Chapter 1

The World of Money

As indicated in the preface, my intention in this book is to prepare readers

to analyze and explain real-world financial conditions and transactions. I
have taken great pains to keep this work squarely on the plane of reality,
because I think that in economics and finance more attention needs to be
paid to history and "politics", and somewhat less to mathematics and certain
esoteric theoretical considerations.
Yes, algebra is important for the study of finance, and later in this book
it is freely used; but first and foremost I like to regard finance as the
physics of economics, and feel that it is one of the few areas in economics
where it is possible to come into contact with, and often practice, the kind
of genuine scientific thinking that we too often fail to encounter in much
of the economics curriculum. As odd as it may sound, learning to handle
scientific concepts does not necessarily mean being overexposed to advanced
mathematics. For instance, Albert Einstein, Enrico Fermi, and Richard
Feynman — Nobel Laureates in physics — made a point of using as little
mathematics as possible, although they had plenty at their disposal.
Of course, when the humorist P.J. O'Rourke writes that "We don't need
to know math to understand economics ..." then our immediate reaction
should be to ponder the identity of the "we" to whom he is referring.
Perhaps it is the famous Mr. O'Rourke himself, although this would
undoubtedly come as a surprise to almost every serious student of economics
between the ski slopes of Northern Sweden and the Capetown (South Africa)
naval yard who perused Chapter 6 of that gentleman's book "Eat the Rich"
(1998).
Before completing this prologue, I would like to assure all readers that
they will know a great deal about the financial structure and logic of the
world in which they live well before they finish the last chapter of this
2 Global Finance and Financial Market: A Modern Introduction

book. In fact, it could happen that they will have a considerable amount of
knowledge about this subject by the time they complete the first (non-
technical) part of the book, and if they do not feel like confronting the
algebra in later chapters right away, they can read the first four chapters
again, and also Chapter 9. As you will ultimately find out, becoming
conversant with the materials in those five chapters, as well as a few topics
from the other chapters, could turn out to be an excellent career move. See
also Marc Levinson (1999).

I. Money and Interest

The purpose of this chapter is to provide an overview of some important
topics in money and finance. It is also designed to give readers an
introduction to the rather special vocabulary of financial markets. This aspect
of the present book is extremely important, and possession of an extensive
financial vocabulary is something that you will find enormously valuable
in many professional and social situations. This is an important reason for
studying the glossary. To begin, let us consider the four most important
functions of money. Money is a means of exchange, a measure of value, and
a store of value. Whether it is satisfactory in these functions — especially
the last two — is a much debated question, but there do not seem to be any
alternatives. Particularly annoying is money's performance as a store of
value, since inflation has occasionally eroded the value of many national
currencies to an alarming extent. Money is also a unit of account.
If we consider the position of the US dollar after the Second World
War, then the dollar was the international unit of account because other
governments used it to define their exchange rates; the means of exchange,
because it was universally acceptable for the payment of international debt;
and an international store of value, since foreign exchange reserves were
mostly held in dollars. The term dollar is derived from the word "thaler",
which is a monetary unit introduced in Joachimstal (Czechoslovakia) in
1518. The dollar became the official US currency unit in 1793, and was
defined as being worth eight Spanish "reales", represented by the symbol
The World of Money 3

/8/. This symbol later became a "$". One year earlier, in 1792, the first
securities were traded on Wall Street (New York).
That was the past, and now for the present. The dollar enters one side
of 90% of the world's interbank foreign exchange transactions, and 90% of
the international trade in commodities is priced in dollars. Moreover, as
Steve Hanke (1999) surprisingly notes, 40% of Japan's manufactured exports,
and 70% of its imports are invoiced in dollars, not yen.
During a large part of the post World War II period, inflation has turned
out to be a tenacious economic dilemma for the governments of many
countries. Inflation is particularly malignant for individuals with a fixed
income (such as pensioners), but even employers in most countries — who
tend to find rising prices a comfort much of the time — have come to
regard inflation as a nemesis: when prices go up, their employees often
insist on compensatory rises in pay, and occasionally they or their unions
are strong enough to obtain them.
At the close of the 20th century, it became clear that inflation was
extremely important for both bond and stock (or share) market values. (Note:
bonds refer to corporate or government debt, while stocks — or equity —
refer to ownership.) If the price of goods and services shows a tendency to
rise, then purchasers of bonds might require higher interest rates in order
to refrain from present consumption to the extent that they continue buying
the same or an increased amount of these securities. And if interest rates
rise then, ceteris paribus (i.e. all things remaining the same) shares lose
some of their attraction. The reason is that the desirability of a financial
asset depends on its yield (or return) and its risk. If bond yields increase
(via a rise in interest rates), then — ceteris paribus — many investors might
consider it prudent to substitute bonds with their (supposedly) guaranteed
yields for some of the riskier shares in their portfolios (i.e. collection of
assets). There have also been occasions when shares became slightly less
attractive, and nervous investors rushed to the conclusion that there was
considerable trouble ahead. If these and then other shareholders begin selling
shares, and this behavior accelerates, then eventually we could be faced
with the kind of stockmarket "meltdown" in which a huge amount of investor
wealth is decimated.
4 Global Finance and Financial Market: A Modern Introduction

A short digression on the concept of yield might be desirable before

continuing. An asset's yield can be calculated from the receipts and costs
resulting from its possession during a specific interval. If these receipts and
costs can be valued in some monetary unit, then the value of the yield can
be determined. (For example, if you buy a bond today for $100, and obtain
$109 in a year, then the nominal (or monetary) yield is 9%. The cost
(= principal) is $100, the interest income is $9, and at the end of the year
the purchaser obtains the principal + interest.) But it is also possible to
think of the yield in terms of satisfaction, or utility, as with a durable good
(such as a washing machine, or TV set). The concept of utility is also
useful in describing or comparing situations in which uncertainty is present.
For many persons, a guaranteed return of 9% has a higher "utility yield"
than a highly likely but still uncertain return of 10.5%.
Labor markets have been "tight" in the US during the late 1990s, and a
great concern was that this would lead to higher wages and salaries, which in
turn will be transformed into higher prices, with the next step being higher
interest rates and the possibility of a traumatic stock market "correction".
Of course, there are economists claiming that a new paradigm (i.e. pattern)
now prevails in countries like Sweden and the US, with high productivity
increases restraining inflation, and thus justifying the lower yields on stocks
that, ceteris paribus, might result from having to pay more for these assets.
(The capital gain on a share costing $50, whose price increases by $5, is
10%; while a $5 price increase on a $100 share yields only 5%. But once
again, it has been contended that investors might be willing to accept modest
yields if the inflation rate is low.)
In considering the foregoing argument, readers should be aware that we
have touched on the difference between money income and real income.
Money income is the compensation received by an employee in money,
while real income is (in theory) the compensation in goods. Quite simply,
if the price of goods and services rises faster than incomes, then real incomes
decrease, and the amount of goods (and services) that can be purchased —
even with a rising income — decreases. This is one of the reasons why,
when consumers see that prices are rising, and/or they expect that prices will
rise, they might demand higher interest rates on bonds, and higher yields
on shares, before they are willing to postpone consumption.
The World of Money 5

By way of clarifying this matter, consider the following example.

