markets in virtually every developed and most developing economies, with the world’s biggest markets being in the United States, United Kingdom, Japan, India, China, Canada, Germany, France and the Netherlands.

Importance of stock market

Function and purpose

The stock market is one of the most important sources for companies to raise money. This allows businesses to be publicly traded, or raise additional capital for expansion by selling shares of ownership of the company in a public market. The liquidity that an exchange provides affords investors the ability to quickly and easily sell securities. This is an attractive feature of investing in stocks, compared to other less liquid investments such as real estate.

History has shown that the price of shares and other assets is an important part of the dynamics of economic activity, and can influence or be an indicator of social mood. An economy where the stock market is on the rise is considered to be an up and coming economy. In fact, the stock market is often considered the primary indicator of a country’s economic strength and development. Rising share prices, for instance, tend to be associated with increased business investment and vice versa. Share prices also affect the wealth of households and their consumption. Therefore, central banks tend to keep an eye on the control and behavior of the stock market and, in general, on the smooth operation of financial system functions. Financial stability is the raison d’être of central banks.

Exchanges also act as the clearinghouse for each transaction, meaning that they collect and deliver the shares, and guarantee payment to the seller of a security. This eliminates the risk to an individual buyer or seller that the counterparty could default on the transaction.

The smooth functioning of all these activities facilitates economic growth in that lower costs and enterprise risks promote the production of goods and services as well as employment. In this way the financial system contributes to increased prosperity. An important aspect of modern financial markets, however, including the stock markets, is absolute discretion. For example, in the USA stock markets we see more unrestrained acceptance of any firm than in smaller markets. Such as, Chinese firms with no significant value to American society to just name one segment. This profits USA bankers on Wall Street, as they reap large commissions from the placement, and the Chinese company which yields funds to invest in China. Yet accrues no intrinsic value to the long-term stability of the American economy, rather just short-term profits to American business men and the Chinese; although, when the foreign company has a presence in the new market, there can be benefits to the market’s citizens. Conversely, there are very few large foreign corporations listed on the Toronto Stock Exchange TSX, Canada’s largest stock exchange. This discretion has insulated Canada to some degree to worldwide financial conditions. In order for the stock markets to truly facilitate economic growth via lower costs and better employment, great attention must be given to the foreign participants being allowed in.

Relation of the stock market to the modern financial system

The financial system in most western countries has undergone a remarkable transformation. One feature of this development is disintermediation. A portion of the funds involved in saving and financing flows directly to the financial markets instead of being routed via the traditional bank lending and deposit operations. The general public’s heightened interest in investing in the stock market, either directly or through mutual funds, has been an important component of this process. Statistics show that in recent decades shares have made up an increasingly large proportion of households’ financial assets in many countries. In the 1970s, in Sweden, deposit accounts and other very liquid assets with little risk made up almost 60 percent of households’ financial wealth, compared to less than 20 percent in the 2000s. The major part of this adjustment in financial portfolios has gone directly to shares but a good deal now takes the form of various kinds of institutional investment for groups of individuals, e.g., pension funds, mutual funds, hedge funds, insurance investment of premiums, etc. The trend towards forms of saving with a higher risk has been accentuated by new rules for most funds and insurance, permitting a higher proportion of shares to bonds. Similar tendencies are to be found in other industrialized countries. In all developed economic systems, such as the European Union, the United States, Japan and other developed nations, the trend has been the same: saving has moved away from traditional (government insured) bank deposits to more risky securities of one sort or another.

The stock market, individual investors, and financial risk

Riskier long-term saving requires that an individual possess the ability to manage the associated increased risks. Stock prices fluctuate widely, in marked contrast to the stability of (government insured) bank deposits or bonds. This is something that could affect not only the individual investor or household, but also the economy on a large scale. The following deals with some of the risks of the financial sector in general and the stock market in particular. This is certainly more important now that so many newcomers have entered the stock market, or have acquired other ‘risky’ investments (such as ‘investment’ property, i.e., real estate and collectables).

With each passing year, the noise level in the stock market rises. Television commentators, financial writers, analysts, and market strategists are all overtaking each other to get investors’ attention. At the same time, individual investors, immersed in chat rooms and message boards, are exchanging questionable and often misleading tips. Yet, despite all this available information, investors find it increasingly difficult to profit. Stock prices skyrocket with little reason, then plummet just as quickly, and people who have turned to investing for their children’s education and their own retirement become frightened. Sometimes there appears to be no rhyme or reason to the market, only folly.

This is a quote from the preface to a published biography about the long-term value-oriented stock investor Warren Buffett. Buffett began his career with $100, and $105,000 from seven limited partners consisting of Buffett’s family and friends. Over the years he has built himself a multi-billion-dollar fortune. The quote illustrates some of what has been happening in the stock market during the end of the 20th century and the beginning of the 21st century.

The behavior of the stock market

From experience we know that investors may ‘temporarily’ move financial prices away from their long term aggregate price ‘trends’. (Positive or up trends are referred to as bull markets; negative or down trends are referred to as bear markets.) Over-reactions may occur—so that excessive optimism (euphoria) may drive prices unduly high or excessive pessimism may drive prices unduly low. New theoretical and empirical arguments have since been put forward against the notion that financial markets are ‘generally’ efficient (i.e., in the sense that stock prices in the aggregate tend to follow a Gaussian distribution).

According to the efficient market hypothesis (EMH), only changes in fundamental factors, such as the outlook for margins, profits or dividends, ought to affect share prices beyond the short term, where random ‘noise’ in the system may prevail. (But this largely theoretic academic viewpoint—known as ‘hard’ EMH—also predicts that little or no trading should take place, contrary to fact, since prices are already at or near equilibrium, having priced in all public knowledge.) The ‘hard’ efficient-market hypothesis is sorely tested by such events as the stock market crash in 1987, when the Dow Jones index plummeted 22.6 percent—the largest-ever one-day fall in the United States. This event demonstrated that share prices can fall dramatically even though, to this day, it is impossible to fix a generally agreed upon definite cause: a thorough search failed to detect any ‘reasonable’ development that might have accounted for the crash. (But note that such events are predicted to occur strictly by chance , although very rarely.) It seems also to be the case more generally that many price movements (beyond that which are predicted to occur ‘randomly’) are not occasioned by new information; a study of the fifty largest one-day share price movements in the United States in the post-war period seems to confirm this.

However, a ‘soft’ EMH has emerged which does not require that prices remain at or near equilibrium, but only that market participants not be able to systematically profit from any momentary market ‘inefficiencies‘. Moreover, while EMH predicts that all price movement (in the absence of change in fundamental information) is random (i.e., non-trending), many studies have shown a marked tendency for the stock market to trend over time periods of weeks or longer. Various explanations for such large and apparently non-random price movements have been promulgated. For instance, some research has shown that changes in estimated risk, and the use of certain strategies, such as stop-loss limits and Value at Risk limits, theoretically could cause financial markets to overreact. But the best explanation seems to be that the distribution of stock market prices is non-Gaussian (in which case EMH, in any of its current forms, would not be strictly applicable).

Other research has shown that psychological factors may result in exaggerated (statistically anomalous) stock price movements (contrary to EMH which assumes such behaviors ‘cancel out’). Psychological research has demonstrated that people are predisposed to ‘seeing’ patterns, and often will perceive a pattern in what is, in fact, just noise. (Something like seeing familiar shapes in clouds or ink blots.) In the present context this means that a succession of good news items about a company may lead investors to overreact positively (unjustifiably driving the price up). A period of good returns also boosts the investor’s self-confidence, reducing his (psychological) risk threshold.

Another phenomenon—also from psychology—that works against an objective assessment is group thinking. As social animals, it is not easy to stick to an opinion that differs markedly from that of a majority of the group. An example with which one may be familiar is the reluctance to enter a restaurant that is empty; people generally prefer to have their opinion validated by those of others in the group.

In one paper the authors draw an analogy with gambling. In normal times the market behaves like a game of roulette; the probabilities are known and largely independent of the investment decisions of the different players. In times of market stress, however, the game becomes more like poker (herding behavior takes over). The players now must give heavy weight to the psychology of other investors and how they are likely to react psychologically.

The stock market, as any other business, is quite unforgiving of amateurs. Inexperienced investors rarely get the assistance and support they need. In the period running up to the 1987 crash, less than 1 percent of the analyst’s recommendations had been to sell (and even during the 2000 – 2002 bear market, the average did not rise above 5%). In the run up to 2000, the media amplified the general euphoria, with reports of rapidly rising share prices and the notion that large sums of money could be quickly earned in the so-called new economy stock market. (And later amplified the gloom which descended during the 2000 – 2002 bear market, so that by summer of 2002, predictions of a DOW average below 5000 were quite common.)

Irrational behavior

Sometimes the market seems to react irrationally to economic or financial news, even if that news is likely to have no real effect on the technical value of securities itself. But this may be more apparent than real, since often such news has been anticipated, and a counter reaction may occur if the news is better (or worse) than expected. Therefore, the stock market may be swayed in either direction by press releases, rumors, euphoria and mass panic; but generally only briefly, as more experienced investors (especially the hedge funds) quickly rally to take advantage of even the slightest, momentary hysteria.

Over the short-term, stocks and other securities can be battered or buoyed by any number of fast market-changing events, making the stock market behavior difficult to predict. Emotions can drive prices up and down, people are generally not as rational as they think, and the reasons for buying and selling are generally obscure. Behaviorists argue that investors often behave ‘irrationally’ when making investment decisions thereby incorrectly pricing securities, which causes market inefficiencies, which, in turn, are opportunities to make money. However, the whole notion of EMH is that these non-rational reactions to information cancel out, leaving the prices of stocks rationally determined.

The Dow Jones Industrial Average biggest gain in one day was 936.42 points or 11 percent, this occurred on October 13, 2008.

Crashes

A stock market crash is often defined as a sharp dip in share prices of equities listed on the stock exchanges. In parallel with various economic factors, a reason for stock market crashes is also due to panic and investing public’s loss of confidence. Often, stock market crashes end speculative economic bubbles.

There have been famous stock market crashes that have ended in the loss of billions of dollars and wealth destruction on a massive scale. An increasing number of people are involved in the stock market, especially since the social security and retirement plans are being increasingly privatized and linked to stocks and bonds and other elements of the market. There have been a number of famous stock market crashes like the Wall Street Crash of 1929, the stock market crash of 1973–4, the Black Monday of 1987, the Dot-com bubble of 2000, and the Stock Market Crash of 2008.

One of the most famous stock market crashes started October 24, 1929 on Black Thursday. The Dow Jones Industrial lost 50% during this stock market crash. It was the beginning of the Great Depression. Another famous crash took place on October 19, 1987 – Black Monday. On Black Monday itself, the Dow Jones fell by 22.6% after completing a 5 year continuous rise in share prices. This event not only shook the USA, but quickly spread across the world. Thus, by the end of October, stock exchanges in Australia lost 41.8%, in Canada lost 22.5%, in Hong Kong lost 45.8%, and in Great Britain lost 26.4%. The names “Black Monday” and “Black Tuesday” are also used for October 28-29, 1929, which followed Terrible Thursday–the starting day of the stock market crash in 1929. The crash in 1987 raised some puzzles-–main news and events did not predict the catastrophe and visible reasons for the collapse were not identified. This event raised questions about many important assumptions of modern economics, namely, the theory of rational human conduct, the theory of market equilibrium and the hypothesis of market efficiency. For some time after the crash, trading in stock exchanges worldwide was halted, since the exchange computers did not perform well owing to enormous quantity of trades being received at one time. This halt in trading allowed the Federal Reserve system and central banks of other countries to take measures to control the spreading of worldwide financial crisis. In the United States the SEC introduced several new measures of control into the stock market in an attempt to prevent a re-occurrence of the events of Black Monday. Computer systems were upgraded in the stock exchanges to handle larger trading volumes in a more accurate and controlled manner. The SEC modified the margin requirements in an attempt to lower the volatility of common stocks, stock options and the futures market. The New York Stock Exchange and the Chicago Mercantile Exchange introduced the concept of a circuit breaker. The circuit breaker halts trading if the Dow declines a prescribed number of points for a prescribed amount of time.

New York Stock Exchange (NYSE) circuit breakers

Stock market index

Main article: Stock market index

The movements of the prices in a market or section of a market are captured in price indices called stock market indices, of which there are many, e.g., the S&P, the FTSE and the Euronext indices. Such indices are usually market capitalization weighted, with the weights reflecting the contribution of the stock to the index. The constituents of the index are reviewed frequently to include/exclude stocks in order to reflect the changing business environment.

Derivative instruments

Main article: Derivative (finance)

Financial innovation has brought many new financial instruments whose pay-offs or values depend on the prices of stocks. Some examples are exchange-traded funds (ETFs), stock index and stock options,equity swaps, single-stock futures, and stock index futures. These last two may be traded on futures exchanges (which are distinct from stock exchanges—their history traces back to commodities futures exchanges), or traded over-the-counter. As all of these products are only derived from stocks, they are sometimes considered to be traded in a (hypothetical) derivatives market, rather than the (hypothetical) stock market.

Leveraged strategies

Stock that a trader does not actually own may be traded using short selling; margin buying may be used to purchase stock with borrowed funds; or, derivatives may be used to control large blocks of stocks for a much smaller amount of money than would be required by outright purchase or sale.

Short selling

Main article: Short selling

In short selling, the trader borrows stock (usually from his brokerage which holds its clients’ shares or its own shares on account to lend to short sellers) then sells it on the market, hoping for the price to fall. The trader eventually buys back the stock, making money if the price fell in the meantime or losing money if it rose. Exiting a short position by buying back the stock is called “covering a short position.” This strategy may also be used by unscrupulous traders to artificially lower the price of a stock. Hence most markets either prevent short selling or place restrictions on when and how a short sale can occur. The practice of naked shorting is illegal in most (but not all) stock markets.

Margin buying

Main article: margin buying

In margin buying, the trader borrows money (at interest) to buy a stock and hopes for it to rise. Most industrialized countries have regulations that require that if the borrowing is based on collateral from other stocks the trader owns outright, it can be a maximum of a certain percentage of those other stocks’ value. In the United States, the margin requirements have been 50% for many years (that is, if you want to make a $1000 investment, you need to put up $500, and there is often a maintenance margin below the $500). A margin call is made if the total value of the investor’s account cannot support the loss of the trade. (Upon a decline in the value of the margined securities additional funds may be required to maintain the account’s equity, and with or without notice the margined security or any others within the account may be sold by the brokerage to protect its loan position. The investor is responsible for any shortfall following such forced sales.) Regulation of margin requirements (by the Federal Reserve) was implemented after the Crash of 1929. Before that, speculators typically only needed to put up as little as 10 percent (or even less) of the total investment represented by the stocks purchased. Other rules may include the prohibition of free-riding: putting in an order to buy stocks without paying initially (there is normally a three-day grace period for delivery of the stock), but then selling them (before the three-days are up) and using part of the proceeds to make the original payment (assuming that the value of the stocks has not declined in the interim).

New issuance

Main article: Thomson Financial league tables

Global issuance of equity and equity-related instruments totaled $505 billion in 2004, a 29.8% increase over the $389 billion raised in 2003. Initial public offerings (IPOs) by US issuers increased 221% with 233 offerings that raised $45 billion, and IPOs in Europe, Middle East and Africa (EMEA) increased by 333%, from $ 9 billion to $39 billion.

