TRƯỜNG ĐẠI HỌC NGOẠI THƯƠNG

KHOA TIẾNG ANH CHUYÊN NGÀNH

PHAN KIM THOA (Chủ biên)

English for
FINANCE AND BANKING
Tiếng Anh chuyên ngành
TÀI CHÍNH NGÂN HÀNG

NHÀ XUẤT BẢN LAO ĐỘNG

Hà Nội, 2021

1
 THAM GIA BIÊN SOẠN
Đặng Thị Mỹ Dung
Mai Hữu Hạnh
Nguyễn Thu Hương
Lê Thị Minh Tâm
Dương Thanh Thủy
Nguyễn Thị Hải Thúy
Tô Thùy Trang

2
 PREFACE

Hello and welcome to the ―English for Finance and Banking”!

This textbook is designed to meet the needs of students studying the majors
involving international banking and finance in terms of language. Each chapter of
this book contains six parts. The first part deals with different Terms, Theories
and Definitions about the topic of the chapter. These are essential for you to
imagine and road map the context that you are going to discover about.
The second part focuses on the Vocabulary issue with which you may find
helpful to read any piece of reading related to the topic in the chapter without
difficulty. This part also aims at enhancing your practical usage of vocabulary in
the real financial world.
The third part contains one or more Readings on the topic of the chapter.
These readings are originated from both theoretical issues and practical views
and articles. They are chosen to offer you a thorough and critical understanding
of the topic. The Reading Comprehension Exercises follows the readings in
this part.
The fourth part is Follow-up exercises to revise all the issues being discussed
in the previous parts. The fifth part - Extension Activities- gives you some
extending activities to work in a group which are mainly conducted in the form
of speaking practice. And the final part gives topics for essay writing.
Naturally, it is advisable to follow these parts of each chapter in its designed
structure. You certainly may find certain concepts, ideas and theories more
familiar than others depending on the background you have accumulated from
other courses of your major at your university. However, the textbook is
designed to also provide readers of different backgrounds with essential language
tools to survive in the financial world. From that perspective, we hope that you
find the textbook a valuable tool in helping you enhance your English language
capability in your finance - related profession.
The authors thank all those who contributed to this textbook during its
preparation, especially the lecturers from Faculty of Banking and Finance, FTU
for their editorial comments on this edition.

3
 ABOUT THE COURSE

This course provides students with opportunities to learn the basic concepts
of different areas of financial business, including international finance and
banking . To that end, students will be able to build up a substantial reservoir of
banking and financial vocabulary throughout the course with reading, discussion
and other practices.
The ―English for Finance and Banking‖ is for students of English anywhere
in general and for the fourth-year students of the Foreign Trade University in
particular whose primary reason in learning English is for the purpose of
conducting business and finance. Many of them will find this book useful for
learning business and financial terminology and concepts. This is to help them
operate more effectively their business dealings in the international marketplace
where communication is mostly conducted in English. The course is organized as
two classes per week, for 10 weeks in total, incorporating instructions and
various practices such as group-work, discussion, and group presentations and
essay writing on a professional topic.
The course emphasizes several skills which students need to develop if they
are to conduct business and finance in English. There are also different types of
vocabulary exercises. Emphasis is placed on developing the ability to learn
meaning from context. Reading exercises give an overview of a particular topic,
introduce key business, financial and economic concepts and teach students to
grasp what has been said by analyzing the passage to find the main ideas, to note
details, and to make inferences. Writing exercises given by the teacher during the
study are included in order to help students develop and express their own
thoughts or opinions about a topic- related to the lesson. There are also additional
proposals for debates, discussion or group presentations to enable students to use
orally some of the words and ideas that have been learned in the course of the unit.
The variety and scope of the exercises, together with the information given in the
reading selections, should further develop both English language skills and student
comprehension of the basic elements of finance and banking. This book not only
provides a good foundation for students to continue a more specialized study in the
field but also illustrates techniques that shall be useful to the professionals in
understanding and writing up presentations in the world of business and finance.
Students are expected to actively participate and contribute in each class. For
each class students should:
 Prepare the topic and/or the handouts BEFORE the class
 Participate in class activities
 Do assignments.

4
 TABLE OF CONTENTS

Unit 1. Introduction ............................................................................................ 7

Unit 2. Time value of moneys ............................................................................12
Unit 3. Interest rates ...........................................................................................31
Unit 4. Financial statements .............................................................................40
Unit 5. Risks and returns ..................................................................................57
Unit 6. Financial markets...................................................................................72
Unit 7. Financial institutions ............................................................................84
Unit 8. Mergers and acquisitions ................................................................... 115
Unit 9. Banking ............................................................................................... 127
Unit 10. Payment methods in international trade ........................................ 139
Compiled from ................................................................................................. 151

5
6
 Unit 1
INTRODUCTION
Reduce the risk
Function Make money
Communicate information to the investor
Why Study Financial Markets?
Financial markets-markets in which funds are transferred from people who
have an excess of available funds to people who have a shortage. Financial
markets, such as bond and stock markets, are crucial to promoting greater
economic efficiency by channeling funds from people who do not have a
productive use for them to those who do. Well-functioning financial markets are a
key factor in producing high economic growth, and poorly-performing financial
markets are one reason that many countries in the world remain desperately poor.
Activities in financial markets also have a direct effect on personal wealth, the
behavior of businesses and consumers, and the cyclical performance of the
economy.
Why Study Financial Institutions and Banking?
Financial institutions and the business of banking- Banks and other financial
institutions are what make financial markets work. Without them, financial
markets would not be able to move funds from people who save to people who
have productive investment opportunities. Thus financial institutions play a
crucial role in the economy.
Structure of the Financial System
The financial system is complex, comprising many different types of private
sector financial institutions, including banks, insurance companies, mutual funds,
finance companies, and investment banks, all of which are heavily regulated by the
government. If an individual wanted to make a loan to IBM or General Motors, for
example, he or she would not go directly to the president of the company and offer
a loan. Instead, he or she would lend to such a company indirectly through
financial intermediaries, which are institutions that borrow funds from people who
have saved and in turn make loans to people who need funds.
Why are financial intermediaries so crucial to well-functioning financial
markets? Why do they extend credit to one party but not to another? Why do they
usually write complicated legal documents when they extend loans? Why are
they the most heavily regulated businesses in the economy?

7
Banks and Other Financial Institutions
Banks are financial institutions that accept deposits and make loans. The term
banks include firms such as commercial banks, savings and loan associations,
mutual savings banks, and credit unions. Banks are the financial intermediaries
that the average person interacts with most frequently.
A person who needs a loan to buy a house or a car usually obtains it from a
local bank. Most Americans keep a large portion of their financial wealth in
banks in the form of checking accounts, savings accounts, or other types of bank
deposits. Because banks are the largest financial intermediaries in our economy,
they deserve the most careful study. However, banks are not the only important
financial institutions. Indeed, in recent years, other financial institutions, such as
insurance companies, finance companies, pension funds, mutual funds, and
investment banks, have been growing at the expense of banks, so we need to
study them as well.
Why Study Money and Monetary Policy
Money, also referred to as the money supply, is defined as anything that is
generally accepted as payment for goods or services or in the repayment of debts.
Money is linked to changes in economic variables that affect all of us and are
important to the health of the economy.
Money and Inflation
The movie you paid $10 to see last week would have set you back only a dollar
or two thirty years ago. In fact, for $10, you probably could have had dinner, seen
the movie, and bought yourself a big bucket of hot buttered popcorn. The average
price of goods and services in an economy is called the aggregate price level or,
more simply, the price level. It is generally regarded as an important problem to be
solved and is often at the top of political and policymaking agendas. To solve the
inflation problem, we need to know something about its causes.
What explains inflation? As we can see, the price level and the money supply
generally rise together. The continuing increase in the money supply might be an
important factor in causing the continuing increase in the price level that we call
inflation. Inflation may be tied to continuing increases in the money supply,
which plots the average inflation rate (the rate of change of the price level,
usually measured as a percentage change per year).

8
 Who set the interest rate? -> the Central Bank
Difference between commercial bank and investment bank
Commercial bank Investment bank
Offer services to small and medium-sized businesses Provide services to large corporations
Primary services are deposits and lending loans Primary services are buying and selling of bonds and stocks

Money and Interest Rates

In addition to other factors, money plays an important role in interest-rate
fluctuations, which are of great concern to businesses and consumers.
Example: As the money growth rate rose in the 1960s and 1970s, the long-
term bond rate rose with it. However, the relationship between money growth
and interest rates has been less clear-cut since 1980.
How We Will Study Money, Banking, and Financial Markets
The study of money, banking, and financial markets is an exciting field that
directly affects your life. Interest rates influence the earnings you make on your
savings and the payments on loans you may seek for a car or a house, and
monetary policy may affect your job prospects and the prices you will pay for
goods in the future. Your study of money, banking, and financial markets will
introduce you to many of the controversies related to economic policy that are
hotly debated in the political arena, and will help you gain a clearer understanding
of the economic phenomena you hear about in the news media. The knowledge
you gain will stay with you and benefit you long after this course is over.

VOCABULARY
Exercise 1: Fill in a blank with the most suitable word:
Bonds deposit mortgage sharestakeover
Capital merger pension stocks Shareholder: cổ đông, mua cổ phiếu doanh nghiệp phát
hành -> được quyền sở hữu, được cổ tức (dividend)

1. A _______________
mortgage is a loan to buy property.
2. Money you put in the bank is called a _______________
deposit
3. Money paid to a retired person is called a _______________
pension
4. Securities representing part-ownership of a company are called_________
stocks
5. The money invested in a business is its _______________
capital
6. _______________
Bonds are interest-paying securities issued by companies that
need to borrow money.
7. A _______________
shares takeover is when a company gains control of another one by
putting its stocks.
Friendlier than shares takeover
8. A ______________
merger is when two formerly separated company join together.

collateral, mortgage: closely related

9
valuable property owned loan to buy real estate
by someone who wants to (house,…)
borrow money
-> asset
 Write your answer here:
1. 2. 3. 4.
5. 6. 7. 8.

Exercise 2: Matching the terms with their definitions

1. conglomerates a. abolished or ended rules and restrictions

2. depositors b. sum of money paid as penalties for breaking the law
Bãi bỏ quy định
3. deregulated c. groups of companies that have joined together
4. fines d. control of something by rules or laws
5. prohibited e. guaranteeing to buy a company‘s newly issued stocks
6. regulation if no one else does

7. repealed f. made it illegal to do something

8. underwriting g. people who place money in bank accounts

some newly
issued stocks and
no one wants to
insurance h. cancelled or ended (a law)
buy -> gurantee
to buy
Write your answer here:

1. c 2. g 3. a 4. b
5. f 6. d 7. h 8. e

Exercise 3: Read the article, and complete it using the words (1-8) in
Exercise 2
Regulation and deregulation
In the late 1920s, several American commercial banks that were (1)
_______________
underwriting security issues for companies weren‘t able to sell the stocks to
the public, because there wasn‘t enough demand. So they used money belonging
to their (2) _______________
depositors to buy securities. If the stock price later fell, their
customers lost a lot of money.
This led government to step up the (3) _______________
regulation of banks, to protect
depositors ‗funds, and to maintain investors‘ confidence in the banking system.
In 1933 the Glass-Steagall Act was passed, which (4) _______________
prohibited
American commercial banks from underwriting securities. Only investment
banks could issue stocks for corporations. In Britain too, retail or commercial
universal bank: ngân hàng đa chức năng (works with different function, function of
commercial bank as well as investment bank)
10
banks remained separate from investment or merchant banks. A similar law was
passed in Japan after World War II.
Half a century later, in the 1980s and 90s, many banks were looking for new
markets and higher profits in a period of increasing globalization. So most
industrialized countries (5) _______________
deregulated their financial systems. The Glass-
Steagall Act was (6) _______________
repealed . A lot of commercial banks merged with
or acquired investment banks and insurance companies, which created large
financial (7) _______________.
conglomerates The larger American and British banks now
offer customers a complete range of financial service, as the universal banks in
Germany and Switzerland have done for a long time. The law forbidding US
commercial banks from operating in more than one state was also abolished. In
Britain, many building societies, which specialized in mortgages, started to offer
the same services as commercial banks.
Yet in al countries, financial institutions, are still quite strictly controlled,
either by the central bank or another financial authority. In 2002, ten of Wall
Street‘s biggest banks paid (8) _______________
fines of $1.4 billion for having
advised investors, in the 1990s, to buy stocks in companies that they knew had
financial difficulties. They had done this in order to get investment banking
business from these companies - exactly the kind of practice that led the US
government to separate commercial and investment banking in the 1930s.

11
 Unit 2
TIME VALUE OF MONEY

A. TERMS, DEFINITIONS, THEORIES

Time value of money (TVM): Time value of money refers to the fact that
money (a dollar, a euro, or a yen) in hand today is worth more than the
expectation of the same amount to be received in the future. Lower risk -> lower return
Principal: the original sum of money borrowed in a loan or put into an
investment.
Interest: the cost of borrowing money, where the borrower pays a fee to the
lender for the loan. The interest, typically expressed as a percentage, can be
either simple or compounded.
Simple Interest: the interest based on the principal amount of a loan or
deposit.
Compound Interest: the interest based on the principal amount and the
interest that accumulates on it in every period.
Compounding: the process in which an asset's earnings, from either capital
gains or interest, are reinvested to generate additional earnings over time. This
growth occurs because the investment will generate earnings from both its initial
principal and the accumulated earnings from preceding periods.
Present value: the current value of a future sum of money or stream cash
flows given a specified rate of return. Present value states that an amount of
money today is worth more than the same amount in the future or money
received in the future is not worth as much as an equal amount received today.
Unspent money today could lose value in the future by an implied annual rate
due to inflation or the rate of return if the money was invested.
Net present value (NPV): the difference between the present value of all
future cash flows minus the present value of all current and future cash outflows.
NPV is used in capital budgeting and investment planning to analyze the
profitability of a projected investment or project. Accept a project if its NPV is
positive. Reject a project if its NPV is negative.

12
 Future value: the amount of money an investment will grow to at some date
in the future by earning interest at some compound rate. For example, suppose
you put $1,000 (the PV) into an account earning an interest rate of 10% per year.
The amount you will have in five years, assuming you take nothing out of the
account before then, is called the future value of $1,000 at an interest rate of 10%
per year for five years.
Opportunity cost of capital: the difference in return between an investment
one makes and another that one chose not to make.
Yield to maturity (YTM) or internal rate of return (IRR): the discount rate
that makes the present value of the future cash inflows equal to the present value
of cash outflows.
Effective annual rate: the actual annual rate which causes present value to
grow to the same future value as under multi-period compounding.
Discounting: the process of calculating present values to know how much we
have to invest now to reach some target amount at a date in the future.
Discounting in finance is very different from discounting in retailing. In
retailing, it means reducing the price in order to sell more goods; in finance it
means computing the present value of a future sum of money. Encourage customers to buy more
products
Annuity: Often the future cash flows in a savings plan, an investment
project, or a loan repayment schedule are the same each year. We call such a
stream of cash flows or payments of an annuity.
Annuity contract: The term comes from the life insurance business, in
which an annuity contract is one that promises a stream of payments to the
purchases for some period of time.
Immediate annuity: If the cash flows start immediately, as in a savings plan
or a lease, it is called an immediate annuity.
Ordinary annuity: If the cash flows start at the end of the current period
rather than immediately, it is called an ordinary annuity.
Perpetuity (Perpetual annuity): a stream of annuity cash flows that lasts
forever. Types of depreciation:
Amortization: the process of paying off a loan‘s principal gradually over its
term. Straight-line
Units of production
Depreciation Amortization Sum of the years’ digits
For tangible asset For intangible assets Declining balance
Double-declining balance
Main purpose: to try to reduce the rev -> reduce the tax that they have to pay 13

Depreciation, amortization: two methods of calculating the value for business assets over time.
 B. VOCABULARY
Match these terms with their definitions.
1. Nominal interest rate a. an interest rate on a loan or security that fluctuates
Adjusted
2. Real interest rate to remove over time because it is based on an underlying
benchmark interest rate or index that changes
3. Fixed interest rate inflation periodically
rate
4. Variable interest rate b. the actual rate of interest paid or charged over one
5. Discount rate year
6. Simple interest c. interest that is calculated on both the amount of
money invested or borrowed and on the interest
7. Compound interest
that has been added to it
8. Inflation rate
d. the rate denominated in dollars or in some other
9. Annual percentage rate currency
10. Effective annual rate e. the rate of return used to discount future cash flows
back to their present value
g. the rate at which someone who borrows money is
charged, calculated over a period of twelve months
h. money that is paid only on an original amount of
money that has been borrowed or invested, and not
on the extra money that the original amount earns
i. an unchanging rate charged on a liability, such as a
loan or mortgage
k. the rate at which prices increase over time, causing
the value of money to fall
l. the rate denominated in units of consumer goods
Write your answer here:

1. d 2. l 3. i 4. a 5. e
6. h 7. c 8. k 9. g 10. b

14
2.
• Medium of exchange: Money serves as a widely accepted means of payment in transactions.
• Unit of account: Money provides a standard measure of value that allows individuals to compare the
worth of different goods and services
• store value: money is an asset that can be invested, stored in a bank, left in a save home and
then later used to purchase goods and services
C. READING
Reading 1: The time value of money
Before you read 1. Economists define "money" as a medium of exchange that is widely accepted in
transactions and serves as a unit of account and a store of value. Examples: Physical
Discuss these questions. currencies: coins and banknotes issued by the government; digital currencies: Bitcoins
1. How do economists define ―money‖? Give examples.
2. What are the functions of money?
3. Why do we need to measure the time value of money?
What would you say if I asked you to borrow $1,000, but that I promise that I
will return that $1,000 in a year? We‘re friends right? I‘m a very trustworthy
person, really I am! No thanks?
My 8-year old daughter recently came to me and asked to borrow some
money to be able to buy an extra book at the book fair that day. She already had
money to buy several others but was a few dollars short of being able to buy an
additional book that she really wanted. I told her that she would have to keep
saving up her allowance if she wanted that other book and we could find
somewhere else to buy it later. ―But mom!‖ she immediately told me, ―I‘ll pay
you some extra money too.‖
And there you have it - time value of money is so simple in theory that even a
kid can understand the concept. My daughter even understood that no one wants
to loan someone money without a return. She‘s going to be an accountant like
her mom someday. Or a politician.
Going back to loaning me that $1,000, one of the reasons that you likely
would not consider that transaction is that you would have an opportunity cost of
not being able to use that money for a year, namely not being able to earn a
return during that time (such as interest or growth on stock investment). Another
factor that comes into play is inflation: a dollar today will buy you more than it
will in several years when prices increase. The last reason you may not be
interested in lending me the money is the risk that I won‘t repay it later and then
you‘ll be out of the money.
Time value of money is simply the concept that money is worth more
today than in the future.
It includes the following basic ideas:
- We would rather have money now than later.

15
 - We expect that providing someone else the use of our money should result
in an additional amount of money to compensate us for that time and risk of not
receiving our money back.
- We would rather pay money later than right now.
- We can anticipate that someone providing us with a loan will expect to
receive additional money in some form of interest that we will be required to pay.
FUTURE VALUE OF A SUM
Let‘s start with the absolute most simple scenario: you receive a sum of
money today and want to know how much it will be worth in the future if
you invest it. This is calculating the future value of a single sum. The power of
compounding interest will be working for us, which means that interest is not
only being earned on the principal sum invested, but also on the interest that was
previously earned. In order to calculate the future value of a sum you need the
following inputs:
- Current amount to be invested
- Length of time (years for our calculations) that you‘ll have to invest your
sum of money
- Interest rate
Assume this example: Your child has just received an inheritance from a
grandparent in the amount of $50,000 and you want to invest the entire sum in a
529 college savings plan, where it will grow tax-free. Any earnings will earn
additional earnings on them as well as the $50,000 you deposited. You want to
know how much you will have in 10 years when your child is ready to start
college. You assume that your investments will earn a rate of 7% annually.

Time Value of Money

FUTURE VALUE
Scenario 1: Future Value of a Single Sum
Description: (example: You invest $50,000 in a college savings plan today and
want to know how much you will have in 10 years at a 7% interest rate.)
Annual Interest Rate 7.00%
Future Value $50,000.00
Number of Years (rounded) 10.00
Current (Present) Value $98,357.57

16
 Based on these assumptions, you will have $98,358 saved in your child‘s 529
college savings plan. Your money is expected to nearly double!
FUTURE VALUE OF A STREAM OF CASH FLOWS
A more complicated and more common situation is to have a stream of cash
flows over time that you want to find the value of at a future date in time.
For this calculation you will need the following inputs:
- Whether you will be investing at the beginning or end of the year
- Initial investment amount and cash inflows for each year
- Length of time (years) that you‘ll be investing the money
- Interest rate
Assume this example: You are suddenly concerned about your retirement
plan (or lack thereof) and decide to max out contributions to a Traditional IRA.
Current maximum contributions per IRS rules are $5,500 annually with an
additional $1,000 contribution allowed for those 50 and older. You want to
know how much you will have when you plan to retire at age 60, which is 20
years away. You assume that your investments will earn a rate of 7% annually.
Time Value of Money
FUTURE VALUE
Scenario 2: Future Value of Future Cash Flows
Description: (example: You decide to max out your contributions to your
Traditional IRA over the next 20 years and want to know how much you will
have in 20 years based on contributing 5,500 for 10 years then 6,500 for the
following 10 years.)
Annual Interest Rate 7.00%
Number of Years 20.00
Current (Present) Date 11/4/2021
Year Beginning of End of the
the Year Year
2021 1 Cash Inflow(Outflow) $5,500.00 $5,500.00
2022 2 Cash Inflow(Outflow) $5,500.00 $5,500.00
2023 3 Cash Inflow(Outflow) $5,500.00 $5,500.00

17
2024 4 Cash Inflow(Outflow) $5,500.00 $5,500.00
2025 5 Cash Inflow(Outflow) $5,500.00 $5,500.00
2026 6 Cash Inflow(Outflow) $5,500.00 $5,500.00
2027 7 Cash Inflow(Outflow) $5,500.00 $5,500.00
2028 8 Cash Inflow(Outflow) $5,500.00 $5,500.00
2029 9 Cash Inflow(Outflow) $5,500.00 $5,500.00
2030 10 Cash Inflow(Outflow) $5,500.00 $5,500.00
2031 11 Cash Inflow(Outflow) $6,500.00 $6,500.00
2032 12 Cash Inflow(Outflow) $6,500.00 $6,500.00
2033 13 Cash Inflow(Outflow) $6,500.00 $6,500.00
2034 14 Cash Inflow(Outflow) $6,500.00 $6,500.00
2035 15 Cash Inflow(Outflow) $6,500.00 $6,500.00
2036 16 Cash Inflow(Outflow) $6,500.00 $6,500.00
2037 17 Cash Inflow(Outflow) $6,500.00 $6,500.00
2038 18 Cash Inflow(Outflow) $6,500.00 $6,500.00
2039 19 Cash Inflow(Outflow) $6,500.00 $6,500.00
2040 20 Cash Inflow(Outflow) $6,500.00 $6,500.00
2041 21 Cash Inflow(Outflow)
2042 22 Cash Inflow(Outflow)
2043 23 Cash Inflow(Outflow)
2044 24 Cash Inflow(Outflow)
2045 25 Cash Inflow(Outflow)
2046 26 Cash Inflow(Outflow)
2047 27 Cash Inflow(Outflow)
2048 28 Cash Inflow(Outflow)
2049 29 Cash Inflow(Outflow)
2050 30 Cash Inflow(Outflow)
Total Cash Inflows (Outflows) $120,000.00 $120,000.00
Future Value of the Cash Flows $256,042.07 $239,291,66

18
 Based on these assumptions, you will have $256,042 if you begin your
traditional IRA savings immediately (beginning of year calculation) and
$239,292 if you begin to save at the end of the year.

PAYMENTS USING FUTURE VALUE

A basic future value situation assumes that you have a specific amount in
the future that you want to achieve through regular, consistent investments.
This will probably be one of your most used time value of money calculations.
Basically, this will be used when you have a long-term financial goal and want to
know how much you need to contribute each year (or month) to meet that end
goal. For this calculation you will need the following inputs:
- Future value amount that you want to achieve (your goal)
- Present value amount (the amount that you already currently have toward
this goal)
- Whether you will be investing at the beginning or end of the year
- Length of time (years) that you‘ll be investing the money
- Interest rate
Assume this example: You have a long-term goal of accumulating $100,000
in your HSA account to cover a portion of your post-retirement health care
costs. You will be retiring in 20 years and currently do not have anything
invested, but plan to start this year. You assume that your investments will earn
7% per year. You want to know how much you need to invest over the next 20
years to be able to have that total amount of $100,000 saved.

Time Value of Money

FUTURE VALUE
Scenario 3: Payments based on Future Value
Description: You want to meet your goal of having $100,000 in your Health
Saving Account (HSA) when you retire in 20 years. You assume a rate of 7% and
want to know the annual or monthly payments that would be required to meet
your goal.