Suppose that you have a certain income, and your tastes are such that
you only consume that wonderful Swedish delicacy, sill chutney. If the
price of sill chutney is unity (p = 1), and the rate of interest is 10%, it
means that if you save 100 dollars, then after a year you receive 110 dollars
(= 100 (1 + r) = 100(1 + 0.10) = $110). If there is no increase in the price
level, then with this money you can consume 110 units of sill chutney. The
real interest rate, which is a commodity rate of interest, is 10% (= (110 —
100)/100) x 100%), which happens in this case to be the same as the money
rate of interest. But suppose that with the same savings and interest rate,
the price rises by 5%: from p = 1 to p = 1.05! Your 100 dollars still grows
to 110 dollars under "the force of interest", but you can only consume 110/
1.05 = 104.76 units. The real rate of interest is therefore only {(104.76 -
100)/100} x 100% = 4.76% = 5%. More generally, if we call g the inflation
rate, and rm the money rate of interest, then the (approximate) real rate of
interest (r r ) is rr = rm - g. If you are concerned with real as opposed to
money (or nominal) rates of interest, and you hear on CNN that labor
markets are "overheated", or the money supply increased by a large amount,
then you might expect an increase in the rate of inflation, and thus a (ceteris
paribus) decline in rr.
It is virtually impossible to overestimate the value of being able to
reason in both real and nominal terms. Debtors, for instance, are quite
partial to allowing inflation to reduce the real value of their debts. Here I
think immediately of student loans in Sweden. More relevant, governments
with long-term nominal debt (e.g. governments that have much of their
outstanding debt in long-term bonds) might be tempted, in theory, to inflate
in order to erode the real value of their obligations. (Of course, the US has
a huge national debt, but has shown no sign of encouraging inflation.)
If you read the financial pages of your local newspaper, or watch TV,
then you know that the stock (or share) market often assumes that if there
is inflation, then an increase in the (money) rate of interest (r m ) will follow;
and as you will learn later, it might lead to a decrease in the demand for
shares.
Inflation is the rate of increase in the price level. In the above, the
price of sill chutney this year is unity, and 1.05 next year, and so the
6 Global Finance and Financial Market: A Modern Introduction

inflation rate is [(1.05 - 1.00)/1] x 100% = 0.05 x 100% = 5%. It sometimes

helps to differentiate between ex-ante (before or expected) and ex-post (after
or realized) entities. In the present exercise, in theory, it might be better to
speak of the expected inflation rate, and write rr = rm - E(g), where E is
called the expectations operator, and thus E(g) is the expected inflation
rate: bond buyers might demand higher interest rates because they expect
inflation to increase, and without these higher rates their increase in
purchasing power in the future due to saving is judged inadequate for the
sacrifice of present consumption. Similarly, deflation is the rate of decline
in the price level, which can also be considered ex-ante and ex-post.
Disinflation is a slowing down in the rate of inflation.
Interestingly enough, the UK government's use of indexed debt in the
1980s helped reduce interest rates because it increased the credibility of the
government's anti-inflation intentions, and as a bonus the fall in interest
rates reduced borrowing costs. (Indexing a loan to inflation means e.g. that
(interest) payments are tied to price increases. Similarly, pensions in many
countries are tied to the inflation rate.)
A popular definition of inflation is "too much money chasing too few
goods". In the last years of the 20th century, we have seen large increases
in productivity that have raised the output of "goods". Technology has been
important, along with changes in work habits and income distributions,
although it is not easy to confirm the economic relationships at work here.
A symbol that you will need later is A (i.e. "delta"), which in words is
interpreted as "the change in". In the calculation above of the inflation rate
we could have written g = [(pt + i - PtVpJ x 100% which in turn can be
written g = (Ap/p) x 100%. Ap is then (p t + i - p t ), which means "the
change in p". In the example Ap = 1.05 - 1.00 = 0.05, and Ap/p is a rate\

Exercises
1. In Switzerland, accounts owned by foreigners sometimes carry a negative
rate of interest. What does this mean for the real rate of interest? Can
you figure out why the Swiss impose this arrangement?
2. Market "watchers" and financial analysts are interested in things like
the money supply, and capacity utilization in industry. Explain why!
The World of Money 7

3. Redo the exercise immediately above in the text, only taking the price
rise as 10%. In words, what does AX/X mean? AX/AY?

II. The Markets for Money

The definition of the money supply is important. The narrowest money-
supply measure is the monetary base, or MO. This consists of currency and
bank reserves. Next comes another narrow money stock (called Ml in the
US, or sometimes "transactions money") consisting basically of currency
(which is about 25% of the narrow money stock in the US) and demand
(or checking or current) deposits in financial institutions. Checks can be
written against these demand deposits, but conventionally they pay little or
no interest. However, in the US, it is possible to transfer checking account
balances above a certain amount to interest bearing savings accounts via
ATS (Automatic-Transfer Savings) accounts, and a transfer can take place
in the other direction via NOW (Negotiable Order of Withdrawal) accounts.
Accordingly, in the narrow money supply, demand deposits should be
replaced by checkable deposits, which includes ATS and NOW accounts,
and also the accounts supporting credit cards and travellers checks.
Electronic currency in the form of debit cards and stored value (or
"smart cards") can in theory be issued for virtually any amount. The most
sophisticated smart cards contain a computer chip, and they can be loaded
with digital cash from its owner's bank account. As an aside, readers might
like to know that coins are believed to have originated in Lydia, a Greek
city-state (about 700 BC), while paper money is thought to have been
introduced in China during the Ming dynasty (1368-1399 AD).
Why this emphasis on the "narrow" money supply (e.g. Ml)? The answer
is that when market watchers and financial analysts in the US were routinely
obsessed by the weekly announcements of money supply statistics, they
inevitably focussed on Ml. The point was to outguess other players as to
how the market reacts to changes in Ml. Needless to say, an adverse reaction
in the US can have serious consequences for many other countries.
There is also a broad money stock which comprises such things as
savings and time deposits. This broad money stock operates on several
8 Global Finance and Financial Market: A Modern Introduction