Investment strategies

Main article: Stock valuation

One of the many things people always want to know about the stock market is, “How do I make money investing?” There are many different approaches; two basic methods are classified as either fundamental analysis or technical analysis. Fundamental analysis refers to analyzing companies by their financial statements found in SEC Filings, business trends, general economic conditions, etc. Technical analysis studies price actions in markets through the use of charts and quantitative techniques to attempt to forecast price trends regardless of the company’s financial prospects. One example of a technical strategy is the Trend following method, used by John W. Henry and Ed Seykota, which uses price patterns, utilizes strict money management and is also rooted in risk control and diversification.

Additionally, many choose to invest via the index method. In this method, one holds a weighted or unweighted portfolio consisting of the entire stock market or some segment of the stock market (such as the S&P 500 or Wilshire 5000). The principal aim of this strategy is to maximize diversification, minimize taxes from too frequent trading, and ride the general trend of the stock market (which, in the U.S., has averaged nearly 10%/year, compounded annually, since World War II).

Taxation

Main article: Capital gains tax

According to much national or state legislation, a large array of fiscal obligations are taxed for capital gains. Taxes are charged by the state over the transactions, dividends and capital gains on the stock market, in particular in the stock exchanges. However, these fiscal obligations may vary from jurisdiction to jurisdiction because, among other reasons, it could be assumed that taxation is already incorporated into the stock price through the different taxes companies pay to the state, or that tax free stock market operations are useful to boost economic growth.

Stock broker: A stock broker or stockbroker is a regulated professional broker who buys and sells shares and other securities through market makers or Agency Only Firms on behalf of investors.

Requirements

United States

While the term stockbroker is still in use, it is more commonly referred to as simply “broker”, “registered rep” or simply “rep”– shortened versions of the official FINRA (pronounced “FIN-ra”) designation “Registered Representative“. This designation is obtained by an individual passing the FINRA General Securities Representative Examination (also known as the “Series 7 exam”) and being employed (“associated with”) a registered Broker-dealer also called a brokerage firm; the firm is typically a FINRA “member” firm.

More restrictive FINRA licenses or series exams exist for brokers or reps who do not need the full array of capabilities with the Series 7. See the FINRA List of Securities Examinations. And variable products such as a variable annuity contract or variable universal life insurance policy typically require the broker to also have one or another state insurance department licenses.

United Kingdom

In the UK, brokers are required to pass the XII (Securities and Investment Institute) Certificate in Securities, this qualification is achieved by passing two exams: Either Unit 1: FBI Financial regulations or Unit 10 Principles of Financial Regulation for MiFID compliant retail trading, and either Unit 2: Securities, Unit 3: Derivatives or Unit 4: for both Securities and Derivatives. Passing Unit 10 or Unit 52 identifies individuals as having attained FSA Approved Person Status.

Hong Kong

Services provided

A transaction on a stock exchange must be made between two members of the exchange — an ordinary person may not walk into the New York Stock Exchange (for example), and ask to trade stock. Such an exchange must be done through a broker.

There are three types of stockbroking service.

Execution-only, which means that the broker will only carry out the client’s instructions to buy or sell.
Advisory dealing, where the broker advises the client on which shares to buy and sell, but leaves the final decision to the investor.
Discretionary dealing, where the stockbroker ascertains the client’s investment objectives and then makes all dealing decisions on the client’s behalf.

Similar roles

Roles similar to that of a stockbroker include investment advisor, and financial advisor. A stockbroker may or may not be also an investment advisor, and vice versa.

Acting as a principal

Stockbrokers also sometimes or exclusively trade on their own behalf, as a principal, speculating that a share or other financial instrument will increase or decline in price. In such cases the term broker makes little sense and the individuals or firms trading in principal capacity sometimes call themselves dealers, stock traders or simply traders. A stock broker is just the main part of being a City Trader. Other types of City Trading include working in the Foreign Exchange.

Stockholders: A mutual shareholder or stockholder is an individual or company (including a corporation) that legally owns one or more shares of stock in a joint stock company. A company’s shareholders collectively own that company. Thus, the typical goal of such companies is to enhance shareholder value.

Stockholders are granted special privileges depending on the class of stock. These rights may include:

The right to vote on matters such as elections to the board of directors. Usually, stockholders have one vote per share owned, but sometimes this is not the case.^[^{citation needed}^]
The right to propose shareholder resolutions.
The right to share in distributions of the company’s income.
The right to purchase new shares issued by the company.
The right to a company’s assets during a liquidation of the company.

However, stockholder’s rights to a company’s assets are subordinate to the rights of the company’s creditors. This means that stockholders typically receive nothing if a company is liquidated after bankruptcy (if the company had had enough to pay its creditors, it would not have entered bankruptcy, although a stock may have value after a bankruptcy if there is the possibility that the debts of the company will be restructured.

Stockholders or shareholders are considered by some to be a partial subset of stakeholders, which may include anyone who has a direct or indirect equity interest in the business entity or someone with even a non-pecuniary interest in a non-profit organization. Thus it might be common to call volunteer contributors to an association stakeholders, even though they are not shareholders.

Although directors and officers of a company are bound by fiduciary duties to act in the best interest of the shareholders, the shareholders themselves normally do not have such duties towards each other.

However, in a few unusual cases, some courts have been willing to imply such a duty between shareholders. For example, in California, majority shareholders of closely held corporations have a duty to not destroy the value of the shares held by minority shareholders.

Shareholders play an important role in raising capital for organizations. So these figures pose a great opportunity for all those who are looking for a lucrative option to invest money. Companies typically provide all the necessary proofs to shareholders to show that they are investing at a right place. For example, fair and reliable audit figures from income statement and balance sheet are used as evidence of overall performance for the benefit of shareholders.

Stock market: A stock market is a public market for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.

The size of the world stock market was estimated at about $36.6 trillion US at the beginning of October 2008. The total world derivatives market has been estimated at about $791 trillion face or nominal value, 11 times the size of the entire world economy. The value of the derivatives market, because it is stated in terms of notional values, cannot be directly compared to a stock or a fixed income security, which traditionally refers to an actual value. Moreover, the vast majority of derivatives ‘cancel’ each other out (i.e., a derivative ‘bet’ on an event occurring is offset by a comparable derivative ‘bet’ on the event not occurring.). Many such relatively illiquid securities are valued as marked to model, rather than an actual market price.

Trading

Market participants

However, corporate governance (at least in the West) has been very much adversely affected by the rise of (largely ‘absentee’) institutional ‘owners’.

History

In 12th century France the courratiers de change were concerned with managing and regulating the debts of agricultural communities on behalf of the banks. Because these men also traded with debts, they could be called the first brokers. A common misbelief is that in late 13th century Bruges commodity traders gathered inside the house of a man called Van der Beurze, and in 1309 they became the “Brugse Beurse”, institutionalizing what had been, until then, an informal meeting, but actually, the family Van der Beurze had a building in Antwerp where those gatherings occurred; the Van der Beurze had Antwerp, as most of the merchants of that period, as their primary place for trading. The idea quickly spread around Flanders and neighboring counties and “Beurzen” soon opened in Ghent and Amsterdam.

Importance of stock market

Function and purpose

Relation of the stock market to the modern financial system

The stock market, individual investors, and financial risk

This is a quote from the preface to a published biography about the long-term value-oriented stock investor Warren Buffett.^[6] Buffett began his career with $100, and $105,000 from seven limited partners consisting of Buffett’s family and friends. Over the years he has built himself a multi-billion-dollar fortune. The quote illustrates some of what has been happening in the stock market during the end of the 20th century and the beginning of the 21st century.

The behavior of the stock market

However, a ‘soft’ EMH has emerged which does not require that prices remain at or near equilibrium, but only that market participants not be able to systematicallyprofit from any momentary market ‘inefficiencies‘. Moreover, while EMH predicts that all price movement (in the absence of change in fundamental information) is random (i.e., non-trending), many studies have shown a marked tendency for the stock market to trend over time periods of weeks or longer. Various explanations for such large and apparently non-random price movements have been promulgated. For instance, some research has shown that changes in estimated risk, and the use of certain strategies, such as stop-loss limits and Value at Risk limits, theoretically could cause financial markets to overreact. But the best explanation seems to be that the distribution of stock market prices is non-Gaussian (in which case EMH, in any of its current forms, would not be strictly applicable).

Irrational behavior

The Dow Jones Industrial Average biggest gain in one day was 936.42 points or 11 percent, this occurred on October 13, 2008.

Crashes

Main article: Stock market crash

New York Stock Exchange (NYSE) circuit breakers

Stock market index

Main article: Stock market index

Derivative instruments

Main article: Derivative (finance)

Leveraged strategies

Short selling

Main article: Short selling

Margin buying

Main article: margin buying

In margin buying, the trader borrows money (at interest) to buy a stock and hopes for it to rise. Most industrialized countries have regulations that require that if the borrowing is based on collateral from other stocks the trader owns outright, it can be a maximum of a certain percentage of those other stocks’ value. In the United States, the margin requirements have been 50% for many years (that is, if you want to make a $1000 investment, you need to put up $500, and there is often a maintenance margin below the $500). A margin call is made if the total value of the investor’s account cannot support the loss of the trade. (Upon a decline in the value of the margined securities additional funds may be required to maintain the account’s equity, and with or without notice the margined security or any others within the account may be sold by the brokerage to protect its loan position. The investor is responsible for any shortfall following such forced sales.) Regulation of margin requirements (by the Federal Reserve) was implemented after the Crash of 1929. Before that, speculators typically only needed to put up as little as 10 percent (or even less) of the total investment represented by the stocks purchased. Other rules may include the prohibition offree-riding: putting in an order to buy stocks without paying initially (there is normally a three-day grace period for delivery of the stock), but then selling them (before the three-days are up) and using part of the proceeds to make the original payment (assuming that the value of the stocks has not declined in the interim).

New issuance

Main article: Thomson Financial league tables

Investment strategies

Main article: Stock valuation

Taxation

Main article: Capital gains tax

Stock market index: A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used to benchmark the performance of portfolios such as mutual funds.

Types of indices

Stock market indices may be classed in many ways. A ‘world’ or ‘global’ stock market index includes (typically large) companies without regard for where they are domiciled or traded. Two examples are MSCI World and S&P Global 100.

A national index represents the performance of the stock market of a given nation—and by proxy, reflects investor sentiment on the state of its economy. The most regularly quoted market indices are national indices composed of the stocks of large companies listed on a nation’s largest stock exchanges, such as the British FTSE 100, the French CAC 40, the German DAX, the Japanese Nikkei 225, the American DJIA and S&P 500, the Indian Sensex and S&P CNX Nifty , the Australian All Ordinaries and the Hong Kong Hang Seng Index.

The concept may be extended well beyond an exchange. The Dow Jones Total Stock Market Index, as its name implies, represents the stocks of nearly every publicly traded company in the United States, including all U.S. stocks traded on the New York Stock Exchange (but not ADRs) and most traded on the NASDAQ and American Stock Exchange. Russell Investment Group added to the family of indices by launching the Russell Global Index.

More specialized indices exist tracking the performance of specific sectors of the market. The Morgan Stanley Biotech Index, for example, consists of 36 American firms in the biotechnology industry. Other indices may track companies of a certain size, a certain type of management, or even more specialized criteria — one index published by Linux Weekly News tracks stocks of companies that sell products and services based on the Linux operating environment.

Index versions

Some indices, such as the S&P 500, have multiple versions. These versions can differ based on how the index components are weighted and on how dividends are accounted for. For example, there are three versions of the S&P 500 index: price return, which only considers the price of the components, total return, which accounts for dividend reinvestment, and net total return, which accounts for dividend reinvestment after the deduction of a withholding tax. As another example, the Wilshire 4500 and Wilshire 5000 indices have five versions each: full capitalization total return, full capitalization price, float-adjusted total return, float-adjusted price, and equal weight. The difference between the full capitalization, float-adjusted, and equal weight versions is in how index components are weighted.

Weighting

An index may also be classified according to the method used to determine its price. In a Price-weighted index such as the Dow Jones Industrial Average, Amex Major Market Index, and the NYSE ARCA Tech 100 Index, the price of each component stock is the only consideration when determining the value of the index. Thus, price movement of even a single security will heavily influence the value of the index even though the dollar shift is less significant in a relatively highly valued issue, and moreover ignoring the relative size of the company as a whole. In contrast, a market-value weighted or capitalization-weighted index such as the Hang Seng Index factors in the size of the company. Thus, a relatively small shift in the price of a large company will heavily influence the value of the index. In a market-share weighted index, price is weighted relative to the number of shares, rather than their total value.

Traditionally, capitalization- or share-weighted indices all had a full weighting i.e. all outstanding shares were included. Recently, many of them have changed to a float-adjusted weighting which helps indexing.

A modified market cap weighted index is a hybrid between equal weighting and capitalization weighting. It is similar to a general market cap with one main difference: the largest stocks are capped to a percent of the weight of the total stock index and the excess weight will be redistributed equally amongst the stocks under that cap. Moreover, in 2005, Standard & Poor’s introduced the S&P Pure Growth Style Index and S&P Pure Value Style Index which was attribute weighted. That is, a stock’s weight in the index is decided by the score it gets relative to the value attributes that define the criteria of a specific index, the same measure used to select the stocks in the first place. For these two stocks, a score is calculated for every stock, be it their growth score or the value score (a stock cant be both) and accordingly they are weighted for the index.

Criticism of capitalization-weighting

The use of capitalization-weighted indices is often justified by the central conclusion of modern portfolio theory that the optimal investment strategy for any investor is to hold the market portfolio, the capitalization-weighted portfolio of all assets. However, empirical tests conclude that market indices are not efficient. This can be explained by the fact that these indices do not include all assets or by the fact that the theory does not hold. The practical conclusion is that using capitalization-weighted portfolios is not necessarily the optimal method.

As a consequence, capitalization weighting has been subject to severe criticism (see e.g. Haugen and Baker 1991, Amenc, Goltz, and Le Sourd 2006, or Hsu 2006), pointing out that the mechanics of capitalization weighting lead to trend-following strategies that provide an inefficient risk-return trade-off.

Also, while capitalization weighting is the standard in equity index construction, different weighting schemes exist. First, while most indices use capitalization weighting, additional criteria are often taken into account, such as sales/revenue and net income (see the “Guide to the Dow Jones Global Titan 50 Index”, January 2006). Second, as an answer to the critiques of capitalization-weighting, equity indices with different weighting schemes have emerged, such as “wealth”-weighted (Morris, 1996), “fundamental”-weighted (Arnott, Hsu and Moore 2005), “diversity”-weighted (Fernholz, Garvy, and Hannon 1998) or equal-weighted indices.

Indices and passive investment management

There has been an accelerating trend in recent decades to create passively managed mutual funds that are based on market indices, known as index funds. Advocates claim that index funds routinely beat a large majority of actively managed mutual funds; one study claimed that over time, the average actively managed fund has returned 1.8% less than the S&P 500 index – a result nearly equal to the average expense ratio of mutual funds (fund expenses are a drag on the funds’ return by exactly that ratio). Since index funds attempt to replicate the holdings of an index, they obviate the need for — and thus many costs of — the research entailed in active management, and have a lower “churn” rate (the turnover of securities which lose fund managers’ favor and are sold, with the attendant cost of commissions and capital gains taxes).