Annual Interest Rate 7.00%

19
 Future Value $100,000.00
Number of Years (rounded) 20.00

Beginning of the Year/ Month Payments:

Annual Payments Required $2,279.71
Monthly Payments Required $190.85

End of the Year/ Month Payments:

Annual Payments Required $2,439.29
Monthly Payments Required $191.97

Based on these assumptions, you will need a monthly contribution of $191 or

$2,280 annually if you start contributing immediately (beginning of the year). If
you start your contributions at the end of the month or year, you will need $192
per month or $2,439 per year to meet the $100,000 goal. Just think of how happy
you are going to be to have that money. Also, are you starting to see the benefit
of investing immediately?

PRESENT VALUE OF A SUM

On the opposite side of the time value of money calculation are the present
value calculations. The simplest form of this is calculating the present
(current) value of one sum of money to be received in the future. For this
calculation, you need the following inputs:
- Future sum amount
- Length of time before you receive the money
- Interest rate
Assume this example: You are expecting that your roof will need to be
replaced in 5 years and want to set aside the money today. It will cost $15,000
and you expect to earn an annual return of 5% since you will be investing in less
risky investments due to the relatively short time period. How much would you
need to set aside today to meet that goal?

20
 Time Value of Money
PRESENT VALUE
Scenario 1: Present Value of a Single Sum
Description: (example: Your roof will need replaced in 5 years and you want to
set aside the money today. How much do you need to set aside to have the
$15,000 in the future based on a 5% interest rate?)

Annual Interest Rate 5.00%

Future Value $15,000.00
Number of Years (rounded) 5.00
Current (Present) Value $11,752.89

Based on these assumptions, you will need to set aside $11,753 today in
investments earning 5% to have the $15,000 in cash that you need to replace your
roof. That sounds like a significance difference from the $15,000, but that‘s the
benefit of investing.

PRESENT VALUE OF A STREAM OF CASH FLOWS

(Net Present Value)
The most complicated present value calculation to understand, but one that is
especially useful and vital for investing is the present value of a stream of cash
flows. This is usually referred to as ―net present value‖ or NPV. This time
value of money calculation shows how much the cash inflows and outflows
would be worth today at a certain rate of return. For this calculation, you need
the following inputs:
- Whether you will be investing at the beginning or end of the year (generally
this calculation is based on end of year)
- Initial investment and cash inflows and outflows for each year
- Length of time that you‘ll be investing the money (years in this situation)
- Interest rate

21
 Assume this example: You are interested in investing in a rental property and
want to know how much of a monetary return you will receive in the next 15
years from the investment in today’s dollars. You assume a 7% required rate of
return and an annual net cash flow of $2,500 for the first 5 years, -$5,000 for the
6th year due to expected improvements and then $3,000 for the remaining 9
years. The initial investment will be $20,000.

Time Value of Money

PRESENT VALUE
Scenario 2: Present Value of Future Cash Flows
Description: (example:) You are deciding whether to invest in a rental property
with a $20,000 initial return, $2,500 cash inflows from year 1-5, -$5,000 cash
outflow in year 6 and $3,000 cash inflows in year 7-15. You want to calculate
the NPV at a 7% rate of return.)
Annual Interest Rate 7.00%
Number of Years 15.00
Current (Present) Date 11/5/2021

Year Beginning of the Year End of the Year

2021 0 Initial Investment ($20,000.00)
2021 1 Cash Inflow(Outflow) $2,500.00
2022 2 Cash Inflow(Outflow) $2,500.00
2023 3 Cash Inflow(Outflow) $2,500.00
2024 4 Cash Inflow(Outflow) $2,500.00
2025 5 Cash Inflow(Outflow) $2,500.00
2026 6 Cash Inflow(Outflow) ($5,000.00)
2027 7 Cash Inflow(Outflow) $3,000.00
2028 8 Cash Inflow(Outflow) $3,000.00
2029 9 Cash Inflow(Outflow) $3,000.00
2030 10 Cash Inflow(Outflow) $3,000.00
2031 11 Cash Inflow(Outflow) $3,000.00

22
2032 12 Cash Inflow(Outflow) $3,000.00
2033 13 Cash Inflow(Outflow) $3,000.00
2034 14 Cash Inflow(Outflow) $3,000.00
2035 15 Cash Inflow(Outflow)
2036 16 Cash Inflow(Outflow)
2037 17 Cash Inflow(Outflow)
2038 18 Cash Inflow(Outflow)
2039 19 Cash Inflow(Outflow)
2040 20 Cash Inflow(Outflow)
2041 21 Cash Inflow(Outflow)
2042 22 Cash Inflow(Outflow)
2043 23 Cash Inflow(Outflow)
2044 24 Cash Inflow(Outflow)
2045 25 Cash Inflow(Outflow)
2046 26 Cash Inflow(Outflow)
2047 27 Cash Inflow(Outflow)
2048 28 Cash Inflow(Outflow)
2049 29 Cash Inflow(Outflow)
2050 30 Cash Inflow(Outflow)
Total Cash Inflows (Outflows) $0.00 $14,500.00
Present Value of the Cash Flows $0.00 ($57.09)
Internal Rate of Return #NUM! 6.96%

Based on these assumptions the net present value of the investment is -$57.
Because this number is negative, it means that this investment will have less
value than a 7% rate of return. If the investment was positive, it would mean that
it returned more than 7% on the investment. Note that the actual cash inflows
will be $14,500, but when they are computed to present value they are not worth
nearly as much due to the time factor.
A related concept to the NPV (net present value) is the IRR or internal rate of
return on the investment. The internal rate of return is calculated at the bottom

23
as the actual return that the investment is getting over the period of time. In this
case, it is 6.96% which is consistent with the previous explanation that the net
present value is slightly negative. This signifies that the real estate investment
was earning slightly less than 7% return.

PAYMENTS USING PRESENT VALUE (A LOAN)

If you take out a loan, your payment will be calculated using present value
calculations. This calculation is used for loans and is used to calculate the
annual or monthly payment required based on giving up an amount now for
future payments with interest. The current value will be the amount you‘re
financing and the future value at the end of the loan term will be zero, which
signifies that you have completely paid off the loan. For this calculation, you
need the following inputs:
- Current lump sum being financed
- Length of time (years) for the financing
- Interest rate
Assume this example: You purchase a car for $22,000 and finance $20,000 of
it through a 60-month vehicle loan with a 3.8% interest rate. You want to know
what your monthly payment will be for the vehicle.

Time Value of Money

PRESENT VALUE
Scenario 3: Payments based on Present Value (Loan)
Description: (example: You take out a $20,000 auto loan for 5 years at a 3.8%
interest rate. You want to know what your monthly payments will be)

Annual Interest Rate 3.80%

Present Value $20,000.00
Number of Years (rounded) 5.00

End of the Year/ Month Payments:

Annual Payments Required $4,467.33
Monthly Payments Required $366.53

24
 Based on these assumptions you would have a monthly payment of $367.
Most loan payments that you will use will be on a monthly payment basis, so you
should generally ignore the annual payment option for your personal loan
calculations.

SUMMARY
Time value of money is an essential concept to master before learning more
about investing. The main takeaways are that:
- Money invested grows in an exponential, not a linear fashion.
- The rate of return makes a huge difference in the amount you will have in
the future.
- Time is an enormous factor in building wealth.

- Analyzing investments requires a consideration of inflation and opportunity

cost even if actual cash inflows exceed outflows.

READING COMPREHENSION TASKS

1. According to the text, what are the reasons for the time value of money
concept?
•…………………………………………………………………………………
Time value of money is simply the concept that money is worth more today than in the future
•…………………………………………………………………………………
It helps individuals and businesses make informed financial decisions by accounting for the
opportunity cost, inflation, risk and the changing value of money over time. It is a fundamental
…………………………………………………………………………………
concept in financial planning, investment analysis and financial management
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………….……………
2. Why is compounding interest more complicated to compute than single
interest?
…………………………………………………………………………………
…………………………………………………………………………………
↑

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

25
 3. Why is it more complicated to measure the present or future value of a
stream of cash flows?
…………………………………………………………………………………
Because we have to complete each cash flow for each year separately and then add them up
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………….……………
4. What is the most used time value of money calculations? Why?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………….……………
5. What calculation is essential for evaluating the profitability of different
projects?
…………………………………………………………………………………
NPV: the difference between the present value of cash inflows and the present value of
cash outflows. A positive NPV indicates that the project is expected to generate more
…………………………………………………………………………………
profits than its cost to implement, making it a ppotentially profitable venture
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
Word search
Find a word or phrase in the text that has a similar meaning.
1. a single payment made at a particular time, as opposed to a number of
smaller payments or installments.
l…………………..
ump s…………………..
um

2. the amount of profit that an investment earns calculated as a percentage of

the money that was originally invested
r……………………
ate o……………………
f r……………………
eturn

26
The relationship between PV and FV:
FV=PV (1+i)^n

3. the loss of potential gain from other alternatives when one alternative is
chosen
o……………………
pportunity c……………………
ost

4. the value of all future cash flows (positive and negative) over the entire life
of an investment discounted to the present
n………………………
et p……………………
resent v……………………
alue

Reading 2: Cash Flow Metrics and Business Ratios Are the Language of
Business
Financial metrics are center-stage in all aspects of the business - planning,
making decisions, evaluating performance.
What are Financial Metrics? help companies to track performance, establish goals and decide whether targets
are realistic, help investor to make their own decisions
The word metrics refers to measurement. Businesspeople speak of software
performance metrics, customer satisfaction metrics, and financial metrics, for
instance. "Metrics" in each case reveal - measure - specific characteristics of data
sets: performance data, customer satisfaction data, or financial data.
Most people in business-even outside of finance or accounting-have heard the
term financial metrics. And, most are aware of examples such as return on
investment or earnings per share. Not everyone understands the unique strengths
and weaknesses of these metrics, however. And, not everyone appreciates their
special data requirements. As a result, many businesspeople use financial metrics
blindly, or in ways that signal misleading information.
Each Financial Metric Sends a Unique Message
Each financial metric conveys a unique message about a body of economic
data. In that way, financial metrics are like descriptive statistics. The statistical
average (arithmetic mean), for instance, reveals the “typical” value in a data set.
Similarly, each financial metric reveals specific characteristics of the
economic dataset. Usually, those characteristics are not readily apparent when
merely reviewing the data. Cash flow investment metrics, for instance, measure
investment performance by evaluating the series of cash inflows and outflows
that follow from the investment. One of these metrics, the payback period,
measures the time required for returns to cover costs. Potential investors can
compare payback periods of different investments, to help decide which is the
better investment.

27
 Prudent investors, however, will also analyze the same investment choices
with other metrics besides payback period. Investors might, for instance, also use
net present value (NPV), return on investment (ROI), and internal rate of return
(IRR) to analyze the same investment choices.
- Each of these compares investment gains to investment costs in a different
way and, as a result, each measures investment performance differently.
- Each metric also has its “blind spots” - insensitivities - to particular
characteristics of the dataset.
Consequently, decision-makers are always well advised not to base critical
decisions on just one metric.
Two Families of Business Metrics
Most financial metrics in business belong to one of two families:
Firstly, Cash Flow Metrics
Cash flow metrics help evaluate streams of cash flow events, such as
investment outcomes or “business case” cash flow estimates. Familiar cash flow
metrics include payback period, breakeven point, net present value (NPV), return
on Investment (ROI), internal rate of return (IRR), and cumulative average
growth rate (CAGR).
Secondly, Financial Statement Metrics (Business Ratios)
Financial statement metrics, not surprisingly, are derived from financial
statement figures. Business people use these metrics to evaluate a firm's financial
position and financial performance. Well-known financial statement metrics
include current ratio, inventory turnover, the debt-to-equity ratio, and earnings
per share.

READING COMPREHENSION TASKS

Mark these statements T (true) or F (false) according to the information in the
text. Find the part of the text that gives the correct information.
1. People are generally clear about the good points and limitations of metrics
in economics. F
2. The payback period is used by investors when they want to choose the
most potential investment.T
3. Investors decides their investment choices based on the payback period
only. F

28
 4. Decision makers normally make their final investment based on several
metrics because they are told to do so. T
5. All financial metrics in business are either Cash flow metrics or Financial
Statement Metrics. F
D. EXERCISES
Exercise 1: Fill in the blanks with one appropriate word from the box.
determinable leaving matures finite maturity infinite
Translate An important, special type of annuity is a perpetual annuity of a perpetuity.
The classic example is the “console” bonds issued by the British government in
the nineteenth century, which pay interest each year on the stated face value of
bonds but have no (1) __________
maturity date. Another example, and perhaps a more
relevant one, is a share of preferred stock that pays a fixed cash dividend each
period (usually every quarter year) and never (2) matures
__________.
Ngày đáo hạn
A disturbing feature of any perpetual annuity is that you cannot compute the
future value of its cash flows because it is (3) __________.
infinite Nevertheless, it has a
perfectly well-defined and (4) __________
determinable present value. It might at first seem
paradoxical that a series of cash flows that lasts forever can have a (5)
__________
finite value today. But consider a perpetual stream of $100 per year. If the
interest rate is 10% per year, how much is this perpetuity worth today?
The answer is $1,000. To see why, consider how much money you would
have to put into a bank account offering interest of 10% per year in order to be
able to take out $100 every year forever. If you put in $1,000, then at the end of
the first year you would have $1,100 in the account. You would take out $100,
(6) leaving
__________ $1,000 for the second year. Clearly, if the interest rate stayed at
10% per year, and you had a fountain of youth nearby, you could go on doing
this forever.

E. EXTENSION ACTIVITIES
1. Suppose you put $1,000 (the PV) into an account earning an interest rate of
5% per year. What is the future value? What are the simple interest and the
compound interest? Suppose n=2
…………………………………………………………………………………
PV = 1000 Total interest: 102.5
…………………………………………………………………………………
FV = 1102.5 Simple interest: 1000 x 5% x 2 = 100
…………………………………………………………………………………
Compound interest: 2.5

29
The difference between preferred stocks and common stocks

I
Preferred stocks Common stocks

Preferred stockholder usually do not have voting rights or have limited voting Common stockholders have ownership in the company and typically
rights have voting rights at shareholder meetings
In the event of bankruptcy or liquidation, preferred stockholders are typically Common stockholders are the last to receive their share of the
paid off before common stockholders. remaining assets after all debts, obligations. If the company's
assets are not sufficient to cover all its obligations, common
stockholders might not receive anything in a bankruptcy scenario.
 …………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………………
2. You take out a loan at an APR of 12% with monthly compounding. What
is the effective annual rate on your loan?
m
EFF = (1 + APR ) -1 = 12.68%
…………………………………………………………………………………
m
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
3. What is the present value of $100 to be received in four years at an interest
rate of 6% per year?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

F. ESSAY WRITING

Essay Topic:
Financial decision-makers are always well advised not to base critical
decisions on just one metric.
To what extent do you agree or disagree with the statement. Support your
view by your own knowledge and experience.
Write at least 300 words.

30
 Coi slide cô gửi
Unit 3
INTEREST RATES
Types, differences between them

A. TERMS, THEORIES AND DEFINITIONS

ơ

An interest rate is the cost of borrowing money. Or, on the other side of the
coin, it is the compensation for the service and risk of lending money. Without it,
people would not be willing to lend or even save their cash, both of which
require a deferment of the opportunity to give up spending at present.
 Real vs nominal interest rates
The nominal interest rate is the amount, in money terms, of interest
payable.
For example, suppose a household deposits $100 with a bank for 1 year and
they receive interest of $10. At the end of the year their balance is $110. In this
case, the nominal interest rate is 10% per annum.
The real interest rate, which measures the purchasing power of interest
receipts, is calculated by adjusting the nominal rate charged to take inflation into
account.
If inflation in the economy has been 10% in the year, then the $110 in the
account at the end of the year buys the same amount as the $100 did a year ago.
The real interest rate, in this case, is zero.
 How Interest Rates are Determined:
- Supply and Demand: Interest rate levels are a factor of the supply and
demand of credit: an increase in the demand for credit will raise interest rates,
while a decrease in the demand for credit will decrease them. Conversely, an
increase in the supply of credit will reduce interest rates while a decrease in the
supply of credit will increase them.
- Inflation: Inflation will also affect interest rate levels. The higher the rate of
inflation, the more interest rates are likely to rise. This occurs because lenders

31
will demand higher interest rates as compensation for the decrease in the
purchasing power of the money they will be repaid in the future.
- Government: The government has a say in how interest rates are affected.
When the government buys more securities, banks are injected with more
money than they can use for lending, and the interest rates then decrease. When
the government sells securities, money from the banks is drained for the
transaction, rendering less funds at the banks' disposal for lending, forcing a
rise in interest rates.
Coupon rate is the yield paid by a fixed income security. The coupon rate is
the yield the bond paid on its issue date. This yield, however, will change as the
value of the bond changes, thus giving the bond's yield to maturity.
Lợi suất đáo hạn
The yield to maturity is the interest rate that equates the present value of
future payments of a debt instrument with the instrument’s value today.
The return on a security, which tells you how well you have done by
holding the security over a stated period of time, can differ substantially from the
interest rate as measured by the yield to maturity.
A variable rate, or variable interest rate, is the amount charged to a borrower
for a variable-rate loan, such as a mortgage. A variable rate is usually expressed
as an annual percentage and fluctuates in tandem with a rate index.
A fixed rate is an interest rate that stays the same for the life of a loan, or for
a portion of the loan term, depending on the loan agreement.
Capital gain refers to an increase in a capital asset's value and is considered
to be realized when the asset is sold. A capital gain may be short-term (one year
or less) or long-term (more than one year) and must be claimed on income taxes.
A dividend is the distribution of some of a company's earnings to a class of
its shareholders, as determined by the company's board of directors. Dividends
are payments made by publicly-listed companies as a reward to investors for
putting their money into the venture.

credit vs debit
Advantage:
- credit can help people to have money immediately ---> increase liquidity
- build the credit, mean increasing credit score
Disavantage:
- fee and interest

32

..
 B. VOCABULARY
Exercise 1: Match the words on the right with their definitions on the
left:
1.mortgage (a) Money.
2.default (b) Stays the same over time.
3.funds (c) Guarantee a loan for somebody else.
4.variable (d) Money that you borrow on a credit card.
5.fixed (e) A check to see how well you can pay back a loan.
6.co-sign (f) The maximum you can borrow.
7.cash advance (g) A loan to buy a house or property.
8.credit rating (h) A bank account you use to save money.
9.credit evaluation (i) Be able to pay for goods or pay back a loan.
10.credit limit (j) Changes over time.
11.annual (k) Not pay back a loan.
12.savings (l) The cost of borrowing money.
13.chequing (m) An opinion on how well you can pay back a loan.
14.afford (n) Your income after you pay income taxes and
expenses.
15.interest (o) The basic interest rate that banks use.
16.net income (p) A bank account you use for day to day expenditures.
17.gross income (q) Yearly.
18. prime (r) Your income before you pay taxes.

Write your answer here:

1. g 2. k 3. a 4. j 5. b 6. c
7. d 8. m 9. e 10. f 11.q 12. h
13. p 14. i 15. l 16. n 17. r 18. o

credit appraisal
credit analysis -

33
 Exercise 2. Fill in the blanks with the vocabulary items listed above each
paragraph:
limit default afford cash advance funds
debt purchase pay back interest

Credit Cards

Credit cards are a convenient way to

(1)__________
purchase goods. They also come in
handy when you have a shortage of
(2)___________.
funds If you need a little extra
money for the weekend, you can take out a
(3)__________
cash ____________.
advance
In spite of these benefits, credit card (4)________
debt can also cause serious
problems for people. People spend more than they can (5)________. afford Also,
because of the high (6)________
interest on money borrowed, the credit card debt
becomes harder and harder to (7)______ pay _______.
back Eventually, some people are
forced to (8)__________
default on their payments. This is why credit card companies
put a (9)_______
limit on the amount that people can borrow.

Exercise 3. Fill in the blanks with the vocabulary items listed above each
paragraph:
credit risk afford mortgage co-sign
savings default credit evaluation
Mortgages
Most people don’t have enough in _(1)__________
savings
to purchase a house so they take out a house loan,
which is called a _(2)________.
mortgage Before you get a
mortgage, the bank will do a thorough _(3)_______credit
__________
evaluation to make sure you can _(4)_________
afford the
loan. If the bank feels you are a _(5)_______ credit risk
________ they may ask you to find somebody else to
(6)__________
co-sign your mortgage.
This person will be responsible to pay your mortgage if you (7)_________.
default

34
 Exercise 4. Match the types of mortgage with the definition.

1. repayment mortgage c a. The mortgage interest rate is linked to the interest

rate of country's central bank.
2. interest-only mortgage d b. The mortgage interest rate stays the same.
3. endowment mortgage f c. You pay the capital sum and the interest.
4. offset mortgage g d. You pay the interest in installments, and you pay
the capital sum by another method.
5. fixed rate mortgage b e. The mortgage interest rate can only rise as far as a
certain level.
6. base-rate tracker f. An interest-only mortgage, with the capital repaid
mortgage a by an endowment.
7. variable rate mortgage h g. Your current and mortgage accounts are combined
to reduce the interest.
8. capped mortgage e h. The mortgage lender can change the interest rate
as they wish.

C. READING
Reading 1:
Bank of England raises interest rate to 5%
1. Mortgage repayments, along with 3. A statement from the Bank of
the cost of England’s monetary policy
committee said that strong growth, a
overdrafts and credit card debts, are
recent recovery in consumer
set to rise after the Bank of England
spending, buoyant export markets
surprised the City yesterday by
and signs of a pick-up in
announcing its first rise in interest
investments meant that action was
rates for more than a year. necessary in order to meet the
2. News of the quarter-point rise to 5% government’s 2.5% inflation target.
was cautiously welcomed by some 4. The statement said: “With inflation
financial institutions, but was likely to remain above target for
largely condemned by industry and some while, it was judged necessary
trades unions. to bring consumer prices inflation
back to target in the medium term.”

35
5. A response from the London Board 7. Few analysts predicted a rate
of Businesses and Exporters increase, and some had even been
described the move as premature, expecting a decrease to help boost a
and likely to damage businesses, subdued housing market. Many
especially those dependent on were talking about the increase
export earnings. being a pre-emptive strike, with the
6. Many homeowners will face higher small increase in borrowing costs
monthly bills through increased now intended to ward off the need
mortgage costs, especially those with for a more painful rise later.
variable rate and base-rate tracker 8. In the City’s money markets,
mortgages. If mortgage lenders pass however, there were expectations of
on the rise in full, it will add around a further tightening of the Bank’s
£20 to the monthly repayments on a policy and further interest rate rises
£100,000 mortgage. According to - perhaps up to 5.75% - unfolding
Sarah Parker of the Family Income over the nexttwelve months. Fears
Monitoring Unit, the average family that further rate increases would
will need to find around another £40 affect consumer spending wiped
a month. £17bn off the value of the London
stock market

D. READING COMPREHENSION EXERCISES

Exercise 1. Choose the definition which is closest to the meaning in the
article.
1. the City (paragraph 1)
a. the people of London
b. financial professionals working in London
2. a quarter-point rise (paragraph 2)
a. a 0.25% rise
b. a 2.5% rise
3. consumer spending (paragraph 3)
a. money spent by businesses
b. money spent by ordinary people

36
 4. a pick-up in investments (paragraph 3)
a. an increase in share prices
b. a drop in share prices
5. in the medium term (paragraph 4)
a. over the next few months
b. over the next few years
6. a pre-emptive strike (paragraph 7)
a. an action taken before it becomes necessary
b. an action taken after it becomes necessary

Exercise 2. Find words in the article with the same meaning as the
following.
7. steady economic expansion (paragraph 3) s___________
trong g_____________
rowth
8. higher than desired (paragraph 4) a______________
bove t______________
arget
9. too soon (paragraph 5) p______________
remature
10. avoid (paragraph 7) w______________
ard o______________
ff
11. occurring (paragraph 8) u______________
nfolding

Exercise 3. Complete the definitions.

12. The move was condemned by industry means businesspeople thought the
action was ____________
a. a good thing b. a bad thing c. neither good nor bad
13. Most banks passed on the 0.25% rise in full means that most banks
increased their lending rates by…
a. less than 0.25% b. 0.25% c. more than 0.25%
14. Base-rate tracker mortgages are ____________ the Bank of England's
interest rate.
a. lower than b. the same as c. linked to
15. I'll need to find an extra £40 a month means that I'll have to
____________ another £40 a month.
a. pay b. earn c. save

37
 16. A further tightening of policy is another ____________
a. review of targets b. policy reversal
c. unpopular implementation of policy
17. £17bn was wiped off the value of the London stock market means that
a. fewer shares were traded in the UK
b. UK share prices mostly went down
c. a lot of UK companies went bankrupt

Reading 2:
1. The yield to maturity, which is the measure that most accurately reflects
the interest rate, is the interest rate that equates the present value of future
payments of a debt instrument with its value today. Application of this principle
reveals that bond prices and interest rates are negatively related: When the
interest rate rises, the price of the bond must fall, and vice versa.
2. Two less accurate measures of interest rates are commonly used to quote
interest rates on coupon and measures are misleading guides to the size of the
interest rate, a change in them always signals a change in the same direction for
the yield to maturity.
3. The return on a security, which tells you how well you have done by
holding this security over a stated period of time, can differ substantially from
the interest rate as measured by the yield to maturity. Long-term bond prices
have substantial fluctuations when interest rates change and thus bear interest-
rate risk. The result is discount bonds. The current yield, which equals the
coupon payment divided by the price of a coupon bond, is a less accurate
measure of the yield to maturity the shorter the maturity of the bond and the
greater the gap between the price and the par value. The yield on a discount basis
(also called the discount yield) understates the yield to maturity on a discount
bond, and the understatement worsens with the distance from maturity of the
discount security. Even though these capital gains and losses can be large, this is
why long- term bonds are not considered to be safe assets with a sure return.
4. The real interest rate is defined as the nominal interest rate minus the
expected rate of inflation. It is a better measure of the incentives to borrow and
lend than the nominal interest rate, and it is a more accurate indicator of the
tightness of credit market conditions than the nominal interest rate.