levels, and is where we introduce expressions such as M2, M3, and so on.
Something that needs to be mentioned here is that during the period when
monetarism was taken seriously — where monetarism as a concept merely
means a steady growth in the money supply, and (in theory) hands-off
management by the authorities — one of the major problems was deciding
"which" money supply was applicable for this steady-growth treatment,
and/or which money supply analysts should be scrutinizing.
One of the difficulties here, according to Charles Goodhart — a former
advisor to the Bank of England — is that when an economic indicator
becomes an instrument of government policy, the behavior of this indicator
shows a tendency to change from its pre-governmental policy status. This
is called "Goodhart's Law", however what it amounts to is a very rough
adaption of Heisenberg's "Uncertainty Principle" in physics. This principle
has sometimes been interpreted to mean that the close observation of certain
aspects of a phenomenon can lead to an inaccurate perception of other
aspects of the same phenomenon. The well known trader Bruce Kovner
feels that applied to financial markets it says that the closer a price pattern
is observed by speculators, the greater the likelihood that false signals will
be generated. (Literally, the Uncertainty Principle maintains the impossibility
of satisfactorily measuring both position and velocity of an elementary
particle: measuring the velocity perfectly means that the particle could be
anywhere.)
Ordinary persons have a number of ways of saving money. They keep
it in a cookie jar or mattress, put it in financial institutions (such as banks),
buy financial assets such as bonds and shares, and so on. As a matter of
definition, bonds originate in the debt market — since they are usually the
debt of corporations or government; while shares (i.e. stocks) indicate
ownership, and are called equities. Bonds are often called fixed income
securities, since unless things go drastically wrong, the owner will always
get a certain amount of money at regular intervals over the maturity of the
bond, and/or the face value of the asset at the maturity or expiry date,
unless the bonds are "callable". If not callable, then e.g. 30-year bonds
"pay-off after 30 years; but if callable the earliest date at which they can
be called is clearly specified. Both bonds and shares are called securities,
The World of Money 9

although a security is usually defined as a promise to pay a specific sum of

money on a specific future date! A share does not usually make this promise.
Persons or institutions that are not so ordinary, such as multi-millionaires
and pension funds, also occasionally use banks, and they definitely buy
bonds and stocks, but in addition they have the option of purchasing certain
money market assets that are specifically tailored for big-ticket savers.
Among these assets are Treasury bills (T-bills), which are usually short-
term (three to six months) government securities that tend to be denominated
in amounts that are beyond the reach of small savers. These bills make just
one future payment. Bills of longer maturity are designated zero-coupon
bonds, and they too promise just one payment. Conventional bonds promise
a series of payments, often every six months, and a payment of the principal
(i.e. the face value of the bond) on the maturity date. Short maturity bonds
— one year or less — are often called notes.
Certificates of deposit (CDs) are a favorite of institutional investors in
the US. These are fixed term deposits that are issued by almost all the
major commercial banks, and can be resold in a secondary market. (The
market in which these assets are issued is called a primary market. The
same thing holds for other financial assets that can be traded — i.e. bought
and sold — after they are issued.) The money market includes the
commercial paper market, which has become extremely important in the
US. Commercial paper usually takes the form of an unsecured short-term
(30-60 days) promissory note that is issued into the money market, where
it is sold at a discount to its face value. Often it is associated with a back-
up (bank) credit facility that can help with funding in case of a liquidity
problem at the time the paper falls due.
There is also the market for bankers' acceptances (i.e. debts between
companies), where banks "accept" bills of exchange, and lend to creditors
(expecting to receive their money later from debtors); and the very important
federal funds market in the US, and the inter-bank market in the UK, where
banks with a surplus of reserves lend them to banks that do not have enough.
Although it seems odd, huge sums of money are loaned overnight, and in
the US, overnight federal funds represent the shortest-term security that is
actually traded. The reserves mentioned here are liquid assets necessary to
10 Global Finance and Financial Market: A Modern Introduction

support bank lending. (An asset can be defined as anything that has economic
value!) Interest rates on these and other financial assets are published daily
in the Wall Street Journal in the "Money Rates" column.
In talking about bank reserves and the unexpected liquidity problems
that are implied by the presence of large overnight loan markets, it is
interesting to note the launching in Europe of US-style liquidity funds for
institutions. The logic here is simple. There are hundreds of billions of
dollars in "cash" — i.e. mostly short-term bank deposits — being held by
e.g. pension funds and large corporations. (UK pension funds traditionally
hold about 4% of their assets in cash.) If a part of these went into e.g. Merrill
Lynch Mercury Funds, they could earn at the present time about 15 basis
points (i.e. 0.15%) more than bank deposits. These liquidity funds channel
their money into highly liquid assets (such as government bonds), and the
clients of these liquidity funds can obtain cash in currency or deposit form
almost as easily as they can withdraw money from an ATM.
Access to the money markets has increased for small savers due to
such innovations as money market mutual funds, that combine the resources
of small savers into amounts that are large enough to purchase the most
expensive shares, bonds, and other assets. The purchase of such items is an
integral part of the process known as disintermediation, in which banks can
be bypassed, and financial assets obtained directly from their issuers.
Similarly, borrowers can obtain money by issuing bonds rather than by
borrowing from banks. Of course, it often happens that it is less expensive
for large corporations to borrow from (a syndicate of) banks than to issue
bonds.
In the US at the beginning of the 21st century, commercial banks' share
of total financial assets has fallen to one-fifth from about half in 1950,
while half of all households own shares directly, or through mutual funds.
Internet brokers now give their customers access to several hundred mutual
funds which do not require entrance or exit costs. This "depot-trade" is
often financed by the funds themselves because it relieves them of a part
of their administrative work. They merely levy a small fee on the amounts
being managed.
A well known fund of this type in the US is Charles Schwab's highly
successful "One Source", where customers are offered a choice of several
The World of Money 11