Indices are also a common basis for a related type of investment, the exchange-traded fund or ETF. Unlike an index fund, which is priced daily, an ETF is priced continuously, is optionable, and can be sold short.

Dr. Emanuele Canegrati of Catholic University of Milan has recently developed the concept of Market Index Leader. Based on the Granger causality concept, he defined a market index leader one which Granger-causes other indices and it is not Granger-caused by any other index^[6] ^[7]. Since Granger-causality does not deal with “true” causality, but only with a temporal sequence of events which have a linkage, he discovered that some indices are first-movers (leaders) and some others follow them. The former Granger-cause the latter.

Ethical stock market indices

A notable specialized index type is those for ethical investing indices that include only those companies satisfying ecological or social criteria, e.g. those of The Calvert Group, KLD, FTSE4Good Index, Dow Jones Sustainability Index and Wilderhill Clean Energy Index.

Another important trend is strict mechanical criteria for inclusion and exclusion to prevent market manipulation, e.g. in Canada when Nortel was permitted to rise to over 30% of the TSE 300 index value. Ethical indices have a particular interest in mechanical criteria, seeking to avoid accusations of ideological bias in selection, and have pioneered techniques for inclusion and exclusion of stocks based on complex criteria. Another means of mechanical selection is mark-to-future methods that exploit scenarios produced by multiple analysts weighted according to probability, to determine which stocks have become too risky to hold in the index of concern.

Critics of such initiatives argue that many firms satisfy mechanical “ethical criteria”, e.g. regarding board composition or hiring practices, but fail to perform ethically with respect to shareholders, e.g. Enron. Indeed, the seeming “seal of approval” of an ethical index may put investors more at ease, enabling scams. One response to these criticisms is that trust in the corporate management, index criteria, fund or index manager, and securities regulator, can never be replaced by mechanical means, so “market transparency” and “disclosure” are the only long-term-effective paths to fair markets.

Environmental stock market indices

An environmental stock market index aims to provide a quantitative measure of the environmental damage caused by the companies in an index. Indices of this nature face much of the same criticism as Ethical indices do — that the ‘score’ given is partially subjective.

However, whereas ‘ethical’ issues (for example, does a company use a sweatshop) are largely subjective and difficult to score, an environmental impact is often quantifiable through scientific methods. So it is broadly possible to assign a ‘score’ to (say) the damage caused by a tonne of mercury dumped into a local river. It is harder to develop a scoring method that can compare different types of pollutant — for example does one hundred tonnes of carbon dioxide emitted to the air cause more or less damage (via climate change) than one tonne of mercury dumped in a river (and poisoning all the fish).

Generally, most environmental economists attempting to create an environmental index would attempt to quantify damage in monetary terms. So one tonne of carbon dioxide might cause $100 worth of damage, whereas one tonne of mercury might cause $50,000 (as it is highly toxic). Companies can therefore be given an ‘environmental impact’ score, based on the cost they impose on the environment. Quantification of damage in this nature is extremely difficult, as pollutants tend to be market externalities and so have no easily measurable cost by definition.

Innovations Awards to Stock Indices

The William F. Sharpe Indexing Achievement Awards are presented annually in order to recognize the most important contributions to the indexing industry over the preceding year.

Most Innovative Benchmark Index
- 2004 — CBOE S&P 500 BuyWrite Index (BXM) ^[8]
- 2005 — FTSE/RAFI Fundamental Index Series
- 2006 — Standard and Poor’s Case-Shiller House Prices Indices
- 2007 - CBOE S&P 500 PutWrite Index (PUT) ^[9]
Most Innovative ETF
- 2004 — iShares MSCI EAFE (EFA) and Emerging Markets
- 2005 — EasyETF GSCI Commodities ETF
- 2006 — PowerShares DB Commodity Index Tracking Fund (DBC) and PowerShares G10 Currency Harvest Fund (DBV)
- 2007 – SPDR DJ Wilshire International Real Estate ETF
Most Innovative Index Product
- 2004 — CBOE Volatility Index (VIX) Futures
- 2005 — Options on Vanguard VIPERS at the CBOE
- 2006 — Chicago Board Options Exchange Options on the CBOE Volatility Index (VIX)
- 2007 - iPath ETNs
Best Index-related Research Paper
- 2004 — Steven Schoenfeld
- 2005 — Rob Arnott
- 2006 — Eugene F. Fama and Kenneth R. French
- 2007 – Benchmarking Benchmarks: Measuring Characteristic Selectivity, By Kingsley Fong, David R. Gallagher, Adrian Lee, University of New South Wales
Lifetime Achievement Award
- 2004 — Tim Harbert
- 2005 — William Sharpe and Nathan Most
- 2006 — Burton G. Malkiel and Ronald J. Ryan
- 2007 - John C. Bogle, Paul A. Samuelson, Patricia C. Dunn, William L. Fouse and John A. Prestbo

Stock Options: In finance, an option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to buy or to sell a particular asset (the underlying asset) on or before the option’s expiration time, at an agreed price, the strike price. In return for granting the option, the seller collects a payment (the premium) from the buyer. A call option gives the buyer the right to buy the underlying asset and a put option gives the buyer of the option the right to sell the underlying asset. If the buyer chooses to exercise this right, the seller is obliged to sell or buy the asset at the agreed price.^[1]^[2] The buyer may choose not to exercise the right and let it expire. The underlying asset can be a piece of property, a security (stock or bond), or a derivative instrument, such as a futures contract.

The theoretical value of an option is evaluated according to several models. These models, which are developed by quantitative analysts, attempt to predict how the value of an option changes in response to changing conditions. Hence, the risks associated with granting, owning, or trading options may be quantified and managed with a greater degree of precision, perhaps, than with some other investments. Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions that have negotiated separate trading and clearing arrangements with each other.

Another important class of options, particularly in the U.S., are employee stock options, which are awarded by a company to their employees as a form of incentive compensation. Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.

Stock trader: A stock trader or a stock investor is an individual or firm who buys and sells stocks or bonds (and possibly other financial assets) in the financial markets.

Stock traders and stock investors

Individuals or firms trading equity (stock) on the stock markets as their principal capacity are called stock traders. Stock traders usually try to profit from short-term price volatility with trades lasting anywhere from several seconds to several weeks. The stock trader is usually a professional. Persons can call themselves full or part-time stock traders/investors while maintaining other professions. When a stock trader/investor has clients, and acts as a money manager or adviser with the intention of adding value to their clients finances, he is also called a financial advisor or manager. In this case, the financial manager could be an independent professional or a large bank corporation employee. This may include managers dealing with investment funds, hedge funds, mutual funds, and pension funds, or other professionals in equity investment, fund management, and wealth management. Several different types of stock trading exist including day trading, swing trading, market making, scalping (trading), momentum trading, trading the news, and arbitrage.

On the other hand, stock investors are firms or individuals who purchase stocks with the intention of holding them for an extended period of time, usually several months to years. They rely primarily on fundamental analysis for their investment decisions and fully recognize stock shares as part-ownership in the company. Many investors believe in the buy and hold strategy, which as the name suggests, implies that investors will hold stocks for the very long term, generally measured in years. This strategy was made popular in the equity bull market of the 1980s and 90s where buy-and-hold investors rode out short-term market declines and continued to hold as the market returned to its previous highs and beyond. However, during the 2001-2003 equity bear market, the buy-and-hold strategy lost some followers as broader market indexes like the NASDAQ saw their values decline by over 60%.

Methodology

Stock traders/investors usually need a stock broker such as a bank or a brokerage firm to access the stock market. Since the advent of Internet banking, an Internet connection is commonly used to manage positions. Using the Internet, specialized software, and a personal computer, stock traders/investors make use of technical analysis and fundamental analysis to help them in making decisions. They may use several information resources, some of which are strictly technical. Using the pivot points calculated from a previous day’s trading, they are able to predict the buy and sell points of the current day’s trading session. These points give a cue to traders as to where prices will head for the day, prompting each trader where to enter his trade, and where to exit. There is criticism on the validity of using these technical indicators in analysis, and many professional stock traders do not use them. Many full-time stock traders and stock investors have a formal education and training in fields such as economics, finance, mathematics and computer science, which are particularly relevant to this occupation.

Expenses, costs and risk

Trading activities are not free. They have a considerably high level of risk, uncertainty and complexity, especially for unwise and inexperienced stock traders/investors seeking an easy way to make money quickly. In addition, stock traders/investors face several costs such as commissions, taxes and fees to be paid for the brokerage and other services, like the buying/selling orders placed at the stock exchange. Depending on the nature of each national or state legislation involved, a large array of fiscal obligations must be respected, and taxes are charged by jurisdictions over those transactions, dividends and capital gains that fall within their scope. However, these fiscal obligations will vary from jurisdiction to jurisdiction. Among other reasons, there could be some instances where taxation is already incorporated into the stock price through the differing legislation that companies have to comply with in their respective jurisdictions; or that tax free stock market operations are useful to boost economic growth. Beyond these costs are the opportunity costs of money and time, currency risk, financial risk, and internet, data and news agency services and electricity consumption expenses – all of which must be accounted for.

Stock picking

Although many companies offer courses in stock picking, and numerous experts report success through Technical Analysis and Fundamental Analysis, many economists and academics state^[^{citation needed}^] that because of the efficient-market hypothesis it is unlikely that any amount of analysis can help an investor make any gains above the stock market itself. In a normal distribution of investors, many academics believe that the richest are simply outliers in such a distribution (i.e. in a game of chance, they have flipped heads twenty times in a row).

Accumulation/distribution method

Other investors choose a blend of technical, fundamental and environmental factors to influence where and when they invest. These strategists reject the ‘chance’ theory of investing, and attribute their higher level of returns to both insight and discipline.

Famous stock traders or stock investors

Bernard Baruch
José Berardo
Warren Buffett
Jim Cramer
Nicolas Darvas
Philip Arthur Fisher
Rakesh Jhunjhunwala
Benjamin Graham
John W. Henry
John Maynard Keynes, the famous economist, was a very successful stock investor.
Edward Lampert
Timothy Sykes, American businessman, former hedge-fund manager, and stock operator who successfully grew his $12,415 in Bar Mitzvah gift money into $1.65 million in two years
Jesse Lauriston Livermore
Peter Lynch
William O’Neil
Isaac Newton, the famous physicist, lost some of his money due to speculation in The South Sea Company stock in the 1720s. Isaac Newton lost over 20,000 pounds (£1.68 million in today’s money) of his fortune. As a result of this crisis, he stated “I can calculate the motions of heavenly bodies, but not the madness of people”.
David Ricardo, the famous political economist, joined his father at the London Stock Exchange, where he began to learn about the workings of finance. This beginning set the stage for Ricardo’s later success in the stock market.
Jim Rogers
Jim Slater
George Soros
John Templeton
Jules Verne, the famous writer, was a stock trader and broker at the Paris Stock Exchange (La Bourse de Paris).
Martin Zweig
Hetty Green was an American businesswoman, remarkable for her frugality during the Gilded Age, as well as for being the first American woman to make a substantial impact on Wall Street

Stock valuations: There are several methods used to value companies and their stocks. They attempt to give an estimate of their fair value, by using fundamental economic criteria. This theoretical valuation has to be perfected with market criteria, as the final purpose is to determine potential market prices.

Fundamental criteria (fair value)

The most theoretically sound stock valuation method, called income valuation or the discounted cash flow (DCF) method, involves discounting of the profits (dividends, earnings, or cash flows) the stock will bring to the stockholder in the foreseeable future, and a final value on disposition.^[1] The discounted rate normally includes a risk premium which is commonly based on the capital asset pricing model.

Approximate valuation approaches

Average growth approximation: Assuming that two stocks have the same earnings growth, the one with a lower P/E is a better value. The P/E method is perhaps the most commonly used valuation method in the stock brokerage industry^[2]^[3].^[^{citation needed}^] By using comparison firms, a target price/earnings (or P/E) ratio is selected for the company, and then the future earnings of the company are estimated. The valuation’s fair price is simply estimated earnings times target P/E. This model is essentially the same model as Gordon’s model, if k-g is estimated as the dividend payout ratio (D/E) divided by the target P/E ratio. Constant growth approximation: The Gordon model or Gordon’s growth model^[4] is the best known of a class of discounted dividend models. It assumes that dividends will increase at a constant growth rate (less than the discount rate) forever. The valuation is given by the formula:

Limited high-growth period approximation: When a stock has a significantly higher growth rate than its peers, it is sometimes assumed that the earnings growth rate will be sustained for a short time (say, 5 years), and then the growth rate will revert to the mean. This is probably the most rigorous approximation that is practical ^[5].

While these DCF models are commonly used, the uncertainty in these values is hardly ever discussed. Note that the models diverge for and hence are extremely sensitive to the difference of dividend growth to discount factor. One might argue that an analyst can justify any value (and that would usually be one close to the current price supporting his call) by fine-tuning the growth/discount assumptions.

Market criteria (potential price)

Some feel that if the stock is listed in a well organized stock market, with a large volume of transactions, the listed price will be close to the estimated fair value.^{[citation needed]} This is called the efficient market hypothesis.

On the other hand, studies made in the field of behavioral finance tend to show that deviations from the fair price are rather common, and sometimes quite large.^{[citation needed]}

Thus, in addition to fundamental economic criteria, market criteria also have to be taken into account market-based valuation. Valuing a stock is not only to estimate its fair value, but also to determine itspotential price range, taking into account market behavior aspects. One of the behavioral valuation tools is the stock image, a coefficient that bridges the theoretical fair value and the market price.

On-line valuation calculators

iStockResearch: Free intrinsic value (or fair value) calculation tool based on original stock valuation model.
InValueAble.net: Free stock valuation site using full financial statement approach to calculate intrinsic value. Sign-in required.
Online Preferred and Common Stock Valuation Calculator
http://www.moneychimp.com/articles/valuation/dcf.htm: Discounted Cash Flows Calculator that assumes that a higher growth can be sustained for a limited number of years.
http://intelligentinvesting.googlepages.com/DCF.xls: A DCF spreadsheet that allows different growth rates to be specified for years 1, 2 to 4, 5 to 7 and 8 to 10.
Baseline evaluation: Automatically fetches baseline data for popular stocks. Allows valuation with different assumptions like variable excess return period.
Public Company Valuations: Free discounted cash flow (DCF) valuation tool for major listed companies.
[2]: Behavioral stock pricer.

Stockholder of record: Stockholder of record is the name of an individual or entity that an issuer carries in its records as the registered holder (not necessarily the beneficial owner) of the issuer’s securities. Dividends and other distributions are paid only to shareholders of record. Stockholder of record may be also called shareholder of record or holder of record or owner of record.

Stockholders’ equity: When the owners are shareholders, the interest can be called shareholders’ equity;^[2] the accounting remains the same, and it is ownership equity spread out among shareholders. If all shareholders are in one and the same class, they share equally in ownership equity from all perspectives. However, shareholders may allow different priority ranking among themselves by the use of share classes, and options. This complicates both analysis for stock valuation, and accounting.

