Finance

Contents
1

Finance

1.1

Areas of nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.1

Personal nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.2

Corporate nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.3

Public nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.2

Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3

Financial theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.1

Financial economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.2

Financial mathematics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.3

Experimental nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.4

Behavioral nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.5

Intangible asset nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.4

Professional qualications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.5

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.6

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.7

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Bond market

2.1

Types of bond markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.2

Bond market participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.3

Bond market size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.3.1

U.S. bond market size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.4

Bond market volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.5

Bond market inuence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.6

Bond investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.7

Bond indices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.8

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.9

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Commodity market

10

3.1

History

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

10

3.2

Commodity price index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

3.3

Commodity index fund . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

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CONTENTS
3.4

Cash commodity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

3.5

Call options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

3.6

Electronic commodities trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

3.6.1

Increased complexity of nancial instruments and interconnectedness of global market . . .

12

3.6.2

Contracts in the commodity market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12

3.6.3

Standardization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12

Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12

3.7.1

Forward contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12

3.7.2

Futures contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

13

3.7.3

Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

13

3.7.4

Exchange-traded commodities (ETCs) . . . . . . . . . . . . . . . . . . . . . . . . . . . .

13

3.7.5

Over-the-counter (OTC) commodities derivatives . . . . . . . . . . . . . . . . . . . . . .

13

3.8

Commodities exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

14

3.9

Traded commodity classes

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

14

3.9.1

Energy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

14

3.9.2

Metals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15

3.9.3

Agriculture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15

3.9.4

Other commodity markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15

3.10 Regulatory bodies and policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

16

3.10.1 United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

16

3.10.2 European Union . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

16

3.11 Trading systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

16

3.12 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

16

3.13 References

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

16

3.14 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

18

3.15 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

18

Money market

19

4.1

Participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

19

4.2

Functions of the money market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

19

4.3

Common money market instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

20

4.4

Discount and accrual instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

20

4.5

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

20

4.6

References

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

21

4.7

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

21

3.7

Over-the-counter (nance)

22

5.1

OTC-traded stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

22

5.2

OTC contracts

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

22

5.3

Counterparty risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23

5.4

Importance of OTC derivatives in modern banking . . . . . . . . . . . . . . . . . . . . . . . . . .

23

5.5

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23

CONTENTS

iii

5.6

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23

5.7

Citations

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

23

5.8

References

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

23

5.9

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

24

Private equity

25

6.1

Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

25

6.1.1

Leveraged buyout . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

25

6.1.2

Growth capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

26

6.1.3

Mezzanine capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

26

6.1.4

Venture capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27

6.1.5

Distressed and special situations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27

6.1.6

Secondaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27

6.1.7

Other strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27

History and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

28

6.2.1

Early history and the development of venture capital . . . . . . . . . . . . . . . . . . . . .

28

6.2.2

Origins of the leveraged buyout . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

28

6.2.3

Private equity in the 1980s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

29

6.2.4

Age of the mega-buyout 20052007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30

Investments in private equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30

6.3.1

Investor categories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30

6.3.2

Direct vs. indirect investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

31

6.3.3

Investment timescales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

31

6.4

Liquidity in the private equity market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

31

6.5

Private equity rms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

32

6.5.1

Versus hedge funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

32

Private equity funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

32

6.6.1

Size of the industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

33

6.6.2

Private equity fund performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

33

6.7

Recording private equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

34

6.8

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

34

6.8.1

Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

34

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

34

6.10 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

37

6.11 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

37

Real estate

38

7.1

Residential real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

38

7.2

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

39

7.3

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

39

7.4

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

39

6.2

6.3

6.6

6.9

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CONTENTS
Spot market

40

8.1

Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

40

8.2

OTC

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

40

8.3

Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

40

8.3.1

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

40

8.4

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

40

8.5

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

40

Energy Spot

Stock market

41

9.1

Size of market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

41

9.2

Stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

41

9.3

Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

41

9.4

Market participant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

42

9.5

History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

42

9.6

Importance of stock market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

43

9.6.1

Function and purpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

43

9.6.2

Relation of the stock market to the modern nancial system . . . . . . . . . . . . . . . . .

44

9.6.3

United States S&P stock market returns . . . . . . . . . . . . . . . . . . . . . . . . . . .

44

9.6.4

Behavior of the stock market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

44

9.6.5

Irrational behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

45

9.6.6

Crashes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

46

9.6.7

Stock market prediction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

47

9.7

Stock market index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

47

9.8

Derivative instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

47

9.9

Leveraged strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

47

9.9.1

Short selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

47

9.9.2

Margin buying . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

9.10 New issuance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

9.11 Investment strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

9.12 Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

9.13 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

9.14 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

49

9.15 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

50

9.16 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

50

10 Financial market participants

51

10.1 Supply side vs. demand side . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

51

10.2 Investor vs. Speculator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

51

10.2.1 Investor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

51

10.2.2 Speculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

51

10.3 Institutional vs. Retail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

51

10.3.1 Institutional investor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

51

CONTENTS

10.3.2 Retail investor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

52

10.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

52

10.5 References

52

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

11 Investor

53

11.1 Essential quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

53

11.2 Types of investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

53

11.3 Investor protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

53

11.3.1 Through government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

53

11.3.2 Through individual . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

54

11.4 Understand the investor plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

54

11.5 Investment tax structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

54

11.6 Discipline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

54

11.7 Constant advantage for retirees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

55

11.8 Investor education . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

55

11.8.1 Basic nancial concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

55

11.9 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

55

11.10References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

55

12 Institutional investor

56

12.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

56

12.1.1 Ancient Rome and Islam . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

56

12.1.2 Pre-industrial Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

56

12.1.3 Before 1980 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

57

12.2 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

57

12.3 Economic theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

57

12.3.1 Institutional investors as nancial intermediaries . . . . . . . . . . . . . . . . . . . . . . .

57

12.3.2 Life cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

57

12.4 Institutional-investor types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

57

12.5 Globalization of nancial markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

58

12.6 Regional . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

58

12.6.1 Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

58

12.6.2 Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

58

12.6.3 United Kingdom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

58

12.7 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

58

12.8 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

58

12.9 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

59

12.10External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

59

13 Retail

60

13.1 Etymology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

60

13.2 Types of retail outlets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

60

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CONTENTS
13.2.1 Types by products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

61

13.2.2 Types by marketing strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

61

13.2.3 Other types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

62

13.3 Global top ten retailers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

62

13.4 Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

62

13.4.1 Retail pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

63

13.4.2 Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

63

13.4.3 Stang . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

63

13.4.4 Transfer mechanisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

63

13.5 Second-hand retail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

63

13.6 Challenges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

64

13.7 Sales techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

64

13.8 Customer service . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

64

13.9 Statistics for national retail sales

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

64

13.9.1 United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

64

13.9.2 CE region . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

65

13.9.3 World . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

65

13.10Consolidation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

65

13.11See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

65

13.12References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

66

13.13Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

66

13.14External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

66

14 Speculation
14.1 History

67
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

67

14.2 Speculation and investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

67

14.3 The economic benets of speculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

67

14.3.1 Sustainable consumption level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

67

14.3.2 Market liquidity and eciency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

68

14.3.3 Bearing risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

68

14.3.4 Finding environmental and other risks . . . . . . . . . . . . . . . . . . . . . . . . . . . .

68

14.3.5 Shorting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

68

14.4 The economic disadvantages of speculation

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

68

14.4.1 Winners curse . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

68

14.4.2 Economic bubbles

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

68

14.4.3 Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

69

14.5 Government responses and regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

69

14.5.1 Food security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

69

14.5.2 Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

69

14.5.3 Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

70

14.6 Books . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

70

14.7 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

70

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vii

14.8 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

71

14.9 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

71

15 Cash

72

15.1 Etymology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

72

15.2 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

72

15.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

73

15.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

73

15.5 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

74

16 Line of credit

75

16.1 Cash credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

75

16.1.1 India . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

75

16.2 Special-purpose line of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

75

16.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

75

16.4 References

75

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

17 Deposit account

76

17.1 Major types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

76

17.2 Legal framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

76

17.3 Regulatory protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

77

17.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

77

17.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

77

18 Derivative (nance)

78

18.1 Collateralised Debt Obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

78

18.2 Credit Default Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

78

18.3 Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

79

18.4 Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

79

18.5 Mortgage Backed Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80

18.6 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80

18.7 Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

81

18.8 Financial derivative trading companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

81

18.9 Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

18.10Size of market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

18.11Usage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

18.11.1 Mechanics and Valuation Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

83

18.11.2 Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

83

18.11.3 Speculation and arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

84

18.11.4 Proportion Used for Hedging and Speculation . . . . . . . . . . . . . . . . . . . . . . . .

84

18.12Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

84

18.12.1 OTC and exchange-traded . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

84

18.12.2 Common derivative contract types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

85

viii

CONTENTS
18.13Economic function of the derivative market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

85

18.14Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

86

18.14.1 Market and arbitrage-free prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

86

18.14.2 Determining the market price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

86

18.14.3 Determining the arbitrage-free price . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

86

18.15Criticisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

86

18.15.1 Hidden tail risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

86

18.15.2 Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

87

18.15.3 Counter party risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

87

18.15.4 Large notional value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

87

18.16Financial Reform and Government Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . .

87

18.16.1 Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

89

18.17Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

89

18.18Financial derivative trading companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

89

18.19See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

90

18.20References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

90

18.21Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

93

18.22External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

93

19 Futures contract

95

19.1 Origin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

95

19.2 Risk mitigation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

95

19.3 Margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

95

19.4 Settlement - physical versus cash-settled futures . . . . . . . . . . . . . . . . . . . . . . . . . . . .

97

19.5 Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

97

19.5.1 Arbitrage arguments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

97

19.5.2 Pricing via expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

98

19.5.3 Relationship between arbitrage arguments and expectation . . . . . . . . . . . . . . . . . .

98

19.5.4 Contango and backwardation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

98

19.6 Futures contracts and exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

98

19.6.1 Codes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

99

19.7 Futures traders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

99

19.7.1 Hedgers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

99

19.7.2 Speculators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

19.8 Options on futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
19.9 Futures contract regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
19.10Denition of futures contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
19.11Forward contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
19.12Futures versus forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
19.12.1 Exchange versus OTC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
19.12.2 Margining . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
19.13Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

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19.14See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

19.15Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
19.16References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
19.17U.S. Futures exchanges and regulators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
19.18External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
20 Loan

104

20.1 Types of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104

20.1.1 Secured . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
20.1.2 Unsecured . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
20.1.3 Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
20.1.4 Subsidized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
20.1.5 Concessional . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
20.2 Target markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
20.2.1 Personal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
20.2.2 Commercial

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

20.3 Loan payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

20.4 Abuses in lending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
20.5 United States taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
20.5.1 Income from discharge of indebtedness . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
20.6 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
20.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
21 Option (nance)

108

21.1 Valuation overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

21.2 Contract specications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
21.3 Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
21.3.1 According to the option rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
21.3.2 According to the underlying assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
21.3.3 According to the trading markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
21.3.4 Other option types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
21.3.5 Option styles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
21.4 Valuation models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
21.4.1 BlackScholes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
21.4.2 Stochastic volatility models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
21.5 Model implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
21.5.1 Analytic techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
21.5.2 Binomial tree pricing model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
21.5.3 Monte Carlo models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
21.5.4 Finite dierence models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
21.5.5 Other models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
21.6 Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

CONTENTS
21.6.1 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
21.6.2 Pin risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
21.6.3 Counterparty risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
21.7 Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
21.8 The basic trades of traded stock options (American style) . . . . . . . . . . . . . . . . . . . . . . 112
21.8.1 Long call . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
21.8.2 Long put . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
21.8.3 Short call . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
21.8.4 Short put . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
21.9 Option strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
21.10Historical uses of options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
21.11See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
21.12References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
21.13Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

22 Call option

117

22.1 Example of a call option on a stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117

22.2 Example of valuing a stock option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
22.3 Value of a call . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
22.4 Price of options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
22.5 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
22.6 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
23 Exotic option

121

23.1 Etymology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

23.2 Development

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

23.3 Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

23.4 Barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
23.5 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
23.6 References

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

23.7 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

23.8 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
24 Put option
24.1 Instrument models

123
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

24.2 Example of a put option on a stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

24.3 Payo of a put . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
24.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
24.4.1 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
24.5 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
25 Security (nance)

126

25.1 Classication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

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25.1.1 New capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

25.1.2 Type of holder . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
25.2 Debt and equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
25.2.1 Debt

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

25.2.2 Equity

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

25.2.3 Hybrid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

25.3 Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
25.3.1 Primary and secondary market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
25.3.2 Public oer and private placement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
25.3.3 Listing and over-the-counter dealing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
25.3.4 Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
25.4 Physical nature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
25.4.1 Certicated securities

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

25.4.2 DRS securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

25.4.3 Non-certicated securities and global certicates

. . . . . . . . . . . . . . . . . . . . . . 129

25.4.4 Divided and undivided security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130

25.4.5 Fungible and non-fungible security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
25.5 Regulation

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130

25.6 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

25.7 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
25.8 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
26 Stock

132

26.1 Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132

26.2 Types of stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
26.2.1 Rule 144 stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
26.3 Stock derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
26.4 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
26.5 Shareholder . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
26.6 Application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
26.6.1 Shareholder rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
26.6.2 Means of nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
26.7 Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
26.7.1 Buying . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
26.7.2 Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
26.7.3 Stock price uctuations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
26.7.4 Share price determination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
26.7.5 Arbitrage trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
26.8 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
26.9 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
26.10External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138

xii

CONTENTS

27 Time deposit

139

27.1 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139

27.2 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
28 Certicate of deposit

140

28.1 How CDs work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140

28.1.1 Closing a CD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
28.1.2 CD renance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
28.1.3 Ladders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
28.2 Deposit insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
28.3 Terms and conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
28.4 Criticism
28.5 References

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142

28.6 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

29 Accounting

144

29.1 Etymology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144

29.1.1 Accounting and accountancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
29.2 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
29.3 Topics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
29.3.1 Financial accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
29.3.2 Management accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
29.3.3 Auditing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
29.3.4 Accounting information systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
29.3.5 Tax accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
29.4 Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
29.4.1 Professional bodies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
29.4.2 Accounting rms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
29.4.3 Standard-setters

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

29.5 Education and qualications

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

29.5.1 Accounting degrees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

29.5.2 Professional qualications
29.6 Accounting research

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

29.7 Accounting and computer software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

29.8 Accounting aects the economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
29.9 Accounting scandals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
29.10See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
29.11References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
30 Audit

151

30.1 Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

30.1.1 Integrated audits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

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30.1.2 Assessments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152

30.1.3 Auditors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
30.2 Performance audits[9] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
30.3 Quality audits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
30.4 Project management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
30.5 Energy audits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
30.6 Operations audit

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

30.7 Forensic audits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

30.8 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
30.9 References

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154

31 Capital budgeting

155

31.1 Net present value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

31.2 Capital Budgeting Denition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
31.2.1 Factors Inuencing Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
31.3 Internal rate of return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
31.4 Equivalent annuity method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
31.5 Real options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
31.6 Ranked Projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
31.7 Funding Sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
31.8 Need For Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
31.9 External links and references . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
32 Credit rating agency

159

32.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

32.1.1 Early history . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
32.1.2 Post-Depression era . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
32.1.3 Growth of bond market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
32.1.4 1980spresent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
32.2 Role in capital markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
32.2.1 Ratings use in bond market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
32.2.2 Accuracy and responsiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
32.2.3 Ratings use in structured nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
32.2.4 Ratings use in sovereign debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
32.2.5 Use by government regulators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
32.3 Industry structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
32.3.1 The Agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
32.3.2 Business models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
32.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
32.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
32.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
32.7 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

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33 Financial risk management

177

33.1 When to use nancial risk management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

33.2 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
33.3 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
33.4 References

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178

33.5 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178

34 Financial statement

179

34.1 Purpose of nancial statements by business entities . . . . . . . . . . . . . . . . . . . . . . . . . . 179

34.2 Consolidated nancial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
34.3 Government nancial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
34.4 Personal nancial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
34.5 Audit and legal implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
34.6 Standards and regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
34.7 Inclusion in annual reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
34.8 Notes to nancial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181
34.9 Management discussion and analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181
34.10Moving to electronic nancial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181
34.11See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181
34.12References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181
34.13Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
34.14External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
35 Leveraged buyout

183

35.1 Characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

35.2 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184
35.2.1 Origins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184
35.2.2 1980s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184
35.2.3 Age of the mega-buyout . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
35.3 Management buyouts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
35.4 Secondary and tertiary buyouts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
35.5 Failures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
35.6 Popular references . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
35.7 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
35.8 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
35.9 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
36 Mergers and acquisitions

189

36.1 Acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189

36.2 Legal structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
36.3 Documentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
36.4 Business valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191

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36.5 Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192

36.5.1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
36.5.2 Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
36.5.3 Financing options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
36.6 Specialist advisory rms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
36.7 Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
36.7.1 Improving nancial performance or reducing risk . . . . . . . . . . . . . . . . . . . . . . 193
36.7.2 Other types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
36.8 Dierent types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
36.8.1 By functional roles in market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
36.8.2 Arms length mergers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
36.8.3 Strategic mergers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
36.8.4 Acqui-hire

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194

36.9 Research and statistics for acquired organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . 195

36.10Brand considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
36.11History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
36.11.1 The Great Merger Movement: 18951905 . . . . . . . . . . . . . . . . . . . . . . . . . . 195
36.12Cross-border . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
36.13Failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
36.14Major . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
36.14.1 1990s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
36.14.2 2000s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
36.14.3 20102014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
36.15See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
36.16References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
36.17Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
37 Structured nance

201

37.1 Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201

37.1.1 Securitization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
37.1.2 Tranching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
37.1.3 Credit enhancement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
37.1.4 Credit ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
37.2 Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
37.2.1 Other structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
37.3 Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
37.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
37.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
37.6 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
38 Venture capital

204

38.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204

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38.1.1 Origins of modern private equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
38.1.2 Early venture capital and the growth of Silicon Valley . . . . . . . . . . . . . . . . . . . . 205
38.1.3 1980s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
38.1.4 Venture capital boom and the Internet Bubble . . . . . . . . . . . . . . . . . . . . . . . . 206
38.1.5 Private equity crash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
38.2 Funding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
38.2.1 Financing stages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
38.3 Firms and funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
38.3.1 Venture capitalists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
38.3.2 Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
38.3.3 Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
38.3.4 Roles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
38.3.5 Structure of the funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
38.3.6 Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
38.3.7 Alternatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
38.4 Geographical dierences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
38.4.1 United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
38.4.2 Mexico . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
38.4.3 Israel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
38.4.4 Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
38.4.5 Switzerland . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
38.4.6 Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
38.4.7 Asia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
38.4.8 Middle East and North Africa . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
38.4.9 Southern Africa . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
38.5 Condential information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
38.6 Governmental Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
38.7 In popular culture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
38.7.1 In books . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
38.7.2 In comics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
38.7.3 In lm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
38.7.4 In television . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
38.8 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
38.9 References

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213

39 Credit (nance)

216

39.1 Types of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216

39.2 Trade credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
39.3 Consumer credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
39.4 The Six Cs of Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
39.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
39.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217

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39.7 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217

40 Consumer debt

218

40.1 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218

40.2 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
40.3 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
41 Employment contract

220

41.1 Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220

41.2 Criticism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
41.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
41.4 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
41.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
42 Financial planner

222

42.1 Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222

42.2 Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
42.3 Licensing, regulations and self-regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
42.3.1 Australia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
42.3.2 Malaysia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
42.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
42.5 References
43 Retirement

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
224

43.1 Retirement in specic countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224

43.2 Data sets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
43.3 Factors aecting retirement decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
43.3.1 EU Member States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
43.3.2 United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
43.4 Saving for retirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
43.4.1 Retirement calculators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
43.4.2 Retirement calculations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
43.4.3 Size of lump sum required . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
43.4.4 Size of lump sum saved . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
43.4.5 Equate and derive necessary saving proportion . . . . . . . . . . . . . . . . . . . . . . . . 229
43.4.6 Sample results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
43.4.7 Monte Carlo: better allowance for randomness . . . . . . . . . . . . . . . . . . . . . . . . 229
43.5 Early retirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
43.5.1 Savings needed for early retirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
43.5.2 Calculations using actual numbers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
43.6 Life after retirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
43.7 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
43.8 References

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231

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43.9 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232

43.10External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
44 Student loan
44.1 Australia

233
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233

44.2 Korea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233

44.2.1 Koreas Student Loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
44.2.2 Main Loan Programs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
44.2.3 Variations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
44.2.4 Current situation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
44.3 United Kingdom

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234

44.4 United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235

44.4.1 Income-Based Repayment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
44.4.2 Qualication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
44.4.3 Repayment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
44.4.4 Criticism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
44.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
44.6 References

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237

44.7 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238

44.8 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238
45 Government spending

239

45.1 Macroeconomic scal policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239

45.2 Current use: nal consumption expenditure

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239

45.3 Infrastructure and investment: gross xed capital formation

45.4 Transfer payments

. . . . . . . . . . . . . . . . . . . . . 239

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240

45.5 International government spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240

45.5.1 Per capita . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
45.5.2 As a percentage of GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
45.5.3 United States of America . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
45.6 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
45.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
45.8 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
46 Government nal consumption expenditure

243

46.1 Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243

46.2 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
46.3 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
46.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
46.5 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
47 Government operations

244

47.1 Size of economic footprint . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244

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47.2 Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244

47.3 Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
47.4 Local government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
47.5 Commonwealth of Nations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
47.6 United Kingdom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
47.7 United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
47.8 Privatization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
47.9 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
47.10External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
47.10.1 United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
48 Redistribution of income and wealth

246

48.1 Types of redistribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246

48.2 Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246
48.2.1 A Moral Obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
48.2.2 'Min-max criterion' for social welfare

. . . . . . . . . . . . . . . . . . . . . . . . . . . . 247

48.3 Economic eects of inequality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247

48.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
48.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
48.6 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
49 Transfer payment

249

49.1 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249

49.2 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
49.3 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
50 Government revenue

250

50.1 Sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

50.2 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
50.3 References
51 Tax

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
251

51.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251

51.2 Purposes and eects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251
51.3 Kinds of taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252
51.3.1 Taxes on income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252
51.3.2 Social security contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
51.3.3 Taxes on payroll or workforce . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
51.3.4 Taxes on property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
51.3.5 Taxes on goods and services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254
51.3.6 Tari . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
51.3.7 Other taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
51.3.8 Descriptive labels given some taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256

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51.3.9 Fees and eective taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257
51.4 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257
51.4.1 Taxation levels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258
51.4.2 Forms of taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258
51.5 Economic eects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
51.5.1 Tax incidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
51.5.2 Increased economic welfare . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
51.5.3 Reduced economic welfare . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
51.6 Taxation in developing countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
51.6.1 Key facts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
51.6.2 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
51.7 Views on taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
51.7.1 Support for taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
51.7.2 Opposition to taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
51.7.3 Socialist view . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
51.7.4 Tax choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
51.8 Theories on taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
51.8.1 Laer curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
51.8.2 Optimal tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
51.8.3 Tax rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
51.9 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
51.9.1 By country or region . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
51.10Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
51.11Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
51.12External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267

52 Decit spending

268

52.1 Controversy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268

52.1.1 Fiscal conservatism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
52.1.2 Post-Keynesian economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
52.2 Government decits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
52.2.1 Keynesian eect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
52.2.2 Loanable funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
52.2.3 Crowding out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
52.2.4 Unintentional decits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
52.2.5 Automatic vs. active decit policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
52.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
52.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
52.5 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
53 Government budget

272

53.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272

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53.2 Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272

53.3 Elements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272
53.4 Special consideration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
53.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
53.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
53.7 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
54 Government budget balance

274

54.1 Primary decit, total decit, and debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274

54.2 Sectoral balances description . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274
54.3 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
54.4 Structural decits, cyclical decits, and the scal gap . . . . . . . . . . . . . . . . . . . . . . . . . 276
54.4.1 National government budgets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
54.5 Early decits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
54.6 Decit spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
54.6.1 Ricardian equivalence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
54.6.2 Crowding-out hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
54.7 Potential policy solutions for unintended decits . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
54.7.1 Increase taxes or reduce government spending . . . . . . . . . . . . . . . . . . . . . . . . 278
54.7.2 Changes in tax code . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
54.7.3 Reduce debt service liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
54.8 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
54.9 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
54.10External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
55 Government debt

280

55.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280

55.2 Government and sovereign bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
55.3 By country

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281

55.4 Municipal, provincial, or state bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282

55.5 Denominated in reserve currencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
55.6 Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
55.7 Clearing and defaults . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
55.8 Economic policy basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
55.9 Structure and risk of a public debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
55.10Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
55.11Implicit debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
55.12See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
55.13References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
55.14External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
55.14.1 Databases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286

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56 Non-tax revenue

287

56.1 Sources of non-tax revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287

56.2 References

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287

57 Warrant of payment

288

57.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288

57.2 Modern warrants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
57.3 In the United Kingdom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
57.4 In Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
57.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
57.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
57.7 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
58 Central bank

290

58.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290

58.1.1 Bank of England . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
58.1.2 Spread around the world . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
58.1.3 Naming of central banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
58.2 Activities and responsibilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
58.2.1 Monetary policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
58.3 Goals of monetary policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
58.3.1 Currency issuance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
58.3.2 Interest rate interventions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
58.3.3 Limits on policy eects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
58.4 Policy instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
58.4.1 Interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
58.4.2 Open market operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
58.4.3 Capital requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
58.4.4 Reserve requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
58.4.5 Exchange requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
58.4.6 Margin requirements and other tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
58.5 Banking supervision and other activities

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297

58.6 Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297

58.7 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
58.8 Notes and references . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
58.9 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
58.10External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
59 Fractional-reserve banking

300

59.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

59.2 How it works . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
59.3 Economic function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301

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xxiii

59.4 Money creation process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301

59.4.1 Example of deposit multiplication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
59.4.2 Money multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
59.4.3 Creation of deposit liabilities through the lending process . . . . . . . . . . . . . . . . . . 303
59.5 Money supplies around the world . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
59.6 Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
59.6.1 Central banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
59.6.2 Reserve requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
59.6.3 Liquidity and capital management for a bank . . . . . . . . . . . . . . . . . . . . . . . . . 305
59.7 Hypothetical example of a bank balance sheet and nancial ratios . . . . . . . . . . . . . . . . . . 305
59.7.1 Other nancial ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
59.8 Criticisms of textbook descriptions of the monetary system

. . . . . . . . . . . . . . . . . . . . . 306

59.9 Criticisms of fractional-reserve banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306

59.10See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
59.11References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
59.12Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
59.13External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
60 Money supply

309

60.1 Empirical measures in the United States Federal Reserve System . . . . . . . . . . . . . . . . . . . 309
60.1.1 Fractional-reserve banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
60.2 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
60.3 Money supplies around the world . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
60.3.1 United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
60.3.2 United Kingdom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
60.3.3 Eurozone . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
60.3.4 Australia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
60.3.5 New Zealand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
60.3.6 India . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
60.3.7 Hong Kong . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
60.3.8 Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
60.4 Link with ination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
60.4.1 Monetary exchange equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
60.4.2 Rates of growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
60.5 Bank reserves at central bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
60.6 Arguments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
60.7 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
60.8 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
60.9 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
60.10External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
61 Lists of banks

319

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61.1 By continent

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319

61.2 By super continent or intercontinental region . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319

61.3 Other lists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
61.4 See Also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
62 Professional certication in nancial services

320

62.1 Certied Financial Planner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320

62.2 Certied Treasury Professional . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
62.3 Chartered Alternative Investment Analyst . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
62.4 Certied International Investment Analyst . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
62.5 Chartered Financial Analyst . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
62.6 Corporate Finance Foundations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
62.7 Fellow Chartered Financial Practitioner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
62.8 Master Financial Professional . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
62.9 Master Financial Controller . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
62.10Registered Financial Planner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
62.11See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
62.12References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
63 Accounting scandals

322

63.1 Causes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322

63.2 List of reported accounting scandals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
63.3 Notable outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
63.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
63.5 References

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324

63.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325

63.7 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
64 International Financial Reporting Standards

326

64.1 Objective of nancial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326

64.2 Qualitative characteristics of nancial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
64.3 Elements of nancial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
64.4 Recognition of elements of nancial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
64.5 Measurement of the elements of nancial statements . . . . . . . . . . . . . . . . . . . . . . . . . 329
64.6 Concepts of capital and capital maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
64.6.1 Concepts of capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
64.6.2 Concepts of capital maintenance and the determination of prot . . . . . . . . . . . . . . . 329
64.7 Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
64.8 Criticisms of IFRS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
64.9 Adoption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
64.9.1 Australia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332
64.9.2 Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332

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64.9.3 European Union . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332

64.9.4 India . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
64.9.5 Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
64.9.6 Montenegro . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
64.9.7 Nepal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
64.9.8 Pakistan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
64.9.9 Russia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
64.9.10 Singapore . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
64.9.11 South Africa . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
64.9.12 Taiwan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
64.9.13 Turkey . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
64.10See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
64.11References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
64.12Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
64.13External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
65 ISO 31000

339

65.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339

65.2 Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
65.3 Risk conceptualisation

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339

65.4 ISO 31000 framework approach

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340

65.5 Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340

65.6 Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
65.7 Managing risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
65.8 Accreditation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
65.9 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
65.10References

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341

65.11External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341

66 History of private equity and venture capital

342

66.1 Pre-history . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342

66.2 Origins of modern private equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
66.3 Early venture capital and the growth of Silicon Valley (19591981) . . . . . . . . . . . . . . . . . 344
66.4 Early history of leveraged buyouts (19551981) . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
66.4.1 McLean Industries and public holding companies . . . . . . . . . . . . . . . . . . . . . . 345
66.4.2 KKR and the pioneers of private equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
66.4.3 Regulatory and tax changes impact the boom . . . . . . . . . . . . . . . . . . . . . . . . . 346
66.5 The rst private equity boom (19821993) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347
66.5.1 Beginning of the LBO boom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347
66.5.2 Venture capital in the 1980s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347
66.5.3 Corporate raiders, hostile takeovers and greenmail . . . . . . . . . . . . . . . . . . . . . . 348
66.5.4 RJR Nabisco and the Barbarians at the Gate . . . . . . . . . . . . . . . . . . . . . . . . . 349

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66.6 LBO bust (19901992) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350

66.6.1 The collapse of Drexel Burnham Lambert . . . . . . . . . . . . . . . . . . . . . . . . . . 350
66.6.2 S&L and the shutdown of the Junk Bond Market . . . . . . . . . . . . . . . . . . . . . . . 350
66.7 The second private equity boom and the origins of modern private equity . . . . . . . . . . . . . . 351
66.7.1 Resurgence of leveraged buyouts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
66.7.2 The venture capital boom and the Internet Bubble (19952000) . . . . . . . . . . . . . . . 352
66.8 The bursting of the Internet Bubble and the private equity crash (20002003) . . . . . . . . . . . . 352
66.8.1 Stagnation in the LBO market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
66.9 The third private equity boom and the Golden Age of Private Equity (20032007) . . . . . . . . . 353
66.9.1 Resurgence of the large buyout . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
66.9.2 Age of the mega-buyout . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
66.9.3 Publicly traded private equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355
66.9.4 Secondary market and the evolution of the private equity asset class . . . . . . . . . . . . . 356
66.10The Credit Crunch and post-modern private equity (20072008) . . . . . . . . . . . . . . . . . . . 356
66.11Responses to private equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
66.11.1 1980s reections of private equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
66.11.2 Contemporary reections of private equity and private equity controversies . . . . . . . . . 357
66.12See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
66.13Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
66.14References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
67 Recession

363

67.1 Denition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363

67.2 Attributes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363
67.2.1 Type of recession or shape . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363
67.2.2 Psychological aspects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
67.2.3 Balance sheet recession . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
67.2.4 Liquidity trap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
67.2.5 Paradoxes of thrift and deleveraging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
67.3 Predictors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
67.4 Government responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
67.5 Stock market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
67.6 Politics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
67.7 Consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
67.7.1 Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
67.7.2 Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
67.7.3 Social eects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
67.8 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
67.8.1 Global . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
67.8.2 United Kingdom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
67.8.3 United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
67.8.4 Late 2000s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367

CONTENTS

xxvii

67.9 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368

67.10References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368
67.11External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370
68 Stock market bubble

371

68.1 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371

68.2 Whether rational or irrational . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
68.3 Positive feedback . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
68.4 Eect of incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
68.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
68.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
68.7 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
69 Stock market crash

374

69.1 Mathematical theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374

69.2 Major crashes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
69.2.1 Wall Street Crash of 1929 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
69.2.2 Crash of 20082009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
69.3 Mitigation strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
69.3.1 United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
69.3.2 France

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376

69.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377

69.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
69.6 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378
69.7 Text and image sources, contributors, and licenses . . . . . . . . . . . . . . . . . . . . . . . . . . 379
69.7.1 Text . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
69.7.2 Images . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
69.7.3 Content license . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414

Chapter 1

Finance
Transference of family across generations (bequests
and inheritance)

Financial redirects here. For the Caucasian newspaper,

see FINANCIAL.

Eects of tax policies (tax subsidies and/or penalties) on management of personal nances

Finance is a eld that deals with the allocation of assets

and liabilities over time under conditions of certainty and
uncertainty. Finance also applies and uses the theories of
economics at some level. Finance can also be dened as
the science of money management. A key point in nance
is the time value of money, which states that purchasing
power of one unit of currency can vary over time. Finance aims to price assets based on their risk level and
their expected rate of return. Finance can be broken into
three dierent sub-categories: public nance, corporate
nance and personal nance.

Eects of credit on individual nancial standing

Planning a secure nancial future in an environment
of economic instability
Personal nance may involve paying for education, nancing durable goods such as real estate and cars, buying
insurance, e.g. health and property insurance, investing
and saving for retirement.
Personal nance may also involve paying for a loan, or
debt obligations. The six key areas of personal nancial
planning, as suggested by the Financial Planning Standards Board, are:[1]

1.1 Areas of nance

1. Financial position: is concerned with understanding the personal resources available by examining
net worth and household cash ow. Net worth is a
persons balance sheet, calculated by adding up all
assets under that persons control, minus all liabilities of the household, at one point in time. Household cash ow totals up all the expected sources of
income within a year, minus all expected expenses
within the same year. From this analysis, the nancial planner can determine to what degree and in
what time the personal goals can be accomplished.
2. Adequate protection: the analysis of how to protect a household from unforeseen risks. These risks
can be divided into liability, property, death, disability, health and long term care. Some of these
risks may be self-insurable, while most will require
the purchase of an insurance contract. Determining
how much insurance to get, at the most cost eective
terms requires knowledge of the market for personal
insurance. Business owners, professionals, athletes
and entertainers require specialized insurance professionals to adequately protect themselves. Since
insurance also enjoys some tax benets, utilizing insurance investment products may be a critical piece
of the overall investment planning.

Wall Street, the center of American nance.

1.1.1

Personal nance

Main article: Personal nance

Questions in personal nance revolve around:
Protection against unforeseen personal events, as
well as events in the wider economy
1

CHAPTER 1. FINANCE
3. Tax planning: typically the income tax is the single
largest expense in a household. Managing taxes is
not a question of if you will pay taxes, but when and
how much. Government gives many incentives in
the form of tax deductions and credits, which can be
used to reduce the lifetime tax burden. Most modern governments use a progressive tax. Typically,
as ones income grows, a higher marginal rate of tax
must be paid. Understanding how to take advantage of the myriad tax breaks when planning ones
personal nances can make a signicant impact in
which it can later save you money in the long term.
4. Investment and accumulation goals: planning
how to accumulate enough money - for large purchases and life events - is what most people consider to be nancial planning. Major reasons to accumulate assets include, purchasing a house or car,
starting a business, paying for education expenses,
and saving for retirement. Achieving these goals
requires projecting what they will cost, and when
you need to withdraw funds that will be necessary
to be able to achieve these goals. A major risk to
the household in achieving their accumulation goal
is the rate of price increases over time, or ination.
Using net present value calculators, the nancial
planner will suggest a combination of asset earmarking and regular savings to be invested in a variety of
investments. In order to overcome the rate of ination, the investment portfolio has to get a higher
rate of return, which typically will subject the portfolio to a number of risks. Managing these portfolio
risks is most often accomplished using asset allocation, which seeks to diversify investment risk and
opportunity. This asset allocation will prescribe a
percentage allocation to be invested in stocks (either preferred stock and/or common stock), bonds
(for example mutual bonds or government bods, or
corporate bonds), cash and alternative investments.
The allocation should also take into consideration
the personal risk prole of every investor, since risk
attitudes vary from person to person.

1.1.2 Corporate nance

Main article: Corporate nance
Corporate nance deals with the sources of funding and
the capital structure of corporations and the actions that
managers take to increase the value of the rm to the
shareholders, as well as the tools and analysis used to allocate nancial resources. Although it is in principle different from managerial nance which studies the nancial management of all rms, rather than corporations
alone, the main concepts in the study of corporate nance are applicable to the nancial problems of all kinds
of rms. Corporate nance generally involves balancing
risk and protability, while attempting to maximize an
entitys wealth and the value of its stock, and generically
entails three primary areas of capital resource allocation.
In the rst, capital budgeting, management must choose
which projects (if any) to undertake. The discipline of
capital budgeting may employ standard business valuation techniques or even extend to real options valuation;
see Financial modeling. The second, sources of capital
relates to how these investments are to be funded: investment capital can be provided through dierent sources,
such as by shareholders, in the form of equity (privately or
via an initial public oering), creditors, often in the form
of bonds, and the rms operations (cash ow). Shortterm funding or working capital is mostly provided by
banks extending a line of credit. The balance between
these elements forms the companys capital structure.
The third, the dividend policy, requires management
to determine whether any unappropriated prot (excess
cash) is to be retained for future investment / operational
requirements, or instead to be distributed to shareholders,
and if so in what form. Short term nancial management
is often termed "working capital management", and relates to cash-, inventory- and debtors management.

Corporate nance also includes within its scope business

valuation, stock investing, or investment management.
An investment is an acquisition of an asset in the hope that
it will maintain or increase its value over time that will
in hope give back a higher rate of return when it comes
to disbursing dividends. In investment management in
5. Retirement planning is the process of understandchoosing a portfolio one has to use nancial analysis to
ing how much it costs to live at retirement, and comdetermine what, how much and when to invest. To do
ing up with a plan to distribute assets to meet any inthis, a company must:
come shortfall. Methods for retirement plan include
taking advantage of government allowed structures
Identify relevant objectives and constraints: instituto manage tax liability including: individual (IRA)
tion or individual goals, time horizon, risk aversion
structures, or employer sponsored retirement plans.
and tax considerations;
6. Estate planning involves planning for the dispo Identify the appropriate strategy: active versus passition of ones assets after death. Typically, there
sive hedging strategy
is a tax due to the state or federal government at
Measure the portfolio performance
ones death. Avoiding these taxes means that more
of ones assets will be distributed to ones heirs. One
can leave ones assets to family, friends or charitable Financial management overlaps with the nancial function of the Accounting profession. However, nancial acgroups.

1.2. CAPITAL
counting is the reporting of historical nancial information, while nancial management is concerned with the
allocation of capital resources to increase a rms value
to the shareholders and increase their rate of return on
the investments.

3
total mix of nancing methods it uses to raise funds. One
method is debt nancing, which includes bank loans and
bond sales. Another method is equity nancing - the sale
of stock by a company to investors, the original shareholders (they own a portion of the business) of a share.
Ownership of a share gives the shareholder certain contractual rights and powers, which typically include the
right to receive declared dividends and to vote the proxy
on important matters (e.g., board elections). The owners of both bonds (either government bonds or corporate
bonds) and stock (whether its preferred stock or common
stock), may be institutional investors - nancial institutions such as investment banks and pension funds or private individuals, called private investors or retail investors.

Financial risk management, an element of corporate nance, is the practice of creating and protecting economic
value in a rm by using nancial instruments to manage exposure to risk, particularly credit risk and market
risk. (Other risk types include Foreign exchange, Shape,
Volatility, Sector, liquidity, Ination risks, etc.) It focuses
on when and how to hedge using nancial instruments;
in this sense it overlaps with nancial engineering. Similar to general risk management, nancial risk management requires identifying its sources, measuring it (see:
Risk measure: Well known risk measures), and formu- 1.1.3 Public nance
lating plans to address these, and can be qualitative and
quantitative. In the banking sector worldwide, the Basel Main article: Public nance
Accords are generally adopted by internationally active
banks for tracking, reporting and exposing operational,
Public nance describes nance as related to sovereign
credit and market risks.
states and sub-national entities (states/provinces, counties, municipalities, etc.) and related public entities (e.g.
school districts) or agencies. It is concerned with:
Financial services
Main article: Financial services

Identication of required expenditure of a public

sector entity

An entity whose income exceeds its expenditure can lend

or invest the excess income to help that excess income
produce more income in the future. Though on the other
hand, an entity whose income is less than its expenditure
can raise capital by borrowing or selling equity claims,
decreasing its expenses, or increasing its income. The
lender can nd a borrower--a nancial intermediary such
as a bank--or buy notes or bonds (corporate bonds, government bonds, or mutual bonds) in the bond market. The
lender receives interest, the borrower pays a higher interest than the lender receives, and the nancial intermediary
earns the dierence for arranging the loan.

Source(s) of that entitys revenue

The budgeting process
Debt issuance (municipal bonds) for public works
projects
Central banks, such as the Federal Reserve System banks
in the United States and Bank of England in the United
Kingdom, are strong players in public nance, acting as
lenders of last resort as well as strong inuences on monetary and credit conditions in the economy.[2]

A bank aggregates the activities of many borrowers and

lenders. A bank accepts deposits from lenders, on which
it pays interest. The bank then lends these deposits to bor- 1.2 Capital
rowers. Banks allow borrowers and lenders, of dierent
sizes, to coordinate their activity.
Main article: Financial capital
Finance is used by individuals (personal nance), by governments (public nance), by businesses (corporate nance) and by a wide variety of other organizations such
as including schools and non-prot organizations. In general, the goals of each of the above activities are achieved
through the use of appropriate nancial instruments and
methodologies, with consideration to their institutional
setting.

Capital, in the nancial sense, is the money that gives the

business the power to buy goods to be used in the production of other goods or the oering of a service. (The
capital has two types of resources, Equity and Debt).

The deployment of capital is decided by the budget. This

may include the objective of business, targets set, and results in nancial terms, e.g., the target set for sale, reFinance is one of the most important aspects of business sulting cost, growth, required investment to achieve the
management and includes analysis related to the use and planned sales, and nancing source for the investment.
acquisition of funds for the enterprise.
A budget may be long term or short term. Long term
In corporate nance, a companys capital structure is the budgets have a time horizon of 510 years giving a vision

CHAPTER 1. FINANCE

to the company; short term is an annual budget which is how rational investors would apply risk and return to the
drawn to control and operate in that particular year.
problem of an investment policy. Here, the twin assumpBudgets will include proposed xed asset requirements tions of rationality and market eciency lead to modern
and how these expenditures will be nanced. Capital portfolio theory (the CAPM), and to the BlackScholes
budgets are often adjusted annually (done every year) and theory for option valuation; it further studies phenomena
should be part of a longer-term Capital Improvements and models where these assumptions do not hold, or are
extended. Financial economics, at least formally, also
Plan.
considers investment under "certainty" (Fisher separaA cash budget is also required. The working capital re- tion theorem, theory of investment value, Modiglianiquirements of a business are monitored at all times to en- Miller theorem) and hence also contributes to corporate
sure that there are sucient funds available to meet short- nance theory. Financial econometrics is the branch of
term expenses.
nancial economics that uses econometric techniques to
The cash budget is basically a detailed plan that shows parameterize the relationships suggested.
all expected sources and uses of cash when it comes to Although closely related, the disciplines of economics
spending it appropriately. The cash budget has the fol- and nance are distinctive. The economy is a social
lowing six main sections:
institution that organizes a societys production, distribution, and consumption of goods and services, all of
1. Beginning Cash Balance - contains the last pe- which must be nanced.
riods closing cash balance, in other words, the re- Economists make a number of abstract assumptions for
maining cash from last years earnings.
purposes of their analyses and predictions. They generally regard nancial markets that function for the nan2. Cash collections - includes all expected cash recial system as an ecient mechanism (Ecient-market
ceipts (all sources of cash for the period considered,
hypothesis). Instead, nancial markets are subject to humainly sales)
man error and emotion.[3] New research discloses the
3. Cash disbursements - lists all planned cash out- mischaracterization of investment safety and measures of
ows for the period such as dividend, excluding in- nancial products and markets so complex that their efterest payments on short-term loans, which appear fects, especially under conditions of uncertainty, are imin the nancing section. All expenses that do not possible to predict. The study of nance is subsumed
aect cash ow are excluded from this list (e.g. de- under economics as nancial economics, but the scope,
speed, power relations and practices of the nancial syspreciation, amortization, etc.)
tem can uplift or cripple whole economies and the well4. Cash excess or deciency - a function of the cash being of households, businesses and governing bodies
needs and cash available. Cash needs are deter- within themsometimes in a single day.
mined by the total cash disbursements plus the minimum cash balance required by company policy. If
total cash available is less than cash needs, a de- 1.3.2 Financial mathematics
ciency exists.
5. Financing - discloses the planned borrowings and Main article: Financial mathematics
repayments of those planned borrowings, including
interest.
Financial mathematics is a eld of applied mathematics, concerned with nancial markets. The subject has
a close relationship with the discipline of nancial economics, which is concerned with much of the underlying
1.3 Financial theory
theory that is involved in nancial mathematics. Generally, mathematical nance will derive, and extend, the
1.3.1 Financial economics
mathematical or numerical models suggested by nancial
economics. In terms of practice, mathematical nance
Main article: Financial economics
also overlaps heavily with the eld of computational nance (also known as nancial engineering). Arguably,
Financial economics is the branch of economics study- these are largely synonymous, although the latter focuses
ing the interrelation of nancial variables, such as prices, on application, while the former focuses on modeling and
interest rates and shares, as opposed to those concerning derivation (see: Quantitative analyst). The eld is largely
the real economy. Financial economics concentrates on focused on the modelling of derivatives, although other
inuences of real economic variables on nancial ones, important subelds include insurance mathematics and
in contrast to pure nance. It centres on managing risk quantitative portfolio problems. See Outline of nance:
in the context of the nancial markets, and the resultant Mathematical tools; Outline of nance: Derivatives priceconomic and nancial models. It essentially explores ing.

1.4. PROFESSIONAL QUALIFICATIONS

1.3.3

Experimental nance

1.3.5 Intangible asset nance

Main article: Experimental nance

Main article: Intangible asset nance

Experimental nance aims to establish dierent market settings and environments to observe experimentally
and provide a lens through which science can analyze
agents behavior and the resulting characteristics of trading ows, information diusion and aggregation, price
setting mechanisms, and returns processes. Researchers
in experimental nance can study to what extent existing
nancial economics theory makes valid predictions and
therefore prove them, and attempt to discover new principles on which such theory can be extended and be applied to future nancial decisions. Research may proceed
by conducting trading simulations or by establishing and
studying the behavior, and the way that these people act
or react, of people in articial competitive market-like
settings.

Intangible asset nance is the area of nance that deals

with intangible assets such as patents, trademarks, goodwill, reputation, etc.

1.3.4

Behavioral nance

Main article: Behavioral economics

Behavioral nance studies how the psychology of investors or managers aects nancial decisions and markets when making a decision that can impact either negatively or positive one of there areas. Behavioral nance
has grown over the last few decades to become central
and very important to nance.
Behavioral nance includes such topics as:
1. Empirical studies that demonstrate signicant deviations from classical theories.
2. Models of how psychology aects and impacts trading and prices
3. Forecasting based on these methods.
4. Studies of experimental asset markets and use of
models to forecast experiments.
A strand of behavioral nance has been dubbed Quantitative Behavioral Finance, which uses mathematical and
statistical methodology to understand behavioral biases
in conjunction with valuation. Some of this endeavor has
been led by Gunduz Caginalp (Professor of Mathematics
and Editor of Journal of Behavioral Finance during 20012004) and collaborators including Vernon Smith (2002
Nobel Laureate in Economics), David Porter, Don Balenovich, Vladimira Ilieva, Ahmet Duran). Studies by Je
Madura, Ray Sturm and others have demonstrated signicant behavioral eects in stocks and exchange traded
funds. Among other topics, quantitative behavioral nance studies behavioral eects together with the nonclassical assumption of the niteness of assets.