hundred no-commission mutual funds that are without transaction or

redemption fees. Instead there is a moderate flat fee that is tied to the
value of the assets under management. This is a typical no-load fund, as
compared to funds where a fee or commission must be paid in order to
become a member. Professor Burton Malkiel once remarked that on the
average the performance of these two types of funds were about the same,
and as a result he always shopped in the no-load market. Why buy something
that you can get free, he asked, although even among the very sophisticated
denizens of high finance it is quite normal to encounter or to hear about
persons who insist on paying for a free lunch.
Two other fund categories can be mentioned here — open end and closed
end funds. In the first shares can be redeemed at any time, at a price that
is tied to the asset value of the fund. The shares of the fund represent a
proportionate ownership in a portfolio of assets held by the mutual fund.
At any time a shareholder can buy additional shares from the fund, or cash
in (i.e. redeem) shares in the fund at their net asset value. In the closed end
arrangement, shares are neither issued nor redeemed after the initial offering.
The buying and selling of these shares takes place in the stock market from
a fixed amount of equities at prices determined by supply and demand.
Closed end funds are in the minority.
Globally, there were thousands of mutual and other types of funds in
existence as the world entered the 21st century, many of them highly
specialized to regions and/or concepts, such as East Asia, Latin America,
Eastern Europe, emerging markets, etc. Included in this roster of mutual
funds are index funds which, since they match market averages, literally
allow investors to buy a "market": for instance, it is possible to "buy"
the Dow Jones index, which is a collection of 30 industrial shares that
supposedly measures the performance of the entire US share market; or the
Standard and Poor's (S&P) 500, or whatever. In the US, 20 cents of every
retail dollar going into mutual funds goes into index funds, where "retail"
means that institutional savers (such as pension-funds) are excluded. (In
the UK, however, by 1999 about 10% of pension-funds' money was invested
in index funds, as compared to 4% in 1993.) This type of investment, which
is sometimes called a "no brainer", routinely yields higher returns than
12 Global Finance and Financial Market: A Modern Introduction

those registered by all except a handful of superstar investors — mostly

high-profile finance professionals. In fact I have never heard of a time —
in either the US or the UK — when, on the average, index funds did not
achieve palpably superior returns to a very large majority of managed funds.
This does not mean, however, that fund managers and brokers are an
endangered species, since their highly specialized knowledge and experience
is often worth a great deal to prospective investors.
As compared to money markets, bonds and shares are issued in capital
markets. Most persons are familiar with stock markets, but they seem
unaware that bond markets can be much larger. During the last year of the
20th century a few starry-eyed stock-market watchers have been claiming
that in the next century, stock market valuations will explode upwards, and
as a result virtually no price is too silly to pay for an equity that has
something to do with the Internet or mobile telephony. Consequently, bonds
and bond funds should be imbibed in the smallest possible doses.
According to Jeremy Siegal, author of the influential book "Stocks for
the Long Run", if your ancestors in the US had invested a dollar in gold
and a dollar in stocks in 1802, then in 1997 the gold "play" would have
been worth $0.84, and the stocks $558,945. All this is very well, but one
of the things I hope that you learn from this book is to be careful where
analytical evidence covering centuries is concerned. If you had bought $100
worth of stocks at random on 1 January 1920, with the intention of holding
them for a decade, then when you sold them on 1 January 1930, you might
been able to buy enough apples to join the hundreds of destitute war veterans
selling that delightful fruit on street corners in New York city. On the other
hand, if you bought a hundred dollars worth of gold on 1 January 1970,
then if you sold it a decade later, it would have financed a pleasant week
of skiing at Sun Valley (Idaho), or a long stay at Miami Beach. As they say
on The Street: "No, Virginia. Now is not the time to turn your back on the
bond market!"
In the US, the derivatives (futures and options) markets for bonds is
huge. London is much more important for the trading of such things as
Eurobonds than for its excellent stock market facilities, even taking into
consideration the modernization and computerization of the London stock
The World of Money 13

exchange in 1986 in an operation that was termed the "Big Bang". (The
Big Bang was immediately preceded by the Financial Services Act, which
was mostly concerned with curtailing the regulation of financial markets.)
Interestingly enough, London is not generally considered to be a really
dominant center for such things as the issuing and trading of corporate
bonds, even though London (and not Tokyo or Frankfurt) is the second
most important global financial center (after New York), and will probably
be the financial capital of the European Union (EU). Frankfurt has recently
developed high hopes of overtaking London in the not too distant future,
especially after its Eurex Exchange surpassed the London International
Financial Futures and Options Exchange (LIFFE) in trading the 10-year
(German) Bund Futures Contract, which in financial prestige is at least the
equivalent of a futures on the US 10-year T-bond (i.e. Treasury bond). "At
least" because the underlying fixed income security, the Bund, though issued
by the German government, is the benchmark (i.e. reference or standard)
bond for the 11-nation Euro-zone bloc.
Regrettably, one swan does not make a summer, and although LIFFE
considered the Bund to be its pride and joy, London's stock market has
twice the market capitalization of Frankfurt's. Three times the number of
overseas banks are associated with the London market, along with a few
battalions of highly successful risk takers and top traders, and it has a long
and successful risk taking tradition. In addition, Frankfurt does not have
a good reputation where that elusive quality known as "openness" is
concerned: it was not until 1995 that insider trading was formally outlawed.
When a firm has a high ratio of debt to equity (i.e. ownership), it is
called highly leveraged in the US, and highly geared in the UK. 1987 and
1988 were years in which leveraged buyouts (LBOs), often financed by
junk bonds reached a new peak. What we usually have here are arrangements
in which various investors buy junk bonds — which are more formally
known as "below investment grade" or "high risk" securities — and thus
become lenders to the buyers of a firm. If lucky, the new owners (who are
sometimes called "raiders", if the projected takeover is "hostile"), obtain
uninhibited access to the firm's cash flow. The problem is that equity in
the taken-over company is literally swamped by new debt, which in theory
14 Global Finance and Financial Market: A Modern Introduction

will be repaid out of higher profits obtained via more efficient management
and higher productivity, and/or, in the best of all possible worlds, an upswing
in the business cycle.
Needless to say, the business cycle often turned in the other direction,
which caused a serious problem for many employees of the taken over firms
— though not those who had come on board wearing golden parachutes;
and in a number of cases the additional debt had to be serviced by the sale
of physical assets, and contracting for even more debt.
There has been a fairly high default rate on junk bonds, and a brief
period in 1990 when the US Congress apparently forced at least some
financial institutions to dump their junk portfolios. The junk bond market
in the US crashed in the mid-nineties, however it appears to be gathering
momentum once again. As will be noted later, Europe is developing an
attachment to junk bonds. A main factor here is that junk spreads —
i.e. yields in excess of those available on top-grade securities of the same
maturity — are higher than at any time since 1985. Firms that are threatened
by takeovers are also prone to float junk bonds in order to secure the
financial capital that will enable them to buy a controlling share of the
outstanding equities of these endangered firms. (Financial capital is stocks,
bonds, etc used to finance the acquisition of physical capital!)
The term often used to describe this defensive ploy is "greenmail".
Another self-defense mechanism is the "poison pill". What happens here is
that the threatened firm gives all shareholders except the "raider" the right
to buy new shares at a large discount. This makes purchasing enough shares
to complete the takeover too expensive. Another nice term is "White
Knight". This is a (possible) rival bidder who is preferable to the original
predator.
There has been a great deal of discussion about the takeover mania of
the 1980s, and one theory is that if it were justified — and this is a big if
— the justification must turn on boosting the price of the stock of the
target companies to a level that is closer to the fundamental value of the
underlying assets. As Tobin and Golub (1998) point out, ordinary investors
may have detected the same undervaluations, but could not take advantage
of them until many more ordinary investors agreed (and presumably began
to purchase these stocks), or a takeover materialized.
The World of Money 15