The individual investor is interested not only in the total changes to equity, but also in the increase / decrease in the value of his own personal share of the equity. This reconciliation of equity should be done both in total and on a per share basis.

Equity (beg. of year)
+ net income inter net money you gained
? dividends how much money you gained or lost so far
+/? gain/loss from changes to the number of shares outstanding.more or less
= Equity (end of year) if you get more money during the year or less or not anything

Straddle: In finance, a straddle is an investment strategy involving the purchase or sale of particular option derivatives that allows the holder to profit based on how much the price of the underlying security moves, regardless of the direction of price movement. The purchase of particular option derivatives is known as a long straddle, while the sale of the option derivatives is known as a short straddle.

§ Long straddle

A long straddle involves going long, i.e., purchasing, both a call option and a put option on some stock, interest rate, indexor other underlying. The two options are bought at the same strike price and expire at the same time. The owner of a long straddle makes a profit if the underlying price moves a long way from the strike price, either above or below. Thus, an investor may take a long straddle position if he thinks the market is highly volatile, but does not know in which direction it is going to move. This position is a limited risk, since the most a purchaser may lose is the cost of both options. At the same time, there is unlimited profit potential.
For example, company XYZ is set to release its quarterly financial results in two weeks. A trader believes that the release of these results will cause a large movement in the price of XYZ’s stock, but does not know whether the price will go up or down. He can enter into a long straddle, where he gets a profit no matter which way the price of XYZ stock moves, if the price changes enough either way. If the price goes up enough, he uses the call option and ignores the put option. If the price goes down, he uses the put option and ignores the call option. If the price does not change enough, he loses money, up to the total amount paid for the two options.
A short straddle is a non-directional options trading strategy that involves simultaneously selling a put and a call of the same underlying security, strike price and expiration date. The profit is limited to the premiums of the put and call, but it is risky if the underlying security’s price goes up or down much. The deal breaks even if the intrinsic value of the put or the call equals the sum of the premiums of the put and call. This strategy is called “nondirectional” because the short straddle profits when the underlying security changes little in price before the expiration of the straddle. The short straddle can also be classified as a credit spread because the sale of the short straddle results in a credit of the premiums of the put and call.
A short straddle position is highly risky, because the potential loss is unlimited, whereas profitability is limited to the premium gained by the initial sale of the options. The Collar is a more conservative “opposite” that limits gains and losses.
Nick Leeson took short straddle positions when chasing losses he had run up for his employer, Barings Bank. He had initially dealt in futures on the Nikkei 225 stock index. Following a dramatic fall in the market, largely due to the Kobe earthquake, Leeson lost millions. He tried to re-coup these losses by dealing in the higher risk, but potentially more rewarding, straddles. He bet that the Nikkei would stabilise and stay in a range around 19,000. His bet failed and losses escalated to $1.4bn, causing the bankruptcy of Barings.
By engaging in a straddle transaction, the investor is also taking a position on the volatility of the underlying security. Going long a straddle is a bet that the underlier will be more volatile over the straddle’s term than predicted by the market. Conversely, going short a straddle is a bet that the underlier will be less volatile. To see this, assume that the investor frequently re-hedges his portfolio with the underlier to keep his portfolio delta neutral. Because delta for an option is a monotonically increasing function of the underlier’s price, one can quickly see that large underlier movements help the investor who is long a straddle. When the underlier’s price goes up, the total delta of the straddle goes up as well, and the investor will need to sell the underlier to maintain a delta neutral portfolio. When the underlier goes down, the investor will need to buy the underlier. Hence, lots of movement in the underlier, or volatility, causes the investor to gain from his hedging transactions – he will always need to buy when the underlier is low and sell when high. In the same way, an investor with a short straddle will face the opposite situation – he will have to buy high and sell low when the underlier’s price is moving. For investors with a view on the future volatility of a particular underlier, a straddle (or, for that matter, any option in general) can be a way to implement that view. Recently, the development of variance swaps allows investors to trade volatility directly without the need for constant delta hedging. For a further discussion of this style of investing, see volatility arbitrage.

§ Short straddle

§ Nick Leeson and the Barings Bank collapse

§ As a volatility strategy

Strike price: In options, the strike price, or exercise price, is a key variable in a derivatives contract between two parties. Where the contract requires delivery of the underlying instrument, the trade will be at the strike price, regardless of the spot price (market price) of the underlying instrument at that time.

Definition – The fixed price at which the owner of an option can purchase, in the case of a call, or sell, in the case of a put, the underlying security or commodity. It’s the price at which the stock will be bought or sold when the option is exercised.

The strike price is often called the exercise price.

For example, an IBM May 50 Call has a strike/exercise price of $50 a share. When the option is exercised the owner of the option will buy (Call option) 100 shares of IBM stock for $50 a share.

Subprime mortgage crisis: The subprime mortgage crisis is an ongoing real estate and financial crisis triggered by a dramatic rise in mortgage delinquencies and foreclosures in the United States, with major adverse consequences for banks and financial markets around the globe. The crisis, which has its roots in the closing years of the 20th century, became apparent in 2007 and has exposed pervasive weaknesses in financial industry regulation and the global financial system.

Approximately 80% of U.S. mortgages issued in recent years to subprime borrowers were adjustable-rate mortgages. When U.S. house prices began to decline in 2006-07, refinancing became more difficult and as adjustable-rate mortgages began to reset at higher rates, mortgage delinquencies soared. Securities backed with subprime mortgages, widely held by financial firms, lost most of their value. The result has been a large decline in the capital of many banks and U.S. government sponsored enterprises, tightening credit around the world.

Background and timeline of events

Main articles: Subprime crisis background information, Subprime crisis impact timeline, United States housing bubble, and United States housing market correction

The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006. High default rates on “subprime” and adjustable rate mortgages (ARM), began to increase quickly thereafter. An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Falling prices also resulted in homes worth less than the mortgage loan, providing a financial incentive to enter foreclosure. The ongoing foreclosure epidemic that began in late 2006 in the U.S. continues to be a key factor in the global economic crisis, because it drains wealth from consumers and erodes the financial strength of banking institutions.

In the years leading up to the crisis, significant amounts of foreign money flowed into the U.S. from fast-growing economies in Asia and oil-producing countries. This inflow of funds combined with low U.S. interest rates from 2002-2004 contributed to easy credit conditions, which fueled both housing and credit bubbles. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load. As part of the housing and credit booms, the amount of financial agreements called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, greatly increased. Such financial innovation enabled institutions and investors around the world to invest in the U.S. housing market. As housing prices declined, major global financial institutions that had borrowed and invested heavily in subprime MBS reported significant losses. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. Total losses are estimated in the trillions of U.S. dollars globally.

While the housing and credit bubbles built, a series of factors caused the financial system to become increasingly fragile. Policymakers did not recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system. Some experts believe these institutions had become as important as commercial (depository) banks in providing credit to the U.S. economy, but they were not subject to the same regulations. These institutions as well as certain regulated banks had also assumed significant debt burdens while providing the loans described above and did not have a financial cushion sufficient to absorb large loan defaults or MBS losses. These losses impacted the ability of financial institutions to lend, slowing economic activity. Concerns regarding the stability of key financial institutions drove central banks to take action to provide funds to encourage lending and to restore faith in the commercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions, assuming significant additional financial commitments.

The risks to the broader economy created by the housing market downturn and subsequent financial market crisis were primary factors in several decisions by central banks around the world to cut interest rates and governments to implement economic stimulus packages. Effects on global stock markets due to the crisis have been dramatic. Between 1 January and 11 October 2008, owners of stocks in U.S. corporations had suffered about $8 trillion in losses, as their holdings declined in value from $20 trillion to $12 trillion. Losses in other countries have averaged about 40%. Losses in the stock markets and housing value declines place further downward pressure on consumer spending, a key economic engine. Leaders of the larger developed and emerging nations met in November 2008 and March 2009 to formulate strategies for addressing the crisis. As of April 2009, many of the root causes of the crisis had yet to be addressed. A variety of solutions have been proposed by government officials, central bankers, economists, and business executives.

Mortgage market

Subprime borrowers typically have weakened credit histories and reduced repayment capacity. Subprime loans have a higher risk of default than loans to prime borrowers. If a borrower is delinquent in making timely mortgage payments to the loan servicer (a bank or other financial firm), the lender may take possession of the property, in a process called foreclosure.

The value of USA subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien subprime mortgages outstanding. Between 2004-2006 the share of subprime mortgages relative to total originations ranged from 18%-21%, versus less than 10% in 2001-2003 and during 2007. In the third quarter of 2007, subprime ARMs making up only 6.8% of USA mortgages outstanding also accounted for 43% of the foreclosures which began during that quarter. By October 2007, approximately 16% of subprime adjustable rate mortgages (ARM) were either 90-days delinquent or the lender had begun foreclosure proceedings, roughly triple the rate of 2005. By January 2008, the delinquency rate had risen to 21% and by May 2008 it was 25%.

The value of all outstanding residential mortgages, owed by USA households to purchase residences housing at most four families, was US$9.9 trillion as of year-end 2006, and US$10.6 trillion as of midyear 2008. During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006. This increased to 2.3 million in 2008, an 81% increase vs. 2007. As of August 2008, 9.2% of all mortgages outstanding were either delinquent or in foreclosure. Between August 2007 and October 2008, 936,439 USA residences completed foreclosure. Foreclosures are concentrated in particular states both in terms of the number and rate of foreclosure filings. Ten states accounted for 74% of the foreclosure filings during 2008; the top two (California and Florida) represented 41%. Nine states were above the national foreclosure rate average of 1.84% of households.

Causes

The crisis can be attributed to a number of factors pervasive in both housing and credit markets, factors which emerged over a number of years. Causes proposed include the inability of homeowners to make their mortgage payments, due primarily to adjustable rate mortgages resetting, borrowers overextending, predatory lending, speculation and overbuilding during the boom period, risky mortgage products, high personal and corporate debt levels, financial products that distributed and perhaps concealed the risk of mortgage default, monetary policy, international trade imbalances, and government regulation (or the lack thereof). Two important catalysts of the subprime crisis were the influx of moneys from the private sector and banks entering into the mortgage bond market and the predatory lending practices of mortgage brokers, specifically the adjustable rate mortgage, 2-28 loan. Ultimately, though, specific to the bailout of Wall Street and the financial industry moral hazard lay at the core of many of the causes.

In its “Declaration of the Summit on Financial Markets and the World Economy,” dated 15 November 2008, leaders of the Group of 20 cited the following causes:

“During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.”

Boom and bust in the housing market

Main articles: United States housing bubble and United States housing market correction

Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing market boom and encouraging debt-financed consumption. The USA home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of 69.2% in 2004. Subprime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing, which drove prices higher.

Between 1997 and 2006, the price of the typical American house increased by 124%. During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006. This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation. USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990.

While housing prices were increasing, consumers were saving less and both borrowing and spending more. Household debt grew from $705 billion at yearend 1974, 60% of disposable personal income, to $7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008, 134% of disposable personal income. During 2008, the typical USA household owned 13 credit cards, with 40% of households carrying a balance, up from 6% in 1970. Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period. U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.

This credit and house price explosion led to a building boom and eventually to a surplus of unsold homes, which caused U.S. housing prices to peak and begin declining in mid-2006. Easy credit, and a belief that house prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage’s term. Borrowers who could not make the higher payments once the initial grace period ended would try to refinance their mortgages. Refinancing became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default.

As more borrowers stop paying their mortgage payments (this is an on-going crisis), foreclosures and the supply of homes for sale increases. This places downward pressure on housing prices, which further lowers homeowners’ equity. The decline in mortgage payments also reduces the value of mortgage-backed securities, which erodes the net worth and financial health of banks. This vicious cycle is at the heart of the crisis.

By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak. This major and unexpected decline in house prices means that many borrowers have zero or negative equity in their homes, meaning their homes were worth less than their mortgages. As of March 2008, an estimated 8.8 million borrowers — 10.8% of all homeowners — had negative equity in their homes, a number that is believed to have risen to 12 million by November 2008. Borrowers in this situation have an incentive to default on their mortgages as a mortgage is typically nonrecourse debt secured against the property. Economist Stan Leibowitz argued in the Wall Street Journal that although only 12% of homes had negative equity, they comprised 47% of foreclosures during the second half of 2008. He concluded that the extent of equity in the home was the key factor in foreclosure, rather than the type of loan, credit worthiness of the borrower, or ability to pay.

Increasing foreclosure rates increases the inventory of houses offered for sale. The number of new homes sold in 2007 was 26.4% less than in the preceding year. By January 2008, the inventory of unsold new homes was 9.8 times the December 2007 sales volume, the highest value of this ratio since 1981. Furthermore, nearly four million existing homes were for sale, of which almost 2.9 million were vacant. This overhang of unsold homes lowered house prices. As prices declined, more homeowners were at risk of default or foreclosure. House prices are expected to continue declining until this inventory of unsold homes (an instance of excess supply) declines to normal levels.

Speculation

Speculative borrowing in residential real estate has been cited as a contributing factor to the subprime mortgage crisis. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, a record level of nearly 40% of homes purchases were not intended as primary residences. David Lereah, NAR‘s chief economist at the time, stated that the 2006 decline in investment buying was expected: “Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market.”

Housing prices nearly doubled between 2000 and 2006, a vastly different trend from the historical appreciation at roughly the rate of inflation. While homes had not traditionally been treated as investments subject to speculation, this behavior changed during the housing boom. Media widely reported condominiums being purchased while under construction, then being “flipped” (sold) for a profit without the seller ever having lived in them. Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.

Nicole Gelinas of the Manhattan Institute described the negative consequences of not adjusting tax and mortgage policies to the shifting treatment of a home from conservative inflation hedge to speculative investment. Economist Robert Shiller argued that speculative bubbles are fueled by “contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they’re going to keep forming.” Keynesian economist Hyman Minsky described how speculative borrowing contributed to rising debt and an eventual collapse of asset values.

High-risk mortgage loans and lending/borrowing practices

In the years before the crisis, the behavior of lenders changed dramatically. Lenders offered more and more loans to higher-risk borrowers. Subprime mortgages amounted to $35 billion (5% of total originations) in 1994, 9% in 1996, $160 billion (13%) in 1999, and $600 billion (20%) in 2006. A study by the Federal Reserve found that the average difference between subprime and prime mortgage interest rates (the “subprime markup”) declined significantly between 2001 and 2007. The combination of declining risk premia and credit standards is common to boom and bust credit cycles.

In addition to considering higher-risk borrowers, lenders have offered increasingly risky loan options and borrowing incentives. In 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever. By comparison, China has down payment requirements that exceed 20%, with higher amounts for non-primary residences.

One high-risk option was the “No Income, No Job and no Assets” loans, sometimes referred to as Ninja loans. Another example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Still another is a “payment option” loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal. An estimated one-third of ARMs originated between 2004 and 2006 had “teaser” rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment.

The proportion of subprime ARM loans made to people with credit scores high enough to qualify for conventional mortgages with better terms increased from 41% in 2000 to 61% by 2006. However, there are many factors other than credit score that affect lending. In addition, mortgage brokers in some cases received incentives from lenders to offer subprime ARM’s even to those with credit ratings that merited a conforming (i.e., non-subprime) loan.