38
 D. READING COMPREHENSION EXERCISES
Matching task.
1. A discount bond a. is what economists mean when they use the term interest
rate.
2. A coupon bond b. make payment only at their maturity dates.
3. The yield to c. is bought at a price below its face value, and the face
maturity value is repaid at the maturity date.
4. Discount bonds d.have payments periodically until maturity.
5. Coupon bonds e. pays the owner of the bond a fixed interest payment
(coupon payment) every year until the maturity date,
when a specified final amount (face value or par value)
is repaid.

E. EXTENTION ACTIVITIES
Group discussion:
1. If there is a decline in interest rates, which would you rather be holding,
long-term bonds or short-term bonds? Why? Which type of bond has the greater
interest-rate risk?
2. You have just won $10 million in the state lottery which promises to pay
you $1 million (tax free) every year for the next ten years. Have you really won
$10 million?

F. ESSAY WRITING
Essay Topic:
Write a 300-word essay to answer the question: How does interest rate affect
an inflation?

39
 In the US, the standard is GAAP

Unit 4
FINANCIAL STATEMENTS

Remind people that profit is the difference between revenue and expense.
This makes you look smart – Scott Adams (1957), creator of the Dilbert comic
strip.

A. TERMS, THEORIES AND DEFINITIONS

There are four different statements that companies include in their Annual
Reports, which shareholders can legally expect to see. The four statements are
the profit and loss account, the balance sheet, the cash flow statement and the
statement of changes in equity. In the USA, and under International Financial
Reporting Standards, the profit and loss account is called the income statement.
This document is fairly self-explanatory: it’s income less expenditure. The
balance sheet is a statement showing what the company has, and what it owes at
the end of the year, while the cash flow statement attempts to show how the
company is generating or consuming cash. The tax authorities require more detail
than is given in these documents; taxable profit is not the same as accounting
profit, so they will expect to see reconciliations between the two. Statement of
changes in equity displays adjustments in ownership interests of the company’s
owners or shareholders over a period. Taxing authorities may require this
statement to verify the accuracy of a company’s financial accounting or
reporting. This statement of changes in equity is primarily important to the equity
shareholders because it shows the changes in the components like retained
earnings during the period. The difference between equity and debt shows the
company’s net worth. A company with a steady increase in retained earnings is
sustainable as opposed to increasing shareholder base.
The financial statements of large companies have to be checked by an
external firm of auditors, who 'sign off on the accounts' (= officially declare the
accounts are correct). They are publicly available, and appear in the company's
annual report. Users of financial statements include shareholders, potential
shareholders, creditors (lenders, e.g. banks), auditors, customers, suppliers,
journalists, financial analysts, government agencies, etc.

40
 People working in accounting area help to prepare the financial statements of
any company. There are different branches of the accounting profession as listed
below.
i. Bookkeepers: record transactions in purchase ledgers and sales ledgers.
ii. Management accountants: interpret the transactions recorded by
bookkeepers.
iii. Senior accountants at financial controller and director level: use
accounting data to make decisions about how the business should
proceed.
iv. Internal auditors: make sure that the management has sufficient control
over what is going on in the company.
v. External auditors: have to verify that a company’s published financial
statements give a true and fair view of its profit, its assets and its
liabilities.
Profit and Loss Account
The profit and loss account (= income statement, or just 'the P&L')
summarizes business activity over a period of time. It begins with total sales (=
revenue) generated during a month, quarter or year. Subsequent lines then
deduct (= subtract) all of the costs related to producing that revenue.
Balance Sheet
The balance sheet reports the company's financial condition on a specific
date. The basic equation that has to balance is: Assets = Liabilities +
Shareholders' equity.
 An 'asset' is anything of value owned by a business.
 A 'liability' is any amount owed to a creditor.
 Shareholders' equity (= owners' equity) is what remains from the assets
after all creditors have theoretically been paid. It is made up of two
elements: share capital (representing the original investment in the
business when shares were first issued) plus any retained profit (=
reserves) that has accumulated over time.
Note the order in which items are listed:
 Assets are listed according to how easily they can be turned into cash,
with 'current assets' being more liquid than 'fixed assets’.

41
  Liabilities are listed according to how quickly creditors have to be paid,
with 'current liabilities' (= bank debt, money owed to suppliers, unpaid
salaries and bills) being paid before 'long-term liabilities’.
Figures for 'current assets' and 'current liabilities' are particularly
important to a business. The amount by which the former exceeds the latter is
called 'working capital'. This gives a quick measure of whether there is enough
cash freely available to keep the business running.
Cash Flow Statement
Companies need a separate record of cash receipts and cash payments.
Why is this? Firstly, for the reason given above - it shows the real cash that is
available to keep the business running day to day (profits are only on paper
until the money actually comes in). Secondly, there are many sophisticated
techniques that accountants can use to manipulate profit, whereas cash is real
money. It is cash that pays the bills, not profits.
There are many reasons why companies can have a problem with cash
flow, even if the business is doing well. Amongst them are:
 Unexpected late payments and non-payments (bad debts).
 Unforeseen costs: a larger than expected tax bill, a strike, etc.
 An unexpected drop in demand.
 Investing too much in fixed assets.
Solutions might include:
 Credit control: chasing overdue accounts.
 Stock control: keeping low levels of stock, minimizing work-in-progress,
delivering to customers more quickly.
 Expenditure control: delaying spending on capital equipment.
 A sales promotion to generate cash quickly.
 Using an outside company to recover a debt (called 'factoring' which
means selling debts or receivables at a discount to someone who will try
to collect the debt at full value).

42
 B. VOCABULARY EXERCISES
Exercise 1: Basic terms in financial statements. Decide which of the
alternatives (a-c) each definition describes.
1. A charge for arranging a transaction (e.g. buying or selling securities)
a. commission b. fee c. tax
2. A charge for a service performed by a bank.
a. commission b. fee c. tax
Thuế xuất
3. Payments for an insurance policy. nhập khẩu

a. commission b. premiums c. tariffs

4. A reduction in the value of an asset, charged against profits.
a. amortization b. loss c. waste
5. Adjective meaning after all deductions have been made.
a. gross b. net c. zero
6. Adjective meaning for a whole group of companies.
Hợp nhất
a. consolidated b. corporate c. mutual
7. Adjective meaning one year or less in financial statements.
a. annual b. long-term c. short-term
8. Part-ownership (less than 50%) of other companies.
a. conglomeration b. liabilities c. minority interests
9. Things of value that cannot be physically touched, such as reputation
(goodwill), brand names and trademarks.
a. Intangi ble assetsb. liabilities c. tangible assets
10. The net worth of a company – the amount by which assets exceed
liabilities.
a. dividends b. profit c. shareholders’ equity

43
 Exercise 2: Match these accounting terms on various types of assets with
the definitions below.
Current assets/circulating assets/floating assets
Fixed assets/capital assets/permanent assets
Intangible assets
Liquid assets/available assets
Net assets
Net current assets/working capital
Wasting assets
1.Liquid
…………………assets are anything that can quickly be turned into cash.
2. Net
………………are
current the excess of current assets (such as cash, inventories,
assets
debtors) over current liabilities (creditors, overdrafts, etc.).
3. ……………….
Wasting assets are those which are gradually exhausted (used up) in
production and cannot be replaced.
4. ………………
Current assets are those which will be consumed or turned into cash in the
ordinary course of business.
5. ……………
Intangible assets are those whose value can only be quantified or turned into

cash with difficulty, such as goodwill, patents, copyrights and trademarks.

6. ……………….,
Net assets or shareholders’ equity, on a business’s balance sheet, is
assets minus liabilities (which is generally equal to fixed assets plus the
difference between current assets and current liabilities).
7. ……………….,
Fixed assets such as land, buildings and machines, cannot be sold or
turned into cash, as they are required for making and selling the firm’s
products.

Exercise 3: Complete the text by inserting the correct form of the verbs
in the box:
allow charge deduct encourage
exist increase involve lose
convert spread wear out write off

44
 Fixed assets such as buildings, plant and machinery (but not land) gradually
(1) ……………
lose value, because they (2) …………………
wear out or decay, or because
more modern and efficient versions are developed. Consequently, they have to be
replaced every so often. The cost of buying or replacing fixed assets that will be
used over many years is not (3) ……………….
deducted from a single year’s profits but is
accounted for over the several years of their use and wearing out. This accords
with the matching principle that costs are identified with related revenues. The
process of (4) ………………
converting an asset into an expense is known as depreciation.
Various methods of depreciation (5) …………………,
exist but they all (6)
………………….
involve estimating the useful life of the asset, and dividing its
estimated cost (e.g. purchase price minus any scrap or second-hand value at the
end of its useful life) by the number of years. The most usual method of
Residual value:
depreciation is the straight line method, which simply spreads the total expected giá trị thu hồi

cost over the number of years of anticipated useful life, and charges an equal sum
each year. The reducing or declining balance method (7) writes ………………….
off
smaller amounts of an asset’s value each year in cases where maintenance costs
for the use of an asset are expected to (8) …………………
increase over time. The
annuity system of depreciation (9) spreads
……………. the cost of an asset equally over
a number of years and (10) charges
…………… this, and an amount representing the
interest on the asset’s current value, each year.
Technology companies use this method
Some tax legislations (11) ………………..
allow accelerated depreciation: writing
off large amounts of the cost of capital investments during the first years of use;
this is a measure to (12) ……………..
encourage investment.
Exercise 4: Insert the following words in the gaps of the text

insolvent liquidity net positive

reputation reserves suppliers working
Cash flow is essentially a company’s ability to earn cash. It is the amount of
cash made during a specified period that a business can use for investment.
(More technically, it is (1) ……………
net profit plus depreciation plus variations in
(2) …………..
reserves ) The flow of funds is cash received and payments made by a
company during a specific period – except that many people also use the term
cash flow to describe this! New companies generally begin with adequate funds
or (3) working
………………. capital for the introductory stage during which they make
contacts, find customers and build up sales and a (4) ……………
reputation But when sales
begin to rise, companies often run out of working capital: their cash is all tied up

Giai đoạn giới thiệu, đưa sản phẩm ra thị trường 45

Exercise 3
Có nhiều phương pháp khấu hao khác nhau, nhưng tất cả đều liên quan đến việc ước tính thời gian
sử dụng hữu ích của tài sản và chia tổng chi phí ước tính của nó (ví dụ như giá mua trừ đi giá trị
phế liệu hoặc giá trị còn lại vào cuối thời gian hữu ích) cho số năm sử dụng. Phương pháp khấu
hao phổ biến nhất là phương pháp khấu hao theo đường thẳng, đơn giản là phân bố tổng chi phí dự
kiến trong suốt số năm sử dụng hữu ích dự kiến, và tính một khoản số bằng nhau mỗi năm.
Phương pháp cân đối giảm dần hoặc sẽ xoá các khoản giá trị nhỏ hơn của tài sản mỗi năm trong
trường hợp chi phí bảo trì cho việc sử dụng tài sản được kỳ vọng tăng theo thời gian. Khấu hao
niên kim phân phối chi phí của một tài sản một cách đồng đều qua một số năm và tính khoản này,
cùng với một số tiền đại diện cho lãi suất trên giá trị hiện tại của tài sản, mỗi năm.

Một số quy định thuế cho phép khấu hao tăng tốc: xoá một số lượng lớn chi phí đầu tư vốn trong
những năm đầu tiên sử dụng; đây là biện pháp khuyến khích đầu tư.

Exercise 4
Dòng tiền thực chất là khả năng kiếm tiền của một công ty. Đó là số tiền mặt được tạo ra trong một khoảng
thời gian nhất định mà một doanh nghiệp có thể sử dụng cho đầu tư. (Về mặt kỹ thuật, đó là lợi nhuận ròng
cộng khấu hao cộng biến đổi trong quỹ dự trữ. Dòng tiền là số tiền mà một công ty nhận vào và thanh toán
trong một khoảng thời gian cụ thể - tuy nhiên nhiều người cũng sử dụng thuật ngữ dòng tiền mặt để mô tả
điều này! Các công ty mới thường bắt đầu với nguồn vốn đủ hoặc vốn làm việc cho giai đoạn giới thiệu trong
đó họ liên lạc, tìm kiếm khách hàng và xây dựng doanh số bán hàng và danh tiếng. Nhưng khi doanh số bán
hàng bắt đầu tăng, các công ty thường thiếu vốn lưu động: tiền mặt của họ bị trói chặt trong công việc dở
dàng, hàng tồn kho và công nợ của khách hàng. Điều không may trong cuộc sống kinh doanh là trong khi
nhà cung cấp thường đòi hỏi thanh toán nhanh chóng, khách hàng thường đòi hỏi gia hạn tín dụng, vì vậy
bạn bán nhiều càng cần nhiều tiền mặt hơn. Điều này gây ra một cuộc khủng hoảng về thanh khoản: doanh
nghiệp không có đủ tiền mặt để thanh toán các khoản chi phí ngắn hạn. Dòng tiền dương chỉ xuất hiện trở
lại khi tốc độ tăng trưởng doanh số bán hàng chậm lại và công ty ngừng "giao dịch quá mức". Nhưng các
công ty chưa sắp xếp đủ tín dụng sẽ không thể đi xa như vậy: họ sẽ thấy mình vỡ nợ - không thể đáp ứng
được các nghĩa vụ của họ.
 To have more
income

in work-in-progress, stocks and credit to customers. It is an unfortunate fact of

business life that while (5) ……………..
suppliers tend to demand quick payment,
customers usually insist on extended credit, so the more you sell, the more cash
you need. This provokes a typical (6) …………………
liquidity crisis: the business does
not have enough cash to pay short-term expenses. A (7) ………………… positive cash
flow will only reappear when sales growth slows down and the company stops
“overtrading”. But companies that have not arranged sufficient credit will not get
this far: they will find themselves (8) insolvent
……………….. - unable to meet their
Mất khả năng thanh toán
liabilities.
Exercise 5: Examine the financial statements of Apple Inc. (as of fiscal
year 2019)
i. Balance Sheet of Apple Inc. (as of 30th September 2019)
ii. Income Statement of Apple Inc. (for fiscal year ended on 30th September
2019)
iii. Cashflow Statement of Apple Inc. (for fiscal year ended on 30th
September 2019)

Vocabulary in financial statements is surprisingly non-standard, with many

companies using a mixture of US and European terms. Below is the list of most
commonly used terms.
Profit and Loss Account (Income Statement) (For the Year Ended Dec 31,
20XX)
‘Revenue’ (= turnover/sales/the top line) means the amount of business done
by a company over a year.
'Cost of goods sold' (= direct costs) includes manufacturing costs, salaries of
manual (= blue-collar) workers etc.
'Operating expenses' (= indirect costs/Overhead (US)/Overheads (GB)) are
the various expenses of operating a business that cannot be charged to any one
product, process or department including salaries of sales and office staff,
marketing costs, utility bills etc.
'Non-operating income' includes profits from investments in other
companies.
'EBITDA' stands for Earnings before Interest, Tax, Depreciation and
Amortization.

46
 'Earnings' (= profit/the bottom line/income) mean the revenues received by
a company during a given period, minus the cost of sales, operating expenses,
and taxes.
'Depreciation' (GB) and 'Amortization' (US) mean the reduction in values
of fixed assets during the years they are in use (charged against profits).
'Depreciation' and 'Amortization' are very similar, and are often used in the
same way. However, 'depreciation' can refer to the loss in value of a tangible
asset (e.g. a vehicle), and 'amortization' to the loss in value of an intangible asset
(e.g. the purchase of a license or trademark). This loss over time is treated as a
cost and written off (= subtracted from the profit) over several years.
'Interest' refers to money paid to the bank for loans (or received from the
bank for cash balances).
'Dividends' is money paid to shareholders.
'Retained profit' is transferred to the Balance Sheet where it joins the
amounts from previous years.
Balance Sheet (E.g., as of December 31, 20XX)
‘Assets’ are anything owned by a business (cash investments, buildings,
machines, and so on) that can be used to produce goods or pay liabilities.
'Accounts receivable' (US) or ‘Debtors’ (GB) is the amount owed to the
business by customers for goods or services purchased on credit.
'Inventory' (US) or ‘Stock’ (GB) is the value of raw materials, work-in-
progress, and finished products stored ready for sale.
'Current assets' may also include 'marketable securities' (= shares intended
for disposal within one year).
'Fixtures' are part of a building that cannot be moved, such as lights.
'Fixed assets' may also include long-term financial investments.
'Intangible assets' include patents, trademarks & 'goodwill' (reputation,
contacts and expertise of companies that have been bought).
‘Liabilities’ are all the money that a company will have to pay to someone
else in the future, including taxes, debts, and interest and mortgage payments.
'Bank debt' (= loan capital) also includes any overdraft (= temporary
negative balance).

47
 'Accounts payable' (US) or ‘Creditors’ (GB) is the sums of money owed to
suppliers for purchases made on credit.
'Accrued' items are those where an expense has been incurred, but the
money is not yet paid. 'Accrued salaries' typically includes future bonuses.
Another item, 'provisions', can appear under current liabilities. These are
amounts set aside for anticipated one-time payments that are not part of regular
operations - perhaps a lawsuit, or a compensation package for employees being
laid off.
A 'mortgage' is a long-term bank loan to buy a property. With bonds, the
'principal' (= amount raised by issuing the bonds) is repayable to the bond
holders at 'maturity'.
'Share capital' (= common stock, AmE) is amount raised at initial flotation
on the stock market.
'Retained profit' (= Reserves / Retained earnings). The figure showing here
is more than the profit transferred from the income statement because it is an
amount accumulated over several years.
Figure 1: Balance Sheet of Apple Inc. (as of 30th September 2019).

48
49
50
 Figure 2: Income Statement of Apple Inc. (1st October 2018 – 30th September
2019)

51
52
 Figure 3: Cash flow Statement of Apple Inc. (Fiscal year of Oct. 2018 - Sep.
2019)

53
 C. READING
Companies are required by law to give their shareholders certain
financial information. Most companies include three financial statements in
their annual reports.
The profit and loss account shows revenue and expenditure. It gives figures for
total sales or turnover (the amount of business done by the company during the
year), and for costs and overheads. The first figure should be greater than the
second: there should generally be a profit - an excess of income over expenditure.
Part of the profit is paid to the government in taxation, part is usually distributed to
shareholders as a dividend, and part is retained by the company to finance further
growth, to repay debts, to allow for future losses, and so on.
The balance sheet shows the financial situation of the company on a particular
date, generally the last day of its financial year. It lists the company's assets, its

54
 Share capital Share premiums
Share capital refers to the total Share premium, on the other hand,
nominal or face value of the is the additional amount that a
shares issued by a company to its company receives when it issues
shareholders. shares at a price higher than their
nominal or face value.
liabilities, and shareholders' funds. A business's assets consist of its cash
investments and property (buildings, machines, and so on), and debtors - amounts
of money owed by customers for goods or services purchased on credit. Liabilities
consist of all the money that a company will have to pay to someone else, such as
taxes, debts, interest and mortgage payments, as well as money owed to suppliers
for purchases made on credit, which are grouped together on the balance sheet as
creditors. Negative items on financial statements such as creditors, taxation, and
dividends paid are usually printed in brackets thus: (5200).
The basic accounting equation, in accordance with the principle of double-
entry bookkeeping, is that Assets = Liabilities + Owners' (or Shareholders')
Equity. This can, of course, also be written as Assets - Liabilities = Equity. An
alternative term for Shareholders' Equity is Net Assets. This includes share
capital (money received from the issue of shares), sometimes share premium
(money realized by selling shares at above their nominal value), and the
company's reserves, including the year's retained profits. A company's market
capitalization - the total value of its shares at any given moment, equal to the
number of shares times their market price - is generally higher than
shareholders' equity or net assets, because items such as goodwill are not
recorded under net assets.
A third financial statement has several names: the source and application
of funds statement, the sources and uses of funds statement, the funds flow
statement, the cash flow statement, the movements of funds statement, or in
the USA the statement of changes in financial position. As all these
alternative names suggest, this statement shows the flow of cash in and out of
the business between balance sheet dates. Sources of funds include trading
profits, depreciation provisions, borrowing, the sale of assets, and the issuing of
shares. Applications of funds include the purchase of fixed or financial assets,
the payment of dividends and the repayment of loans, and, in a bad year,
trading losses.
If a company has a majority interest in other companies, the balance sheets
and profit and loss accounts of the parent company and the subsidiaries are
normally combined in consolidated accounts.
D. READING COMPREHENSION EXERCISES
Exercise 1: According to the text, are the following TRUE or FALSE?
1. Company profits are generally divided three ways. True
2. Balance sheets show a company's financial situation on 31 December. False
Not necessarily on 31 December

55
5. False -> The text does not express a preference for financial statements to contain no items
in brackets. In fact, it is common to use brackets to indicate negative items on financial
statements.

3. The totals in balance sheets generally include sums of money that have
not yet been paid.
4. Assets are what you own; liabilities are what you owe. True
5. Ideally, managers would like financial statements to contain no items in
brackets. False
6. Limited companies cannot make a loss because assets always equal
shareholders' equity. False
7. A company's shares are often worth more than its assets. True
8. The two sides of a funds flow statement show trading profits and losses. False
9. Depreciation is a source rather than a use of funds. True
10. A consolidated account is a combination of a balance sheet and a profit
and loss account. False -> thiếu subsidiaries
Exercise 2: The text above contains various British terms that are not
used in the USA. Match up the following British and American terms.
British American
1. creditors a. accounts payable
2. debtors b. accounts receivable
3. overheads c. income statement
4. profit and loss account d. overhead
5. shareholder e. paid-in surplus
6. share premium f. stockholder

E. ESSAY WRITING
It is said that every company indeed maneuvers the numbers, to a certain
extent, as formally reported in its financial statements to achieve budgetary
targets and generously reward senior managers. Do you agree or disagree with
the statement?
Give reasons for your answer and include any relevant examples from your
own knowledge and experience.
Write at least 300 words.

56
 Consideration for investors: financial metrics
Unit 5
RISKS AND RETURNS

A. TERMS, DEFINITIONS, THEORIESNs, theories

What Is Risk?
Risk is defined in financial terms as the chance that an outcome or
investment's actual gains will differ from an expected outcome or return. Risk
includes the possibility of losing some or all of an original investment.
Quantifiably, risk is usually assessed by considering historical behaviors and
outcomes. In finance, standard deviation is a common metric associated with
risk. Standard deviation provides a measure of the volatility of asset prices in
comparison to their historical averages in a given time frame.
Overall, it is possible and prudent to manage investing risks by understanding
the basics of risk and how it is measured. Learning the risks that can apply to
different scenarios and some of the ways to manage them holistically will help all
types of investors and business managers to avoid unnecessary and costly losses.
• Systematic Risk:
Business organizations are part of society that is dynamic. Various changes
occur in a society like economic, political and social systems that have influence
on the performance of companies and thereby on their expected returns. These
changes affect all organizations to varying degrees. Hence the impact of these
changes is system-wide and the portion of total variability in returns caused by
such across the board factors is referred to as systematic risk. These risks are
further subdivided into interest rate risk, market risk, and purchasing power risk.
• Unsystematic Risk:
The returns of a company may vary due to certain factors that affect only that
company. Examples of such factors are raw material scarcity, labour strike,
management inefficiency, etc. When the variability in returns occurs due to such
Bear market Bull market
Is market downturn Refers to major upswing in the market 57
firm-specific factors it is known as unsystematic risk. This risk is unique or
peculiar to a specific organization and affects it in addition to the systematic risk.
These risks are subdivided into business risk and financial risk.
What is return?
In finance, return is a profit on an investment. It comprises any change in
value of the investment, and/or cash flows which the investor receives from the
investment, such as interest payments or dividends. It may be measured either in
absolute terms (e.g., dollars) or as a percentage of the amount invested. The latter
is also called the holding period return.
A loss instead of a profit is described as a negative return, assuming the
amount invested is greater than zero.
To compare returns over time periods of different lengths on an equal basis, it
is useful to convert each return into a return over a period of time of a standard
length. The result of the conversion is called the rate of return. Typically, the
period of time is a year, in which case the rate of return is also called the
annualised return and the conversion process, described below, is called
annualisation.
The return on investment (ROI) is return per dollar invested. It is a measure
of investment performance, as opposed to size (c.f. return on equity, return on
assets, return on capital employed).
What is Risk-Return Tradeoff?
The risk-return tradeoff states that the potential return rises with an increase
in risk. Using this principle, individuals associate low levels of uncertainty with
low potential returns, and high levels of uncertainty or risk with high potential
returns. According to the risk-return tradeoff, invested money can render higher
profits only if the investor will accept a higher possibility of losses.
Understanding Risk-Return Tradeoff
The risk-return tradeoff is the trading principle that links high risk with high
reward. The appropriate risk-return tradeoff depends on a variety of factors
including an investor’s risk tolerance, the investor’s years to retirement and the
potential to replace lost funds. Time also plays an essential role in determining a
portfolio with the appropriate levels of risk and reward. For example, if an
investor has the ability to invest in equities over the long term, that provides the
investor with the potential to recover from the risks of bear markets and

58
participate in bull markets, while if an investor can only invest in a short time
frame, the same equities have a higher risk proposition.
Investors use the risk-return tradeoff as one of the essential components of
each investment decision, as well as to assess their portfolios. At the portfolio
level, the risk-return tradeoff can include assessments of the concentration or the
diversity of holdings and whether the mix presents too much risk or a lower-than-
desired potential for returns.
KEY TAKEAWAYS
 The risk-return tradeoff is an investment principle that indicates that the
higher the risk, the higher the potential reward.
 To calculate an appropriate risk-return tradeoff, investors must consider
many factors, including overall risk tolerance, the potential to replace lost
funds and more.
 Investors consider the risk-return tradeoff on individual investments and
across portfolios when making investment decisions.
Special Considerations
Measuring Singular Risk in Context
When an investor considers high-risk-high-return investments, the investor
can apply the risk-return tradeoff to the vehicle on a singular basis as well as
within the context of the portfolio as a whole. Examples of high-risk-high return
investments include options, penny stocks and leveraged exchange-traded funds
(ETFs). Generally speaking, a diversified portfolio reduces the risk presented by
individual investment positions. For example, a penny stock position may have a
high risk on a singular basis, but if it is the only position of its kind in a larger
portfolio, the risk incurred by holding the stock is minimal. Blue chip stock: stock issued by a
large, well-established, financially-sound
Risk-Return Tradeoff at the Portfolio Level
company with an excellent reputation.
That said, the risk-return tradeoff also exists at the portfolio level. For
example, a portfolio composed of all equities presents both higher risk and higher
potential returns. Within an all-equity portfolio, risk and reward can be increased
by concentrating investments in specific sectors or by taking on single positions
that represent a large percentage of holdings. For investors, assessing the
cumulative risk-return tradeoff of all positions can provide insight on whether a
portfolio assumes enough risk to achieve long-term return objectives or if the risk
levels are too high with the existing mix of holdings.