III. Banks, Bankers' Banks, and the Euromarket

Banking is an art, or science, that reportedly had its roots in ancient Egypt
or Assyria, although modern fractional reserve commercial banking seems
to have had its origins in Italy in the 15th century. But there are other types
of banks. Investment banks, for instance, specialize in raising money for
businesses via bond and stock issues, giving advice, and like the larger
commercial banks they are active traders in various financial markets. Invest-
ment banking can be a very good business, although stunning miscalculations
occasionally take place: in 1998 Credit Suisse First Boston lost an entire
annual profit (more than a billion dollars) on some bad investments in Russia,
and they were not alone. The fixed income division of Goldman Sachs also
lost a billion dollars in the same country that year, and a year later lost
something approaching 100 million on a bet involving the spread between
government bond yields and the yield on another financial asset: this spread
widened instead of narrowing, as predicted by Goldman Sachs experts.
(However, as far as I can tell, Goldman Sachs is rated the top investment
bank in the world at the beginning of the 21st century.)
Many investment banks function as underwriters. They guarantee the
corporate or government borrower a price for their securities, and then sell
them to the public at whatever price they will bring. This takes both capital
and nerve. Japanese investment banks were originally called securities
houses, because of the importance placed on underwriting.
Asset management — which involves "looking after other peoples'
money" — is another major activity of investment banks. It is considered
less glamorous than the multibillion-dollar merger and acquisition (M&A)
deals that you can hardly avoid reading about these days, but the fee-based
income that it generates is less volatile than the profits realized from the
heavy trading of financial assets. For instance, in 1997 Morgan Stanley's
net income from asset management was reportedly $400 million, although
Switzerland's UBS — with well over $1 trillion under management — still
leads the world in this field. The "other people" mentioned here include
high-net-worth individuals, corporations, and many pension funds.
Another type of bank is the merchant bank, which was orginally a British
phenomenon. In some respects they resemble investment banks, but they
16 Global Finance and Financial Market: A Modern Introduction

tend to be much smaller, and occasionally they take deposits — but mainly
from important customers. They are, however, very fond of giving expensive
advice to rich clients; acting as intermediaries in complicated business deals;
trading large amounts of currencies, and in the 1980s became heavily
involved in the leveraged buyout game. Something that should be appreciated
here is that in the US, the Glass-Steagall Act of 1933 separated investment
banking from commercial banking, but this act recently became history.
There are some observers who claim that repealing the Glass-Stegall Act
will pose considerable financial dangers to the entire US economy, because
it will mean a huge displacement of liquidity from the commercial banking
system to the investment banking community. This might also be the place
to mention such institutions as "private banks", whose principal activity is
managing the portfolios of wealthy clients (i.e. making investments for these
clients), and the French banques d'affaires. The latter are similar to merchant
banks, but often use their own money to build up a portfolio of shares.
The student of finance should be aware that in the United States,
"merchant banking" is the designation of an activity within investment banks,
and in this context explicitly means investing the firm's own money in
things like mergers and leveraged buyouts. Once it was said to be Wall
Street's "hottest" profit center, although it is ridiculed by some observers,
who say that when a high level of risk is present, it is always best to use
the money of outsiders. These same observers, however, do not ridicule
proprietary trading. This is when the bank uses its own money to trade
currencies, futures, options, etc. For example, at Salomon Brothers — one
of the largest investment banks — bond arbitrage was the leading money
maker, although at least one merchant bank — Barings (of London) —
unfortunately collapsed due to the misfortunes of one of its ace foreign
exchange and derivatives traders. Goldman Sachs is constantly boasting of
its M&A and its asset management skills, however about 40% of its revenues
originates in its trading rooms.
A very different type of institution is the central bank. Every country
has one of these, and the Swedish central bank (the Riksbank) is the oldest
(1668). The British central bank (the Bank of England) is second in
longevity, dating from 1694. Central banks manage the money supply, and
The World of Money 17

often they help ensure that governments have the finance they need: both
the Swedish and UK central banks seem to have been established to help
their governments fund various military adventures. In the United States,
the chairman of the central bank (The Federal Reserve System) has
occasionally been called the second most powerful man in the country.
Managing the money supply, and setting interest rate policy are traditionally
the most important functions of central banks; and the recent hue and cry
about making central banks independent of governments is intended to
remove these institutions from the control of governments and politicians,
and thus prevent them from being too aggressive in the expansion of the
money supply when the economy is weak and unemployment is high.
When government spending exceeds tax reviews, the difference is
covered by borrowing. Government bonds are then sold to private individuals
or institutions, both domestically and abroad. Japan, for example, has bought
huge amounts of US debt. There was a time, however, when central banks
bought a great many government securities, paying for them with newly
printed money, and thus increasing the money supply. This is known as
"monetizing the deficit" or, less politely, "printing money".
The newly formed European Central Bank, for instance, is a highly
independent institution that places the fight against inflation first on its
agenda. Many people in the Scandinavian countries are not enthusiastic
about a brand of economic policy whose main concern is not the suppression
of unemployment; but as they will almost certainly find out some sweet
day, once you sign on with this particular bank, it will not be easy to sign
off. In addition, something that seems to have been forgotten is that perhaps
the worst inflation in modern times took place in Germany (in 1922-1923)
when the central bank of that country was completely independent of all
external supervision.
The Euromarket is based on cross border banking, and features such
things as the depositing of dollars in various European banks, and the lending
by these banks of dollars in the Eurocurrency market (which features
"short-term" debt); or, e.g. the issuing of dollar denominated Eurobonds in
e.g. London. This is "long-term" debt, where long-term usually indicates a
maturity of over one year. To be precise, Eurocurrency markets are defined
18 Global Finance and Financial Market: A Modern Introduction