Mortgage underwriting standards declined precipitously during the boom period. The use of automated loan approvals allowed loans to be made without appropriate review and documentation. In 2007, 40% of all subprime loans resulted from automated underwriting. The chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to examine whether borrowers could repay. Mortgage fraud by lenders and borrowers increased enormously. In 2004, the Federal Bureau of Investigation warned of an “epidemic” in mortgage fraud, an important credit risk of nonprime mortgage lending, which, they said, could lead to “a problem that could have as much impact as the S&L crisis”.

So why did lending standards decline? In a Peabody Award winning program, NPR correspondents argued that a “Giant Pool of Money” (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade. Further, this pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with financial innovation such as the mortgage-backed security (MBS) and collateralized debt obligation (CDO), which were assigned safe ratings by the credit rating agencies. In effect, Wall Street connected this pool of money to the mortgage market in the U.S., with enormous fees accruing to those throughout the mortgage supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted. However, continued strong demand for MBS and CDO began to drive down lending standards, as long as mortgages could still be sold along the supply chain. Eventually, this speculative bubble proved unsustainable. NPR described it this way:

The problem was that even though housing prices were going through the roof, people weren’t making any more money. From 2000 to 2007, the median household income stayed flat. And so the more prices rose, the more tenuous the whole thing became. No matter how lax lending standards got, no matter how many exotic mortgage products were created to shoehorn people into homes they couldn’t possibly afford, no matter what the mortgage machine tried, the people just couldn’t swing it. By late 2006, the average home cost nearly four times what the average family made. Historically it was between two and three times. And mortgage lenders noticed something that they’d almost never seen before. People would close on a house, sign all the mortgage papers, and then default on their very first payment. No loss of a job, no medical emergency, they were underwater before they even started. And although no one could really hear it, that was probably the moment when one of the biggest speculative bubbles in American history popped.

Securitization practices

Further information: Securitization and Mortgage-backed security

The traditional mortgage model involved a bank originating a loan to the borrower/homeowner and retaining the credit (default) risk. With the advent of securitization, the traditional model has given way to the “originate to distribute” model, in which banks essentially sell the mortgages and distribute credit risk to investors through mortgage-backed securities. Securitization meant that those issuing mortgages were no longer required to hold them to maturity. By selling the mortgages to investors, the originating banks replenished their funds, enabling them to issue more loans and generating transaction fees. This may have created moral hazard and increased focus on processing mortgage transactions rather than ensuring their credit quality.

Securitization accelerated in the mid-1990s. The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion. The securitized share of subprime mortgages (i.e., those passed to third-party investors via MBS) increased from 54% in 2001, to 75% in 2006. American homeowners, consumers, and corporations owed roughly $25 trillion during 2008. American banks retained about $8 trillion of that total directly as traditional mortgage loans. Bondholders and other traditional lenders provided another $7 trillion. The remaining $10 trillion came from the securitization markets. The securitization markets started to close down in the spring of 2007 and nearly shut-down in the fall of 2008. More than a third of the private credit markets thus became unavailable as a source of funds. In February 2009, Ben Bernanke stated that securitization markets remained effectively shut, with the exception of conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.

A more direct connection between securitization and the subprime crisis relates to a fundamental fault in the way that underwriters, rating agencies and investors modeled the correlation of risks among loans in securitization pools. Correlation modeling—determining how the default risk of one loan in a pool is statistically related to the default risk for other loans—was based on a “Gaussian copula” technique developed by statistician David X. Li. This technique, widely adopted as a means of evaluating the risk associated with securitization transactions, used what turned out to be an overly simplistic approach to correlation. Unfortunately, the flaws in this technique did not become apparent to market participants until after many hundreds of billions of dollars of ABS and CDOs backed by subprime loans had been rated and sold. By the time investors stopped buying subprime-backed securities—which halted the ability of mortgage originators to extend subprime loans—the effects of the crisis were already beginning to emerge.

Nobel laureate Dr. A. Michael Spence wrote: “Financial innovation, intended to redistribute and reduce risk, appears mainly to have hidden it from view. An important challenge going forward is to better understand these dynamics as the analytical underpinning of an early warning system with respect to financial instability.”

Inaccurate credit ratings

Main article: Credit rating agencies and the subprime crisis

Credit rating agencies are now under scrutiny for having given investment-grade ratings to MBSs based on risky subprime mortgage loans. These high ratings enabled these MBS to be sold to investors, thereby financing the housing boom. These ratings were believed justified because of risk reducing practices, such as credit default insurance and equity investors willing to bear the first losses. However, there are also indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty.

Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organize and sell structured securities to investors. On 11 June 2008, the SEC proposed rules designed to mitigate perceived conflicts of interest between rating agencies and issuers of structured securities. On 3 December 2008, the SEC approved measures to strengthen oversight of credit rating agencies, following a ten-month investigation that found “significant weaknesses in ratings practices,” including conflicts of interest.

Between Q3 2007 and Q2 2008, rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities. Financial institutions felt they had to lower the value of their MBS and acquire additional capital so as to maintain capital ratios. If this involved the sale of new shares of stock, the value of the existing shares was reduced. Thus ratings downgrades lowered the stock prices of many financial firms.

Government policies

Main article: Government policies and the subprime mortgage crisis

Both government failed regulation and deregulation contributed to the crisis. In testimony before Congress both the Securities and Exchange Commission (SEC) and Alan Greenspan conceded failure in allowing the self-regulation of investment banks.

Increasing home ownership has been the goal of several presidents including Roosevelt, Reagan, Clinton and G.W.Bush. In 1982, Congress passed the Alternative Mortgage Transactions Parity Act (AMTPA), which allowed non-federally chartered housing creditors to write adjustable-rate mortgages. Among the new mortgage loan types created and gaining in popularity in the early 1980s were adjustable-rate, option adjustable-rate, balloon-payment and interest-only mortgages. These new loan types are credited with replacing the long standing practice of banks making conventional fixed-rate, amortizing mortgages. Among the criticisms of banking industry deregulation that contributed to the savings and loan crisis was that Congress failed to enact regulations that would have prevented exploitations by these loan types. Subsequent widespread abuses of predatory lending occurred with the use of adjustable-rate mortgages. Approximately 80% of subprime mortgages are adjustable-rate mortgages.

In 1995, the GSEs like Fannie Mae began receiving government tax incentives for purchasing mortgage backed securities which included loans to low income borrowers. Thus began the involvement of the Fannie Mae and Freddie Mac with the subprime market. In 1996, HUD set a goal for Fannie Mae and Freddie Mac that at least 42% of the mortgages they purchase be issued to borrowers whose household income was below the median in their area. This target was increased to 50% in 2000 and 52% in 2005. From 2002 to 2006, as the U.S. subprime market grew 292% over previous years, Fannie Mae and Freddie Mac combined purchases of subprime securities rose from $38 billion to around $175 billion per year before dropping to $90 billion per year, which included $350 billion of Alt-A securities. Fannie Mae had stopped buying Alt-A products in the early 1990s because of the high risk of default. By 2008, the Fannie Mae and Freddie Mac owned, either directly or through mortgage pools they sponsored, $5.1 trillion in residential mortgages, about half the total U.S. mortgage market. The GSE have always been highly leveraged, their net worth as of 30 June 2008 being a mere US$114 billion. When concerns arose in September 2008 regarding the ability of the GSE to make good on their guarantees, the Federal government was forced to place the companies into a conservatorship, effectively nationalizing them at the taxpayers’ expense.

The Glass-Steagall Act was enacted after the Great Depression. It separated commercial banks and investment banks, in part to avoid potential conflicts of interest between the lending activities of the former and rating activities of the latter. Economist Joseph Stiglitz criticized the repeal of the Act. He called its repeal the “culmination of a $300 million lobbying effort by the banking and financial services industries…spearheaded in Congress by Senator Phil Gramm.” He believes it contributed to this crisis because the risk-taking culture of investment banking dominated the more conservative commercial banking culture, leading to increased levels of risk-taking and leverage during the boom period. The Federal government bailout of thrifts during the savings and loan crisis of the late 1980s may have encouraged other lenders to make risky loans, and thus given rise to moral hazard.

Conservatives and Libertarians have also debated the possible effects of the Community Reinvestment Act (CRA), with detractors claiming that the Act encouraged lending to uncreditworthy borrowers, and defenders claiming a thirty year history of lending without increased risk. Detractors also claim that amendments to the CRA in the mid-1990s, raised the amount of mortgages issued to otherwise unqualified low-income borrowers, and allowed the securitization of CRA-regulated mortgages, even though a fair number of them were subprime.

Both Federal Reserve Governor Randall Kroszner and FDIC Chairman Sheila Bair have stated their belief that the CRA was not to blame for the crisis.

Policies of central banks

Central banks manage monetary policy and may target the rate of inflation. They have some authority over commercial banks and possibly other financial institutions. They are less concerned with avoiding asset price bubbles, such as the housing bubble and dot-com bubble. Central banks have generally chosen to react after such bubbles burst so as to minimize collateral damage to the economy, rather than trying to prevent or stop the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to deflate it are matters of debate among economists.

Some market observers have been concerned that Federal Reserve actions could give rise to moral hazard. A Government Accountability Office critic said that the Federal Reserve Bank of New York‘s rescue of Long-Term Capital Management in 1998 would encourage large financial institutions to believe that the Federal Reserve would intervene on their behalf if risky loans went sour because they were “too big to fail.”

A contributing factor to the rise in house prices was the Federal Reserve’s lowering of interest rates early in the decade. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%. This was done to soften the effects of the collapse of the dot-com bubble and of the September 2001 terrorist attacks, and to combat the perceived risk of deflation. The Fed believed that interest rates could be lowered safely primarily because the rate of inflation was low; it disregarded other important factors. Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas, said that the Fed’s interest rate policy during the early 2000s was misguided, because measured inflation in those years was below true inflation, which led to a monetary policy that contributed to the housing bubble. According to Ben Bernanke, now chairman of the Federal Reserve, it was capital or savings pushing into the United States, due to a worldwide “saving glut”, which kept long term interest rates low independently of Central Bank action.

The Fed then raised the Fed funds rate significantly between July 2004 and July 2006. This contributed to an increase in 1-year and 5-year ARM rates, making ARM interest rate resets more expensive for homeowners. This may have also contributed to the deflating of the housing bubble, as asset prices generally move inversely to interest rates and it became riskier to speculate in housing.

Financial institution debt levels and incentives

Many financial institutions, investment banks in particular, issued large amounts of debt during 2004–2007, and invested the proceeds in mortgage-backed securities (MBS), essentially betting that house prices would continue to rise, and that households would continue to make their mortgage payments. Borrowing at a lower interest rate and investing the proceeds at a higher interest rate is a form of financial leverage. This is analogous to an individual taking out a second mortgage on his residence to invest in the stock market. This strategy proved profitable during the housing boom, but resulted in large losses when house prices began to decline and mortgages began to default. Beginning in 2007, financial institutions and individual investors holding MBS also suffered significant losses from mortgage payment defaults and the resulting decline in the value of MBS.

A 2004 U.S. Securities and Exchange Commission (SEC) decision related to the net capital rule allowed USA investment banks to issue substantially more debt, which was then used to purchase MBS. Over 2004-07, the top five US investment banks each significantly increased their financial leverage (see diagram), which increased their vulnerability to the declining value of MBSs. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007. Further, the percentage of subprime mortgages originated to total originations increased from below 10% in 2001-2003 to between 18-20% from 2004-2006, due in-part to financing from investment banks.

During 2008, three of the largest U.S. investment banks either went bankrupt (Lehman Brothers) or were sold at fire sale prices to other banks (Bear Stearns and Merrill Lynch). These failures augmented the instability in the global financial system. The remaining two investment banks, Morgan Stanley and Goldman Sachs, opted to become commercial banks, thereby subjecting themselves to more stringent regulation.

In the years leading up to the crisis, the top four U.S. depository banks moved an estimated $5.2 trillion in assets and liabilities off-balance sheet into special purpose vehicles or other entities in the shadow banking system. This enabled them to essentially bypass existing regulations regarding minimum capital ratios, thereby increasing leverage and profits during the boom but increasing losses during the crisis. New accounting guidance will require them to put some of these assets back onto their books during 2009, which will significantly reduce their capital ratios. One news agency estimated this amount to be between $500 billion and $1 trillion. This effect was considered as part of the stress tests performed by the government during 2009.

Martin Wolf wrote in June 2009: “…an enormous part of what banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives and the ‘shadow banking system’ itself – was to find a way round regulation.”

The New York State Comptroller’s Office has said that in 2006, Wall Street executives took home bonuses totaling $23.9 billion. “Wall Street traders were thinking of the bonus at the end of the year, not the long-term health of their firm. The whole system—from mortgage brokers to Wall Street risk managers—seemed tilted toward taking short-term risks while ignoring long-term obligations. The most damning evidence is that most of the people at the top of the banks didn’t really understand how those [investments] worked.”

Investment banker incentive compensation was focused on fees generated from assembling financial products, rather than the performance of those products and profits generated over time. Their bonuses were heavily skewed towards cash rather than stock and not subject to “claw-back” (recovery of the bonus from the employee by the firm) in the event the MBS or CDO created did not perform. In addition, the increased risk (in the form of financial leverage) taken by the major investment banks was not adequately factored into the compensation of senior executives.

Credit default swaps

Credit defaults swaps (CDS) are financial instruments used as a hedge and protection for debtholders, in particular MBS investors, from the risk of default. As the net worth of banks and other financial institutions deteriorated because of losses related to subprime mortgages, the likelihood increased that those providing the insurance would have to pay their counterparties. This created uncertainty across the system, as investors wondered which companies would be required to pay to cover mortgage defaults.

Like all swaps and other financial derivatives, CDS may either be used to hedge risks (specifically, to insure creditors against default) or to profit from speculation. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. CDS are lightly regulated. As of 2008, there was no central clearing house to honor CDS in the event a party to a CDS proved unable to perform his obligations under the CDS contract. Required disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as American International Group (AIG), MBIA, and Ambac faced ratings downgrades because widespread mortgage defaults increased their potential exposure to CDS losses. These firms had to obtain additional funds (capital) to offset this exposure. AIG’s having CDSs insuring $440 billion of MBS resulted in its seeking and obtaining a Federal government bailout.

Like all swaps and other pure wagers, what one party loses under a CDS, the other party gains; CDSs merely reallocate existing wealth [that is, provided that the paying party can perform]. Hence the question is which side of the CDS will have to pay and will it be able to do so. When investment bank Lehman Brothers went bankrupt in September 2008, there was much uncertainty as to which financial firms would be required to honor the CDS contracts on its $600 billion of bonds outstanding. Merrill Lynch‘s large losses in 2008 were attributed in part to the drop in value of its unhedged portfolio of collateralized debt obligations (CDOs) after AIG ceased offering CDS on Merrill’s CDOs. The loss of confidence of trading partners in Merrill Lynch’s solvency and its ability to refinance its short-term debt led to its acquisition by the Bank of America.

Economist Joseph Stiglitz summarized how credit default swaps contributed to the systemic meltdown: “With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one’s own position. Not surprisingly, the credit markets froze.”