59
 B. VOCABULARY
Match these terms with their definitions.

a. a balancing of two opposing situations or qualities, both of

1 render
which are desired
b. person who sells shares when prices are expected to fall,
2 tradeoff in order to make a profit by buying them back again at
a lower price
c. a share with a very low value because it
3 portfolio is considered a high-risk investment, for example in
a company that is small, little known, or not very successful
d. something that you own such as shares in
4 reward
a company or buildings, or land that you rent and farm
e. increasing by one addition after another, and including all
5 bear
the amounts that have been added before
6 Bull market f. money that is earned from successful investments
g. to officially prepare financial records, bills, etc. and give
7 holding
them to someone or make them available
h. the value of a company, divided into
many equal parts owned by the shareholders, or one of
8 Penny stock
the equal parts into which the value of
a company is divided
9 cumulative i. a time when the prices of most shares are rising
j. a collection of company shares and other investments that
10 equity
are owned by a particular person or organization

Write your answer here:

1. g 2. a 3. j 4. f 5. b
6. i 7. d 8. c 9. e 10. h

60
 Capital appreciation Capital gain

Difference between purchase the profit that investor can gain

price and sell price from the deal

C. READING
Reading 1
Before you read
Discuss these questions. The profit the investor expect to gain
1. How many kinds of rate of return do you know? (expected rate of return
and required rate of return) the minimum level of expected return that an investor
requires over a specified period
2. What does return from equity comprise? (Return from equity comprises
dividend and capital appreciation).
3. What is the most challenging problem for an investor? ( is to estimate the
highest level of risk he is able to assume).
Risk and Return on Investment
Risk and Required Return:
The expected rate of return of an investment reflects the return an investor
anticipates receiving from an investment. The required rate of return reflects the
return an investor demands as compensation for postponing consumption and
assuming risk. The required rate of return of an investment depends on the risk-
free return, premium required for compensating business and financial risks
attached with the firm’s security.
The required rate of return also reflects the default risk, managerial risk and
marketability of a particular security. Investors are generally risk averse. If odds
of winning or losing are identical, they are likely to reject the gamble. Why
anyone would want to expose himself to a risk without a corresponding return.
A rational investor would have some degree of risk aversion, he would accept
the risk if he is compensated adequately for it. The greater the risk, the greater
the compensation one would require. This compensation is in the form of
increased rate of return. Investments which carry low risks, such as high-grade
bonds, will offer a lower expected rate of return than those which carry high risk
such as common stock of a new unproven company. When one formulates an
investment plan, this risk-return trade-off is an important consideration.
In determining the level of expected return that one wishes to receive, he will
also be determining the level of risk which one will have to accept. Conversely,
in accepting a certain level of risk in designing a portfolio, the level of expected
return is also get determined.
• your finance (in case risk happen, how much money can you bear -> credit check
Factors that • Internal factor: scarcity, unsystematic risk (kind of risk) 61
help you make • External
an investment • the risk for different kinds of securities: which one is safer
decision
• which type of person do you belong to?
 It may be difficult to quantify these levels, but one would at least have to
think on a relative basis; that is a low, medium, or high degree of risk. There is a
positive relationship between the amount of risk assumed and the amount of
expected return. That is, the greater the risk, the larger the expected return and
the larger the chances of substantial loss.
One of the most difficult problems for an investor is to estimate the highest
level of risk he is able to assume. Any such estimate is essentially subjective,
although attempts to quantify the willingness of an investor to assume various
levels of risk can be made, the relationship between the amount of risk assumed
in managing a portfolio of securities and the amount of expected return can be
graphed as following in figure 3.5.

Risk is measured along the horizontal axis and increases from left to right.
Expected rate of return is measured on the vertical axis and rises from bottom to
top, the line from 0 to R (f) is called the rate of return on risk less investments
commonly associated with the yield on government securities. The diagonal line
from R (f) to E (r) illustrates the concept of expected rate of return increasing as
level of risk increases.
The example shows a linear relationship between risk and return, but it need
not be linear. Most of the theoretical work on portfolio management assumes a
linear relationship between risk and return which may be true for an efficiently
run competitive market in developed economies, but in developing countries like
ours with administered interest rates and many other restrictive regulations, this
linear relationship generally does not hold.

62
 Risk-Return Relationship:
The entire scenario of security analysis is built on two concepts of security:
return and risk. The risk and return constitute the framework for taking
investment decision. Return from equity comprises dividend and capital
appreciation.

To earn return on investment, that is, to earn dividend and to get capital
appreciation, investment has to be made for some period which in turn implies
passage of time. Dealing with the return to be achieved requires estimate of the
return on investment over the time period. Risk denotes deviation of actual return
from the estimated return. This deviation of actual return from expected return
may be on either side -both above and below the expected return. Figure 3.6
represents the relationship between risk and return.
However, investors are more concerned with the downside risk. The risk in
holding security-deviation of return- deviation of dividend and capital
appreciation from the expected return may arise due to internal and external
forces. The fact that investors do not hold a single security which they consider
most profitable is enough to say that they are not only interested in the
maximization of return, but also minimization of risk.
The investors increase their required return as perceived uncertaintyN
increases. The rate of return differs substantially among alternative investments,
and because the required return on specific investments changes over time, the
factors that influence the required rate of return must be considered.

63
 The slope of the market line in figure 3.7 indicates the return per unit of risk
required by all investors highly risk- averse investors would have a steeper line,
and vice versa. Yields on apparently similar stocks may differ. Differences in
price, and therefore yield, reflect the market’s assessment of the issuing
company’s standing and of the risk elements in the particular stocks.
A high yield in relation to the market in general shows an above average risk
element. Given the composite market line prevailing at a point of time, investors
would select investments that are consistent with their risk preferences. Some
will consider low risk investments, while others prefer high risk investments.
Reading comprehension tasks
Understanding details
Mark these statements T (true) or F (false) according to the information in the
text. Find the part of the text that gives the correct information.
Risk and Required Return:
1. The expected rate of return of an investment reflects the return an investor
demands as compensation for postponing consumption and assuming risk. F
2. The required rate of return of an investment is subject to the risk-free
return only. F
3. If the probability of winning or losing is identical, they are likely to reject
the gamble. T
4. The greater the risk, the lower the compensation one would require. F

64
5. When one devises an investment plan, this risk-return trade-off is a crucial
consideration. T
Risk-Return Relationship
6. Dealing with the return to be achieved doesn’t need estimate of the return
on investment over the time period. F
7. The fact that investors do not hold a single security which they consider
most profitable is enough to say that they factor in not only the
maximization of return, but also minimization of risk. T
8. The investors decrease their required return as perceived uncertainty
increases.F 9. As the required return on specific investments fluctuate over
time, the factors that affect the required rate of return don’t need to be
considered. False
10. A high yield in relation to the market usually indicates an above average
risk element. T
Word search
Find a word or phrase in the text that has a similar meaning.
1. an amount of something positive, such as food or profit, that is produced
or supplied:
y…………………..
ield

2. the difference between a particular number and the average or normal

number:
d………………………
eviation
decrease
3. an increase in value:
d……………………
4. a disadvantage of a situation:
d……………………….
ownsize

5. a collection of investments that are owned by a particular person or

organization:
p…………………..
ortfolio

65
 Reading 2:
Determining Risk and the Risk Pyramid
You might be familiar with the concept of risk-reward, which states that the
higher the risk of a particular investment, the higher the possible return. But
many individual investors do not understand how to determine the
appropriate risk level their portfolios should bear. This article provides a general
framework that any investor can use to assess his or her personal risk level and
how this level relates to different investments.
Risk-Reward Concept
Risk-reward is a general trade-off underlying nearly anything from which a
return can be generated. Anytime you invest money into something, there is a
risk, whether large or small, that you might not get your money back—that the
investment may fail. For bearing that risk, you expect a return that compensates
you for potential losses. In theory, the higher the risk the more you should
receive for holding the investment, and the lower the risk, the less you should
receive, on average.
For investment securities, we can create a chart with the different types of
securities and their associated risk/reward profiles.

Although this chart is by no means scientific, it provides a guideline that

investors can use when picking different investments. Located on the upper
portion of this chart are investments that have higher risks but might offer
investors a higher potential for above-average returns. On the lower portion are
much safer investments, but these investments have a lower potential for high
returns.

66
 Determining Your Risk Preference
With so many different types of investments to choose from, how does an
investor determine how much risk he or she can handle? Every individual is
different, and it's hard to create a steadfast model applicable to everyone, but
here are two important things you should consider when deciding how much
risk to take:
 Time Horizon: Before you make any investment, you should always
determine the amount of time you have to keep your money invested. If you
have $20,000 to invest today but need it in one year for a down payment on
a new house, investing the money in higher-risk stocks is not the best
strategy. The riskier an investment is, the greater its volatility or price
fluctuations. So if your time horizon is relatively short, you may be forced
to sell your securities at a significant loss. With a longer time horizon,
investors have more time to recoup any possible losses and are therefore
theoretically more tolerant of higher risks. For example, if that $20,000 is
meant for a lakeside cottage that you are planning to buy in 10 years, you
can invest the money into higher-risk stocks. Why? Because there is more
time available to recover any losses and less likelihood of being forced to
sell out of the position too early.
 Bankroll: Determining the amount of money you can stand to lose is
another important factor in figuring out your risk tolerance. This might not
be the most optimistic method of investing; however, it is the most realistic.
By investing only money that you can afford to lose or afford to have tied
up for some period of time, you won't be pressured to sell off any
investments because of panic or liquidity issues. The more money you have,
the more risk you are able to take. Compare, for instance, a person who has
a net worth of $50,000 to another person who has a net worth of $5 million.
If both invest $25,000 of their net worth into securities, the person with the
lower net worth will be more affected by a decline than the person with the
higher net worth.
Investment Risk Pyramid
After deciding how much risk is acceptable in your portfolio by
acknowledging your time horizon and bankroll, you can use the investment
pyramid approach for balancing your assets.

67
 This pyramid can be thought of as an asset allocation tool that investors can
use to diversify their portfolio investments according to the risk profile of each
security. The pyramid, representing the investor's portfolio, has three distinct
tiers:
The Base of the Pyramid: The foundation of the pyramid represents the
strongest portion, which supports everything above it. This area should consist of
investments that are low in risk and have foreseeable returns. It is the largest area
and comprises the bulk of your assets.
Middle Portion: This area should be made up of medium-risk investments
that offer a stable return while still allowing for capital appreciation. Although
riskier than the assets creating the base, these investments should still be
relatively safe.
Summit: Reserved specifically for high-risk investments, this is the smallest
area of the pyramid (portfolio) and should consist of money you can lose without
any serious repercussions. Furthermore, money in the summit should be fairly
disposable so you don't have to sell prematurely in instances where there are
capital losses.
The Bottom Line
Not all investors are created equal. While some prefer less risk, other
investors prefer even more risk than those who have a larger net worth. This
diversity leads to the beauty of the investment pyramid. Those who want more
risk in their portfolios can increase the size of the summit by decreasing the other
two sections, and those wanting less risk can increase the size of the base. The
pyramid representing your portfolio should be customized to your risk
preference.

68
 Maximize the return, minimize the risk
It is important for investors to understand the idea of risk and how it applies
to them. Making informed investment decisions entails not only researching
individual securities but also understanding your own finances and risk profile.
To get an estimate of the securities suitable for certain levels of risk tolerance and
to maximize returns, investors should have an idea of how much time and money
they have to invest and the returns they are seeking.

D. EXERCISES

Exercise 1: Information search

Match the words (1-10) with the matching meanings.

1 bear a. to get back money that you have spent or lost

2 framework b. having the ability to bear something unpleasant or
annoying, or to keep going despite difficulties
3 preference c. to support a person or activity financially
4 Volatility d. to pay someone money in exchange for something that has
been lost or damaged or for some problem
5 bankroll e. investment in a company or in government debt that can
be traded on the financial markets and produces an
income for the investor
6 steadfast f. to accept, tolerate, or endure something, especially
something unpleasant
7 tolerant g. staying the same for a long time and not changing quickly
or unexpectedly
8 security h. the fact that you like something or someone more than
another thing or person
9 recoup k. the quality or state of being likely to change suddenly,
especially by becoming worse
10 compensate l. a system of rules, ideas, or beliefs that is used to plan or
decide something

69
 Write your answer here:
1. b 2. l 3. h 4. k 5. c
6. g 7. f 8. e 9. a 10. d
Exercise 2: Complete the sentence
Use an appropriate form of the words in the box to complete the sentences
below

application balancing prematurely bulk panic

customize liquid disposable repercussion allocate
Disposable income and discretionary income are key economic indicators
1. -----------
income remaining after used to gauge companies' and individuals' financial health.
deduction of taxes
allocation strategies that don’t collapse with our
and other mandatory 2. We can create income ---------
charges confidence when the market goes haywire — and that can reduce income
volatility to near zero.
Liquid
3. --------- ratios are an important class of financial metrics used to determine
a debtor's ability to pay off current debt obligations without raising
external capital.
applicable to companies employing more than five
4. This part of the law is only --------
people.
5. This article is written for users who have purchased a new machine with a
----------. in a way that happens
1 year warranty, but found that their warranty expired prematurely
or is done too soon
bulk
6. The ------- of the asset reduction comes from changes in the way Shell's
pension plan holdings are recorded, the company said.
panic
7. The decline began in the market and led to --------- selling as more
investors were unwilling to risk additional losses. The market sharply
declined and was followed by the Great Depression.
repercussion
8. But the only -------- for lying on the declaration or refusing to wear a mask
on the plane is getting banned from the airline, if caught.
customized
9. Each move is completely -------- to catered to the customers’ needs.
balance the
10. If the business loses any more money, we won't be able to --------
books this year.

70
 E. EXTENSION ACTIVITIESON activities
1. What are High Return, Low Risk Investments for Retirees according to
you?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
……………………………………………………………………….………
2. What is your checklist when choosing investments?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
……………………………………………………………………….………
3. What are stock investing tips for beginners?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
F. ESSAY WRITING
Essay Topic
What are the pros and cons of portfolio diversification?
Give reasons for your answer and include any relevant examples from your
own knowledge and experience. Write at least 300 words.

71
 Unit 6
FINANCIAL MARKETS

A. TERMS, DEFINITIONS, THEORIES

Financial markets (bond and stock markets) and financial intermediaries
(such as banks, insurance companies, and pension funds) serve the basic function
of getting people like Inez and Walter together so that funds can move from those
who have a surplus of funds (Walter) to those who have a shortage of funds
(Inez). Financial markets perform the essential economic function of channeling
funds from households, firms, and governments that have saved surplus by
spending less than their income to those that have a shortage of funds because
they wish to spend more than their income.
A primary market: a financial market in which new issues of a security,
such as a bond or a stock, are sold to initial buyers by the corporation or
government agency borrowing the funds.
A secondary market: a financial market in which securities that have been
previously issued can be resold.
Investment bank: an important financial institution that assists in the initial
sale of securities in the primary market. The investment bank does this by
underwriting securities: it guarantees a price for a corporation’s securities and
then sells them to the public.
Brokers: agents of investors who match buyers with sellers of securities; link
buyers and sellers by buying and selling securities at stated prices.
Money market: A financial market in which only short-term debt
instruments (generally those with original maturity terms of less than one year)
are traded.
Capital market: The market in which longer-term debt instruments
(generally those with original maturity terms of one year or greater) and equity
instruments are traded.
U.S. Treasury Bills: short-term debt instruments of the US government and
are issued in one-, three-, and six-month maturities to finance the federal
government.

72
 A repurchase agreement (or Repo): is a short-term agreement to sell
securities in order to buy them back at a slightly higher price.
Commercial paper: is a commonly used type of unsecured, short-term debt
instrument issued by corporations, typically used for the financing of payroll,
accounts payable and inventories, and meeting other short-term liabilities.
Federal Funds: often referred to as fed funds, are excess reserves
that commercial banks and other financial institutions deposit at regional Federal
Reserve banks; these funds can be lent, then, to other market participants with
insufficient cash on hand to meet their lending and reserve needs. The loans are
unsecured and are made at a relatively low interest rate, called the federal funds
rate or overnight rate, as that is the period for which most such loans are made.
The banker's acceptance: is a negotiable piece of paper that functions like a
post-dated check, although the bank rather than an account holder guarantees the
payment. Banker's acceptances are used by companies as a relatively safe form of
payment for large transactions.
Certificate of Deposit (CD): a debt instrument sold by a bank to depositors
that pays annual interest of a given amount and at maturity
Over-the-counter (OTC) market: a secondary market in which dealers at
different locations who have an inventory of securities stand ready to buy and
sell securities “over the counter” to anyone who comes to them and is willing to
accept their prices.
A Stock Exchange: acts as a market where stock buyers connect with stock
sellers. Stocks can be traded on several exchanges such as the New York Stock
Exchange (NYSE) or the Nasdaq.
Stocks: are equity claims on the net income and assets of a corporation.
Mortgages: loans to house-holds or firms to purchase land, housing, or other
real structures, in which the structure or land itself serves as collateral for the
loans.
Corporate Bonds: long-term bonds are issued by corporations with very
strong credit ratings.
Derivatives market: is the financial market for derivatives, financial
instruments like futures contracts or options, which are derived from other forms
of assets.

73
 A Futures contract: is the obligation to sell or buy an asset at a later date at
an agreed-upon price.
An Options contract: gives an investor the right, but not the obligation, to
buy (or sell) shares at a specific price at any time, as long as the contract is in
effect.
A Swap: is a derivative contract through which two parties exchange the cash
flows or liabilities from two different financial instruments.
Hedging: is an investment that is made with the intention of reducing the risk
of adverse price movements in an asset. Normally, a hedge consists of taking an
offsetting or opposite position in a related security.
Speculation: refers to the act of conducting a financial transaction that has
substantial risk of losing value but also holds the expectation of a significant gain
or other major value.

B. VOCABULARY
Match these terms with their definitions.

1. Stocks or shares a. A detailed examination of a company and its financial

situation.
2. Financial results
b. A document inviting the public to buy stocks, giving
3. Nominal value
information about the company and stating the terms
4. Secondary market of sale.
5. Market price c. Certificates representing part-ownership of a company
6. Primary market d. Details about sales, costs, debts, profits, losses, etc.
7. Underwrite e. The market on which new stocks are sold
8. Prospectus f. The market on which stocks can be re-sold.
9. Due diligence g. The price at which a stock is currently being traded on
the stock exchange.
10. Market makers
Nhà tạo lập thị h. The price written on a stock (which never changes).
trường
i. The guarantee to buy newly issued stocks if no other
buyers can be found.
k. Traders in stocks who quote bid (buying) and offer
(selling) prices

74
 Write your answer here:
1. c 2. d 3. h 4. f 5. g
6. e 7. i 8. b 9. a 10. k

D. READING
Reading 1
Before you read
Discuss these questions.
1. How many kinds of bonds are there?
2. What is the primary market and secondary market and explain?
BONDS
Bonds are loans raised by national and local governments and companies to
finance expenditure or investment. Government bonds, which can last up to 30
years or more, are know as Treasury notes and Treasury bonds in the USA and
Treasury stock, gilt-edged stock or just “gilts” in Britain.
Large corporate borrowers find it cheaper to borrow directly by issuing bonds
(usually underwritten by an investment bank) than to borrow from a commercial
bank. The buyers of bonds lend money to the issuer, and generally receive fixed,
six-monthly or annual interest payments (the bond’s “coupon”). The borrowed
money (or principal) is repaid on a given maturity date, usually after 5 to 10
years.
Corporate bonds are generally considered to be safer than stocks, because a
company that cannot repay its debts can be declared bankrupt, and have its assets
sold to repay creditors, including bondholders. However, a company’s financial
situation can change during the life of a bond. Furthermore, on average, stocks
pay a higher return than bonds over the medium or long term. Issuers are given
credit ratings by credit rating agencies. The highest grade (Aaa or AAA) means
that there is virtually no risks of default; lower grades (e.g. AA, BBB, BB, B+,
etc.) indicate progressively greater degrees of risk that the borrower will not be
able to repay. Governments and companies with higher credit ratings can borrow
at lower rates.
For companies, debt financing (issuing bonds) has an advantage over equity
financing (issuing stocks) in that bond interest is tax deductible: companies

75
deduct their interest payments from their profits before paying tax, whereas
dividends paid to stockholders come from already-taxed profits. On the other
hand, debt has to repaid, unlike equities which do not, and unlike dividends, bond
interest has to be paid, even in a year without any profits to deduct it from.
Bonds are traded on the secondary market by banks and brokerage companies
which act as market-makers on behalf of their customers. Bond traders make a
market with a bid price at which they buy and an offer price at which they sell,
with a very small spread between them. The price of bonds on the secondary
market includes accrued interest.
The price of bonds varies inversely with interest rates. If interest rates rise, so
new bond issues pay a higher rate existing bonds lose value, and sell for less than
their norminal value (below par). Conversely, if interest rates fall, existing bonds
paying more than the market rate will logically increase in value, and trade above
par. Therefore, the yield of a bond depends on both its purchase price and its
coupon.

READING COMPREHENSION TASKS

Exercise 1: Find words in the text that mean the following:

Statement Answer
1. The organization raising money by offering issuer
bonds for sales
2. The amount of interest paid by a bond coupon

3. The amount of capital making up a loan. principal

4. Failure to pay interest or repay a loan at the default

scheduled time.
5. People or organizations that buy or sell market-makers
securities for customers
6. The difference between the buying and selling spread
prices of securities.
7. The rate of income a bondholder receives,
yield
taking into account the bond’s purchase price.

76
 Exercise 2: Match up the half-sentences:

1. Investment banks generally guarantee

2. Bondholders can sell at a profit
3. Although companies do not have to pay dividends
4. The amount of interest a bond pays
5. Companies can deduct interest expenses

A. depends on the issuer’s credit rating

B. from their taxable profits
C. if market interest rates fall
D. they are obliged to honor bond interest payments
E. to find buyers new bond issues

Answer:
1. E 2. C 3. D 4. A 5. B

Exercise 3: Read the text and decide where the part-sentences below it
should be inserted
Some companies issue floating-rate notes – bonds whose coupon varies with
market interest rates- __________(1).
If they wish to pay a lower interest rate, companies can also issue
convertible bonds, which are bonds that give the owner the option to exchange
them for a fixed number of shares of the company’s common stock. Convertibles
pay lower interest rates than ordinary bonds because the buyer gets the
possibility of making a profit with the convertible option, ________(2).
Some companies also issue warrants attached to bonds, giving the right, but
not the obligation, to buy stocks in the future at a particular price. Although they
are usually issued bonds, warrant can be detached from the bonds and traded
separately. Like convertibles, ______(3).
Some companies also issue zero coupon bonds which pay no interest but are
sold at a discount on their par value, and redeemed at 100% at maturity. Some
investors buy them in order to make a capital gain at maturity, _______(4).

77
 Bonds that pay a high interest rate are called high yield bonds or junk
bonds. Some are issued to finance leveraged buyouts, _______(5).