1.4 Professional qualications

There are several related professional qualications, that
can lead to the eld:
Generalist Finance qualications:
Degrees: Master of Science in Finance
(MSF), Master of Finance (M.Fin), Master of
Financial Economics, Master of Applied Finance
Certications: Chartered Financial Analyst
(CFA), Certied Treasury Professional (CTP),
Certied Valuation Analyst (CVA), Certied
Patent Valuation Analyst (CPVA), Chartered
Business Valuator (CBV), Certied International Investment Analyst (CIIA), Financial
Risk Manager (FRM), Professional Risk
Manager (PRM), Association of Corporate
Treasurers (ACT), Certied Market Analyst
(CMA/FAD) Dual Designation, Corporate Finance Qualication (CF), Chartered Alternative Investment Analyst (CAIA), Chartered
Investment Manager (CIM)
Quantitative Finance qualications: Master of
Financial Engineering (MSFE), Master of Quantitative Finance (MQF), Master of Computational
Finance (MCF), Master of Financial Mathematics
(MFM), Certicate in Quantitative Finance (CQF).
Accountancy qualications:
Qualied accountant: Chartered Accountant
(The Institute of Chartered Accountant of
Pakistan - ICAP), Chartered Accountant (The
Institute of Chartered Accountants of India
- ICAI), Chartered Accountant (ACA - UK
certication / CA - certication in Commonwealth countries), Chartered Certied Accountant (ACCA, UK certication), Certied
Public Accountant (CPA, US certication),
ACMA/FCMA (Associate/Fellow Chartered
Management Accountant) from Chartered Institute of Management Accountant (CIMA),
UK.
Non-statutory qualications: Chartered Cost
Accountant CCA Designation from AAFM

CHAPTER 1. FINANCE
Business qualications: Master of Business Administration (MBA), Master of Management (MM),
Master of Commerce (M.Comm), Master of Science in Management (MSM), Doctor of Business
Administration (DBA)

1.5 See also

Outline of nance
Financial crisis of 20072010

1.6 References
[1] Financial Planning Curriculum Framework. Financial
Planning Standards Board. 2011. Retrieved 7 April 2012.
[2] Board of Governors of Federal Reserve System of the
United States. Mission of the Federal Reserve System.
Federalreserve.gov Accessed: 2010-01-16. (Archived by
WebCite at Webcitation.org)
[3] Berezin, M. (2005). Emotions and the Economy in
Smelser, N.J. and R. Swedberg (eds.) The Handbook of
Economic Sociology, Second Edition. Princeton University Press: Princeton, NJ

1.7 External links

Learn Finance Step by step with infographics tools
OECD work on nancial markets Observation of
UK Finance Market
Wharton Finance Knowledge Project - aimed to offer free access to nance knowledge for students,
teachers, and self-learners.
Professor Aswath Damodaran (New York University Stern School of Business) - provides resources
covering three areas in nance: corporate nance,
valuation and investment management and syndicate
nance.

Chapter 2

Bond market
Funding

The bond market (also debt market or credit market)

is a nancial market where participants can issue new
debt, known as the primary market, or buy and sell debt
securities, known as the secondary market. This is usually in the form of bonds, but it may include notes, bills,
and so on.

2.2 Bond market participants

Bond market participants are similar to participants in
most nancial markets and are essentially either buyers
(debt issuer) of funds or sellers (institution) of funds and
often both.

Its primary goal is to provide long-term funding for public and private expenditures. The bond market has largely
been dominated by the United States, which accounts
for about 44% of the market.[1] As of 2009, the size
of the worldwide bond market (total debt outstanding)
is an estimated at $82.2 trillion,[2] of which the size of
the outstanding U.S. bond market debt was $31.2 trillion
according to Bank for International Settlements (BIS),
or alternatively $35.2 trillion as of Q2 2011 according
to Securities Industry and Financial Markets Association
(SIFMA).[2]

Participants include:
Institutional investors
Governments
Traders

Individuals
Nearly all of the average daily trading in the U.S. bond
market takes place between broker-dealers and large
institutions in a decentralized over-the-counter (OTC) Because of the specicity of individual bond issues, and
market.[3] However, a small number of bonds, primarily the lack of liquidity in many smaller issues, the majority
of outstanding bonds are held by institutions like pension
corporate ones, are listed on exchanges.
funds, banks and mutual funds. In the United States, apAn important part of the bond market is the government
proximately 10% of the market is held by private individbond market, because of its size and liquidity. Governuals.
ment bonds are often used to compare other bonds to
measure credit risk. Because of the inverse relationship
between bond valuation and interest rates, the bond market is often used to indicate changes in interest rates or the 2.3 Bond market size
shape of the yield curve, the measure of cost of funding.
Amounts outstanding on the global bond market increased by 2% in the twelve months to March 2012 to
nearly $100 trillion. Domestic bonds accounted for 70%
2.1 Types of bond markets
of the total and international bonds for the remainder.
The United States was the largest market with 33% of the
The Securities Industry and Financial Markets Associatotal followed by Japan (14%). As a proportion of global
tion (SIFMA) classies the broader bond market into ve
GDP, the bond market increased to over 140% in 2011
specic bond markets.
from 119% in 2008 and 80% a decade earlier. The considerable growth means that in March 2012 it was much
Corporate
larger than the global equity market which had a market
capitalisation of around $53 trillion. Growth of the mar Government and agency
ket since the start of the economic slowdown was largely
Municipal
a result of an increase in issuance by governments.
Mortgage-backed, asset-backed, and collateralized The outstanding value of international bonds increased by
debt obligations
2% in 2011 to $30 trillion. The $1.2 trillion issued during
7

CHAPTER 2. BOND MARKET

the year was down by around a fth on the previous years

total. The rst half of 2012 was o to a strong start with
issuance of over $800 billion. The United States was the
leading center in terms of value outstanding with 24% of
the total followed by the UK 13%.[4]

2.3.1

U.S. bond market size

Bond market prices.

monetary policy and bond market volatility is a response

to expected monetary policy and economic changes.

Treasury (29.72%)
Corporate Debt (24.49%)
Mortgage Related (21.86%)
Municipal (9.21%)
Money Markets (6.36%)
Agency Securities (5.16%)
Asset-backed (3.20%)

Economists views of economic indicators versus actual

released data contribute to market volatility. A tight consensus is generally reected in bond prices and there is
little price movement in the market after the release of
in-line data. If the economic release diers from the
consensus view, the market usually undergoes rapid price
movement as participants interpret the data. Uncertainty
(as measured by a wide consensus) generally brings more
volatility before and after a release. Economic releases
vary in importance and impact depending on where the
economy is in the business cycle.

According to the Securities Industry and Financial Markets Association (SIFMA),[5] as of Q4 2013, the U.S.
bond market size is (in billions):

2.5 Bond market inuence

Note that the total federal government debts recognized

by SIFMA are signicantly less than the total bills, notes
and bonds issued by the U.S. Treasury Department,[6] of
some $17.5 trillion at the time. This gure is likely to
have excluded the inter-governmental debts such as those
held by the Federal Reserve and the Social Security Trust
Fund.

Bond markets determine the price in terms of yield that

a borrower must pay in order to receive funding. In one
notable instance, when President Bill Clinton attempted
to increase the U.S. budget decit in the 1990s, it led to
such a sell-o (decreasing prices; increasing yields) that
he was forced to abandon the strategy and instead balance
the budget. [7][8]

2.4 Bond market volatility

For market participants who own a bond, collect the
coupon and hold it to maturity, market volatility is irrelevant; principal and interest are received according to a
pre-determined schedule.
But participants who buy and sell bonds before maturity
are exposed to many risks, most importantly changes in
interest rates. When interest rates increase, the value of
existing bonds falls, since new issues pay a higher yield.
Likewise, when interest rates decrease, the value of existing bonds rises, since new issues pay a lower yield. This
is the fundamental concept of bond market volatility
changes in bond prices are inverse to changes in interest
rates. Fluctuating interest rates are part of a countrys

I used to think that if there was reincarnation, I wanted to come back as the president or
the pope or as a .400 baseball hitter. But now
I would like to come back as the bond market.
You can intimidate everybody.
James Carville, political advisor to President Clinton, Bloomberg [8]

2.6 Bond investments

Bonds typically trade in $1,000 increments and are priced
as a percentage of par value (100%). Many bonds have
minimums imposed by the bond or the dealer. Typical sizes oered are increments of $10,000. For bro-

2.9. REFERENCES
ker/dealers, however, anything smaller than a $100,000
trade is viewed as an odd lot.
Bonds typically pay interest at set intervals. Bonds with
xed coupons divide the stated coupon into parts dened
by their payment schedule, for example, semi-annual pay.
Bonds with oating rate coupons have set calculation
schedules where the oating rate is calculated shortly before the next payment. Zero-coupon bonds do not pay
interest. They are issued at a deep discount to account
for the implied interest.

9
Deferred nancing costs
Government bond
Interest rate risk
Primary market
Secondary market
Bullet strategy

Barbell strategy
Because most bonds have predictable income, they are
War Bond
typically purchased as part of a more conservative investment scheme. Nevertheless, investors have the ability
to actively trade bonds, especially corporate bonds and Specic:
municipal bonds with the market and can make or lose
money depending on economic, interest rate, and issuer
US Savings Bonds
factors.
Foreign exchange reserves of the Peoples Republic
Bond interest is taxed as ordinary income, in contrast to
of China
dividend income, which receives favorable taxation rates.
However many government and municipal bonds are exempt from one or more types of taxation.
Investment companies allow individual investors the ability to participate in the bond markets through bond funds,
closed-end funds and unit-investment trusts. In 2006 total bond fund net inows increased 97% from $30.8 billion in 2005 to $60.8 billion in 2006.[9] Exchange-traded
funds (ETFs) are another alternative to trading or investing directly in a bond issue. These securities allow individual investors the ability to overcome large initial and
incremental trading sizes. One rm that leverages on the
debt market is Ted Virtue's MidOcean Partners.

2.7 Bond indices

2.9 References
[1] http://www.investinginbondseurope.org/Pages/
LearnAboutBonds.aspx?folder_id=464
[2] Outstanding World Bond Market Debt from the Bank for
International Settlements via Asset Allocation Advisor.
Original BIS data as of March 31, 2009; Asset Allocation
Advisor compilation as of November 15, 2009. Accessed
January 7, 2010.
[3] Avg Daily Trading Volume SIFMA 2009 Jan-Nov Average Daily Trading Volume. Accessed January 6, 2010.
[4] Bond Markets 2012 report
[5] SIFMA Statistics

Main article: Bond market index

A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to
the S&P 500 or Russell Indexes for stocks. The most
common American benchmarks are the Barclays Capital
Aggregate Bond Index, Citigroup BIG and Merrill Lynch
Domestic Master. Most indices are parts of families of
broader indices that can be used to measure global bond
portfolios, or may be further subdivided by maturity or
sector for managing specialized portfolios.

2.8 See also

Bond
Bond market index
Bond valuation
Corporate bond

[6] Treasury Bulletin

[7] M&G Investments - Bond Vigilantes - Are the bond vigilantes vigilant enough?, 20 February 2009
[8] Bloomberg - Bond Vigilantes Push U.S. Treasuries Into
Bear Market, 10 February 2009
[9] Bond fund ows SIFMA. Accessed April 30, 2007.

Chapter 3

Commodity market
into between the contracting parties directly.[5] [6]
Exchange-traded funds (ETFs) began to feature commodities in 2003. Gold ETFs are based on electronic
gold that does not entail the ownership of physical bullion, with its added costs of insurance and storage in
repositories such as the London bullion market. According to the World Gold Council, ETFs allow investors to be exposed to the gold market without the
risk of price volatility associated with gold as a physical
commodity.[7][8][notes 1]

3.1 History
Chicago Board of Trade Futures market

A commodity market is a market that trades in primary

rather than manufactured products. Soft commodities
are agricultural products such as wheat, coee, cocoa and
sugar. Hard commodities are mined, such as gold, rubber
and oil.[1] Investors access about 50 major commodity
markets worldwide with purely nancial transactions increasingly outnumbering physical trades in which goods
are delivered. Futures contracts are the oldest way of investing in commodities. Futures are secured by physical
assets.[2] Commodity markets can include physical trading and derivatives trading using spot prices, forwards,
futures, and options on futures. Farmers have used a simple form of derivative trading in the commodity market
for centuries for price risk management.[3]

Commodity-based money and commodity markets in a

crude early form are believed to have originated in Sumer
between 4500 BC and 4000 BC. Sumerians rst used clay
tokens sealed in a clay vessel, then clay writing tablets to
represent the amountfor example, the number of goats,
to be delivered.[9][10] These promises of time and date of
delivery resemble futures contract.
Early civilizations variously used pigs, rare seashells, or
other items as commodity money. Since that time traders
have sought ways to simplify and standardize trade contracts.
Gold and silver markets evolved in classical civilizations. At rst the precious metals for valued for their
beauty and intrinsic worth and were associated with royalty. In time, they were used for trading and were exchanged for other goods and commodities, or for payments of labor.[11] Gold, measured out, then became
money. Golds scarcity, unique density and the way it
could be easily melted, shaped, and measured made it a
natural trading asset.[12]

A nancial derivative is a nancial instrument whose

value is derived from a commodity termed an underlier.[2]
Derivatives are either exchange-traded or over-thecounter (OTC). An increasing number of derivatives are
traded via clearing houses some with Central Counterparty Clearing, which provide clearing and settlement Beginning in the late 10th century, commodity markets
services on a futures exchange, as well as o-exchange grew as a mechanism for allocating goods, labor, land
in the OTC market.[4]
and capital across Europe. Between the late 11th and
Derivatives such as futures contracts, Swaps (1970s-), the late 13th century, English urbanization, regional speExchange-traded Commodities (ETC) (2003-), forward cialization, expanded and improved infrastructure, the incontracts have become the primary trading instruments creased use of coinage and the proliferation of markets
in commodity markets. Futures are traded on regulated and fairs were evidence of commercialization.[13] The
commodities exchanges. Over-the-counter (OTC) con- spread of markets is illustrated by the 1466 installation of
tracts are privately negotiated bilateral contracts entered reliable scales in the villages of Sloten and Osdorp so vil10

3.4. CASH COMMODITY

11

lagers no longer had to travel to Haarlem or Amsterdam which began in 1958. Its construction made it unuseful as
to weigh their locally produced cheese and butter.[13]
an investment index. The rst practically investable comGoldman Sachs CommodIndeed, the Amsterdam Stock Exchange, often cited as modity futures index was the
[19]
ity
Index,
created
in
1991,
and known as the GSCI.
the rst stock exchange, originated as a market for the exThe
next
was
the
Dow
Jones
AIG
Commodity Index. It
change of commodities. Early trading on the Amsterdam
diered
from
the
GSCI
primarily
in
the weights allocated
Stock Exchange often involved the use of very sophistito
each
commodity.
The
DJ
AIG
had
mechanisms to pecated contracts, including short sales, forward contracts,
riodically
limit
the
weight
of
any
one
commodity and to
and options. Trading took place at the Amsterdam
remove commodities whose weights became too small.
Bourse, an open aired venue, which was created as a commodity exchange in 1530 and rebuilt in 1608. Commod- After AIG's nancial problems in 2008 the Index rights
were sold to UBS and it is now known as the DJUBS
ity exchanges themselves were a relatively recent invenindex. Other commodity indices include the Reuters /
[14]
tion, existing in only a handful of cities.
CRB index (which is the old CRB Index as re-structured
In 1864, in the United States, wheat, corn, cattle, and in 2005) and the Rogers Index.
pigs were widely traded using standard instruments on
the Chicago Board of Trade (CBOT), the worlds oldest
futures and options exchange. Other food commodities
3.4 Cash commodity
were added to the Commodity Exchange Act and traded
through CBOT in the 1930s and 1940s, expanding the
list from grains to include rice, mill feeds, butter, eggs, Cash commodities or actuals refer to the physical
Irish potatoes and soybeans.[15] Successful commodity goodse.g., wheat, corn, soybeans, crude oil, gold,
markets require broad consensus on product variations to silverthat someone is buying/selling/trading as distin[3]
make each commodity acceptable for trading, such as the guished from derivatives.
purity of gold in bullion. Classical civilizations built complex global markets trading gold or silver for spices, cloth,
wood and weapons, most of which had standards of qual- 3.5 Call options
ity and timeliness.
Through the 19th century the exchanges became effective spokesmen for, and innovators of, improvements
in transportation, warehousing, and nancing, which
paved the way to expanded interstate and international
trade.[16]

In a call option counterparties enter into a nancial contract option where the buyer purchases the right but not
the obligation to buy an agreed quantity of a particular
commodity or nancial instrument (the underlying) from
the seller of the option at a certain time (the expiration
Reputation and clearing became central concerns, and date) for a certain price (the strike price). The seller (or
states that could handle them most eectively developed writer) is obligated to sell the commodity or nancial
instrument should the buyer so decide. The buyer pays a
powerful nancial centers.[17]
fee (called a premium) for this right.[20]

3.2 Commodity price index

In 1934, the US Bureau of Labor Statistics began the
computation of a daily Commodity price index that became available to the public in 1940. By 1952, the Bureau of Labor Statistics issued a Spot Market Price Index
that measured the price movements of 22 sensitive basic
commodities whose markets are presumed to be among
the rst to be inuenced by changes in economic conditions. As such, it serves as one early indication of impending changes in business activity.[18]

3.3 Commodity index fund

A commodity index fund is a fund whose assets are invested in nancial instruments based on or linked to a
commodity index. In just about every case the index is
in fact a Commodity Futures Index. The rst such index was the Commodity Research Bureau (CRB) Index,

3.6 Electronic commodities trading

In traditional stock market exchanges such as the New
York Stock Exchange (NYSE), most trading activity
took place in the trading pits in face-to-face interactions between brokers and dealers in open outcry trading.[21] In 1992 the Financial Information eXchange
(FIX) protocol was introduced, allowing international
real-time exchange of information regarding market
transactions. The U.S. Securities and Exchange Commission ordered U.S. stock markets to convert from the
fractional system to a decimal system by April 2001.
Metrication, conversion from the imperial system of
measurement to the metrical, increased throughout the
20th century.[22] Eventually FIX-compliant interfaces
were adopted globally by commodity exchanges using the
FIX Protocol.[23] In 2001 the Chicago Board of Trade
and the Chicago Mercantile Exchange (later merged into

12

CHAPTER 3. COMMODITY MARKET

the CME group, the worlds largest futures exchange ket. Derivatives markets, on the other hand, require the
company)[22] launched their FIX-compliant interface.
existence of agreed standards so that trades can be made
By 2011, the alternative trading system (ATS) of without visual inspection.
electronic trading featured computers buying and selling
without human dealer intermediation. High-frequency
3.6.3 Standardization
trading (HFT) algorithmic trading, had almost phased out
[21][notes 2]
dinosaur oor-traders.
US soybean futures, for example, are of standard grade if
they are GMO or a mixture of GMO and Non-GMO No.
3.6.1 Increased complexity of nancial in- 2 yellow soybeans of Indiana, Ohio and Michigan origin
produced in the U.S.A. (Non-screened, stored in silo)".
struments and interconnectedness of They are of deliverable grade if they are GMO or a
global market
mixture of GMO and Non-GMO No. 2 yellow soybeans
of Iowa, Illinois and Wisconsin origin produced in the
The robust growth of emerging market economies U.S.A. (Non-screened, stored in silo)". Note the distinc(EMEs), (such as Brazil, Russia, India, and China) in the tion between states, and the need to clearly mention their
1990s, propelled commodity markets into a supercycle. status as GMO (Genetically Modied Organism) which
The size and diversity of commodity markets expanded makes them unacceptable to most organic food buyers.
internationally.[24]
Similar specications apply for cotton, orange juice, coIn 2012, as emerging-market economies slowed down, coa, sugar, wheat, corn, barley, pork bellies, milk, feedcommodity prices declined. From 2005-13 energy and stus, fruits, vegetables, other grains, other beans, hay,
metals real prices remained well above their long-term other livestock, meats, poultry, eggs, or any other comaverages. In 2012 real food prices were at their highest modity which is so traded.
level since 1982.[24]
Standardization has also occurred technologically, as the
The price of gold bullion fell dramatically on April 12, use of the FIX Protocol by commodities exchanges has
2013 and analysts frantically sought explanations. Ru- allowed trade messages to be sent, received and processed
mors spread that the European Central Bank (ECB) in the same format as stocks or equities. This process
would force Cyprus to sell its gold reserves in re- began in 2001 when the Chicago Mercantile Exchange
sponse to its nancial crisis. Major banks such as launched a FIX-compliant interface that was adopted by
Goldman Sachs began immediately to short gold bullion. commodity exchanges around the world.[23]
Investors scrambled to liquidate their exchange-traded
funds (ETFs)[notes 3] and margin call selling accelerated.
George Gero, precious metals commodities expert at the
Royal Bank of Canada (RBC) Wealth Management sec- 3.7 Derivatives
tion reported that he had not seen selling of gold bullion as panicked as this in his forty years in commodity Derivatives are nancial evolved from simple commodity future contracts into a diverse group of nancial inmarkets.[25]
struments that apply to every kind of asset, including
The earliest commodity exchange-traded fund (ETFs),
mortgages, insurance and many more. Futures contracts,
such as SPDR Gold Shares NYSE Arca: GLD and
Swaps (1970s-), Exchange-traded Commodities (ETC)
iShares Silver Trust NYSE Arca: SLV, actually owned
(2003-), forward contracts, etc. are examples. They can
the physical commodities. Similar to these are NYSE
be traded through formal exchanges or through OverArca: PALL (palladium) and NYSE Arca: PPLT
the-counter (OTC). Commodity market derivatives un(platinum). However, most Exchange Traded Commodilike credit default derivatives for example, are secured by
ties (ETCs) implement a futures trading strategy. At the
the physical assets or commodities.[2]
time Russian Prime Minister Dmitry Medvedev warned
that Russia could sink into recession. He argued that We
live in a dynamic, fast-developing world. It is so global 3.7.1 Forward contracts
and so complex that we sometimes cannot keep up with
the changes. Analysts have claimed that Russias econ- A forward contract is an agreement between two parties
omy is overly dependent on commodities. [26]
to exchange at some xed future date a given quantity of a
commodity for a price dened when the contract is nal3.6.2 Contracts in the commodity market ized. The xed price is known as the forward price. Such
forward contracts began as a way of reducing pricing risk
A Spot contract is an agreement where delivery and pay- in food and agricultural product markets, because farmment either takes place immediately, or with a short lag. ers knew what price they would receive for their output.
Physical trading normally involves a visual inspection and Forward contracts for example, were used for rice in sevis carried out in physical markets such as a farmers mar- enteenth century Japan.

3.7. DERIVATIVES

3.7.2

13

Futures contract

launched on the NYSE in 2006. As of November 2010

a commodity ETF, namely SPDR Gold Shares, was the
Futures contracts are standardized forward contracts that second-largest ETF by market capitalization.[34]
are transacted through an exchange. In futures contracts Generally, commodity ETFs are index funds tracking
the buyer and the seller stipulate product, grade, quantity non-security indices. Because they do not invest in secuand location and leaving price as the only variable.[27]
rities, commodity ETFs are not regulated as investment
Agricultural futures contracts are the oldest, in use in the
United States for more than 170 years.[28] Modern futures agreements, began in Chicago in the 1840s, with
the appearance of the railroads. Chicago, centrally located, emerged as the hub between Midwestern farmers
and east coast consumer population centers.

companies under the Investment Company Act of 1940

in the United States, although their public oering is subject to SEC review and they need an SEC no-action letter
under the Securities Exchange Act of 1934. They may,
however, be subject to regulation by the Commodity Futures Trading Commission.[35][36]

The earliest commodity ETFs, such as SPDR Gold

Shares NYSE Arca: GLD and iShares Silver Trust NYSE
3.7.3 Swaps
Arca: SLV, actually owned the physical commodity (e.g.,
gold and silver bars). Similar to these are NYSE Arca:
A Swaps is a derivative in which counterparties exchange
PALL (palladium) and NYSE Arca: PPLT (platinum).
the cash ows of one partys nancial instrument for those
However, most ETCs implement a futures trading stratof the other partys nancial instrument. They were introegy, which may produce quite dierent results from ownduced in the 1970s.[29][30]
ing the commodity.
Commodity ETFs trade provide exposure to an increas-

3.7.4

Exchange-traded
(ETCs)

commodities ing range of commodities and commodity indices, includ-

ing energy, metals, softs and agriculture. Many commodity funds, such as oil roll so-called front-month futures
contracts from month to month. This provides exposure
Main article: Exchange-traded product
to the commodity, but subjects the investor to risks involved in dierent prices along the term structure, such as
Exchange-traded commodity is a term used for commod- a high cost to roll.[7][8]
ity exchange-traded funds (which are funds) or commodity exchange-traded notes (which are notes). These track ETCs in China and India gained in importance due to
the performance of an underlying commodity index in- those countries emergence as commodities consumers
cluding total return indices based on a single commodity. and producers. China accounted for more than 60% of
They are similar to ETFs and traded and settled exactly exchange-traded commodities in 2009, up from 40% the
like stock funds. ETCs have market maker support with previous year. The global volume of ETCs increased by a
guaranteed liquidity, enabling investors to easily invest in 20% in 2010, and 50% since 2008, to around 2.5 billion
million contracts.
commodities.
They were introduced in 2003.
At rst only professional institutional investors had access, but online exchanges opened some ETC markets to
almost anyone. ETCs were introduced partly in response
to the tight supply of commodities in 2000, combined
with record low inventories and increasing demand from
emerging markets such as China and India.[31]

3.7.5 Over-the-counter (OTC) commodities derivatives

Benchmark Asset Management Company Private Ltd in

India, when they led a proposal with the SEBI in May
2002.[33] The rst gold exchange-traded fund was Gold
Bullion Securities launched on the ASX in 2003, and the
rst silver exchange-traded fund was iShares Silver Trust

Money under management more than doubled between

2008 and 2010 to nearly $380 billion. Inows into the
sector totaled over $60 billion in 2010, the second highest
year on record, down from $72bn the previous year. The
bulk of funds went into precious metals and energy prod-

Over-the-counter (OTC) commodities derivatives trading

originally involved two parties, without an exchange. Exchange trading oers greater transparency and regulatory
Prior to the introduction of ETCs, by the 1990s ETFs pio- protections. In an OTC trade, the price is not generally
OTC are higher risk but may also lead to
neered by Barclays Global Investors (BGI) revolutionized made public. [37]
higher
prots.
[31]
By the end of December
the mutual funds industry.
2009 BGI assets hit an all-time high of $1 trillion.[32]
Between 2007 and 2010, global physical exports of comGold was the rst commodity to be securitised through modities fell by 2%, while the outstanding value of OTC
an Exchange Traded Fund (ETF) in the early 1990s, commodities derivatives declined by two-thirds as inbut it was not available for trade until 2003.[31] The vestors reduced risk following a ve-fold increase in the
idea of a Gold ETF was rst ocially conceptualised by previous three years.

14
ucts. The growth in prices of many commodities in 2010
contributed to the increase in the value of commodities
funds under management.[38]

CHAPTER 3. COMMODITY MARKET

New York Mercantile Exchange
New York Board of Trade
Rosario Board of Trade

3.8 Commodities exchange

Tokyo Commodity Exchange

Main article: Commodities exchange

Winnipeg Commodity Exchange

A commodities exchange is an exchange where various

3.9 Traded commodity classes
commodities and derivatives are traded. Most commodity markets across the world trade in agricultural products
and other raw materials (like wheat, barley, sugar, maize, Main article: List of traded commodities
cotton, Cocoa bean|cocoa, coee, milk products, pork
bellies, oil, metals, etc.) and contracts based on them. Source: International Trade Centre[40]
These contracts can include spot prices, forwards, futures
and options on futures. Other sophisticated products may
include interest rates, environmental instruments, swaps, 3.9.1 Energy
or freight contracts.[3]
Energy commodities include crude oil particularly West
Texas Intermediate (WTI) crude oil and Brent crude oil,
Abuja Securities and Commodities Exchange
natural gas, heating oil, ethanol and puried terephthalic
Africa Mercantile Exchange
acid. Hedging is a common practice for these commodities.
Bhatinda Om & Oil Exchange Bathinda
Brazilian Mercantile and Futures Exchange
Chicago Board of Trade
Chicago Mercantile Exchange

Crude oil and natural gas

See also: Chronology of world oil market events (1970
2005)

Commodity Exchange Bratislava, JSC

Dalian Commodity Exchange
Dubai Mercantile Exchange
Dubai Gold & Commodities Exchange
Euronext.lie
Hong Kong Mercantile Exchange
Indian Commodity Exchange
Intercontinental Exchange
Iranian Oil Bourse
Kansas City Board of Trade
London Metal Exchange
Minneapolis Grain Exchange
Multi Commodity Exchange
National Commodity and Derivatives Exchange
National Multi-Commodity Exchange of India Ltd
National Food Exchange
National Spot Exchange

For many years, West Texas Intermediate (WTI) crude

oil, a light, sweet crude oil, was the worlds most-traded
commodity. WTI is a grade used as a benchmark in oil
pricing. It is the underlying commodity of Chicago Mercantile Exchanges oil futures contracts. WTI is often
referenced in news reports on oil prices, alongside Brent
Crude. WTI is lighter and sweeter than Brent and considerably lighter and sweeter than Dubai or Oman.[41]
From April through October 2012, Brent futures contracts exceeded those for WTI, the longest streak since
at least 1995.[42]
Crude oil can be light or heavy. Oil was the rst form
of energy to be widely traded. Some commodity market speculation is directly related to the stability of certain states, e.g., Iraq, Bahrain, Iran, Venezuela and many
others. Most commodities markets are not so tied to the
politics of volatile regions.
Oil and gasoline are traded in units of 1,000 barrels (42,000 US gallons). WTI crude oil is traded
through NYMEX under trading symbol CL and through
Intercontinental Exchange (ICE) under trading symbol
WTI. Brent crude oil is traded in through Intercontinental
Exchange under trading symbol B. Gulf Coast Gasoline is
traded through NYMEX with the trading symbol of LR.
Gasoline (reformulated gasoline blendstock for oxygen

3.9. TRADED COMMODITY CLASSES

blending or RBOB) is traded through NYMEX via trading symbol RB. Propane is traded through NYMEX, a
subsidiary of Intercontinental Exchange since early 2013,
via trading symbol PN.
Natural gas is traded through NYMEX a subsidiary of Intercontinental Exchange in units of 10,000 mmBTU with
the trading symbol of NG. Heating oil is traded through
NYMEX, a subsidiary of Intercontinental Exchange, under trading symbol HO.
Others

15
ily for human food, shelter, animal feed, or natural ber.
Three other categories were explained and listed.[45]
In February 2013, Cornell Law School included lumber,
soybeans, oilseeds, livestock (live cattle and hogs), dairy
products. Agricultural commodities can include lumber
(timber and forests), grains excluding stored grain (wheat,
oats, barley, rye, grain sorghum, cotton, ax, forage, tame
hay, native grass), vegetables (potatoes, tomatoes, sweet
corn, dry beans, dry peas, freezing and canning peas),
fruit (citrus such as oranges, apples, grapes) corn, tobacco, rice, peanuts, sugar beets, sugar cane, sunowers,
raisins, nursery crops, nuts, soybean complex, aquacultural sh farm species such as nsh, mollusk, crustacean,
aquatic invertebrate, amphibian, reptile, or plant life cultivated in aquatic plant farms.[46] [47]

Puried terephthalic acid (PTA) is traded through ZCE in

units of 5 tons with the trading symbol of TA. Ethanol is
traded at CBOT in units of 29,000 U.S. gal under trading
In 1900, corn acreage was double that of wheat in the
symbols AC (Open Auction) and ZE (Electronic).
United States. But from the 1930s through the 1970s soybean acreage surpassed corn. Early in the 1970s grain and
soybean prices, which had been relatively stable, soared
3.9.2 Metals
to levels that were unimaginable at the time. There were
a number of factors aecting prices including the surge
Precious metals
in crude oil prices caused by the Arab Oil Embargo in
Precious metals currently traded on the commodity mar- October 1973 (US ination reached 11% in 1975).[48]
ket include gold, platinum, palladium and silver which are
sold by the troy ounce. One of the main exchanges for
these precious metals is COMEX.
Diamonds

According to the World Gold Council, investments in

gold are the primary driver of industry growth. Gold As of 2012, diamond was not traded as a commodity.
prices are highly volatile, driven by large ows of spec- Institutional investors were repelled by campaign against
ulative money.[43]
"blood diamonds", the monopoly structure of the diamond market and the lack of uniform standards for diamond pricing. In 2012 the SEC reviewed a proposal to
Industrial metals
create the rst diamond-backed exchange-traded fund
that would trade on-line in units of one-carat diamonds
Industrial metals are sold by the metric ton through the
with a storage vault and delivery point in Antwerp, home
London Metal Exchange and New York Mercantile Exof the Antwerp Diamond Bourse. The exchange fund
change. The London Metal Exchange trades include
was backed by a company based in New York called
copper, aluminium, lead, tin, aluminium alloy, nickel,
IndexIQ. IndexIQ had already introduced 14 exchangecobalt and molybdenum. In 2007, steel began trading on
traded funds since 2008.[43][49][notes 4]
the London Metal Exchange.
According to Citigroup analysts, the annual production
of polished diamonds is about $18 billion. Like gold, di3.9.3 Agriculture
amonds are easily authenticated and durable. Diamond
prices have been more stable than the metals, as the global
See also: Agricultural commodities and price hedging
diamond monopoly De Beers once held almost 90% (by
2013 reduced to 40%) of the new diamond market.[43]
Agricultural commodities include grains, food and ber
as well as livestock and meat, various regulatory bodies
dene agricultural products.[44]
3.9.4 Other commodity markets
On July 21, 2010, United States Congress passed the
DoddFrank Wall Street Reform and Consumer Protec- Rubber trades on the Singapore Commodity Exchange in
tion Act with changes to the denition of agricultural units of 1 kg priced in US cents. Palm oil is traded on the
commodity. The operational denition used by Dodd- Malaysian Ringgit (RM), Bursa Malaysia in units of 1 kg
Frank includes "[a]ll other commodities that are, or once priced in US cents. Wool is traded on the AUD in units of
were, or are derived from, living organisms, including 1 kg. Polypropylene and Linear Low Density Polyethyplant, animal and aquatic life, which are generally fungi- lene (LL) did trade on the London Metal Exchange in
ble, within their respective classes, and are used primar- units of 1,000 kg priced in USD but was dropped in 2011.

16

CHAPTER 3. COMMODITY MARKET

3.10 Regulatory bodies and poli- 3.11 Trading systems

cies
3.10.1

United States

In the United States, the principal regulator of commodity and futures markets is the Commodity Futures Trading Commission (CFTC). The National Futures Association (NFA) formed in 1976 and is the futures industrys
self-regulatory organization. The NFAs rst regulatory
operations began in 1982 and fall under the Commodity
Exchange Act of the Commodity Futures Trading Commission Act.[50]
Dodd-Frank was enacted in response to the 2008 nancial crisis. It called for strong measures to limit
speculation in agricultural commodities calling upon
the Commodity Futures Trading Commission (CFTC) to
further limit positions and to regulate over-the-counter
trades.[51]

3.10.2

European Union

Markets in Financial Instruments Directive (MiFID) is

the cornerstone of the European Commission's Financial
Services Action Plan that regulate operations of the EU
nancial service markets. It was reviewed in 2012 by the
European Parliament (EP) and the Economic and Financial Aairs Council (ECOFIN).[52] The European Parliament adopted a revised version of Mid II on October 26, 2012 which include provisions for position limits on commodity derivatives, aimed at preventing market abuse and supporting orderly pricing and settlement
conditions.[53]
The European Securities and Markets Authority (Esma),
based in Paris and formed in 2011, is an EU-wide nancial markets watchdog. Esma sets position limits on
commodity derivatives as described in Mid II.[53]
The EP voted in favor of stronger regulation of commodity derivative markets in September 2012 to end
abusive speculation in commodity markets that were
driving global food prices increases and price volatility. In July 2012 food prices globally soared by 10
percent (World Bank 2012) Senior British MEP Arlene McCarthy called for putting a brake on excessive
food speculation and speculating giants proting from
hunger ending immoral practices that only serve the
interests of proteers.[54] In March 2012, EP Member Markus Ferber suggested amendments to the European Commissions proposals, intended to strengthen restrictions on high-frequency trading and commodity price
manipulation.[55]

Software for managing trading systems has been available for several decades in various congurations. This
includes software as a service. So-called Energy Trading Risk Management (ETRM) includes software such as
Triple Point Technology, SolArc, OpenLink and Agiboo.
One of the more popular soft commodity solutions is
called Just Commodity, based in Singapore this application caters to a large number of palm oil, edible oil, sugar
and wheat trading businesses.

3.12 Notes
[1] This article covers physical product (food, metals, energy)
markets but not the ways that services, including those of
governments, nor investment, nor debt, can be seen as a
commodity. Articles on reinsurance markets, stock markets, bond markets, and currency markets cover those concerns separately and in more depth.
[2] In July 2009, when a high-frequency trading platform with
proprietary algorithmic trading code used by Goldman
Sach to allegedly generate massive prots in the commodity market was stolen by Sergey Aleynikov there was
widespread concern about the unintended economic consequences of HFT.
[3] Exchange Traded Funds revolutionized the mutual funds
industry when they were introduced. Exchange Traded
Commodities, sold rst by pioneering investors group
Barclays Global Investors (BGI) (now owned by BlackRock) revolutionized the commodity market. By the end
of December 2009 Barclays Global Investors (BGI) assets
hit an all-time high of $1 trillion ($1,032 billion).
[4] IndexIQ registered Adam S. Patti as Chief Executive Ocer (CEO) and David Fogel as Chief Financial Ocer and
Executive Vice President in the City of Rye Brook, New
York, on January 31, 2013 as representatives of IndexIQ
Advisors LLC sponsoring the IQ Physical Diamond Trust.

3.13 References
[1] Soft Commodity Denition. Investopedia. 2009-02-15.
Retrieved 2012-12-06.
[2] O'Harrow, Robert (21 April 2010). A primer on nancial
derivatives. Washington Post.
[3] Opportunities and Risk: an Educational Guide to Trading
Futures and Options on Futures (PDF). Chicago, Illinois:
National Futures Association. 2006. p. 6.
[4] http://chicagofed.org/webpages/publications/
understanding_derivatives/index.cfm
[5] The Regulation of Derivatives in Canada. Expert Panel.
2007.

3.13. REFERENCES

[6] Loder, Asjylyn (18 July 2010). Commodity Manipulation May Be Easier to Prove After Overhaul. Bloomberg.
[7] Bytom Lauricella (2009-11-02). Gold Mutual Funds Vs.
Gold ETFs: It Depends on the Goal. Wall Street Journal.
Retrieved 2011-10-03.
[8] The Future of Commodity ETFs. Morningstar. 200908-25. Retrieved 2011-10-03.
[9] Banerjee, Jasodhara (16 January 2013). Origins of
Growing Money. India: Forbes India Magazine.
[10] Sinha, Ram Pratap; Bhuniya, Ashis (7 January 2011).
Risk Transfer Through Commodity Derivatives: A Study
of Soyabean Oil. Social Science Research Network
(SSRN).
[11] http://commodityhq.com/2012/
a-brief-2000-year-history-of-silver-prices/
[12] http://www.onlygold.com/tutorialpages/historyfs.htm
Early history of gold and how it became used as money.
[13] Dijkman, Jessica Elisabeth Catharina (18 June 2010).
Medieval market institutions: The organisation of commodity markets in Holland, c. 1200 c. 1450 (PDF). p.
2.
[14] Stringham, Edward (2003). The Extralegal Development of Securities Trading in Seventeenth Century Amsterdam. Quarterly Review of Economics and Finance 43
(2): 321. Retrieved 12 January 2015.
[15] History of the CFTC: U.S. Futures Trading and Regulation Before the Creation of the CFTC. U.S. Commodity
Futures Trading Commission.
[16] US Commodity Futures Trading Handbook Volume 1
Strategic Information and Regultions. ISBN 1577516095.
[17] Markham, Jerry W. (1987). The History of Commodity
Futures Trading and Its Regulation. Praeger. p. 305.
[18] CRB BLS Spot Indices. Commodity Research Bureau (CRB). 2006.
[19] The Food Bubble, Frederick Kaufman, Harpers, 2010
July
[20] Sullivan, arthur; Steven M. Sherin (2003). Economics:
Principles in Action. Upper Saddle River, NJ: Pearson
Prentice Hall. p. 288. ISBN 0-13-063085-3.
[21] McGowan, Michael (2011). The rise of computerized
high frequency trading: use and controversy. Duke Law
& Technology Review.
[22] Johnson, David. Stock Market Goes Decimal: Complicated fractions abandoned in favor of pennies.
[23] Malabre, Fred; Mendelson, Don (15 December 2011).
Commodities Trading with FIX (FIXGlobal) Commodities Trading with FIX. CME Group.
[24] Lane (Deputy Governor of the Bank of Canada), Timothy
(25 September 2012). Financing Commodities Markets
presented to the CFA Society of Calgary. Calgary, Alberta.

17

[25] Fontevecchia, Agustino (15 April 2013). Violent And

Panicky Gold Selling Collapse Bullion And Commodity
Markets. Forbes.
[26] Gorst, Isabel (17 April 2013). Russia and less than $100
oil. Financial Times Blog. Retrieved 17 April 2013.
[27] Garner, Carley. A Traders First Book on Commodities.
(New Jersey: FT Press, 2010): pg 19.
[28] Futures Trading Act of 1921, Declared unconstitutional in
Hill v. Wallace 259 U.S. 44 (1922), the Grain Futures Act
of 1922 and Board of Trade of City of Chicago v. Olsen
262 U.S. 1 (1923).
[29] William D. Coleman (2003). Governing Global Finance:
Financial derivatives, liberal states, and transformative capacity (PDF). GHC Working Paper 01/2.
[30] Dennis W. Carlton (1984). Futures Markets: Their Purpose, Their History, Their Growth, Their Successes and
Failures. Journal of Futures Markets 4 (3): 23771.
doi:10.1002/fut.3990040302.
[31] Bienkowski, Nik. Exchange Traded Commodities Led
by Gold, ETCs Opened the World of Commodities to Investors (PDF). Alchemist (The London Bullion Market
Association) (48).
[32] Opalesque (14 January 2010). BlackRocks global ETFs
hit an all time high of $1tln.
[33] Benchmark Asset Management Company conceptualises
Gold ETF. Etfglobalinvestor.net. Retrieved 2011-10-03.
[34] Largest ETFs: Top 25 ETFs By Market Cap. ETFdb.
Retrieved 2010-11-03.
[35] Michael Sackheim, Michael Schmidtberger & James
Munsell, DB Commodity Index Tracking Fund: An
Innovative Exchange-Traded Fund, Futures Industry
(May/June 2006).
[36] Koyfman, Yevgeniy (2009-08-21). No Gas: Barclays
Halts Issuance of Natural Gas ETN. Indexuniverse.com.
Retrieved 2011-10-03.
[37] Jon Gregory. Counterparty credit risk. ISBN 978-0-47068576-1. p. 7.
[38] Commodities Trading report
[39] Web Volume Report CMEG (PDF).
[40] Trade statistics for international business development.
Trade Map. 2013-09-20. Retrieved 2013-09-26.
[41] Marius Vassiliou (2009). Historical Dictionary of the
Petroleum Industry. Lanham, MD: Scarecrow Press.
ISBN 0-8108-5993-9.
[42] Smith, Grant (26 November 2012). Brent Poised to Depose WTI as Most-Traded Oil Futures. Bloomberg.
[43] Popper, Nathanial (13 April 2012). Diamonds as a Commodity. The New York Times.

18

[44] See the Futures Trading Act of 1921, Declared unconstitutional in Hill v. Wallace 259 U.S. 44 (1922), the Grain Futures Act of 1922 and Board of Trade of City of Chicago
v. Olsen 262 US 1 (1923).
[45] Final Rule Regarding the Denition of Agricultural
Commodity (PDF). Commodity Futures Trading Commission Oce of Public Aairs. 21 July 2010.
[46] Denition of Agricultural Commodities. Law at Cornell. Cornell University. February 2013.
[47] Brown, Veronica (15 April 2013). Gold set for worst
two-day loss since 1983. Reuters.
[48] Encyclopedia of Commodity and Financial Prices:
Grains and Oilseeds (PDF). Commodity Research Bureau (CRB). pp. 172187.
[49] IQ Physical Diamond Trust. 5 February 2013.
[50] National Futures Association. National Futures Association.
[51] Clapp, Jennifer (5 December 2012). Position Limits for
Agricultural Commodity Derivatives: Getting Tougher or
Tough to Get?". Triple Crisis.
[52] Henn, Markus (October 2012). European Parliament decides to tackle commodity speculation: a little bit. Centre
for Research on Multinational Corporations (SOMO) (14).
[53] Maroo, Jay (13 Nov 2012). Commodity position limits
cause Mid II confusion. Energy Risk.
[54] Banks, Martin (27 September 2012). EU parliament approves moves to end 'abusive' speculation in commodity
markets. European Parliament.
[55] Reeve, Nick (March 29, 2012). Mid amendment calls
for commission ban to be scrapped. Financial Times.

3.14 Further reading

Understanding Derivatives: Markets and Infrastructure Federal Reserve Bank of Chicago, Financial
Markets Group
Opportunities and Risk: an Educational Guide to
Trading Futures and Options on Futures (PDF).
Chicago, Illinois: National Futures Association.
2006. p. 48.
Markham, Jerry W. (1987). The History of Commodity Futures Trading and Its Regulation. Praeger.
p. 305.
Longstreth, Andrew (26 May 2011). Alden Bentley,
editor, ed. CFTC faces high hurdles in oil manipulation case. Reuters.

CHAPTER 3. COMMODITY MARKET

3.15 External links

Open Historical Commodity Price Data
5 Mistakes of Commodity Trading

Chapter 4

Money market
For other uses, see Money market (disambiguation).
As money became a commodity, the money market became a component of the nancial markets for assets involved in short-term borrowing, lending, buying and selling with original maturities of one year or less. Trading in the money markets is done over the counter and
is wholesale. Various instruments exist, such as Treasury
bills, commercial paper, bankers acceptances, deposits,
certicates of deposit, bills of exchange, repurchase
agreements, federal funds, and short-lived mortgage-, and
asset-backed securities.[1] It provides liquidity funding for
the global nancial system. Money markets and capital
markets are parts of nancial markets. The instruments
bear diering maturities, currencies, credit risks, and
structure. Therefore they may be used to distribute the
exposure.[2]

tions with strong credit ratings, such as General Electric,

issue commercial paper on their own credit. Other large
corporations arrange for banks to issue commercial paper
on their behalf via commercial paper lines.
In the United States, federal, state and local governments
all issue paper to meet funding needs. States and local
governments issue municipal paper, while the US Treasury issues Treasury bills to fund the US public debt:
Trading companies often purchase bankers acceptances to be tendered for payment to overseas suppliers.
Retail and institutional money market funds
Banks
Central banks
Cash management programs
Merchant banks

4.1 Participants
The money market consists of nancial institutions and
dealers in money or credit who wish to either borrow
or lend. Participants borrow and lend for short periods
of time, typically up to thirteen months. Money market trades in short-term nancial instruments commonly
called paper. This contrasts with the capital market
for longer-term funding, which is supplied by bonds and
equity.

4.2 Functions of the money market

The money market functions are:[3][4]
1. Financing Trade:

Money Market plays crucial role in nancing both internal as well as international trade. Commercial nance is
made available to the traders through bills of exchange,
The core of the money market consists of interbank lend- which are discounted by the bill market. The acceptance
ingbanks borrowing and lending to each other using houses and discount markets help in nancing foreign
commercial paper, repurchase agreements and similar in- trade.
struments. These instruments are often benchmarked to 2. Financing Industry:
(i.e. priced by reference to) the London Interbank Offered Rate (LIBOR) for the appropriate term and cur- Money market contributes to the growth of industries in
two ways:
rency.
Finance companies typically fund themselves by issu- (a) Money market helps the industries in securing shorting large amounts of asset-backed commercial paper term loans to meet their working capital requirements
(ABCP) which is secured by the pledge of eligible as- through the system of nance bills, commercial papers,
sets into an ABCP conduit. Examples of eligible as- etc.
sets include auto loans, credit card receivables, residen- (b) Industries generally need long-term loans, which are
tial/commercial mortgage loans, mortgage-backed secu- provided in the capital market. However, capital marrities and similar nancial assets. Certain large corpora- ket depends upon the nature of and the conditions in
19

20
the money market. The short-term interest rates of the
money market inuence the long-term interest rates of
the capital market. Thus, money market indirectly helps
the industries through its link with and inuence on longterm capital market.
3. Protable Investment:
Money market enables the commercial banks to use their
excess reserves in protable investment. The main objective of the commercial banks is to earn income from its
reserves as well as maintain liquidity to meet the uncertain cash demand of the depositors. In the money market,
the excess reserves of the commercial banks are invested
in near-money assets (e.g. short-term bills of exchange)
which are highly liquid and can be easily converted into
cash. Thus, the commercial banks earn prots without
losing liquidity.
4. Self-Suciency of Commercial Bank:

CHAPTER 4. MONEY MARKET

notes issued by company at discount to face value
and redeemed at face value
Eurodollar deposit - Deposits made in U.S. dollars
at a bank or bank branch located outside the United
States.
Federal agency short-term securities - (in the U.S.).
Short-term securities issued by government sponsored enterprises such as the Farm Credit System,
the Federal Home Loan Banks and the Federal National Mortgage Association.
Federal funds - (in the U.S.). Interest-bearing deposits held by banks and other depository institutions at the Federal Reserve; these are immediately
available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the
federal funds rate.

Developed money market helps the commercial banks

to become self-sucient. In the situation of emergency,
when the commercial banks have scarcity of funds, they
need not approach the central bank and borrow at a higher
interest rate. On the other hand, they can meet their requirements by recalling their old short-run loans from the
money market.

Municipal notes - (in the U.S.). Short-term notes issued by municipalities in anticipation of tax receipts
or other revenues.

5. Help to Central Bank:

Money funds - Pooled short maturity, high quality

investments which buy money market securities on
behalf of retail or institutional investors.

Though the central bank can function and inuence the

banking system in the absence of a money market, the existence of a developed money market smoothens the functioning and increases the eciency of the central bank.
Money market helps the central bank in two ways:
(a) The short-run interest rates of the money market
serves as an indicator of the monetary and banking conditions in the country and, in this way, guide the central
bank to adopt an appropriate banking policy,

Treasury bills - Short-term debt obligations of a national government that are issued to mature in three
to twelve months.