as banking markets located outside the legal jurisdiction of the authorities

who have issued the relevant currencies: e.g. Euromarks are deutschemarks
(DM) held in e.g. Rome or Paris.
Some investigators say that the beginnings of the Euromarket can be
traced to the Cold War, when the Russians and Chinese ostensibly deposited
dollars in West European financial institutions for trade purposes. At the
same time that regulations on interest rates in the US (e.g. Regulation "Q")
discouraged dollars that were earned abroad from returning to the United
States, British banks were put in a position where it became highly profitable
to lend dollars: in the UK the government placed severe restrictions on the
lending of pounds, but financial institutions were left to their own devices
where the lending of dollars was concerned.
Between 1965 and 1995 the rate of growth of the Eurodollar market was
22% (gross). Pilbeam (1998) gives as the main reason for the success of the
Euromarkets their comparative advantage due to a minimum of regulation (as
compared to banking practices in the US or Japan). Thus they could pay a
higher rate for deposits, while charging a lower rate for loans. The difference
between these two rates is called the spread, which is also the name for the
difference between the bid (or buying) and ask (or offer) price of a financial
asset. At your local bank you can always view the spread for various
currencies, and occasionally they are very large. (Ask, or offer, is the selling
price.)
The Eurobond market specializes in syndicated loans where many banks
form a syndicate for the purpose of raising a large sum of money for a
single borrower. Syndicated loans are still about 50% of the long-term capital
raised on international markets, where international markets means capital
raised across international borders: e.g. bonds issued in Stockholm and sold
internationally. In 1998, financial institutions collected at least $6 billion in
fees for arranging syndicated loans. Behind this figure is a new wave of
corporate consolidation and reorganization.
Traditionally, one of the banks will be the lead manager for the syndicate.
The first of these Eurobond operations involved the well known London
merchant bank S.G. Warburg "leading" a 15-million-dollar issue, with Banque
de Bruxelles SA, Deutsche Bank AG, and Rotterdamsche Bank NV as
The World of Money 19

co-managers. (If you are curious about the composition of syndicates,

then you can examine a "tombstone announcement" in e.g. The Wall Street
Journal. These announcements have to do with completed deals.) There
were 60,000 bonds with a face value of $250 each, and carrying a fixed
coupon of 5.5%. As it happened, this issue — whose emission date was
July 15, 1963 — was subjected to the interest equalization tax of 15%
imposed by President Kennedy the same year on the purchase price of
foreign bonds. This tax was designed to make bonds issued in Europe less
attractive to US investors, and therefore relieve pressure on the US balance
of payments (and the value of the dollar) caused by what the Kennedy
government regarded as excessive capital outflow.
At the present time many Eurobonds are priced in terms of LIBOR —
the London Interbank Offer Rate — which is the (loan) interest rate quoted
each other by the best London banks. (There is also something called LIBID
— the London Interbank Bid Rate — which is the rate bid to attract a
deposit.) Eurobond loans can be fixed rate or floating rate, where floating
rate usually means that the interest rate paid by the borrower is adjusted
every three or six months with reference to some index. In discussing bonds,
the expression maturity often comes up. The maturity is the "running time"
of the bond, and the maturity date is the date when the holder of the bond
should receive the principal or face value of the bond. Please remember
too that there is a huge secondary market for bonds, and during the last ten
years there were periods when higher profits could be realized by trading
bonds than by speculating in stocks. (Tom Wolfe's "master of the universe"
in his virtuoso novel "Bonfire of the Vanities" was a Wall Street bond
trader.) How were these profits realized? Quite simply by having the acumen
to know when certain bonds are underpriced, buying them, and waiting for
the good news to appear in the form of a decline in interest rates: a fall in
interest rates is tantamount to a rise in bond prices.
It is useful to distinguish between so-called "foreign bonds" and
Eurobonds. An example of foreign bonds would be German bonds issued in
the US, and denominated in US dollars: like other foreign bonds issued in
the US, they are called "Yankee bonds". Another example is Swiss bonds
issued in Japan, and denominated in yen. (These bonds are designated
20 Global Finance and Financial Market: A Modern Introduction

"Samurai bonds".) On the other hand, Eurobonds are bonds denominated in

a currency that is different from the currency of the country where they are
sold — such as dollar denominated Eurobonds in London. Finally, Dragon
Bonds are listed and promoted in Asia, while Eurocurrencies are foreign
currencies deposited in banks outside the home country (of the currency).
An important feature of Eurobonds is that for the most part they are
bearer bonds, which means that unlike e.g. Yankee bonds, they are
unregistered, and mere possession amounts to ownership. They are therefore
very attractive to bond thieves (as in the Donald Westlake novel "Cops and
Robbers"), and persons with a strong preference for anonymity, such as tax
avoiders. (On this point it should be noted that Eurobonds are not subject
to a withholding tax. The market is "telephone intensive", with London
being the hub. Investors simply give brokers details of the bonds they desire
to purchase.) Two famous bond offerings took place in 1984, with Sweden
making a 500-million-US-dollar floating rate placement in the Eurobond
market. These bonds had a 40-year maturity, which at that time was the
longest in Eurobond history, and carried a semiannual interest rate of
LIBOR + 0.125%. On the emission date of the bonds, LIBOR was
10.4375%, and thus over the first six months after their issue the bonds
yielded approximately (10.4375 + 0.1250)/2 = 5.2812%. In the second six
months, their yield was increased or decreased if LIBOR changed.
Similarly, in 1984, the World Bank emitted US$250 million of ten-year
floating rate notes on which the interest rate was 35 basis points (= 0.35%,
since one basis point is equal to 1/100 = 0.01%) above the money-market
yield on prespecified US 91-day treasury bills. Interest, in this case, was
paid on a quarterly basis.

IV. A Simple Case Study

One of the most brilliant essays of L.J. Davis (1983), winner of the 1982
Gerald Loeb award for distinguished business and financial journalism, is
called "The Road to West Jockstrap", and concerns the decline and fall of
the Penn Central Railroad. All this took place at the end of the 1960s, and
The World of Money 21

the story of that misadventure has been repeated many times since in other
commercial and government undertakings. One of the things that we find
in most of these melodramas is the irresponsible optimism of many directors,
CEOs (chief executive officers), chairmen and chairwomen of the board,
and other persons and personalities with an almost psycotic belief in their
ability to strike bargains with fate.
What happened with Penn Central was the arrival on the scene of a
new CEO with a plan to make railroad history by combining the tracks,
terminals, etc. of the two largest railroads in the American Northeast — the
Pennsylvania, and the New York Central — which would then be designated
the Penn Central. The theory was that if things went well, it could be
operated at a level of profitability well above that prevailing in the not
very profitable railroad business. Needless to say, financing investments of
the type alluded to above required obtaining access to huge amounts of
money.
According to Davis, there was an extremely heavy reliance on bank
loans, the sale of a great many bonds, a major resort to commercial paper,
and perhaps the first large scale tapping of the Euromarket by an American
firm. Something else of importance was the ambition of the chairman of
the board of Penn Central to make this railroad a part of a conglomerate.
Briefly put, a conglomerate involves bringing under single ownership all
types of companies. The modus operandi is to buy anything that is profitable.
The two great conglomateers of the 1960s were Charles Bludorn — Viennese
born, but fluent in American profanity; and James Ling of Texas. Both
came crashing down when the banks started calling in their loans, which
was also the eventual fate of Penn Central. Another interesting example
was the brilliant Palestinian refugee Yusef Beidas, with properties in New
York, London, and Paris under management. His mistake was to put too much
short-term money into property that was not liquid, and because his personal
chemistry was not always congenial, the Lebanese Central Bank and some
of Beirut's financial community apparently conspired in his downfall.
One of the reasons that Penn Central chose to rely so heavily on bank
loans was that some of the officers of that firm were able to convince the
directors of many large banks that they were becoming involved in a very
22 Global Finance and Financial Market: A Modern Introduction