A. and their value increases if the stock price rises.

B. especially when interest rates are high and expected to fall.
C. others are issued by companies with a credit rating below investment
grade, and therefore with a higher risk of default.
D. they allow an issuer to reduce the interest rate that the bond offers.
E. which is taxed at a lower rate than that applied to interest payments
Answer:
1. B 2. A 3. D 4. E 5. C

Reading 2: Read the text and complete the sentences below

Hedge funds and structured products
Hedge funds are private investment funds for financial institutions and
wealthy investors that try to get high returns whether markets move up or down.
They use a wider variety of risky investment strategies than traditional
investment funds, notably including trading in derivatives, and using short –
selling and leverage. This enables them to make huge profits, but also huge
losses if things go wrong. In most countries, hedge funds are only open to a small
number of professional and wealthy investors, who are aware of the risks
involved, but willing to take them because of the high potential returns. As they
are private funds, they do not have to follow the same regulations as ordinary
investment funds, or disclose as much information about their activities.
As the name suggests, hedge funds originally specialized in hedging-
protecting themselves against future price changes. They would buy risky
derivatives but at the same time also buy another smaller product to go against
the risk involved with the derivative. For example, they would take a short
position (also called short-selling or shorting or going short), which means
borrowing securities (for a small fee) from another institution (usually a broker)
and selling them, hoping to be able to buy back identical securities at a later date
at a lower price, and return them to the lender. This enables the fund to profit
from falling prices, unlike traditional investors who can only profit from taking
long positions: buying securities and selling them after their price has risen.

78
Shorting is also the name given to entering into any contract in which the
investor profits from a fall in the value of an asset.
Whereas traditional institutional investors generally keep securities for a long
period of time, hedge funds often buy and sell in a very short time. Today there
are many other speculators who do the same thing, including day traders, who
buy stocks, usually from online brokers charging low transaction fees, and sell
them again before the settlement day on which they have to pay for the stocks
they have purchased. If day traders sell at a profit before settlement day, they
never have to pay for their shares.
Hedge funds also use leverage, which means borrowing large amounts of
money to trade with, on top of the funds paid in by their investors.
Investors in hedge funds generally pay both a management fee, often 2% of
the fund’s net asset value, as well as a performance fee, often 20% of the fund’s
annual profit.
Retail investors who do not have enough funds to join a hedge fund can buy
structured products from investment banks. These are customized (specially
designed) products which use futures, forwards, commodities, currencies,
options, warrants, swaps, etc. in a way similar to hedge funds, but with the
potential risks clearly explained to customers.
1. Hedging (which is not the only strategy used by hedge funds)
means_______
protecting themselves against future price changes
2. Making a profit from a fall in the value of an asset is called_______
shorting
3. Borrowing money on top of one’s own money to increase the size of one’s
investments is called using________
leverage
4. Buying and keeping assets and selling them later if their price rises is
called_____
5. Day traders never have to pay for their stocks if they sell them at a profit
before______
settlement day
Reading 3:
Futures and Derivatives
Derivatives are financial market products whose value depends on (is derived
from) the price of an underlying asset. The main derivative instruments are
futures, options, and swaps. They can be used for both hedging and speculation.

79
 Futures contracts are agreements to buy or sell an asset at a fixed price in
the next few months. They can be used to hedge – to insure against future price
changes. For example, wheat producers can make contracts to sell wheat to a
food processing company at a fixed price on a future date. In this way, the seller
is protected from a fall in price and they buyer from a rise in price. There are
futures markets for various commodities including foodstuffs (wheat, maize,
soybeans, pork beef, sugar, etc.), beverages (tea, coffee, cocoa, orange juice),
oil, precious metal (gold, silver, platinum) and non-precious metals (copper,
nickel, etc.)
Financial futures are contracts to buy and sell financial assets like currencies,
bonds, stocks and stock indexes at a future date. Just like commodity futures,
they can be used to speculate as well as to hedge, as they give the possibility of
making large gains by correctly anticipating changes in stock prices, interest
rates, exchange rates, etc. Futures are standardized contracts traded on
specialized derivatives exchanges. Non-standardized contracts, negotiated and
traded directly between two parties, are called forward contracts or simply
forwards. Contracts negotiated without using an exchange are described as over-
the-counter (OTC) trades.
Options differ from futures in that they give the right, but not the obligation,
to buy or sell an asset in the future. Buying a call option gives you the right to
buy an asset for a specific price (the strike price or exercise price), either within a
specific period (an American-style option) or on a specific future date (a
European-style option). Thus if you expect the price of a stock to rise you can
buy a call option giving the right to buy that stock in the future at the current
market price. Call options are similar to warrants, except that they usually only
last for 3, 6 or 9 months, whereas warrants can have a maturity of several years.
Buying a put option, on the contrary, gives you the right to sell an asset at a
specific price within a specified period or on a specific future date. So if you
think the price of a stock will fall in the next few weeks or months you can buy
the right to sell it at a price you think will be above its market price.
The person or organization that underwrites (or sells) options contracts
accepts the obligation to deliver or buy the assets according to the terms of the
contract. For this the write (seller) receives a fee from the buyer, called a
premium. Obviously, the writer has opposite expectations about the future value
of the asset than the buyer. If the write is right, the buyer will never exercise the
option to buy or sell, so the writer gains the premium. Yet a writer who is wrong

80
can lose an enormous amount, depending on how far the price of the asset
changes.
Borrowers and lenders can also undertake interest rate or exchange rate or
currency swaps. For instance, a company that has borrowed money with floating-
rate notes could protect itself from a rise in interest rate by arranging with
another company to swap or exchange its floating-rate payments for fixed-rate
payments. Swaps are usually over-the-counter operations.
Simple and common derivatives are often described as ‘plain vanilla’
derivatives, and more complicated and specialized ones as exotic derivatives.
Exercise 1: Find words or expressions in the text that mean the following:

Statements Words /expressions

1. A contract made directly between two parties, not
forwards contract
using an exchange.
2. An exchange of future payments on borrowed money
swaps
according to specified terms.
3. An option giving the buyer the right to buy something. call option
4. An option giving the buyer the right to sell something. put option

5. Contracts for non-standardized quantities or time non-standardized

periods contracts

6. Contracts to buy or sell standardized quantities on an futures contract

exchange
7. Making risky transactions, hoping to make a gain by
anticipating future price changes
8. Making transactions designed to diminish future price hedging
risks
9. Substances like agricultural products and metals which commodities
can be bought or sold with futures contracts.
10. The money the writer of an option receives premium

11. The price at which un underlying asset will be traded. strike price
12. To use or implement an option (to take up the exercise the option
possibility of buying or selling something)

81
 Exercise 2: Are the following statements are True or False?

Statements True False

1. The price of a futures contract is determined at the moment the
contract is made.
2. Hedging is another name for speculating.
3. Both parties cannot make money out of the same futures
contract, as futures are a ‘zero-sum-game’ – one party gains as
much as the other party loses, compared with the market price.
4. You can only hedge if someone who expects a price to move in
the opposite direction is willing to buy or sell a contract.
5. Commodities exchanges specialize in over-the-counter trades.
6. In options, ‘call’ means buy and ‘put’ means sell.
7. The amount of money one can make or lose on a derivative
contract is determined at the moment the contract is made.
8. If you think a stock will rise, you can profit by buying a put
option at the current price, or a warrant.
9. If you think a stock will rise, you can also profit by writing a
put option giving someone else the right to sell the stock at the
current price
10. If you think the value of an asset you own will fall below its
current price, you can profitably buy a call option at this price
or write a put option.
11. You only exercise a put option if the market price is lower
than the strike price.
12. Writers of options take greater risks than buyers.

E. EXTENSION ACTIVITIES
1. How many possible effects are there on interest rates of an increase in the
money supply? Briefly explain
…………………………………………………………………………………
…………………………………………………………………………………

82
 …………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………..………
2. Why will bonds with the same maturity have different interest rates?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………….…………

3. What is the interaction among traders in the market?

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………….…

F. ESSAY WRITING

What are financial markets? What function do they perform? How would
and economy be worse off without them?
Give reasons for your answer and include any relevant examples from your
own knowledge and experience.
Write at least 300 words.

83
 Unit 7
FINANCIAL INSTITUTIONS
Reduce the risk (risk sharing), deal with asymmetric information (adverse
selection, moral hazard), lower transaction cost
A. TERMS, DEFINITIONS
Financial intermediation: the process of transferring sums of money from
economic agents with surplus funds to economic agents that would like to utilize
those funds.
Financial intermediary: A financial firm, such as a bank, that borrows
funds from savers and lends them to borrowers.
Mortgage: loan backed by real property in the form of buildings and houses
Mortgage-backed security: debt security created by pooling together a
group of mortgage loans
Depository institutions: the institutions accept deposits from individuals and
then lend pooled deposits to firms, governments, and individuals
Contractual savings organizations: savings institutions that obtain funds
through long-term contractual arrangements and invest these funds on the capital
markets. Securities firms: financial insitutions that faciliate financial market
trades between buyers and sellers for a fee.
Securities firms: financial insitutions that faciliate financial market trades
between buyers and sellers for a fee.
Brokerage firms: assist individuals to purchase new or existing securities
issues or to sell previously purchased securities
Finance companies: organizations that make loans to individuals and
businesses.
Commercial banks: A financial firm that serves as a financial intermediary
by taking in deposits and using them to make loans.
Thrift institutions: depository institutions that specialize in taking deposits
and make home mortgages.
Savings banks: accept the savings of individuals and lend pooled savings to
individuals primarily in the form of mortgage loans

84
 Savings and loan associations (S&Ls): accept individual savings and lend
pooled savings to individuals, primarily in the form of mortgage loans.
Credit unions: Non-profit cooperative financial institution that provides
credit to its members.Investment companies: sell shares in their firms to
individuals and others and invest the pooled proceeds in corporate and
government securities
Mutual funds: open-end investment companies that can issue an unlimited
number of their shares to their investors and use the pooled proceeds to purchase
corporate and government securities
Investment bank: sell or market new securities issued by businesses to
individual and institutional investors
Financial Services: a broad range of more specific activities such as
banking, investing, and insurance. Financial services are limited to the activity of
financial services firms and their professionals while financial products are the
actual goods, accounts, or investments they provide.
Bank risk management: Risk management is important for a bank to ensure
its profitability and soundness. It is also a concern of regulators to maintain the
safety and soundness of the financial system. Bank risk management has become
the major concern of banking regulators and policy makers.

B. VOCABULARY
Match these terms with their definitions.
1. financial a. the riskiness of earnings and returns on bank
intermediaries assets caused by interest-rate changes

2. economies of scales b. the primary route for moving funds from lenders
to borrowers
3. financial c. the reduction in transaction costs per dollar of
intermediation transactions as the size (or scale) of transactions
increases
4. transaction costs d. financial intermediaries that accept deposits
from individuals and institutions and make loans
5. liquidity services e. the widespread collapse of financial
intermediaries
6. depository institutions f. the time and money spent in carrying out
financial transactions

85
 7. thrift institutions g. financial institutions that acquire funds by
(thrifts) issuing liabilities, and in turn, use those funds to
acquire assets by pursuing securities or making
loans.
8. financial panic h. the risk arising because borrowers may default

9. credit risk i. services that make it easier for customers to

conduct transactions
10. interest-rate risk j. savings and loan associations, mutual savings
banks, and credit unions
Write your answer here
1. g 2. c 3. b 4. f 5. i
6. d 7. j 8. e 9. a 10. h

E. READING
Reading 1
Before you read
Discussion
1. Explain the major functions of financial institutions in the economy.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………………………….…………………………
……………………………………………………………………………………
……………………………………………………………………………………
2. Distinguish commercial banks and other depository intermediaries.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………………………….…..……………………

86
3. Distinguish commercial banks and investment banks.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
……………………………………………………………………..….………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………………

4. Why should commercial banks be under the heaviest regulation?

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
……………………………………………………………………….………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
5. What is the rationale of the government regulation on financial markets
and institutions?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
……………………………………………………………………..….………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

87
 FUNCTION OF FINANCIAL INTERMEDIARIES: INDIRECT FINANCE
Funds can move from lenders to borrowers by a second route, called indirect
finance because it involves a financial intermediary that stands between the
lender-savers and the borrower-spenders and helps transfer funds from one to the
other. A financial intermediary does this by borrowing funds from lender-savers
and then using these funds to make loans to borrower-spenders. For example, a
bank might acquire funds by issuing a liability to the public in the form of
savings deposits (an asset for the public). It might then use the funds to acquire
an asset by making a loan to General Motors or by buying a U.S. Treasury bond
in the financial market. The ultimate result is that funds have been transferred
from the public (the lender-savers) to General Motors or the U.S. Treasury (the
borrower-spender) with the help of the financial intermediary (the bank).
The process of indirect financing using financial intermediaries, called
financial intermediation, is the primary route for moving funds from lenders to
borrowers. Indeed, although the media focus much of their attention on securities
markets, particularly the stock market, financial intermediaries are a far more
important source of financing for corporations than securities markets are. This is
true not only for the United States but for other industrialized countries as well.

TYPES OF FINANCIAL INTERMEDIARIES

We have seen why financial intermediaries have such an important function
in the economy. Now we take a look at the principal financial intermediaries and
how they perform the intermediation function. Financial intermediaries fall into
three categories: depository institutions (banks), contractual savings institutions,
and investment intermediaries.
Depository Institutions
Depository institutions (for simplicity, we refer to these as banks throughout
this text) are financial intermediaries that accept deposits from individuals and
institutions and make loans. The study of money and banking focuses special
attention on this group of financial institutions because they are involved in the
creation of deposits, an important component of the money supply. These
institutions include commercial banks and the so-called thrift institutions
(thrifts): savings and loan associations, mutual savings banks, and credit unions.

88
 TABLE 7.1: Primary Assets and Liabilities of Financial Intermediaries

Type of Intermediary Primary Liabilities Primary Assets

(Sources of Funds) (Uses of Funds)
Depository institutions Deposits Business and consumer
(banks) loans,
Commercial banks
Savings and loan associations Deposits mortgages, U.S. government
securities, and municipal
bonds
Mortgages
Mutual savings banks Deposits Mortgages
Credit unions Deposits Consumer loans
Contractual savings Premiums from Corporate bonds and
institutions policies mortgages
Life insurance companies
Fire and casualty insurance Premiums from Municipal bonds, corporate
policies bonds
companies and stock, and U.S.
government
Pension funds, government Employer and Securities
employee Corporate bonds and stock
retirement funds contributions
Investment intermediaries Commercial paper, Consumer and business
Finance companies stocks, loans
Mutual funds bonds Stocks, bonds
Shares
Money market mutual funds Shares Money market instruments
Hedge funds Partnership Stocks, bonds, loans, foreign
participation currencies, and many other
assets

89
 Commercial Banks: These financial intermediaries raise funds primarily by
issuing checkable deposits (deposits on which checks can be written), savings
deposits (deposits that are payable on demand but do not allow their owners to
write checks), and time deposits (deposits with fixed terms to maturity). They
then use these funds to make commercial, consumer, and mortgage loans and to
buy U.S. government securities and municipal bonds. Around 5,000 commercial
banks are found in the United States and, as a group, they are the largest financial
intermediary and have the most diversified portfolios (collections) of assets.
Savings and Loan Associations (S&Ls) and Mutual Savings Banks:
These depository institutions, of which there are approximately 1,000 in the
United States, obtain funds primarily through savings deposits (often called
shares) and time and checkable deposits. In the past, these institutions were
constrained in their activities and mostly made mortgage loans for residential
housing. Over time, these restrictions have been loosened, so the distinction
between these depository institutions and commercial banks has blurred. These
intermediaries have become more alike and are now more competitive with each
other.
Credit Unions: These financial institutions, numbering about 6,000 in the
United States, are typically very small cooperative lending institutions organized
around a particular group: union members, employees of a particular firm, and so
forth. They acquire funds from deposits called shares and primarily make
consumer loans.
Contractual Savings Institutions:
Contractual savings institutions, such as insurance companies and pension
funds, are financial intermediaries that acquire funds at periodic intervals on a
contractual basis. Because they can predict with reasonable accuracy how much
they will have to pay out in benefits in the coming years, they do not have to
worry as much as depository institutions about losing funds quickly. As a result,
the liquidity of assets is not as important a consideration for them as it is for
-
depository institutions, and they tend to invest their funds primarily in long-term
securities such as corporate bonds, stocks, and mortgages.
Life Insurance Companies: Life insurance companies insure people against
financial hazards following a death and sell annuities (annual income payments
upon retirement). They acquire funds from the premiums that people pay to keep
their policies in force and use them mainly to buy corporate bonds and

90
mortgages. They also purchase stocks but are restricted in the amount that they
can hold. Currently, with around $7 trillion in assets, they are among the largest
of the contractual savings institutions.
Fire and Casualty Insurance Companies: These companies insure their
policyholders against loss from theft, fire, and accidents. They are very much like
life insurance companies, receiving funds through premiums for their policies,
but they have a greater possibility of loss of funds if major disasters occur. For
this reason, they use their funds to buy more liquid assets than life insurance
companies do. Their largest holding of assets consists of municipal bonds; they
also hold corporate bonds and stocks and U.S. government securities.
Pension Funds and Government Retirement Funds: Private pension funds
and state and local retirement funds provide retirement income in the form of
annuities to employees who are covered by a pension plan. Funds are acquired by
contributions from employers and from employees, who either have a
contribution automatically deducted from their paychecks or contribute
voluntarily. The largest asset holdings of pension funds are corporate bonds and
stocks. The establishment of pension funds has been actively encouraged by the
federal government, both through legislation requiring pension plans and through
tax incentives to encourage contributions.

Investment Intermediaries
This category of financial intermediary includes finance companies, mutual
funds, money market mutual funds, and hedge funds.
Finance Companies: Finance companies raise funds by selling commercial
paper (a short-term debt instrument) and by issuing stocks and bonds. They lend
these funds to consumers, who use them to purchase such items as furniture,
automobiles, and home improvements, and to small businesses. Some finance
companies are organized by a parent corporation to help sell its product. For
example, Ford Motor Credit Company makes loans to consumers who purchase
Ford automobiles.
Mutual Funds: These financial intermediaries acquire funds by selling
shares to many individuals and then using the proceeds to purchase diversified
portfolios of stocks and bonds. Mutual funds allow shareholders to pool their
resources so that they can take advantage of lower transaction costs when buying
large blocks of stocks or bonds. In addition, mutual funds allow shareholders to
hold more diversified portfolios than they otherwise would. Shareholders can sell

91
(redeem) shares at any time, but the value of these shares will be determined by
the value of the mutual fund’s holdings of securities. Because these fluctuate
greatly, the value of mutual fund shares does, too; therefore, investments in
mutual funds can be risky.
Money Market Mutual Funds: These financial institutions are similar to
mutual funds but also function to some extent as depository institutions because
they offer deposit-type accounts. Like most mutual funds, they sell shares to
acquire funds. These funds are then used to buy money market instruments that
are both safe and very liquid. The interest on these assets is paid out to the
shareholders.
A key feature of these funds is that shareholders can write checks against the
value of their shareholdings. In effect, shares in a money market mutual fund
function like checking account deposits that pay interest. Money market mutual
funds have experienced extraordinary growth since 1971, when they first
appeared. In 2016, their assets had climbed to $2.7 trillion.
Hedge Funds: Hedge funds are a type of mutual fund with special
characteristics. Hedge funds are organized as limited partnerships with minimum
investments ranging from $100,000 to, more typically, $1 million or more. These
limitations mean that hedge funds are subject to much weaker regulation than
other mutual funds. Hedge funds invest in many types of assets, with some
specializing in stocks, others in bonds, others in foreign currencies, and still
others in far more exotic assets.
Investment Banks: Despite its name, an investment bank is not a bank or a
financial intermediary in the ordinary sense; that is, it does not take in funds and
then lend them out. Instead, an investment bank is a different type of
intermediary that helps a corporation issue securities. First it advises the
corporation on which type of securities to issue (stocks or bonds); then it helps
sell (underwrite) the securities by purchasing them from the corporation at a
predetermined price and reselling them in the market. Investment banks also act
as deal makers and earn enormous fees by helping corporations acquire other
companies through mergers or acquisitions.
READING COMPREHENSION TASKS
Understanding main points
Read the above text and answer the following questions.

92
 1. Why do financial intermediaries play an important role in the financial
system?
………………………………………………………………………………
Allow risk sharing, help lower transactions cost, solve the problem created by moral hazard
and adverse selection, help to allow savers and borrowers work more efficiently
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………..….……
…………………………………………………………………………………
2. What may happen if the economies of scope that help make financial
intermediaries successful?
………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………..….……
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
3. What are the government regulations for controlling the financial markets
and financial intermediaries?
………………………………………………………………………………
Help to have a good control of financial market and financial. Intermediaries
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………..….……
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
Understanding details
Mark these statements T (True) or F (False) according to the information in
the text. Find the part of the text that gives the correct information.

93
 1. Financial intermediaries can lower transaction costs. True
2. Financial intermediaries and indirect finance are not really significant in
financial markets. False
3. Successful financial intermediaries are more likely to gain higher earnings
on their investments than small savers. True
4. Lack of information only creates problems in the financial system before
the transaction is entered into. False
5. Financial intermediaries can be called financial intermediation. True false
6. Thrifts belong to financial intermediaries. True
7. Credit Unions gain funds from deposits and mainly give consumer loans. True
8. Money Market Mutual Funds sell shares to gain funds. False true

9. An investment bank is a bank or a financial intermediary. False

10. Investments in mutual funds is very safe. False

Choose the best answer.

1. Examples of REAL assets include
A. bridges.
B. human capital.
C. preferred stock shares.
D. all of the above.
E. only A and B above.
2. By definition, key activities of INVESTMENT BANKS include:
A. taking in deposits and making loans.
B. offering investment (stock pick) advice to stock traders.
C. underwriting of initial public offerings of corporate bonds.
D. investing in portfolios of assets to increase returns to shareholders.
3. By definition, examples of FINANCIAL assets include
A. ATM machines.
B. special financial knowledge acquired through working as a bank manager.

94
 C. 100 shares of General Motors stock.
D. all of the above.
4. By definition, which (if any) of the following statements describing
dealers, brokers, and financial intermediaries are TRUE?
A. Brokers stand ready to buy or sell the assets in which they trade should
gaps arise between the amount demanded and the amount supplied, a
process known as “brokerage commissioning.”
B. Financial intermediaries sell lower-risk assets with short maturities to
savers and then use these funds to buy higher-risk assets with longer
maturities from borrowers, a process known as “asset transformation.”
C. Dealers sell lower-risk assets with short maturities to buyers and then
use these funds to buy higher-risk assets with longer maturities from
sellers, a process known as “making the market.”
D. none of the above.
Discussion
Discussion question
Assume you want to open both a check-writing account and a savings
account. Would
you prefer holding the accounts in a commercial bank, savings and loan
association, or a credit union? Why?
Reading 2
Transaction costs, the time and money spent in carrying out financial
transactions, are a major problem for people who have excess funds to lend. As
we have seen, Carl the Carpenter needs $1,000 for his new tool, and you know
that it is an excellent investment opportunity. You have the cash and would like
to lend him the money, but to protect your investment, you have to hire a lawyer
to write up the loan contract that specifies how much interest Carl will pay you,
when he will make these interest payments, and when he will repay you the
$1,000. Obtaining the contract will cost you $500. When you figure in this
transaction cost for making the loan, you realize that you can’t earn enough from
the deal (you spend $500 to make perhaps $100) and reluctantly tell Carl that he
will have to look elsewhere.

95
 This example illustrates that small savers like you or potential borrowers like
Carl might be frozen out of financial markets and thus be unable to benefit from
them. Can anyone come to the rescue? Financial intermediaries can.
Financial intermediaries can substantially reduce transaction costs because
they have developed expertise in lowering them and because their large size
allows them to take advantage of economies of scale, the reduction in transaction
costs per dollar of transactions as the size (scale) of transactions increases. For
example, a bank knows how to find a good lawyer to produce an airtight loan
contract, and this contract can be used over and over again in its loan
transactions, thus lowering the legal cost per transaction. Instead of a loan
contract (which may not be all that well written) costing $500, a bank can hire a
top-flight lawyer for $5,000 to draw up an airtight loan contract that can be used
for 2,000 loans at a cost of $2.50 per loan. At a cost of $2.50 per loan, it now
becomes profitable for the financial intermediary to lend Carl the $1,000.
Because financial intermediaries are able to reduce transaction costs
substantially, they make it possible for you to provide funds indirectly to people
like Carl with productive investment opportunities. In addition, a financial
intermediary’s low transaction costs mean that it can provide its customers with
liquidity services, services that make it easier for customers to conduct
transactions. For example, banks provide depositors with checking accounts that
enable them to pay their bills easily. In addition, depositors can earn interest on
checking and savings accounts and yet still convert them into goods and services
whenever necessary.
Risk Sharing
Another benefit made possible by the low transaction costs of financial
institutions is that these institutions can help reduce the exposure of investors to
risk-that is, uncertainty about the returns investors will earn on assets. Financial
intermediaries do this through the process known as risk sharing: They create
and sell assets with risk characteristics that people are comfortable with, and the
intermediaries then use the funds they acquire by selling these assets to purchase
other assets that may have far more risk. Low transaction costs allow financial
intermediaries to share risk at low cost, enabling them to earn a profit on the
spread between the returns they earn on risky assets and the payments they make
on the assets they have sold. This process of risk sharing is also sometimes
referred to as asset transformation, because in a sense, risky assets are turned
into safer assets for investors.