Foreign exchange swaps - Exchanging a set of currencies in spot date and the reversal of the exchange
of currencies at a predetermined time in the future.
Short-lived mortgage- and asset-backed securities

4.4 Discount and accrual instru-

(b) The sensitive and integrated money market helps the

ments
central bank to secure quick and widespread inuence on
the sub-markets, and thus achieve eective implementaThere are two types of instruments in the xed income
tion of its policy.
market that pay the interest at maturity, instead of paying
it as coupons. Discount instruments, like repurchase
agreements, are issued at a discount of the face value,
4.3 Common money market instru- and their maturity value is the face value. Accrual inments
struments are issued at the face value and mature at the
face value plus interest.[5]
Certicate of deposit - Time deposit, commonly offered to consumers by banks, thrift institutions, and
credit unions.
Repurchase agreements - Short-term loans
normally for less than two weeks and frequently
for one dayarranged by selling securities to an
investor with an agreement to repurchase them at a
xed price on a xed date.
Commercial paper - short term usanse promissory

4.5 See also

Interbank lending market
Liquidity crisis
Lombard Street: A Description of the Money Market
One of the earliest popular books on the money
market

4.7. EXTERNAL LINKS

Money fund
Money market account
Money supply
Overnight market
Sweep account

4.6 References
[1] Frank J. Fabozzi, Steve V. Mann, Moorad Choudhry, The
Global Money Markets, Wiley Finance, Wiley & Sons
(2002), ISBN 0-471-22093-0
[2] Money Market, Investopedia.
[3] Money Market and Money Market Instruments
[4] Functions and importance of Money Market
[5] Discount Instrument, riskglossary.com, accessed 201205-14.

4.7 External links

Money Market Funds Enter a World of Risk
September 18, 2008, New York Times.
Dierence between Money Market and Capital
Market
Study on the identication of euro money market
transactions in TARGET2

21

Chapter 5

Over-the-counter (nance)
Over-the-counter (OTC) or o-exchange trading is
done directly between two parties, without any supervision of an exchange. It is contrasted with exchange trading, which occurs via exchanges. A stock exchange has
the benet of facilitating liquidity, mitigates all credit risk
concerning the default of one party in the transaction,
provides transparency, and maintains the current market
price. In an OTC trade, the price is not necessarily published for the public.

Markets Group) and the OTC Bulletin Board (OTCBB,

operated by FINRA). The OTCBB licenses the services
of OTC Link for their OTCBB securities. Although
exchange-listed stocks can be traded OTC on the third
market, it is rarely the case. Usually OTC stocks are
not listed nor traded on exchanges, and vice versa. Although stocks quoted on the OTCBB must comply with
U.S. Securities and Exchange Commission (SEC) reporting requirements, other OTC stocks have alternative disOTC trading, as well as exchange trading, occurs with closure guidelines (for example, OTCQX stocks through
commodities, nancial instruments (including stocks), OTC Market Group Inc), and others have no reporting
and derivatives of such. Products traded on the exchange requirements, for example Pink Sheets securities.
must be well standardized. This means that exchanged Some companies, with Wal-Mart as one of the largest,[5]
deliverables match a narrow range of quantity, quality, began trading as OTC stocks and eventually upgraded to
and identity which is dened by the exchange and iden- a listing on fully regulated market. By 1969 Wal-Mart
tical to all transactions of that product. This is necessary Stores Inc. was incorporated. In 1972, with stores in
for there to be transparency in trading. The OTC market ve states, including Arkansas, Kansas, Louisiana, Okladoes not have this limitation. They may agree on an un- homa and Missouri, Wal-Mart began trading as over-theusual quantity, for example.[1] In OTC market contracts counter (OTC) stocks. By 1972 Walmart had earned over
are bilateral (i.e. contract between only two parties), each US$1 billion in sales the fastest company to ever acparty could have credit risk concerns with respect to the complish this. In 1972 Wal-Mart was listed on the New
other party. OTC derivative market is signicant in some York Stock Exchange (NYSE) under the ticker symbol
asset classes: interest rate, foreign exchange, stocks, and WMT.[5]
commodities.[2]
In 2008 approximately 16 percent of all U.S. stock trades
were o-exchange trading"; by April 2014 that number
increased to about forty percent.[1] Although the notional
amount outstanding of OTC derivatives in late 2012 had
declined 3.3% over the previous year, the volume of
cleared transactions at the end of 2012 totalled US$346.4
trillion.[3] The Bank for International Settlements statistics on OTC derivatives markets showed that notional
amounts outstanding totalled $693 trillion at the end of
June 2013... [T]he gross market value of OTC derivatives
that is, the cost of replacing all outstanding contracts at
current market prices declined between end-2012 and
end-June 2013, from $25 trillion to $20 trillion.[4]

5.2 OTC contracts

An over-the-counter is a bilateral contract in which two
parties (or their brokers or bankers as intermediaries)
agree on how a particular trade or agreement is to be settled in the future. It is usually from an investment bank
to its clients directly. Forwards and swaps are prime examples of such contracts. It is mostly done online or by
telephone. For derivatives, these agreements are usually
governed by an International Swaps and Derivatives Association agreement. This segment of the OTC market
is occasionally referred to as the "Fourth Market. Critics have labelled the OTC market as the dark market
because prices are often unpublished and unregulated.[1]

5.1 OTC-traded stocks

Over-the-counter derivatives are especially important for

hedging risk in that they can be used to create a perfect
In the United States, over-the-counter trading in stock is hedge. With exchange traded contracts, standardization
carried out by market makers using inter-dealer quotation does not allow for as much exibility to hedge risk beservices such as OTC Link (a service oered by OTC cause the contract is a one-size-ts-all instrument. With
22

5.5. SEE ALSO

23

OTC derivatives, though, a rm can tailor the contract turbulence in the late 1990s revealed the risks posed to
specications to best suit its risk exposure. [6]
market stability originated in features of OTC derivatives
instruments and markets.[11]

5.3 Counterparty risk

OTC derivatives can lead to signicant risks. Especially counterparty risk has gained particular emphasis
due to the credit crisis in 2007. Counterparty risk is
the risk that a counterparty in a derivatives transaction
will default prior to expiration of the trade and will not
make the current and future payments required by the
contract.[7] There are many ways to limit counterparty
risk. One of them focuses on controlling credit exposure with diversication, netting, collateralisation and
hedging.[8]
In their market review published in 2010 the International
Swaps and Derivatives Association [Notes 1] examined OTC
Derivative Bilateral Collateralization Practice as one way
of mitigating risk.[9]

5.4 Importance of OTC derivatives

in modern banking
OTC derivatives are signicant part of the world of
global nance. The OTC derivatives markets are large.
They grew exponentially from 1980 through 2000. The
expansion has been driven by interest rate products,
foreign exchange instruments and credit default swaps.
The notional outstanding of OTC derivatives markets
rose throughout the period and totalled approximately
US$601 trillion at December 31, 2010.[9]

The NYMEX has created a clearing mechanism for a

slate of commonly traded OTC energy derivatives which
allows counterparties of many bilateral OTC transactions
to mutually agree to transfer the trade to ClearPort, the
exchanges clearing house, thus eliminating credit and
performance risk of the initial OTC transaction counterparts.

5.5 See also

Collateral management
Delta One

5.6 Notes
[1] ISDA 2012 Market Analysis drew on information
sources including LCH.Clearnets SwapClear, TriOptima,
the DTCC Trade Information Warehouse, Markit, ICE,
CME, ISDAs 2012 Margin Survey and other clearinghouses and trade vendors.

5.7 Citations
[1] McCrank 2014.
[2] Gregory 2011, p. 7.
[3] ISDA 2013.

In their 2000 paper by Schinasi et al. published by the [4] Bank for International Settlements (BIS) 2013.
International Monetary Fund in 2001, the authors ob[5] Better Trades 2012.
served that the increase in OTC derivatives transactions
would have been impossible without the dramatic ad- [6] http://chicagofed.org/digital_assets/publications/
understanding_derivatives/understanding_derivatives_
vances in information and computer technologies that
chapter_3_over_the_counter_derivatives.pdf
occurred from 1980 to 2000.[10] During that time, major
internationally active nancial institutions signicantly
[7] Gregory 2011, p. 17.
increased the share of their earnings from derivatives activities. These institutions manage portfolios of deriva- [8] Gregory 2011, p. 25.
tives involving tens of thousand of positions and aggre[9] International Swaps and Derivatives Association (ISDA)
gate global turnover over $1 trillion. At that time prior
2010.
to the nancial crisis of 2008, the OTC market was an
informal network of bilateral counterparty relationships [10] Schinasi et al. 2001, p. 5-7.
and dynamic, time-varying credit exposures whose size
and distribution tied to important asset markets. Interna- [11] Mathieson & Schinasi 2000, p. 3.
tional nancial institutions increasingly nurtured the ability to prot from OTC derivatives activities and nancial
markets participants benetted from them. In 2000 the 5.8 References
authors acknowledged that the growth in OTC transac Monetary and Economic Department (November
tions in many ways made possible, the modernization of
2013), Statistical release OTC derivatives statistics
commercial and investment banking and the globalization
at end June 2013 (PDF), Bank for International Setof nance.[10] However, in September, an IMF team led
by Mathieson and Schinasi cautioned that episodes of
tlements (BIS), retrieved 12 April 2014

24
WMT Overview, Better Trades, 2012, retrieved
12 April 2014
Market Review of OTC Derivative Bilateral Collateralization Practices (PDF), International Swaps
and Derivatives Association (ISDA), 1 March 2010,
retrieved 12 April 2014
OTC Derivatives Market Analysis, Year-End
2010, ISDA (PDF), 26 May 2011
OTC Derivatives Market Analysis, Year-End
2012, ISDA (PDF), June 2013
Gregory, Jon (7 September 2011), Counterparty
Credit Risk: The new challenge for global nancial markets, John Wiley & Sons, ISBN 978-0-47068576-1
Mathieson, Donald J.; Schinasi, Garry J. (September 2000), International Capital Markets: Developments, Prospects, and Key Policy Issues (PDF),
World Economic and Financial Surveys
McCrank, John (6 April 2014), Dark markets may
be more harmful than high-frequency trading, New
York: Reuters, retrieved 12 April 2014
Schinasi, Garry J.; Craig, R. Sean; Drees, Burkhard;
Kramer, Charles (9 January 2001), Modern Banking
and OTC Derivatives Markets: The Transformation
of Global Finance and its Implications for Systemic
Risk, International Monetary Fund, ISBN 1-55775999-5, retrieved 12 April 2014

5.9 External links

European Union proposals on derivatives regulation
- 2008 onwards
Understanding Derivatives: Markets and Infrastructure - Chapter 3, Over-the-Counter Derivatives By
Richard Heckinger, Ivana Runi, and Kirstin Wells
(Federal Reserve Bank of Chicago)

CHAPTER 5. OVER-THE-COUNTER (FINANCE)

Chapter 6

Private equity
In nance, private equity is an asset class consisting of
equity securities and debt in operating companies that are
not publicly traded on a stock exchange.[1]
A private equity investment will generally be made by a
private equity rm, a venture capital rm or an angel investor. Each of these categories of investor has its own set
of goals, preferences and investment strategies; however,
all provide working capital to a target company to nurture
expansion, new-product development, or restructuring of
the companys operations, management, or ownership.[2]
Bloomberg Businessweek has called private equity a rebranding of leveraged buyout rms after the 1980s.
Among the most common investment strategies in private
equity are: leveraged buyouts, venture capital, growth
capital, distressed investments and mezzanine capital. In
a typical leveraged buyout transaction, a private equity
rm buys majority control of an existing or mature rm.
This is distinct from a venture capital or growth capital
investment, in which the investors (typically venture capital rms or angel investors) invest in young, growing or
emerging companies, and rarely obtain majority control.

Diagram of the basic structure of a generic leveraged buyout

transaction

companies as either Platform companies which have sufcient scale and a successful business model to act as a
stand-alone entity, or as add-on or tuck-in acquisitions,
which would include companies with insucient scale or
other decits.[5][6]

Leveraged buyouts involve a nancial sponsor agreeing

to an acquisition without itself committing all the capital required for the acquisition. To do this, the nancial sponsor will raise acquisition debt which ultimately
looks to the cash ows of the acquisition target to make
interest and principal payments.[7] Acquisition debt in an
LBO is often non-recourse to the nancial sponsor and
6.1 Strategies
has no claim on other investments managed by the nancial sponsor. Therefore, an LBO transactions nancial
The strategies private equity rms may use are as follows, structure is particularly attractive to a funds limited partners, allowing them the benets of leverage but greatly
leveraged buyout being the most important.
limiting the degree of recourse of that leverage. This kind
of nancing structure leverage benets an LBOs nancial
sponsor in two ways: (1) the investor itself only needs to
6.1.1 Leveraged buyout
provide a fraction of the capital for the acquisition, and
(2) the returns to the investor will be enhanced (as long
Main article: Leveraged buyout
[8]
Leveraged buyout, LBO or Buyout refers to a strat- as the return on assets exceeds the cost of the debt).
egy of making equity investments as part of a transac- As a percentage of the purchase price for a leverage buytion in which a company, business unit or business assets out target, the amount of debt used to nance a transacis acquired from the current shareholders typically with tion varies according to the nancial condition and histhe use of nancial leverage.[3] The companies involved tory of the acquisition target, market conditions, the willin these transactions are typically mature and generate ingness of lenders to extend credit (both to the LBOs
operating cash ows.[4] Private equity rms view target nancial sponsors and the company to be acquired) as
Private equity is also often grouped into a broader category called private capital, generally used to describe capital supporting any long-term, illiquid investment strategy.

25

26
well as the interest costs and the ability of the company
to cover those costs. Historically the debt portion of a
LBO will range from 60%90% of the purchase price, although during certain periods the debt ratio can be higher
or lower than the historical averages.[9] Between 2000
2005 debt averaged between 59.4% and 67.9% of total
purchase price for LBOs in the United States.[10]

Simple example of leveraged buyout

CHAPTER 6. PRIVATE EQUITY

6.1.2 Growth capital

Main article: Growth capital
Growth Capital refers to equity investments, most often
minority investments, in relatively mature companies that
are looking for capital to expand or restructure operations, enter new markets or nance a major acquisition
without a change of control of the business.

Companies that seek growth capital will often do so in

order to nance a transformational event in their life cycle. These companies are likely to be more mature than
venture capital funded companies, able to generate revenue and operating prots but unable to generate sucient cash to fund major expansions, acquisitions or other
investments. Because of this lack of scale these companies generally can nd few alternative conduits to secure
capital for growth, so access to growth equity can be critical to pursue necessary facility expansion, sales and marketing initiatives, equipment purchases, and new product
development.[13] The primary owner of the company may
not be willing to take the nancial risk alone. By selling part of the company to private equity, the owner can
take out some value and share the risk of growth with
partners.[14] Capital can also be used to eect a restructuring of a companys balance sheet, particularly to reduce the amount of leverage (or debt) the company has
on its balance sheet.[15] A Private investment in public
equity, or PIPEs, refer to a form of growth capital investment made into a publicly traded company. PIPE investments are typically made in the form of a convertible or
Notes:
preferred security that is unregistered for a certain period
of time.[16][17] The Registered Direct, or RD, is another
The lenders (the people who put up the $9bn in the common nancing vehicle used for growth capital. A regexample) can insure against default by syndicating istered direct is similar to a PIPE but is instead sold as a
the loan to spread the risk, or by buying credit registered security.
default swaps (CDSs) or selling collateralised debt
obligations (CDOs) from/to other institutions (although this no business of the private equity rm). 6.1.3 Mezzanine capital

A private equity fund, ABC Capital II, borrows $9bn

from a bank (or other lender). To this it adds $2bn of
equity money from its own partners and from limited
partners (pension funds, rich individuals, etc.). With this
$11bn it buys all the shares of an underperforming company, XYZ Industrial (after due diligence, i.e. checking
the books). It replaces the senior management in XYZ Industrial, and they set out to streamline it. The workforce
is reduced, some assets are sold o, etc. The objective
is to increase the value of the company for an early sale.
The stock market is experiencing a bull market, and XYZ
Industrial is sold two years after the buy-out for $13bn,
yielding a prot of $2bn. The original loan can now
be paid o with interest of say $0.5bn. The remaining
prot of $1.5bn is shared among the partners. Taxation
of such gains is at capital gains rates. Note that part of
that prot results from turning the company around, and
part results from the general increase in share prices in a
buoyant stock market, the latter often being the greater
component.[11]

Often the loan/equity ($11bn above) is not paid o

after sale but left on the books of the company (XYZ
Industrial) for it to pay o over time. This can be advantageous since the interest is typically osettable
against the prots of the company, thus reducing, or
even eliminating, tax.
Most buyout deals are much smaller; the global average purchase in 2013 was $89m, for example.[12]
The target company (XYZ Industrials here) does not
have to be oated on the stockmarket; indeed most
buyout exits are not IPOs.
Buy-out operations can go wrong and in such cases
the loss is increased by leverage, just as the prot is
if all goes well.

Main article: Mezzanine capital

Mezzanine capital refers to subordinated debt or
preferred equity securities that often represent the most
junior portion of a companys capital structure that is senior to the companys common equity. This form of nancing is often used by private equity investors to reduce the amount of equity capital required to nance a
leveraged buyout or major expansion. Mezzanine capital, which is often used by smaller companies that are
unable to access the high yield market, allows such companies to borrow additional capital beyond the levels that
traditional lenders are willing to provide through bank
loans.[18] In compensation for the increased risk, mezzanine debt holders require a higher return for their investment than secured or other more senior lenders.[19][20]
Mezzanine securities are often structured with a current

6.1. STRATEGIES
income coupon.

6.1.4

Venture capital

Main article: Venture capital

Venture capital[21] is a broad subcategory of private equity that refers to equity investments made, typically in
less mature companies, for the launch of a seed or startup company, early stage development, or expansion of a
business. Venture investment is most often found in the
application of new technology, new marketing concepts
and new products that do not have a proven track record
or stable revenue streams.[22][23]
Venture capital is often sub-divided by the stage of development of the company ranging from early stage capital
used for the launch of start-up companies to late stage
and growth capital that is often used to fund expansion of
existing business that are generating revenue but may not
yet be protable or generating cash ow to fund future
growth.[24]
Entrepreneurs often develop products and ideas that require substantial capital during the formative stages of
their companies life cycles.[25] Many entrepreneurs do
not have sucient funds to nance projects themselves,
and they must therefore seek outside nancing.[26] The
venture capitalists need to deliver high returns to compensate for the risk of these investments makes venture
funding an expensive capital source for companies. Being able to secure nancing is critical to any business,
whether it is a start-up seeking venture capital or a midsized rm that needs more cash to grow.[27] Venture capital is most suitable for businesses with large up-front
capital requirements which cannot be nanced by cheaper
alternatives such as debt. Although venture capital is often most closely associated with fast-growing technology,
healthcare and biotechnology elds, venture funding has
been used for other more traditional businesses.[22][28]

27
Distressed-to-Control or Loan-to-Own strategies where the investor acquires debt securities in
the hopes of emerging from a corporate restructuring in control of the companys equity;[32]
"Special Situations" or Turnaround strategies
where an investor will provide debt and equity investments, often rescue nancing to companies
undergoing operational or nancial challenges.[33]
In addition to these private equity strategies, hedge funds
employ a variety of distressed investment strategies including the active trading of loans and bonds issued by
distressed companies.

6.1.6 Secondaries
Main article: Private equity secondary market
Secondary investments refer to investments made in existing private equity assets. These transactions can involve the sale of private equity fund interests or portfolios of direct investments in privately held companies
through the purchase of these investments from existing
institutional investors.[34] By its nature, the private equity asset class is illiquid, intended to be a long-term investment for buy and hold investors. Secondary investments provide institutional investors with the ability to
improve vintage diversication, particularly for investors
that are new to the asset class. Secondaries also typically experience a dierent cash ow prole, diminishing the j-curve eect of investing in new private equity
funds.[35][36] Often investments in secondaries are made
through third party fund vehicle, structured similar to a
fund of funds although many large institutional investors
have purchased private equity fund interests through secondary transactions.[37] Sellers of private equity fund investments sell not only the investments in the fund but
also their remaining unfunded commitments to the funds.

Investors generally commit to venture capital funds as

part of a wider diversied private equity portfolio, but 6.1.7 Other strategies
also to pursue the larger returns the strategy has the potential to oer. However, venture capital funds have pro- Other strategies that can be considered private equity or
duced lower returns for investors over recent years com- a close adjacent market include:
pared to other private equity fund types, particularly buyout.
Real Estate: in the context of private equity this will
typically refer to the riskier end of the investment
spectrum including value added and opportunity
6.1.5 Distressed and special situations
funds where the investments often more closely resemble leveraged buyouts than traditional real estate
Main article: Distressed securities
investments. Certain investors in private equity consider real estate to be a separate asset class.
Distressed or Special Situations is a broad category referring to investments in equity or debt securities of nancially stressed companies.[29][30][31] The distressed
category encompasses two broad sub-strategies including:

Infrastructure: investments in various public works

(e.g., bridges, tunnels, toll roads, airports, public
transportation and other public works) that are made

28

CHAPTER 6. PRIVATE EQUITY

typically as part of a privatization initiative on the The seeds of the US private equity industry were
part of a government entity.[38][39][40]
planted in 1946 with the founding of two venture capital
rms: American Research and Development Corporation
[43]
Energy and Power: investments in a wide variety of (ARDC) and J.H. Whitney & Company. Before World
companies (rather than assets) engaged in the pro- War II, venture capital investments (originally known
duction and sale of energy, including fuel extraction, as development capital) were primarily the domain of
manufacturing, rening and distribution (Energy) or wealthy individuals and families. In 1901 J.P. Morcompanies engaged in the production or transmis- gan arguably managed the rst leveraged buyout of the
Carnegie Steel Company using private equity.[44] Modsion of electrical power (Power).
ern era private equity, however, is credited to Georges
of venture capitalism with the found Merchant banking: negotiated private equity in- Doriot, the father
[45]
ing
of
ARDC
and
founder of INSEAD, with capital
vestment by nancial institutions in the unregisraised
from
institutional
investors, to encourage private
tered securities of either privately or publicly held
sector
investments
in
businesses
run by soldiers who were
[41]
companies.
returning from World War II. ARDC is credited with the
rst major venture capital success story when its 1957
Fund of funds: investments made in a fund whose
investment of $70,000 in Digital Equipment Corporaprimary activity is investing in other private equity
tion (DEC) would be valued at over $355 million after
funds. The fund of funds model is used by investors
the companys initial public oering in 1968 (representlooking for:
ing a return of over 500 times on its investment and an
annualized rate of return of 101%).[46] It is commonly
Diversication but have insucient capnoted that the rst venture-backed startup is Fairchild
ital to diversify their portfolio by themSemiconductor (which produced the rst commercially
selves
practicable integrated circuit), funded in 1959 by what
would later become Venrock Associates.[47]
Access to top performing funds that are
otherwise oversubscribed
Experience in a particular fund type or
strategy before investing directly in funds
in that niche
Exposure to dicult-to-reach and/or
emerging markets
Superior fund selection by high-talent
fund of fund managers/teams
Royalty fund: an investment that purchases a consistent revenue stream deriving from the payment of
royalties. One growing subset of this category is the
healthcare royalty fund, in which a private equity
fund manager purchases a royalty stream paid by
a pharmaceutical company to a drug patent holder.
The drug patent holder can be another company, an
individual inventor, or some sort of institution, such
as a research university.[42]

6.2 History and development

Main article: History of private equity and venture capital

6.2.1

Early history and the development of

venture capital

6.2.2 Origins of the leveraged buyout

Main articles: History of private equity and venture
capital and Early history of private equity
The rst leveraged buyout may have been the purchase by
McLean Industries, Inc. of Pan-Atlantic Steamship Company in January 1955 and Waterman Steamship Corporation in May 1955[48] Under the terms of that transaction,
McLean borrowed $42 million and raised an additional
$7 million through an issue of preferred stock. When
the deal closed, $20 million of Waterman cash and assets
were used to retire $20 million of the loan debt.[49] Similar to the approach employed in the McLean transaction,
the use of publicly traded holding companies as investment vehicles to acquire portfolios of investments in corporate assets was a relatively new trend in the 1960s popularized by the likes of Warren Buett (Berkshire Hathaway) and Victor Posner (DWG Corporation) and later
adopted by Nelson Peltz (Triarc), Saul Steinberg (Reliance Insurance) and Gerry Schwartz (Onex Corporation). These investment vehicles would utilize a number
of the same tactics and target the same type of companies
as more traditional leveraged buyouts and in many ways
could be considered a forerunner of the later private equity rms. In fact it is Posner who is often credited with
coining the term "leveraged buyout" or LBO[50]

The leveraged buyout boom of the 1980s was conceived

Main articles: History of private equity and venture by a number of corporate nanciers, most notably Jerome
capital and Early history of private equity
Kohlberg, Jr. and later his protg Henry Kravis. Working for Bear Stearns at the time, Kohlberg and Kravis

6.2. HISTORY AND DEVELOPMENT

along with Kravis cousin George Roberts began a series
of what they described as bootstrap investments. Many
of these companies lacked a viable or attractive exit for
their founders as they were too small to be taken public and the founders were reluctant to sell out to competitors and so a sale to a nancial buyer could prove attractive. Their acquisition of Orkin Exterminating Company in 1964 is among the rst signicant leveraged buyout transactions.[51] In the following years the three Bear
Stearns bankers would complete a series of buyouts including Stern Metals (1965), Incom (a division of Rockwood International, 1971), Cobblers Industries (1971),
and Boren Clay (1973) as well as Thompson Wire, Eagle Motors and Barrows through their investment in Stern
Metals.[52] By 1976, tensions had built up between Bear
Stearns and Kohlberg, Kravis and Roberts leading to their
departure and the formation of Kohlberg Kravis Roberts
in that year.

6.2.3

Private equity in the 1980s

Main articles: History of private equity and venture

capital and Private equity in the 1980s
In January 1982, former United States Secretary of the
Treasury William Simon and a group of investors acquired Gibson Greetings, a producer of greeting cards,
for $80 million, of which only $1 million was rumored
to have been contributed by the investors. By mid-1983,
just sixteen months after the original deal, Gibson completed a $290 million IPO and Simon made approximately $66 million.[53][54]
The success of the Gibson Greetings investment attracted
the attention of the wider media to the nascent boom in
leveraged buyouts. Between 1979 and 1989, it was estimated that there were over 2,000 leveraged buyouts valued in excess of $250 million[55]
During the 1980s, constituencies within acquired companies and the media ascribed the "corporate raid" label to many private equity investments, particularly those
that featured a hostile takeover of the company, perceived
asset stripping, major layos or other signicant corporate restructuring activities. Among the most notable investors to be labeled corporate raiders in the 1980s included Carl Icahn, Victor Posner, Nelson Peltz, Robert
M. Bass, T. Boone Pickens, Harold Clark Simmons,
Kirk Kerkorian, Sir James Goldsmith, Saul Steinberg and
Asher Edelman. Carl Icahn developed a reputation as
a ruthless corporate raider after his hostile takeover of
TWA in 1985.[56][57][58] Many of the corporate raiders
were onetime clients of Michael Milken, whose investment banking rm, Drexel Burnham Lambert helped
raise blind pools of capital with which corporate raiders
could make a legitimate attempt to take over a company
and provided high-yield debt (junk bonds) nancing of
the buyouts.

29
One of the nal major buyouts of the 1980s proved
to be its most ambitious and marked both a high-water
mark and a sign of the beginning of the end of the
boom that had begun nearly a decade earlier. In 1989,
KKR (Kohlberg Kravis Roberts) closed in on a $31.1
billion takeover of RJR Nabisco. It was, at that time
and for over 17 years, the largest leverage buyout in history. The event was chronicled in the book (and later
the movie), Barbarians at the Gate: The Fall of RJR
Nabisco. KKR would eventually prevail in acquiring RJR
Nabisco at $109 per share, marking a dramatic increase
from the original announcement that Shearson Lehman
Hutton would take RJR Nabisco private at $75 per share.
A erce series of negotiations and horse-trading ensued
which pitted KKR against Shearson and later Forstmann
Little & Co. Many of the major banking players of the
day, including Morgan Stanley, Goldman Sachs, Salomon
Brothers, and Merrill Lynch were actively involved in advising and nancing the parties. After Shearsons original
bid, KKR quickly introduced a tender oer to obtain RJR
Nabisco for $90 per sharea price that enabled it to proceed without the approval of RJR Nabiscos management.
RJRs management team, working with Shearson and Salomon Brothers, submitted a bid of $112, a gure they
felt certain would enable them to outank any response
by Kraviss team. KKRs nal bid of $109, while a lower
dollar gure, was ultimately accepted by the board of directors of RJR Nabisco.[59] At $31.1 billion of transaction
value, RJR Nabisco was by far the largest leveraged buyouts in history. In 2006 and 2007, a number of leveraged
buyout transactions were completed that for the rst time
surpassed the RJR Nabisco leveraged buyout in terms of
nominal purchase price. However, adjusted for ination,
none of the leveraged buyouts of the 20062007 period
would surpass RJR Nabisco. By the end of the 1980s the
excesses of the buyout market were beginning to show,
with the bankruptcy of several large buyouts including
Robert Campeau's 1988 buyout of Federated Department
Stores, the 1986 buyout of the Revco drug stores, Walter
Industries, FEB Trucking and Eaton Leonard. Additionally, the RJR Nabisco deal was showing signs of strain,
leading to a recapitalization in 1990 that involved the contribution of $1.7 billion of new equity from KKR.[60] In
the end, KKR lost $700 million on RJR.[61]
Drexel reached an agreement with the government in
which it pleaded nolo contendere (no contest) to six
felonies three counts of stock parking and three counts
of stock manipulation.[62] It also agreed to pay a ne of
$650 million at the time, the largest ne ever levied under securities laws. Milken left the rm after his own indictment in March 1989.[63][64] On 13 February 1990 after being advised by United States Secretary of the Treasury Nicholas F. Brady, the U.S. Securities and Exchange
Commission (SEC), the New York Stock Exchange and
the Federal Reserve, Drexel Burnham Lambert ocially
led for Chapter 11 bankruptcy protection.[63]

30

6.2.4

CHAPTER 6. PRIVATE EQUITY

Age of the mega-buyout 20052007

buyouts had come to an end. Nevertheless, private equity continues to be a large and active asset class and the
Main articles: History of private equity and venture private equity rms, with hundreds of billions of dollars
of committed capital from investors are looking to deploy
capital and Private equity in the 21st century
capital in new and dierent transactions.
The combination of decreasing interest rates, loosening lending standards and regulatory changes for publicly
traded companies (specically the Sarbanes-Oxley Act)
would set the stage for the largest boom private equity had
seen. Marked by the buyout of Dex Media in 2002, large
multi-billion dollar U.S. buyouts could once again obtain
signicant high yield debt nancing and larger transactions could be completed. By 2004 and 2005, major
buyouts were once again becoming common, including
the acquisitions of Toys R Us,[65] The Hertz Corporation,[66][67] Metro-Goldwyn-Mayer[68] and SunGard[69] in
2005.

As a result of the global nancial crisis, private equity

has become subject to increased regulation in Europe and
is now subject, among other things, to rules preventing
asset stripping of portfolio companies and requiring the
notication and disclosure of information in connection
with buy-out activity.[79]

6.3 Investments in private equity

As 2005 ended and 2006 began, new largest buyout

records were set and surpassed several times with nine
of the top ten buyouts at the end of 2007 having been announced in an 18-month window from the beginning of
2006 through the middle of 2007. In 2006, private equity rms bought 654 U.S. companies for $375 billion,
representing 18 times the level of transactions closed in
2003.[70] Additionally, U.S. based private equity rms
raised $215.4 billion in investor commitments to 322
funds, surpassing the previous record set in 2000 by 22%
and 33% higher than the 2005 fundraising total[71] The
following year, despite the onset of turmoil in the credit
markets in the summer, saw yet another record year of Diagram of the structure of a generic private equity fund
fundraising with $302 billion of investor commitments to
415 funds[72] Among the mega-buyouts completed during
Although the capital for private equity originally came
the 2006 to 2007 boom were: Equity Oce Properties,
from individual investors or corporations, in the 1970s,
HCA,[73] Alliance Boots[74] and TXU.[75]
private equity became an asset class in which various
In July 2007, turmoil that had been aecting the institutional investors allocated capital in the hopes of
mortgage markets, spilled over into the leveraged nance achieving risk adjusted returns that exceed those possiand high-yield debt markets.[76][77] The markets had been ble in the public equity markets. In the 1980s, insurers
highly robust during the rst six months of 2007, with were major private equity investors. Later, public penhighly issuer friendly developments including PIK and sion funds and university and other endowments became
PIK Toggle (interest is "Payable In Kind) and covenant more signicant sources of capital.[80] For most institulight debt widely available to nance large leveraged buy- tional investors, private equity investments are made as
outs. July and August saw a notable slowdown in is- part of a broad asset allocation that includes traditional
suance levels in the high yield and leveraged loan markets assets (e.g., public equity and bonds) and other alternative
with few issuers accessing the market. Uncertain market assets (e.g., hedge funds, real estate, commodities).
conditions led to a signicant widening of yield spreads,
which coupled with the typical summer slowdown led
many companies and investment banks to put their plans
to issue debt on hold until the autumn. However, the 6.3.1 Investor categories
expected rebound in the market after 1 May 2007 did
not materialize, and the lack of market condence pre- US, Canadian and European public and private pension
vented deals from pricing. By the end of September, the schemes have invested in the asset class since the early
full extent of the credit situation became obvious as ma- 1980s to diversify away from their core holdings (public
jor lenders including Citigroup and UBS AG announced equity and xed income).[81] Today pension investment in
major writedowns due to credit losses. The leveraged - private equity accounts for more than a third of all monies
nance markets came to a near standstill during a week allocated to the asset class, ahead of other institutional
in 2007.[78] As 2007 ended and 2008 began, it was clear investors such as insurance companies, endowments, and
that lending standards had tightened and the era of mega- sovereign wealth funds.

6.4. LIQUIDITY IN THE PRIVATE EQUITY MARKET

6.3.2

31

Direct vs. indirect investment

Most institutional investors do not invest directly in

privately held companies, lacking the expertise and resources necessary to structure and monitor the investment. Instead, institutional investors will invest indirectly
through a private equity fund. Certain institutional investors have the scale necessary to develop a diversied
portfolio of private equity funds themselves, while others will invest through a fund of funds to allow a portfolio more diversied than one a single investor could construct.

6.3.3

Investment timescales

Returns on private equity investments are created through

one or a combination of three factors that include: debt
repayment or cash accumulation through cash ows from
operations, operational improvements that increase earnings over the life of the investment and multiple expansion, selling the business for a higher multiple of earnings than was originally paid. A key component of private equity as an asset class for institutional investors is
that investments are typically realized after some period
of time, which will vary depending on the investment
strategy. Private equity investments are typically realized
through one of the following avenues:

Diagram of a simple secondary market transfer of a limited partnership fund interest. The buyer exchanges a single cash payment to the seller for both the investments in the fund plus any
unfunded commitments to the fund.

The private equity secondary market (also often called

private equity secondaries) refers to the buying and selling of pre-existing investor commitments to private equity and other alternative investment funds. Sellers of
private equity investments sell not only the investments
in the fund but also their remaining unfunded commitments to the funds. By its nature, the private equity asset
class is illiquid, intended to be a long-term investment
for buy-and-hold investors. For the vast majority of pri an initial public oering (IPO) shares of the com- vate equity investments, there is no listed public market;
pany are oered to the public, typically providing a however, there is a robust and maturing secondary market
partial immediate realization to the nancial spon- available for sellers of private equity assets.
sor as well as a public market into which it can later Increasingly, secondaries are considered a distinct asset
sell additional shares;
class with a cash ow prole that is not correlated with

a merger or acquisition the company is sold for ei- other private equity investments. As a result, investors
are allocating capital to secondary investments to diverther cash or shares in another company;
sify their private equity programs. Driven by strong de a recapitalization cash is distributed to the share- mand for private equity exposure, a signicant amount
holders (in this case the nancial sponsor) and its of capital has been committed to secondary investments
private equity funds either from cash ow generated from investors looking to increase and diversify their priby the company or through raising debt or other se- vate equity exposure.
curities to fund the distribution.
Investors seeking access to private equity have been restricted to investments with structural impediments such
Large institutional asset owners such as pension funds as long lock-up periods, lack of transparency, unlimited
(with typically long-dated liabilities), insurance compa- leverage, concentrated holdings of illiquid securities and
nies, sovereign wealth and national reserve funds have a high investment minimums.
generally low likelihood of facing liquidity shocks in the
medium term, and thus can aord the required long hold- Secondary transactions can be generally split into two baing periods characteristic of private equity investment.[82] sic categories:
The median horizon for a LBO transaction is 8 years.[83]

6.4 Liquidity in the private equity

market
Main article: Private equity secondary market

Sale of Limited Partnership Interests The most

common secondary transaction, this category includes the sale of an investors interest in a private
equity fund or portfolio of interests in various funds
through the transfer of the investors limited partnership interest in the fund(s). Nearly all types of private equity funds (e.g., including buyout, growth equity, venture capital, mezzanine, distressed and real

32

CHAPTER 6. PRIVATE EQUITY

estate) can be sold in the secondary market. The
transfer of the limited partnership interest typically
will allow the investor to receive some liquidity for
the funded investments as well as a release from any
remaining unfunded obligations to the fund.

25 largest private equity investment managers. Among

the larger rms in that ranking were AlpInvest Partners, Ardian (formerly AXA Private Equity), AIG Investments, and Goldman Sachs Capital Partners. The
European Private Equity and Venture Capital Association (EVCA) publishes a yearbook which analyses industry trends derived from data disclosed by over 1, 300 European private equity funds. Finally, websites such as
AskIvy.net[85] provide lists of London-based private equity rms.

Sale of Direct Interests Secondary Directs or

Synthetic secondaries, this category refers to the sale
of portfolios of direct investments in operating companies, rather than limited partnership interests in
investment funds. These portfolios historically have
originated from either corporate development pro6.5.1
grams or large nancial institutions.

6.5 Private equity rms

Main articles: Private equity rm and List of private
equity rms
According to an updated 2013 ranking created by industry magazine Private Equity International[84] (published
by PEI Media called the PEI 300), the largest private equity rm in the world today is TPG, based on the amount
of private equity direct-investment capital raised over a
ve-year window. As ranked by the PEI 300, the 10
largest private equity rms in the world are:
1. TPG Capital
2. The Carlyle Group
3. The Blackstone Group
4. Kohlberg Kravis Roberts
5. Warburg Pincus

Versus hedge funds

The investment strategies of private equity rms dier

to those of hedge funds. Typically, private equity investment groups are geared towards long-hold, multiple-year
investment strategies in illiquid assets (whole companies,
large-scale real estate projects, or other tangibles not easily converted to cash) where they have more control and
inuence over operations or asset management to inuence their long-term returns. Hedge funds usually focus on short or medium term liquid securities which are
more quickly convertible to cash, and they do not have
direct control over the business or asset in which they are
investing.[86] Both private equity rms and hedge funds
often specialize in specic types of investments and transactions. Private equity specialization is usually in specic
industry sector asset management while hedge fund specialization is in industry sector risk capital management.
Private equity strategies can include wholesale purchase
of a privately held company or set of assets, mezzanine nancing for start-up projects, growth capital investments
in existing businesses or leveraged buyout of a publicly
held asset converting it to private control.[87] Finally, private equity rms only take long positions, for short selling
is not possible in this asset class.

6. Goldman Sachs Principal Investment Area

7. Advent International

6.6 Private equity funds

8. Apollo Global Management

Main article: Private equity fund

9. Bain Capital
10. CVC Capital Partners
Because private equity rms are continuously in the process of raising, investing and distributing their private equity funds, capital raised can often be the easiest to measure. Other metrics can include the total value of companies purchased by a rm or an estimate of the size of
a rms active portfolio plus capital available for new investments. As with any list that focuses on size, the list
does not provide any indication as to relative investment
performance of these funds or managers.
Additionally, Preqin (formerly known as Private Equity
Intelligence), an independent data provider, ranks the

Private equity fundraising refers to the action of private

equity rms seeking capital from investors for their funds.
Typically an investor will invest in a specic fund managed by a rm, becoming a limited partner in the fund,
rather than an investor in the rm itself. As a result, an investor will only benet from investments made by a rm
where the investment is made from the specic fund in
which it has invested.
Fund of funds. These are private equity funds that
invest in other private equity funds in order to provide investors with a lower risk product through exposure to a large number of vehicles often of different type and regional focus. Fund of funds ac-

6.6. PRIVATE EQUITY FUNDS

counted for 14% of global commitments made to
private equity funds in 2006.

33

6.6.1 Size of the industry

The state of the industry around the end of 2011 was as
follows.[88]

Individuals with substantial net worth. Substantial

net worth is often required of investors by the law,
since private equity funds are generally less regulated than ordinary mutual funds. For example in
the US, most funds require potential investors to
qualify as accredited investors, which requires $1
million of net worth, $200,000 of individual income, or $300,000 of joint income (with spouse)
for two documented years and an expectation that
such income level will continue.

As fundraising has grown over the past few years, so too

has the number of investors in the average fund. In 2004
there were 26 investors in the average private equity fund,
this gure has now grown to 42 according to Preqin ltd.
(formerly known as Private Equity Intelligence).

Private equity assets under management probably exceeded $2.0 trillion at the end of March 2012, and funds
available for investment totalled $949bn (about 47% of
overall assets under management).
Some $246bn of private equity was invested globally in
2011, down 6% on the previous year and around twothirds below the peak activity in 2006 and 2007. Following on from a strong start, deal activity slowed in the second half of 2011 due to concerns over the global economy
and sovereign debt crisis in Europe. There was $93bn in
investments during the rst half of this year as the slowdown persisted into 2012. This was down a quarter on the
same period in the previous year. Private-equity backed
buyouts generated some 6.9% of global M&A volume in
2011 and 5.9% in the rst half of 2012. This was down
on 7.4% in 2010 and well below the all-time high of 21%
in 2006.

Global exit activity totalled $252bn in 2011, practically

The managers of private equity funds will also invest in unchanged from the previous year, but well up on 2008
their own vehicles, typically providing between 15% of and 2009 as private equity rms sought to take advantage
the overall capital.
of improved market conditions at the start of the year to
Often private equity fund managers will employ the ser- realise investments. Exit activity however, has lost movices of external fundraising teams known as placement mentum following a peak of $113bn in the second quaragents in order to raise capital for their vehicles. The use ter of 2011. TheCityUK estimates total exit activity of
of placement agents has grown over the past few years, some $100bn in the rst half of 2012, well down on the
with 40% of funds closed in 2006 employing their ser- same period in the previous year.
vices, according to Preqin ltd. Placement agents will approach potential investors on behalf of the fund manager,
and will typically take a fee of around 1% of the commitments that they are able to garner.
The amount of time that a private equity rm spends raising capital varies depending on the level of interest among
investors, which is dened by current market conditions
and also the track record of previous funds raised by the
rm in question. Firms can spend as little as one or two
months raising capital when they are able to reach the
target that they set for their funds relatively easily, often
through gaining commitments from existing investors in
their previous funds, or where strong past performance
leads to strong levels of investor interest. Other managers may nd fundraising taking considerably longer,
with managers of less popular fund types (such as US
and European venture fund managers in the current climate) nding the fundraising process more tough. It is
not unheard of for funds to spend as long as two years on
the road seeking capital, although the majority of fund
managers will complete fundraising within nine months
to fteen months.
Once a fund has reached its fundraising target, it will have
a nal close. After this point it is not normally possible
for new investors to invest in the fund, unless they were to
purchase an interest in the fund on the secondary market.

The fund raising environment remained stable for the

third year running in 2011 with $270bn in new funds
raised, slightly down on the previous years total. Around
$130bn in funds was raised in the rst half of 2012, down
around a fth on the rst half of 2011. The average time
for funds to achieve a nal close fell to 16.7 months in
the rst half of 2012, from 18.5 months in 2011. Private
equity funds available for investment (dry powder) totalled $949bn at the end of q1-2012, down around 6%
on the previous year. Including unrealised funds in existing investments, private equity funds under management
probably totalled over $2.0 trillion.
Public pensions are a major source of capital for private
equity funds. Increasingly, sovereign wealth funds are
growing as an investor class for private equity.[89]

6.6.2 Private equity fund performance

Due to limited disclosure, studying the returns to private
equity is relatively dicult. Unlike mutual funds, private
equity funds need not disclose performance data. And, as
they invest in private companies, it is dicult to examine
the underlying investments. It is challenging to compare
private equity performance to public equity performance,
in particular because private equity fund investments are

34

CHAPTER 6. PRIVATE EQUITY

drawn and returned over time as investments are made tion whereas in the case of private equity the investor can
and subsequently realized.
reclaim their money after a revaluation period and make
An oft-cited academic paper (Kaplan and Shoar, speculative investments in other nancial assets.
2005)[90] suggests that the net-of-fees returns to PE funds Presently, most countries report private equity as a part
are roughly comparable to the S&P 500 (or even slightly of FDI.[96]
under). This analysis may actually overstate the returns
because it relies on voluntarily reported data and hence
suers from survivorship bias (i.e. funds that fail won't 6.8 See also
report data). One should also note that these returns are
not risk-adjusted. A more recent paper (Harris, Jenk History of private equity and venture capital
inson and Kaplan, 2012)[91] found that average buyout
fund returns in the U.S. have actually exceeded that of
Private investment in public equity
public markets. These ndings were supported by earlier
Publicly traded private equity
work, using a dierent data set (Robinson and Sensoy,
[92]
2011).
Specialized investment fund
Commentators have argued that a standard methodology
is needed to present an accurate picture of performance,
to make individual private equity funds comparable and 6.8.1 Organizations
so the asset class as a whole can be matched against public
Private Equity Growth Capital Council advocacy
markets and other types of investment. It is also claimed
organization for the private equity industry
that PE fund managers manipulate data to present themselves as strong performers, which makes it even more
Institutional Limited Partners Association advoessential to standardize the industry.[93]
cacy organization for investors in private equity
Two other ndings in Kaplan and Schoar (2005): First,
Association for Corporate Growth organization for
there is considerable variation in performance across PE
the middle-market private equity industry
funds. Second, unlike the mutual fund industry, there appears to be performance persistence in PE funds. That is,
PE funds that perform well over one period, tend to also
perform well the next period. Persistence is stronger for
VC rms than for LBO rms.
The application of the Freedom of Information Act
(FOIA) in certain states in the United States has made
certain performance data more readily available. Specifically, FOIA has required certain public agencies to disclose private equity performance data directly on the their
websites.[94]
In the United Kingdom, the second largest market for
private equity, more data has become available since the
2007 publication of the David Walker Guidelines for Disclosure and Transparency in Private Equity.[95]

6.9 Notes
[1] Investments in private equity An Introduction to Private ,
including dierences in terminology.
[2] Private Company Knowledge Bank. Privco.com. Retrieved 18 May 2012.
[3] Investopedia LBO Denition. Investopedia.com. 15
February 2009. Retrieved 18 May 2012.
[4] The balance between debt and added value. Financial
Times, 29 September 2006
[5] Frequently Asked Question: What is a tuck-in acquisition?". Investopedia. 30 September 2008. Retrieved 5
January 2013.

6.7 Recording private equity

[6] Add-On/Bolt-On Acquisition dened.

trieved 5 January 2013.

There is a burgeoning debate of the purpose behind private equity, a common misconception to treat private equity separately from foreign direct investment (FDI). The
dierence is blurred on account of private equity not entering the country through the stock market. Private equity generally ows to unlisted rms and to rms where
the percentage of shares is relatively smaller than the promoter or investor held shares (also known as free-oating
shares).

[7] Note on Leveraged Buyouts. Tuck School of Business at

Dartmouth: Center for Private Equity and Entrepreneurship, 2002. Accessed 20 February 2009

PrivCo.

Re-

[8] Ulf Axelson, Tim Jenkinson, Per Strmberg, and Michael

S. Weisbach. Leverage and Pricing in Buyouts: An Empirical Analysis. 28 August 2007
[9] Steven N. Kaplan and Per Strmberg. Leveraged Buyouts and Private Equity, Social Science Research Network, June 2008

The main point of contention behind dierentiating private equity from FDI is that FDI is used solely for produc- [10] Trenwith Group M&A Review, (Second Quarter, 2006)

6.9. NOTES

35

[11] Peston, Robert (2008). Who runs Britain?. London:

Hodder & Stoughton. pp. 2867. ISBN 978-0-34083942-3.