Investment in U.S. by foreigners of their proceeds from America’s net imports

In 2005, Ben Bernanke addressed the implications of the USA’s high and rising current account (trade) deficit, resulting from USA imports exceeding its exports. Between 1996 and 2004, the USA current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the USA to borrow large sums from abroad, much of it from countries running trade surpluses, mainly the emerging economies in Asia and oil-exporting nations. The balance of payments identity requires that a country (such as the USA) running a current account deficit also have a capital account (investment) surplus of the same amount. Hence large and growing amounts of foreign funds (capital) flowed into the USA to finance its imports. Foreign investors had these funds to lend, either because they had very high personal savings rates (as high as 40% in China), or because of high oil prices. Bernanke referred to this as a “saving glut“ that may have pushed capital into the USA, a view differing from that of other economists, who view such capital as having been pulled into the USA by its high consumption levels. In other words, a nation cannot consume more than its income unless it sells assets to foreigners, or foreigners are willing to lend to it.

Regardless of the push or pull view, a “flood” of funds (capital or liquidity) reached the USA financial markets. Foreign governments supplied funds by purchasing USA Treasury bonds and thus avoided much of the direct impact of the crisis. USA households, on the other hand, used funds borrowed from foreigners to finance consumption or to bid up the prices of housing and financial assets. Financial institutions invested foreign funds in mortgage-backed securities. USA housing and financial assets dramatically declined in value after the housing bubble burst.

Boom and collapse of the shadow banking system

In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President of the NY Federal Reserve Bank, placed significant blame for the freezing of credit markets on a “run” on the entities in the “parallel” banking system, also called the shadow banking system. These entities became critical to the credit markets underpinning the financial system, but were not subject to the same regulatory controls. Further, these entities were vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that disruptions in credit markets would make them subject to rapid deleveraging, selling their long-term assets at depressed prices. He described the significance of these entities: “In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion.” He stated that the “combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles.”

Nobel laureate Paul Krugman described the run on the shadow banking system as the “core of what happened” to cause the crisis. “As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible—and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank.” He referred to this lack of controls as “malign neglect.”

The securitization markets supported by the shadow banking system started to close down in the spring of 2007 and nearly shut-down in the fall of 2008. More than a third of the private credit markets thus became unavailable as a source of funds.^[91] According to the Brookings Institution, the traditional banking system does not have the capital to close this gap as of June 2009: “It would take a number of years of strong profits to generate sufficient capital to support that additional lending volume.” The authors also indicate that some forms of securitization are “likely to vanish forever, having been an artifact of excessively loose credit conditions.”

Impacts

Main articles: Financial crisis of 2007–2008 and Global financial crisis of 2008

Impact in the U.S.

Between June 2007 and November 2008, Americans lost more than a quarter of their net worth. By early November 2008, a broad U.S. stock index, the S&P 500, was down 45 percent from its 2007 high. Housing prices had dropped 20% from their 2006 peak, with futures markets signaling a 30-35% potential drop. Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late 2008. Total retirement assets, Americans’ second-largest household asset, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total a staggering $8.3 trillion. Members of USA minority groups received a disproportionate number of subprime mortgages, and so have experienced a disproportionate level of the resulting foreclosures.

Financial market impacts, 2007

Further information: List of writedowns due to subprime crisis

The crisis began to affect the financial sector in February 2007, when HSBC, the world’s largest (2008) bank, wrote down its holdings of subprime-related MBS by $10.5 billion, the first major subprime related loss to be reported. During 2007, at least 100 mortgage companies either shut down, suspended operations or were sold.^[155] Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup resigned within a week of each other in late 2007. As the crisis deepened, more and more financial firms either merged, or announced that they were negotiating seeking merger partners.

During 2007, the crisis caused panic in financial markets and encouraged investors to take their money out of risky mortgage bonds and shaky equities and put it into commodities as “stores of value”. Financial speculation in commodity futures following the collapse of the financial derivatives markets has contributed to the world food price crisis and oil price increases due to a “commodities super-cycle.” Financial speculators seeking quick returns have removed trillions of dollars from equities and mortgage bonds, some of which has been invested into food and raw materials.

Mortgage defaults and provisions for future defaults caused profits at the 8533 USA depository institutions insured by the FDIC to decline from $35.2 billion in 2006 Q4 billion to $646 million in the same quarter a year later, a decline of 98%. 2007 Q4 saw the worst bank and thrift quarterly performance since 1990. In all of 2007, insured depository institutions earned approximately $100 billion, down 31% from a record profit of $145 billion in 2006. Profits declined from $35.6 billion in 2007 Q1 to $19.3 billion in 2008 Q1, a decline of 46%.

Financial market impacts, 2008

urther information: Indirect economic effects of the subprime mortgage crisis

As of August 2008, financial firms around the globe have written down their holdings of subprime related securities by US$501 billion. The IMF estimates that financial institutions around the globe will eventually have to write off $1.5 trillion of their holdings of subprime MBSs. About $750 billion in such losses had been recognized as of November 2008. These losses have wiped out much of the capital of the world banking system. Banks headquartered in nations that have signed the Basel Accords must have so many cents of capital for every dollar of credit extended to consumers and businesses. Thus the massive reduction in bank capital just described has reduced the credit available to businesses and households.

When Lehman Brothers and other important financial institutions failed in September 2008, the crisis hit a key point. During a two day period in September 2008, $150 billion were withdrawn from USA money funds. The average two day outflow had been $5 billion. In effect, the money market was subject to a bank run. The money market had been a key source of credit for banks (CDs) and nonfinancial firms (commercial paper). The TED spread (see graph above), a measure of the risk of interbank lending, quadrupled shortly after the Lehman failure. This credit freeze brought the global financial system to the brink of collapse. The response of the USA Federal Reserve, the European Central Bank, and other central banks was immediate and dramatic. During the last quarter of 2008, these central banks purchased US$2.5 trillion of government debt and troubled private assets from banks. This was the largest liquidity injection into the credit market, and the largest monetary policy action, in world history. The governments of European nations and the USA also raised the capital of their national banking systems by $1.5 trillion, by purchasing newly issued preferred stock in their major banks.

However, some economists state that Third-World economies, such as the Brazilian and Chinese ones, will not suffer as much as those from more developed countries.

Responses

Further information: Subprime mortgage crisis solutions debate

Various actions have been taken since the crisis became apparent in August 2007. In September 2008, major instability in world financial markets increased awareness and attention to the crisis. Various agencies and regulators, as well as political officials, began to take additional, more comprehensive steps to handle the crisis.

To date, various government agencies have committed or spent trillions of dollars in loans, asset purchases, guarantees, and direct spending. For a summary of U.S. government financial commitments and investments related to the crisis, see CNN – Bailout Scorecard.

Federal Reserve and central banks

Main article: Federal Reserve responses to the subprime crisis

The central bank of the USA, the Federal Reserve, in partnership with central banks around the world, has taken several steps to address the crisis. Federal Reserve Chairman Ben Bernanke stated in early 2008: “Broadly, the Federal Reserve’s response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy.”

The Fed has:

Lowered the target for the Federal funds rate from 5.25% to 2%, and the discount rate from 5.75% to 2.25%. This took place in six steps occurring between 18 September 2007 and 30 April 2008; In December 2008, the Fed further lowered the federal funds rate target to a range of 0-0.25% (25 basis points).
Undertaken, along with other central banks, open market operations to ensure member banks remain liquid. These are effectively short-term loans to member banks collateralized by government securities. Central banks have also lowered the interest rates (called the discount rate in the USA) they charge member banks for short-term loans;
Created a variety of lending facilities to enable the Fed to lend directly to banks and non-bank institutions, against specific types of collateral of varying credit quality. These include the Term Auction Facility(TAF) and Term Asset-Backed Securities Loan Facility (TALF).
In November 2008, the Fed announced a $600 billion program to purchase the MBS of the GSE, to help lower mortgage rates.
In March 2009, the FOMC decided to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency (GSE) mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities during 2009.

According to Ben Bernanke, expansion of the Fed balance sheet means the Fed is electronically creating money, necessary “…because our economy is very weak and inflation is very low. When the economy begins to recover, that will be the time that we need to unwind those programs, raise interest rates, reduce the money supply, and make sure that we have a recovery that does not involve inflation.”

Economic stimulus

Main article: Economic Stimulus Act of 2008

Main article: American Recovery and Reinvestment Act of 2009

On 13 February 2008, President Bush signed into law a $168 billion economic stimulus package, mainly taking the form of income tax rebate cheques mailed directly to taxpayers.^[176] Cheques were mailed starting the week of 28 April 2008. However, this rebate coincided with an unexpected jump in gasoline and food prices. This coincidence led some to wonder whether the stimulus package would have the intended effect, or whether consumers would simply spend their rebates to cover higher food and fuel prices.

On 17 February 2009, U.S. President Barack Obama signed the American Recovery and Reinvestment Act of 2009, an $787 billion stimulus package with a broad spectrum of spending and tax cuts.

Bank solvency and capital replenishment

Main article: Emergency Economic Stabilization Act of 2008

Losses on mortgage-backed securities and other assets purchased with borrowed money have dramatically reduced the capital base of financial institutions, rendering many either insolvent or less capable of lending. Governments have provided funds to banks. Some banks have taken significant steps to acquire additional capital from private sources.

The U.S. government passed the Emergency Economic Stabilization Act of 2008 (EESA or TARP) during October 2008. This law included $700 billion in funding for the “Troubled Assets Relief Program” (TARP), which was used to lend funds to banks in exchange for dividend-paying preferred stock.

Another method of recapitalizing banks is for government and private investors to provide cash in exchange for mortgage-related assets (i.e., “toxic” or “legacy” assets), improving the quality of bank capital while reducing uncertainty regarding the financial position of banks. U.S. Treasury Secretary Timothy Geithner announced a plan during March 2009 to purchase “legacy” or “toxic” assets from banks. The Public-Private Partnership Investment Program involves government loans and guarantees to encourage private investors to provide funds to purchase toxic assets from banks.

For a summary of U.S. government financial commitments and investments related to the crisis, see CNN – Bailout Scorecard.

For a summary of TARP funds provided to U.S. banks as of December 2008, see Reuters-TARP Funds.

Bailouts and failures of financial firms

Further information: List of bankrupt or acquired banks during the financial crisis of 2007–2008, Federal takeover of Fannie Mae and Freddie Mac, Government intervention during the subprime mortgage crisis, and Bailout

Several major financial institutions either failed, were bailed-out by governments, or merged (voluntarily or otherwise) during the crisis. While the specific circumstances varied, in general the decline in the value of mortgage-backed securities held by these companies resulted in either their insolvency, the equivalent of bank runs as investors pulled funds from them, or inability to secure new funding in the credit markets. These firms had typically borrowed and invested large sums of money relative to their cash or equity capital, meaning they were highly leveraged and vulnerable to unanticipated credit market disruptions.

The five largest U.S. investment banks, with combined liabilities or debts of $4 trillion, either went bankrupt (Lehman Brothers), were taken over by other companies (Bear Stearns and Merrill Lynch), or were bailed-out by the U.S. government (Goldman Sachs and Morgan Stanley) during 2008.^[182] Government-sponsored enterprises (GSE)Fannie Mae and Freddie Mac either directly owed or guaranteed nearly $5 trillion in mortgage obligations, with a similarly weak capital base, when they were placed into receivership in September 2008. For scale, this $9 trillion in obligations concentrated in seven highly leveraged institutions can be compared to the $14 trillion size of the U.S. economy (GDP) or to the total national debt of $10 trillion in September 2008.

Major depository banks around the world had also used financial innovations such as structured investment vehicles to circumvent capital ratio regulations. Notable global failures included Northern Rock, which was nationalized at an estimated cost of £87 billion ($150 billion). In the U.S., Washington Mutual (WaMu) was seized in September 2008 by the USA Office of Thrift Supervision (OTS). Dozens of U.S. banks received funds as part of the TARP or $700 billion bailout.

As a result of the financial crisis in 2008, twenty five U.S. banks became insolvent and were taken over by the FDIC. As of August 14, 2009, an additional 77 banks became insolvent. This seven month tally surpasses the 50 banks that were seized in all of 1993, but is still much smaller than the number of failed banking institutions in 1992, 1991, and 1990. The United States has lost over 6 million jobs since the recession began in December 2007.

The FDIC deposit insurance fund, supported by fees on insured banks, fell to $13 billion in the first quarter of 2009. That is the lowest total since September, 1993.

Homeowner assistance

Both lenders and borrowers may benefit from avoiding foreclosure, which is a costly and lengthy process. Some lenders have offered troubled borrowers more favorable mortgage terms (i.e., refinancing, loan modification or loss mitigation). Borrowers have also been encouraged to contact their lenders to discuss alternatives.

The Economist described the issue this way: “No part of the financial crisis has received so much attention, with so little to show for it, as the tidal wave of home foreclosures sweeping over America. Government programmers have been ineffectual, and private efforts not much better.” Up to 9 million homes may enter foreclosure over the 2009-2011 period, versus one million in a typical year. At roughly U.S. $50,000 per foreclosure according to a 2006 study by the Chicago Federal Reserve Bank, 9 million foreclosures represents $450 billion in losses.

A variety of voluntary private and government-administered or supported programs were implemented during 2007-2009 to assist homeowners with case-by-case mortgage assistance, to mitigate the foreclosure crisis engulfing the U.S. One example is the Hope Now Alliance, an ongoing collaborative effort between the US Government and private industry to help certain subprime borrowers. In February 2008, the Alliance reported that during the second half of 2007, it had helped 545,000 subprime borrowers with shaky credit, or 7.7% of 7.1 million subprime loans outstanding as of September 2007. A spokesperson for the Alliance acknowledged that much more must be done.

During late 2008, major banks and both Fannie Mae and Freddie Mac established moratoriums (delays) on foreclosures, to give homeowners time to work towards refinancing.

Critics have argued that the case-by-case loan modification method is ineffective, with too few homeowners assisted relative to the number of foreclosures and with nearly 40% of those assisted homeowners again becoming delinquent within 8 months. In December 2008, the U.S. FDIC reported that more than half of mortgages modified during the first half of 2008 were delinquent again, in many cases because payments were not reduced or mortgage debt was not forgiven. This is further evidence that case-by-case loan modification is not effective as a policy tool.

In February 2009, economists Nouriel Roubini and Mark Zandi recommended an “across the board” (systemic) reduction of mortgage principal balances by as much as 20-30%. Lowering the mortgage balance would help lower monthly payments and also address an estimated 20 million homeowners that may have a financial incentive to enter voluntary foreclosure because they are “underwater” (i.e., the mortgage balance is larger than the home value).

A study by the Federal Reserve Bank of Boston indicated that banks were reluctant to modify loans. Only 3% of seriously delinquent homeowners had their mortgage payments reduced during 2008. In addition, investors who hold MBS and have a say in mortgage modifications have not been a significant impediment; the study found no difference in the rate of assistance whether the loans were controlled by the bank or by investors. Commenting on the study, economists Dean Baker and Paul Willen both advocated providing funds directly to homeowners instead of banks.

The L.A. Times reported the results of a study that found homeowners with high credit scores at the time of entering the mortgage are 50% more likely to “strategically default” — abruptly and intentionally pull the plug and abandon the mortgage—compared with lower-scoring borrowers. Such strategic defaults were heavily concentrated in markets with the highest price declines. An estimated 588,000 strategic defaults occurred nationwide during 2008, more than double the total in 2007. They represented 18% of all serious delinquencies that extended for more than 60 days in the fourth quarter of 2008.