96
 Financial intermediaries also promote risk sharing by helping individuals to
diversify and thereby lower the amount of risk to which they are exposed.
Diversification entails investing in a collection (portfolio) of assets whose
returns do not always move together, with the result that overall risk is lower
than for individual assets. (Diversification is just another name for the old adage
“You shouldn’t put all your eggs in one basket.”) Low transaction costs allow
financial intermediaries to pool a collection of assets into a new asset and then
sell it to individuals.
Asymmetric Information: Adverse Selection and Moral Hazard
The presence of transaction costs in financial markets explains, in part, why
financial intermediaries and indirect finance play such an important role in
financial markets. An additional reason is that in financial markets, one party
often does not know enough about the other party to make accurate decisions.
This inequality is called asymmetric information. For example, a borrower who
takes out a loan usually has better information about the potential returns and
risks associated with the investment projects for which the funds are earmarked
than the lender does. Lack of information creates problems in the financial
system on two fronts: before the transaction is entered into, and afterward.
Adverse selection is the problem created by asymmetric information before
the transaction occurs. Adverse selection in financial markets occurs when the
potential borrowers who are the most likely to produce an undesirable (adverse)
outcome-the bad credit risks-are the ones who most actively seek out a loan and
are thus most likely to be selected. Because adverse selection makes it more
likely that loans might be made to bad credit risks, lenders may decide not to
make any loans, even though good credit risks exist in the marketplace.
To understand why adverse selection occurs, suppose you have two aunts to
whom you might make a loan-Aunt Louise and Aunt Sheila. Aunt Louise is a
conservative type who borrows only when she has an investment she is quite sure
will pay off. Aunt Sheila, by contrast, is an inveterate gambler who has just come
across a get-rich-quick scheme that will make her a millionaire if she can just
borrow $1,000 to invest in it. Unfortunately, as with most get-rich-quick
schemes, the probability is high that the investment won’t pay off and that Aunt
Sheila will lose the $1,000.
Which of your aunts is more likely to call you to ask for a loan? Aunt Sheila,
of course, because she has so much to gain if the investment pays off. You,

97
however, would not want to make a loan to her because the probability is high
that her investment will turn sour and she will be unable to pay you back.
If you know both your aunts very well-that is, if your information is not
asymmetric you won’t have a problem, because you will know that Aunt Sheila
is a bad risk and so you will not lend to her. Suppose, though, that you don’t
know your aunts well. You will be more likely to lend to Aunt Sheila than to
Aunt Louise because Aunt Sheila will be hounding you for the loan. Because of
the possibility of adverse selection, you might decide not to lend to either of your
aunts, even though there are times when Aunt Louise, who is an excellent credit
risk, might need a loan for a worthwhile investment.
Moral hazard is the problem created by asymmetric information after the
transaction occurs. Moral hazard in financial markets is the risk (hazard) that the
borrower might engage in activities that are undesirable (immoral) from the
lender’s point of view, because they make it less likely that the loan will be paid
back. Because moral hazard lowers the probability that the loan will be repaid,
lenders may decide that they would rather not make a loan.
As an example of moral hazard, suppose that you made a $1,000 loan to
another relative, Uncle Melvin, who needs the money to purchase a computer so
that he can set up a business typing students’ term papers. Once you have made
the loan, however, Uncle Melvin is more likely to slip off to the track and play
the horses than to purchase the computer. If he bets on a 20-to-1 long shot and
wins with your money, he is able to pay back your $1,000 and live high-off-the-
hog with the remaining $19,000. But if he loses, as is likely, you won’t get paid
back, and all he has lost is his reputation as a reliable, upstanding uncle. Uncle
Melvin therefore has an incentive to go to the track because his gains ($19,000) if
he bets correctly are much greater than the cost to him (his reputation) if he bets
incorrectly. If you knew what Uncle Melvin was up to, you would prevent him
from going to the track, and he would not be able to increase the moral hazard.
However, because it is hard for you to keep informed of his whereabouts-that is,
because information is asymmetric-there is a good chance that Uncle Melvin will
go to the track and you will not get paid back. The risk of moral hazard might
therefore discourage you from making the $1,000 loan to Uncle Melvin, even if
you are sure that you will be paid back if he uses it to set up his business.
The problems created by adverse selection and moral hazard are a major
impediment to well-functioning financial markets. Again, financial intermediaries
can alleviate these problems.

98
 With financial intermediaries in the economy, small savers can provide their
funds to the financial markets by lending these funds to a trustworthy
intermediary-say, the Honest John Bank-which in turn lends the funds out either
by making loans or by buying securities such as stocks or bonds. Successful
financial intermediaries have higher earnings on their investments than do small
savers because they are better equipped than individuals to screen out bad credit
risks from good ones, thereby reducing losses due to adverse selection. In
addition, financial intermediaries have high earnings because they develop
expertise in monitoring the parties they lend to, thus reducing losses due to moral
hazard. The result is that financial intermediaries can afford to pay lender-savers
interest or provide substantial services and still earn a profit.
As we have seen, financial intermediaries play an important role in the
economy because they provide liquidity services, promote risk sharing, and solve
information problems, thereby allowing small savers and borrowers to benefit
from the existence of financial markets. The success of financial intermediaries
in performing this role is evidenced by the fact that most Americans invest their
savings with them and obtain loans from them. Financial intermediaries play a
key role in improving economic efficiency because they help financial markets
channel funds from lender-savers to people with productive investment
opportunities.
Economies of Scope and Conflicts of Interest
Another reason why financial intermediaries play such an important part in
the economy is that by providing multiple financial services to their customers,
such as offering them bank loans or selling their bonds for them, they can also
achieve economies of scope; that is, they can lower the cost of information
production for each service by applying one information resource to many
different services. A bank, for example, when making a loan to a corporation, can
evaluate how good a credit risk the firm is, which then helps the bank decide
whether it would be easy to sell the bonds of this corporation to the public.
Although economies of scope may substantially benefit financial institutions,
they also create potential costs in terms of conflicts of interest. Conflicts of
interest, a type of moral hazard problem, arise when a person or institution has
multiple objectives (interests), some of which conflict with each other. Conflicts
of interest are especially likely to occur when a financial institution provides
multiple services. The potentially competing interests of those services may lead
an individual or firm to conceal information or disseminate misleading
information. We care about conflicts of interest because a substantial reduction in

99
the quality of information in financial markets increases asymmetric information
problems and prevents financial markets from channeling funds into the most
productive investment opportunities. Consequently, the financial markets and the
economy become less efficient.
How Transaction Costs Influence Financial Structure
Say you have $5,000 that you would like to invest, and you are thinking
about investing in the stock market. Because you have only $5,000, you can buy
only a small number of shares. Even if you use online trading, your purchase is
so small that the brokerage commission for buying the stock you pick will be a
large percentage of the purchase price of the shares. If, instead, you decide to buy
a bond, the problem becomes even worse; the smallest denomination offered on
some bonds that you might want to buy is as large as $10,000, and you do not
have that much money to invest. You are disappointed and realize that you will
not be able to use financial markets to earn a return on your hard-earned savings.
You can take some consolation, however, in the fact that you are not alone in
being stymied by high transaction costs. This is a fact of life for many of us:
Only about one-half of American households own any securities.
You also face another problem related to transaction costs. Because you have
only a small amount of funds available, you can make only a restricted number of
investments, because a large number of small transactions would result in very
high transaction costs. That is, you have to put all your eggs in one basket, and
your inability to diversify will subject you to a lot of risk.
How Financial Intermediaries Reduce Transaction Costs
Financial intermediaries, an important part of the financial structure, have
evolved to reduce transaction costs and allow small savers and borrowers to
benefit from the existence of financial markets.
Economies of Scale: One solution to the problem of high transaction costs is
to bundle the funds of many investors together so that they can take advantage of
economies of scale, the reduction in transaction costs per dollar of investment as
the size (scale) of transactions increases. Bundling investors’ funds together
reduces transaction costs for each individual investor. Economies of scale exist
because the total cost of carrying out a transaction in financial markets increases
only a little as the size of the transaction grows. For example, the cost of
arranging a purchase of 10,000 shares of stock is not much greater than the cost
of arranging a purchase of 50 shares of stock.

100
 The presence of economies of scale in financial markets helps explain the
development of financial intermediaries and why financial intermediaries have
become such an important part of our financial structure. The clearest example of
a financial intermediary that arose because of economies of scale is a mutual
fund. A mutual fund is a financial intermediary that sells shares to individuals
and then invests the proceeds in bonds or stocks. Because it buys large blocks of
stocks or bonds, a mutual fund can take advantage of lower transaction costs.
These cost savings are then passed on to individual investors after the mutual
fund has taken its cut in the form of management fees for administering their
accounts. An additional benefit for individual investors is that a mutual fund is
large enough to purchase a widely diversified portfolio of securities. The
increased diversification for individual investors reduces their risk, making them
better off.
Economies of scale are also important in lowering the costs of resources that
financial institutions need to accomplish their tasks, such as computer
technology. Once a large mutual fund has invested a lot of money in setting up a
telecommunications system, for example, the system can be used for a huge
number of transactions at a low cost per transaction.
Expertis: Financial intermediaries are also better able to develop expertise
that can be used to lower transaction costs. Their expertise in computer
technology, for example, enables them to offer their customers convenient
services such as check-writing privileges on their accounts and toll-free numbers
that customers can call for information on how well their investments are doing.
Low transaction costs enable financial intermediaries to provide their
customers with liquidity services, which are services that make it easier for
customers to conduct transactions. Money market mutual funds, for example, not
only pay shareholders relatively high interest rates but also allow them to write
checks for convenient bill paying.

ASYMMETRIC INFORMATION: ADVERSE SELECTION AND MORAL

HAZARD
Asymmetric information-a situation that arises when one party’s insufficient
knowledge about the other party involved in a transaction makes it impossible for
the first party to make accurate decisions when conducting the transaction-is an
important aspect of financial markets. For example, managers of a corporation

101
know whether they are honest and usually have better information about how
well their business is doing than stockholders do. The presence of asymmetric
information leads to adverse selection and moral hazard problems.
Adverse selection is an asymmetric information problem that occurs before a
transaction occurs: Potential bad credit risks are the ones who most actively seek
out loans. Thus the parties who are most likely to produce an undesirable
outcome are also the ones most likely to want to engage in the transaction. For
example, big risk takers or outright crooks are often the most eager to take out a
loan because they know they are unlikely to pay it back. Because adverse
selection increases the chances that a loan might be made to a bad credit risk,
lenders might decide not to make any loans, even though good credit risks can be
found in the marketplace.
Moral hazard arises after the transaction occurs: The lender runs the risk that
the borrower will engage in activities that are undesirable from the lender’s point
of view, because such activities make it less likely that the loan will be paid back.
For example, once borrowers have obtained a loan, they may take on big risks
(which have possible high returns but also run a greater risk of default) because
they are playing with someone else’s money. Because moral hazard lowers the
probability that the loan will be repaid, lenders may decide that they would rather
not make a loan.
The analysis of how asymmetric information problems affect economic
behavior is called agency theory. We will apply this theory here to explain why
financial structure takes the form it does.

THE LEMONS PROBLEM: HOW ADVERSE SELECTION INFLUENCES

FINANCIAL STRUCTURE
A particular aspect of the way the adverse selection problem interferes with
the efficient functioning of a market was outlined in a famous article by Nobel
Prize winner George Akerlof. It is called the “lemons problem” because it
resembles the problem created by “lemons,” that is, bad cars, in the used-car
market. Potential buyers of used cars are frequently unable to assess the quality
of a car; that is, they can’t tell whether a particular used car is one that will run
well or a lemon that will continually give them grief. The price that a buyer pays
must therefore reflect the average quality of the cars in the market, somewhere
between the low value of a lemon and the high value of a good car.

102
 The owner of a used car, by contrast, is more likely to know whether the car
is a peach or a lemon. If the car is a lemon, the owner is more than happy to sell
it at the price the buyer is willing to pay, which, being somewhere between the
value of a lemon and that of a good car, is greater than the lemon’s value.
However, if the car is a peach, that is, a good car, the owner knows that the car is
undervalued at the price the buyer is willing to pay, and so the owner may not
want to sell it. As a result of this adverse selection problem, fewer good used cars
will come to the market. Because the average quality of a used car available in
the market will be low, and because very few people want to buy a lemon, there
will be few sales. The used-car market will function poorly, if at all.
Lemons in the Stock and Bond Markets
A similar lemons problem arises in securities markets-that is, the debt (bond)
and equity (stock) markets. Suppose that our friend Irving the Investor, a
potential buyer of securities such as common stock, can’t distinguish between
good firms with high expected profits and low risk and bad firms with low
expected profits and high risk. In this situation, Irving will be willing to pay only
a price that reflects the average quality of firms issuing securities-a price that lies
between the value of securities from bad firms and the value of those from good
firms. If the owners or managers of a good firm have better information than
Irving and know that they have a good firm, then they know that their securities
are undervalued and will not want to sell them to Irving at the price he is willing
to pay. The only firms willing to sell Irving securities will be bad firms (because
his price is higher than the securities are worth). Our friend Irving is not stupid;
he does not want to hold securities in bad firms, and hence he will decide not to
purchase securities in the market. In an outcome similar to that in the used-car
market, this securities market will not work very well because few firms will sell
securities in it to raise capital.
The analysis is similar if Irving considers purchasing a corporate debt
instrument in the bond market rather than an equity share. Irving will buy a bond
only if its interest rate is high enough to compensate him for the average default
risk of the good and bad firms trying to sell the debt. The knowledgeable owners
of a good firm realize that they will be paying a higher interest rate than they
should, so they are unlikely to want to borrow in this market. Only the bad firms
will be willing to borrow, and because investors like Irving are not eager to buy
bonds issued by bad firms, they will probably not buy any bonds at all. Few
bonds are likely to sell in this market, so it will not be a good source of financing.

103
 The analysis we have just conducted explains fact 2-why marketable securities
are not the primary source of financing for businesses in any country in the world.
It also partly explains fact 1-why stocks are not the most important source of
financing for American businesses. The presence of the lemons problem keeps
securities markets such as the stock and bond markets from being effective in
channeling funds from savers to borrowers.
Tools to Help Solve Adverse Selection Problems
In the absence of asymmetric information, the lemons problem goes away. If
buyers know as much about the quality of used cars as sellers, so that all
involved can tell a good car from a bad one, buyers will be willing to pay full
value for good used cars.
Because the owners of good used cars can now get a fair price, they will be
willing to sell them in the market. The market will have many transactions and
will perform its intended job of channeling good cars to people who want them.
Similarly, if purchasers of securities can distinguish good firms from bad,
they will pay the full value of securities issued by good firms, and good firms
will sell their securities in the market. The securities market will then be able to
move funds to the good firms that have the most productive investment
opportunities.
Private Production and Sale of Information: The solution to the adverse
selection problem in financial markets is to reduce asymmetric information by
furnishing the people supplying funds with more details about the individuals or
firms seeking to finance their investment activities. One way for saver-lenders to
get this information is through private companies that collect and produce
information distinguishing good firms from bad firms, and then sell it to the
saver-lenders. In the United States, companies such as Standard and Poor’s,
Moody’s, and Value Line gather information on firms’ balance sheet positions
and investment activities, publish these data, and sell them to subscribers
(individuals, libraries, and financial intermediaries involved in purchasing
securities).
The system of private production and sale of information does not completely
solve the adverse selection problem in securities markets, however, because of
the free-rider problem. The free-rider problem occurs when people who do not
pay for information take advantage of the information that other people have paid
for. The free-rider problem suggests that the private sale of information is only a

104
partial solution to the lemons problem. To see why, suppose you have just
purchased information that tells you which firms are good and which are bad.
You believe that this purchase is worthwhile because you can make up the cost
of acquiring this information, and then some, by purchasing the securities of
good firms that are undervalued. However, when our savvy (free-riding) investor
Irving sees you buying certain securities, he buys right along with you, even
though he has not paid for any information. If many other investors act as Irving
does, the increased demand for the undervalued good securities causes their low
price to be bid up immediately to reflect the securities’ true value. Because of all
these free riders, you can no longer buy the securities for less than their true
value. Now, because you will not gain any profit from purchasing the
information, you realize that you never should have paid for the information in
the first place. If other investors come to the same realization, private firms and
individuals may not be able to sell enough of this information to make it worth
their while to gather and produce it. The weakened ability of private firms to
profit from selling information will mean that less information is produced in the
marketplace, so adverse selection (the lemons problem) will still interfere with
the efficient functioning of securities markets.
Government Regulation to Increase Information: The free-rider problem
prevents the private market from producing enough information to eliminate all the
asymmetric information that leads to adverse selection. Could financial markets
benefit from government intervention? The government could, for instance,
produce information to help investors distinguish good from bad firms and provide
it to the public free of charge. This solution, however, would involve the
government releasing negative information about firms, a practice that might be
politically difficult. A second possibility (and one followed by the United States
and most governments throughout the world) is for the government to regulate
securities markets in a way that encourages firms to reveal honest information
about themselves so that investors can determine how good or bad the firms are. In
the United States, the Securities and Exchange Commission (SEC) is the
government agency that requires firms selling their securities to undergo
independent audits, in which accounting firms certify that the firm is adhering to
standard accounting principles and disclosing accurate information about sales,
assets, and earnings. Similar regulations are found in other countries. However,
disclosure requirements do not always work well, as the collapse of Enron and
accounting scandals at other corporations, such as WorldCom and Parmalat (an
Italian company), suggest (see the FYI box, “The Enron Implosion”).

105
 The asymmetric information problem of adverse selection in financial
markets helps explain why financial markets are among the most heavily
regulated sectors of the economy (fact 5). Government regulation aimed at
increasing the information available to investors is necessary to reduce the
adverse selection problem, which interferes with the efficient functioning of
securities (stock and bond) markets.
Although government regulation lessens the adverse selection problem, it does
not eliminate it entirely. Even when firms provide information to the public about
their sales, assets, or earnings, they still have more information than investors: A
lot more is involved in knowing the quality of a firm than statistics alone can
provide. Furthermore, bad firms have an incentive to make themselves look like
good firms because this enables them to fetch a higher price for their securities.
Bad firms will slant the information they are required to transmit to the public, thus
making it harder for investors to sort out the good firms from the bad.
Financial Intermediation: So far we have seen that private production of
information and government regulation to encourage provision of information
lessen, but do not eliminate, the adverse selection problem in financial markets.
How, then, can the financial structure help promote the flow of funds to people
with productive investment opportunities when asymmetric information exists?
A clue is provided by the structure of the used-car market.
An important feature of the used-car market is that most used cars are not
sold directly by one individual to another. An individual who considers buying a
used car might pay for privately produced information by subscribing to a
magazine like Consumer Reports to find out if a particular make of car has a
good repair record. Nevertheless, reading Consumer Reports does not solve the
adverse selection problem, because even if a particular make of car has a good
reputation, the specific car someone is trying to sell could be a lemon. The
prospective buyer might also bring the used car to a mechanic for a once-over.
But what if the prospective buyer doesn’t know a mechanic who can be trusted or
the mechanic charges a high fee to evaluate the car?
Because these roadblocks make it hard for individuals to acquire enough
information about used cars, most used cars are not sold directly by one
individual to another. Instead, they are sold by an intermediary, a used-car dealer
who purchases used cars from individuals and resells them to other individuals.
Used-car dealers produce information in the market by becoming experts in
determining whether a car is a peach or a lemon. Once a dealer knows that a car

106
is good, the dealer can sell it with some form of a guarantee: either an explicit
guarantee such as a warranty or an implicit guarantee in which the dealer stands
by its reputation for honesty. People are more likely to purchase a used car
because of a dealer’s guarantee, and the dealer is able to sell the used car at a
higher price than the dealer paid for it. Thus the dealer profits from the
production of information about automobile quality. If dealers purchase and then
resell cars on which they have produced information, they avoid the problem of
other people free-riding on the information they produced.
Just as used-car dealers help solve adverse selection problems in the
automobile market, financial intermediaries play a similar role in financial
markets. A financial intermediary, such as a bank, becomes an expert in
producing information about firms so that it can sort out good credit risks from
bad ones. It then can acquire funds from depositors and lend them to the good
firms. Because the bank is able to lend mostly to good firms, it is able to earn a
higher return on its loans than the interest it has to pay to its depositors. The
resulting profit that the bank earns gives it the incentive to engage in this
information production activity.
An important element of the bank’s ability to profit from the information it
produces is that it avoids the free-rider problem by primarily making private
loans, rather than by purchasing securities that are traded in the open market.
Because a private loan is not traded, other investors cannot watch what the bank
is doing and bid down the loan’s interest rate to the point that the bank receives
no compensation for the information it has produced. The bank’s role as an
intermediary that holds mostly nontraded loans is the key to its success in
reducing asymmetric information in financial markets.
Our analysis of adverse selection indicates that financial intermediaries in
general-and banks in particular, because they hold a large fraction of nontraded
loans-should play a greater role in moving funds to corporations than securities
markets do. Our analysis thus explains facts 3 and 4: why indirect finance is so
much more important than direct finance and why banks are the most important
source of external funds for financing businesses.
Our analysis also explains the greater importance of banks, as opposed to
securities markets, in the financial systems of developing countries. As we have
seen, better information about the quality of firms lessens asymmetric
information problems, making it easier for firms to issue securities. Information
about private firms is harder to collect in developing countries than in
industrialized countries; therefore, the smaller role played by securities markets

107
leads to a greater role for financial intermediaries such as banks. As a corollary to
our analysis, as information about firms becomes easier to acquire, the role of
banks should decline. A major development in the past 30 years in the United
States has been huge improvements in information technology. Thus our analysis
suggests that the lending role of financial institutions such as banks in the United
States should have declined.
Our analysis of adverse selection also explains fact 6, which questions why
large firms are more likely to obtain funds from securities markets, a direct route,
rather than from banks and financial intermediaries, an indirect route. The better
known a corporation is, the more information about its activities is available in
the marketplace. Thus it is easier for investors to evaluate the quality of the
corporation and determine whether it is a good firm or a bad one. Because
investors have fewer worries about adverse selection when dealing with well-
known corporations, they are more willing to invest directly in their securities.
Thus, in accordance with adverse selection, a pecking order for firms that can
issue securities should exist. Hence we have an explanation for fact 6: The larger
and more established a corporation is, the more likely it will be to issue securities
to raise funds.
Collateral and Net Worth: Adverse selection interferes with the functioning
of financial markets only if a lender suffers a loss when a borrower is unable to
make loan payments and thereby defaults on the loan. Collateral, property
promised to the lender if the borrower defaults, reduces the consequences of
adverse selection because it reduces the lender’s losses in the event of a default.
If a borrower defaults on a loan, the lender can sell the collateral and use the
proceeds to make up for the losses on the loan. For example, if you fail to make
your mortgage payments, the lender can take the title to your house, auction it
off, and use the receipts to pay off the loan. Lenders are thus more willing to
make loans secured by collateral, and borrowers are willing to supply collateral
because the reduced risk for the lender makes it more likely that the loan will be
made, perhaps even at a better loan rate. The presence of adverse selection in
credit markets thus explains why collateral is an important feature of debt
contracts (fact 7).
Net worth (also called equity capital), the difference between a firm’s assets
(what it owns or is owed) and its liabilities (what it owes), can perform a similar
role to that of collateral. If a firm has a high net worth, then even if it engages in
investments that lead to negative profits and so defaults on its debt payments, the
lender can take title to the firm’s net worth, sell it off, and use the proceeds to

108
recoup some of the losses from the loan. In addition, the more net worth a firm
has in the first place, the less likely it is to default, because the firm has a cushion
of assets that it can use to pay off its loans. Hence, when firms seeking credit
have high net worth, the consequences of adverse selection are less important and
lenders are more willing to make loans. This concept lies behind the often-heard
lament, “Only the people who don’t need money can borrow it!”
Reading comprehension
Exercise 1: Answer the following questions
1. Summarise the text ( about 150 words)
………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………..….……
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

2. How can economies of scale help explain the existence of financial

intermediaries?
……………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
……..….……………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………

3. What are the problems of asymmetric information?

……………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………

109
 ………………………………………………………………………………………………………………………
……..….……………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
4. Does adverse selection influence the functioning of financial markets?
……………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
……..….……………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
5. That are the tools to reduce the adverse selection problem?
…………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………..….…………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
Exercise 2:
Choose the best answer
1. The largest source of EXTERNAL FINANCE for U.S. businesses is.
A. stocks
B. bonds
C. bank and nonbank loans
D. venture capital firms
E. retained earnings

110
2. The TRANSACTIONS COSTS associated with a loan contract refer to
A. the principal plus interest payments of the borrower under the loan
contract.
B. the costs of bringing together borrowers and lenders and preparing the
loan contract.
C. the costs of reducing asymmetric information problems associated with
the loan contract.
D. all of the above.

3. The following tools help solve ADVERSE SELECTION PROBLEMS in

financial markets:
A. private production and sale of credit ratings for individuals and firms
B. government regulation to increase information to investors
C. use of financial intermediaries that specialize in the gathering of
information about would-be borrowers
D. inclusion of collateral requirements in loan contracts as a quality signal
E. all of the above

4. Which of the following is NOT a tool used by corporations to reduce

PRINCIPAL AGENT PROBLEMS.
A. Stockholders engage in costly state verification by auditing an
observing management.
B. Venture capital firms provide funds to new firms in exchange for
equity and membership on the board of directors.
C. Firms issue equity instead of debt because principal-agent problems are
smaller with equity.
D. Governments regulate firms by imposing standard accounting
principles and punishing fraud.