[33] Distressed Private Equity: Spinning Hay into Gold. Harvard Business School: Working Knowledge, 16 February
2004. Accessed 27 February 2009

[12] Zephyr Annual M&A Report: Global Private Equity,

2013. Bureau van Dijk. Bureau van Dijk. 2014. Retrieved 22 May 2014.

[34] The Private Equity Secondaries Market, A complete guide

to its structure, operation and performance The Private
Equity Secondaries Market, 2008

[13] GROWTH CAPITAL MANAGEMENT

[35] Grabenwarter, Ulrich. Exposed to the J-Curve: Understanding and Managing Private Equity Fund Investments,
2005

[14] Loewen, Jacoline (2008). Money Magnet: Attract Investors to Your Business: John Wiley & Sons. ISBN 9780-470-15575-2.
[15] Driving Growth: How Private Equity Investments
Strengthen American Companies. Private Equity Council. Accessed 20 February 2009
[16] When Private Mixes With Public; A Financing Technique
Grows More Popular and Also Raises Concerns. The New
York Times, 5 June 2004
[17] Gretchen Morgenson and Jenny Anderson. Secrets in the
Pipeline. The New York Times, 13 August 2006
[18] Marks, Kenneth H. and Robbins, Larry E. The handbook
of nancing growth: strategies and capital structure. 2005
[19] Mezz Looking Up; Its Not A Long Way Down. Reuters
Buyouts, 11 May 2006
[20] A higher yield. Smart Business Online, August 2009
[21] In the United Kingdom, venture capital is often used instead of private equity to describe the overal asset class
and investment strategy described here as private equity.
[22] Joseph W. Bartlett. What Is Venture Capital?" The Encyclopedia of Private Equity. Accessed 20 February 2009

[36] A discussion on the J-Curve in private equity. AltAssets,

2006
[37] A Secondary Market for Private Equity is Born, The Industry Standard, 28 August 2001
[38] Investors Scramble for Infrastructure (Financial News,
2008)
[39] Is It Time to Add a Parking Lot to Your Portfolio? (The
New York Times, 2006
[40] [Buyout rms put energy infrastructure in pipeline] (MSN
Money, 2008)
[41] Merchant Banking: Past and Present. Fdic.gov. Retrieved 18 May 2012.
[42] Joseph Haas (Sep 9, 2013). DRI Capital To Pursue
Phase III Assets With Some Of Its Third Royalty Fund.
The Pink Sheet Daily.
[43] Wilson, John. The New Ventures, Inside the High Stakes
World of Venture Capital.
[44] A Short (Sometimes Protable) History of Private Equity,
Wall Street Journal, 17 January 2012.

[23] Joshua Lerner. Something Ventured, Something Gained.

Harvard Business School, 24 July 2000. Retrieved 20
February 2009

[45] WGBH Public Broadcasting Service, Who made

America?"-Georges Doriot

[24] A Kink in Venture Capitals Gold Chain. The New York

Times, 7 October 2006

[46] Joseph W. Bartlett, What Is Venture Capital?"". Vcexperts.com. Retrieved 18 May 2012.

[25] An equation for valuation. Financial Post, 27 June 2009

[47] The Future of Securities Regulation speech by Brian

G. Cartwright, General Counsel U.S. Securities and Exchange Commission. University of Pennsylvania Law
School Institute for Law and Economics Philadelphia,
Pennsylvania. 24 October 2007.

[26] Paul A. Gompers. The Rise and Fall of Venture Capital. Graduate School of Business University of Chicago.
Accessed 20 February 2009
[27] Equity Financing Globe & Mail, 4 March 2011
[28] The Principles of Venture Capital. National Venture Capital Association. Accessed 20 February 2009
[29] The turnaround business. AltAssets, 24 August 2001
[30] Guide to Distressed Debt. Private Equity International,
2007. Accessed 27 February 2009
[31] Distress investors take private equity cues. Reuters, 9 August 2007
[32] Bad News Is Good News: 'Distressed for Control' Investing. Wharton School of Business: Knowledge @ Wharton, 26 April 2006. Accessed 27 February 2009

[48] On 21 January 1955, McLean Industries, Inc. purchased

the capital stock of Pan Atlantic Steamship Corporation
and Gulf Florida Terminal Company, Inc. from Waterman Steamship Corporation. In May McLean Industries,
Inc. completed the acquisition of the common stock of
Waterman Steamship Corporation from its founders and
other stockholders.
[49] Marc Levinson, The Box: How the Shipping Container
Made the World Smaller and the World Economy Bigger,
pp. 4447 (Princeton Univ. Press 2006). The details of
this transaction are set out in ICC Case No. MC-F-5976,
McLean Trucking Company and Pan-Atlantic American
Steamship CorporationInvestigation of Control, 8 July
1957.

36

[50] Trehan, R. (2006). The History Of Leveraged Buyouts. 4

December 2006. Retrieved 22 May 2008
[51] [spam lter website:
investmentu.com/research/
private-equity-history.html The History of Private
Equity] (Investment U, The Oxford Club
[52] Burrough, Bryan. Barbarians at the Gate. New York :
Harper & Row, 1990, p. 133-136
[53] Taylor, Alexander L. "Buyout Binge". TIME magazine,
16 July 1984.
[54] David Carey and John E. Morris, King of Capital The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman
and Blackstone (Crown 2010), pp. 1526
[55] Opler, T. and Titman, S. The determinants of leveraged
buyout activity: Free cash ow vs. nancial distress costs.
Journal of Finance, 1993.

CHAPTER 6. PRIVATE EQUITY

[71] Dow Jones Private Equity Analyst as referenced in U.S.

private-equity funds break record Associated Press, 11
January 2007.
[72] Dow Jones Private Equity Analyst as referenced in Private
equity fund raising up in 2007: report, Reuters, 8 January
2008.
[73] SORKIN, ANDREW ROSS. "HCA Buyout Highlights
Era of Going Private. The New York Times, 25 July 2006.
[74] WERDIGIER, JULIA. "Equity Firm Wins Bidding for a
Retailer, Alliance Boots. The New York Times, 25 April
2007
[75] Lonkevich, Dan and Klump, Edward. KKR, Texas Pacic
Will Acquire TXU for $45 Billion Bloomberg, 26 February 2007.

[56] King of Capital, pp. 3144

[76] SORKIN, ANDREW ROSS and de la MERCED,

MICHAEL J. "Private Equity Investors Hint at Cool
Down. The New York Times, 26 June 2007

[57] 10 Questions for Carl Icahn by Barbara Kiviat, TIME

magazine, 15 February 2007

[77] SORKIN, ANDREW ROSS. "Sorting Through the Buyout Freezeout. The New York Times, 12 August 2007.

[58] TWA Death Of A Legend by Elaine X. Grant, St Louis

Magazine, Oct 2005

[78] Turmoil in the markets, The Economist 27 July 2007

[59] Game of Greed (TIME magazine, 1988)

[60] Wallace, Anise C. "Nabisco Renance Plan Set. The New
York Times, 16 July 1990.
[61] King of Capital, pp. 9799
[62] Stone, Dan G. (1990). April Fools: An Insiders Account
of the Rise and Collapse of Drexel Burnham. New York
City: Donald I. Fine. ISBN 1-55611-228-9.
[63] Den of Thieves. Stewart, J. B. New York: Simon & Schuster, 1991. ISBN 0-671-63802-5.
[64] New Street Capital Inc. Company Prole, Information,
Business Description, History, Background Information
on New Street Capital Inc at ReferenceForBusiness.com
[65] SORKIN, ANDREW ROSS and ROZHON, TRACIE.
"Three Firms Are Said to Buy Toys 'R' Us for $6 Billion
. The New York Times, 17 March 2005.
[66] ANDREW ROSS SORKIN and DANNY HAKIM. "Ford
Said to Be Ready to Pursue a Hertz Sale. The New York
Times, 8 September 2005
[67] PETERS, JEREMY W. "Ford Completes Sale of Hertz to
3 Firms. The New York Times, 13 September 2005
[68] SORKIN, ANDREW ROSS. "Sony-Led Group Makes a
Late Bid to Wrest MGM From Time Warner. The New
York Times, 14 September 2004

[79] See Private equity deal making post-AIFMD: asset stripping rules by Giuseppe Giusti http://www.dirittobancario.
it/approfondimenti/private-equity-e-venture-capital/
private-equity-deal-making-post-aifmd-asset-stripping-rules
and
Private
equity
deal
making
postAIFMD: notication and disclosure rules by
Giuseppe
Giusti
http://www.dirittobancario.it/
approfondimenti/private-equity-e-venture-capital/
private-equity-deal-making-post-aifmd-notification-and-disclosure-rules
[80] King of Capital, pp. 213214
[81] M. Nicolas J. Firzli : The New Drivers of Pension Investment in Private Equity, Revue Analyse Financire, Q3
2014 Issue N52
[82] M. Nicolas J. Firzli : The New Drivers of Pension Investment in Private Equity, Revue Analyse Financire, Q3
2014 Issue N52
[83] Per Stromberg:'The new demography of Private Equity',
Master Thesis, Swedish Institute for Financial Research,
Stockholm School of Economics
[84] Top 300 PE funds from PEI Media
[85] London-based PE funds. Askivy.net. Retrieved 18 May
2012.
[86] Private equity versus hedge funds, QuantNet, 9 July 2007.
[87] Understanding private equity strategies, QFinance, June
2008.
[88] Private Equity Report, 2012 (PDF). TheCityUK.

[69] "Capital Firms Agree to Buy SunGard Data in Cash Deal.

Bloomberg L.P., 29 March 2005
[70] Samuelson, Robert J. "The Private Equity Boom". The
Washington Post, 15 March 2007.

[89] Why Rubenstein Believes SWFs May Become the

Biggest Single Capital Source for Private Equity.
Sovereign Wealth Fund Institute. 2014-03-05. Retrieved
2014-07-28.

6.11. EXTERNAL LINKS

37

[90] Kaplan, Steven Neil; Schoar, Antoinette (2005). Private

Equity Performance: Returns, Persistence, and Capital Flows. The Journal of Finance (American Finance
Association) 60 (4): 17911823. doi:10.1111/j.15406261.2005.00780.x. Retrieved 10 February 2012.

Leleux, Benoit; Hans van Swaay (2006). Growth at

All Costs: Private Equity as Capitalism on Steroids.
Basingstoke: Palgrave Macmillan. ISBN 1-40398634-7.

[91] Harris, Robert S.; Jenkinson, Tim; Kaplan, Steven N.

(10 February 2012). Private Equity Performance: What
Do We Know?". Social Science Research Network. Retrieved 10 February 2012.

Fraser-Sampson, Guy (2007). Private Equity as an

Asset Class. Hoboken, NJ: John Wiley & Sons.
ISBN 0-470-06645-8.

[92] Robinson, David T.; Sensoy, Berk A. (15 July 2011).

Private Equity in the 21st Century: Liquidity, Cash
Flows and Performance from 19842010. National Bureau of Economic Research. Retrieved 10 February 2012.

Bassi, Iggy; Jeremy Grant (2006). Structuring European Private Equity. London: Euromoney Books.
ISBN 1-84374-262-4.

[93] Academic pans PE returns, Real Deals.

Realdeals.eu.com. 17 June 2011. Retrieved 18 May 2012.

Thorsten, Grne (2005). Private Equity in Germany

Evaluation of the Value Creation Potential for German Mid-Cap Companies. Stuttgart: Ibidem-Verl.
ISBN 3-89821-620-9.

[94] In the United States, FOIA is individually legislated at the

state level, and so disclosed private equity performance
data will vary widely. Notable examples of agencies that
are mandated to disclose private equity information include CalPERS, CalSTRS and Pennsylvania State Employees Retirement System and the Ohio Bureau of Workers Compensation
[95] Guidelines for Disclosure and Transparency in Private Equity
[96] Private Equity and Indias FDI boom. The Hindu Business
Line, 1 May 2007

6.10 Further reading

David Stowell (2010). An Introduction to Investment
Banks, Hedge Funds, and Private Equity: The New
Paradigm. Academic Press.
Lemke, Thomas P.; Lins, Gerald T.; Hoenig,
Kathryn L.; Rube, Patricia S. (2013). Hedge Funds
and Other Private Funds: Regulation and Compliance. Thomson West.
Cendrowski, Harry; Martin, James P.; Petro, Louis
W. (2008). Private Equity: History, Governance,
and Operations. Hoboken: John Wiley & Sons.
ISBN 0-470-17846-9.
Davido, Steven M. (2009). Gods at War: Shotgun Takeovers, Government by Deal and the Private
Equity Implosion. Hoboken: John Wiley & Sons.
ISBN 0-470-43129-6.
Davis, E. Philip; Steil, Benn (2001). Institutional
Investors. MIT Press. ISBN 0-262-04192-8.
Maxwell, Ray (2007). Private Equity Funds: A
Practical Guide for Investors. New York: John Wiley & Sons. ISBN 0-470-02818-1.

Rosenbaum, Joshua; Joshua Pearl (2009). Investment Banking: Valuation, Leveraged Buyouts, and
Mergers & Acquisitions. Hoboken, NJ: John Wiley
& Sons. ISBN 0-470-44220-4.
Lerner, Joshua (2000). Venture Capital and Private
Equity: A Casebook. New York: John Wiley &
Sons. ISBN 0-471-32286-5.
Grabenwarter, Ulrich; Tom Weidig (2005). Exposed to the J Curve: Understanding and Managing Private Equity Fund Investments. London: Euromoney Institutional Investor. ISBN 1-84374-1490.
Loewen, Jacoline (2008). Money Magnet: Attract
Investors to Your Business. Canada, Toronto: John
Wiley & Sons. ISBN 978-0-470-15575-2.
Private Inequity by James Surowiecki, The Financial
Page, The New Yorker, 30 January 2012.
Gilligan, John; Mike Wright (2010). Private Equity
Demystied. 2nd Edition. London: ICAEW. ISBN
978-1-84152-830-4.
Gladstone, David; Laura Gladstone (2004). Venture Capital Investing, the complete handbook for investing in new businesses. Upper Saddle River, NJ:
Pearson Education. ISBN 0-13-101885-X.

6.11 External links

Archive of articles on private equity controversies in
the 21-st century, Naked Capitalism

Chapter 7

Real estate
This article is about the business of buying, selling, and
renting real property. For the legal concept, see real
property. For the indie rock band, see Real Estate (band).
Real estate is property consisting of land and the buildings on it, along with its natural resources such as crops,
minerals, or water; immovable property of this nature;
an interest vested in this (also) an item of real property;
(more generally) buildings or housing in general. Also:
the business of real estate; the profession of buying, selling, or renting land, buildings or housing.[1]
It is a legal term used in jurisdictions such as the United
States, United Kingdom, Canada, Nigeria, Australia, and 'Single-family detached home'
New Zealand.
detached buildings, where each oor is a separate apartment or unit.

7.1 Residential real estate

The legal arrangement for the right to occupy a dwelling
in some countries is known as the housing tenure.
Types of housing tenure include owner occupancy,
tenancy, housing cooperative, condominiums (individually parceled properties in a single building), public housing, squatting, and cohousing. The occupants of a residence constitute a household.
Residences can be classied by, if, and how they are
connected to neighboring residences and land. Dierent
types of housing tenure can be used for the same physical
type. For example, connected residents might be owned
by a single entity and leased out, or owned separately with
an agreement covering the relationship between units and
common areas and concerns.
Major categories in North America and Europe

Terraced house (a. k. a. townhouse or rowhouse) A number of single or multi-unit

buildings in a continuous row with shared walls
and no intervening space.
Condominium Building or complex, similar
to apartments, owned by individuals. Common grounds and common areas within the
complex are owned and shared jointly. There
are townhouse or rowhouse style condominiums as well.
Cooperative (a. k. a. co-op) A type of
multiple ownership in which the residents of a
multi-unit housing complex own shares in the
cooperative corporation that owns the property, giving each resident the right to occupy
a specic apartment or unit.
Semi-detached dwellings (in UK, a semi is by definition two units with a party wall).

Attached / multi-unit dwellings

Apartment An individual unit in a multiunit building. The boundaries of the apartment are generally dened by a perimeter of
locked or lockable doors. Often seen in multistory apartment buildings.
Multi-family house Often seen in multi-story
38

Duplex Two units with one shared wall. (in

UK, a duplex is an apartment on more than one
storey)
Single-family detached home
Portable dwellings

7.2. SEE ALSO

Mobile homes Potentially a full-time residence which can be (might not in practice be)
movable on wheels.
Houseboats A oating home
Tents Usually very temporary, with roof and
walls consisting only of fabric-like material.
The size of an apartment or house can be described in
square feet or meters. In the United States, this includes
the area of living space, excluding the garage and other
non-living spaces. The square meters gure of a house
in Europe may report the total area of the walls enclosing
the home, thus including any attached garage and nonliving spaces, which makes it important to inquire what
kind of surface denition has been used.
It can be described more roughly by the number of rooms.
A studio apartment has a single bedroom with no living room (possibly a separate kitchen). A one-bedroom
apartment has a living or dining room separate from the
bedroom. Two bedroom, three bedroom, and larger units
are common. (A bedroom is dened as a room with a
closet for clothes storage.)
Major categories in India and the Asian Subcontinent

Co-operative Housing Societies (CHS)

Condominiums
Builder ats
Chawls
Villas
Lanes Houses[2]
Tianjin
Kothis
Havelis
Independent Floors
Lal Dora Where people carry out commercial and
residential activities both.
The size is measured in Gaz (square yards), Quila, Marla,
Beegha, and acre.
See List of house types for a complete listing of housing types and layouts, real estate trends for shifts in the
market and house or home for more general information.

39

7.2 See also

7.3 References
[1] Real estate": Oxford English Dictionary online: Retrieved September 18, 2011
[2] Medium (2015-01-04). Shanghai Real Estate Trends
2015. Medium Inc. Retrieved 6 January 2015.

7.4 External links

The dictionary denition of real estate at Wiktionary

Chapter 8

Spot market
The spot market or cash market is a public nancial
market in which nancial instruments or commodities are
traded for immediate delivery. It contrasts with a futures
market, in which delivery is due at a later date. In spot
market, settlement happens in t+2 working days, i.e., delivery of cash and commodity must be done after two
working days of the trade date. A spot market can be:
an organized market;
an exchange; or
Over-the-counter (OTC)
Spot markets can operate wherever the infrastructure exists to conduct the transaction.

8.3.1 Energy Spot

The spot energy market allows producers of surplus energy to instantly locate available buyers for this energy,
negotiate prices within milliseconds, and deliver energy
to the customer just a few minutes later. Spot markets
can be either privately operated or controlled by industry
organizations or government agencies. They frequently
attract speculators, since spot market prices are known to
the public almost as soon as deals are transacted. Examples of energy spot markets for natural gas in Europe are
the Title Transfer Facility (TTF) in the Netherlands and
the National Balancing Point (NBP) in the United Kingdom.

8.4 See also

Spot rating

8.1 Exchange

Spot date

Security (i.e. nancial instrument) or commodity is

traded on an exchange using, making and possibly changing, the current market price.

8.5 References

8.2 OTC
In the over the counter market, trades are based on contracts made directly between two parties, and not subject
to the rules of an exchange. The contract terms are agreed
between the parties and may be non-standard. The price
will probably not be published.

8.3 Examples
The spot foreign exchange market imposes a two-day delivery period, originally due to the time it would take
to move cash from one bank to another. Most speculative retail forex trading is done as spot transactions on an
online trading platform.
40

Chapter 9

Stock market
A stock market or equity market is the aggregation of
buyers and sellers (a loose network of economic transactions, not a physical facility or discrete entity) of stocks
(also called shares); these may include securities listed on
a stock exchange as well as those only traded privately.

9.1 Size of market

Stocks can be categorized in various ways. One common way is by the country where the company is domiciled. For example, Nestl and Novartis are domiciled
in Switzerland, so they may be considered as part of the
Swiss stock market, although their stock may also be
The New York Stock Exchange
traded at exchanges in other countries.
At the close of 2012, the size of the world stock market
(total market capitalisation) was about US$55 trillion.[1]
By country, the largest market was the United States
(about 34%), followed by Japan (about 6%) and the
United Kingdom (about 6%).[2] This went up more in
2013.[3]

9.2 Stock exchange

Main article: Stock exchange
A stock exchange is a place or organization by which
stock traders (people and companies) can trade stocks. The London Stock Exchange
Companies may want to get their stock listed on a stock
exchange. Other stocks may be traded over the counter,
that is, through a dealer. A large company will usu- shares) confer an ownership interest in a particular comally have its stock listed on many exchanges across the pany.
world.[4]
Participants in the stock market range from small indiExchanges may also cover other types of security such as vidual stock investors to larger traders investors, who can
xed interest securities or indeed derivatives.
be based anywhere in the world, and may include banks,
insurance companies or pension funds, and hedge funds.
Their buy or sell orders may be executed on their behalf
by a stock exchange trader.
9.3 Trade
Some exchanges are physical locations where transactions
Trade in stock markets means the transfer for money of are carried out on a trading oor, by a method known
a stock or security from a seller to a buyer. This requires as open outcry. This method is used in some stock exthese two parties to agree on a price. Equities (Stocks or changes and commodity exchanges, and involves traders
41

42

CHAPTER 9. STOCK MARKET

entering oral bids and oers simultaneously. An exam- commissions of the exchange. However, it also has probple of such an exchange is the New York Stock Exchange. lems such as adverse selection.[6] Financial regulators are
The other type of stock exchange is a virtual kind, com- probing dark pools.[7]
posed of a network of computers where trades are made
electronically by traders. An example of such an exchange is the NASDAQ.
9.4 Market participant
A potential buyer bids a specic price for a stock, and a
potential seller asks a specic price for the same stock.
Buying or selling at market means you will accept any
ask price or bid price for the stock, respectively. When
the bid and ask prices match, a sale takes place, on a rstcome-rst-served basis if there are multiple bidders or
askers at a given price.
The purpose of a stock exchange is to facilitate the exchange of securities between buyers and sellers, thus providing a marketplace (virtual or real). The exchanges provide real-time trading information on the listed securities,
facilitating price discovery.
The New York Stock Exchange (NYSE) is a physical exchange, with a hybrid market for placing orders both electronically and manually on the trading oor. Orders executed on the trading oor enter by way of exchange members and ow down to a oor broker, who goes to the oor
trading post specialist for that stock to trade the order.
The specialists job is to match buy and sell orders using open outcry. If a spread exists, no trade immediately
takes placein this case the specialist should use his/her
own resources (money or stock) to close the dierence
after his/her judged time. Once a trade has been made
the details are reported on the "tape" and sent back to
the brokerage rm, which then noties the investor who
placed the order. Although there is a signicant amount
of human contact in this process, computers play an important role, especially for so-called "program trading".

The oces of Bursa Malaysia, Malaysias national stock exchange (known before demutualization as Kuala Lumpur Stock
Exchange)

Market participants include individual retail investors, institutional investors such as mutual funds, banks, insurance companies and hedge funds, and also publicly traded
corporations trading in their own shares. Some studies
have suggested that institutional investors and corporations trading in their own shares generally receive higher
risk-adjusted returns than retail investors.[8]

The NASDAQ is a virtual listed exchange, where all of

the trading is done over a computer network. The process is similar to the New York Stock Exchange. However, buyers and sellers are electronically matched. One
or more NASDAQ market makers will always provide a
bid and ask price at which they will always purchase or
sell 'their' stock.[5]

A few decades ago, worldwide, buyers and sellers were

individual investors, such as wealthy businessmen, usually with long family histories to particular corporations. Over time, markets have become more institutionalized"; buyers and sellers are largely institutions
(e.g., pension funds, insurance companies, mutual funds,
index funds, exchange-traded funds, hedge funds, investor groups, banks and various other nancial institutions).

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

The rise of the institutional investor has brought with

it some improvements in market operations. There has
been a gradual tendency for xed (and exorbitant) fees
being reduced for all investors, partly from falling administration costs but also assisted by large institutions challenging brokers oligopolistic approach to setting standardised fees.

People trading stock will prefer to trade on the most popular exchange since this gives the largest number of potential counterparties (buyers for a seller, sellers for a
buyer). and probably the best price. However, there have
always been alternatives such as brokers trying to bring
parties together to trade outside the exchange. Some third
markets that were popular are Instinet, and later Island
and Archipelago. One advantage is that this avoids the

9.5 History
In 12th century France the courretiers de change were
concerned with managing and regulating the debts of
agricultural communities on behalf of the banks. Because these men also traded with debts, they could be

9.6. IMPORTANCE OF STOCK MARKET

43
banned by the Dutch authorities as early as 1610.[10]
There are now stock markets in virtually every developed and most developing economies, with the worlds
largest markets being in the United States, United Kingdom, Japan, India, Pakistan, China, Canada, Germany
(Frankfurt Stock Exchange), France, South Korea and
the Netherlands.[11]

9.6 Importance of stock market

9.6.1 Function and purpose

Established in 1875, the Bombay Stock Exchange is Asias rst

stock exchange

called the rst brokers. A common misbelief is that in

late 13th century Bruges commodity traders gathered inside the house of a man called Van der Beurze, and in
1409 they became the Brugse Beurse, institutionalizing what had been, until then, an informal meeting, but
actually, the family Van der Beurze had a building in
Antwerp where those gatherings occurred;[9] the Van der
Beurze had Antwerp, as most of the merchants of that period, as their primary place for trading. The idea quickly
spread around Flanders and neighboring countries and
Beurzen soon opened in Ghent and Rotterdam.
In the middle of the 13th century, Venetian bankers began to trade in government securities. In 1351 the Venetian government outlawed spreading rumors intended to
lower the price of government funds. Bankers in Pisa,
Verona, Genoa and Florence also began trading in government securities during the 14th century. This was only
possible because these were independent city states not
ruled by a duke but a council of inuential citizens. Italian companies were also the rst to issue shares. Companies in England and the Low Countries followed in the
16th century.

The main trading room of the Tokyo Stock Exchange,where trading is currently completed through computers.

The stock market is one of the most important ways for

companies to raise money, along with debt markets which
are generally more imposing but do not trade publicly.[12]
This allows businesses to be publicly traded, and raise additional nancial capital for expansion by selling shares
of ownership of the company in a public market. The
liquidity that an exchange aords the investors enables
their holders to quickly and easily sell securities. This is
an attractive feature of investing in stocks, compared to
The Dutch East India Company (founded in 1602) was other less liquid investments such as property and other
actively increase
the rst joint-stock company to get a xed capital stock immoveable assets. Some companies [13][14]
liquidity
by
trading
in
their
own
shares.
and as a result, continuous trade in company stock occurred on the Amsterdam Exchange. Soon thereafter, a History has shown that the price of stocks and other assets
lively trade in various derivatives, among which options is an important part of the dynamics of economic activand repos, emerged on the Amsterdam market. Dutch ity, and can inuence or be an indicator of social mood.
traders also pioneered short selling a practice which was An economy where the stock market is on the rise is con-

44

CHAPTER 9. STOCK MARKET

sidered to be an up-and-coming economy. In fact, the Similar tendencies are to be found in other industrialized
stock market is often considered the primary indicator of countries. In all developed economic systems, such as the
a countrys economic strength and development.[15]
European Union, the United States, Japan and other deRising share prices, for instance, tend to be associated veloped nations, the trend has been the same: saving has
with increased business investment and vice versa. Share moved away from traditional (government insured) bank
prices also aect the wealth of households and their con- deposits to more risky securities of one sort or another.
sumption. Therefore, central banks tend to keep an eye A second transformation is the move to electronic trading
on the control and behavior of the stock market and, in to replace human trading of listed securities.[18]
general, on the smooth operation of nancial system functions. Financial stability is the raison d'tre of central
banks.
9.6.3 United States S&P stock market re-

turns
Exchanges also act as the clearinghouse for each transaction, meaning that they collect and deliver the shares,
and guarantee payment to the seller of a security. This (assumes 2% annual dividend)
eliminates the risk to an individual buyer or seller that Compared to Other Asset Classes Over the long term,
the counterparty could default on the transaction.
investing in a well diversied portfolio of stocks such as
The smooth functioning of all these activities facilitates an S&P 500 Index outperforms other investment vehieconomic growth in that lower costs and enterprise risks cles such as Treasury Bills and Bonds, with the S&P 500
promote the production of goods and services as well as having a geometric annual average of 9.55% from 1928possibly employment. In this way the nancial system is 2013.[20]
assumed to contribute to increased prosperity, although
some controversy exists as to whether the optimal nancial system is bank-based or market-based.[16]
9.6.4 Behavior of the stock market
Recent events such as the Global Financial Crisis have
prompted a heightened degree of scrutiny of the impact
of the structure of stock markets[17][18] (called market microstructure), in particular to the stability of the nancial
system and the transmission of systemic risk.[19]

9.6.2

Relation of the stock market to the

modern nancial system

The nancial system in most western countries has undergone a remarkable transformation. One feature of this
development is disintermediation. A portion of the funds
involved in saving and nancing, ows directly to the nancial markets instead of being routed via the traditional
bank lending and deposit operations. The general public
interest in investing in the stock market, either directly or
through mutual funds, has been an important component
of this process.
Statistics show that in recent decades, shares have made
up an increasingly large proportion of households nancial assets in many countries. In the 1970s, in Sweden,
deposit accounts and other very liquid assets with little
risk made up almost 60 percent of households nancial
wealth, compared to less than 20 percent in the 2000s.
The major part of this adjustment is that nancial portfolios have gone directly to shares but a good deal now takes
the form of various kinds of institutional investment for
groups of individuals, e.g., pension funds, mutual funds, NASDAQ in Times Square, New York City
hedge funds, insurance investment of premiums, etc.
The trend towards forms of saving with a higher risk has From experience it is known that investors may 'tembeen accentuated by new rules for most funds and insur- porarily' move nancial prices away from their long term
ance, permitting a higher proportion of shares to bonds. aggregate price 'trends. Over-reactions may occurso

9.6. IMPORTANCE OF STOCK MARKET

45

that excessive optimism (euphoria) may drive prices unduly high or excessive pessimism may drive prices unduly low. Economists continue to debate whether nancial markets are 'generally' ecient.

succession of good news items about a company may

lead investors to overreact positively (unjustiably driving the price up). A period of good returns also boosts the
investors self-condence, reducing their (psychological)
[24]
According to one interpretation of the ecient-market risk threshold.
hypothesis (EMH), only changes in fundamental factors, Another phenomenonalso from psychologythat
such as the outlook for margins, prots or dividends, works against an objective assessment is group thinking.
ought to aect share prices beyond the short term, where As social animals, it is not easy to stick to an opinion
random 'noise' in the system may prevail. (But this that diers markedly from that of a majority of the
largely theoretic academic viewpointknown as 'hard' group. An example with which one may be familiar is
EMHalso predicts that little or no trading should take the reluctance to enter a restaurant that is empty; people
place, contrary to fact, since prices are already at or generally prefer to have their opinion validated by those
near equilibrium, having priced in all public knowledge.) of others in the group.
The 'hard' ecient-market hypothesis is sorely tested and In one paper the authors draw an analogy with
does not explain the cause of events such as the crash gambling.[25] In normal times the market behaves like a
in 1987, when the Dow Jones Industrial Average plum- game of roulette; the probabilities are known and largely
meted 22.6 percentthe largest-ever one-day fall in the independent of the investment decisions of the dierent
United States.[21]
players. In times of market stress, however, the game
This event demonstrated that share prices can fall dramatically even though, to this day, it is impossible to x a
generally agreed upon denite cause: a thorough search
failed to detect any 'reasonable' development that might
have accounted for the crash. (But note that such events
are predicted to occur strictly by chance, although very
rarely.) It seems also to be the case more generally that
many price movements (beyond that which are predicted
to occur 'randomly') are not occasioned by new information; a study of the fty largest one-day share price movements in the United States in the post-war period seems
to conrm this.[21]
A 'soft' EMH has emerged which does not require that
prices remain at or near equilibrium, but only that market participants not be able to systematically prot from
any momentary market 'ineciencies'. Moreover, while
EMH predicts that all price movement (in the absence
of change in fundamental information) is random (i.e.,
non-trending), many studies have shown a marked tendency for the stock market to trend over time periods of
weeks or longer. Various explanations for such large and
apparently non-random price movements have been promulgated. For instance, some research has shown that
changes in estimated risk, and the use of certain strategies, such as stop-loss limits and value at risk limits, theoretically could cause nancial markets to overreact. But
the best explanation seems to be that the distribution
of stock market prices is non-Gaussian (in which case
EMH, in any of its current forms, would not be strictly
applicable).[22][23]

becomes more like poker (herding behavior takes over).

The players now must give heavy weight to the psychology of other investors and how they are likely to react
psychologically.
The stock market, as with any other business, is quite unforgiving of amateurs. Inexperienced investors rarely get
the assistance and support they need. In the period running up to the 1987 crash, less than 1 percent of the analysts recommendations had been to sell (and even during the 20002002 bear market, the average did not rise
above 5%). In the run up to 2000, the media amplied
the general euphoria, with reports of rapidly rising share
prices and the notion that large sums of money could be
quickly earned in the so-called new economy stock market. (And later amplied the gloom which descended during the 20002002 bear market, so that by summer of
2002, predictions of a DOW average below 5000 were
quite common)

On the other hand, Stock markets play an essential role

in growing industries that ultimately aect the economy
through transferring available funds from units that have
excess funds (savings) to those who are suering from
funds decit (borrowings) (Padhi and Naik, 2012). In
other words, capital markets facilitate funds movement
between the above-mentioned units. This process leads
to the enhancement of available nancial resources which
in turn aects the economic growth positively. Moreover, both of economic and nancial theories argue that
stocks prices are aected by the performance of main
macroeconomic variables, see Al-Majali and Al-Assaf
Other research has shown that psychological factors may (2014).[26]
result in exaggerated (statistically anomalous) stock price
movements (contrary to EMH which assumes such behaviors 'cancel out'). Psychological research has demon- 9.6.5 Irrational behavior
strated that people are predisposed to 'seeing' patterns,
and often will perceive a pattern in what is, in fact, just Sometimes, the market seems to react irrationally to econoise. (Something like seeing familiar shapes in clouds nomic or nancial news, even if that news is likely to
or ink blots.) In the present context this means that a have no real eect on the fundamental value of securities itself.[27] But, this may be more apparent than real,

46

CHAPTER 9. STOCK MARKET

since often such news has been anticipated, and a counterreaction may occur if the news is better (or worse) than
expected. Therefore, the stock market may be swayed in
either direction by press releases, rumors, euphoria and
mass panic.
Over the short-term, stocks and other securities can
be battered or buoyed by any number of fast marketchanging events, making the stock market behavior difcult to predict. Emotions can drive prices up and down,
people are generally not as rational as they think, and the
reasons for buying and selling are generally obscure. Behaviorists argue that investors often behave 'irrationally'
when making investment decisions thereby incorrectly
pricing securities, which causes market ineciencies,
which, in turn, are opportunities to make money.[28]
However, the whole notion of EMH is that these nonrational reactions to information cancel out, leaving the
prices of stocks rationally determined.
The Dow Jones Industrial Average biggest gain in one day
was 936.42 points or 11 percent, this occurred on October
13, 2008.[29]

9.6.6

Crashes

Main article: Stock market crash

Further information: List of stock market crashes
A stock market crash is often dened as a sharp dip in

Price-Earnings ratios as a predictor of twenty-year returns based

upon the plot by Robert Shiller (Figure 10.1,[30] source). The
horizontal axis shows the real price-earnings ratio of the S&P
Composite Stock Price Index as computed in Irrational Exuberance (ination adjusted price divided by the prior ten-year mean
of ination-adjusted earnings). The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty
years later. Data from dierent twenty-year periods is colorcoded as shown in the key. See also ten-year returns. Shiller
states that this plot conrms that long-term investorsinvestors
who commit their money to an investment for ten full yearsdid
do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well advised,
individually, to lower their exposure to the stock market when it
is high, as it has been recently, and get into the market when it is
low.[30]

struction on a massive scale. An increasing number of

people are involved in the stock market, especially since
the social security and retirement plans are being increasingly privatized and linked to stocks and bonds and other
elements of the market. There have been a number of famous stock market crashes like the Wall Street Crash of
1929, the stock market crash of 19734, the Black Monday of 1987, the Dot-com bubble of 2000, and the Stock
Robert Shiller's plot of the S&P Composite Real Price Index, Market Crash of 2008.
Earnings, Dividends, and Interest Rates, from Irrational Exuber- One of the most famous stock market crashes started Ocance, 2d ed.[30] In the preface to this edition, Shiller warns, The tober 24, 1929 on Black Thursday. The Dow Jones Instock market has not come down to historical levels: the pricedustrial Average lost 50% during this stock market crash.
earnings ratio as I dene it in this book is still, at this writing
It was the beginning of the Great Depression. Another fa[2005], in the mid-20s, far higher than the historical average...
People still place too much condence in the markets and have mous crash took place on October 19, 1987 Black Montoo strong a belief that paying attention to the gyrations in their day. The crash began in Hong Kong and quickly spread
investments will someday make them rich, and so they do not around the world.
make conservative preparations for possible bad outcomes.

share prices of stocks listed on the stock exchanges. In

parallel with various economic factors, a reason for stock
market crashes is also due to panic and investing publics
loss of condence. Often, stock market crashes end speculative economic bubbles.
There have been famous stock market crashes that have
ended in the loss of billions of dollars and wealth de-

By the end of October, stock markets in Hong Kong had

fallen 45.5%, Australia 41.8%, Spain 31%, the United
Kingdom 26.4%, the United States 22.68%, and Canada
22.5%. Black Monday itself was the largest one-day percentage decline in stock market history the Dow Jones
fell by 22.6% in a day. The names Black Monday and
Black Tuesday are also used for October 2829, 1929,
which followed Terrible Thursdaythe starting day of
the stock market crash in 1929.

9.8. DERIVATIVE INSTRUMENTS

47

The crash in 1987 raised some puzzles main news and

events did not predict the catastrophe and visible reasons
for the collapse were not identied. This event raised
questions about many important assumptions of modern
economics, namely, the theory of rational human conduct, the theory of market equilibrium and the ecientmarket hypothesis. For some time after the crash, trading in stock exchanges worldwide was halted, since the
exchange computers did not perform well owing to enormous quantity of trades being received at one time. This
halt in trading allowed the Federal Reserve System and
central banks of other countries to take measures to control the spreading of worldwide nancial crisis. In the
United States the SEC introduced several new measures
of control into the stock market in an attempt to prevent
a re-occurrence of the events of Black Monday.

The movements of the prices in a market or section of

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

Since the early 1990s, many of the largest exchanges

have adopted electronic 'matching engines to bring together buyers and sellers, replacing the open outcry system. Electronic trading now accounts for the majority of
trading in many developed countries. Computer systems
were upgraded in the stock exchanges to handle larger
trading volumes in a more accurate and controlled manner. The SEC modied the margin requirements in an
attempt to lower the volatility of common stocks, stock
options and the futures market. The New York Stock Exchange and the Chicago Mercantile Exchange introduced
the concept of a circuit breaker. The circuit breaker halts
trading if the Dow declines a prescribed number of points
for a prescribed amount of time. In February 2012, the
Investment Industry Regulatory Organization of Canada
(IIROC) introduced single-stock circuit breakers.[31]

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

9.8 Derivative instruments

Main article: Derivative (nance)

9.9 Leveraged strategies

Stock that a trader does not actually own may be traded

New York Stock Exchange (NYSE) circuit using short selling; margin buying may be used to purbreakers[32]
chase stock with borrowed funds; or, derivatives may be
used to control large blocks of stocks for a much smaller
amount of money than would be required by outright purchase or sales.
9.6.7 Stock market prediction
Main article: Stock market prediction
Tobias Preis and his colleagues Helen Susannah Moat and
H. Eugene Stanley introduced a method to identify online
precursors for stock market moves, using trading strategies based on search volume data provided by Google
Trends.[33] Their analysis of Google search volume for
98 terms of varying nancial relevance, published in
Scientic Reports,[34] suggests that increases in search volume for nancially relevant search terms tend to precede
large losses in nancial markets.[35][36][37][38][39][40]

9.7 Stock market index

Main article: Stock market index

9.9.1 Short selling

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

48

9.9.2

CHAPTER 9. STOCK MARKET

Margin buying

Main article: margin buying

sic methods are classied by either fundamental analysis or technical analysis. Fundamental analysis refers to
analyzing companies by their nancial statements found
in SEC lings, business trends, general economic conditions, etc. Technical analysis studies price actions in markets through the use of charts and quantitative techniques
to attempt to forecast price trends regardless of the companys nancial prospects. One example of a technical
strategy is the Trend following method, used by John W.
Henry and Ed Seykota, which uses price patterns, utilizes
strict money management and is also rooted in risk control and diversication.

In margin buying, the trader borrows money (at interest)

to buy a stock and hopes for it to rise. Most industrialized countries have regulations that require that if the borrowing is based on collateral from other stocks the trader
owns outright, it can be a maximum of a certain percentage of those other stocks value. In the United States, the
margin requirements have been 50% for many years (that
is, if you want to make a $1000 investment, you need to
put up $500, and there is often a maintenance margin be- Additionally, many choose to invest via the index method.
In this method, one holds a weighted or unweighted
low the $500).
portfolio consisting of the entire stock market or some
A margin call is made if the total value of the investors
segment of the stock market (such as the S&P 500 or
account cannot support the loss of the trade. (Upon a
Wilshire 5000). The principal aim of this strategy is to
decline in the value of the margined securities additional
maximize diversication, minimize taxes from too frefunds may be required to maintain the accounts equity,
quent trading, and ride the general trend of the stock marand with or without notice the margined security or any
ket (which, in the U.S., has averaged nearly 10% per year,
others within the account may be sold by the brokerage
compounded annually, since World War II).
to protect its loan position. The investor is responsible for
any shortfall following such forced sales.)
Regulation of margin requirements (by the Federal Reserve) was implemented after the Crash of 1929. Before
that, speculators typically only needed to put up as little
as 10 percent (or even less) of the total investment represented by the stocks purchased. Other rules may include
the prohibition of free-riding: putting in an order to buy
stocks without paying initially (there is normally a threeday grace period for delivery of the stock), but then selling them (before the three-days are up) and using part of
the proceeds to make the original payment (assuming that
the value of the stocks has not declined in the interim).

9.10 New issuance

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

Main article: Thomson Reuters league tables

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

9.13 See also

Balance sheet
Dead cat bounce
List of market opening times
List of recessions
List of stock exchanges

9.11 Investment strategies

List of stock market indices

Main article: Investment strategy

Modeling and analysis of nancial markets

NASDAQ-100

One of the many things people always want to know

about the stock market is, How do I make money investing?" There are many dierent approaches; two ba-

Securities regulation in the United States

Slippage (nance)

9.14. REFERENCES
Stock market bubble
Stock market cycles
Stock market data systems
Mr. Market
Stock fund

9.14 References
[1] World stock market capitalization closes year at $54.6 trillion
[2] WFE 2012 Market Highlights
[3] Global Stock Rally: World Market Cap Reached Record
High In March | Seeking Alpha.
[4] IBM Investor relations - FAQ | On what stock exchanges
is IBM listed ?". IBM.
[5] Whats the dierence between a Nasdaq market maker
and a NYSE specialist?". Investopedia.com. Retrieved
March 5, 2010.
[6] Ortega, Edgar; Yalman, Onaran (December 4, 2006).
UBS, Goldman Threaten NYSE, Nasdaq With Rival
Stock Markets. Bloomberg.com. Retrieved 2011-05-31.

49

[17] http://www.iosco.org/library/pubdocs/pdf/
IOSCOPD354.pdf
[18] https://www.gov.uk/government/collections/
future-of-computer-trading
[19] K Alexander, R Dhumale, J Eatwell, Global governance of
nancial systems: the international regulation of systemic
risk, Oxford University Press2006
[20] http://pages.stern.nyu.edu/~{}adamodar/New_Home_
Page/datafile/histretSP.html
[21] Cutler, D. Poterba, J. & Summers, L. (1991). Speculative dynamics. Review of Economic Studies 58 (3): 520
546. doi:10.2307/2298010.
[22] Mandelbrot, Benoit & Hudson, Richard L. (2006). The
Misbehavior of Markets: A Fractal View of Financial Turbulence, annot. ed. Basic Books. ISBN 0-465-04357-7.
[23] Taleb, Nassim Nicholas (2008). Fooled by Randomness:
The Hidden Role of Chance in Life and in the Markets, 2nd
ed. Random House. ISBN 1-4000-6793-6.
[24] Tversky, A. & Kahneman, D. (1974). Judgement under
uncertainty: heuristics and biases. Science 185 (4157):
11241131. doi:10.1126/science.185.4157.1124. PMID
17835457.
[25] Morris, Stephen; Shin, Hyun Song (1999). Risk management with interdependent choice. Oxford Review of Economic Policy 15 (3): 5262. doi:10.1093/oxrep/15.3.52.

[7] Financial regulators probe dark pools Financial Times

[8] Amedeo De Cesari, Susanne Espenlaub, Arif Khurshed,
and Michael Simkovic, The Eects of Ownership and
Stock Liquidity on the Timing of Repurchase Transactions (October 2010). Paolo Ba Centre Research Paper
No. 2011-100.
[9] 16de eeuwse traditionele bak- en zandsteenarchitectuur
Oude Beurs Antwerpen 1 (centrum) / Antwerp foto. Belgiumview.com. Retrieved March 5, 2010.
[10] PhD thesis 'The worlds rst stock exchange'". Retrieved
2011-10-01.
[11] World Federation of Exchanges Monthly YTD Data.
World-exchanges.org. Retrieved 2011-05-31.
[12] http://www.eurocapitalmarkets.org/?q=node/176

[26] Al-Majali A., and Al-Assaf G., (2014), LONG-RUN

AND SHORT-RUN RELATIONSHIP BETWEEN
STOCK MARKET INDEX AND MAIN MACROECONOMIC VARIABLES PERFORMANCE IN
JORDAN, European Scientic Journal,Vol. 10, No. 10.
http://eujournal.org/index.php/esj/article/view/3129
[27] Why The Market Doesn't Care Where You Think It
Should Go | Seeking Alpha
[28] Sergey Perminov, Trendocracy and Stock Market Manipulations (2008, ISBN 978-1-4357-5244-3).
[29] News Headlines. Cnbc.com. October 13, 2008. Retrieved March 5, 2010.
[30] Shiller, Robert (2005). Irrational Exuberance (2d ed.).
Princeton University Press. ISBN 0-691-12335-7.

[13] Cesari, Amedeo De; Espenlaub, Susanne; Khurshed,

Arif; Simkovic, Michael (2010). The Eects of Ownership and Stock Liquidity on the Timing of Repurchase
Transactions. Paolo Ba Centre Research Paper No.
2011-100. SSRN 1884171.

[31] Completing the Circuit:

Global, February 2012

[14] Simkovic, Michael (2009). The Eect of Enhanced Disclosure on Open Market Stock Repurchases. Berkeley
Business Law Journal 6 (1). SSRN 1117303.

[33] Philip Ball (April 26, 2013). Counting Google searches

predicts market movements. Nature. Retrieved August
28, 2013.

[15] Mahipal Singh, 2011, ISBN 9788182055193, April 2011

[34] Tobias Preis, Helen Susannah Moat and H. Eugene Stanley (2013). Quantifying Trading Behavior in Financial Markets Using Google Trends. Scientic Reports 3:
1684. doi:10.1038/srep01684.

[16] http://wdi.umich.edu/files/publications/workingpapers/
wp442.pdf

Canadian Regulation, FIX-

[32] Chris Farrell. Where are the circuit breakers. Retrieved

October 16, 2008.

50

[35] Nick Bilton (April 26, 2013). Google Search Terms Can
Predict Stock Market, Study Finds. New York Times. Retrieved August 28, 2013.
[36] Christopher Matthews (April 26, 2013). Trouble With
Your Investment Portfolio? Google It!". TIME Magazine.
Retrieved August 28, 2013.
[37] Bernhard Warner (April 25, 2013).
"'Big Data'
Researchers Turn to Google to Beat the Markets.
Bloomberg Businessweek. Retrieved August 28, 2013.
[38] Hamish McRae (April 28, 2013). Hamish McRae: Need
a valuable handle on investor sentiment? Google it. The
Independent. Retrieved August 28, 2013.
[39] Richard Waters (April 25, 2013). Google search proves
to be new word in stock market prediction. Financial
Times. Retrieved August 28, 2013.
[40] Jason Palmer (April 25, 2013). Google searches predict
market moves. BBC. Retrieved August 28, 2013.

9.15 Further reading

Hamilton, W. P. (1922).
The Stock Market
Baraometer. New York: John Wiley & Sons Inc
(1998 reprint). ISBN 0-471-24764-2.
Preda, Alex (2009). Framing Finance: The Boundaries of Markets and Modern Capitalism. University
of Chicago Press. ISBN 978-0-226-67932-7.
Siegel, Jeremy J. (2008). Stock Market. In
David R. Henderson (ed.). Concise Encyclopedia
of Economics (2nd ed.). Indianapolis: Library of
Economics and Liberty. ISBN 978-0865976658.
OCLC 237794267.

9.16 External links

Stock exchanges at DMOZ
Stocks investing at DMOZ

CHAPTER 9. STOCK MARKET

Chapter 10

Financial market participants

There are two basic nancial market participant cat- An investor is any party that makes an Investment.
egories, Investor vs. Speculator and Institutional vs.
However, the term has taken on a specic meaning
Retail. Action in nancial markets by central banks is in nance to describe the particular types of people
usually regarded as intervention rather than participation.
and companies that regularly purchase equity or debt
securities for nancial gain in exchange for funding an
expanding company. Less frequently the term is applied
10.1 Supply side vs. demand side to parties who purchase real estate, currency, commodity
derivatives, personal property, or other assets.
A market participant may either be coming from the Supply Side, hence supplying excess money (in the form of
investments) in favor of the demand side; or coming from
the Demand Side, hence demanding excess money (in the
form of borrowed equity) in favor of the Supply Side.
This equation originated from Keynesian Advocates. The
theory explains that a given market may have excess cash;
hence the supplier of funds may lend it; and those in need
of cash may borrow the funds supplied. Hence, the equation: aggregate savings equals aggregate investments.
The demand side consists of: those in need of cash ows
(daily operational needs); those in need of interim nancing (bridge nancing); those in need of long-term funds
for special projects (capital funds for venture nancing).

10.2.2 Speculation
Main article: Speculation
Speculation, in the narrow sense of nancial speculation,
involves the buying, holding, selling, and short-selling of
stocks, bonds, commodities, currencies, collectibles, real
estate, derivatives or any valuable nancial instrument to
prot from uctuations in its price as opposed to buying
it for use or for income via methods such as dividends or
interest. Speculation or agiotage represents one of three
market roles in western nancial markets, distinct from
hedging, long term investing and arbitrage. Speculators in
an asset may have no intention to have long term exposure
to that asset.