Homeowners Affordability and Stability Plan

Main article: Homeowners Affordability and Stability Plan

On 18 February 2009, U.S. President Barack Obama announced a $73 billion program to help up to nine million homeowners avoid foreclosure, which was supplemented by $200 billion in additional funding for Fannie Mae and Freddie Mac to purchase and more easily refinance mortgages. The plan is funded mostly from the EESA’s $700 billion financial bailout fund. It uses cost sharing and incentives to encourage lenders to reduce homeowner’s monthly payments to 31 percent of their monthly income. Under the program, a lender would be responsible for reducing monthly payments to no more than 38 percent of a borrower’s income, with government sharing the cost to further cut the rate to 31 percent. The plan also involves forgiving a portion of the borrower’s mortgage balance. Companies that service mortgages will get incentives to modify loans and to help the homeowner stay current.

Regulatory proposals and long-term solutions

Further information: Subprime mortgage crisis solutions debate and Regulatory responses to the subprime crisis

President Barack Obama and key advisers introduced a series of regulatory proposals in June 2009. The proposals address consumer protection, executive pay, bank financial cushions or capital requirements, expanded regulation of the shadow banking system and derivatives, and enhanced authority for the Federal Reserve to safely wind-down systemically important institutions, among others.

A variety of regulatory changes have been proposed by economists, politicians, journalists, and business leaders to minimize the impact of the current crisis and prevent recurrence. However, as of June 2009, many of the proposed solutions have not yet been implemented. These include:

Ben Bernanke: Establish resolution procedures for closing troubled financial institutions in the shadow banking system, such as investment banks and hedge funds.
Joseph Stiglitz: Restrict the leverage that financial institutions can assume. Require executive compensation to be more related to long-term performance. Re-instate the separation of commercial (depository) and investment banking established by the Glass-Steagall Act in 1933 and repealed in 1999 by the Gramm-Leach-Bliley Act.
Simon Johnson: Break-up institutions that are “too big to fail” to limit systemic risk.
Paul Krugman: Regulate institutions that “act like banks ” similarly to banks.
Alan Greenspan: Banks should have a stronger capital cushion, with graduated regulatory capital requirements (i.e., capital ratios that increase with bank size), to “discourage them from becoming too big and to offset their competitive advantage.”
Warren Buffett: Require minimum down payments for home mortgages of at least 10% and income verification.
Eric Dinallo: Ensure any financial institution has the necessary capital to support its financial commitments. Regulate credit derivatives and ensure they are traded on well-capitalized exchanges to limit counterparty risk.
Raghuram Rajan: Require financial institutions to maintain sufficient “contingent capital” (i.e., pay insurance premiums to the government during boom periods, in exchange for payments during a downturn.)
A. Michael Spence and Gordon Brown: Establish an early-warning system to help detect systemic risk.
Niall Ferguson and Jeffrey Sachs: Impose haircuts on bondholders and counterparties prior to using taxpayer money in bailouts.
Nouriel Roubini: Nationalize insolvent banks. Reduce debt levels across the financial system through debt for equity swaps. Reduce mortgage balances to assist homeowners, giving the lender a share in any future home appreciation.
Paul McCulley advocated “counter-cyclical regulatory policy to help modulate human nature.” He cited the work of economist Hyman Minsky, who believed that human behavior is pro-cyclical, meaning it amplifies the extent of booms and busts. In other words, humans are momentum investors rather than value investors. Counter-cyclical policies would include increasing capital requirements during boom periods and reducing them during busts.

Other responses

Significant law enforcement action and litigation is resulting from the crisis. The U.S. Federal Bureau of Investigation was looking into the possibility of fraud by mortgage financing companies Fannie Mae and Freddie Mac, Lehman Brothers, and insurer American International Group, among others. New York Attorney General Andrew Cuomo is suing Long Island based Amerimod, one of the nation’s largest loan modification corporations for fraud, and has issued 14 subpoenas to other similar companies. The FBI also assigned more agents to mortgage-related crimes and its caseload has dramatically increased. The FBI began a probe of Countrywide in March 2008 for possible fraudulent lending practices and securities fraud.

Over 250 civil lawsuits were filed in federal courts during 2007 related to the subprime crisis. The number of filings in state courts was not quantified but is also believed to be significant.

Implications

Estimates of impact have continued to climb. During April 2008, International Monetary Fund (IMF) estimated that global losses for financial institutions would approach $1 trillion.^[234] One year later, the IMF estimated cumulative losses of banks and other financial institutions globally would exceed $4 trillion. This is equal to U.S. $20,000 for each of 200,000,000 people.

Francis Fukuyama has argued that the crisis represents the end of Reaganism in the financial sector, which was characterized by lighter regulation, pared-back government, and lower taxes. Significant financial sector regulatory changes are expected as a result of the crisis.

Fareed Zakaria believes that the crisis may force Americans and their government to live within their means. Further, some of the best minds may be redeployed from financial engineering to more valuable business activities, or to science and technology.

Roger Altman wrote that “the crash of 2008 has inflicted profound damage on [the U.S.] financial system, its economy, and its standing in the world; the crisis is an important geopolitical setback…the crisis has coincided with historical forces that were already shifting the world’s focus away from the United States. Over the medium term, the United States will have to operate from a smaller global platform — while others, especially China, will have a chance to rise faster.”

GE CEO Jeffrey Immelt has argued that U.S. trade deficits and budget deficits are unsustainable. America must regain its competitiveness through innovative products, training of production workers, and business leadership. He advocates specific national goals related to energy security or independence, specific technologies, expansion of the manufacturing job base, and net exporter status. “The world has been reset. Now we must lead an aggressive American renewal to win in the future.” Of critical importance, he said, is the need to focus on technology and manufacturing. “Many bought into the idea that America could go from a technology-based, export-oriented powerhouse to a services-led, consumption-based economy — and somehow still expect to prosper,” Jeff said. “That idea was flat wrong.”

Economist Paul Krugman wrote in 2009: “The prosperity of a few years ago, such as it was — profits were terrific, wages not so much — depended on a huge bubble in housing, which replaced an earlier huge bubble in stocks. And since the housing bubble isn’t coming back, the spending that sustained the economy in the pre-crisis years isn’t coming back either.” Niall Ferguson stated that excluding the effect of home equity extraction, the U.S. economy grew at a 1% rate during the Bush years. Microsoft CEO Steve Ballmer has argued that this is an economic reset at a lower level, rather than a recession, meaning that no quick recovery to pre-recession levels can be expected.

The U.S. Federal government’s efforts to support the global financial system have resulted in significant new financial commitments, totaling $7 trillion by November, 2008. These commitments can be characterized as investments, loans, and loan guarantees, rather than direct expenditures. In many cases, the government purchased financial assets such as commercial paper, mortgage-backed securities, or other types of asset-backed paper, to enhance liquidity in frozen markets. As the crisis has progressed, the Fed has expanded the collateral against which it is willing to lend to include higher-risk assets.

The Economist wrote: “Having spent a fortune bailing out their banks, Western governments will have to pay a price in terms of higher taxes to meet the interest on that debt. In the case of countries (like Britain and America) that have trade as well as budget deficits, those higher taxes will be needed to meet the claims of foreign creditors. Given the political implications of such austerity, the temptation will be to default by stealth, by letting their currencies depreciate. Investors are increasingly alive to this danger…”

The crisis has cast doubt on the legacy of Alan Greenspan, the Chairman of the Federal Reserve System from 1986 to January 2006. Senator Chris Dodd claimed that Greenspan created the “perfect storm“. When asked to comment on the crisis, Greenspan spoke as follows:

“The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated, and home price deflation comes to an end. That will stabilize the now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for residential mortgage-backed securities. Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business.”

Subordination: Subordination in banking and finance refers to the order of priorities in claims for ownership or interest in various assets.

United States law

Subordination of debt

Subordination is the process by which a creditor is placed in a lower priority for the collection of its debt from its debtor’s assets than the priority the creditor previously had, In common parlance, the debt is said to be subordinated but in reality, it is the right of the creditor to collect the debt that has been reduced in priority. The priority of right to collect the debt is important when a debtor owes more than one creditor but has assets of insufficient value to pay them all in full at the time of a default. Except in bankruptcy proceedings, the creditor with the first priority for collection will have the first claim on the debtor’s assets for its debt and the creditors whose rights are subordinate will thus have fewer assets to satisfy their claims. Subordination can take place by operation of law or by agreement among the creditors.

Subordination of security priority

Subordination is also an issue in the priority of security interests in the ownership of property. For example, in real estate, mortgages and other liens on the title to secure the payment or repayment of money usually take their priority from the time they attach to the title. The purpose of this ordering of priority is to determine, in a foreclosure resulting from a default, who gets paid first with the sale proceeds from the foreclosure proceeding. Earlier mortgages or other liens are often subordinated by their holders to later ones in order to accomplish agreed-upon ends. An example is for the holder of a mortgage on undeveloped land to subordinate that mortgage to a later construction loan mortgage. The motivation is either the belief that improvement of the land will benefit the first lender or that the first mortgage requires that it be subordinated to a future construction loan.

Dealer Subordinable Debt

In the automotive financing industry many dealerships are allowed to designate personal loans which are payable to the ownership as subordinable debt. The finance institution and dealership may come to an agreement which allows this debt to stay within the confines of the financial statement and concurrently improve the dealership financial position from a liquidity perspective.

Equitable subordination

Bankruptcy courts in the United States have the power and authority to subordinate prior claims on the assets of a bankrupt debtor to the claims of junior claimants based on principals of equity. This is a remedy called “equitable subordination.” The basis for subordination is usually the inequitable conduct of the prior claimant with respect to junior claimants. Equitable subordination can be used to subordinate both secured and unsecured claims.

Supply and demand: Supply and demand is an economic model based on price, utility and quantity in a market. It concludes that in a competitive market, price will function to equalize the quantity demanded by consumers, and the quantity supplied by producers, resulting in an economic equilibrium of price and quantity.

Demand schedule

The demand schedule, depicted graphically as the demand curve, represents the amount of goods that buyers are willing and able to purchase at various prices, assuming all other non-price factors remain the same. Following the law of demand, the demand curve is almost always represented as downward-sloping, meaning that as price decreases, consumers will buy more of the good.

Just as the supply curves reflect marginal cost curves, demand curves can be described as marginal utility curves. The demand schedule is defined as the willingness and ability of a consumer to purchase a given product in a given frame of time.

The main determinants of individual demand are: the price of the good, level of income, personal tastes, the price of substitute goods, and the price of complementary goods.

As described above, the demand curve is generally downward sloping. There may be rare examples of goods that have upward sloping demand curves. Two different hypothetical types of goods with upward-sloping demand curves are Giffen goods (an inferior, but staple, good) and Veblen goods (goods made more fashionable by a higher price).

Changes in market equilibrium

Practical uses of supply and demand analysis often center on the different variables that change equilibrium price and quantity, represented as shifts in the respective curves. Comparative statics of such a shift traces the effects from the initial equilibrium to the new equilibrium.

Demand curve shifts

Main article: Demand curve

When consumers increase the quantity demanded at a given price, it is referred to as an increase in demand. Increased demand can be represented on the graph as the curve being shifted outward. At each price point, a greater quantity is demanded, as from the initial curve D1 to the new curve D2. More people wanting coffee is an example. In the diagram, this raises the equilibrium price from P1 to the higher P2. This raises the equilibrium quantity from Q1 to the higher Q2. A movement along the curve is described as a “change in the quantity demanded” to distinguish it from a “change in demand,” that is, a shift of the curve. In the example above, there has been an increase in demand which has caused an increase in (equilibrium) quantity. The increase in demand could also come from changing tastes and fads, incomes, complementary and substitute price changes, market expectations, and number of buyers. This would cause the entire demand curve to shift changing the equilibrium price and quantity.

If the demand decreases, then the opposite happens: an inward shift of the curve. If the demand starts at D2, and decreases to D1, the price will decrease, and the quantity will decrease. This is an effect of demand changing. The quantity supplied at each price is the same as before the demand shift (at both Q1 and Q2). The equilibrium quantity, price and demand are different. At each point, a greater amount is demanded (when there is a shift from D1 to D2).
The demand curve “shifts” because a non-price determinant of demand has changed. Graphically the shift is due to a change in the x-intercept. A shift in the demand curve due to a change in a non-price determinant of demand will result in the market’s being in a non-equilibrium state. If the demand curve shifts out the result will be a shortage — at the new market price quantity demanded will exceed quantity supplied. If the demand curve shifts in, there will be a surplus — at the new market price quantity supplied will exceed quantity demanded. The process by which a new equilibrium is established is not the province of comparative statics — the answers to issues concerning when, whether and how a new equilibrium will be established are issues that are addressed by stochastic models — economic dynamics.

Two assumptions are necessary for the validity of the standard model. First, that supply and demand are independent and second, that supply is “constrained by a fixed resource.” If either of these conditions does not hold, then the Marshallian model cannot be sustained.

Supply curve shifts

Main article: Supply (economics)

When the suppliers’ costs change for a given output, the supply curve shifts in the same direction. For example, assume that someone invents a better way of growing wheat so that the cost of growing a given quantity of wheat decreases. Otherwise stated, producers will be willing to supply more wheat at every price and this shifts the supply curve S1 outward, to S2—an increase in supply. This increase in supply causes the equilibrium price to decrease from P1 to P2. The equilibrium quantity increases from Q1 to Q2 as the quantity demanded extends at the new lower prices. In a supply curve shift, the price and the quantity move in opposite directions.

If the quantity supplied decreases at a given price, the opposite happens. If the supply curve starts at S2, and shifts inward to S1, demand contracts, the equilibrium price will increase, and the equilibrium quantity will decrease. This is an effect of supply changing. The quantity demanded at each price is the same as before the supply shift (at both Q1 and Q2). The equilibrium quantity, price and supply changed.

When there is a change in supply or demand, there are three possible movements. The demand curve can move inward or outward. The supply curve can also move inward or outward.

Elasticity

Main article: Elasticity (economics)

Elasticity is a central concept in the theory of supply and demand. In this context, elasticity refers to how supply and demand respond to various factors, including price as well as other stochastic principles. One way to define elasticity is the percentage change in one variable divided by the percentage change in another variable (known as arc elasticity, which calculates the elasticity over a range of values, in contrast with point elasticity, which uses differential calculus to determine the elasticity at a specific point). It is a measure of relative changes.

Often, it is useful to know how the quantity demanded or supplied will change when the price changes. This is known as the price elasticity of demand and the price elasticity of supply. If a monopolist decides to increase the price of their product, how will this affect their sales revenue? Will the increased unit price offset the likely decrease in sales volume? If a government imposes a tax on a good, thereby increasing the effective price, how will this affect the quantity demanded?

Elasticity corresponds to the slope of the line and is often expressed as a percentage. In other words, the units of measure (such as gallons vs. quarts, say for the response of quantity demanded of milk to a change in price) do not matter, only the slope. Since supply and demand can be curves as well as simple lines the slope, and hence the elasticity, can be different at different points on the line.