profitable project. The same story was true of many of the property loans
of the 1980s and early 1990s, when many top bankers seemed to have
completely lost their sense of perspective.
In 1968, Penn Central received permission from the US government's
financial regulators to sell 100 million dollars of commercial paper, and
later was able to increase this amount to 200 million. The broker for this
frivolous undertaking was Goldman Sachs, one of the great New York
investment houses; however, in the end, the cachet of their distinguished
intermediary did not amount to the proverbial hill of beans, since most
purchasers of this paper ended up receiving 20 cents on the dollar.
Now for the Euromarket. In the late 1960s, the Euromarket was just
getting up steam, and European banks were filled with dollars looking for
borrowers. Furthermore, the directors of many of these banks were not
particularly skilled in handling greenbacks, and so they were often prepared
to lend to any organization with a recognizable name, whose CEO had a
pleasing personality. In the transaction being discussed here, Penn Central
had the distinction of employing a lawyer who, somewhat later, allegedly
attempted to defraud the United States Navy; but it is also possible that
Penn Central was too early out where the Euromarket was concerned. Had
they been on the borrowing side of this market after it started receiving
large injections of OPEC cash (i.e. petrodollars), they could have borrowed
any amount they wanted, and forgotten about such things as commercial
paper.
Why did the bandwagon come to a screeching halt? If we exclude bad
management, and bad luck in the form of a regulatory structure that was
guaranteed to make the railroad business a lost cause, the answer might be
that Penn Central was burdened with too much short-term debt. Davis
apparently believed that short-term debt can be converted to long-term debt
by simply "rolling it over" — i.e. paying off the outstanding indebtedness
with new loans; but clearly new lenders with the required amount of naivete
become progressively more difficult to find.
When Penn Central's severe financial defects were fully digested by
interested parties, the institutional insiders (e.g. mutual funds) unloaded well
over a million shares of Penn Central equity, with the last increment being
The World of Money 23

divested just a day before the firm officially confirmed the rumors that it
was bankrupt. In July 1968, Penn Central stock had sold for 85.5 dollars/
share, and by the time bankruptcy was declared — which was June 20,
1970 — this price had touched 11 dollars. Apparently, some of the directors
of the firm, while loudly proclaiming the soundness of their organization,
began getting rid of their shares as soon as they first got wind of how
things might turn out. Many of the smaller stockholders received nothing,
because in their capacity as "owners" of the firm, they could only legally
lay claim to what is left after all debts are paid. As they soon found out,
Penn Central's creditors (e.g. bondholders) took just about everything.
It is also astounding to realize that many of the small equity owners, as
well as some of the large, sincerely believed to the last minute that the US
government would not permit one of the most important transportation
networks in the US to fail. As things turned out, they believed incorrectly,
Davis states that the Penn Central collapse triggered a three-billion-
dollar selloff of commercial paper. Exactly what he meant is difficult to
say, but a possibility is that when more than 80 million dollars of Penn
Central paper went bad, it soured the market on all assets of this description,
and where this kind of paper could be traded in a secondary market, it was
immediately unloaded for whatever it would bring, which wasn't much.
Here we have a situation that will become familiar to readers: markets
suddenly becoming illiquid, which in this case meant a pronounced absence
of buyers! What happened next was that the Federal Reserve — the US's
central bank — declared itself the "lender of last resort", and made it clear
to the (several thousand) members of the Federal Reserve System that the
Fed's "discount window" would be open indefinitely. ("Discounting" — or
"rediscounting" as it is often called — means the lending by the central
bank to commercial banks, and usually at a relatively low rate of interest.)
In addition, the famous — or infamous — Regulation Q, which limited the
interest rates on deposits in domestic US banks was relaxed, which attracted
more money into the banking system.
Finally, let me mention that an economist who has become a kind of
saint in some quarters, Frederich Hayek, would have declared the above
cited behavior by the Federal Reserve to be irresponsible and economically
24 Global Finance and Financial Market: A Modern Introduction

unjustifiable. As it happens, however, if the authorities had remained passive,

there could have been a nation-wide financial panic. The same applies to
the near collapse of the "hedge" fund Long- Term Capital Management
(LTCM) in the late 1990s. That firm, whose own capital was five billion
dollars, had borrowed approximately 125 billion from institutions like Chase
Manhattan. Had nature been permitted to take its course, the macroeconomic
consequences could have been calamitous.

V. Financial Market Structure, and Final Remarks

The London stock exchange traces its origins to a coffeehouse club of
brokers in the 1760s, although the oldest stock exchange is probably
Hamburg (Germany), which dates from 1538. A common name for the
stock exchange in France and Northern Europe is "bourse". This expression
goes back to a commodity exchange in Bruges, Belgium, founded in 1360
in front of the home of the Chevalier van de Buerse.
In speaking of stock exchanges (or bourses), we think of a certain way
to do business — a way that is quite different from selling pizzas at the
nearest one-stop pasta emporium. Leon Walras, who could probably be called
the grandfather of mathematical economics, observed more than a hundred
years ago that "The more perfect competition functions, the more rigorous
is the manner of arriving at value in exchange. The markets that are best
organized from the competitive standpoint are those in which purchases
and sales are made by auction, through the instrumentality of stockholders,
commercial brokers, or criers acting as agents who centralize transactions
in such a way that the terms of every exchange are openly announced, and
an opportunity is given to sellers to lower their prices, and to buyers to
raise their prices".
If we take a careful look at modern exchanges, we see what Maureen
O'Hara (1995) calls four "categories" of players. We can start with order
submitting customers; then brokers who transmit orders, and almost in the
same category dealers, who often trade for themselves, but who might
also handle the orders of customers. These are sometimes designated
The World of Money 25