The supply side consists of: those who have aggregate savings (retirement funds, pension funds, insurance
funds) that can be used in favor of demand side. The
origin of the savings (funds) can be local savings or foreign savings. So much pensions or savings can be invested
for school buildings; orphanages; (but not earning) or for
road network (toll ways) or port development (capable of 10.3 Institutional vs. Retail
earnings). The earnings go to owner (Savers or Lenders)
and the margin goes to the banks. When the principal
and interest are added up, it will reect the amount paid 10.3.1 Institutional investor
for the user (borrower) of the funds. Thus, an interest
Main article: Institutional investor
percentage for the cost of using the funds.

10.2 Investor vs. Speculator

10.2.1

Investor

Main article: Investor

An institutional investor is an investor, such as a bank,

insurance company, retirement fund, hedge fund, or mutual fund, that is nancially sophisticated and makes large
investments, often held in very large portfolios of investments. Because of their sophistication, institutional investors may often participate in private placements of securities, in which certain aspects of the securities laws
may be inapplicable.
51

52

10.3.2

CHAPTER 10. FINANCIAL MARKET PARTICIPANTS

Retail investor

A retail investor is an individual investor possessing

shares of a given security. Retail investors can be further
divided into two categories of share ownership.
1. A Benecial Shareholder is a retail investor who
holds shares of their securities in the account of a
bank or broker, also known as in Street Name. The
broker is in possession of the securities on behalf of
the underlying shareholder.
2. A Registered Shareholder is a retail investor who
holds shares of their securities directly through the
issuer or its transfer agent. Many registered shareholders have physical copies of their stock certicates.
In the United States, as of 2005 about 57 million households owned stocks, and in total individual investors
owned 26% of equities.[1]

10.4 See also

Financial market eciency

10.5 References
[1] Harris L. (2010). Missing in Activism: Retail Investor
Absence in Corporate Elections. Columbia Business Law
Review

Chapter 11

Investor
Venture capital funds, which serve as investment
collectives on behalf of individuals, companies,
pension plans, insurance reserves, or other funds.

For the Swedish investment company, see Investor AB.

An investor is a person who allocates capital with the
expectation of a nancial return. Types of investments
include: equity, debt securities, real estate, currency,
commodity, derivatives such as put and call options, etc.
This denition makes no distinction between those in the
primary and secondary markets. That is, someone who
provides a business with capital and someone who buys a
stock are both investors. An investor who owns a stock is
a shareholder.

Businesses that make investments, either directly or

via a captive fund
Investment trusts, including real estate investment
trusts
Mutual funds, hedge funds, and other funds, ownership of which may or may not be publicly traded
(these funds typically pool money raised from their
owner-subscribers to invest in securities)

11.1 Essential quality

Sovereign wealth funds

The assumption of risk in anticipation of gain but recog- Investors might also be classied according to their styles.
nizing a higher than average possibility of loss. The term In this respect, an important distinctive investor psycholspeculation implies that a business or investment risk can ogy trait is risk attitude.
be analyzed and measured, and its distinction from the
term Investment is one of degree of risk. It diers from
gambling, which is based on random outcomes.[1]

11.3 Investor protection

Investors can include stock traders but with this distinguishing characteristic: investors are owners of a comThe term investor protection denes the entity of efpany which entails responsibilities.[2]
forts and activities to observe, safeguard and enforce the
rights and claims of a person in his role as an investor.
This includes advice and legal action. The assumption of
11.2 Types of investors
a need of protection is based on the experience that nancial investors are usually structurally inferior to providers
The following classes of investors are not mutually exclu- of nancial services and products due to lack of professive:
sional knowledge, information or experience. Countries
with stronger investor protections tend to grow faster than
Retail investor
those with poor investor protections. Investor protection includes accurate nancial reporting by public com Individuals gambling in games of chance.
panies so the investors can make an informed decision.
Individual investors (including trusts on behalf of in- Investor protection also includes fairness of the market
dividuals, and umbrella companies formed by two or which means all participants in the market have access to
the same information.
more to pool investment funds)
Collectors of art, antiques, and other things of value
Angel investors (individuals and groups)

11.3.1 Through government

Sweat equity investor

Investor protection through government is regulations and

enforcements by government agencies to ensure that market is fair and fraudulent activities are eliminated. An ex-

Institutional investor

53

54

CHAPTER 11. INVESTOR

ample of government agency that provides protection to

investors is SEC.

11.3.2

Through individual

Investor protection through individual is the strategy that

one utilizes to minimize loss. An investor can protect
him/herself by purchasing only shares of businesses that
s/he understands or remain calm through market volatility.
An individual investor may be protected by the strategy
he uses in investment. The strategy includes an appropriate price of the stocks or assets in the right time he enters.
Its hard to x what an appropriate price is, and when
it is appropriate because no one makes a purchase or a
sale absolutely in his most favorable situation. However,
determination may be made when the price of such share
or assets are undervalued comparing to its potentiality. This is called the margin of safety where an investor
can feel at east when the price of the stocks is alarmingly
down.

11.4 Understand the investor plan

In various instances, the term investor is associated with
a means of getting rich quickly. Historically, the road
to successful investment is founded on preparation, with
various short-term goals that help smooth the journey to
the ultimate and determined nancial achievement. To be
successful, authorities, such as Investopedia advise that
an investment plan must include a dened objective, a determined period of time for completion and the resources
needed. A planned investment structure would be dependent on the desired investment target.
Knowledge, related to the various aspects of the investment process, and the optimization of portfolios, is emphasized by the need for diversication, which inuences
the investment procedure towards the fundamentals of
nance. For an investor, understanding the inuencing
factors related to nance is a valuable asset, which can be
gained from various sources. A nancial awareness will
help any investor learn and understand the mechanism of
the investment marketplace, with the rules and guidelines
that can prove successful. Warren Buett, an established
and recognized expert on the subject of successful investing, has a simple philosophy; If I cannot understand it, I
will not invest in it.
Various researches conducted, support the approach of
Warren Buett, with the most favorable results related to
investment portfolios, being achieved, by the individual
investor, who has a developed analytical behavior pattern
and condence. Investment success is achievable, with
the appropriate strategy and core assets being managed
with systematic and disciplined methods.

11.5 Investment tax structures

While a tax structure may change, it is generally accepted
by Marketwatch that long-term capital gains will maintain
their position of providing an advantage to investors. This
is countered by the opinion that after-tax returns should
be considered, especially during retirement, on the basis
that allocation to equities is in general, lower, than any
returns and should be maximized, to the most lucrative
extent. In the current circumstances, long-term capital
gains oer one of the best opportunities in the United
States tax structure.
It is made easier for investors to generate long-term capital gains by the employment of exchange-traded funds
(ETFs); the process if investment in broad-based index
funds, without required indicators. Although some outlandish ETFs could provide investors with the opportunity to venture into previously inaccessible markets and
employ dierent strategies, the unpredictable nature of
these holdings frequently result in short-term transactions, surprising tax equations and general performance
results issues. Marketwatch believes that it is not necessary for any retiree to become involved in this aspect of
investment.
Company dividends are paid from after-tax prots, with
the tax already deducted. Therefore, shareholders are
given some respite with a preferential tax rate of 15% on
qualied dividends in the event of the company being
domiciled in the United States. Alternatively, in another
country having a double-taxation treaty with the USA, accepted by the IRS;. Non-qualied dividends paid by other
foreign companies or entities; for example, those receiving income derived from interest on bonds held by a mutual fund, are taxed at the regular and generally higher rate
of income tax. When applied to 2013, this is on a sliding scale up to 39.6%, with an additional 3.8% surtax for
high-income taxpayers ($200,000 for singles, $250,000
for married couples).[3]

11.6 Discipline
A disciplined and structured investment plan prevents
emotional investing which can be related to impulsive
buying. This factor can be utilized to counteract the sentiments of a marketplace, which is often reective of the
emotional state of an entire population. Short-term activity in stock prices or the broader markets can frequently
be compared to impulsive actions. This is seen in the
term bull run which can induce investors to leap into an
investment, as opposed to a bearish market that could
inuence a sell-o. It is these types of market scenarios that can cause investors to abandon their investment
strategies. Investor discipline is the ability to maintain an
investment strategy even in the most tempting, or extreme
conditions in the marketplace.

11.9. SEE ALSO

55

An established and popular method for stock market in- 11.8.1 Basic nancial concepts
vestors is Systematic Investment Plans (SIPs) especially
Time value of money
for those who have a regular, monthly surplus income.
The provision for reaping maximum benets from these
Compound interest
plans is that a disciplined strategy is maintained, one of
the foremost advantages for a successful investor.
According to Marketwatch, consistency is closely associated with an investment strategy and can be related to various, adopted, proven techniques; for example, predicting
outperforming funds, valuation, or a technical strategy.
A strategic advantage that meets the required consistency
is long-term investment, which in turn, oers investors
long-term capital gains tax advantages. While many investors try to exercise a long-term disciplined approach,
the investment marketplace can provide various, tempting options; for instance, a sudden drop in the marketplace, or a pending worldwide event. This is particularly
prevalent for retired investors, who are preserving their
capital with care.
Disciplined investment strategies say Marketwatch
should be maintained in any eventuality, including taking
advantage of available, favorable opportunities, such
as, following a downturn in the market or the ability to
remain steady in times of severe market uctuations.

11.9 See also

Businessperson
Corporate nance
Crowd funding
Financier
Growth capital
Investment
Investor prole
Model audit
Private equity
Real estate investor
Saving account

11.7 Constant advantage for retirees

In general, core indexes remain constant making it unnecessary for investors to move from one to another. Although an investor could transfer holdings; despite a maturation of the companies and their markets; a large-cap
exchange-traded fund would never require being switched
for a similar holding. A large-cap ETF will always remain
so and an investor will usually want to retain at least a part
allocation to large-cap equities in their portfolio.
It is consistency that is a signicant advantage for ETF investors and one that makes it convenient to retain investment positions and benet from long-term capital gains
tax. Despite a potential reduction in the capital gains tax
advantage, it is an advantage that should continue to provide some positive benets in producing after-tax returns.
This is a factor that could become an important issue in
the future as taxes increase, aecting the lifestyles of retirees. It can be added to by additional taxes generated
in short-term trading, exacerbating the situation, due to
normal income-tax rates increases.

11.8 Investor education

Investor education refers to eorts by the public
government, nonprot institutionsto enhance the
nancial literacy of common investors.

Securities oering
Stock investor
Venture capitalist

11.10 References
[1] Barrons ISBN 0-8120-4631-3
[2] Looking at Corporate Governance from the Investors
Perspective. Sec.gov. April 21, 2014. Retrieved 22
April 2014.
[3] Investment Tax Basics for All Investors. Investopedia.
Retrieved 30 December 2014.

Chapter 12

Institutional investor
For the magazine, see Institutional Investor (magazine).
Institutional investors are organizations which pool
large sums of money and invest those sums in securities,
real property and other investment assets. They can also
include operating companies which decide to invest their
prots to some degree in these types of assets.
Typical investors include banks, insurance companies, retirement or pension funds, hedge funds, investment advisors and mutual funds. Their role in the economy is to act
as highly specialized investors on behalf of others. For
instance, an ordinary person will have a pension from his
employer. The employer gives that persons pension contributions to a fund. The fund will buy shares in a company, or some other nancial product. Funds are useful
because they will hold a broad portfolio of investments in
many companies. This spreads risk, so if one company
fails, it will be only a small part of the whole funds investment.
An institutional investor can have some inuence in the
management of corporations because it will be entitled to
exercise the voting rights in a company. Thus, it can actively engage in corporate governance. Furthermore, because institutional investors have the freedom to buy and
sell shares, they can play a large part in which companies
stay solvent, and which go under. Inuencing the conduct
of listed companies, and providing them with capital are
all part of the job of investment management.

12.1 History
12.1.1

Inscription honoring Aristoxnos, son of Demophon, probably

benefactor of the gymnasium in Athens, late third or second century BC., Muse du Louvre.

times nanced in a similar fashion.[2]

The legal principle of juristic person might have appeared
with the rise of monasteries in the early centuries of
Christianity. The concept then might have been adopted
by the emerging Islamic law. The waqf (charitable institution) became a cornerstone of the nancing of education, waterworks, welfare and even the construction of
monuments.[3] Alongside some Christian monasteries[4]
the waqfs created in the 10th century AD are amongst the
longest standing charities in the world (see for instance
the Imam Reza shrine).

12.1.2 Pre-industrial Europe

Ancient Rome and Islam

Roman law ignored the concept of juristic person, yet at

the time the practice of private evergetism (which dates
to, at least, the 4th century BC in Greece) sometimes led
to the creation of revenues-producing capital which may
be interpreted as an early form of charitable institution.
In some African colonies in particular, part of the citys
entertainment was nanced by the revenue generated by
shops and baking-ovens originally oered by a wealthy
benefactor.[1] In the South of Gaul, aqueducts were some-

Following the spread of monasteries, almhouses and other

hospitals, donating sometimes large sums of money to institutions became a common practice in medieval Western Europe. In the process, over the centuries those
institutions acquired sizable estates and large fortunes
in bullion. Following the collapse of the agrarian revenues, many of these institution moved away from rural real estate to concentrate on bonds emitted by the
local sovereign (the shift dates back to the 15th century for Venice,[5] and the 17th century for France[6] and
the Dutch Republic[7] ). The importance of lay and re-

56

12.3. ECONOMIC THEORY

ligious institutional ownership in the pre-industrial European economy cannot be overstated, they commonly possessed 10 to 30% of a given region arable land.
In the 18th century, private investors pool their resources
to pursue lottery tickets and tontine shares allowing them
to spread risk and become some of the earliest speculative
institutions known in the West.

12.1.3

57
a natural person with income exceeding $200,000
in each of the two most recent years or joint income
with a spouse exceeding $300,000 for those years
and a reasonable expectation of the same income
level in the current year; or
a trust with assets in excess of $5 million, not formed
to acquire the securities oered, whose purchases a
sophisticated person makes.

Before 1980

Following several waves of dissolution (mostly during the

Reformation and the Revolutionary period) the weight
of the traditional charities in the economy collapsed; by
1800, institutions solely owned 2% of the arable land in
England and Wales.[8] New types of institutions emerged
(banks, insurance companies), yet despite some success
stories, they failed to attract a large share of the publics
savings and, for instance, by 1950, they owned 48% of
US equities and certainly even less in other countries.[9]

12.2 Overview

12.3 Economic theory

By denition, institutional investors are opposed to individual actors on the nancial markets. This specicity
has majors consequences in the eyes of economic theory.

12.3.1 Institutional investors as nancial

intermediaries
Numerous institutional investors act as intermediaries between lenders and borrowers. As such, they have a critical importance in the functioning of the nancial markets. Economies of scale imply that they increase returns
on investments and diminish the cost of capital for entrepreneurs. Acting as savings pools, they also play a critical role in guaranteeing a sucient diversication of the
investors portfolios. Their greater ability to monitor corporate behaviour as well to select investors proles implies that they help diminish agency costs.

Because of their sophistication, institutional investors

may often participate in private placements of securities,
in which certain aspects of the securities laws may be inapplicable. For example, in the United States, a private
placement under Rule 506 of Regulation D may be made
to an "accredited investor" without registering the oering of securities with the U.S. Securities and Exchange
Commission. In essence institutional investor, an accredited investor is dened in the rule as:
12.3.2
a bank, insurance company, registered investment
company (generally speaking, a mutual fund), business development company, or small business investment company;
an employee benet plan, within the meaning of
the Employee Retirement Income Security Act, if a
bank, insurance company, or registered investment
adviser makes the investment decisions, or if the
plan has total assets in excess of $5 million;
a charitable organization, corporation, or partnership with assets exceeding $5 million;
a director, executive ocer, or general partner of the
company selling the securities;
a business in which all the equity owners are accredited investors;
a natural person who has individual net worth, or
joint net worth with the persons spouse, that exceeds $1 million at the time of the purchase;

Life cycle

Institutional investors dier among each other but they

all have in common the fact of not sharing the same life
cycle as human beings. Unlike individuals, they do not
have a phase of accumulation (active work life) followed
by one of consumption (retirement), and they do not die.
Here insurance companies dier from the rest of the institutional investors; as they cannot guess when they will
have to repay their clients, they need highly liquid assets which reduces their investment opportunities. Others
like pension funds can predict long ahead when they will
have to repay their investors allowing them to invest in
less liquid assets such as private equities, hedge funds or
commodities. Finally, other institutions have an investment horizon extremely vast allowing them to invest in
highly illiquid assets since they are unlikely to be forced
to sell them before term. A famous example of this type
of investors are US universities endowment funds.

12.4 Institutional-investor types

endowment fund

58

CHAPTER 12. INSTITUTIONAL INVESTOR

hedge fund

Caisse de dpt et placement du Qubec (C$200.1

billion [2013])

insurance companies

Ontario Teachers Pension Plan (C$129.5 billion

[2012])

investment banking
investment trust

British Columbia Investment

(C$102.8 billion [2013])

mutual fund
pension fund

Management

Alberta Investment Management (C$69.7 billion

[2012])

sovereign wealth fund

unit trust and unit investment trust

12.6.3 United Kingdom

In the UK, institutional investors may play a major role

in economic aairs, and are highly concentrated in the
City of London's square mile. Their wealth accounts for
around two thirds of the equity in public listed companies.
When considered from a strictly local standpoint, insti- For any given company, the largest 25 investors would
[11]
tutional investors are sometimes called foreign institu- have to be able to muster over half of the votes.
tional investors (FIIs). This expression is mostly used in The major investor associations are:
emerging markets such as Malaysia and India.

12.5 Globalization
markets

of

nancial

In countries like India, statutory agencies like the

Securities and Exchange Board of India have prescribed
norms to register FIIs and also to regulate such investments owing in through FIIs. In 2008, FIIs represented
the largest institution investment category, with an estimated US$ 751.14 billion.[10]

12.6 Regional
In various countries dierent types of institutional investors may be more important. In oil-exporting countries sovereign wealth funds are very important, while in
developed countries, pension funds may be more important.

Investment Management Association[12]

Association of British Insurers
National Association of Pension Funds
The Association of Investment Trust Companies
The IMA, ABI, NAPF, and AITC, plus the British Merchant Banking and Securities House Association are also
represented by the Institutional Shareholder Committee.

12.7 See also

Global assets under management

12.6.1

Japan

Japan is home to the worlds largest pension fund (GPI)

and is home to 63 of the top 300 pension funds worldwide
(by Assets Under Management). These include:
Government Pension Investment ($1045.5 billion
[2011])
Local Government Ocials ($165 billion [2004])
Pension Fund Association ($117 billion [2004])

12.6.2

Canada

The most important Canadian institutional investors are:

Canada Pension Plan (C$201.5 Billion [2013])

Investment management
Private placement
List of institutional investors in the United Kingdom

12.8 Notes
[1] N. Tran (2008) Les cits et le monde du travail urbain en Afrique romaine, in Le quotidien municipal dans
l'Occident romain, M. Cbeillac-Gervasoni, C. Berrendonner and L. Lamoine (ed.), pp. 33348.
[2] R. Biundo (2008) Acqua publica: proprit et gestion de
l'eau dans l'conomie des cits de l'Empire, in Le quotidien municipal dans l'Occident romain, M. CbeillacGervasoni, C. Berrendonner and L. Lamoine (ed.) ,
pp.36578

12.10. EXTERNAL LINKS

[3] J. Loiseau (2004) La Porte du vizir : programmes monumentaux et contrle territorial au Caire la n du XIVe
sicle. Histoire urbaine 9/1: 727.
[4] For an example ad absurdo: M. Lewis (oct. 2010) Beware
of Greeks Bearing Bonds. Vanity Fair.
[5] Pullan, B. (1971) Rich and poor in Renaissance Venice.
The Social Institutions of a Catholic State, to 1620. Oxford.
[6] Berger P. (1978) Rural Charity in Late Seventeenth Century France: The Pontchartrain Case. French Historical
Studies, 10/3: 393415.
[7] Gelderblom O. and J. Jonker (2007) With a view to hold.
The emergence of institutional investors on the Amsterdam securities market during the 17th and 18th centuries.
Utrecht University Working Papers (pdf)
[8] G. Clark and A. Clark (2001) Common Rights to Land in
England, 14751839. The Journal of Economic History,
61/4: 10091036.
[9] Chen X., J. Harford and K. Li (2007) Monitoring: Which
institutions matter?. Journal of Financial Economics, 86:
279305.
[10] . India Brand Equity Foundation.
[11] see Brian Chens, Company Law, Theory Structure and
Operation (1997) Oxford University Press, pp.636 .
[12] The IMA is the result of a merger in 2002 between the
Institutional Fund Managers Association and the Association of Unit Trusts and Investment Funds

59
PL Davies, Institutional investors in the United
Kingdom in T Baums et al., Institutional Investors
and Corporate Governance (Walter de Gruyter
1994) ch 9
MN Firzli & V Bazi, Infrastructure Investments in
an Age of Austerity : The Pension and Sovereign
Funds Perspective, USAK/JTW 30 July 2011 and
Revue Analyse Financire, Q4 2011
KU Schmolke, Institutional Investors Mandatory
Voting Disclosure: The Proposal of the European
Commission against the Background of the US Experience (2006) EBOLR 767
Books
A Chandler, The Visible Hand (1977)
PL Davis et al., Institutional Investors (MIT Press
2001)
MC Jensen (ed), Studies in the Theory of Capital
Markets (F. Praeger 1972)
GP Stapledon, Institutional Shareholders and Corporate Governance (Oxford 1996)

12.10 External links

Sovereign Wealth Fund Institute - Source for
Sovereign Wealth Funds

12.9 References
Articles
AA Berle, Property, Production and Revolution
(1965) 65 Columbia Law Review 1
LW Beeferman, Pension Fund Investment in Infrastructure: A Resource Paper, Capital Matter
(Occasional Paper Series), No.3 December 2008
BS Black and JC Coee, Hail Britannia?: Institutional Investor Behavior under Limited Regulation
(1994) 92(7) Michigan Law Review 1997
G Clark and A Clark, Common Rights to Land in
England, 14751839 (2001) 61(4) The Journal of
Economic History 1009
JC Coee, Liquidity versus Control: The Institutional Investor as Corporate Monitor (1991) 91
Columbia Law Review 12771368
BL Connelly, R Hoskisson, L Tihanyi & ST
Certo, Ownership as a Form of Corporate Governance (2010) Journal of Management Studies, Vol
47(8):1561-1589.

Institutional Investor Magazine

Public Investor League Table - SWFI

Chapter 13

Retail
Retail stores redirects here. For the comic strip by
Norm Feuti, see Retail (comic strip).
Retail is the process of selling consumer goods and/or
services to customers through multiple channels of distribution to earn a prot. Demand is created through diverse target markets and promotional tactics, satisfying
consumers wants and needs through a lean supply chain.
In the 2000s, an increasing amount of retailing is done
online using electronic payment and delivery via a courier
or postal mail. Retailing includes subordinated services,
such as delivery. The term retailer is also applied where
a service provider services the needs of a large number
of individuals, such as for the public. Shops may be on
residential streets, streets with few or no houses, or in Fruit shop in Naggar, Himachal Pradesh, India
a shopping mall. Shopping streets may be for pedestrians only. Sometimes a shopping street has a partial or
full roof to protect customers from precipitation. Online retailing, a type of electronic commerce used for
business-to-consumer (B2C) transactions and mail order,
are forms of non-shop retailing.
Shopping generally refers to the act of buying products.
Sometimes this is done to obtain necessities such as food
and clothing; sometimes it is done as a recreational activity. Recreational shopping often involves window shopping (just looking, not buying) and browsing and does not
always result in a purchase.
San Juan de Dios Market in Guadalajara, Jalisco

13.2 Types of retail outlets

A marketplace is a location where goods and services are
exchanged. The traditional market square is a city square
where traders set up stalls and buyers browse the stores.
This kind of market is very old, and countless such marRetail comes from the Old French word tailler, which kets are still in operation around the whole world.
means to cut o, clip, pare, divide in terms of tailoring In some parts of the world, the retail business is still dom(1365). It was rst recorded as a noun with the mean- inated by small family-run stores, but this market is ining of a sale in small quantities in 1433 (from the Mid- creasingly being taken over by large retail chains. Most
dle French retail, piece cut o, shred, scrap, paring).[1] of these stores are called high street stores. Gradually
Like in French, the word retail in both Dutch and German high street stores are being re-grouped at single locations
also refers to the sale of small quantities of items.
called malls. These are more dened and planned spaces

13.1 Etymology

60

13.2. TYPES OF RETAIL OUTLETS

61

13.2.2 Types by marketing strategy

There are the following types of retailers by marketing
strategy:
Department store

Inside a supermarket in Russia

Department stores are very large stores oering a huge

assortment of soft and hard goods; often bear a resemblance to a collection of specialty stores. A retailer
of such store carries variety of categories and has broad
assortment at average price. They oer considerable customer service.
Discount store
Discount stores tend to oer a wide array of products
and services, but they compete mainly on price oers extensive assortment of merchandise at aordable and cutrate prices. Normally, retailers sell less fashion-oriented
brands.
Warehouse store
Warehouses that oer low-cost, often high-quantity goods
piled on pallets or steel shelves; warehouse clubs charge a
membership fee.

Walnut Market in Katra, Jammu & Kashmir, India

Variety store

for retail stores and brands.

Variety stores oer extremely low-cost goods, with limited selection.

13.2.1

Types by products

Retail is usually classied by type of products as follows:

Demographic
Retailers that aim at one particular segment (e.g., highend retailers focusing on wealthy individuals).

Food products typically require cold storage fa- Mom-And-Pop

cilities.
A small retail outlet owned and operated by an individual
Hard goods or durable goods (hardline retailers)[2] or family. Focuses on a relatively limited and selective set
automobiles, appliances, electronics, furniture, of products.
sporting goods, lumber, etc., and parts for them.
Goods that do not quickly wear out and provide util- Specialty store
ity over time.
A specialty (BE: speciality) store has a narrow marketing
focus - either specializing on specic merchandise, such
as toys, shoes, or clothing, or on a target audience, such
as children, tourists, or oversize women.[5] Size of store
varies - some specialty stores might be retail giants such
as Toys R Us, Foot Locker, and The Body Shop, while
others might be small, individual shops such as Nutters
Arts Contemporary art galleries, Bookstores, of Savile Row.[5] Such stores, regardless of size, tend to
Handicrafts, Musical instruments, Gift shops, and have a greater depth of the specialist stock than general
supplies for them.
stores, and generally oer specialist product knowledge
Soft goods or consumables[3][4] clothing,
other fabrics, footwear, cosmetics, medicines and
stationery. Goods that are consumed after one
use or have a limited period (typically under three
years) in which you may use them.

62
valued by the consumer. Pricing is usually not the priority when consumers are deciding upon a specialty store;
factors such as branding image, selection choice, and purchasing assistance are seen as important.[5] They dier
from department stores and supermarkets which carry a
wide range of merchandise.[6]
Boutique

CHAPTER 13. RETAIL

By supplying wide assortment in a single category for
lower prices a category killer retailer can kill that category for other retailers. For few categories, such as electronics, the products are displayed at the centre of the
store and sales person will be available to address customer queries and give suggestions when required. Other
retail format stores are forced to reduce the prices if a
category specialist retail store is present in the vicinity.

Boutique or concept stores are similar to specialty stores.

Concept stores are very small in size, and only ever
stock one brand. They are run by the brand that controls them. An example of brand that distributes largely
through their own widely distributed concept stores is
L'OCCITANE en Provence. The limited size and oering of L'OCCITANEs stores are too small to be considered a specialty store proper.

E-tailer

Convenience store

Vending machine

A convenience store provides limited amount of merchandise at more than average prices with a speedy checkout. This store is ideal for emergency and immediate purchases as it often works with extended hours, stocking
everyday;

A vending machine is an automated piece of equipment

wherein customers can drop the money in the machine
and acquire the products. Some stores take a no frills approach, while others are mid-range or high end, depending on what income level they target.

The customer can shop and order through the internet and
the merchandise is dropped at the customers doorstep
or an e-tailer. Here the retailers use drop shipping technique. They accept the payment for the product but the
customer receives the product directly from the manufacturer or a wholesaler. This format is ideal for customers
who do not want to travel to retail stores and are interested
in home shopping. However, it is important for the cusGeneral store
tomer to be wary about defective products and non secure
A general store is a rural store that supplies the main needs credit card transaction. Examples include Amazon.com,
Pennyful, and eBay.
for the local community;

Hypermarkets

13.2.3 Other types

Provides variety and huge volumes of exclusive merchan- Other types of retail store include:
dise at low margins. The operating cost is comparatively
less than other retail formats.
Automated Retail stores self-service, robotic
kiosks located in airports, malls and grocery stores.
Supermarket
The stores accept credit cards and are usually open
24/7. Examples include ZoomShops and Redbox.
A supermarket is a self-service store consisting mainly of
grocery and limited products on non food items. They
Big-box stores encompass larger department, dismay adopt a Hi-Lo or an EDLP strategy for pricing.
count, general merchandise, and warehouse stores.
The supermarkets can be anywhere between 20,000 and
40,000 square feet (3,700 m2 ). Example: SPAR superRetailers can opt for a format as each provides dierent
market.
retail mix to its customers based on their customer demographics, lifestyle and purchase behaviour. A good forMall
mat will lend a hand to display products well and entice
the target customers to spawn sales.
A shopping mall has a range of retail shops at a single outlet. They can include products, food and entertainment
under one roof. Malls provide 7% of retail revenue in In- 13.3 Global top ten retailers
dia, 10% in Vietnam, 25% in China, 28% in Indonesia,
39% in the Philippines, and 45% in Thailand.[7]

13.4 Operations

Category killer or specialist

13.5. SECOND-HAND RETAIL

13.4.1

Retail pricing

The pricing technique used by most retailers is cost-plus

pricing. This involves adding a markup amount (or percentage) to the retailers cost. Another common technique is suggested retail pricing. This simply involves
charging the amount suggested by the manufacturer and
usually printed on the product by the manufacturer.
In Western countries, retail prices are often called
psychological prices or odd prices. Often prices are xed
and displayed on signs or labels. Alternatively, when
prices are not clearly displayed, there can be price discrimination, where the sale price is dependent upon who
the customer is. For example, a customer may have to
pay more if the seller determines that he or she is willing
and/or able to. Another example would be the practice
of discounting for youths, students, or senior citizens.

13.4.2

Competition

Retail stores may or may not have competitors close

enough to aect their pricing, product availability, and
other operations. A 2006 survey found that only 38% of
retail stores in India believed they faced more than slight
competition.[10] Competition also aected less than half
of retail stores in Kazakhstan, Bulgaria, and Azerbaijan.
In all countries the main competition was domestic, not
foreign.[11]
Retail trade provides 9% of all jobs in India and 14% of
GDP.[10]

13.4.3

Stang

Because patronage at a retail outlet varies, exibility in

scheduling is desirable. Employee scheduling software is
sold, which, using known patterns of customer patronage,
more or less reliably predicts the need for stang for various functions at times of the year, day of the month or
week, and time of day. Usually needs vary widely. Conforming sta utilization to stang needs requires a exible workforce which is available when needed but does
not have to be paid when they are not, part-time workers;
as of 2012 70% of retail workers in the United States
were part-time. This may result in nancial problems for
the workers, who while they are required to be available
at all times if their work hours are to be maximized, may
not have sucient income to meet their family and other
obligations.[12]

63
Counter service, where goods are out of reach of
buyers and must be obtained from the seller. This
type of retail is common for small expensive items
(e.g. jewelry) and controlled items like medicine
and liquor. It was common before the 1900s in the
United States and is more common in certain countries like India.
Delivery, where goods are shipped directly to consumers homes or workplaces. Mail order from a
printed catalog was invented in 1744 and was common in the late 19th and early 20th centuries. Ordering by telephone was common in the 20th century,
either from a catalog, newspaper, television advertisement or a local restaurant menu, for immediate
service (especially for pizza delivery), remaining in
common use for food orders. Internet shopping - a
form of delivery - has eclipsed phone-ordering, and,
in several sectors - such as books and music - all
other forms of buying. Direct marketing, including
telemarketing and television shopping channels, are
also used to generate telephone orders. started gaining signicant market share in developed countries
in the 2000s.
Door-to-door sales, where the salesperson sometimes travels with the goods for sale.
Self-service, where goods may be handled and examined prior to purchase.
Digital delivery or Download, where intangible
goods, such as music, lm, and electronic books and
subscriptions to magazines, are delivered directly to
the consumer in the form of information transmitted
either over wires or air-waves, and is reconstituted
by a device which the consumer controls (such as
an MP3 player; see digital rights management). The
digital sale of models for 3D printing also ts here,
as do the media leasing types of services, such as
streaming.

13.5 Second-hand retail

See also: Charity shop
Some shops sell second-hand goods. In the case of a
nonprot shop, the public donates goods to the shop to
be sold. In give-away shops goods can be taken for free.

Another form is the pawnshop, in which goods are sold

that were used as collateral for loans. There are also
"consignment" shops, which are where a person can place
an item in a store and if it sells, the person gives the
shop owner a percentage of the sale price. The advan13.4.4 Transfer mechanisms
tage of selling an item this way is that the established shop
gives the item exposure to more potential buyers.E-tailers
There are several ways in which consumers can receive like OLX,Quikr etc. also working on second hand goods
goods from a retailer:
sales.

64

13.6 Challenges

CHAPTER 13. RETAIL

13.8 Customer service

To achieve and maintain a foothold in an existing mar- Customer service is the sum of acts and elements that
ket, a prospective retail establishment must overcome the allow consumers to receive what they need or desire from
your retail establishment. It is important for a sales asfollowing hurdles:
sociate to greet the customer and make himself available
to help the customer nd whatever he needs. When a
Regulatory barriers including
customer enters the store, it is important that the sales
Restrictions on real estate purchases, espe- associate does everything in his power to make the cuscially as imposed by local governments and tomer feel welcomed, important, and make sure he leaves
the store satised. Giving the customer full, undivided
against big-box chain retailers;
attention and helping him nd what he is looking for
Restrictions on foreign investment in retailers,
will contribute to the customers satisfaction.[13] For rein terms of both absolute amount of nancing
tail store owners, it is extremely important to train yourprovided and percentage share of voting stock
self and your sta to provide excellent customer service
(e.g., common stock) purchased;
skills. By providing excellent customer service, you build
Unfavorable taxation structures, especially those de- a good relationship with the customer and eventually will
signed to penalize or keep out big box retailers attract more new customers and turn them into regular
customers. Looking at long term perspectives, excellent
(see Regulatory above);
customer skills give your retail business a good ongoing
Absence of developed supply chain and integrated reputation and competitive advantage.[14]
IT management;
High competitiveness among existing market participants and resulting low prot margins, caused in
part by

13.9 Statistics for national retail

sales

Constant advances in product design resulting

in constant threat of product obsolescence and 13.9.1 United States
price declines for existing inventory; and
The United States retail sector features the largest number
Lack of properly educated and/or trained work of large, lucrative retailers in the world. A 2012 Deloitte
force, often including management, caused in part report published in STORES magazine indicated that of
the worlds top 250 largest retailers by retail sales revenue
by loss in Business.
in scal year 2010, 32% of those retailers were based in
Lack of educational infrastructure enabling the United States, and those 32% accounted for 41% of
prospective market entrants to respond to the the total retail sales revenue of the top 250.[15]
above challenges.

13.7 Sales techniques

Behind the scenes at retail, there is another factor at work.
Corporations and independent store owners alike are always trying to get the edge on their competitors. One
way to do this is to hire a merchandising solutions company to design custom store displays that will attract more
customers in a certain demographic. The nations largest
retailers spend millions every year on in-store marketing
programs that correspond to seasonal and promotional
changes. As products change, so will a retail landscape.
Retailers can also use facing techniques to create the look
U.S. Monthly Retail Sales, 19922010
of a perfectly stocked store, even when it is not.
A destination store is one that customers will initiate a
trip specically to visit, sometimes over a large area.
These stores are often used to "anchor" a shopping mall
or plaza, generating foot trac, which is capitalized upon
by smaller retailers.

Since 1951, the U.S. Census Bureau has published the

Retail Sales report every month. It is a measure of
consumer spending, an important indicator of the US
GDP. Retail rms provide data on the dollar value of their
retail sales and inventories. A sample of 12,000 rms is

13.11. SEE ALSO

included in the nal survey and 5,000 in the advanced
one. The advanced estimated data is based on a subsample from the US CB complete retail & food services
sample.[16]

13.9.2

CE region

In 2011, the grocery market in six Central European (CE)

countries was worth nearly 107bn, 2.8% more than the
previous year when expressed in local currencies. The increase was generated foremost by the discount stores and
supermarket segments, and was driven by the skyrocketing prices of foodstus. This information is based on
the latest PMR report entitled Grocery retail in Central
Europe 2012[17]

13.9.3

World

National accounts show a combined total of retail and

wholesale trade, with hotels and restaurants. in 2012 the
sector provides over a fth of GDP in tourist-oriented island economies, as well as in other major countries such
as Brazil, Pakistan, Russia, and Spain. In all four of the
latter countries, this fraction is an increase over 1970,
but there are other countries where the sector has declined since 1970, sometimes in absolute terms, where
other sectors have replaced its role in the economy. In
the United States the sector has declined from 19% of
GDP to 14%, though it has risen in absolute terms from
$4,500 to $7,400 per capita per year. In China the sector
has grown from 7.3% to 11.5%, and in India even more,
from 8.4% to 18.7%.

65
Retail concentration
Retail design
Retail software
Shopping mall
Specialist store
Stand-alone store
Store manager
Tuangou
Visual merchandising
Wardrobing
Types of store or shop:
Anchor store
Big-box store
Chain store
Confectionery store
Convenience store
Department store
Discount store
General store
Grocery store
Hardware store

13.10 Consolidation
Among retailers and retails chains a lot of consolidation has appeared over the last couple of decades. Between 1988 and 2010, worldwide 40,788 mergers & acquisitions with a total known value of 2.255 trillion USD
have been announced.[19] The largest transactions with
involvement of retailers in/from the United States have
been: the acquisition of Albertsons Inc. for 17 bil. USD
in 2006,[20] the merger between Federated Department
Stores Inc with May Department Stores valued at 16.5 bil.
USD in 2005[21] - now Macys, and the merger between
Kmart Holding Corp and Sears Roebuck & Co with a
value of 10.9 bil. USD in 2004.[22]

Health food store

Hobby store
Hypermarket
Liquor store
Newsagent
Online shopping
Outlet store
Pet store
Pop-up retail
Specialty store

13.11 See also

State store

List of department stores by country

Store-within-a-store

Point of sales

Supermarket

Point of sales terminal

Surplus store

66
Survival store
Toy store
Variety store
Warehouse club
Warehouse store

13.12 References
[1] Harper, Douglas. retail. Online Etymology Dictionary.
Retrieved 2008-03-16.
[2] hard goods. Investor Words. Retrieved 22 May 2014.
[3] Ferrara, J. Susan. The World of Retail: Hardlines vs.
Softlines. Value Line. Retrieved 22 May 2014.
[4] Time, Forest. What Is Soft Merchandising?". Houston
Chronicle. Retrieved 22 May 2014.

CHAPTER 13. RETAIL

[19] full citation needed] Statistics on Mergers & Acquisitions

(M&A) - M&A Courses | Company Valuation Courses
| Mergers & Acquisitions Courses. Imaa-institute.org.
Retrieved 2012-11-02.
[20] SuperValu-CVS group buys Albertsons for $17B.
Phoenix Business Journal. January 2006. Retrieved 9 July
2014.
[21] full citation needed] Press Release - Investor Relations
- Macys Inc. Phx.corporate-ir.net. Retrieved 2012-1102.
[22] full citation needed] Sears Holdings Press Releases.
Searsholdings.com. Retrieved 2012-11-02.

13.13 Further reading

Krat, Manfred; Mantrala, Murali K. (eds.) (2006).
Retailing in the 21st Century: Current and Future
Trends. New York: Springer Verlag. ISBN 3-54028399-4.

[5] Charles Lamb, Joe Hair, Carl McDaniel (14 Jan 2008).
Essentials of Marketing. Cengage Learning. p. 363.
[6] William M Pride, Robert James Hughes, Jack R. Kapoor
(2011). Business. Cengage Learning. ISBN 9780538478083.
[7] Retail Realty in India: Evolution and Potential. Jones Lang
LaSalle. 2014. p. 6.
[8] 2013 Top 250 Global Retailers. Retrieved March 2014.
[9] Global Powers of Retailing 2014. Deloitte. Retrieved
March 2014.
[10] Mohammad Amin (2007). Competition and Labor Productivity in Indias Retail Stores, p.1. World Bank. p. 57.
[11] Mohammad Amin (2007). Competition and Labor Productivity in Indias Retail Stores, p.30. World Bank. p. 57.
[12] Steven Greenhouse (October 27, 2012). A Part-Time
Life, as Hours Shrink and Shift. The New York Times.
Retrieved October 28, 2012.
[13] Philip H. Mitchell 2008, Discovery-Based Retail, Bascom
Hill Publishing Group ISBN 978-0-9798467-9-3
[14] How to provide excellent customer service in retailCustomer Service: Facts, Quotes and Statistics
[15] Deloitte, Switching Channels: Global Powers of Retailing
2012, STORES, January 2012, G20.
[16] US Census Bureau Retail sales Retail SalesRetail Sales
Denition
[17] Grocery retail in Central Europe 2012 Retail in Central
Europe
[18] UN National Accounts Main Aggregates Database. UN
Statistics Division. December 2013. Retrieved 16 May
2014.

13.14 External links

ECRoPEDIA - Free Global Collection of Retail/FMCG Best practices by ECR Community
Investopedia.The Industry Handbook: The Retailing Industry
National Retail Federation (U.S.-based trade association)
2011 Top 250 Global Retailers
New Paradigm Emerging in Retailing Industry

Chapter 14

Speculation
Speculator redirects here. For the Montana mining
incident, see Speculator Mine disaster.
This article is about the nancial term. For other uses,
see Speculation (disambiguation).

of investment. Others dene speculation more narrowly

as positions not characterized as hedging.[2] The U.S.
Commodity Futures Trading Commission denes a speculator as a trader who does not hedge, but who trades
with the objective of achieving prots through the successful anticipation of price movements.[3] The agency
Speculation is the practice of engaging in risky nancial
transactions in an attempt to prot from uctuations in emphasizes that speculators serve important market functions, but denes excessive speculation as harmful to the
the market value of a tradable good such as a nancial
[4]
instrument, rather than attempting to prot from the un- proper functioning of futures markets.
derlying nancial attributes embodied in the instrument According to Ben Graham in The Intelligent Investor, the
such as capital gains, interest, or dividends. Many specu- prototypical defensive investor is "...one interested chiey
lators pay little attention to the fundamental value of a in safety plus freedom from bother. He admits, howsecurity and instead focus purely on price movements. ever, that "...some speculation is necessary and unavoidSpeculation can in principle involve any tradable good or able, for in many common-stock situations, there are subnancial instrument. Speculators are particularly com- stantial possibilities of both prot and loss, and the risks
mon in the markets for stocks, bonds, commodity fu- therein must be assumed by someone. Thus, many longtures, currencies, ne art, collectibles, real estate, and term investors, even those who buy and hold for decades,
may be classied as speculators, excepting only the rare
derivatives.
safety of
Speculators play one of four primary roles in nancial few who are primarily motivated by income or
[5]
principal
and
not
eventually
selling
at
a
prot.
markets, along with hedgers who engage in transactions
to oset some other pre existing risk, arbitrageurs who
seek to prot from situations where fungible instruments
trade at dierent prices in dierent market segments, and
investors who seek prot through long-term ownership of
an instruments underlying attributes.

14.3 The economic benets of speculation

14.3.1 Sustainable consumption level

14.1 History
With the appearance of the stock ticker machine in 1867,
which abrogated the need for traders to be physically
present on the oor of a stock exchange, stock speculation underwent a dramatic expansion through to the end
of the 1920s, the number of shareholders increasing, perhaps, from 4.4 million in 1900 to 26 million in 1932.[1]

14.2 Speculation and investment

The view of what distinguishes investment from speculation and speculation from excessive speculation varies
widely among pundits, legislators and academics. Some
sources note that speculation is simply a higher risk form Speculation usually involves more risks than investment.
67

68

CHAPTER 14. SPECULATION

The speculator Victor Niederhoer, in The Speculator 14.3.3 Bearing risks

as Hero[6] describes the benets of speculation:
Speculators also perform a very important risk bearing
role that is benecial to society. For example, a farmer
might be considering planting corn on some unused farmLets consider some of the principles that
land. Alas, he might not want to do so because he is conexplain the causes of shortages and surpluses
cerned that the price might fall too far by harvest time. By
and the role of speculators. When a harvest is
selling his crop in advance at a xed price to a speculatoo small to satisfy consumption at its normal
tor, the farmer can hedge the price risk and is now willing
rate, speculators come in, hoping to prot from
to plant the corn. Thus, speculators can actually increase
the scarcity by buying. Their purchases raise
production through their willingness to take on risk.
the price, thereby checking consumption so
that the smaller supply will last longer. Producers encouraged by the high price further lessen
14.3.4 Finding environmental and other
the shortage by growing or importing to reduce
risks
the shortage. On the other side, when the price
is higher than the speculators think the facts
Hedge funds that do fundamental analysis are far more
warrant, they sell. This reduces prices, encourlikely than other investors to try to identify a rms oaging consumption and exports and helping to
balance-sheet exposures, including environmental or
reduce the surplus.
social liabilities present in a market or company but not
explicitly accounted for in traditional numeric valuation
or mainstream investor analysis, and hence make the
Another service provided by speculators to a market is prices better reect the true quality of operation of the
that by risking their own capital in the hope of prot, they rms.[9]
add liquidity to the market and make it easier or even possible for others to oset risk, including those who may be
classied as hedgers and arbitrageurs.
14.3.5 Shorting

14.3.2

Market liquidity and eciency

If any particular marketfor example, pork bellieshad

no speculators, then only producers (the hog farmers) and
consumers (butchers, etc.) would participate in that market. With fewer players in the market, there would be
a larger spread between the current bid and ask price of
pork bellies. Any new entrant in the market who wanted
to trade pork bellies would be forced to accept an illiquid
market, may trade at market prices with large bid-ask
spreads, or even face diculty nding a co-party to buy
or sell to.
A commodity speculator may prot the dierence in the
spread and, in competition with other speculators, reduce
the spread. Some schools of thought argue that speculators increase the liquidity in a market, and therefore promote an ecient market.[7] As more and more speculators participate in a market, underlying real demand and
supply can become diminishingly small compared to trading volume, and prices may become distorted. [8] Without speculators, it is dicult to create an ecient market. Speculators are there to take information, and speculate on how it eects prices, producers and consumers,
who may want to hedge their risks, need counter-parties,
if they could nd each other without markets it certainly
would happen as it would be cheaper. The benet of price
discovery provided as a byproduct by speculators is of
great benet to the economy as a whole as well.

Shorting may act as a canary in a coal mine to stop unsustainable practices earlier and thus reduce damages and
forming market bubbles.[9]

14.4 The economic disadvantages

of speculation
14.4.1 Winners curse
Auctions are a method of squeezing out speculators from
a transaction, but they may have their own perverse effects; see winners curse. The winners curse is however
not very signicant to markets with high liquidity for both
buyers and sellers, as the auction for selling the product
and the auction for buying the product occur simultaneously, and the two prices are separated only by a relatively small spread. This mechanism prevents the winners curse phenomenon from causing mispricing to any
degree greater than the spread.

14.4.2 Economic bubbles

Speculation is often associated with economic bubbles.
A bubble occurs when the price for an asset exceeds
its intrinsic value by a signicant margin.,[10] although
not all bubbles occur because of speculation.[11] Speculative bubbles are characterized by rapid market expansion driven by word-of-mouth feedback loops as ini-

14.5. GOVERNMENT RESPONSES AND REGULATION

69

tial rises in asset price attract new buyers and generate further ination.[12] The creation of the bubble is
followed by a precipitous collapse fueled by the same
phenomenon.[10][13] Speculative bubbles are essentially
social epidemics whose contagion is mediated by the
structure of the market.[13] Some economists link asset
price movements within a bubble to fundamental economic factors such as cash ows and discount rates.[14]

14.5 Government responses and

regulation

In 1936 John Maynard Keynes wrote: Speculators may

do no harm as bubbles on a steady stream of enterprise.
But the situation is serious when enterprise becomes the
bubble on a whirlpool of speculation. (1936:159)"[15] Mr
Keynes himself enjoyed speculation to the fullest, running an early precursor of a hedge fund. As the Bursar of the Cambridge University Kings College, he managed two investment funds, one of which, called Chest
Fund, invested not only in the then 'emerging' market
US stocks, but also periodically included commodity futures and foreign currencies, albeit to a smaller extent (see
Chua and Woodward, 1983) . His fund achieved positive returns in almost every year, averaging 13% p.a.,
even during the Great Depression, thanks to very modern investment strategies, which included inter-market
diversication (i.e., invested not only in stocks but also
commodities and currencies) as well as shorting, i.e., selling borrowed stocks or futures to make money on falling
prices, which Keynes advocated among the principles of
successful investment in his 1933 report (a balanced investment position [...] and if possible, opposed risks.)

The economic disadvantages of speculators has resulted

in a number of attempts over the years to introduce regulations and restrictions to try and limit or reduce the
impact of speculators. Such nancial regulation is often
enacted in response to a crisis as was the case with the
Bubble Act 1720 which was passed by the British government at the height of the South Sea Bubble to try stop
speculation in such schemes. This act was left in place
for over a hundred years and was repealed in 1825. Another example was the GlassSteagall legislation passed
in 1933 during the Great Depression in the United States,
most of the Glass-Steagall provisions were repealed during the 1980s and 1990s. The Onion Futures Act bans
the trading of futures contracts on onions in the United
States, after speculators successfully cornered the market
in the mid-1950s; it remains in eect as of 2013.