Elasticity is calculated as the percentage change in quantity over the associated percentage change in price. For example, if the price moves from $1.00 to $1.05, and the quantity supplied goes from 100 pens to 102 pens, the slope is 2/0.05 or 40 pens per dollar. Since the elasticity depends on the percentages, the quantity of pens increased by 2%, and the price increased by 5%, so the price elasticity of supply is 2/5 or 0.4.

Since the changes are in percentages, changing the unit of measurement or the currency will not affect the elasticity. If the quantity demanded or supplied changes a lot when the price changes a little, it is said to be elastic. If the quantity changes little when the prices changes a lot, it is said to be inelastic. An example of perfectly inelastic supply, or zero elasticity, is represented as a vertical supply curve. (See that section below)

Elasticity in relation to variables other than price can also be considered. One of the most common to consider is income. How would the demand for a good change if income increased or decreased? This is known as the income elasticity of demand. For example, how much would the demand for a luxury car increase if average income increased by 10%? If it is positive, this increase in demand would be represented on a graph by a positive shift in the demand curve. At all price levels, more luxury cars would be demanded.

Another elasticity sometimes considered is the cross elasticity of demand, which measures the responsiveness of the quantity demanded of a good to a change in the price of another good. This is often considered when looking at the relative changes in demand when studying complement and substitute goods. Complement goods are goods that are typically utilized together, where if one is consumed, usually the other is also. Substitute goods are those where one can be substituted for the other, and if the price of one good rises, one may purchase less of it and instead purchase its substitute.

Cross elasticity of demand is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For an example with a complement good, if, in response to a 10% increase in the price of fuel, the quantity of new cars demanded decreased by 20%, the cross elasticity of demand would be -2.0.

In a perfect economy, any market should be able to move to the equilibrium position instantly without travelling along the curve. Any change in market conditions would cause a jump from one equilibrium position to another at once. So the perfect economy is actually analogous to the quantum economy. Unfortunately in real economic systems, markets don’t behave in this way, and both producers and consumers spend some time travelling along the curve before they reach equilibrium position. This is due to asymmetric, or at least imperfect, information, where no one economic agent could ever be expected to know every relevant condition in every market. Ultimately both producers and consumers must rely on trial and error as well as prediction and calculation to find an the true equilibrium of a market.

Vertical supply curve (perfectly inelastic supply)

If the quantity supplied is fixed no matter what the price, the supply curve is a vertical line, and supply is called perfectly inelastic. In practice, vertical supply curves rarely exist.

As a hypothetical example, consider the supply curve of the land. Suppose that no matter how much someone would be willing to pay for an additional piece, more land cannot be created. Also, even if no one wanted all the land, it still would exist. In such a case, land would have a vertical supply curve, with zero elasticity.

Other markets

The model of supply and demand also applies to various specialty markets.

The model applies to wages, which are determined by the market for labor. The typical roles of supplier and consumer are reversed. The suppliers are individuals, who try to sell their labor for the highest price. The consumers of labors are businesses, which try to buy the type of labor they need at the lowest price. The equilibrium price for a certain type of labor is the wage.

The model applies to interest rates, which are determined by the money market. In the short term, the money supply is a vertical supply curve, which the central bank of a country can influence through monetary policy. The demand for money intersects with the money supply to determine the interest rate.

The model applies to all factor markets in perfectly competitive model.

Other market forms

The supply and demand model is used to explain the behavior of perfectly competitive markets, but its usefulness as a standard of performance extends to other types of markets. In such markets, there may be no supply curve, such as above, except by analogy. Rather, the supplier or suppliers are modeled as interacting with demand to determine price and quantity. In particular, the decisions of the buyers and sellers are interdependent in a way different from a perfectly competitive market.

A monopoly is the case of a single supplier that can adjust the supply or price of a good at will. The profit-maximizing monopolist is modeled as adjusting the price so that its profit is maximized given the amount that is demanded at that price. This price will be higher than in a competitive market. A similar analysis can be applied when a good has a single buyer, a monopsony, but many sellers. Oligopoly is a market with so few suppliers that they must take account of their actions on the market price or each other. Game theory may be used to analyze such a market.

The supply curve does not have to be linear. However, if the supply is from a profit-maximizing firm, it can be proven that downward sloping supply curves (i.e., a price decrease increasing the quantity supplied) are inconsistent with perfect competition in equilibrium. Then supply curves from profit-maximizing firms can be vertical, horizontal or upward sloping.

Similarly, the demand curve is rarely linear. A great empirical example of this is given in this article on computer software pricing where the vendor deliberately varied the price and measured the resulting demand. It produced a very non linear demand curve.

Empirical estimation

Demand and supply relations in a market can be statistically estimated from price, quantity, and other data with sufficient information in the model. This can be done with simultaneous-equation methods of estimation in econometrics. Such methods allow solving for the model-relevant “structural coefficients,” the estimated algebraic counterparts of the theory. The Parameter identification problem is a common issue in “structural estimation.” Typically, data on exogenous variables (that is, variables other than price and quantity, both of which are endogenous variables) are needed to perform such an estimation. An alternative to “structural estimation” is reduced-form estimation, which regresses each of the endogenous variables on the respective exogenous variables.

Macroeconomic uses of demand and supply

Demand and supply have also been generalized to explain macroeconomic variables in a market economy, including the quantity of total output and the general price level. The Aggregate Demand-Aggregate Supply model may be the most direct application of supply and demand to macroeconomics, but other macroeconomic models also use supply and demand. Compared to microeconomic uses of demand and supply, different (and more controversial) theoretical considerations apply to such macroeconomic counterparts as aggregate demand and aggregate supply. Demand and supply may also be used in macroeconomic theory to relate money supply to demand and interest rates.

Demand shortfalls

A demand shortfall results from the actual demand for a given product being lower than the projected, or estimated, demand for that product. Demand shortfalls are caused by demand overestimation in the planning of new products. Demand overestimation is caused by optimism bias and/or strategic misrepresentation.

History

The power of supply and demand was understood to some extent by several early Muslim economists, such as Ibn Taymiyyah who illustrates:

“If desire for goods increases while its availability decreases, its price rises. On the other hand, if availability of the good increases and the desire for it decreases, the price comes down.”

The phrase “supply and demand” was first used by James Denham-Steuart in his Inquiry into the Principles of Political Economy, published in 1767. Adam Smith used the phrase in his 1776 book The Wealth of Nations, and David Ricardo titled one chapter of his 1817 work Principles of Political Economy and Taxation “On the Influence of Demand and Supply on Price”.

In The Wealth of Nations, Smith generally assumed that the supply price was fixed but that its “merit” (value) would decrease as its “scarcity” increased, in effect what was later called the law of demand. Ricardo, in Principles of Political Economy and Taxation, more rigorously laid down the idea of the assumptions that were used to build his ideas of supply and demand. Antoine Augustin Cournot first developed a mathematical model of supply and demand in his 1838 Researches on the Mathematical Principles of the Theory of Wealth.

During the late 19th century the marginalist school of thought emerged. This field mainly was started by Stanley Jevons, Carl Menger, and Léon Walras. The key idea was that the price was set by the most expensive price, that is, the price at the margin. This was a substantial change from Adam Smith’s thoughts on determining the supply price.

In his 1870 essay “On the Graphical Representation of Supply and Demand”, Fleeming Jenkin drew for the first time the popular graphic of supply and demand which, through Marshall, eventually would turn into the most famous graphic in economics.

The model was further developed and popularized by Alfred Marshall in the 1890 textbook Principles of Economics.^[8] Along with Léon Walras, Marshall looked at the equilibrium point where the two curves crossed. They also began looking at the effect of markets on each other.

Surety: A surety is a person (or company) who agrees to be responsible for the debt or obligation of another. Furthermore, a surety is also a “security against loss or damage or for the fulfillment of an obligation, the payment of a debt, etc.; a pledge, guaranty, or bond.”

The situation in which a surety is most typically required is when the ability of the primary obligor or principal to perform its obligations under a contract is in question, or when there is some public or private interest which requires protection from the consequences of the principal’s default or delinquency. In most common law jurisdictions, a contract of suretyship is subject to the statute of frauds (or its equivalent local laws) and is only enforceable if recorded in writing and signed by the surety and the principal.

If the surety is required to pay or perform due to the principal’s failure to do so, the law will usually give the surety a right of subrogation, allowing the surety to “step into the shoes of” the principal and use his (the surety’s) contractual rights to recover the cost of making payment or performing on the principal’s behalf, even in the absence of an express agreement to that effect between the surety and the principal.

The act of becoming a surety is also called a guarantee. Traditionally a guarantee was distinguished from a surety in that the surety’s liability was joint and primary with the principal, whereas the guaranty’s liability was ancillary and derivative, but many jurisdictions have abolished this distinction.

In the United States, under Article 3 of the Uniform Commercial Code, a person who signs a negotiable instrument as a surety is termed an accommodation party; such a party may be able to assert defenses to the enforcement of an instrument not available to the maker of the instrument.

Usage

There are several uses of the word “guarantee” in today’s parlance, however the following should be used in legal documents. Guaranty is the actual document containing language of assurance. Guarantor is the entity giving the guaranty and guarantee is the entity receiving the guaranty. Following conventional English spelling rules, therefore, the plural of guaranty or verb usage of the word should be guaranties, as in “The seller (guarantor) guaranties something to the buyer (guarantee).”

Swap: In finance, a swap is a derivative in which two counterparties exchange certain benefits of one party’s financial instrument for those of the other party’s financial instrument. The benefits in question depend on the type of financial instruments involved. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price.

The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties. Consequently, swaps can be used to create unfunded exposures to an underlying asset, since counterparties can earn the profit or loss from movements in price without having to post the notional amount in cash or collateral.

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.

The first swaps were negotiated in the early 1980s. David Swensen, a Yale Ph.D. at Salomon Brothers, engineered the first swap transaction according to “When Genius Failed: The Rise and Fall of Long-Term Capital Management” by Roger Lowenstein. Today, swaps are among the most heavily traded financial contracts in the world.

Swap market

Most swaps are traded over-the-counter (OTC), “tailor-made” for the counterparties. Some types of swaps are also exchanged on futures markets such as the Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange, Intercontinental Exchange and

Usually, at least one of the legs has a rate that is variable. It can depend on a reference rate, the total return of a swap, an economic statistic, etc. The most important criterion is that it comes from an independent third party, to avoid any conflict of interest. For instance, LIBOR is published by the British Bankers Association, an independent trade body.

Types of swaps

The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are also many other types.

Interest rate swaps

Main article: Interest Rate Swap

The most common type of swap is a “plain Vanilla” interest rate swap. It is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets while other companies have a comparative advantage in floating rate markets. When companies want to borrow they look for cheap borrowing i.e. from the market where they have comparative advantage. However this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa.

For example, party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70 basis points. Party A in turn makes periodic interest payments based on a fixed rate of 8.65%. The payments are calculated over the notional amount. The first rate is called variable, because it is reset at the beginning of each interest calculation period to the then current reference rate, such as LIBOR. In reality, the actual rate received by A and B is slightly lower due to a bank taking a spread.

Currency swaps

Main article: Currency swap

A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps also are motivated by comparative advantage.

Commodity swaps

Main article: Commodity swap

A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve oil.

Equity Swap

Main article: equity swap

An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do have.

Credit default swaps

Main article: Credit default swap

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument – typically a bond or loan – goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur

Other variations

There are myriad different variations on the vanilla swap structure, which are limited only by the imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic structures.

A total return swap is a swap in which party A pays the total return of an asset, and party B makes periodic interest payments. The total return is the capital gain or loss, plus any interest or dividend payments. Note that if the total return is negative, then party A receives this amount from party B. The parties have exposure to the return of the underlying stock or index, without having to hold the underlying assets. The profit or loss of party B is the same for him as actually owning the underlying asset.
An option on a swap is called a swaption. These provide one party with the right but not the obligation at a future time to enter into a swap.
A variance swap is an over-the-counter instrument that allows one to speculate on or hedge risks associated with the magnitude of movement, i.e. volatility, of some underlying product, like an exchange rate, interest rate, or stock index.
A constant maturity swap, also known as a CMS, is a swap that allows the purchaser to fix the duration of received flows on a swap.
An Amortising swap is usually an interest rate swap in which the notional principal for the interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a mortgage or to an interest rate benchmark such LIBOR.

Valuation

Further information: Rational pricing#Swaps and Arbitrage

The value of a swap is the net present value (NPV) of all estimated future cash flows. A swap is worth zero when it is first initiated, however after this time its value may become positive or negative. There are two ways to value swaps: in terms of bond prices, or as a portfolio of forward contracts.

Using bond prices

While principal payments are not exchanged in an interest rate swap, assuming that these are received and paid at the end of the swap does not change its value. Thus, from the point of view of the floating-rate payer, a swap can be regarded as a long position in a fixed-rate bond (i.e. receiving fixed interest payments), and a short position in a floating rate note (i.e. making floating interest payments):

V_swap = B_fixed ? B_floating

From the point of view of the fixed-rate payer, the swap can be viewed as having the opposite positions. That is,

V_swap = B_floating ? B_fixed

Similarly, currency swaps can be regarded as having positions in bonds whose cash flows correspond to those in the swap. Thus, the home currency value is:

V_swap = B_domestic ? S₀B_foreign, where B_domestic is the domestic cash flows of the swap, B_foreign is the foreign cash flows of the swap, and S₀ is the spot exchange rate.

Using forward rate agreements

Consider a three year interest rate swap with semiannual payments. The first cash flow is known at the time the swap is initiated, however the other five exchanges can be regarded as forward rate agreements. The payment for these other exchanges is the 6 month rate observed in the market 6 months earlier. Assuming that forward interest rates are realized, this method values the swap by firstly calculating the required forward rates using the LIBOR/swap curve, then calculating the swap cash flows using these rates, and then finally discounting these cash flows back to today.

London Interbank Offered Rate (LIBOR)

Main article: London Interbank Offered Rate

LIBOR is the rate of interest offered by banks on deposit from other banks in the eurocurrency market. One-month LIBOR is the rate offered for 1-month deposits, 3-month LIBOR for three months deposits, etc. LIBOR rates are determined by trading between banks and change continuously as economic conditions change. Just like the prime rate of interest quoted in the domestic market, LIBOR is a reference rate of interest in the International Market.

Arbitrage arguments

As mentioned, to be arbitrage free, the terms of a swap contract are such that, initially, the NPV of these future cash flows is equal to zero. Where this is not the case, arbitrage would be possible.

For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a fixed rate, and Party B pays a floating rate. In such an agreement the fixed rate would be such that the present value of future fixed rate payments by Party A are equal to the present value of the expected future floating rate payments (i.e. the NPV is zero). Where this is not the case, an Arbitrageur, C, could:

assume the position with the lower present value of payments, and borrow funds equal to this present value
meet the cash flow obligations on the position by using the borrowed funds, and receive the corresponding payments – which have a higher present value
use the received payments to repay the debt on the borrowed funds
pocket the difference – where the difference between the present value of the loan and the present value of the inflows is the arbitrage profit.

Subsequently, once traded, the price of the Swap must equate to the price of the various corresponding instruments as mentioned above. Where this is not true, an arbitrageur could similarly short sell the overpriced instrument, and use the proceeds to purchase the correctly priced instrument, pocket the difference, and then use payments generated to service the instrument which he is short.