broker-dealers. Finally, there are the specialists or market makers, who

usually post prices for one or more assets that they are prepared to buy or
sell.
The US Commodity Exchange Act of 1974 defines a market as meeting
the public interest if it satisfies three requirements: reliable price discovery,
broad-based price dissemination, and effective hedging against price risk.
In my own work on energy, I have taken a particular interest in the last of
these, and come to the conclusion that often it is incompatible with the
first: the use of exchange traded derivatives (or derivative products, as they
are sometimes called) will often — but definitely not always — provide
effective hedging; while the derivative product that is sometimes the most
suitable for hedging purposes, swaps, does not provide a high degree of
price discovery (because swap rates are usually not made public).
Of late, there has been a tendency to play down price discovery in the
name of transparency. Ostensibly, in a world where information is generated
faster than the managers of many exchanges thought was possible, such
things as trading by open outcry are viewed by the new generation of screen
warriors and their gurus as reactionary nonsense. They are not concerned
with how prices are formed, but with their visibility. The ultimate goal is
fully electronic exchanges and, worldwide, only a few of these.
Some simple exercises follow. Please remember that the purpose of
these is not to trip you up, but to increase your self-confidence. I can recall
a member of my platoon telling me that when he left the army, he was
going to return to school. As he put it, "the more I know, the better I feel".
Testing your knowledge with simple exercises that you learn to answer
without hesitation will eventually help you to feel better than you have
ever felt.

Exercises
1. Make sure that you know the meaning of the terms merchant bank,
merchant banking, proprietary trading, capital market, fixed-income
securities, "big bang", real rate of interest, secondary market, disinter-
mediation, money market, disinflation!
26 Global Finance and Financial Market: A Modern Introduction

2. Distinguish between real and money wages; and real and money incomes!
Construct a numerical example involving 15% inflation, and if you can,
put this illustration in algebraic (i.e. symbolic) form!
3. In the basic course in economics, many students come to the conclusion
that central banks can stop inflation any time they please by simply
raising the rate of interest. At times this might be true, but there might
be costs involved. Discuss this issue!
4. In the light of the discussion in this chapter, why might foreign investors
be worried if the inflation rate in the US began to escalate?
5. Suppose that on Jan 1, 2002, you look in the paper and see that your
government has just issued a batch of 30-year bonds with a 10% rate of
interest, and with a face value of $1,000. They will also guarantee that
the central bank will completely suppress inflation. If you buy a $1,000
bond on that date, then you will obtain $100 on Jan 1 of the next 30
years, and your $1000 at the end of 30 years (along with the final
payment of interest). This seems like an attractive proposition, and so
you buy a bond. At the beginning of the following week, you look in
the paper and see that the interest rate on a new issue of 30-year
government bonds is 20%, but you suddenly find that you have financial
problems, and instead of buying another bond, must sell the one you
have in the secondary market. Are you in trouble? (Hint: the person to
whom you sell the bond will continue to obtain the bond yield (or return)
of $100/year.) Ignore the fact that the bond is now a week old, and the
purchaser is one week closer to collecting his or her first $100!

VI. Appendix*
All discussions marked with an asterisk (*) can be skipped if the reader
desires. Of course, as you may remember, the only technical materials in this
chapter concerned the real rate of interest, and the algebra involved was the
kind that you were introduced to in a late course in primary school, or an early
course in secondary school. The same is true here. To be exact, we saw that
the real rate of interest (rr) could be written rr = rm - E(g), where rm is the
money (or nominal) rate of interest, and E(g) is the expected rate of inflation.
The World of Money 27

Suppose that we have two countries, Japan and the US. For Japan,
this expression would be rrj = r m j -E(gj), and for the US, we have
r
r,us = rm,us _ E(g us ). Now, in case a couple of charming and well spoken
young people appear at your door to interview you for a 150,000 dollar/
year in the financial district of Chicago, and the question of interest rates
pops up, you can begin your presentation by saying that a number of
theorists like to claim that while money interest rates are different between
countries, real interest rates "tend" to even out. Thus, we would have from
this hypothesis rmj -E(gj) = r mus -E(g u s ), which can be solved to give
r
m,us _r mj = E(g us ) -E(gj). Accordingly, you would conclude your pre-
sentation by suggesting that on the average, differences in nominal interest
rates — which are often considered the principal cause of capital (i.e. money)
flows between countries — might be caused by differences in inflationary
expectations. Whether the interviewers buy this or not, and whether you
get your job, remains to be seen, but you can thank them warmly for joining
you in your humble abode on the South Side, and after they leave, return
to the study of this book. As an aside, you might point out that exchange
rates are also influenced by inflation and/or inflationary expectations.
"On the average"? Your visitors turn at the door, and in a not so polite
tone of voice ask you what a concept like "average" is doing in an interview
where precision is supposed to be the keystone. The correct answer on this
occasion is that the great English mathematician Bertrand Russell once said
"Although this may seem a paradox, all science is dominated by the idea
of approximation". The implied approximation here is that "on the average"
this hypothesis will be useful to hardworking young (and not-so-young)
financial market players in pursuit of their first million, and so they should
not hesitate to include it in their intellectual armory.

Exercises
1. What is the bid rate? The offer rate? The spread?
2. There seems to be a great deal of pressure at the present time on pension
fund managers to replace some of the bonds in their portfolios by stocks.
Why? What do you think about this?
28 Global Finance and Financial Market: A Modern Introduction

3. Portfolio managers in the US probably prefer a strong appreciation of

the US dollar to a strong depreciation. Why?
4. What are "spreads"? Give two examples! What is Goodhart's Law? What
is "monetizing the deficit"? What is a bearer bond?
5. Asymetric information means that one party does not know enough about
the other party to make accurate decisions. Adverse selection is the
problem created by asymetric information before a transaction occurs,
while moral hazard is the problem created by asymetric information
after the transaction occurs. Think about and discuss these terms in
relation to loan markets.

If you had no trouble with this chapter, then let me suggest that you
examine Chapter 9. That chapter is another non-technical survey that is
designed to cover some last minute developments. Let's take a few more
exercises.

6. In a formal sense, the first banknotes were issued by the Bank of Sweden
in 1661; but earlier, banknotes were 'invented' by goldsmiths in the
UK. Explain how this invention could have come about.
7. There is a common belief in finance that in every market there is a fool.
Comment! Warren Buffett has apparently said (according to Michael
Lewis) that any player unaware of the fool's identity is probably filling
that role himself. (The definition of a fool is someone willing to trade
an asset for less than its worth, where its worth is determined by the
person who valued it properly.) Is this science or nonsense?
8. Pension schemes have traditionally involved pay-as-you-go arrangements,
with current employees being taked pay current pensioners. The theory
now being offered in many countries is that pre-funded individual
pensions are better, where employees have an account in which money
must be saved — and therefore invested — until retirement. Comment
on these approaches, and what they could mean for the holding of
financial assets.