14.5.1 Food security

Some nations have moved to limit foreign ownership of
cropland in order to ensure that food is available for local
consumption while others have sold food land and depend
on the World Food Programme.[18]

In 1935 the Indian government passed a law allowing the

government to in part restrict and directly control food
production (Defence of India Act, 1935). This included
the ability to restrict or ban the trading in derivatives
on those food commodities. Post independence, in the
1950s, India continued to struggle with feeding its population and the government increasingly restricting trading
in food commodities. Just at the time the Forward Markets Commission was established, the government felt
14.4.3 Volatility
that derivative markets increased speculation which led
to increased costs and price instabilities. And in 1953 According to Ziemba and Ziemba (2007), Keynes risk- nally prohibited options and futures trading altogether.[19]
taking reached 'cowboy' proportions, i.e. 80% of the These restrictions were not lifted until the 1980s.
maximum rationally justiable levels (of the so-called
Kelly criterion), with overall return volatility approximately three times higher than the stock market index 14.5.2 Regulations
benchmark. Such levels of volatility, responsible for his
spectacular investment performance, would be achiev- In the US following passage of the Dodd-Frank Wall
able today only through the most aggressive instruments Street Reform and Consumer Protection Act, the U.S.,
(such as 3:1 leveraged exchange-traded funds). He chose Commodity Futures Trading Commission (CFTC) has
modern speculation techniques practiced today by hedge proposed regulations aimed at limiting speculation in fufunds, which are quite dierent from the simple buy-and- tures markets by instituting position limits. The CFTC
oers three basic elements for their regulatory framehold long-term investing.[17]
It is a controversial point whether the presence of specu- work: the size (or levels) of the limits themselves; the
lators increases or decreases the short-term volatility in exemptions from the limits (for example, hedged posiaccounts for pura market. Their provision of capital and information tions) and; the policy on aggregating
[20]
The
proposed
position
poses
of
applying
the
limits.
may help stabilize prices closer to their true values. On
limits
apply
to
28
physical
commodities
traded
in
various
the other hand, crowd behavior and positive feedback
[21]
exchanges
across
the
U.S.
loops in market participants may also increase volatility
[16]

at times.

Another part of the Dodd-Frank Act established the

70

CHAPTER 14. SPECULATION

Volcker Rule which deals with speculative investments

of banks that don't benet their customers. The Volcker
Rule passed on 21 January 2010 states that these investments played a key role in the nancial crisis of 2007
2010.[22]

14.5.3

Proposals

See also: Speculative attack, Currency crisis, Black

Wednesday, Fictitious capital, Financial transaction tax,
Currency transaction tax, Tobin tax and Spahn tax
A number of proposals have been made in the past to try
and limit speculation that were never enacted, these have
included:
The Tobin tax is a tax intended to reduce short-term
currency speculation, ostensibly to stabilize foreign
exchange.
In May 2008 German leaders planned to propose a
worldwide ban on oil trading by speculators, blaming the 2008 oil price rises on manipulation by hedge
funds.[23]
On 3 December 2009 U.S. Congressman Peter DeFazio, who blamed reckless speculation for the
2008 nancial crisis, proposed the introduction of
a nancial transaction tax, which would specically target speculators by taxing nancial market
securities transactions.

Patterson, Scott The Quants, How a New Breed

of Math Whizzes Conquered Wall Street and
Nearly Destroyed it Crown Business, 2010 ISBN
9780307453372
Schwartz, Martin Buzzy. Pit Bull: Lessons from
Wall Streets Champion Trader HarperCollins, 2007
ISBN 9780061844638
Schwager, Jack D. Trading with the Market Wizards:
The Complete Market Wizards Series John Wiley &
Sons 2013 ISBN 9781118582978
Tharp, Van K. Denitive Guide to Position Sizing
International Institute of Trading Mastery, 2008.
ISBN 0935219099

14.7 See also

Adventurer
Behavioral nance
Black Wednesday
Carbon credits
Currency crisis
Currency transaction tax
DeFazio nancial transaction tax
Domain name speculation
Equity (nance)
European crime

14.6 Books
Covel, Michael. The Complete Turtle Trader.
HarperCollins, 2007. ISBN 9780061241703
Douglas, Mark. The Disciplined Trader. New York
Institute of Finance, 1990. ISBN 0-13-215757-8
Gunther, Max The Zurich Axioms Souvenir Press
(1st print 1985) ISBN 0-285-63095-4.
Fox, Justin. The Myth of the Rational Market.
HarperCollings, 2009. ISBN 9780060598990
Lefvre, Edwin. Reminiscences of a Stock Operator
John Wiley & Sons Inc., 2005 (1st print 1923) ISBN
0471678767
Neill, Humphrey B. The Art of Contrary Thinking
Caxton Press 1954.
Niederhoer, Victor Practical Speculation John Wiley & Sons Inc., 2005 ISBN 0-471-67774-4
Sobel, Robert The Money Manias: The Eras of Great
Speculation in America, 1770-1970 Beard Books
1973 ISBN 1-58798-028-2

Fictitious capital
Financial market
Financial regulatory reform
Day trading
George Soros
Jesse Lauriston Livermore
Seasonal traders
Short selling
Slippage (nance)
Spahn tax
Speculative attack
Stock market bubble
Stock trader
Tobin tax
Tulip mania
Volcker Rule

14.9. EXTERNAL LINKS

14.8 References
Citations

71

[17] Ziemba, Rachel and William Ziemba (2007). Good and

Bad properties of the Kelly criterion. John Wiley & Sons.
pp. 2931. Retrieved 26 January 2010.

[1] Stheli 2013, p. 4.

[18] Valente, Marcela. Curbing foreign ownership of farmland. IPS, 22 May 2011.

[2] Szado, Edward (2011). Dening Speculation: The First

Step toward a Rational Dialogue. The Journal of Alternative Investments. CAIA Association.

[19] Frida Youssef (October 2000). Integrated report on

Commodity Exchanges And Forward Market Commission (FMC)". FMC.

[3] CFTC Glossary: A guide to the language of the futures

industry. cftc.gov. Commodity Futures Trading Commission. Retrieved 28 August 2012.

[20] Speculative Limits. U.S. Commodity Futures Trading

Commission. Retrieved 21 August 2012.

[4] Sta Report on Commodity Swap Dealers & Index

Traders with Commission Recommendations. U.S.
Commodity Futures Trading Commission. 2008. Retrieved 27 August 2012.
[5] Graham, Benjamin (1973). The Intelligent Investor.
HarperCollins Books. ISBN 0-06-055566-1.
[6] Victor Niederhoer, The Wall Street Journal, 10 February
1989 Daily Speculations
[7] http://chicagofed.org/digital_assets/publications/
understanding_derivatives/understanding_derivatives_
chapter_1_derivatives_overview.pdf
[8] http://chicagofed.org/digital_assets/publications/
understanding_derivatives/understanding_derivatives_
chapter_1_derivatives_overview.pdf
[9] Unlikely heroes - Can hedge funds save the world? One
pundit thinks so, The Economist, 16 February 2010
[10] Hollander, Barbara Gottfried (2011). Booms, Bubbles, &
Busts (The Global Marketplace). Heinemann Library. pp.
4041. ISBN 1432954776.
[11] Lei, Noussair & Plott 2001, p. 831: In a setting in which
speculation is not possible, bubbles and crashes are observed. The results suggest that the departures from fundamental values are not caused by the lack of common
knowledge of rationality leading to speculation, but rather
by behavior that itself exhibits elements of irrationality.
[12] Rosser, J. Barkley (2000). From Catastrophe to Chaos: A
General Theory of Economic Discontinuities: Mathematics, Microeconomics, Macroeconomics, and Finance. p.
107.
[13] Shiller, Robert J. (23 July 2012). Bubbles without Markets. Retrieved 29 August 2012.
[14] Siegel, Journal (2003). What Is an Asset Price Bubble?
An Operation Denition. European Financial Management 9 (1): 1124. doi:10.1111/1468-036x.00206.
[15] Dr. Stephen Spratt of Intelligence Capital (September
2006). A Sterling Solution. Stamp Out Poverty report.
Stamp Out Poverty Campaign. p. 15. Retrieved 2 January 2010.
[16] Chua, J. H. and R. S. Woodward (1983). The Investment
Wizardry of J.M. Keynes. Financial Analysts Journal 39
(3). pp. 3537. JSTOR 4478643.

[21] CFTC Approves Notice of Proposed Rulemaking Regarding Regulations on Aggregation for Position Limits
for Futures and Swaps. U.S. Commodity Futures Trading Commission. Retrieved 21 August 2012.
[22] David Cho and Binyamin Appelbaum (22 January 2010).
Obamas 'Volcker Rule' shifts power away from Geithner. The Washington Post. Retrieved 13 February 2010.
[23] Evans-Pritchard, Ambrose (26 May 2008). Germany in
call for ban on oil speculation. The Daily Telegraph (The
Daily Telegraph). Retrieved 28 May 2008.

Bibliography
Lei, Vivian; Noussair, Charles N.; Plott, Charles
R. (2001). Nonspeculative Bubbles in Experimental Asset Markets: Lack of Common Knowledge of
Rationality Vs. Actual Irrationality. Econometrica
69 (4): 831859. doi:10.1111/1468-0262.00222.
JSTOR 2692246.
Stheli, Urs (2013).
Spectacular Speculation:
Thrills, the Economy, and Popular Discourse. Stanford, CA: Stanford University Press. ISBN 978-0804-77131-3.

14.9 External links

Hidden Collective Factors in Speculative Trading
Understanding Derivatives: Markets and Infrastructure Federal Reserve Bank of Chicago, Financial
Markets Group

Chapter 15

Cash
15.2 History

For other uses, see Cash (disambiguation).

In English vernacular cash refers to money in the phys-

Traditional holed Chinese coinage is also known as Cash.

A wad of United States currency

ical form of currency, such as banknotes and coins.

In bookkeeping and nance, cash refers to current assets
comprising currency or currency equivalents that can be
accessed immediately or near-immediately (as in the case
of money market accounts). Cash is seen either as a reserve for payments, in case of a structural or incidental
negative cash ow or as a way to avoid a downturn on
nancial markets.

15.1 Etymology
The word is variously attributed. Some claim that the
word cash comes from the modern French word caisse,
which means (money) box, from the Provenal word
caissa, from the Italian cassa, from the Latin capsa all
meaning box. In the 18th century, the word passed to
refer to the money instead of the actual box containing
it.[1] Another claim is that it was derived from Tamil word
ksu (Tamil: ) or Malayalam word ku (Malayalam:
) meaning a coin, by East India Company.[2][3][4]

In Western Europe, after the Collapse of the Western Roman Empire, coins, silver jewelry and hacksilver (silver
objects hacked into pieces) were for centuries the only
form of money, until Venetian merchants started using
silver bars for large transactions in the early Middle Ages.
In a separate development, Venetian merchants started
using paper bills, instructing their banker to make payments. Similar marked silver bars were in use in lands
where the Venetian merchants had established representative oces. The Byzantine empire and several states in
the Balkan area and Kievan Rus also used marked silver
bars for large payments. As the world economy developed and silver supplies increased, in particular after the
colonization of South America, coins became larger and
a standard coin for international payment developed from
the 15th century: the Spanish and Spanish colonial coin
of 8 reales. Its counterpart in gold was the Venetian ducat.

Coin types would compete for markets. By conquering foreign markets, the issuing rulers would enjoy extra income from seigniorage (the dierence between the
value of the coin and the value of the metal the coin was
made of). Successful coin types of high nobility would
be copied by lower nobility for seigniorage. Imitations
were usually of a lower weight, undermining the popularCash used as a verb means to convert to cash"; for ex- ity of the original. As feudal states coalesced into kingample in the expression to cash a cheque.
doms, imitation of silver types abated, but gold coins, in
72

15.3. SEE ALSO

73

particular the gold ducat and the gold orin were still issued as trade coins: coins without a xed value, going by
weight. Colonial powers also sought to take away market share from Spain by issuing trade coin equivalents of
silver Spanish coins, without much success.

ply. Its remaining role is to provide a form of currency

storage and payment for those who do not wish to take
part in other systems, and make small payments conveniently and promptly, though this latter role is being replaced more and more frequently by electronic payment
In the early part of the 17th century, English East In- systems. Research has found that the demand for cash dedia Company coins were minted in England and shipped creases as debit card usage increases because merchants
[5]
to the East. In England over time the word Cash was need to make less change for customer purchases.
adopted from Sanskrit karsa, a weight of gold or sil- Cash is increasing in circulation. The value of the United
ver but akin to Old Persian
karsha, unit of weight States dollar in circulation increased by 42% from 2007
(83.30 grams). East India Company coinage had both to 2012.[6] The value of Pound Sterling banknotes in cirUrdu and English writing on it, to facilitate its use within culation increased by 29% from 2008 to 2013.[7] The
trade. In 1671 the directors of The East India Company value of the Euro in circulation increased by 34% from
ordered a mint to be established at Bombay, known as August 2008 to August 2013 (2% of the increase was due
Bombain. In 1677 this was sanctioned by the Crown, the to the adoption of Euro in Slovakia 2009 and in Estonia
coins, having received royal sanction were struck as silver 2011).[8]
Rupees; the inscription runs The Rupee of Bombaim, by
authority of Charles II.
At about this time coins were also being produced for The
East India Company at the Madras mint. The currency at
The Companys Bombay and Bengal administrative regions was The Rupee. At Madras, however, the Companys accounts were reckoned in pagodas, fractions,
fanams, faluce and cash. This system was maintained until 1818 when the rupee was adopted as the unit
of currency for the Companys operations, the relation between the two systems being 1 pagoda = 3-91 rupees and
1 rupee = 12 fanams.
Meanwhile, paper money had been developed. At rst,
it was thought of for emergency issues, hence were most
popular in the colonies of European powers. In the 18th
century, important paper issues were made in colonies
such as Ceylon and the bordering colonies of Essequibo,
Demerara and Berbice. John Law did pioneering work on
banknotes with the Banque Royale. However, the relation
between money supply and ination was still imperfectly
understood and the bank went under, while its notes became worthless when they were over-issued. The lessons
learned were applied to the Bank of England, which
played a crucial role in nancing Wellington's Peninsular
war, against French troops, hamstrung by a metallic Franc
de Germinal.
The ability to create paper money made nation-states responsible for the management of ination, through control of the money supply. It also made a direct relation
between the metal of the coin and its denomination superuous. From 1816, coins generally became token money,
though some large silver and gold coins remained standard coins until 1927. The rst world war saw standard
coins disappear to a very large extent. Afterwards, standard gold coins, mainly British sovereigns, would still be
used in colonies and less developed economies and silver Maria Theresa thalers dated 1780 would be struck as
trade coins for countries in East Asia until 1946 and possibly later locally.
Cash has now become a very small part of the money sup-

15.3 See also

Cash seal (China)
Cash register
Cash transfers
Cash and cash equivalents
Cash ow
Cash counter
Cash management
Petty cash
Cashback
Cash reconciliation

15.4 References
[1] Online Etymology Dictionary. Etymonline.com. Retrieved 15 November 2013.
[2] http://www.theeastindiacompany.com/24/
story-of-cash?iframe=true&width=800&height=
400|archiveurl=http://web.archive.org/web/
20100728112432/http://www.theeastindiacompany.
com/24/story-of-cash?iframe=true&width=800&
height=400|archivedate=28 July 2010
[3] Hobson-Jobson. Dsal.uchicago.edu. 2001-09-01. Retrieved 15 November 2013.
[4] Burrow, T. A Dravidian etymological dictionary. Oxford University Press. Retrieved 22 September 2013.
[5] Federal Reserve Bank of Chicago, ''Debit Card and Cash
Usage: A Cross-Country Analysis', March 2007 (PDF).
Retrieved 15 November 2013.

74

CHAPTER 15. CASH

[6] Williams, John. Cash Is Dead! Long Live Cash!". Federal Reserve Bank of San Francisco.
[7] Banknote Statistics. Bank of England.
[8] Banknotes and coins circulation.
Bank.

European Central

15.5 Further reading

Clyn Davies - A History of Money From Ancient
Times to the Present Day (University of Wales Press,
1994) ISBN 0-7083-1351-5
Peter Spuord - How rarely did medieval merchants
use coin? (Geldmuseum, Utrecht, 2008) ISBN 97890-73882-21-8

Chapter 16

Line of credit
A line of credit is credit source extended to a government, business or individual by a bank or other nancial
institution. A line of credit may take several forms, such
as overdraft protection, demand loan, special purpose,
export packing credit, term loan, discounting, purchase
of commercial bills, traditional revolving credit card account, etc. It is eectively a source of funds that can readily be tapped at the borrowers discretion. Interest is paid
only on money actually withdrawn. (However, the borrower may be required to pay an unused line fee, often an
annualized percentage fee on the money not withdrawn.)
Lines of credit can be secured by collateral, or may be
unsecured.
Lines of credit are often extended by banks, nancial institutions and other licensed consumer lenders to creditworthy customers (though certain special-purpose lines
of credit may not have creditworthiness requirements) to
address liquidity problems; such a line of credit is often
called a personal line of credit. The term is also used to
mean the credit limit of a customer, that is, the maximum
amount of credit a customer is allowed.

16.1 Cash credit

A cash credit is a short-term cash loan to a company. A
bank provides this type of funding, but only after the required security is given to secure the loan. Once a security
for repayment has been given, the business that receives
the loan can continuously draw from the bank up to a certain specied amount.

16.1.1

drawing is limited to the cash credit limit that the bank

sanctioned. This sanction is based on an assessment of
the maximum working capital requirement of the organization minus the margin. The organization nances the
margin amount from its own funds.
Generally, a cash credit account is secured by a charge
on the current assets (inventory) of the organization.
The kind of charge created can be either pledge or
hypothecation.[1]

16.2 Special-purpose line of credit

A relatively recent credit product has arisen due to economic trends and the impact of the economy on individuals, specically on those disadvantaged due to special
circumstances, aliations, or external biases. Lenders
of many types have explored providing targeted services
to select groups. However, most successful attempts were
performed by consumer lending entities (licensed and unlicensed) generally fullling niche credit services abandoned by traditional providers. Consumer lending entities
are credit services that, based on one or more pre-dened
criteria, may qualify a borrower for their credit services.

16.3 See also

Home equity line of credit
Logbook loan
Signature line of credit

India

Unsecured debt

In India, banks oer cash credit accounts to businesses

to nance their working capital requirements (requirements to buy raw materials or current assets, as opposed to machinery or buildings, which would be called
"xed assets"). The cash credit account is similar to current accounts as it is a running account (i.e., payable on
demand) with cheque book facility. But unlike ordinary
current accounts, which are supposed to be overdrawn
only occasionally, the cash credit account is supposed to
be overdrawn almost continuously. The extent of over-

16.4 References

75

[1] http://www.indiainbusiness.nic.in/investment/funding_
option.htm

Chapter 17

Deposit account
Deposits redirects here. For other uses, see Deposit
(disambiguation).

these accounts let customers keep liquid assets

while still earning a monetary return.
Time deposit

A deposit account is a savings account, current account

or any other type of bank account that allows money to
be deposited and withdrawn by the account holder. These
transactions are recorded on the banks books, and the resulting balance is recorded as a liability for the bank and
represents the amount owed by the bank to the customer.
Some banks may charge a fee for this service, while others may pay the customer interest on the funds deposited.

A money deposit at a banking institution that

cannot be withdrawn for a preset xed 'term' or
period of time. When the term is over it can be
withdrawn or it can be rolled over for another
term. Generally speaking, the longer the term
the better the yield on the money.
Call deposit

17.1 Major types

A deposit account that allows for the withdrawal of funds without penalty, generally
without notication to the bank. Often it bears
a favourable interest rate, but also requires a
minimum balance to take advantage of the benets [1]

Transactional account
Current account (Commonwealth)/Checking account (US)
A deposit account held at a bank or other nancial institution, for the purpose of securely and
quickly providing frequent access to funds on
demand, through a variety of dierent channels. Because money is available on demand
these accounts are also referred to as demand
accounts or demand deposit accounts, except
in the case of NOW Accounts.
Money market account
A deposit account that pays interest, and for
which short notice (or no notice) is required for
withdrawals. In the United States, it is a style of
instant access deposit subject to federal savings
account regulations, such as a monthly transaction limit.
Savings account
Accounts maintained by retail banks that pay
interest but can not be used directly as money
(for example, by writing a cheque). Although
not as convenient to use as checking accounts,

17.2 Legal framework

Subject to restrictions imposed by the terms and conditions of the account, the account holder (customer) retains the right to have their money repaid on demand. The
customer may or may not be able to pay money into or out
of the account by cheque, internet banking, EFTPOS or
other channels, depending on those terms and conditions.
The banking terms deposit and withdrawal mean a
customer paying money into, and taking money out of,
the account. From a legal and nancial accounting standpoint, the term deposit is used by the banking industry
in nancial statements to describe the liability owed by
the bank to its depositor, and not the funds that the bank
holds as a result of the deposit, which are shown as assets
of the bank.
For example, a depositor opening a checking account at
a bank in the United States with $100 in cash surrenders
legal title to the $100 in cash, which becomes an asset
of the bank. On the banks books, the bank debits its
currency and coin on hand account for the $100 in cash,
76

17.4. SEE ALSO

and credits a liability account (called a demand deposit
account, checking account, etc.) for an equal amount.
(See double-entry bookkeeping system.)
In the audited nancial statements of the bank, the $100
in currency would be shown on the balance sheet as an
asset of the bank on the left side, and the deposit account
would be shown as a liability owed by the bank to its customer, on the right side of the balance sheet. The banks
nancial statement reects the economic substance of the
transactionwhich is that the bank has borrowed $100
from its depositor and has contractually obliged itself to
repay the customer according to the terms of the agreement. To oset this deposit liability, the bank now owns
the funds deposited (either in notes and coin or more usually as a debt owed by another bank) and the bank shows
those funds as an asset of the bank. These physical reserve funds may be held as deposits at the relevant central
bank and will receive the interest as per monetary policy.
Typically, an account provider will not hold the entire
sum in reserve, but will loan most of the money out to
other clients, in a process known as fractional-reserve
banking. This allows providers to earn interest on the asset and hence to pay out interest on deposits.
By transferring the ownership of deposits from one party
to another, banks can avoid using physical cash as a
method of payment. Commercial bank deposits account
for most of the money supply in use today. For example,
if a bank in the United States makes a loan to a customer
by depositing the loan proceeds in that customers checking account, the bank typically records this event by debiting an asset account on the banks books (called loans receivable or some similar name) and credits the deposit liability or checking account of the customer on the banks
books. From an economic standpoint, the bank has essentially created economic money (although not legal tender). The customers checking account balance has no
dollar bills in it, as a demand deposit account is simply
a liability owed by the bank to its customer. In this way,
commercial banks are allowed to increase the money supply (without printing currency, or legal tender).

17.3 Regulatory protection

Main article: Banking regulation
Banks are normally subject to prudential regulation which
has the purpose of reducing the risk of failure of the bank.
It may also have the purpose of reducing the extent of
depositor losses in the event of bank failure.
Main article: Deposit insurance
Bank deposits may also be insured by a deposit insurance
scheme, if applicable.

77

17.4 See also

Sweep account
Trading account assets

17.5 References
[1] Call Deposit, http://www.deposits.org, accessed 201205-14.

Chapter 18

Derivative (nance)
In nance, a derivative is a contract that derives its value
from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and
is often called the underlying.[1][2] Derivatives can be
used for a number of purposes - including insuring against
price movements (hedging), increasing exposure to price
movements for speculation or getting access to otherwise
hard to trade assets or markets.[3] Some of the more common derivatives include forwards, futures, options, swaps,
and variations of these such as collateralized debt obligations, credit default swaps, and mortgage-backed securities. Most derivatives are traded over-the-counter (oexchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have
developed into a separate industry. Derivatives are one
of the three main categories of nancial instruments, the
other two being stocks (i.e. equities or shares) and debt
(i.e. bonds and mortgages).

times known as super senior); Junior AAA; AA; A;

BBB; Residual.[7] Separate special purpose entities
rather than the parent investment bankissue the CDOs
and pay interest to investors. As CDOs developed, some
sponsors repackaged tranches into yet another iteration,
knows as CDO-squared or CDOs of CDOs.[7] In the
early 2000s, CDOs were generally diversied,[8] but by
20062007when the CDO market grew to $100s of
billionsthis changed. CDO collateral became dominated not by loans, but by lower level (BBB or A) tranches
recycled from other asset-backed securities, whose assets
were usually non-prime mortgages.[9] These CDOs have
been called the engine that powered the mortgage supply chain for nonprime mortgages,[10] and are credited
with giving lenders greater incentive to make non-prime
loans[11] leading up to the 2007-9 subprime mortgage crisis.

18.1 Collateralised Debt Obliga- 18.2 Credit Default Swap

tion
A credit default swap (CDS) is a nancial swap agreeA collateralised debt obligation (CDO) is a type of
structured asset-backed security (ABS).[4] Originally developed for the corporate debt markets, over time CDOs
evolved to encompass the mortgage and mortgage-backed
security (MBS) markets.[5] Like other private label securities backed by assets, a CDO can be thought of as a
promise to pay investors in a prescribed sequence, based
on the cash ow the CDO collects from the pool of
bonds or other assets it owns. The CDO is sliced into
tranches, which catch the cash ow of interest and
principal payments in sequence based on seniority.[6] If
some loans default and the cash collected by the CDO is
insucient to pay all of its investors, those in the lowest, most junior tranches suer losses rst. The last
to lose payment from default are the safest, most senior tranches. Consequently coupon payments (and interest rates) vary by tranche with the safest/most senior
tranches paying the lowest and the lowest tranches paying the highest rates to compensate for higher default
risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA (some-

ment that the seller of the CDS will compensate the buyer
(the creditor of the reference loan) in the event of a loan
default (by the debtor) or other credit event. The buyer of
the CDS makes a series of payments (the CDS fee or
spread) to the seller and, in exchange, receives a payo if the loan defaults. It was invented by Blythe Masters from JP Morgan in 1994. In the event of default the
buyer of the CDS receives compensation (usually the face
value of the loan), and the seller of the CDS takes possession of the defaulted loan.[12] However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan
(these are called naked CDSs). If there are more CDS
contracts outstanding than bonds in existence, a protocol
exists to hold a credit event auction; the payment received
is usually substantially less than the face value of the
loan.[13] Credit default swaps have existed since the early
1990s, and increased in use after 2003. By the end of
2007, the outstanding CDS amount was $62.2 trillion,[14]
falling to $26.3 trillion by mid-year 2010[15] but reportedly $25.5[16] trillion in early 2012. CDSs are not traded
on an exchange and there is no required reporting of

78

18.4. FUTURES
transactions to a government agency.[17] During the 20072010 nancial crisis the lack of transparency in this large
market became a concern to regulators as it could pose a
systemic risk.[18][19][20][21] In March 2010, the [DTCC]
Trade Information Warehouse (see Sources of Market
Data) announced it would give regulators greater access to
its credit default swaps database.[22] CDS data can be used
by nancial professionals, regulators, and the media to
monitor how the market views credit risk of any entity on
which a CDS is available, which can be compared to that
provided by the Credit Rating Agencies. U.S. Courts may
soon be following suit.[12] Most CDSs are documented
using standard forms drafted by the International Swaps
and Derivatives Association (ISDA), although there are
many variants.[18] In addition to the basic, single-name
swaps, there are basket default swaps (BDSs), index
CDSs, funded CDSs (also called credit-linked notes), as
well as loan-only credit default swaps (LCDS). In addition to corporations and governments, the reference entity can include a special purpose vehicle issuing assetbacked securities.[23] Some claim that derivatives such as
CDS are potentially dangerous in that they combine priority in bankruptcy with a lack of transparency.[19] A CDS
can be unsecured (without collateral) and be at higher risk
for a default.

18.3 Forwards
In nance, a forward contract or simply a forward
is a non-standardized contract between two parties to
buy or to sell an asset at a specied future time at a
price agreed upon today, making it a type of derivative
instrument.[24][25] This is in contrast to a spot contract,
which is an agreement to buy or sell an asset on its Spot
Date, which may vary depending on the instrument, for
example most of the FX contracts have Spot Date two
business days from today. The party agreeing to buy the
underlying asset in the future assumes a long position, and
the party agreeing to sell the asset in the future assumes
a short position. The price agreed upon is called the
delivery price, which is equal to the forward price at the
time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control
of the instrument changes. This is one of the many forms
of buy/sell orders where the time and date of trade is not
the same as the value date where the securities themselves
are exchanged. The forward price of such a contract is
commonly contrasted with the spot price, which is the
price at which the asset changes hands on the spot date.
The dierence between the spot and the forward price is
the forward premium or forward discount, generally considered in the form of a prot, or loss, by the purchasing
party. Forwards, like other derivative securities, can be
used to hedge risk (typically currency or exchange rate
risk), as a means of speculation, or to allow a party to
take advantage of a quality of the underlying instrument
which is time-sensitive. A closely related contract is a

79
futures contract; they dier in certain respects. Forward
contracts are very similar to futures contracts, except
they are not exchange-traded, or dened on standardized
assets.[26] Forwards also typically have no interim partial
settlements or true-ups in margin requirements like futures such that the parties do not exchange additional
property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open.
However, being traded over the counter (OTC), forward
contracts specication can be customized and may include mark-to-market and daily margin calls. Hence, a
forward contract arrangement might call for the loss party
to pledge collateral or additional collateral to better secure the party at gain. In other words, the terms of the
forward contract will determine the collateral calls based
upon certain trigger events relevant to a particular counterparty such as among other things, credit ratings, value
of assets under management or redemptions over a specic time frame, e.g., quarterly, annually, etc.

18.4 Futures
In nance, a futures contract (more colloquially, futures) is a standardized contract between two parties to
buy or sell a specied asset of standardized quantity and
quality for a price agreed upon today (the futures price)
with delivery and payment occurring at a specied future date, the delivery date, making it a derivative product (i.e. a nancial product that is derived from an underlying asset). The contracts are negotiated at a futures
exchange, which acts as an intermediary between buyer
and seller. The party agreeing to buy the underlying asset in the future, the buyer of the contract, is said to be
"long", and the party agreeing to sell the asset in the future, the seller of the contract, is said to be "short".[27]
While the futures contract species a trade taking place
in the future, the purpose of the futures exchange is to act
as intermediary and mitigate the risk of default by either
party in the intervening period. For this reason, the futures exchange requires both parties to put up an initial
amount of cash (performance bond), the margin. Margins, sometimes set as a percentage of the value of the
futures contact needs to be proportionally maintained at
all times during the life of the contract to underpin this
mitigation because the price of the contract will vary in
keeping with supply and demand and will change daily
and thus one party or the other will theoretically be making or losing money. To mitigate risk and the possibility of default by either party, the product is marked to
market on a daily basis whereby the dierence between
the prior agreed-upon price and the actual daily futures
price is settled on a daily basis. This is sometimes known
as the variation margin where the Futures Exchange will
draw money out of the losing partys margin account and
put it into the other partys thus ensuring that the correct
daily loss or prot is reected in the respective account.
If the margin account goes below a certain value set by

80
the Exchange, then a margin call is made and the account
owner must replenish the margin account. This process is
known as marking to market. Thus on the delivery date,
the amount exchanged is not the specied price on the
contract but the spot value (i.e. the original value agreed
upon, since any gain or loss has already been previously
settled by marking to market). Upon marketing the strike
price is often reached and creates lots of income for the
caller. A closely related contract is a forward contract.
A forward is like a futures in that it species the exchange
of goods for a specied price at a specied future date.
However, a forward is not traded on an exchange and thus
does not have the interim partial payments due to marking to market. Nor is the contract standardized, as on
the exchange. Unlike an option, both parties of a futures
contract must fulll the contract on the delivery date. The
seller delivers the underlying asset to the buyer, or, if it
is a cash-settled futures contract, then cash is transferred
from the futures trader who sustained a loss to the one
who made a prot. To exit the commitment prior to the
settlement date, the holder of a futures position can close
out its contract obligations by taking the opposite position
on another futures contract on the same asset and settlement date. The dierence in futures prices is then a prot
or loss.

CHAPTER 18. DERIVATIVE (FINANCE)

subprime mortgage crisis of 20068. The total face value
of an MBS decreases over time, because like mortgages,
and unlike bonds, and most other xed-income securities, the principal in an MBS is not paid back as a single payment to the bond holder at maturity but rather
is paid along with the interest in each periodic payment
(monthly, quarterly, etc.). This decrease in face value is
measured by the MBSs factor, the percentage of the
original face that remains to be repaid.

18.6 Options

In nance, an option is a contract which gives the buyer

(the owner) the right, but not the obligation, to buy or
sell an underlying asset or instrument at a specied strike
price on or before a specied date. The seller has the
corresponding obligation to fulll the transaction that
is to sell or buy if the buyer (owner) exercises the
option. The buyer pays a premium to the seller for this
right. An option which conveys to the owner the right to
buy something at a specic price is referred to as a call; an
option which conveys the right of the owner to sell something at a specic price is referred to as a put. Both are
commonly traded, but for clarity, the call option is more
frequently discussed. Options valuation is a topic of on18.5 Mortgage Backed Securities going research in academic and practical nance. In basic
terms, the value of an option is commonly decomposed
A mortgage-backed security (MBS) is a asset-backed into two parts:
security that is secured by a mortgage, or more commonly a collection (pool) of sometimes hundreds of
The rst part is the intrinsic value, which is dened
mortgages. The mortgages are sold to a group of indias the dierence between the market value of the
viduals (a government agency or investment bank) that
underlying and the strike price of the given option.
"securitizes", or packages, the loans together into a security that can be sold to investors. The mortgages of
The second part is the time value, which dean MBS may be residential or commercial, depending on
pends on a set of other factors which, through a
whether it is an Agency MBS or a Non-Agency MBS;
multi-variable, non-linear interrelationship, reect
in the United States they may be issued by structures
the discounted expected value of that dierence at
set up by government-sponsored enterprises like Fannie
expiration.
Mae or Freddie Mac, or they can be private-label, issued by structures set up by investment banks. The structure of the MBS may be known as pass-through, where Although options valuation has been studied at least since
the interest and principal payments from the borrower or the nineteenth century, the contemporary approach is
homebuyer pass through it to the MBS holder, or it may based on the BlackScholes model which was rst pubbe more complex, made up of a pool of other MBSs. lished in 1973.[30][31] Options contracts have been known
Other types of MBS include collateralized mortgage obli- for many centuries, however both trading activity and
gations (CMOs, often structured as real estate mortgage academic interest increased when, as from 1973, options
investment conduits) and collateralized debt obligations were issued with standardized terms and traded through a
(CDOs).[28] The shares of subprime MBSs issued by var- guaranteed clearing house at the Chicago Board Options
ious structures, such as CMOs, are not identical but rather Exchange. Today many options are created in a standardissued as tranches (French for slices), each with a dif- ized form and traded through clearing houses on regulated
ferent level of priority in the debt repayment stream, giv- options exchanges, while other over-the-counter options
ing them dierent levels of risk and reward. Tranches are written as bilateral, customized contracts between a
especially the lower-priority, higher-interest tranches single buyer and seller, one or both of which may be a
of an MBS are/were often further repackaged and resold dealer or market-maker. Options are part of a larger class
as collaterized debt obligations.[29] These subprime MBSs of nancial instruments known as derivative products, or
issued by investment banks were a major issue in the simply, derivatives.[32][33]

18.8. FINANCIAL DERIVATIVE TRADING COMPANIES

18.7 Swaps
A swap is a derivative in which two counterparties
exchange cash ows of one partys nancial instrument
for those of the other partys nancial instrument. The
benets in question depend on the type of nancial instruments involved. For example, in the case of a swap
involving two bonds, the benets in question can be the
periodic interest (coupon) payments associated with such
bonds. Specically, two counterparties agree to exchange one stream of cash ows against another stream.
These streams are called the legs of the swap. The swap
agreement denes the dates when the cash ows are to be
paid and the way they are accrued and calculated.[24] Usually at the time when the contract is initiated, at least one
of these series of cash ows is determined by an uncertain
variable such as a oating interest rate, foreign exchange
rate, equity price, or commodity price.[24] The cash ows
are calculated over a notional principal amount. Contrary
to a future, a forward or an option, the notional amount
is usually not exchanged between counterparties. Consequently, swaps can be in cash or collateral. Swaps can be
used to hedge certain risks such as interest rate risk, or to
speculate on changes in the expected direction of underlying prices.[27] Swaps were rst introduced to the public in
1981 when IBM and the World Bank entered into a swap
agreement.[34] Today, swaps are among the most heavily
traded nancial contracts in the world: the total amount
of interest rates and currency swaps outstanding is more
thn $348 trillion in 2010, according to Bank for International Settlements (BIS). The ve generic types of swaps,
in order of their quantitative importance, are: interest rate
swaps, currency swaps, credit swaps, commodity swaps
and equity swaps. There are also many other types of
swaps.

18.8 Financial derivative trading

companies
Anyoption
Banc de Binary
Cantor Fitzgerald
CitiFXPro
City Index Group
CMC Markets
Currenex

81
First Prudential Markets
FXCM
FXdirekt Bank
FXOpen
FXPro
Gain Capital
Henyep
Hirose Financial UK Ltd.
HXPM Gold
I-Access Investors
IDealing
IG Group
InstaForex
Interactive Brokers
InterTrader
Marex Spectron
MF Global
MRC Markets
Oanda Corporation
OptionsXpress
Pepperstone
Plus 500
Saxo Bank
Spread Co.
Spreadex
Sucden
TeleTrade
TFI Markets
Thinkorswim
Varen Gold

DBF

Wizetrade

EToro

Worldspreads

ETX Capital

X-Trade Brokers

Finspreads

Zulu Trade

82

18.9 Basics
Derivatives are contracts between two parties that specify
conditions (especially the dates, resulting values and definitions of the underlying variables, the parties contractual obligations, and the notional amount) under which
payments are to be made between the parties.[35][36] The
most common underlying assets include commodities,
stocks, bonds, interest rates and currencies, but they can
also be other derivatives, which adds another layer of
complexity to proper valuation. The components of a
rms capital structure, e.g. bonds and stock, can also
be considered derivatives, more precisely options, with
the underlying being the rms assets, but this is unusual
outside of technical contexts.
From the economic point of view, nancial derivatives
are cash ows, that are conditionally stochastically and
discounted to present value. The market risk inherent in
the underlying asset is attached to the nancial derivative through contractual agreements and hence can be
traded separately.[37] The underlying asset does not have
to be acquired. Derivatives therefore allow the breakup of
ownership and participation in the market value of an asset. This also provides a considerable amount of freedom
regarding the contract design. That contractual freedom
allows to modify the participation in the performance of
the underlying asset almost arbitrarily. Thus, the participation in the market value of the underlying can be
eectively weaker, stronger (leverage eect), or implemented as inverse. Hence, specically the market price
risk of the underlying asset can be controlled in almost
every situation.[37]
There are two groups of derivative contracts: the privately traded over-the-counter (OTC) derivatives such as
swaps that do not go through an exchange or other intermediary, and exchange-traded derivatives (ETD) that are
traded through specialized derivatives exchanges or other
exchanges.[27]

CHAPTER 18. DERIVATIVE (FINANCE)

Derivatives can be used either for risk management (i.e.
to hedge by providing osetting compensation in case
of an undesired event, a kind of insurance) or for speculation (i.e. making a nancial bet). This distinction is
important because the former is a prudent aspect of operations and nancial management for many rms across
many industries; the latter oers managers and investors
a risky opportunity to increase prot, which may not be
properly disclosed to stakeholders.[27]
Along with many other nancial products and services,
derivatives reform is an element of the DoddFrank Wall
Street Reform and Consumer Protection Act of 2010.
The Act delegated many rule-making details of regulatory oversight to the Commodity Futures Trading Commission and those details are not nalized nor fully implemented as of late 2012.

18.10 Size of market

To give an idea of the size of the derivative market,
The Economist magazine has reported that as of June
2011, the over-the-counter (OTC) derivatives market
amounted to approximately $700 trillion, and the size
of the market traded on exchanges totaled an additional
$83 trillion.[39] However, these are notional values, and
some economists say that this value greatly exaggerates
the market value and the true credit risk faced by the parties involved. For example, in 2010, while the aggregate
of OTC derivatives exceeded $600 trillion, the value of
the market was estimated much lower, at $21 trillion. The
credit risk equivalent of the derivative contracts was estimated at $3.3 trillion.[40]

Still, even these scaled down gures represent huge

amounts of money. For perspective, the budget for total expenditure of the United States Government during 2012 was $3.5 trillion,[41] and the total current value
of the US stock market is an estimated $23 trillion.[42]
The world annual Gross Domestic Product is about $65
Derivatives are more common in the modern era, but their trillion.[43]
origins trace back several centuries. One of the oldest
derivatives is rice futures, which have been traded on the And for one type of derivative at least, Credit Default
Dojima Rice Exchange since the eighteenth century.[38] Swaps (CDS), for which the inherent risk is considered
Derivatives are broadly categorized by the relationship high, the higher, nominal value, remains relevant. It was
between the underlying asset and the derivative (such this type of derivative that investment magnate Warren
as forward, option, swap); the type of underlying as- Buet referred to in his famous 2002 speech in which he
set (such as equity derivatives, foreign exchange deriva- warned against weapons of nancial mass destruction.
to $25.5 triltives, interest rate derivatives, commodity derivatives, or CDS notional value in early 2012 amounted
[44]
lion,
down
from
$55
trillion
in
2008.
credit derivatives); the market in which they trade (such
as exchange-traded or over-the-counter); and their payo prole.

18.11 Usage

Derivatives may broadly be categorized as lock or option products. Lock products (such as swaps, futures,
or forwards) obligate the contractual parties to the terms Derivatives are used for the following:
over the life of the contract. Option products (such as
interest rate caps) provide the buyer the right, but not the
Hedge or mitigate risk in the underlying, by entering
obligation to enter the contract under the terms specied.
into a derivative contract whose value moves in the

18.11. USAGE

83

opposite direction to their underlying position and 18.11.2

cancels part or all of it out[45][46]

Hedging

Create option ability where the value of the deriva- Main article: Hedge (nance)
tive is linked to a specic condition or event (e.g. the
underlying reaching a specic price level)
Derivatives allow risk related to the price of the under Obtain exposure to the underlying where it is not lying asset to be transferred from one party to another.
possible to trade in the underlying (e.g. weather For example, a wheat farmer and a miller could sign a
derivatives)[47]
futures contract to exchange a specied amount of cash
Provide leverage (or gearing), such that a small for a specied amount of wheat in the future. Both parties
movement in the underlying value can cause a large have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of
dierence in the value of the derivative[48]
wheat. However, there is still the risk that no wheat will
Speculate and make a prot if the value of the under- be available because of events unspecied by the contract,
lying asset moves the way they expect (e.g. moves in such as the weather, or that one party will renege on the
a given direction, stays in or out of a specied range, contract. Although a third party, called a clearing house,
reaches a certain level)
insures a futures contract, not all derivatives are insured
against counter-party risk.[27]
Switch asset allocations between dierent asset
classes without disturbing the underlying assets, as From another perspective, the farmer and the miller both
reduce a risk and acquire a risk when they sign the fupart of transition management
tures contract: the farmer reduces the risk that the price
Avoid paying taxes. For example, an equity swap of wheat will fall below the price specied in the conallows an investor to receive steady payments, e.g. tract and acquires the risk that the price of wheat will rise
based on LIBOR rate, while avoiding paying capital above the price specied in the contract (thereby losing
gains tax and keeping the stock.
additional income that he could have earned). The miller,
on the other hand, acquires the risk that the price of wheat
will fall below the price specied in the contract (thereby
18.11.1 Mechanics and Valuation Basics
paying more in the future than he otherwise would have)
Lock products are theoretically valued at zero at the time and reduces the risk that the price of wheat will rise above
of execution and thus do not typically require an up-front the price specied in the contract. In this sense, one party
exchange between the parties. Based upon movements in is the insurer (risk taker) for one type of risk, and the
is the insurer (risk taker) for another type
the underlying asset over time, however, the value of the counter-party
[27]
of
risk.
contract will uctuate, and the derivative may be either
an asset (i.e. "in the money") or a liability (i.e. "out of
the money") at dierent points throughout its life. Importantly, either party is therefore exposed to the credit
quality of its counterparty and is interested in protecting
itself in an event of default.
Option products have immediate value at the outset because they provide specied protection (intrinsic value)
over a given time period (time value). One common form
of option product familiar to many consumers is insurance for homes and automobiles. The insured would pay
more for a policy with greater liability protections (intrinsic value) and one that extends for a year rather than
six months (time value). Because of the immediate option value, the option purchaser typically pays an up front
premium. Just like for lock products, movements in the
underlying asset will cause the options intrinsic value to
change over time while its time value deteriorates steadily
until the contract expires. An important dierence between a lock product is that, after the initial exchange,
the option purchaser has no further liability to its counterparty; upon maturity, the purchaser will execute the
option if it has positive value (i.e. if it is in the money)
or expire at no cost (other than to the initial premium)
(i.e. if the option is out of the money).

Hedging also occurs when an individual or institution

buys an asset (such as a commodity, a bond that has
coupon payments, a stock that pays dividends, and so on)
and sells it using a futures contract. The individual or
institution has access to the asset for a specied amount
of time, and can then sell it in the future at a specied
price according to the futures contract. Of course, this
allows the individual or institution the benet of holding
the asset, while reducing the risk that the future selling
price will deviate unexpectedly from the markets current
assessment of the future value of the asset.
Derivatives trading of this kind may serve the nancial interests of certain particular businesses.[49] For example, a
corporation borrows a large sum of money at a specic interest rate.[50] The interest rate on the loan reprices every
six months. The corporation is concerned that the rate of
interest may be much higher in six months. The corporation could buy a forward rate agreement (FRA), which is
a contract to pay a xed rate of interest six months after
purchases on a notional amount of money.[51] If the interest rate after six months is above the contract rate, the
seller will pay the dierence to the corporation, or FRA
buyer. If the rate is lower, the corporation will pay the
dierence to the seller. The purchase of the FRA serves

84

CHAPTER 18. DERIVATIVE (FINANCE)

18.12 Types
18.12.1 OTC and exchange-traded
In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded
in the market:

Derivatives traders at the Chicago Board of Trade

to reduce the uncertainty concerning the rate increase and

stabilize earnings.

18.11.3

Speculation and arbitrage

Derivatives can be used to acquire risk, rather than to

hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on
the value of the underlying asset, betting that the party
seeking insurance will be wrong about the future value
of the underlying asset. Speculators look to buy an asset in the future at a low price according to a derivative
contract when the future market price is high, or to sell an
asset in the future at a high price according to a derivative
contract when the future market price is less.
Individuals and institutions may also look for arbitrage
opportunities, as when the current buying price of an asset
falls below the price specied in a futures contract to sell
the asset.
Speculative trading in derivatives gained a great deal of
notoriety in 1995 when Nick Leeson, a trader at Barings
Bank, made poor and unauthorized investments in futures
contracts. Through a combination of poor judgment, lack
of oversight by the banks management and regulators,
and unfortunate events like the Kobe earthquake, Leeson incurred a US$1.3 billion loss that bankrupted the
centuries-old institution.[52]

18.11.4

Proportion Used for Hedging and

Speculation

The true proportion of derivatives contracts used for

hedging purposes is unknown [53] (and perhaps unknowable), but it appears to be relatively small.[54][55] Also,
derivatives contracts account for only 36% of the median rms total currency and interest rate exposure.[56]
Nonetheless, we know that many rms derivatives activities have at least some speculative component for a variety of reasons.[56]

Over-the-counter (OTC) derivatives are contracts

that are traded (and privately negotiated) directly
between two parties, without going through an exchange or other intermediary. Products such as
swaps, forward rate agreements, exotic options and
other exotic derivatives are almost always traded in
this way. The OTC derivative market is the largest
market for derivatives, and is largely unregulated
with respect to disclosure of information between
the parties, since the OTC market is made up of
banks and other highly sophisticated parties, such as
hedge funds. Reporting of OTC amounts is dicult
because trades can occur in private, without activity
being visible on any exchange.
According to the Bank for International Settlements, who
rst surveyed OTC derivatives in 1995,[57] reported that
the "gross market value, which represent the cost of replacing all open contracts at the prevailing market prices,
... increased by 74% since 2004, to $11 trillion at the end
of June 2007 (BIS 2007:24). [57] Positions in the OTC
derivatives market increased to $516 trillion at the end of
June 2007, 135% higher than the level recorded in 2004.
the total outstanding notional amount is US$708 trillion
(as of June 2011).[58] Of this total notional amount, 67%
are interest rate contracts, 8% are credit default swaps
(CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are
other. Because OTC derivatives are not traded on an exchange, there is no central counter-party. Therefore, they
are subject to counterparty risk, like an ordinary contract,
since each counter-party relies on the other to perform.
Exchange-traded derivatives (ETD) are those
derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A
derivatives exchange is a market where individuals
trade standardized contracts that have been dened
by the exchange.[59] A derivatives exchange acts as
an intermediary to all related transactions, and takes
initial margin from both sides of the trade to act as
a guarantee. The worlds largest[60] derivatives exchanges (by number of transactions) are the Korea
Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European
products such as interest rate & index products),
and CME Group (made up of the 2007 merger of
the Chicago Mercantile Exchange and the Chicago
Board of Trade and the 2008 acquisition of the New

18.13. ECONOMIC FUNCTION OF THE DERIVATIVE MARKET

York Mercantile Exchange). According to BIS, the
combined turnover in the worlds derivatives exchanges totaled USD 344 trillion during Q4 2005.
By December 2007 the Bank for International Settlements reported [57] that derivatives traded on exchanges surged 27% to a record $681 trillion.[57]

18.12.2

Common derivative contract types

Some of the common variants of derivative contracts are

as follows:
1. Forwards: A tailored contract between two parties,
where payment takes place at a specic time in the
future at todays pre-determined price.
2. Futures: are contracts to buy or sell an asset on a future date at a price specied today. A futures contract diers from a forward contract in that the futures contract is a standardized contract written by a
clearing house that operates an exchange where the
contract can be bought and sold; the forward contract is a non-standardized contract written by the
parties themselves.
3. Options are contracts that give the owner the right,
but not the obligation, to buy (in the case of a call
option) or sell (in the case of a put option) an asset.
The price at which the sale takes place is known as
the strike price, and is specied at the time the parties enter into the option. The option contract also
species a maturity date. In the case of a European
option, the owner has the right to require the sale
to take place on (but not before) the maturity date;
in the case of an American option, the owner can
require the sale to take place at any time up to the
maturity date. If the owner of the contract exercises this right, the counter-party has the obligation
to carry out the transaction. Options are of two
types: call option and put option. The buyer of a
Call option has a right to buy a certain quantity of
the underlying asset, at a specied price on or before
a given date in the future, he however has no obligation whatsoever to carry out this right. Similarly, the
buyer of a Put option has the right to sell a certain
quantity of an underlying asset, at a specied price
on or before a given date in the future, he however
has no obligation whatsoever to carry out this right.
4. Binary options are contracts that provide the owner
with an all-or-nothing prot prole.
5. Warrants: Apart from the commonly used shortdated options which have a maximum maturity period of 1 year, there exists certain long-dated options
as well, known as Warrant (nance). These are generally traded over-the-counter.