Exercise 3:
Word search
Find a word or phrase in the text that has a similar meaning.

111
 1. a type of moral hazard problem, arise when a person or institution has
multiple objectives (interests), some of which conflict with each other
…………………..
conflicts of interest

2. the problem created by asymmetric information after the transaction occurs

…………………..
moral hazard

3. the problem created by asymmetric information before the transaction

occurs
…………………..
adverse selection

4. annual income payments upon retirement

…………………..
annuities

5. a short-term debt instrument issued by large banks and well-known

corporations
…………………..
6. the primary route for moving funds from lenders to borrowers
…………………..
financial intermediation

7. the time and money spent in carrying out financial transactions

…………………..
transaction costs

8. uncertainty about the returns investors will earn on assets

…………………..
risk

9. This process of risk sharing

…………………..
asset transformation .

10. financial intermediaries that accept deposits from individuals and

institutions and make loans
…………………..
depository institutions

E. EXTENSION ACTIVITIES
1. In your own words, provide a brief but careful summarization of the key
ideas of Nobel prize winner George Akerlof on the “lemons problem” as set out
at the following web reference:
www.nobel.se/economics/laureates/2001/public.html

112
 …………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
2. In your own words, provide a brief but careful summarization of the
importance of the “lemons problem” for the efficient functioning of financial
markets.
.………………………………………………………………………………
…………….…………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………….…..

Review
A healthy and vibrant economy requires a financial system that moves funds
from people who save to people who have productive investment opportunities.
But how does the financial system make sure that your hard-earned savings get
channeled to Paula the Productive Investor rather than to Benny the Bum?
The reading passage answers that question by providing an economic
analysis of how our financial structure is designed to promote economic
efficiency. The analysis focuses on a few simple but powerful economic concepts
that enable us to explain features of our financial system, such as why financial
contracts are written as they are and why financial intermediaries are more
important than securities markets for getting funds to borrowers. The analysis
also demonstrates the important link between the financial system and the
performance of the aggregate economy.

113
 ESSAY WRITING

Wealthy people often worry that others will seek to marry them only for their
money. Is this a problem of adverse selection?
Support your view by your own knowledge and experience.
Write at least 300 words.

114
 Reverse takeover Reverse merger
A situation in which a smaller company buys A small company try to acquire the larger one
a bigger one -> save time to go public (buy entity)

Horizontal merger: an occasion when one company combines with another that makes similar products or provide a similar service ->
purpose: reduce competition, increase market share
Vertical merger -> reduce costs Unit 8
MERGERS AND ACQUISITIONS
Conglomerate merger: diversify one company’s portfolio

How do you make money? Spin-offs, split-ups, liquidations, mergers and

acquisitions. - Mario Gabelli (1942), American businessman.

A. TERMS, THEORIES AND DEFINITIONS

Mergers and acquisitions (abbreviated M&As) refers to the aspect of
corporate strategy, corporate finance and management dealing with the buying,
selling, dividing and combining of different companies and similar entities that
can aid, finance, or help an enterprise grow rapidly in its sector or location of
origin or a new field or new location without creating a subsidiary, other child
entity or using a joint venture. The distinction between a "merger" and an
"acquisition" has become increasingly blurred in various aspects (particularly in
terms of the ultimate economic outcome), although it has not completely
disappeared in all situations.
A merger refers to the absorption of one firm by another. The acquiring firm
retains its name and identity, and it acquires all of the assets and liabilities of the
acquired firm. After a merger, the acquired firm ceases to exist as a separate
business entity.
An acquisition is the purchase of one business or company by another
company or other business entity. Consolidation occurs when two companies
combine together to form a new enterprise altogether, and neither of the previous
companies survives independently. Acquisitions are divided into "private" and
"public" acquisitions, depending on whether the acquiree or merging company
(also termed a target) is or is not listed on public stock markets. An additional
dimension or categorization consists of whether an acquisition is friendly or
hostile.
Achieving acquisition success has proven to be very difficult, while various
studies have shown that 50% of acquisitions were unsuccessful.The acquisition
process is very complex, with many dimensions influencing its outcome.
LPO: leverage buyout: one way of the acquisition
of another company (finance,…)
115
 Whether a purchase is perceived as being a "friendly" one or a "hostile"
depends significantly on how the proposed acquisition is communicated to and
perceived by the target company's board of directors, employees and
shareholders. It is normal for M&A deal communications to take place in a so-
called 'confidentiality bubble' wherein the flow of information is restricted
pursuant to confidentiality agreements. In the case of a friendly transaction, the
companies cooperate in negotiations; in the case of a hostile deal, the board
and/or management of the target is unwilling to be bought or the target's board
has no prior knowledge of the offer. Hostile acquisitions can, and often do,
ultimately become "friendly", as the acquiror secures endorsement of the
transaction from the board of the acquiree company. This usually requires an
improvement in the terms of the offer and/or through negotiation.
"Acquisition" usually refers to a purchase of a smaller firm by a larger one.
Sometimes, however, a smaller firm will acquire management control of a larger
and/or longer-established company and retain the name of the latter for the post-
acquisition combined entity. This is known as a reverse takeover. Another type
of acquisition is the reverse merger, a form of transaction that enables a private
company to be publicly listed in a relatively short time frame. A reverse merger
occurs when a privately held company (often one that has strong prospects and is
eager to raise financing) buys a publicly listed shell company, usually one with
no business and limited assets.
Mergers vs. Acquisitions
Although often used synonymously, the terms merger and acquisition mean
slightly different things. When one company takes over another and clearly
establishes itself as the new owner, the purchase is called an acquisition. From a
legal point of view, the target company ceases to exist, the buyer "swallows" the
business and the buyer's stock continues to be traded.
In the pure sense of the term, a merger happens when two firms agree to go
forward as a single new company rather than remain separately owned and
operated. This kind of action is more precisely referred to as a "merger of
equals". The firms are often of about the same size. Both companies' stocks are
surrendered and new company stock is issued in its place. For example, in the
1999 merger of Glaxo Wellcome and SmithKline Beecham, both firms ceased to
exist when they merged, and a new company, GlaxoSmithKline, was created.
In practice, however, actual mergers of equals don't happen very often.
Usually, one company will buy another and, as part of the deal's terms, simply

116
allow the acquired firm to proclaim that the action is a merger of equals, even if
it is technically an acquisition. Being bought out often carries negative
connotations; therefore, by describing the deal euphemistically as a merger, deal
makers and top managers try to make the takeover more palatable. An example
of this would be the takeover of Chrysler by Daimler-Benz in 1999 which was
widely referred to as a merger at the time.
A purchase deal will also be called a merger when both CEOs agree that
joining together is in the best interest of both of their companies. But when the
deal is unfriendly (that is, when the target company does not want to be
purchased) it is always regarded as an acquisition.
Takeover is a general and imprecise term referring to the transfer of control
of a firm from one group of shareholders to another. A firm that has decided to
take over another firm is usually referred to as the bidder. The bidder offers to
pay cash or securities to obtain the stock or assets of another company. If the
offer is accepted, the target firm will give up control over its stock or assets to the
bidder in exchange for consideration (i.e., its stock, its debt, or cash). Takeovers
can occur by acquisitions, proxy contests, and going-private transactions.
Terms and definitions:
i. To merge: to unite, combine, amalgamate, integrate or join together.
ii. To acquire: to buy, to gain to get, to receive, to take possession of
something; to take over a company by buying its shares; to make an
acquisition.
iii. A raid means buying another company’s shares on the stock exchange,
hoping to persuade enough other shareholders to sell to take control of the
company.
iv. A takeover bid is a public offer to a company’s shareholders to buy their
shares, at a particular price during a particular period, so as to acquire a
company. (to make a takeover bid vs. to withdraw a takeover bid)
v. Horizontal integration is to merge with or take over other firms producing
the same type of goods or services.
vi. Vertical integration means joining with firms in other stages of the
production or sale of a product.
vii. Backward integration is a merger with or the acquisition of one’s
suppliers.

117
 viii. Forward integration is a merger with or the acquisition of one’s
marketing outlets.
ix. Synergy means combined production that is greater than the sum of the
separate parts.
x. Acquisition accounting means a full consolidation, where the assets of a
subsidiary company which has been purchased are included in the parent
company’s balance sheet, and the premium paid for the goodwill is written
off against the year’s earnings.

B. VOCABULARY EXERCISES
Exercise 1: Complete the texts with the words in the boxes.

diversifying optimizing rationalizing

reducing reinforcing searching

Sooner or later, all companies need to introduce new products and services.
Large companies often have the choice of innovating – developing new products,
services or markets themselves – or of buying another, smaller company with
successful products. If the other company is too big to acquire, another
possibility is to merge or amalgamate with it. Other reasons for taking over or
combining with other companies include:
(1) ……………………..
Reinforcing your company’s position;
(2) ……………………..
Reducing competition;
(3) ……………………..
Rationalizing production;
(4) …………………….
Optimizing the use of a plant or invested capital;
(5) …………………….
Diversifying products or markets; and
(6) …………………….
Searching for synergy (the belief that together the companies
will produce more than the sum of the two separate parts).

buy grow increase launch persuade sell

A company that wants to (7) ………………..

grow or diversify can (8)
…………………
launch a raid - in other words, simply (9) ………………
buy a large

118
quantity of another company’s shares on the stock exchange. A “dawn raid”
consists of buying shares through several brokers early in the morning, before the
market has time to notice the rising price, and before speculators join in. This
will immediately (10) ……………….
increase the share price, and may (11)
………………
persuade a sufficient number of other shareholders to (12)
……………………. for the raider to take control of the company.
sell

Exercise 2. Choose the best word to go into the space.

1. Berlin Brothers bought a __________ shareholding in Anderson
Accounting. Majority shareholder: a person or entity that owns and
controls more than 50% of a company’s outstanding
a. more-than-half b. biggest shares c. majority
2. In the UK, mergers and acquisitions are not __________ by the
government.
a. controlled b. checked c. regulated
3. However, they are subject to a voluntary __________.
a. code of conduct b. code of practice c. way of doing things
4. Buying a company for less than the value of its assets, then selling those
assets to make a profit is called__________.
a. asset stripping b. profiteering c. exploitation
5. Sometimes a controlling interest in a company is bought by its managers.
This is called a management__________.
a. buy-out b. buy-up c. buy-in
6. In the past, a lot of small banks were __________ by larger ones.
a. bought up b. eaten up c. chewed up
7. In other words, there was __________ in the banking industry.
a. amalgamation b. combining c. consolidation
8. A takeover of a foreign company is known as a __________ deal.
a. cross-boundary b. cross-border c. cross-state
Exercise 3. Choose the best word from each pair in bold type.
1. Anderson Accounting has been taken over / taken up by Berlin Brothers.
2. Collins Corporation has made a bid / play for Dacher Deutsche

119
 3. The board of Dacher Deutsche rejected / denied Collins Corporation's
offer.
4. Eastern Electricity has joined / merged with Grampian Gas
5. Inter-tek has been sold by its father / parent company, Harrison Holdings.
6. Inter-tek has been acquired / got by Johnson & Johnson
7. Harrison Holdings is expected to sell more of its subsidiaries/children in
the future.

C. READING
Reading 1: Read the article below and decide if the author is generally
optimistic or pessimistic about future strategic alliances.

Spring in their steps. Some notes for company bosses out on the prowl.
(Adapted from The Economist. February, 2004.)
1. After a long hibernation, company bosses are beginning to rediscover their
animal spirits. The $145 billion-worth of global mergers and acquisitions
announced last month was the highest for any month in over three years.
There are now lots of chief executives thinking about what target they
might attack in order to add growth and value to their companies and glory
to themselves. Although they slowed down for a while because of the dot-
com boom, they are once again on the prowl.
2. What should CEOs do to improve their chances of success in the coming
rush to buy? First of all, they should not worry too much about widely-
quoted statistics suggesting that as many as three out of every four deals
have failed to create shareholder value for the acquiring company. The
figures are heavily influenced by the time period chosen and in any case
one out of four is not bad when compared with the chances of getting a
new business started. So, they should keep looking for good targets.
3. There was a time when top executives considered any type of business to
be a good target. But in the 1990s the idea of the conglomerate, the
holding company with a diverse portfolio of businesses, went out of
fashion as some of its most prominent protagonists - CBS and Hanson
Trust, for example -- faltered. Companies had found by then that they
could add more value by concentrating on their 'core competence',

120
 although one of the most successful companies of that decade, General
Electric, was little more than an old-style conglomerate with a particularly
fast-changing portfolio.
4. Brian Roberts, the man who built Comcast into a giant cable company, was
always known for concentrating on his core product -- until his
recent bid for Disney, that is. It is not yet clear whether his bid is an
opportunistic attempt to acquire and break up an undervalued firm, or
whether he is chasing the media industry's dream of combining
entertainment content with distribution, a strategy which has made
fortunes for a few but which regularly proves the ruin of many big media
takeovers.
5. If vertical integration is Comcast's aim, then it will be imperative for Mr.
Roberts to have a clear plan of how to achieve that. For in the end, CEOs
will be judged less for spotting a good target than for digesting it well, a
much more difficult task. The assumption will be that, if they are paying a
lot of money for a business, they know exactly what they want to do with
it.
6. If CEOs wish to avoid some of the failures of the 1990s, they should not
forget that they are subject to the eternal tendency of business planners to
be over-confident. It is a near certainty that, if asked, almost 99 per cent of
them would describe themselves as 'above average' at making mergers and
acquisitions work. Sad as it may be, that can never be true.
7. They should also be aware that they will be powerfully influenced by the
herd instinct, the feeling that it is better to be wrong in large numbers than
to be right alone. In the coming months they will have to watch carefully
to be sure that the competitive space into which the predator in front of
them is so joyfully leaping does not lie at the edge of a cliff.

READING COMPREHENSION EXERCISES

Exercise 1. Read the article again. Are these statements true or false?
1. In the first paragraph, the author says that CEOs can no longer find targets
for mergers and acquisitions. False
2. Studying facts and figures from the recent past won't necessarily help
CEOs to form a successful alliance. True

121
 3. The trend in the 1990s was for companies to build portfolios with diverse
investments. False
4. The author suggests that media mergers are always likely to improve share
value. False
5. CEOs need above all to find the right company to acquire. true

6. If business planners wish to avoid some of the errors of the 1990s, they
should be prudent when taking risks. true

Exercise 2. Vocabulary Practice:

Find the words in italics in the text and match them with their meaning
below.
_______________ A collection of companies.
_______________ An offer to buy.
_______________ Most important activity.
_______________ Controlling all stages of one particular type of business.
_______________ Organization comprising several companies.
_______________ What stocks in a public company are worth.
Reading 2:

Successful companies generally want to diversify; to introduce new

products or services and enter new markets. Yet entering new markets with
new brands is usually a slow, expensive and risky process, so buying
another company with existing products and customers is often cheaper and
safer. If a company is too big to acquire, another possibility is to merge
A
with it, forming a new company out of the two old ones. Apart from
diversifying, reasons for acquiring companies include getting stronger
position in a market and a larger market share, reducing competition,
benefiting from economies of scale, and making better use of plant and
equipment.
There are two ways to acquire a company: a raid or a takeover bid. A raid
simply involves buying as many of a company’s stocks as possible on the
B
stock market. Of course, if there is more demand for stock than there are
sellers, this increases the stock price. A takeover bid is a public offer to a

122
 company’s stockholders to buy their stocks at a certain price (higher than
the current market price) during a limited period of time. This can be much
more expensive than a raid, because if all the stockholders accept the bid,
the buyer has to purchase 100% of the company’s stocks, even though they
only need 50% plus one to gain control of a company. (In fact, they often
need much less, many stockholders do not vote at stockholders’ meetings.)
If stockholders accept a bid, but receive stocks in the other company instead
of cash, it is not always clear if the operation is a takeover or a merger –
journalists sometimes use both terms.
Companies are sometimes encouraged to take over other ones by
investment banks, if researchers in their Mergers and Acquisitions
C
departments consider that the target companies are undervalued. Banks can
earn high fees for advising on takeovers.
Yet there are also a number of good arguments against takeovers.
Diversification can damage a company’s image, goodwill and shared values
(e.g. quality, good service, innovation). After a hostile takeover (where the
managers of a company do not want it to be taken over), the top executives
of the newly acquired company are often replaced or choose to leave. This
D is a problem if what made the company special was its staff (or ‘human
capital’) rather than its products and customer base. Furthermore, a
company’s optimum size or market share can be quite small, and large
conglomerates can become unmanageable and inefficient. Takeovers do not
always result in synergy. In fact, statistics show that most mergers and
acquisitions reduce rather than increase the company’s value.
Consequently, corporate raider and private equity companies look for large
conglomerates (formed by a series of takeovers) which have become
inefficient, and so are undervalued. In other words, their market
capitalization (the price of all their stocks) is less than the value of their
total assets, including land, buildings and – unfortunately – pension funds.
Raiders can borrow money, usually by issuing bonds and buy the
E
companies. They then split them up or sell off the assets, and then pay back
the bonds while making a large profit. Until the law was changed, they
were also able to appropriate the pension funds. This is known as asset-
stripping, and such takeovers are called leveraged buyouts or LBOs. If a
company’s own managers buy its stocks, this is a management buyout or
MBO.

123
 READING COMPREHENSION EXERCISES
Exercise 1. Read the text and match the titles (1- 5) to the paragraphs
(A-E).
1 Disadvantages of takeovers
2 Raiders and assets-stripping
3 Raids and bids
4 The ‘make-or-buy’ decision
5 The role of banks

Exercise 2. Find words or phrases in the text that mean the following:

1 Adding new and different products or services

A company’s sales expressed as a percentage of the total
2
sales in a market
3 Reductions in costs resulting from increased production
4 Money paid to investment banks for work done
All the individuals or organizations that regularly or
5
occasionally purchase goods or services from a company
6 Best, perfect or ideal (adjective)
Combined production or productivity that is greater than the
7
sum of the separate parts
People or companies that try to buy and sell other companies
8
to make a profit
Large corporations or groups of companies offering a number
9
of different products or services
Buying a company in order to sell its most valuable assets at
10
a profit

Reading 3: Leveraged Buyouts

One indication that the people who warn against takeovers might be right is
the existence of leveraged buyouts.

124
 In the 1960s, a big wave of takeovers in the US created conglomerates –
collections of unrelated businesses combined into a single corporate structure. It
later became clear that many of these conglomerates consisted of too many
companies and not enough synergy. After the recession of the early 1980s, there
were many large companies on the US stock market with good earnings but low
stock prices. Their assets were worth more than the companies’ market value.
Such conglomerates were clearly not maximizing stockholder value. The
individual companies might have been more efficient if liberated from central
management. Consequently, raiders were able to borrow money, buy badly-
managed, inefficient and underpriced corporations, and then restructure them,
split them up, and resell them at a profit.
Conventional financial theory argues that stock markets are efficient,
meaning that all relevant information about companies is built into their share
prices. Raiders in the 1980s discovered that this was quite simply untrue.
Although the market could understand data concerning companies’ earnings, it
was highly inefficient in valuing assets, including land, buildings and pension
funds. Asset-stripping – selling off the assets of poorly performing or under –
valued companies – proved to be highly lucrative.
Theoretically, there was little risk of making a loss with a buyout, as the
debts incurred were guaranteed by the companies’ assets. The ideal targets for
such buyouts were companies with huge cash reserves that enabled the buyer to
pay the interest on the debt, or companies with successful subsidiaries that could
be sold to repay the principal, or companies in fields that are not sensitive to a
recession, such as food and tobacco.
Takeovers using borrowed money are called ‘leveraged buyouts’ or ‘LBOs’.
Leverage means having a large proportion of debt compared to equity capital.
(Where a company is bought by its existing managers, we talk of a management
buyout or MBO). Much of the money for LBOs was provided by the American
investment bank Drexel Burnham Lambert, where Michael Milken was able to
convince investors that the high returns on debt issued by risky enterprises
more than compensated for their riskiness, as the rate of default was lower than
might be expected. He created a huge and liquid market of up to 300 billion
dollars for ‘junk bonds’. (Milken was later arrested and charged with 98
different felonies, including a lot of insider dealing, and Drexel Burnham
Lambert went bankrupt in 1990).

125
Bear raid Dawn raid

Raiders and their supporters argue that the permanent threat of takeovers is a
challenge to company managers and directors to do their jobs better, and that
well-run businesses that are not undervalued are at little risk. The threat of raids
forces companies to put capital to productive use. Fat or lazy companies that fail
to do this will be taken over by raiders who will use assets more efficiently, cut
costs, and increase shareholder value.

READING COMPREHENSION EXERCISES

Exercise 1: Underline the arguments in favour of leveraged buyouts.
Exercise 2: Complete the following sentences, which summarize the text
above.
1. The fact that many large conglomerates’ assets were worth more than their
stock market valuation demonstrated that …………
2. Raiders bought conglomerates in order to ………..
3. Raiders showed that the stock market did not ………….
4. Raiders were particularly interested in ……………
5. Investors were prepared to lend money to finance LBOs because …………
6. Raiders argue that the possibility of a buyout ……………

D. ESSAY WRITING

Some people say that engaging in mergers and acquisitions does not always
bring about the results as being expected or wished for by acquirers. Do you
agree or disagree with this statement?
Give reasons for your answer and include any relevant examples from your
own knowledge and experience.
Write at least 300 words.

Prefer IPO or LPO?

126
1. many conglomerates consisted of too many companies and not enough synergy
2. strip them of their assets
3. working efficiently in valuing assets, including land,
 Unit 9
BANKING

A. TERMS, THEORIES AND DEFINITIONS

Banks: Banks are financial institutions that accept deposits and make loans.
The term banks includes firms such as commercial banks, savings and loan
associations, mutual savings banks, and credit unions. Banks are the financial
intermediaries that the average person interacts with most frequently. A person
who needs a loan to buy a house or a car usually obtains it from a local bank.
Most people keep a large portion of their financial wealth in banks in the form of
checking accounts, savings accounts, or other types of bank deposits.
Banking: The business activity of accepting and safeguarding money owned
by other individuals and entities, and then lending out this money in order to earn
a profit.
Commercial Bank: A commercial bank is a type of financial intermediary
and a type of bank. It is a bank that provides checking accounts, savings
accounts, and money market accounts and that accepts time deposits. It raises
funds by collecting deposits from businesses and consumers via checkable
deposits, savings deposits, and time (or term) deposits. It makes loans to
businesses and consumers. It also buys corporate bonds and government bonds.
Its primary liabilities are deposits and primary assets are loans and bonds.
Investment Bank: An Investment Bank is a financial institution that deals
with raising capital, trading in securities and managing corporate mergers and
acquisitions.
Merchant bank: In banking, a merchant bank is a financial institution
primarily engaged in offering financial services and advice to corporations and
wealthy individuals on how to use their money.
Universal Bank: A universal bank participates in many kinds of banking
activities and is both a Commercial bank and an Investment bank. Combine the function of investment
bank and commercial bank
Building society: A building society is a financial institution, owned by its
members, that offers banking and other financial services, especially mortgage
lending.

127
 Finance house: The Finance House provides customers with the ability to
source Mortgages, Insurance and much more.
Supranational bank: A supranational entity is formed by two or more
central governments to promote economic development for the member
countries. Supranational Institutions finance their activities by issuing bond debt
and are usually considered part of the sub-sovereign debt market. Some well-
known examples of supranational institutions are the World Bank, European
Bank for Reconstruction and Development; European Investment Bank; Asian
Development Bank, Inter-American Development Bank.
A demand deposit account, or checking account, is offered to customers
who desire to write checks against their account.
A savings account is the passbook savings account, which does not permit
check writing. Passbook savings accounts continue to attract savers with a small
amount of funds, as such accounts often have no required minimum balance.
Time deposits are deposits that cannot be withdrawn until a specified
maturity date.
The two most common types of time deposits are certificates of deposit
(CDs) and negotiable certificates of deposit.
Money market deposit accounts (MMDAs) differ from conventional time
deposits in that they do not specify a maturity. From the depositor’s point of
view, MMDAs are more liquid than retail CDs but offer a lower interest rate.
A central bank, reserve bank, or monetary authority is the entity responsible
for the monetary policy of a country or of a group of member states. It is a bank
that can lend money to other banks in times of need. It is the Government's
banker and the bankers' bank ("lender of last resort").
Market risk is the change in net asset value due to changes in underlying
economic factors, such as interest rates, exchange rates, and equity and
commodity prices.
Credit risk is the change in net asset value due to changes in the perceived or
actual ability of counter-parties to meet their contractual obligations.
Operational risk results from costs incurred through mistakes made in
carrying out transactions such as settlement failures, failures to meet regulatory
requirements, and untimely collections.

128
 Performance risk encompasses losses resulting from the failure to properly
monitor employees or to use appropriate methods (including model risk).