85

6. Swaps are contracts to exchange cash (ows) on

or before a specied future date based on the
underlying value of currencies exchange rates,
bonds/interest rates, commodities exchange, stocks
or other assets. Another term which is commonly
associated to Swap is Swaption which is basically
an option on the forward Swap. Similar to a Call
and Put option, a Swaption is of two kinds: a receiver Swaption and a payer Swaption. While on
one hand, in case of a receiver Swaption there is an
option wherein you can receive xed and pay oating, a payer swaption on the other hand is an option
to pay xed and receive oating.
Swaps can basically be categorized
into two types:
Interest rate swap: These basically necessitate swapping only
interest associated cash ows
in the same currency, between
two parties.
Currency swap: In this kind
of swapping, the cash ow
between the two parties includes both principal and interest. Also, the money which
is being swapped is in dierent
currency for both parties.[61]
Some common examples of these derivatives are the following:

18.13 Economic function of the

derivative market
Some of the salient economic functions of the derivative
market include:
1. Prices in a structured derivative market not only
replicate the discernment of the market participants about the future but also lead the prices of
underlying to the professed future level. On the
expiration of the derivative contract, the prices of
derivatives congregate with the prices of the underlying. Therefore, derivatives are essential tools to
determine both current and future prices.
2. The derivatives market reallocates risk from the people who prefer risk aversion to the people who have
an appetite for risk.
3. The intrinsic nature of derivatives market associates
them to the underlying Spot market. Due to derivatives there is a considerable increase in trade volumes of the underlying Spot market. The dominant

86

CHAPTER 18. DERIVATIVE (FINANCE)

factor behind such an escalation is increased participation by additional players who would not have otherwise participated due to absence of any procedure
to transfer risk.

particular contract at any one time). Complications can

arise with OTC or oor-traded contracts though, as trading is handled manually, making it dicult to automatically broadcast prices. In particular with OTC contracts,
there is no central exchange to collate and disseminate
4. As supervision, reconnaissance of the activities of prices.
various participants becomes tremendously dicult
in assorted markets; the establishment of an organized form of market becomes all the more imper- 18.14.3 Determining the arbitrage-free
ative. Therefore, in the presence of an organized
price
derivatives market, speculation can be controlled,
resulting in a more meticulous environment.
See List of nance topics# Derivatives pricing.
5. Third parties can use publicly available derivative
prices as educated predictions of uncertain future The arbitrage-free price for a derivatives contract can be
outcomes, for example, the likelihood that a corpo- complex, and there are many dierent variables to consider. Arbitrage-free pricing is a central topic of nancial
ration will default on its debts.[62]
mathematics. For futures/forwards the arbitrage free
price is relatively straightforward, involving the price of
In a nutshell, there is a substantial increase in savings and
the underlying together with the cost of carry (income
investment in the long run due to augmented activities by
received less interest costs), although there can be com[63]
derivative Market participant.
plexities.

18.14 Valuation

Total world derivatives from 1998 to 2007[64] compared to total

world wealth in the year 2000[65]

18.14.1

However, for options and more complex derivatives, pricing involves developing a complex pricing model: understanding the stochastic process of the price of the underlying asset is often crucial. A key equation for the theoretical valuation of options is the BlackScholes formula,
which is based on the assumption that the cash ows from
a European stock option can be replicated by a continuous
buying and selling strategy using only the stock. A simplied version of this valuation technique is the binomial
options model.
OTC represents the biggest challenge in using models
to price derivatives. Since these contracts are not publicly traded, no market price is available to validate the
theoretical valuation. Most of the models results are
input-dependent (meaning the nal price depends heavily on how we derive the pricing inputs).[66] Therefore it
is common that OTC derivatives are priced by Independent Agents that both counterparties involved in the deal
designate upfront (when signing the contract).

Market and arbitrage-free prices

Two common measures of value are:

18.15 Criticisms

Market price, i.e. the price at which traders are will- Derivatives are often subject to the following criticisms:
ing to buy or sell the contract
Arbitrage-free price, meaning that no risk-free prof- 18.15.1 Hidden tail risk
its can be made by trading in these contracts (see
According to Raghuram Rajan, a former chief economist
rational pricing)
of the International Monetary Fund (IMF), "... it may
well be that the managers of these rms [investment
funds] have gured out the correlations between the var18.14.2 Determining the market price
ious instruments they hold and believe they are hedged.
For exchange-traded derivatives, market price is usually Yet as Chan and others (2005) point out, the lessons of
transparent (often published in real time by the exchange, summer 1998 following the default on Russian governbased on all the current bids and oers placed on that ment debt is that correlations that are zero or negative in

18.16. FINANCIAL REFORM AND GOVERNMENT REGULATION

87

normal times can turn overnight to one a phenomenon 18.15.3 Counter party risk
they term phase lock-in. A hedged position can become
unhedged at the worst times, inicting substantial losses Some derivatives (especially swaps) expose investors to
on those who mistakenly believe they are protected.[67] counterparty risk, or risk arising from the other party in a
nancial transaction. Dierent types of derivatives have
dierent levels of counter party risk. For example, standardized stock options by law require the party at risk
18.15.2 Risks
to have a certain amount deposited with the exchange,
showing that they can pay for any losses; banks that help
See also: List of trading losses
businesses swap variable for xed rates on loans may do
credit checks on both parties. However, in private agreeThe use of derivatives can result in large losses because ments between two companies, for example, there may
of the use of leverage, or borrowing. Derivatives allow not be benchmarks for performing due diligence and risk
investors to earn large returns from small movements in analysis.
the underlying assets price. However, investors could
lose large amounts if the price of the underlying moves
against them signicantly. There have been several in- 18.15.4 Large notional value
stances of massive losses in derivative markets, such as
the following:
Derivatives typically have a large notional value. As
American International Group (AIG) lost
more than US$18 billion through a subsidiary over the preceding three quarters
on credit default swaps (CDSs).[68] The
United States Federal Reserve Bank announced the creation of a secured credit
facility of up to US$85 billion, to prevent
the companys collapse by enabling AIG
to meet its obligations to deliver additional collateral to its credit default swap
trading partners.[69]
The loss of US$7.2 Billion by Socit
Gnrale in January 2008 through misuse of futures contracts.
The loss of US$6.4 billion in the failed
fund Amaranth Advisors, which was long
natural gas in September 2006 when the
price plummeted.
The loss of US$4.6 billion in the failed
fund Long-Term Capital Management in
1998.
The loss of US$1.3 billion equivalent
in oil derivatives in 1993 and 1994 by
Metallgesellschaft AG.[70]
The loss of US$1.2 billion equivalent
in equity derivatives in 1995 by Barings
Bank.[71]
UBS AG, Switzerlands biggest bank,
suered a $2 billion loss through unauthorized trading discovered in September
2011.[72]

such, there is the danger that their use could result in

losses for which the investor would be unable to compensate. The possibility that this could lead to a chain
reaction ensuing in an economic crisis was pointed out
by famed investor Warren Buett in Berkshire Hathaway's 2002 annual report. Buett called them 'nancial
weapons of mass destruction.' A potential problem with
derivatives is that they comprise an increasingly larger notional amount of assets which may lead to distortions in
the underlying capital and equities markets themselves.
Investors begin to look at the derivatives markets to make
a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes
a leading indicator.(See Berkshire Hathaway Annual Report for 2002)

18.16 Financial Reform and Government Regulation

Under US law and the laws of most other developed
countries, derivatives have special legal exemptions that
make them a particularly attractive legal form to extend credit.[73] The strong creditor protections aorded
to derivatives counterparties, in combination with their
complexity and lack of transparency however, can cause
capital markets to underprice credit risk. This can contribute to credit booms, and increase systemic risks.[73]
Indeed, the use of derivatives to conceal credit risk from
third parties while protecting derivative counterparties
contributed to the nancial crisis of 2008 in the United
States.[73][74]

In the context of a 2010 examination of the ICE Trust, an

industry self-regulatory body, Gary Gensler, the chairman of the Commodity Futures Trading Commission
This comes to a staggering $39.5 billion, the majority in which regulates most derivatives, was quoted saying that
the last decade after the Commodity Futures Moderniza- the derivatives marketplace as it functions now adds up
tion Act of 2000 was passed.
to higher costs to all Americans. More oversight of the

88
banks in this market is needed, he also said. Additionally, the report said, "[t]he Department of Justice is looking into derivatives, too. The departments antitrust unit
is actively investigating 'the possibility of anticompetitive
practices in the credit derivatives clearing, trading and information services industries,' according to a department
spokeswoman.[75]
For legislators and committees responsible for nancial
reform related to derivatives in the United States and elsewhere, distinguishing between hedging and speculative
derivatives activities has been a nontrivial challenge. The
distinction is critical because regulation should help to
isolate and curtail speculation with derivatives, especially
for systemically signicant institutions whose default
could be large enough to threaten the entire nancial system. At the same time, the legislation should allow for
responsible parties to hedge risk without unduly tying up
working capital as collateral that rms may better employ elsewhere in their operations and investment.[76] In
this regard, it is important to distinguish between nancial
(e.g. banks) and non-nancial end-users of derivatives
(e.g. real estate development companies) because these
rms derivatives usage is inherently dierent. More importantly, the reasonable collateral that secures these different counterparties can be very dierent. The distinction between these rms is not always straight forward
(e.g. hedge funds or even some private equity rms do
not neatly t either category). Finally, even nancial users
must be dierentiated, as 'large' banks may classied
as systemically signicant whose derivatives activities
must be more tightly monitored and restricted than those
of smaller, local and regional banks.
Over-the-counter dealing will be less common as the
DoddFrank Wall Street Reform and Consumer Protection Act comes into eect. The law mandated the clearing of certain swaps at registered exchanges and imposed
various restrictions on derivatives. To implement DoddFrank, the CFTC developed new rules in at least 30 areas.
The Commission determines which swaps are subject to
mandatory clearing and whether a derivatives exchange is
eligible to clear a certain type of swap contract.
Nonetheless, the above and other challenges of the rulemaking process have delayed full enactment of aspects of
the legislation relating to derivatives. The challenges are
further complicated by the necessity to orchestrate globalized nancial reform among the nations that comprise
the worlds major nancial markets, a primary responsibility of the Financial Stability Board whose progress is
ongoing.[77]
In the U.S., by February 2012 the combined eort of the
SEC and CFTC had produced over 70 proposed and nal
derivatives rules.[78] However, both of them had delayed
adoption of a number of derivatives regulations because
of the burden of other rulemaking, litigation and opposition to the rules, and many core denitions (such as
the terms swap, security-based swap, swap dealer,

CHAPTER 18. DERIVATIVE (FINANCE)

security-based swap dealer, major swap participant
and major security-based swap participant) had still not
been adopted.[78] SEC Chairman Mary Schapiro opined:
At the end of the day, it probably does not make sense
to harmonize everything [between the SEC and CFTC
rules] because some of these products are quite dierent
and certainly the market structures are quite dierent.[79]
On February 11, 2015, the Securities and Exchange
Commission (SEC) released two nal rules toward establishing a reporting and public disclosure framework for
security-based swap transaction data.[80] The two rules
are not completely harmonized with the requirements
with CFTC requirements.

Country leaders at the 2009 G-20 Pittsburgh summit

In November 2012, the SEC and regulators from Australia, Brazil, the European Union, Hong Kong, Japan,
Ontario, Quebec, Singapore, and Switzerland met to discuss reforming the OTC derivatives market, as had been
agreed by leaders at the 2009 G-20 Pittsburgh summit
in September 2009.[81] In December 2012, they released
a joint statement to the eect that they recognized that
the market is a global one and rmly support the adoption and enforcement of robust and consistent standards
in and across jurisdictions, with the goals of mitigating
risk, improving transparency, protecting against market
abuse, preventing regulatory gaps, reducing the potential
for arbitrage opportunities, and fostering a level playing
eld for market participants.[81] They also agreed on the
need to reduce regulatory uncertainty and provide market
participants with sucient clarity on laws and regulations
by avoiding, to the extent possible, the application of conicting rules to the same entities and transactions, and
minimizing the application of inconsistent and duplicative rules.[81] At the same time, they noted that complete
harmonization perfect alignment of rules across jurisdictions would be dicult, because of jurisdictions differences in law, policy, markets, implementation timing,
and legislative and regulatory processes.[81]
On December 20, 2013 the CFTC provided information
on its swaps regulation comparability determinations.
The release addressed the CFTCs cross-border compliance exceptions. Specically it addressed which entity
level and in some cases transaction-level requirements in

18.18. FINANCIAL DERIVATIVE TRADING COMPANIES

six jurisdictions (Australia, Canada, the European Union,
Hong Kong, Japan, and Switzerland) it found comparable
to its own rules, thus permitting non-US swap dealers,
major swap participants, and the foreign branches of US
Swap Dealers and major swap participants in these jurisdictions to comply with local rules in lieu of Commission
rules.[82]

18.16.1

Reporting

Mandatory reporting regulations are being nalized in

a number of countries, such as Dodd Frank Act in
the US, the European Market Infrastructure Regulations
(EMIR) in Europe, as well as regulations in Hong Kong,
Japan, Singapore, Canada, and other countries.[83] The
OTC Derivatives Regulators Forum (ODRF), a group
of over 40 world-wide regulators, provided trade repositories with a set of guidelines regarding data access to
regulators, and the Financial Stability Board and CPSS
IOSCO also made recommendations in with regard to
reporting.[83]

89
deposits, swaps, futures, options, caps, oors, collars, forwards and various combinations thereof.
Exchange-traded derivative contracts: Standardized derivative contracts (e.g., futures contracts and
options) that are transacted on an organized futures
exchange.
[Gross negative fair value: The sum of the fair values of contracts where the bank owes money to
its counter-parties, without taking into account netting. This represents the maximum losses the banks
counter-parties would incur if the bank defaults and
there is no netting of contracts, and no bank collateral was held by the counter-parties.
Gross positive fair value: The sum total of the fair
values of contracts where the bank is owed money
by its counter-parties, without taking into account
netting. This represents the maximum losses a bank
could incur if all its counter-parties default and there
is no netting of contracts, and the bank holds no
counter-party collateral.

DTCC, through its Global Trade Repository (GTR)

service, manages global trade repositories for interest
rates, and commodities, foreign exchange, credit, and
equity derivatives.[83] It makes global trade reports to
the CFTC in the U.S., and plans to do the same for
ESMA in Europe and for regulators in Hong Kong, Japan,
and Singapore.[83] It covers cleared and uncleared OTC
derivatives products, whether or not a trade is electronically processed or bespoke.[83][84][85]

High-risk mortgage securities: Securities where the

price or expected average life is highly sensitive to
interest rate changes, as determined by the U.S.
Federal Financial Institutions Examination Council
policy statement on high-risk mortgage securities.

18.17 Glossary

Over-the-counter (OTC) derivative contracts: Privately negotiated derivative contracts that are transacted o organized futures exchanges.

Bilateral netting: A legally enforceable arrangement

between a bank and a counter-party that creates a
single legal obligation covering all included individual contracts. This means that a banks obligation,
in the event of the default or insolvency of one of the
parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral
netting arrangement.
Counterparty: The legal and nancial term for the
other party in a nancial transaction.
Credit derivative: A contract that transfers credit
risk from a protection buyer to a credit protection
seller. Credit derivative products can take many
forms, such as credit default swaps, credit linked
notes and total return swaps.
Derivative: A nancial contract whose value is derived from the performance of assets, interest rates,
currency exchange rates, or indexes. Derivative
transactions include a wide assortment of nancial
contracts including structured debt obligations and

Notional amount: The nominal or face amount that

is used to calculate payments made on swaps and
other risk management products. This amount generally does not change hands and is thus referred to
as notional.

Structured notes: Non-mortgage-backed debt securities, whose cash ow characteristics depend on one
or more indices and / or have embedded forwards or
options.
Total risk-based capital: The sum of tier 1 plus tier
2 capital. Tier 1 capital consists of common shareholders equity, perpetual preferred shareholders equity with noncumulative dividends, retained earnings, and minority interests in the equity accounts
of consolidated subsidiaries. Tier 2 capital consists
of subordinated debt, intermediate-term preferred
stock, cumulative and long-term preferred stock,
and a portion of a banks allowance for loan and lease
losses.

18.18 Financial derivative trading

companies
Alpari Group

90

CHAPTER 18. DERIVATIVE (FINANCE)

Anyoption

Sucden

Banc de Binary

TeleTrade

Cantor Fitzgerald

TFI Markets

CitiFXPro

Thinkorswim

City Index Group

Varen Gold

CMC Markets

Wizetrade

Currenex

Worldspreads

DBF

X-Trade Brokers

EToro

Zulu Trade

ETX Capital
Finspreads
First Prudential Markets
FXCM
FXdirekt Bank
FXOpen
FXPro
Gain Capital
Henyep
Hirose Financial UK Ltd.

18.19 See also

Property derivatives
Freight derivative
Ination derivative
Weather derivative
Interest rate derivative
foreign exchange derivative
Credit derivative
equity derivative

HXPM Gold
I-Access Investors

18.20 References

IDealing
IG Group
InstaForex
Interactive Brokers
InterTrader
Marex Spectron
MF Global
MRC Markets
Oanda Corporation
OptionsXpress
Pepperstone
Plus 500
Saxo Bank
Spread Co.
Spreadex

[1] Derivatives (Report). Oce of the Comptroller of

the Currency, U.S. Department of Treasury. Retrieved
February 2013. A derivative is a nancial contract whose
value is derived from the performance of some underlying
market factors, such as interest rates, currency exchange
rates, and commodity, credit, or equity prices. Derivative
transactions include an assortment of nancial contracts,
including structured debt obligations and deposits, swaps,
futures, options, caps, oors, collars, forwards, and various combinations thereof.
[2] Derivative Denition Investopedia
[3] Koehler, Christian. The Relationship between the Complexity of Financial Derivatives and Systemic Risk.
Working Paper: 1011.
[4] An asset-backed security is used as an umbrella term for
a type of security backed by a pool of assetsincluding
collateralized debt obligations and mortgage-backed securities (Example: The capital market in which assetbacked securities are issued and traded is composed of
three main categories: ABS, MBS and CDOs. (italics
added) (source: Vink, Dennis. ABS, MBS and CDO
compared: an empirical analysis. August 2007. Munich
Personal RePEc Archive. Retrieved 13 July 2013.)

18.20. REFERENCES

91

and sometimes for a particular type of that security

one backed by consumer loans (example: As a rule
of thumb, securitization issues backed by mortgages are
called MBS, and securitization issues backed by debt obligations are called CDO, [and] Securitization issues backed
by consumer-backed productscar loans, consumer loans
and credit cards, among othersare called ABS ... (italics added, source Vink, Dennis. ABS, MBS and CDO
compared: an empirical analysis. August 2007. Munich
Personal RePEc Archive. Retrieved 13 July 2013.,
see also What are Asset-Backed Securities?". SIFMA.
Retrieved 13 July 2013. Asset-backed securities, called
ABS, are bonds or notes backed by nancial assets. Typically these assets consist of receivables other than mortgage loans, such as credit card receivables, auto loans,
manufactured-housing contracts and home-equity loans.)

[18] Weistroer, Christian; Deutsche Bank Research (December 21, 2009). Credit default swaps: Heading towards
a more stable system (PDF). Deutsche Bank Research:
Current Issues. Retrieved April 15, 2010.

[5] Lemke, Lins and Picard, Mortgage-Backed Securities,

5:15 (Thomson West, 2014).

[22] Media Statement: DTCC Policy for Releasing CDS Data

to Global Regulators. Depository Trust & Clearing Corporation. March 23, 2010. Retrieved April 22, 2010.

[6] Koehler, Christian. The Relationship between the Complexity of Financial Derivatives and Systemic Risk.
Working Paper: 17.
[7] Lemke, Lins and Smith, Regulation of Investment Companies (Matthew Bender, 2014 ed.).
[8] McLean, Bethany and Joe Nocera, All the Devils Are Here,
the Hidden History of the Financial Crisis, Portfolio, Penguin, 2010, p.120
[9] Final Report of the National Commission on the Causes
of the Financial and Economic Crisis in the United States,
a.k.a. The Financial Crisis Inquiry Report, p.127
[10] The Financial Crisis Inquiry Report, 2011, p.130

[19] Simkovic, Michael, Secret Liens and the Financial Crisis

of 2008.
[20] Sirri, Erik, Director, Division of Trading and Markets
U.S. Securities and Exchange Commission. Testimony
Concerning Credit Default Swas Before the House Committee on Agriculture October 15, 2008. Retrieved April
2, 2010.
[21] Partnoy, Frank; David A. Skeel, Jr. (2007). The Promise
And Perils of Credit Derivatives. University of Cincinnati
Law Review 75: 10191051. SSRN 929747.

[23] Mengle, David (Fourth Quarter 2007). Credit Derivatives: An Overview (PDF). Economic Review (FRB Atlanta) 92 (4). Retrieved April 2, 2010. Check date values
in: |date= (help)
[24] John C Hull, Options, Futures and Other Derivatives (6th
edition), Prentice Hall: New Jersey, USA, 2006, 3
[25] Understanding Derivatives: Markets and Infrastructure,
Federal Reserve Bank of Chicago
[26] Forward Contract on Wikinvest
[27] http://chicagofed.org/webpages/publications/
understanding_derivatives/index.cfm

[11] The Financial Crisis Inquiry Report, 2011, p.133

[28] Lemke, Lins and Picard, Mortgage-Backed Securities,

Chapters 4 and 5 (Thomson West, 2013 ed.).

[12] Simkovic, Michael, Leveraged Buyout Bankruptcies, the

Problem of Hindsight Bias, and the Credit Default Swap
Solution, Columbia Business Law Review (Vol. 2011, No.
1, pp. 118), 2011.

[29] How can mortgage-backed securities bring down the U.S.

economy?| Josh Clark| How Stu Works

[13] Pollack, Lisa (January 5, 2012). Credit event auctions:

Why do they exist?". FT Alphaville. Retrieved January 5,
2012.
[14] Chart; ISDA Market Survey; Notional amounts outstanding at year-end, all surveyed contracts, 1987present (PDF). International Swaps and Derivatives Association (ISDA). Retrieved April 8, 2010.

[30] Benhamou, Eric. Options pre-Black Scholes.

[31] Black, Fischer; Scholes, Myron (1973). The Pricing of
Options and Corporate Liabilities. Journal of Political
Economy 81 (3): 637654. doi:10.1086/260062. JSTOR
1831029.
[32] Brealey, Richard A.; Myers, Stewart (2003), Principles of
Corporate Finance (7th ed.), McGraw-Hill, Chapter 20

[15] ISDA 2010 MID-YEAR MARKET SURVEY. Latest

available a/o 2012-03-01.

[33] Hull, John C. (2005), Options, Futures and Other Derivatives (excerpt by Fan Zhang) (6th ed.), Pg 6: Prentice-Hall,
ISBN 0-13-149908-4

[16] ISDA: CDS Marketplace :: Market Statistics. Isdacdsmarketplace.com. December 31, 2010. Retrieved March
12, 2012.

[34] Ross, Westereld, & Jordan (2010). Fundamentals of

Corporate Finance (9th, alternate ed.). McGraw Hill. p.
746.

[17] Ki, John; Jennifer Elliott; Elias Kazarian; Jodi Scarlata;

Carolyne Spackman (November 2009). Credit Derivatives: Systemic Risks and Policy Options (PDF). International Monetary Fund: IMF Working Paper (WP/09/254).
Retrieved April 25, 2010.

[35] Rubinstein, Mark (1999). Rubinstein on derivatives. Risk

Books. ISBN 1-899332-53-7.
[36] Hull, John C. (2006). Options, Futures and Other Derivatives, Sixth Edition. Prentice Hall. p. 1.

92

[37] Koehler, Christian. The Relationship between the Complexity of Financial Derivatives and Systemic Risk.
Working Paper: 10.
[38] Kaori Suzuki and David Turner (December 10, 2005).
Sensitive politics over Japans staple crop delays rice futures plan. The Financial Times. Retrieved October 23,
2010.

CHAPTER 18. DERIVATIVE (FINANCE)

[53] Chernenko, Sergey and Faulkender, Michael. The Two

Sides of Derivatives Usage: Hedging and Speculating
with Interest Rate Swaps http://www.rhsmith.umd.edu/
faculty/faulkender/swaps_JFQA_final.pdf
[54] Knowledge@Wharton (2012).
The Changing Use
of Derivatives: More Hedging, Less Speculation
http://knowledge.wharton.upenn.edu/article.cfm?
articleid=709

[39] Clear and Present Danger; Centrally cleared derivatives.(clearing houses)". The Economist (Economist
Newspaper Ltd.(subscription required)). 2012-04-12.
Retrieved 2013-05-10.

[55] Guay, Wayne R. and Kothari, S.P. (2001). How Much do

Firms Hedge with Derivatives?" http://papers.ssrn.com/
sol3/papers.cfm?abstract_id=253036

[40] Liu, Qiao; Lejot, Paul (2013). Debt, Derivatives and

complex interactions. Finance in Asia: Institutions, Regulation and Policy. Douglas W. Arne. New York: Routledge. p. 343. ISBN 978-0-415-42319-9.

[56] Knowledge@Wharton (2006). The Role of Derivatives in Corporate Finances: Are Firms Betting the
Ranch?" http://knowledge.wharton.upenn.edu/article.
cfm?articleid=1346

[41] Summary Table1. The Budget and Economic Outlook:

Fiscal Years 2013 to 2023. Congressional Budget Oce.
February 5, 2013. Retrieved March 15, 2013.
[42] Swapping bad ideas: A big battle is unfolding over an
even bigger market. The Economist (Economist Newspaper Ltd.). 2013-04-27. Retrieved 2013-05-10.
[43] World GDP: In search of growth. The Economist
(Economist Newspaper Ltd.). 2011-05-25. Retrieved
2013-05-10.
[44] Sheridan, Barrett (April 2008). 600,000,000,000,000?".
Newsweek Inc. Retrieved 12 May 2013. via HighBeam
(subscription required)
[45] Khullar, Sanjeev (2009). Using Derivatives to Create Alpha. In John M. Longo. Hedge Fund Alpha: A Framework for Generating and Understanding Investment Performance. Singapore: World Scientic. p. 105. ISBN
978-981-283-465-2. Retrieved September 14, 2011.
[46] Lemke and Lins, Soft Dollars and Other Trading Activities,
2:47 - 2:54 (Thomson West, 2013-2014 ed.).
[47] Don M. Chance; Robert Brooks (2010). Advanced
Derivatives and Strategies. Introduction to Derivatives
and Risk Management (8th ed.). Mason, Ohio: Cengage
Learning. pp. 483515. ISBN 978-0-324-60120-6. Retrieved September 14, 2011.
[48] Shirre, David (2004). Derivatives and leverage.
Dealing With Financial Risk. USA: The Economist. p.
23. ISBN 1-57660-162-5. Retrieved September 14,
2011.
[49] Peterson, Sam (2010).
The Atlantic.
Theres
a
Derivative
in
Your
Cereal
http://www.
theatlantic.com/business/archive/2010/07/
theres-a-derivative-in-your-cereal/60582/
[50] Chisolm, Derivatives Demystied (Wiley 2004)
[51] Chisolm, Derivatives Demystied (Wiley 2004) Notional
sum means there is no actual principal.
[52] News.BBC.co.uk, How Leeson broke the bank BBC
Economy

[57] Ryan Stever; Christian Upper; Goetz von Peter (December 2007). BIS Quarterly Review (PDF) (Report). Bank
for International Settlements.
[58] BIS survey: The Bank for International Settlements (BIS)
semi-annual OTC [derivatives market report, for end
of June 2008, showed US$683.7 trillion total notional
amounts outstanding of OTC derivatives with a gross market value of US$20 trillion. See also Prior Period Regular
OTC Derivatives Market Statistics.
[59] Hull, J.C. (2009). Options, futures, and other derivatives
. Upper Saddle River, NJ : Pearson/Prentice Hall, c2009
[60] Futures and Options Week: According to gures published
in F&O Week October 10, 2005. See also FOW Website.
[61] Financial Markets: A Beginners Module.
[62] Michael Simkovic and Benjamin Kaminetzky (August 29,
2010). Leveraged Buyout Bankruptcies, the Problem of
Hindsight Bias, and the Credit Default Swap Solution.
Columbia Business Law Review, Vol. 2011, No. 1, p.
118, 2011. Retrieved March 5, 2013.
[63] Currency Derivatives: A Beginners Module.
[64] Bis.org. Bis.org. May 7, 2010. Retrieved August 29,
2010.
[65] Launch of the WIDER study on The World Distribution
of Household Wealth: 5 December 2006. Retrieved June
9, 2009.
[66] Boumlouka,
Makrem
(2009),"Alternatives
in OTC Pricing, Hedge Funds Review, 10http://www.hedgefundsreview.
30-2009.
com/hedge-funds-review/news/1560286/
otc-pricing-deal-struck-fitch-solutions-pricing-partners
[67] Raghuram G. Rajan (September 2006). Has Financial
Development Made the World Riskier?". European Financial Management (EUROPEAN FINANCIAL MANAGEMENT) 12 (4): 499533. doi:10.1111/j.1468036X.2006.00330.x. Retrieved January 17, 2012.
[68] Kelleher, James B. (September 18, 2008). ""Buetts
Time Bomb Goes O on Wall Street by James B. Kelleher of Reuters. Reuters.com. Retrieved August 29,
2010.

18.21. FURTHER READING

[69] Feds $85 billion Loan Rescues Insurer

[70] Edwards, Franklin (1995). Derivatives Can Be Hazardous To Your Health: The Case of Metallgesellschaft.
Derivatives Quarterly (Spring 1995): 817
[71] Whaley, Robert (2006). Derivatives: markets, valuation,
and risk management. John Wiley and Sons. p. 506.
ISBN 0-471-78632-2.
[72] UBS Loss Shows Banks Fail to Learn From Kerviel, Leeson. Businessweek. September 15, 2011. Retrieved
March 5, 2013.
[73] Michael Simkovic, Secret Liens and the Financial Crisis
of 2008.. American Bankruptcy Law Journal, Vol. 83,
p. 253. 2009. Retrieved March 5, 2013.
[74] Michael Simkovic (January 11, 2011). Bankruptcy
Immunities,
Transparency,
and Capital Structure, Presentation at the World Bank. Ssrn.com.
doi:10.2139/ssrn.1738539. Retrieved March 5, 2013.
[75] Story, Louise, A Secretive Banking Elite Rules Trading
in Derivatives, The New York Times, December 11, 2010
(December 12, 2010, p. A1 NY ed.). Retrieved December 12, 2010.
[76] Zubrod, Luke (2011).
The Atlantic.
Will the
'Cure' for Systemic Risk Kill the Economy?"
http://www.theatlantic.com/business/archive/2011/
06/will-the-cure-for-systemic-risk-kill-the-economy/
240600/
[77] Financial Stability Board (2012). OTC Derivatives
Market Reforms Third Progress Report on Implementation June 15, 2012 http://www.financialstabilityboard.
org/publications/r_120615.pdf
[78] Proskauer Rose LLP. SEC and CFTC oversight of
derivatives: a status report. Lexology. Retrieved March
5, 2013.
[79] Younglai, Rachelle. INTERVIEW Not all SEC, CFTC
rules must be harmonized. Reuters. Retrieved March 5,
2013.
[80] First take: Ten key points from the SECs swaps
reporting and disclosure rules. http://www.pwc.com/
us/en/financial-services/regulatory-services/publications/
sec-swap-reporting-and-disclosure.jhtml''. PwC Financial Services Regulatory Practice, February, 2015.
[81] Joint Press Statement of Leaders on Operating Principles
and Areas of Exploration in the Regulation of the CrossBorder OTC Derivatives Market; 2012-251. Sec.gov.
December 4, 2012. Retrieved March 5, 2013.
[82] Derivatives:
A rst take on cross-border
comparability.
http://www.pwc.com/us/en/
financial-services/regulatory-services/publications/
dodd-frank-cftc-derivatives.jhtml, December, 2013.

93

[85] Release, Press (August 5, 2010). Derivatives trades will

be tracked by Depository Trust. Futuresmag.com. Retrieved March 5, 2013.

18.21 Further reading

Bartram, Shnke M.; Brown, Gregory W.; Conrad, Jennifer C. (August 2011). The Eects of
Derivatives on Firm Risk and Value. Journal of Financial and Quantitative Analysis 46 (4): 967999.
doi:10.1017/s0022109011000275.
Aretz, Kevin; Bartram, Shnke M. (Winter 2010).
Corporate Hedging and Shareholder Value. Journal of Financial Research 33 (4): 317371.
doi:10.1111/j.1475-6803.2010.01278.x.
Bartram, Shnke M.; Brown, Gregory W.; Fehle,
Frank R. (Spring 2009). International Evidence
on Financial Derivatives Usage. Financial Management 38 (1): 185206. doi:10.1111/j.1755053x.2009.01033.x.
Lemke, Lins (20132014). Soft Dollars and Other
Trading Activities. Thomson West.
Institute for Financial Markets (2011). Futures and
Options (2nd ed.). Washington DC: Institute for Financial Markets. ISBN 978-0-615-35082-0.
Hull, John C. (2011). Options, Futures and Other
Derivatives (8th ed.). Harlow: Pearson Education.
ISBN 978-0-13-260460-4.
Durbin, Michael (2011). All About Derivatives (2nd
ed.). New York: McGraw-Hill. ISBN 978-0-07174351-8.
Mattoo, Mehraj (1997). Structured Derivatives:
New Tools for Investment Management: A Handbook
of Structuring, Pricing & Investor Applications. London: Financial Times. ISBN 978-0-273-61120-2.
Soklakov, A.N, Deriving Derivatives (2013),
http://papers.ssrn.com/sol3/papers.cfm?abstract_
id=2262941 and Elasticity Theory of Structuring
(2013), http://papers.ssrn.com/sol3/papers.cfm?
abstract_id=2262963

18.22 External links

Understanding Derivatives: Markets and Infrastructure (Federal Reserve Bank of Chicago)

[83] DTCCs Global Trade Repository for OTC Derivatives

(GTR)". Dtcc.com. Retrieved March 5, 2013.

BBC News Derivatives simple guide

[84] U.S. DTCC says barriers hinder full derivatives picture.

Reuters. February 12, 2013. Retrieved March 5, 2013.

European Union proposals on derivatives regulation

2008 onwards

94
PwC Financial Services Regulatory Practice Derivatives Regulatory Roulette
NISM Derivatives Certications in India -

CHAPTER 18. DERIVATIVE (FINANCE)

Chapter 19

Futures contract
In nance, a futures contract (more colloquially, futures) is a contract between two parties to buy or sell an
asset for a price agreed upon today (the futures price) with
delivery and payment occurring at a future point, the delivery date. Because it is a function of an underlying asset, a futures contract is considered a derivative product.
Contracts are negotiated at futures exchanges, which act
as a marketplace between buyer and seller. The buyer of
the contract is said to be "long", and the party selling the
contract is said to be "short".[1]

19.2 Risk mitigation

However futures contracts also oer opportunities for

speculation in that a trader who predicts that the price
of an asset will move in a particular direction can contract to buy or sell it in the future at a price which (if the
prediction is correct) will yield a prot.

money out of the losing partys margin account and put

it into that of the other party, ensuring the correct loss or
prot is reected daily.

Although futures contract are oriented towards a future

time point, their main purpose is to mitigate risk of default by either party in the intervening period. In this vein,
the futures exchange requires both parties to put up initial cash, or a performance bond, known as the margin.
Margins, sometimes set as a percentage of the value of
the futures contract, must be maintained throughout the
life of the contract to guarantee the agreement, as over
The original use of futures contracts was to mitigate the this time the price of the contract can vary as a function
risk of price or exchange rate movements by allowing par- of supply and demand, causing one side of the exchange
ties to x prices or rates in advance for future transactions. to lose money at the expense of the other.
This could be advantageous when (for example) a party To mitigate the risk of default, the product is marked
expects to receive payment in foreign currency in the fu- to market on a daily basis where the dierence between
ture, and wishes to guard against an unfavorable move- the initial agreed-upon price and the actual daily futures
ment of the currency in the interval before payment is price is reevaluated daily. This is sometimes known as the
received.
variation margin, where the Futures Exchange will draw

If the margin account goes below a certain value set by

the Exchange, then a margin call is made and the account
owner must replenish the margin account. This process is
known as marking to market. Thus on the delivery date,
the amount exchanged is not the specied price on the
contract but the spot value (i.e. the original value agreed
upon, since any gain or loss has already been previously
19.1 Origin
settled by marking to market). Upon marketing the strike
price is often reached and creates lots of income for the
The rst futures exchange market was the Djima Rice caller.
Exchange in Japan in the 1730s, to meet the needs of
samurai whobeing paid in rice, and after a series of
bad harvestsneeded a stable conversion to coin.[2]
The Chicago Board of Trade (CBOT) listed the rst-ever
standardized 'exchange traded' forward contracts in 1864,
which were called futures contracts. This contract was
based on grain trading and started a trend that saw contracts created on a number of dierent commodities as
well as a number of futures exchanges set up in countries
around the world.[3] By 1875 cotton futures were being
traded in Mumbai in India and within a few years this
had expanded to futures on edible oilseeds complex, raw
jute and jute goods and bullion.[4]

19.3 Margin

Main article: Margin (nance)

To minimize credit risk to the exchange, traders must
post a margin or a performance bond, typically 5%15%
of the contracts value.
To minimize counterparty risk to traders, trades executed
on regulated futures exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each
seller, and the seller to each Buyer, so that in the event

95

96

CHAPTER 19. FUTURES CONTRACT

change concerned.
In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order
to restore the amount of initial margin available. Often
referred to as variation margin, margin called for this
reason is usually done on a daily basis, however, in times
of high volatility a broker can make a margin call or calls
intra-day.
Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right
to close sucient positions to meet the amount called by
way of margin. After the position is closed-out the client
is liable for any resulting decit in the clients account.
Some U.S. exchanges also use the term maintenance
margin, which in eect denes by how much the value
of the initial margin can reduce before a margin call is
made. However, most non-US brokers only use the term
initial margin and variation margin.
The Initial Margin requirement is established by the Futures exchange, in contrast to other securities Initial Margin (which is set by the Federal Reserve in the U.S. Markets).

A futures account is marked to market daily. If the margin drops below the margin maintenance requirement esof a counterparty default the clearer assumes the risk of tablished by the exchange listing the futures, a margin call
loss. This enables traders to transact without performing will be issued to bring the account back up to the required
level.
due diligence on their counterparty.
Margin requirements are waived or reduced in some cases
for hedgers who have physical ownership of the covered
commodity or spread traders who have osetting contracts balancing the position.
Clearing margin are nancial safeguards to ensure that
companies or corporations perform on their customers
open futures and options contracts. Clearing margins are
distinct from customer margins that individual buyers and
sellers of futures and options contracts are required to deposit with brokers.
Customer margin Within the futures industry, nancial
guarantees required of both buyers and sellers of futures
contracts and sellers of options contracts to ensure fulllment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin
accounts. Margins are determined on the basis of market
risk and contract value. Also referred to as performance
bond margin.
Initial margin is the equity required to initiate a futures
position. This is a type of performance bond. The maximum exposure is not limited to the amount of the initial
margin, however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. Initial margin is set by
the exchange.

Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain
in their margin account.
Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being
held as margin at any particular time. The low margin
requirements of futures results in substantial leverage of
the investment. However, the exchanges require a minimum amount that varies depending on the contract and
the trader. The broker may set the requirement higher,
but may not set it lower. A trader, of course, can set it
above that, if he does not want to be subject to margin
calls.
Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or
an options seller to ensure performance of the term of the
contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather
it is a security deposit.

Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchanges perceived risk as reected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal
to (ROM+1)(year/trade_duration) 1. For example if a trader
earns 10% on margin in two months, that would be about
If a position involves an exchange-traded product, the 77% annualized.
amount or percentage of initial margin is set by the ex-

19.5. PRICING

97

19.4 Settlement - physical versus 19.5 Pricing

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

When the deliverable asset exists in plentiful supply, or

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

Physical delivery - the amount specied of the underlying asset of the contract is delivered by the
seller of the contract to the exchange, and by the
exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In
practice, it occurs only on a minority of contracts.
Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to
liquidate an earlier purchase (covering a long). The
Nymex crude futures contract uses this method of
19.5.1
settlement upon expiration
Cash settlement - a cash payment is made based on
the underlying reference rate, such as a short-term
interest rate index such as 90 Day T-Bills, or the
closing value of a stock market index. The parties
settle by paying/receiving the loss/gain related to the
contract in cash when the contract expires.[5] Cash
settled futures are those that, as a practical matter,
could not be settled by delivery of the referenced
item - i.e. how would one deliver an index? A futures contract might also opt to settle against an index based on trade in a related spot market. ICE
Brent futures use this method.
Expiry (or Expiration in the U.S.) is the time and the
day that a particular delivery month of a futures contract
stops trading, as well as the nal settlement price for that
contract. For many equity index and interest rate futures
contracts (as well as for most equity options), this happens on the third Friday of certain trading months. On
this day the t+1 futures contract becomes the t futures
contract. For example, for most CME and CBOT contracts, at the expiration of the December contract, the
March futures become the nearest contract. This is an exciting time for arbitrage desks, which try to make quick
prots during the short period (perhaps 30 minutes) during which the underlying cash price and the futures price
sometimes struggle to converge. At this moment the futures and the underlying assets are extremely liquid and
any disparity between an index and an underlying asset
is quickly traded by arbitrageurs. At this moment also,
the increase in volume is caused by traders rolling over
positions to the next contract or, in the case of equity index futures, purchasing underlying components of those
indexes to hedge against current index positions. On the
expiry date, a European equity arbitrage trading desk in
London or Frankfurt will see positions expire in as many
as eight major markets almost every half an hour.

Arbitrage arguments

Arbitrage arguments ("Rational pricing") apply when the

deliverable asset exists in plentiful supply, or may be
freely created. Here, the forward price represents the
expected future value of the underlying discounted at
the risk free rateas any deviation from the theoretical
price will aord investors a riskless prot opportunity and
should be arbitraged away. We dene the forward price
to be the strike K such that the contract has 0 value at the
present time. Assuming interest rates are constant the forward price of the futures is equal to the forward price of
the forward contract with the same strike and maturity.
It is also the same if the underlying asset is uncorrelated
with interest rates. Otherwise the dierence between the
forward price on the futures (futures price) and forward
price on the asset, is proportional to the covariance between the underlying asset price and interest rates. For
example, a futures on a zero coupon bond will have a futures price lower than the forward price. This is called
the futures convexity correction.
Thus, assuming constant rates, for a simple, non-dividend
paying asset, the value of the futures/forward price,
F(t,T), will be found by compounding the present value
S(t) at time t to maturity T by the rate of risk-free return
r.
F (t, T ) = S(t) (1 + r)(T t)
or, with continuous compounding
F (t, T ) = S(t)er(T t)
This relationship may be modied for storage costs, dividends, dividend yields, and convenience yields.
In a perfect market the relationship between futures and
spot prices depends only on the above variables; in practice there are various market imperfections (transaction

98

CHAPTER 19. FUTURES CONTRACT

costs, dierential borrowing and lending rates, restrictions on short selling) that prevent complete arbitrage.
Thus, the futures price in fact varies within arbitrage
boundaries around the theoretical price.

There are many dierent kinds of futures contracts, reecting the many dierent kinds of tradable assets
about which the contract may be based such as commodities, securities (such as single-stock futures), currencies or intangibles such as interest rates and indexes.
For information on futures markets in specic underly19.5.2 Pricing via expectation
ing commodity markets, follow the links. For a list of
tradable commodities futures contracts, see List of traded
When the deliverable commodity is not in plentiful sup- commodities. See also the futures exchange article.
ply (or when it does not yet exist) rational pricing cannot
be applied, as the arbitrage mechanism is not applica Foreign exchange market
ble. Here the price of the futures is determined by todays
supply and demand for the underlying asset in the future.
Money market
In a deep and liquid market, supply and demand would
be expected to balance out at a price which represents
an unbiased expectation of the future price of the actual
asset and so be given by the simple relationship.

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

19.5.3

Relationship between arbitrage arguments and expectation

The expectation based relationship will also hold in a noarbitrage setting when we take expectations with respect
to the risk-neutral probability. In other words: a futures
price is martingale with respect to the risk-neutral probability. With this pricing rule, a speculator is expected
to break even when the futures market fairly prices the
deliverable commodity.

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

Contracts on nancial instruments were introduced in the

1970s by the Chicago Mercantile Exchange (CME) and
these instruments became hugely successful and quickly
overtook commodities futures in terms of trading volume
and global accessibility to the markets. This innovation
led to the introduction of many new futures exchanges
worldwide, such as the London International Financial
19.5.4 Contango and backwardation
Futures Exchange in 1982 (now Euronext.lie), Deutsche
Terminbrse (now Eurex) and the Tokyo Commodity ExThe situation where the price of a commodity for future change (TOCOM). Today, there are more than 90 futures
delivery is higher than the spot price, or where a far future and futures options exchanges worldwide trading to indelivery price is higher than a nearer future delivery, is clude:
known as contango. The reverse, where the price of a
commodity for future delivery is lower than the spot price,
CME Group (formerly CBOT and CME) -- Currenor where a far future delivery price is lower than a nearer
cies, Various Interest Rate derivatives (including US
future delivery, is known as backwardation.
Bonds); Agricultural (Corn, Soybeans, Soy Prod-

19.6 Futures contracts and exchanges

Contracts

ucts, Wheat, Pork, Cattle, Butter, Milk); Indices

(Dow Jones Industrial Average, NASDAQ Composite, S&P 500, etc.); Metals (Gold, Silver)
IntercontinentalExchange (ICE Futures Europe) formerly the International Petroleum Exchange
trades energy including crude oil, heating oil, gas oil

19.7. FUTURES TRADERS

99

(diesel), rened petroleum products, electric power, 19.6.1 Codes

coal, natural gas, and emissions
Most Futures contracts codes are ve characters. The
NYSE Euronext - which absorbed Euronext into rst two characters identify the contract type, the third
which London International Financial Futures and character identies the month and the last two characters
Options Exchange or LIFFE (pronounced 'LIFE') identify the year.
was merged. (LIFFE had taken over London ComThird (month) futures contract codes are
modities Exchange (LCE) in 1996)- softs: grains
and meats. Inactive market in Baltic Exchange ship January = F
ping. Index futures include EURIBOR, FTSE 100,
CAC 40, AEX index.