B. VOCABULARY EXERCISES
Exercise 1: Match up the terms with the definitions:
cash card cash dispenser or ATM credit card home banking
loan mortgage overdraft standing order
direct debit/current account or checking account deposit account or time or
notice account
1. an arrangement by which a customer can withdraw more from a bank
account than has been deposited in it, up to an agreed limit; interest on the
debt is calculated daily overdraft
2. a card which guarantees payment for goods and services purchased by the
cardholder, who pays back the bank or finance company at a later date
credit card
3. a computerized machine that allows bank customers to withdraw money,
check their balance and so on ATM
4. a fixed sum of money on which interest is paid, lent for a fixed period, and
usually for a specific purpose loan
5. an instruction to a bank to pay fixed sums of money to certain people or
organization at stated times standing order
6. a loan, usually to buy property, which serves as a security for the loan Mortgage
7. a plastic card issued to bank customers for use in cash dispensers cash card
8. doing banking transactions by telephone or from one’s own personal
computer Home banking
9. one that generally pays little or no interest, but allows the holder to
withdraw his or her cash without any restrictions Direct debit
10.one that pays interest, but usually cannot be used for paying cheques or
checks, and on which notice is often required to withdraw money notice account
Write your answer here:

1. 2. 3. 4. 5.
6. 7. 8. 9. 10.

129
 Exercise 2: Match the words with the correct definitions:
1. dispenser A. the remaining amount of money in an account
2. teller B. money paid into a bank
3. cashier C. a record of the financial transactions of a person or business
4. withdrawal D. an amount of money in an account
5. balance E. note to a bank asking it to pay money from your account to a
named person or business
6. deposit F. money in the form of bank notes and coins
7. cheque G. an amount of money deducted from an account
8. credit H. the removal of money from an account
9. debit I. a machine or person who count out money
10. cash J. a container designed to give out money in regulated amounts
11. statement K. a clerk who pays out and receive cash at a bank
Write your answer here:

1. J 2. K 3. I 4. H 5. A
6. B 7. E 8. G 9. D 10. F

Exercise 3: Match the verbs with the correct explanations:

Write your answer here:

1. H 2. G 3. B 4. A
5. F 6. C 7. D 8. E

1. honour A. pass the cheque through the clearing system

2. present B. write a cheque
3. draw C. make two accounts agree
4. clear D. change an account
5. cross E. move around the country
6. reconcile F. draw two lines down the middle of a cheque
7. adjust G. show and ask for payment
8. circulate H. pay

130
 C. READING
Read the text below and write short headings for each paragraph:
Types of Bank
1............................................
Commercial banks

Banks are businesses that trade in money. They receive and hold deposits,
pay money according to customer’s instructions, lend money, offer investment
advice, exchange foreign currencies, and so on. They make a profit from the
difference (known as a spread or a margin) between the interest rates they pay to
lenders or depositors and those they charge to borrowers. Banks also create
credit, because the money they lend, from their deposits, is generally spent
(either on goods or services, or to settle debts), and in this way transferred to
another bank account – often by way of a bank transfer or a cheque (check)
rather than the use of notes and coins - from where it can be lent to another
borrower, and so on. When lending money, bankers have to find a balance
between yield and risk, and between liquidity and different maturities.
2.............................................
Investment banks

Banks raise funds for industry on the various financial markets, finance
international trade, issue and underwrite securities, deal with takeover and
mergers, and issue government bonds. They also generally offer stock broking
and portfolio management services to rich corporate and individual client.
Investment banks make their profits from the fees and commissions they charge
for their services.
3...............................................
Universal banks

In some European countries (notably Germany, Switzerland and Austria)

there have always been banks combining deposit and loan banking with share
and bond dealing and investment services, but for much of the 20th century,
American legislation enforced a strict separation between commercial and
investment banks. The Glass-Steagall Act, passed during the Depression in 1934,
prevented commercial banks from underwriting securities. This act was repealed
in 1999. The Japanese equivalent was abolished the previous year, and the
banking industry in Britain was also deregulated in 1990s, and financial
conglomerates now combine the services previously offered by banks,
stockbrokers, and insurance companies.

Takeover bid: an offer or attempt to take control of the company by buying enough of its share

131
 4...............................................
Central bank

A country’s minimum interest rate is usually fixed by the central bank. This
is the discount rate, at which the central bank makes secured loans to commercial
banks. Banks lend to blue chip borrowers (very safe large companies) at the base
rate or the prime rate; all other borrowers pay more, depending on their credit
standing (or credit rating, or creditworthiness): the lender’s estimation of their
present and future solvency. Borrowers can usually get a lower interest rate if the
loan is secured or guaranteed by some kind of asset, known as collateral.
5.................................................
Eurocurrencies

In most financial centers, there are also branches of lots of foreign banks,
largely dong Eurocurrency business, A Eurocurrency is any currency held
outside its country of origin. The first significant Eurocurrency market was for
US dollars in Europe, but the name is now used for foreign currencies held
anywhere in the world (e.g. yen in the US, euros in Japan). Since the US$ is the
world’s most important trading currency – and because the US for the many
years had a huge trade deficit – there is a market of many billions of Eurodollars,
including the oil-exporting countries’ ‘petrodollars’. Although a central bank can
determine the minimum lending rate for its national currency it has no control
over foreign currencies. Furthermore, banks are not obliged to deposit any of
their Eurocurrency assets at 0% interest with the central bank, which means that
they can usually offer better rates to borrowers and depositors than in the home
country.

C. READING COMPREHENSION EXERCISES

1. Summarize the text (in how many words?)

............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................

132
2. Find the words or expressions in the text which mean the following
a. to place money in a bank; or money placed in a bank: …………………
b. the money used in countries other than one’s own: ……………………
c. how much money a loan pays, expressed as a percentage:……………
d. available cash, and how easily other assets can be turned into cash:………
e. the date when a loan becomes repayable: ………………………………
f. to guarantee to buy all the new shares that a company issues, if they
cannot be sold to the public: ……………………………………………….
g. when a company buy or acquires another one: ……………………………
h. when a company combines with another one: ………………………….
i. buying and selling stocks or shares for clients: ……………………………
j. taking care of all a client’s investments: ………………………………...
k. the ending or relaxing of legal restrictions: ……………………………..
l. a group of companies, operating in different fields, that have joined
together:……………………….
m. a company considered to be without risk: ………………………………
n. ability to pay liabilities when they become due: ……………………….
o. anything that acts as a security or guarantee for a loan: ………………..

3. Match up the verbs and nouns below to make common collocations

charge advice
do bonds
exchange business
issue currencies
make deposits
offer funds
pay interest
raise loans
receive profits
underwrite security issues

133
 D. EXERCISES

Exercise 1: This exercise defines the most important kinds of bank. Fill
in the blank the name of each type of bank:
(1).............................................
Central bank supervise the banking system; fix the
minimum interest rate; issue bank notes, control the money supply; influence
exchange rates; and act as lender of last resort.
(2).............................................
commercial banks are businesses that trade in money. They
receive and hold deposits in current account and saving accounts, pay money
according to customer’s instructions, lend money, and offer investment advice,
foreign exchange facilities and so on. In some countries such as England these
banks have branches in all major towns, in other countries there are smaller
regional banks. Under American law, for example, banks can operate in only one
state. Some countries have banks that were originally confined to a single
industry, e.g. the Credit Agricole in France, but these now usually have a far
wider customer base.
In some European countries, notably Germany, Austria, and Switzerland,
there are (3).............................................
universal banks which combine deposit and loan
banking with share and bond dealing, investment advice, etc. yet even universal
banks usually from a subsidiary, known as a (4).............................................,
finance house to
lend money – at several per cent over the base lending rate – for hire purchase or
instalment credit, that is, loans to consumers that are repaid in regular, equal
monthly amounts. provide financial services individuals

In Britain, the USA and Japan, however, there is, or used to be, a strict
separation between commercial banks and banks that do stockbroking or bond
dealing. Thus in Britain, (5).............................................
merchant banks specialize in raising
funds for industry on the various financial markets, financing international trade,
issuing and underwriting securities, dealing with takeovers and mergers, issuing
government bonds, and so on. They also offer stockbroking and portfolio
management services to rich corporate and individual clients.
(6).............................................
investment banks in the USA are similar, but they can only act as
intermediaries offering advisory services, and do not offer loans themselves.
Yet despite the Glass-Steagall Act in the USA, and Article 65, imposed by
the Americans in Japan in 1945, which enforce this separation, the distinction
between commercial and merchant or investment banks has become less clear in
recent years. Deregulations in the US and Britain is leading to the creation of

134
“financial supermarkets” – conglomerates combining the services previously
offered by stockbrokers, banks, insurance companies, etc.
In Britain there are also (7).............................................
building societies that provide
mortgages, i.e. they lend money to home-buyers on the security of house and
flats, and attract savers by paying higher interest than the banks. The saving and
loan associations in the United States served a similar function, until most of
them went spectacularly bankrupt at the end of the 1980s.
There are also (8).............................................
supranational banks such as the World Bank or the
European Bank for Reconstruction and Development, which are generally
concerned with economic development.

Exercise 2: Complete the text using these words:

accounts bank loan cheque customers’
current account debt depositors deposits
lend liabilities liquidity optimize
overdraft salary spread standing order
return transfer wages withdraw

Commercial banks are businesses that trade in money. They receive and hold
(1)..............................,
deposits pay money according to (2)..............................
instructions, (3).............................. money etc.
There are still many people in Britain who do not have bank
(4)............................... Traditionally, factory workers were paid
(5).............................. in cash on Fridays. Non-manual workers, however, usually
receive a monthly (6).............................. in the form of cheque or a
(7).............................. paid directly into their bank account.
A (8).............................. usually pays little or no interest, but allows the
holder to (9).............................. his or her cash with no restrictions. Deposit
accounts pay interest. They do not usually provide (10)..............................
facilities, and notice is often required to withdraw money. (11)..............................
and direct debits are ways of paying regular bills at regular intervals.
Banks offer both loans and overdrafts. A (12).............................. is a fixed
sum of money, lent for a fixed period, on which interest is paid, bank usually

135
require some form of security or guarantee before lending. An
(13).............................. is an arrangement by which a customer can overdraw an
account, i.e. run up a debt to an agreed limit; interest on the
(14).............................. is calculated daily.
Banks make a profit from the (15).............................. or differential between
the interest rates they pay on deposits and those they charge on loans. They are
also able to lend more money than they receive in deposits because
(16).............................. rarely withdraw all their money at the same time. In order
to (17).............................. the return on their assets (loans), bankers have to find a
balance between yield and risk, and (18).............................. and different
maturities, and to match these with their (19).............................. (Deposits). The
maturity of a loan is how long it will last; the yield of the loan is its annual
(20).............................. – how much money it pays – expressed as a percentage.
Exercise 3: Put the correct prepositions to complete each sentence:
1. A cheque is simply an order to your bank to pay money .......................
your account ....................... someone else’s.
2. A customer can pay ....................... cheque ....................... goods and
services.
3. With a bank card, the customer’s bank guarantees payment ................a
limit, say $500.
4. When an account holder pays a cheque ....................... her bank, the bank
credits the amount of the cheque ....................... her account and sends the
cheque to be presented ....................... the drawer’s bank.
5. In Britain the clearing system is operated ....................... the Clearing
House in London.
6. The Clearing House adds up the total each bank owes to each other bank
and reconciles the difference ....................... the bank’s accounts
....................... the Bank of England.
7. This process, from the time when the payee pays the cheque .......................
her bank until the cheque is debited ....................... the drawer’s bank
account, takes three days.

136
E.EXTENTION ACTIVITIES
1. Which banking services have you ultized?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………….…………

2. What services do commercial banks offer in your country?

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………..………
3. Discuss the impact of technology on banking services.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
……………………………………………………………………………..…

137
 4. Have you experienced digital banking services?
Pros and cons of non-cash payments
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

F. ESSAY WRITING

Essay Topic:
“Vietnamese banks have recently recorded strong growth thanks to retail
banking and financial services.”

To what extent do you agree or disagree with the statement. Support your
view by your own knowledge and experience.
Write at least 300 words.

138
 Unit 10
PAYMENT METHODS IN INTERNATIONAL TRADE

A. TERMS, DEFINITIONS, AND THEORIES

International trade: Purchase, sale, or exchange of goods and services
across national borders.
International payment: the transmission of some commonly accepted liquid
asset in exchange for goods, services, or non-liquid assets across national
borders.
Open account: Open account means the exporter ships the goods to the
buyer and just waits till a fixed date as agreed in their contract for payment from
the buyer. Normally, the exporter only accepts open account method of payment
if he has known the buyer quite well and they have established a long-term and
trustworthy business relationship.
Documentary letter of credit: A document issued by a bank, whereby the
bank replaces the buyer as the paying party. The exporter is basing his risk of
getting paid on the bank rather than on the importer. The bank will have to be
reimbursed by the importer.
Types of Letter of credit
Revocable letter of credit: A letter of credit that may be canceled at any
moment without prior notice to the beneficiary
Irrevocable letter of credit: A letter of credit that cannot be canceled nor
amended without agreement of all parties
Deferred payment letter of credit: A letter of credit under which the
documents are forwarded to the importer’s bank, while sight draft is presented at
a latter future date
Red clause letter of credit: A letter of credit permitting the beneficiary to
receive a sum prior to shipment

139
 Transferable letter of credit: A letter of credit that can be utilized by
someone designated by the original beneficiary
Revolving letter of credit: A letter of credit calling for renewed credit to be
made available when the issuing bank informs the beneficiary that the buyer has
reimbursed the issuing bank for the drafts already drawn
Back to back letter of credit: Two letter of credit with identical
documentary requirements, except for the difference in the price as shown by the
invoice and draft.
Standby letter of credit: A letter of credit that can be drawn against, but
only if another business transaction is not performed.
Advised letter of credit: A letter of credit issued by a bank and forwarded to
the beneficiary by a second bank in his area. The second bank validates the
signatures and attests to the legitimacy of the first bank.
Confirmed letter of credit: A letter of credit issued by one bank to which a
second bank adds its commitment to pay.
Usance draft (Time draft): A draft that has been drawn to be payable after a
specific number of days.
Banker’s acceptance: A usance draft drawn on a bank that stamp
ACCEPTED across the face, thereby making it a prime obligation of that bank to
pay. It is used to finance specified short-term, self-liquidating transaction,
including foreign trade.
Bills for collection: A negotiation instrument, drawn by a company or
individual, that is presented to the drawee bank for payment.
Clean collection: A negotiable instrument presented for collection with no
document attached.
Documentary collection: A collection item with title documents that
accompany the draft. The documents are released to the drawee, upon payment of
the draft.
Advance payment: the payment method that the buyer agrees to make
payment of whole grand values or part of values to the seller before sending the
cargo.

140
 B. VOCABULARY
Match these terms with their definitions.
1. invoice (a) document that shows details of goods being
2. clean collection transported; it entitles the receiver to collect the
goods on arrival
3. documentary
(b) list of goods sold as a request for payment
collection
(c) bank that issues a letter of credit (i.e. the
4. bill of exchange importer’s bank)
5. bill of lading (d) bank that receives payment of bills, etc. for their
6. document of title customer’s account (i.e. the exporter’s bank)
7. issuing bank (e) document allowing someone to claim ownership
8. collecting bank of goods

9. confirming bank (f) payment by bill of exchange to which

documents are not attached
10. letter of credit
(g) signed document that orders a person or
organization to pay a fixed sum of money on
demand or on a specified date
(h) bank that confirms they will pay the exporter on
evidence of shipment of goods
(y) method of financing overseas trade where
payment is made by a bank in return for
delivery of commercial documents, provided
that the terms and conditions of the contract are
met
(k) payment by bill of exchange to which
commercial documents (and sometimes a
document of title) are attached

Write your answer here:

1. 2. 3. 4. 5.
6. 7. 8. 9. 10.

141
 C. READING
Reading 1
Before you read
Discuss these questions.
1. What are some of the risks involved in international trading?
2. What payment methods do you know that are used when exporting or
importing goods? (what are payment methods that can be used in
international trade?)
3. What are advantages and disadvantages of different methods of payments
for an exporter/importer?
4. Discuss the uncertainty of foreign currency transactions.
5. What is the role of the banks in international trade?
Open Account
The goods, and relevant documents, are sent by the exporter directly to the
overseas buyer, who will have agreed to remit payment of the invoice back to the
exporter upon arrival of the documents or within a certain period after the invoice
date. The exporter loses all control of the goods, trusting that payment will be
made by the importer in accordance with the original sales contract.
Documentary Credit
Documentary Credit is often referred to as a Letter of Credit. This is an
undertaking issued by an overseas bank to a UK exporter through a bank in the
UK, to pay for the goods provided that the exporter complies fully with the
conditions established by the Documentary Credit.
Additional security can be obtained by obtaining the ‘confirmation’ of a UK
bank1 to the transaction, thereby transferring the responsibility from the
importer’s bank overseas to a more familiar bank in the country of the exporter.
Very few risks arise for the exporter because the potential problem areas of the
buyer risk and country risk can be eliminated. However, the exporter must present
the correct documents and comply fully with the terms and conditions of the credit.
Failure to do so could result in the exporter losing the protection of the credit.

142
 Bills for Collection
Trade collections are initiated when an exporter draws a bill of exchange on
an overseas buyer. This is forwarded by the exporter’s bank in the importer’s
country.
Such collections may be either ‘documentary’ or ‘clean’2. A documentary
collection is one in which the commercial documents and, if appropriate, the
documents of title to the goods are enclosed with the bill of exchange. These are
sent by the exporter’s bank to a bank in the importer’s country together with
instructions to release the documentation against either payment or acceptance of
the bill.
The risks that the exporter has to face are that the importer fails to accept the
bill of exchange or dishonours an accepted bill3 upon maturity. This means that
the exporter may have to consider shipping the goods back to the UK, finding an
alternative buyer or even abandoning the consignment, all of which could be
expensive.
In many areas of the world it is common practice to defer presentation4,
payment or acceptance until arrival of the carrying vessel. Collection and
remittance charges can also be relatively high.
If the exporter retains control over the goods by remitting a full set of Bills of
Lading5 through the intermediary of the banking system, control of the goods
will be handed over to the importer only against payment or acceptance of the
bill by the importer. If the documents are released against the importer’s
acceptance of the bill, control of the goods is lost and the accepted bill of
exchange may be dishonoured at maturity.
Advance Payment
Exporters receive payment from an overseas buyer in full, or in part, before
the goods are dispatched. This means that the exporter has no risks associated
with non-payment.
1. This bank is then known as the confirming bank.
2. Clean means that no documents are involved.
3. The importer does not pay, although he had previously agreed to pay.
4. This means to delay passing the bill to the importer.
5. This means sending all the necessary shipping documents.

143
 READING COMPREHENSION TASKS
Understanding main points
Read the above text about payment methods for exporters and write the four
methods in the correct positions according to their risks for the exporter.
Least secure Payment method: 1. ……………. open account...……
2. ………………………………..…
3. …………………………….….…
Most secure
4. …………………………….….…
……
Understanding details
Mark these statements T (true) or F (false) according to the information in the
text. Find the part of the text that gives the correct information.
Open Account
1. The importer pays for the goods after receiving the documents.
2. There is no contract involved.
3. The exporter must be able to trust the buyer.
Documentary Credit
4. If a letter of credit is issued, the importer’s bank agrees to pay for the
goods without conditions.
5. If a letter of credit is confirmed, the exporter’s bank takes responsibility
for payment.
Bills for Collection
6. Commercial documents and the document of title are always enclosed
with a bill of exchange.
7. Importers may not accept the bill of exchange until the goods arrive.
8. Exporters can keep control of goods by sending bills of lading through the
banking system.
9. Exporters reduce risk if documents are released against acceptance of the
bill rather than payment.
Advance Payment
10. This means that the importer has to pay before any goods are dispatched.

144
 Word search
Find a word or phrase in the text that has a similar meaning.
1. promise or guarantee given to or by a bank
u…………………..
2. load of goods sent to a customer
c……………………
3. person or company that acts as a middleman in a transaction
i……………………
4. date when a bill of exchange is due for payment
m………………………

Reading 2: How a letter of credit works

1. Read about the first four steps in a transaction involving a letter of
credit, and number the steps 1 to 4, using the diagram below to help you.
a. The advising bank authenticates the letter of credit and sends the
beneficiary (the seller) the details. The seller examines the details of the
letter of credit to make sure that he or she can meet all the conditions. If
necessary, he or she contacts the buyer and asks for amendments to be
made.
b. The applicant (the buyer) completes a contract with the seller.
c. The issuing bank (the buyer’s bank) approves the application and sends the
letter of credit details to the seller’s bank (the advising bank).
d. The buyer fills in a letter of credit application form and sends it to his or
her bank for approval.

145
 2. Now read about the next six steps, and number them 5 to 10 using the
diagram below.
e. If the documents are in order, the advising bank sends them to the issuing
bank for payment or acceptance. If the details are not correct, the advising
bank tells the seller and waits for corrected documents or further
instructions.
f. The advising/confirming bank pays the seller and notifies him or her that
the payment has been made.
g. The issuing bank advises the advising (or confirming) bank that the
payment has been made.
h. The issuing bank (the buyer’s bank) examines the documents from the
advising bank. If they are in order, the bank releases the documents to the
buyer, pays the money promised or agrees to pay it in the future, and
advises the buyer about the payment. (If the details are not correct, the
issuing bank contacts the buyer for authorization to pay or accept the
documents.) The buyer collects the goods.
i. The seller presents the documents to his or her bankers (the advising bank).
The advising bank examines these documents against the details of the
letter of credit and the International Chamber of Commerce rules.
k. When the seller (beneficiary) is satisfied with the conditions of the letter of
credit, he or she ships the goods.

146
 D. EXERCISES
Exercise 1: Information search
Match the risks (a-g) with the payment methods.
a) Exporters must comply with the conditions of the credit documents.
b) Importers may delay payment.
c) Importers may not pay at all.
d) It takes a long time to process payment in some countries.
e) Importers may not accept the bill of exchange.
f) Bank charges may be high.
g) Exporters must take care to present the correct document.

1. Open account
2. Documentary credit
3. Bills for collection
4. Advance payment

Write your answer here:

1. 2. 3. 4.

Exercise 2: Complete the sentence

Use an appropriate form of the words in the box to complete the sentences
which describe the procedure for documentary collection.
draw accept dishonour release remit forward dispatch present
present

1. The first step the exporter takes is to ask his bank to ………….. a bill of
exchange on the overseas buyer.
2. The exporter’s bank ………………. the bill of exchange, together with the
commercial documents, to the importer’s bank.
3. At the same time, the exporter…………………. the goods.
4. The exporter must take care to ………………….the correct documents to
the bank.

147
 5. When the importer……the bill of exchange, the bank will………….the
documents of title to the goods.
6. If the importer…………………..the bill, the exporter may have to find an
alternative buyer or ship the goods back again.
7. In some parts of the world, banks may be slow to …………….. payment to
the exporter’s bank.

E. EXTENSION ACTIVITIES
1. The above reading describes the risks of each payment method from the
exporter’s point of view. What are the risks for the importer? Which
methods will be secure and why?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………
2. Imagine you are a banker talking to one of your customers who has never
exported before. Explain how documentary credit works.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………….……………………………
3. Recommendations to deal with uncertainty/risk in international trade
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

148
 Revision
If you work at a bank’s international banking department and each of the
following statements has been made by a customer, explain the type of letter of
credit you would recommend. Write down the words or clause you would insert
in a letter of credit to make your suggestion effective.
1. “My purchasing manager is going to Japan to buy dinner sets from a
number of manufactures, each of whom will want a letter of credit. I want
him to take one letter of credit with him for this.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
……………………………………………………………………………
2. Our company’s overseas purchasing manager live in Brazil. I need to get
money to him so he can purchase coffee from inland growers and then ship
it on a letter of credit.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
……………………………………………………………………………
3. I have a contract to purchase sugar from Haiti over the next six months. I
know my credit line is only for $50,000, but how can I get a letter of credit
for the entire shipment of $200,000?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………….………………………………………..……
4. The buyer of my motorcycles needs six months before he can pay me. I
can’t wait that long for my money, but I want to make this sale.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

149
 5. I just received this letter of credit from Jamaica. Is the bank good? How do
I know I’ll get paid?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
……………………………………………………………………………
6. I am the agent for New York’s largest department store. It wants to buy
furs from Russia, but it doesn’t want the Russian to know it is buying, so I
will make the purchase in my name. The Russians want a letter of credit.
The complete order is $1,000,000. What do I do?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………….…

F. ESSAY WRITING
Essay Topic :
Open account is one of the methods of payment in international trade. What
are advantages and disadvantages of open account?
Support your view by your own knowledge and experience.
Write at least 300 words.

150
 COMPILED FROM

Business School – University of Bedfordshire (2008) Core Program – Level

2, Pearson Custom Publishing
Emmerson, P. (2007) Business English Handbook: Advanced, Macmillan
Frendo, E. & Mahoney, S (2007) English for Accounting – Express Series,
Oxford University Press
Johnson, C. (2000) Banking and Finance – Business English, Longman.
MacKenzie, I. (2002) English for Business Studies: A Course for Business
Studies and Economics Students, Cambridge University Press.
Mackenzie, I. (1997) Financial English, Thompson, Heinle
Mackenzie, I. (2008) English for the Financial Sector Learning, Cambridge
University Press.
Sweeney, S. (2002) Test Your Professional English: Management, Penguin
Melicher, R. & Norton, E. (2017). Introduction to Finance: Market,
Investments and Financial Management. 16th Edition. Wiley & Sons, Inc.
Mishkin, F. (2019). The economics of money, banking, and financial markets.
12th Edition. Pearson

151
152