February = G

South African Futures Exchange - SAFEX

March = H

Sydney Futures Exchange

April = J

Tokyo Stock Exchange TSE (JGB Futures, TOPIX

Futures)

May = K

Tokyo Commodity Exchange TOCOM

July = N

Tokyo Financial Exchange - TFX - (Euroyen Futures, OverNight CallRate Futures, SpotNext RepoRate Futures)

August = Q

Osaka Securities Exchange OSE (Nikkei Futures,

RNP Futures)
London Metal Exchange - metals:
copper,
aluminium, lead, zinc, nickel, tin and steel

June = M

September = U
October = V
November = X
December = Z

Example: CLX14 is a Crude Oil (CL), November (X)

IntercontinentalExchange (ICE Futures U.S.) - for- 2014 (14) contract.[6]
merly New York Board of Trade - softs: cocoa,
coee, cotton, orange juice, sugar

19.7 Futures traders

New York Mercantile Exchange CME Group- energy and metals: crude oil, gasoline, heating oil,
natural gas, coal, propane, gold, silver, platinum, Futures traders are traditionally placed in one of two
groups: hedgers, who have an interest in the underlying
copper, aluminum and palladium
asset (which could include an intangible such as an index
or interest rate) and are seeking to hedge out the risk of
Dubai Mercantile Exchange
price changes; and speculators, who seek to make a prot
JFX Jakarta Futures Exchange
by predicting market moves and opening a derivative contract related to the asset on paper, while they have no
Montreal Exchange (MX) (owned by the TMX practical use for or intent to actually take or make delivGroup) also known in French as Bourse De Mon- ery of the underlying asset. In other words, the investor
treal: Interest Rate and Cash Derivatives: Cana- is seeking exposure to the asset in a long futures or the
dian 90 Days Bankers Acceptance Futures, Cana- opposite eect via a short futures contract.
dian government bond futures, S&P/TSX 60 Index
Futures, and various other Index Futures
Korea Exchange - KRX

19.7.1 Hedgers

Hedgers typically include producers and consumers of a

Singapore Exchange - SGX - into which merged commodity or the owner of an asset or assets subject to
Singapore International Monetary Exchange certain inuences such as an interest rate.
(SIMEX)
For example, in traditional commodity markets, farmers
often sell futures contracts for the crops and livestock they
ROFEX - Rosario (Argentina) Futures Exchange
produce to guarantee a certain price, making it easier for
NCDEX - National Commodity and Derivatives Ex- them to plan. Similarly, livestock producers often purchange, India
chase futures to cover their feed costs, so that they can

100

CHAPTER 19. FUTURES CONTRACT

plan on a xed cost for feed. In modern (nancial) markets, producers of interest rate swaps or equity derivative products will use nancial futures or equity index futures to reduce or remove the risk on the swap.
Those that buy or sell commodity futures need to be careful. If a company buys contracts hedging against price
increases, but in fact the market price of the commodity is substantially lower at time of delivery, they could
nd themselves disastrously non-competitive (for example see: VeraSun Energy).

19.7.2

Speculators

mium is not due until unwound, the positions are commonly referred to as a fution, as they act like options,
however, they settle like futures.
Investors can either take on the role of option
seller/option writer or the option buyer.
Option
sellers are generally seen as taking on more risk because
they are contractually obligated to take the opposite
futures position if the options buyer exercises their
right to the futures position specied in the option. The
price of an option is determined by supply and demand
principles and consists of the option premium, or the
price paid to the option seller for oering the option and
taking on risk.[8]

Speculators typically fall into three categories: position

traders, day traders, and swing traders (swing trading), 19.9 Futures contract regulations
though many hybrid types and unique styles exist. With
many investors pouring into the futures markets in recent
years controversy has risen about whether speculators are All futures transactions in the United States are reguresponsible for increased volatility in commodities like lated by the Commodity Futures Trading Commission
(CFTC), an independent agency of the United States govoil, and experts are divided on the matter. [7]
ernment. The Commission has the right to hand out nes
An example that has both hedge and speculative notions and other punishments for an individual or company who
involves a mutual fund or separately managed account breaks any rules. Although by law the commission regwhose investment objective is to track the performance ulates all transactions, each exchange can have its own
of a stock index such as the S&P 500 stock index. The rule, and under contract can ne companies for dierent
Portfolio manager often equitizes cash inows in an things or extend the ne that the CFTC hands out.
easy and cost eective manner by investing in (opening
long) S&P 500 stock index futures. This gains the port- The CFTC publishes weekly reports containing details of
folio exposure to the index which is consistent with the the open interest of market participants for each marketfund or account investment objective without having to segment that has more than 20 participants. These rebuy an appropriate proportion of each of the individual ports are released every Friday (including data from the
500 stocks just yet. This also preserves balanced diversi- previous Tuesday) and contain data on open interest split
cation, maintains a higher degree of the percent of as- by reportable and non-reportable open interest as well as
sets invested in the market and helps reduce tracking error commercial and non-commercial open interest. This type
in the performance of the fund/account. When it is eco- of report is referred to as the 'Commitments of Traders
nomically feasible (an ecient amount of shares of every Report', COT-Report or simply COTR.
individual position within the fund or account can be purchased), the portfolio manager can close the contract and
19.10 Denition of futures conmake purchases of each individual stock.

tract
The social utility of futures markets is considered to be
mainly in the transfer of risk, and increased liquidity between traders with dierent risk and time preferences, Following Bjrk[9] we give a denition of a futures confrom a hedger to a speculator, for example.[1]
tract. We describe a futures contract with delivery of item
J at the time T:
19.8 Options on futures
In many cases, options are traded on futures, sometimes
called simply futures options. A put is the option to sell
a futures contract, and a call is the option to buy a futures
contract. For both, the option strike price is the specied
futures price at which the future is traded if the option is
exercised. Futures are often used since they are delta one
instruments. Calls and options on futures may be priced
similarly to those on traded assets by using an extension
of the Black-Scholes formula, namely the BlackScholes
model for futures. For options on futures, where the pre-

There exists in the market a quoted price F(t,T),

which is known as the futures price at time t for delivery of J at time T.
The price of entering a futures contract is equal to
zero.
During any time interval [t, s] , the holder receives
the amount F (s, T )F (t, T ) . (this reects instantaneous marking to market)
At time T, the holder pays F(T,T) and is entitled to
receive J. Note that F(T,T) should be the spot price
of J at time T.

19.12. FUTURES VERSUS FORWARDS

101

19.11 Forward contracts

In the case of physical delivery, the forward contract

species to whom to make the delivery. The counterparty for delivery on a futures contract is chosen
by the clearing house.

A closely related contract is a forward contract. A forward is like a futures in that it species the exchange
of goods for a specied price at a specied future date.
However, a forward is not traded on an exchange and thus
does not have the interim partial payments due to mark- 19.12.2 Margining
ing to market. Nor is the contract standardized, as on the
For more details on Margin, see Margin (nance).
exchange.
Unlike an option, both parties of a futures contract must
fulll the contract on the delivery date. The seller delivers
the underlying asset to the buyer, or, if it is a cash-settled
futures contract, then cash is transferred from the futures
trader who sustained a loss to the one who made a prot.
To exit the commitment prior to the settlement date, the
holder of a futures position can close out its contract obligations by taking the opposite position on another futures
contract on the same asset and settlement date. The difference in futures prices is then a prot or loss.

Futures are margined daily to the daily spot price of a

forward with the same agreed-upon delivery price and underlying asset (based on mark to market).
Forwards do not have a standard. They may transact only
on the settlement date. More typical would be for the
parties to agree to true up, for example, every quarter.
The fact that forwards are not margined daily means that,
due to movements in the price of the underlying asset, a
large dierential can build up between the forwards delivery price and the settlement price, and in any event, an
unrealized gain (loss) can build up.

19.12 Futures versus forwards

Again, this diers from futures which get 'trued-up' typically daily by a comparison of the market value of the fuWhile futures and forward contracts are both contracts to ture to the collateral securing the contract to keep it in line
deliver an asset on a future date at a prearranged price, with the brokerage margin requirements. This true-ing up
occurs by the loss party providing additional collateral;
they are dierent in two main respects:
so if the buyer of the contract incurs a drop in value, the
shortfall or variation margin would typically be shored up
Futures are exchange-traded, while forwards are by the investor wiring or depositing additional cash in the
traded over-the-counter.
brokerage account.
Thus futures are standardized and face
an exchange, while forwards are customized and face a non-exchange counterparty.
Futures are margined, while forwards are not.
Thus futures have signicantly less
credit risk, and have dierent funding.

In a forward though, the spread in exchange rates is not

trued up regularly but, rather, it builds up as unrealized
gain (loss) depending on which side of the trade being
discussed. This means that entire unrealized gain (loss)
becomes realized at the time of delivery (or as what typically occurs, the time the contract is closed prior to expiration) - assuming the parties must transact at the underlying currencys spot price to facilitate receipt/delivery.
The result is that forwards have higher credit risk than
futures, and that funding is charged dierently.

The Futures Industry Association (FIA) estimates that In most cases involving institutional investors, the daily
6.97 billion futures contracts were traded in 2007, an in- variation margin settlement guidelines for futures call for
crease of nearly 32% over the 2006 gure.
actual money movement only above some insignicant
amount to avoid wiring back and forth small sums of cash.
The threshold amount for daily futures variation margin
19.12.1 Exchange versus OTC
for institutional investors is often $1,000.
The situation for forwards, however, where no daily trueFutures are always traded on an exchange, whereas forup takes place in turn creates credit risk for forwards, but
wards always trade over-the-counter, or can simply be a
not so much for futures. Simply put, the risk of a forward
signed contract between two parties.
contract is that the supplier will be unable to deliver the
Thus:
referenced asset, or that the buyer will be unable to pay
for it on the delivery date or the date at which the opening
Futures are highly standardized, being exchange- party closes the contract.
traded, whereas forwards can be unique, being over- The margining of futures eliminates much of this credit
the-counter.
risk by forcing the holders to update daily to the price

102

CHAPTER 19. FUTURES CONTRACT

of an equivalent forward purchased that day. This means

that there will usually be very little additional money due
on the nal day to settle the futures contract: only the nal
days gain or loss, not the gain or loss over the life of the
contract.
In addition, the daily futures-settlement failure risk is
borne by an exchange, rather than an individual party,
further limiting credit risk in futures.
Example: Consider a futures contract with a $100 price:
Lets say that on day 50, a futures contract with a $100
delivery price (on the same underlying asset as the future)
costs $88. On day 51, that futures contract costs $90.
This means that the mark-to-market calculation would
requires the holder of one side of the future to pay $2 on
day 51 to track the changes of the forward price (post
$2 of margin). This money goes, via margin accounts,
to the holder of the other side of the future. That is, the
loss party wires cash to the other party.
A forward-holder, however, may pay nothing until settlement on the nal day, potentially building up a large balance; this may be reected in the mark by an allowance
for credit risk. So, except for tiny eects of convexity
bias (due to earning or paying interest on margin), futures
and forwards with equal delivery prices result in the same
total loss or gain, but holders of futures experience that
loss/gain in daily increments which track the forwards
daily price changes, while the forwards spot price converges to the settlement price. Thus, while under mark to
market accounting, for both
assets the gain or loss accrues over the holding
period; for a futures this gain or loss is realized
daily, while for a forward contract the gain or
loss remains unrealized until expiry.
Note that, due to the path dependence of funding, a futures contract is not, strictly speaking, a European-style
derivative: the total gain or loss of the trade depends not
only on the value of the underlying asset at expiry, but
also on the path of prices on the way. This dierence is
generally quite small though.
With an exchange-traded future, the clearing house interposes itself on every trade. Thus there is no risk of
counterparty default. The only risk is that the clearing
house defaults (e.g. become bankrupt), which is considered very unlikely.

19.13 Further reading

The National Futures Association (2006). An Educational Guide to Trading Futures and Options on
Futures. Chicago, Illinois.

19.14 See also

1256 Contract
Commodity Exchange Act
Freight derivatives
Fuel price risk management
Grain Futures Act
List of nance topics
List of traded commodities
London Metal Exchange
Oil-storage trade
Onion Futures Act
Prediction market
Seasonal spread trading
Single-stock futures
Cannon Trading

19.15 Notes
[1] http://chicagofed.org/webpages/publications/
understanding_derivatives/index.cfm
[2] Schaede, Ulrike (September 1989). Forwards and futures in tokugawa-period Japan: A new perspective on the
Djima rice market. Journal of Banking & Finance 13
(45): 487513. doi:10.1016/0378-4266(89)90028-9.
[3] timeline-of-achievements. CME Group. Retrieved August 5, 2010.
[4] Inter-Ministerial task force (chaired by Wajahat Habibullah) (May 2003). Convergence of Securities and Commodity Markets report. Forward Markets Commission
(India). Retrieved August 5, 2010.
[5] Cash settlement on Wikinvest
[6] http://www.cmegroup.com/product-codes-listing/
month-codes.html
[7] Dreibus, Tony C. Commodity Bubbles Caused by Speculators Need Intervention, UN Agency Says, Bloomberg,
June 5, 2011. Accessed July 2, 2011
[8] CME Group. CME Options on Futures: The Basics.
Retrieved 8 February 2011.
[9] Bjrk: Arbitrage theory in continuous time, Cambridge
university press, 2004

19.18. EXTERNAL LINKS

19.16 References
Redhead, Keith (1997). Financial Derivatives:
An Introduction to Futures, Forwards, Options and
Swaps. London: Prentice-Hall. ISBN 0-13241399-X.
Lioui, Abraham; Poncet, Patrice (2005). Dynamic
Asset Allocation with Forwards and Futures. New
York: Springer. ISBN 0-387-24107-8.
Valdez, Steven (2000). An Introduction To Global
Financial Markets (3rd ed.). Basingstoke, Hampshire: Macmillan Press. ISBN 0-333-76447-1.
Arditti, Fred D. (1996). Derivatives: A Comprehensive Resource for Options, Futures, Interest Rate
Swaps, and Mortgage Securities. Boston: Harvard
Business School Press. ISBN 0-87584-560-6.

19.17 U.S. Futures exchanges and

regulators
Chicago Board of Trade, now part of CME Group
Chicago Mercantile Exchange, now part of CME
Group
Commodity Futures Trading Commission
National Futures Association
Kansas City Board of Trade
New York Board of Trade now ICE
New York Mercantile Exchange, now part of CME
Group
Minneapolis Grain Exchange

19.18 External links

Understanding Derivatives: Markets and Infrastructure Federal Reserve Bank of Chicago, Financial
Markets Group
CME Group futures contracts product codes
Trading terms glossary
S&P500 Emini Futures Trading
Futures Data - free, historical data in CSV, Excel,
JSON or XML format
Futures Contract Specications and Tick Values at
ExcelTradingModels.com

103

Chapter 20

Loan
For other uses, see Loan (disambiguation).
In nance, a loan is a debt provided by one entity (organization or individual) to another entity at an interest rate,
and evidenced by a note which species, among other
things, the principal amount, interest rate, and date of
repayment. A loan entails the reallocation of the subject
asset(s) for a period of time, between the lender and the
borrower.

In some instances, a loan taken out to purchase a new or

used car may be secured by the car, in much the same
way as a mortgage is secured by housing. The duration
of the loan period is considerably shorter often corresponding to the useful life of the car. There are two types
of auto loans, direct and indirect. A direct auto loan is
where a bank gives the loan directly to a consumer. An
indirect auto loan is where a car dealership acts as an intermediary between the bank or nancial institution and
the consumer.

In a loan, the borrower initially receives or borrows an

amount of money, called the principal, from the lender,
and is obligated to pay back or repay an equal amount of 20.1.2 Unsecured
money to the lender at a later time.
Unsecured loans are monetary loans that are not secured
The loan is generally provided at a cost, referred to as
against the borrowers assets. These may be available
interest on the debt, which provides an incentive for the
from nancial institutions under many dierent guises or
lender to engage in the loan. In a legal loan, each of these
marketing packages:
obligations and restrictions is enforced by contract, which
can also place the borrower under additional restrictions
credit card debt
known as loan covenants. Although this article focuses
on monetary loans, in practice any material object might
personal loans
be lent.
bank overdrafts
Acting as a provider of loans is one of the principal tasks
for nancial institutions. For other institutions, issuing of
credit facilities or lines of credit
debt contracts such as bonds is a typical source of funding.
corporate bonds (may be secured or unsecured)
peer-to-peer lending

20.1 Types of loans

20.1.1

Secured

See also: Loan guarantee

The interest rates applicable to these dierent forms may

vary depending on the lender and the borrower. These
may or may not be regulated by law. In the United Kingdom, when applied to individuals, these may come under
the Consumer Credit Act 1974.

Interest rates on unsecured loans are nearly always higher

A secured loan is a loan in which the borrower pledges than for secured loans, because an unsecured lenders opsome asset (e.g. a car or property) as collateral.
tions for recourse against the borrower in the event of deA mortgage loan is a very common type of money, used fault are severely limited. An unsecured lender must sue
by many individuals to purchase things. In this arrange- the borrower, obtain a money judgment for breach of conment, the money is used to purchase the property. The tract, and then pursue execution of the judgment against
nancial institution, however, is given security a lien the borrowers unencumbered assets (that is, the ones not
on the title to the house until the mortgage is paid o in already pledged to secured lenders). In insolvency profull. If the borrower defaults on the loan, the bank would ceedings, secured lenders traditionally have priority over
have the legal right to repossess the house and sell it, to unsecured lenders when a court divides up the borrowers
recover sums owing to it.
assets. Thus, a higher interest rate reects the additional
104

20.3. LOAN PAYMENT

risk that in the event of insolvency, the debt may be uncollectible. Payment terms are usually stated on the invoice. These may specify that the buyer has a maximum
number of weeks in which to pay, and is sometimes offered a glass of wine if paid before the sell-by date. The
buyer could have already paid for the groceries or services
listed on the Stock Exchange. In the rental industry, an
invoice must include a specic reference to the duration
of the time being billed, so in addition to quantity, price
and discount the invoicing amount is also based on duration. Generally each line of a rental invoice will refer to
the actual hours, days, weeks, months, etc., being billed.
From the point of view of a seller, an invoice is a sales
invoice. From the point of view of a buyer, an invoice
is a purchase invoice. The invoice showcases the buyer
and seller, but the term invoice indicates money is owed
or owing.

20.1.3

Demand

Demand loans are short term loans [1] that are typically
in that they do not have xed dates for repayment and
carry a oating interest rate which varies according to the
prime lending rate. They can be called for repayment
by the lending institution at any time. Demand loans may
be unsecured or secured.

20.1.4

Subsidized

105
car loans, home equity lines of credit, credit cards,
installment loans and payday loans. The credit score of
the borrower is a major component in and underwriting
and interest rates (APR) of these loans. The monthly
payments of personal loans can be decreased by selecting
longer payment terms, but overall interest paid increases
as well. For car loans in the U.S., the average term was
about 60 months in 2009.

20.2.2 Commercial
Loans to businesses are similar to the above, but also include commercial mortgages and corporate bonds. Underwriting is not based upon credit score but rather credit
rating.

20.3 Loan payment

The most typical loan payment type is the fully amortizing
payment in which each monthly rate has the same value
over time.[4]
The xed monthly payment P for a loan of L for n months
and a monthly interest rate c is:

P =L

c (1 + c)n
(1 + c)n 1

For more information see Monthly loan or mortgage

A subsidized loan is a loan on which the interest is re- payments under Compound Interest
duced by an explicit or hidden subsidy. In the context
of college loans in the [United States], it refers to a loan
on which no interest is accrued while a student remains 20.4 Abuses in lending
enrolled in education.[2]
Predatory lending is one form of abuse in the granting of
loans. It usually involves granting a loan in order to put the
20.1.5 Concessional
borrower in a position that one can gain advantage over
A concessional loan, sometimes called a soft loan, is him or her. Where the moneylender is not authorized,
granted on terms substantially more generous than market they could be considered a loan shark.
loans either through below-market interest rates, by grace Usury is a dierent form of abuse, where the lender
periods or a combination of both.[3] Such loans may be charges excessive interest. In dierent time periods and
made by foreign governments to developing countries or cultures the acceptable interest rate has varied, from no
may be oered to employees of lending institutions as an interest at all to unlimited interest rates. Credit card
employee benet.
companies in some countries have been accused by consumer organizations of lending at usurious interest rates
and making money out of frivolous extra charges.[5]

20.2 Target markets

20.2.1

Personal

Abuses can also take place in the form of the customer

abusing the lender by not repaying the loan or with an
intent to defraud the lender.

See also: Credit_(nance) Consumer_credit

20.5 United States taxes

Loans can also be subcategorized according to whether
the debtor is an individual person (consumer) or a busi- Most of the basic rules governing how loans are handled
ness. Common personal loans include mortgage loans, for tax purposes in the United States are codied by both

106

CHAPTER 20. LOAN

Congress (the Internal Revenue Code) and the Treasury

Department (Treasury Regulations another set of rules
that interpret the Internal Revenue Code).[6]

Government debt
Bank, Fractional-reserve banking, Building society

1. A loan is not gross income to the borrower.[6] Since

the borrower has the obligation to repay the loan, the borrower has no accession to wealth.[6][7]

Annual percentage rate (a.k.a. Eective annual rate)

2. The lender may not deduct (from own gross income)

the amount of the loan.[8] The rationale here is that one
asset (the cash) has been converted into a dierent asset
(a promise of repayment).[6] Deductions are not typically
available when an outlay serves to create a new or dierent asset.[6]

Interest-only loan, Negative amortization, PIK loan

3. The amount paid to satisfy the loan obligation is not

deductible (from own gross income) by the borrower.[6]

Payday loan

4. Repayment of the loan is not gross income to the

lender.[6] In eect, the promise of repayment is converted
back to cash, with no accession to wealth by the lender.[6]
5. Interest paid to the lender is included in the lenders
gross income.[9] Interest paid represents compensation
for the use of the lenders money or property and thus represents prot or an accession to wealth to the lender.[10]
Interest income can be attributed to lenders even if the
lender doesnt charge a minimum amount of interest.[11]

Default (nance)

Leveraged loan
Loan guarantee
Loan sale

Refund Anticipation Loan

Student loan
Syndicated loan
Title loan
Legal nancing
Pay it forward

6. Interest paid to the lender may be deductible by the

US specic:
borrower.[6] In general, interest paid in connection with
the borrowers business activity is deductible, while inter FAFSA
est paid on personal loans are not deductible.[6] The major
[6]
exception here is interest paid on a home mortgage.
Federal student loan consolidation

20.5.1

Income from discharge of indebtedness

Although a loan does not start out as income to the borrower, it becomes income to the borrower if the borrower is discharged of indebtedness. [6][12] Thus, if a debt
is discharged, then the borrower essentially has received
income equal to the amount of the indebtedness. The
Internal Revenue Code lists Income from Discharge of
Indebtedness in Section 61(a)(12) as a source of gross
income.
Example: X owes Y $50,000. If Y discharges the indebtedness, then X no longer owes Y $50,000. For purposes
of calculating income, this is treated the same way as if
Y gave X $50,000.
For a more detailed description of the discharge of indebtedness, look at Section 108 (Cancellation of Debt
(COD) Income) of the Internal Revenue Code.[13][14]

20.6 See also

Consumer

George D. Sax and the Exchange National Bank of

Chicago - Innovation of instant loans
Staord loan
Student loan default

20.7 References
[1] Signoriello, Vincent J. (1991), Commercial Loan Practices
and Operations, ISBN 978-1-55520-134-0
[2] Subsidized Loan - Denition and Overview at About.com.
Retrieved 2011-12-21.
[3] Concessional Loans, Glossary of Statistical Terms,
oecd.org, Retrieved on 5/5/2013
[4] Guttentag, Jack (October 6, 2007). The Math Behind
Your Home Loan. The Washington Post. Retrieved May
11, 2010.
[5] Credit card holders pay Rs 6,000 cr 'extra' May 3, 2007

Finance, Personal nance, Settlement (nance)

Debt,

Federal Perkins Loan

debt,

Debt

consolidation,

[6] Samuel A. Donaldson, Federal Income Taxation of Individuals: Cases, Problems and Materials, 2nd Ed. 111
(2007).

20.7. REFERENCES

[7] See Commissioner v. Glenshaw Glass Co., 348 U.S. 426

(1955) (giving the three-prong standard for what is income for tax purposes: (1) accession to wealth, (2)
clearly realized, (3) over which the taxpayer has complete
dominion).
[8] Donaldson, at 111.
[9] Id.; 26 U.S.C. 61(a)(4)(2007).
[10] Id.
[11] Id. at 112.
[12] 26 U.S.C. 61(a)(12)(2007).
[13] Id.; 26 U.S.C. 108(2007).
[14] EUGENE A. LUDWIG AND PAUL A. VOLCKER,
16 November 2012 Banks Need Long-Term Rainy Day
Funds, Start reading from smallloansfor12months.co.uk

107

Chapter 21

Option (nance)
Stock option redirects here. For the employee incen- and traded through clearing houses on regulated options
tive, see Employee stock option.
exchanges, while other over-the-counter options are written as bilateral, customized contracts between a single
buyer and seller, one or both of which may be a dealer or
In nance, an option is a contract which gives the buyer
(the owner) the right, but not the obligation, to buy or market-maker. Options are part of a larger class of nancial instruments known as derivative products, or simply,
sell an underlying asset or instrument at a specied strike
[3][4]
price on or before a specied date. The seller has the cor- derivatives.
responding obligation to fulll the transaction that is to
sell or buy if the buyer (owner) exercises the option.
The buyer pays a premium to the seller for this right. An
option that conveys to the owner the right to buy something at a specic price is referred to as a call; an option
that conveys the right of the owner to sell something at a
specic price is referred to as a put. Both are commonly
traded, but for clarity, the call option is more frequently
discussed.

21.2 Contract specications

Every nancial option is a contract between two counterparties with the terms of the option specied in a
term sheet. Option contracts may be quite complicated;
however, at minimum, they usually contain the following
specications:[5]

21.1 Valuation overview

whether the option holder has the right to buy (a call

option) or the right to sell (a put option)

Options valuation is a topic of ongoing research in academic and practical nance. In basic terms, the value of
an option is commonly decomposed into two parts:

the quantity and class of the underlying asset(s) (e.g.,

100 shares of XYZ Co. B stock)

The rst part is the intrinsic value, which is dened

as the dierence between the market value of the
underlying and the strike price of the given option.

the strike price, also known as the exercise price,

which is the price at which the underlying transaction will occur upon exercise

The second part is the time value, which depends on a set of other factors which, through a
multi-variable, non-linear interrelationship, reect
the discounted expected value of that dierence at
expiration.

the expiration date, or expiry, which is the last date

the option can be exercised

Although options valuation has been studied at least since

the nineteenth century, the contemporary approach is
based on the BlackScholes model which was rst published in 1973.[1][2]

the settlement terms, for instance whether the writer

must deliver the actual asset on exercise, or may simply tender the equivalent cash amount
the terms by which the option is quoted in the market
to convert the quoted price into the actual premium
the total amount paid by the holder to the writer

Options contracts have been known for many centuries,

however both trading activity and academic interest increased when, as from 1973, options were issued with
standardized terms and traded through a guaranteed 21.3 Types
clearing house at the Chicago Board Options Exchange.
Today many options are created in a standardized form Options can be classied in a few ways.
108

21.4. VALUATION MODELS

21.3.1

According to the option rights

109

21.3.4 Other option types

Call options give you the rightbut not the Another important class of options, particularly in the
obligationto buy something at a specic price for U.S., are employee stock options, which are awarded by a
a specic time period.
company to their employees as a form of incentive compensation. Other types of options exist in many nan Put options give you the rightbut not the cial contracts, for example real estate options are often
obligationto sell something at a specic price for used to assemble large parcels of land, and prepayment
a specic time period.
options are usually included in mortgage loans. However,
many of the valuation and risk management principles apply across all nancial options.

21.3.2

According to the underlying assets

Equity option

21.3.5 Option styles

Bond option

Main article: Option style

Future option
Index option
Commodity option
Currency Option

21.3.3

According to the trading markets

Exchange-traded options (also called listed options) are a class of exchange-traded derivatives.
Exchange traded options have standardized contracts, and are settled through a clearing house with
fulllment guaranteed by the Options Clearing Corporation (OCC). Since the contracts are standardized, accurate pricing models are often available.
Exchange-traded options include:[6][7]
stock options,
bond options and other interest rate options
stock market index options or, simply, index
options and
options on futures contracts
callable bull/bear contract

Naming conventions are used to help identify properties

common to many dierent types of options. These include:
European option an option that may only be
exercised on expiration.
American option an option that may be exercised
on any trading day on or before expiry.
Bermudan option an option that may be exercised
only on specied dates on or before expiration.
Asian option an option whose payo is determined by the average underlying price over some
preset time period.
Barrier option any option with the general characteristic that the underlying securitys price must pass
a certain level or barrier before it can be exercised.
Binary option An all-or-nothing option that pays
the full amount if the underlying security meets the
dened condition on expiration otherwise it expires
worthless.
Exotic option any of a broad category of options
that may include complex nancial structures.[8]

Over-the-counter options (OTC options, also

Vanilla option any option that is not exotic.
called dealer options) are traded between two private parties, and are not listed on an exchange. The
terms of an OTC option are unrestricted and may be
individually tailored to meet any business need. In 21.4 Valuation models
general, at least one of the counterparties to an OTC
option is a well-capitalized institution. Option types
Main article: Valuation of options
commonly traded over the counter include:
1. interest rate options
2. currency cross rate options, and
3. options on swaps or swaptions.

The value of an option can be estimated using a variety of quantitative techniques based on the concept of
risk neutral pricing and using stochastic calculus. The
most basic model is the BlackScholes model. More sophisticated models are used to model the volatility smile.

110

CHAPTER 21. OPTION (FINANCE)

These models are implemented using a variety of numer- Since the market crash of 1987, it has been observed that
ical techniques.[9] In general, standard option valuation market implied volatility for options of lower strike prices
models depend on the following factors:
are typically higher than for higher strike prices, suggesting that volatility is stochastic, varying both for time and
The current market price of the underlying security, for the price level of the underlying security. Stochastic
volatility models have been developed including one de the strike price of the option, particularly in relation veloped by S.L. Heston.[13] One principal advantage of
to the current market price of the underlying (in the the Heston model is that it can be solved in closed-form,
money vs. out of the money),
while other stochastic volatility models require complex
numerical methods.[13]
the cost of holding a position in the underlying seSee also: SABR Volatility Model
curity, including interest and dividends,
the time to expiration together with any restrictions
on when exercise may occur, and
an estimate of the future volatility of the underlying
securitys price over the life of the option.

21.5 Model implementation

Further information: Valuation of options

More advanced models can require additional factors,
such as an estimate of how volatility changes over time
and for various underlying price levels, or the dynamics Once a valuation model has been chosen, there are a number of dierent techniques used to take the mathematical
of stochastic interest rates.
models to implement the models.
The following are some of the principal valuation techniques used in practice to evaluate option contracts.

21.5.1 Analytic techniques

21.4.1

BlackScholes

Main article: BlackScholes

Following early work by Louis Bachelier and later work
by Robert C. Merton, Fischer Black and Myron Scholes
made a major breakthrough by deriving a dierential
equation that must be satised by the price of any derivative dependent on a non-dividend-paying stock. By employing the technique of constructing a risk neutral portfolio that replicates the returns of holding an option,
Black and Scholes produced a closed-form solution for
a European options theoretical price.[10] At the same
time, the model generates hedge parameters necessary
for eective risk management of option holdings. While
the ideas behind the BlackScholes model were groundbreaking and eventually led to Scholes and Merton receiving the Swedish Central Bank's associated Prize for
Achievement in Economics (a.k.a., the Nobel Prize in
Economics),[11] the application of the model in actual options trading is clumsy because of the assumptions of continuous trading, constant volatility, and a constant interest
rate. Nevertheless, the BlackScholes model is still one
of the most important methods and foundations for the
existing nancial market in which the result is within the
reasonable range.[12]

21.4.2

Stochastic volatility models

Main article: Heston model

In some cases, one can take the mathematical model

and using analytical methods develop closed form solutions such as BlackScholes and the Black model. The
resulting solutions are readily computable, as are their
Greeks. Although the Roll-Geske-Whaley model applies to an American call with one dividend, for other
cases of American options, closed form solutions are not
available; approximations here include Barone-Adesi and
Whaley, Bjerksund and Stensland and others.

21.5.2 Binomial tree pricing model

Main article: Binomial options pricing model
Closely following the derivation of Black and Scholes,
John Cox, Stephen Ross and Mark Rubinstein developed the original version of the binomial options pricing model.[14] [15] It models the dynamics of the options
theoretical value for discrete time intervals over the options life. The model starts with a binomial tree of discrete future possible underlying stock prices. By constructing a riskless portfolio of an option and stock (as in
the BlackScholes model) a simple formula can be used
to nd the option price at each node in the tree. This
value can approximate the theoretical value produced by
Black Scholes, to the desired degree of precision. However, the binomial model is considered more accurate
than BlackScholes because it is more exible; e.g., discrete future dividend payments can be modeled correctly
at the proper forward time steps, and American options

21.6. RISKS
can be modeled as well as European ones. Binomial models are widely used by professional option traders. The
Trinomial tree is a similar model, allowing for an up,
down or stable path; although considered more accurate,
particularly when fewer time-steps are modelled, it is less
commonly used as its implementation is more complex.

21.5.3

Monte Carlo models

Main article: Monte Carlo methods for option pricing

For many classes of options, traditional valuation techniques are intractable because of the complexity of the
instrument. In these cases, a Monte Carlo approach may
often be useful. Rather than attempt to solve the dierential equations of motion that describe the options value in
relation to the underlying securitys price, a Monte Carlo
model uses simulation to generate random price paths of
the underlying asset, each of which results in a payo
for the option. The average of these payos can be discounted to yield an expectation value for the option.[16]
Note though, that despite its exibility, using simulation
for American styled options is somewhat more complex
than for lattice based models.

111

21.6 Risks
As with all securities, trading options entails the risk of
the options value changing over time. However, unlike
traditional securities, the return from holding an option
varies non-linearly with the value of the underlying and
other factors. Therefore, the risks associated with holding
options are more complicated to understand and predict.
In general, the change in the value of an option can be
derived from It's lemma as:

dC = dS +

dS 2
+ d + dt
2

where the Greeks , , and are the standard hedge

parameters calculated from an option valuation model,
such as BlackScholes, and dS , d and dt are unit
changes in the underlyings price, the underlyings volatility and time, respectively.

Thus, at any point in time, one can estimate the risk inherent in holding an option by calculating its hedge parameters and then estimating the expected change in the model
inputs, dS , d and dt , provided the changes in these
values are small. This technique can be used eectively
to understand and manage the risks associated with stan21.5.4 Finite dierence models
dard options. For instance, by osetting a holding in an
Main article: Finite dierence methods for option pricing option with the quantity of shares in the underlying,
a trader can form a delta neutral portfolio that is hedged
from loss for small changes in the underlyings price. The
The equations used to model the option are often ex- corresponding price sensitivity formula for this portfolio
pressed as partial dierential equations (see for example is:
BlackScholes equation). Once expressed in this form,
a nite dierence model can be derived, and the valuation obtained. A number of implementations of nite
dierence methods exist for option valuation, including:
dS 2
dS 2
+d+dt =
+d+dt
explicit nite dierence, implicit nite dierence and the d = dS +
2
2
Crank-Nicholson method. A trinomial tree option pricing model can be shown to be a simplied application of
the explicit nite dierence method. Although the nite 21.6.1 Example
dierence approach is mathematically sophisticated, it is
particularly useful where changes are assumed over time A call option expiring in 99 days on 100 shares of XYZ
in model inputs for example dividend yield, risk free stock is struck at $50, with XYZ currently trading at $48.
rate, or volatility, or some combination of these that With future realized volatility over the life of the option
are not tractable in closed form.
estimated at 25%, the theoretical value of the option is
$1.89. The hedge parameters , , , are (0.439,
0.0631, 9.6, and 0.022), respectively. Assume that on
the following day, XYZ stock rises to $48.5 and volatility
21.5.5 Other models
falls to 23.5%. We can calculate the estimated value of
Other numerical implementations which have been used the call option by applying the hedge parameters to the
to value options include nite element methods. Addi- new model inputs as:
tionally, various short rate models have been developed
for the valuation of interest rate derivatives, bond options
and swaptions. These, similarly, allow for closed-form,
(
)
lattice-based, and simulation-based modelling, with cor0.52
dC = (0.4390.5)+ 0.0631
+(9.60.015)+(0.0221) = 0.06
responding advantages and considerations.
2

112

CHAPTER 21. OPTION (FINANCE)

Under this scenario, the value of the option increases by

$0.0614 to $1.9514, realizing a prot of $6.14. Note that
for a delta neutral portfolio, whereby the trader had also
sold 44 shares of XYZ stock as a hedge, the net loss under
the same scenario would be ($15.86).

21.6.2

Pin risk

Main article: Pin risk

A special situation called pin risk can arise when the underlying closes at or very close to the options strike value
on the last day the option is traded prior to expiration.
The option writer (seller) may not know with certainty
whether or not the option will actually be exercised or be
allowed to expire worthless. Therefore, the option writer
may end up with a large, unwanted residual position in
the underlying when the markets open on the next trading
day after expiration, regardless of his or her best eorts
to avoid such a residual.

Over-the-counter options contracts are not traded on exchanges, but instead between two independent parties.
Ordinarily, at least one of the counterparties is a wellcapitalized institution. By avoiding an exchange, users
of OTC options can narrowly tailor the terms of the option contract to suit individual business requirements. In
addition, OTC option transactions generally do not need
to be advertised to the market and face little or no regulatory requirements. However, OTC counterparties must
establish credit lines with each other, and conform to each
others clearing and settlement procedures.
With few exceptions,[18] there are no secondary markets
for employee stock options. These must either be exercised by the original grantee or allowed to expire worthless.

21.8 The basic trades of traded

stock options (American style)

it
Pr
of

21.7 Trading

Pa

yo
ff

These trades are described from the point of view of a

speculator. If they are combined with other positions,
they can also be used in hedging. An option contract in
21.6.3 Counterparty risk
US markets usually represents 100 shares of the underlyA further, often ignored, risk in derivatives such as op- ing security.[19]
tions is counterparty risk. In an option contract this risk
is that the seller won't sell or buy the underlying asset as
agreed. The risk can be minimized by using a nancially 21.8.1 Long call
strong intermediary able to make good on the trade, but
in a major panic or crash the number of defaults can overwhelm even the strongest intermediaries.

Premium

Profit

The most common way to trade options is via standardized options contracts that are listed by various futures
and options exchanges. [17] Listings and prices are
tracked and can be looked up by ticker symbol. By pubShare Price at Maturity
Strike
Long Call
lishing continuous, live markets for option prices, an exPrice
change enables independent parties to engage in price discovery and execute transactions. As an intermediary to Payo from buying a call.
both sides of the transaction, the benets the exchange
provides to the transaction include:
A trader who believes that a stocks price will increase
might buy the right to purchase the stock (a call option) at
fulllment of the contract is backed by the credit of a xed price, rather than just purchase the stock itself. He
the exchange, which typically has the highest rating would have no obligation to buy the stock, only the right
to do so until the expiration date. If the stock price(spot
(AAA),
Price,S) at expiration is above the exercise price(X) by
more than the premium (price) paid P, he will prot i.e.
counterparties remain anonymous,
if S-X>P, the deal is protable. If the stock price at ex enforcement of market regulation to ensure fairness piration is lower than the exercise price, he will let the
call contract expire worthless, and only lose the amount
and transparency, and
of the premium. A trader might buy the option instead
maintenance of orderly markets, especially during of shares, because for the same amount of money, he can
fast trading conditions.
control (leverage) a much larger number of shares. For

21.9. OPTION STRATEGIES

113

example, if exercise price is 100, premium paid is 10, amount of the premium. If the stock price increases over
then a spot price of 100 to 110 is not protable. He would the exercise price by more than the amount of the preearn prot if the spot price is above 110.
mium, the short will lose money, with the potential loss
unlimited.

Long put

21.8.4 Short put

Premium

Profit
Share Price at Maturity

Strike
Price

Long Put

Payoff

Profit

Premium

fit

it
of

ff
yo
Pa

Pr

Pr
o

21.8.2

Share Price at Maturity

Strike
Price

Short Put

Payo from buying a put.

Payo from writing a put.

A trader who believes that a stocks price will decrease

can buy the right to sell the stock at a xed price (a put
option). He will be under no obligation to sell the stock,
but has the right to do so until the expiration date. If
the stock price at expiration is below the exercise price
by more than the premium paid, he will prot. If the
stock price at expiration is above the exercise price, he
will let the put contract expire worthless and only lose
the premium paid. In the whole story, the premium also
plays a major role as it enhances the break-even point.
For example, if exercise price is 100, premium paid is
10, then a spot price of 100 to 90 is not protable. He
would earn prot if the spot price is below 90.

A trader who believes that a stock price will increase can

sell the stock or instead sell, or write, a put. The trader
selling a put has an obligation to buy the stock from the
put buyer, at the buyers option. If the stock price at expiration is above the exercise price, the short put position
will make a prot in the amount of the premium. If the
stock price at expiration is below the exercise price by
more than the amount of the premium, the trader will
lose money, with the potential loss being up to the full
value of the stock. A benchmark index for the performance of a cash-secured short put option position is the
CBOE S&P 500 PutWrite Index (ticker PUT).

21.8.3

21.9 Option strategies

Short call

Main article: Option strategies

Combining any of the four basic kinds of option trades
Premium

fit

o
Pr

Payoff

Payo from writing a call.

Strike
Price

Short Call

Profit

Premium

Profit

Share Price at Maturity

Payoff

Profit

Share Price at Maturity

Long Butterfly

A trader who believes that a stock price will decrease can

sell the stock short or instead sell, or write, a call. The Payos from buying a buttery spread.
trader selling a call has an obligation to sell the stock to
the call buyer, at the buyers option. If the stock price (possibly with dierent exercise prices and maturities)
decreases, the short call position will make a prot in the and the two basic kinds of stock trades (long and short)

114

CHAPTER 21. OPTION (FINANCE)

and the trader will get a xed prot. If the stock price
falls, the call will not be exercised, and any loss incurred
to the trader will be partially oset by the premium received from selling the call. Overall, the payos match
the payos from selling a put. This relationship is known
as put-call parity and oers insights for nancial theory.
A benchmark index for the performance of a buy-write
strategy is the CBOE S&P 500 BuyWrite Index (ticker
symbol BXM).

Profit

Pa
yo

ff

Pr

of

it

Premium

Share Price at Maturity

Short Straddle

Payos from selling a straddle.

21.10 Historical uses of options

Contracts similar to options have been used since ancient
times.[20] In the real estate market, call options have long
been used to assemble large parcels of land from separate owners; e.g., a developer pays for the right to buy
several adjacent plots, but is not obligated to buy these
plots and might not unless he can buy all the plots in the
entire parcel. Film or theatrical producers often buy the
right but not the obligation to dramatize a specic
book or script. Lines of credit give the potential borrower
the right but not the obligation to borrow within a
specied time period.

Many choices, or embedded options, have traditionally

been included in bond contracts. For example many
bonds are convertible into common stock at the buyers
Payos from a covered call.
option, or may be called (bought back) at specied prices
at the issuers option. Mortgage borrowers have long had
allows a variety of options strategies. Simple strategies the option to repay the loan early, which corresponds to a
usually combine only a few trades, while more compli- callable bond option.
cated strategies can combine several.
In London, puts and refusals (calls) rst became wellStrategies are often used to engineer a particular risk prole to movements in the underlying security. For example, buying a buttery spread (long one X1 call, short two
X2 calls, and long one X3 call) allows a trader to prot if
the stock price on the expiration date is near the middle
exercise price, X2, and does not expose the trader to a
large loss.

known trading instruments in the 1690s during the reign

of William and Mary.[21]

Privileges were options sold over the counter in nineteenth

century America, with both puts and calls on shares offered by specialized dealers. Their exercise price was
xed at a rounded-o market price on the day or week
that the option was bought, and the expiry date was genAn Iron condor is a strategy that is similar to a buttery erally three months after purchase. They were not traded
spread, but with dierent strikes for the short options in secondary markets.
oering a larger likelihood of prot but with a lower net Supposedly the rst option buyer in the world was the
credit compared to the buttery spread.
ancient Greek mathematician and philosopher Thales of
Miletus. On a certain occasion, it was predicted that the
seasons olive harvest would be larger than usual, and during the o-season he acquired the right to use a number
of olive presses the following spring. When spring came
and the olive harvest was larger than expected he exerSimilar to the straddle is the strangle which is also concised his options and then rented the presses out at much
structed by a call and a put, but whose strikes are dierhigher price than he paid for his 'option'.[22][23]
ent, reducing the net debit of the trade, but also reducing
the risk of loss in the trade.
Selling a straddle (selling both a put and a call at the same
exercise price) would give a trader a greater prot than a
buttery if the nal stock price is near the exercise price,
but might result in a large loss.

One well-known strategy is the covered call, in which

a trader buys a stock (or holds a previously-purchased
long stock position), and sells a call. If the stock price
rises above the exercise price, the call will be exercised

21.11 See also

American Stock Exchange

21.13. FURTHER READING

Chicago Board Options Exchange
Eurex
Euronext.lie
International Securities Exchange
NYSE Arca
Philadelphia Stock Exchange
LEAPS (nance)
Real options analysis
PnL Explained
Pin risk (options)

21.12 References
[1] Benhamou, Eric. Options pre-Black Scholes.
[2] Black, Fischer; Scholes, Myron (1973). The Pricing of
Options and Corporate Liabilities. Journal of Political
Economy 81 (3): 637654. doi:10.1086/260062. JSTOR
1831029.

115

[13] Jim Gatheral (2006), The Volatility Surface, A Practitioners Guide, Wiley Finance, ISBN 978-0-471-79251-2
[14] Cox JC, Ross SA and Rubinstein M. 1979. Options pricing: a simplied approach, Journal of Financial Economics, 7:229263.
[15] Cox, John C.; Rubinstein, Mark (1985), Options Markets,
Prentice-Hall, Chapter 5
[16] Crack, Timothy Falcon (2004), Basic BlackScholes: Option Pricing and Trading (1st ed.), pp. 91102, ISBN 09700552-2-6
[17] Harris, Larry (2003), Trading and Exchanges, Oxford
University Press, pp.2627
[18] Elinor Mills (December 12, 2006), Google unveils unorthodox stock option auction, CNet, retrieved June 19,
2007
[19] invest-faq or Law & Valuation for typical size of option
contract
[20] Abraham, Stephan (May 13, 2010). History of Financial
Options - Investopedia. Investopedia. Retrieved Jun 2,
2014.
[21] Smith, B. Mark (2003), History of the Global Stock Market from Ancient Rome to Silicon Valley, University of
Chicago Press, p. 20, ISBN 0-226-76404-4

[3] Brealey, Richard A.; Myers, Stewart (2003), Principles of

Corporate Finance (7th ed.), McGraw-Hill, Chapter 20

[22] Mattias Sander. Bondessons Representation of the Variance Gamma Model and Monte Carlo Option Pricing.
Lunds Tekniska Hgskola 2008

[4] Hull, John C. (2005), Options, Futures and Other Derivatives (excerpt by Fan Zhang) (6th ed.), Pg 6: Prentice-Hall,
ISBN 0-13-149908-4

[23] Aristotle. Politics.

[5] Characteristics and Risks of Standardized Options (PDF),

Options Clearing Corporation, retrieved June 21, 2007

21.13 Further reading

[6] Trade CME Products, Chicago Mercantile Exchange, retrieved June 21, 2007
[7] ISE Traded Products, International Securities Exchange,
archived from the original on May 11, 2007, retrieved
June 21, 2007
[8] Fabozzi, Frank J. (2002), The Handbook of Financial Instruments (Page. 471) (1st ed.), New Jersey: John Wiley
and Sons Inc, ISBN 0-471-22092-2
[9] Reilly, Frank K.; Brown, Keith C. (2003), Investment
Analysis and Portfolio Management (7th ed.), Thomson
Southwestern, Chapter 23
[10] Black, Fischer and Myron S. Scholes. The Pricing of Options and Corporate Liabilities, Journal of Political Economy, 81 (3), 637654 (1973).
[11] Das, Satyajit (2006), Traders, Guns & Money: Knowns
and unknowns in the dazzling world of derivatives (6th
ed.), London: Prentice-Hall, Chapter 1 'Financial WMDs
derivatives demagoguery,' p.22, ISBN 978-0-27370474-4
[12] Hull, John C. (2005), Options, Futures and Other Derivatives (6th ed.), Prentice-Hall, ISBN 0-13-149908-4

Fischer Black and Myron S. Scholes. The Pricing of Options and Corporate Liabilities, Journal
of Political Economy, 81 (3), 637654 (1973).
Feldman, Barry and Dhuv Roy. Passive OptionsBased Investment Strategies: The Case of the
CBOE S&P 500 BuyWrite Index. The Journal of
Investing, (Summer 2005).
Kleinert, Hagen, Path Integrals in Quantum Mechanics, Statistics, Polymer Physics, and Financial
Markets, 4th edition, World Scientic (Singapore,
2004); Paperback ISBN 981-238-107-4 (also available online: PDF-les)
Hill, Joanne, Venkatesh Balasubramanian, Krag
(Buzz) Gregory, and Ingrid Tierens. Finding Alpha via Covered Index Writing. Financial Analysts
Journal. (Sept.-Oct. 2006). pp. 2946.
Millman, Gregory J. (2008), Futures and Options
Markets, in David R. Henderson (ed.), Concise
Encyclopedia of Economics (2nd ed.), Indianapolis: Library of Economics and Liberty, ISBN 9780865976658, OCLC 237794267

116
Moran, Matthew. Risk-adjusted Performance for
Derivatives-based Indexes Tools to Help Stabilize
Returns. The Journal of Indexes. (Fourth Quarter,
2002) pp. 34 40.
Reilly, Frank and Keith C. Brown, Investment
Analysis and Portfolio Management, 7th edition,
Thompson Southwestern, 2003, pp. 9945.
Schneeweis, Thomas, and Richard Spurgin. The
Benets of Index Option-Based Strategies for Institutional Portfolios The Journal of Alternative Investments, (Spring 2001), pp. 44 52.
Whaley, Robert. Risk and Return of the CBOE
BuyWrite Monthly Index The Journal of Derivatives, (Winter 2002), pp. 35 42.
Bloss, Michael; Ernst, Dietmar; Hcker Joachim
(2008): Derivatives An authoritative guide to
derivatives for nancial intermediaries and investors
Oldenbourg Verlag Mnchen ISBN 978-3-48658632-9
Espen Gaarder Haug & Nassim Nicholas Taleb
(2008): Why We Have Never Used the Black
ScholesMerton Option Pricing Formula

CHAPTER 21. OPTION (FINANCE)

Chapter 22

Call option
This article is about nancial options. For call options in
general, see Option (law).

1. Strike price: this is the price at which you can buy

the stock (if you have bought a call option) or the
price at which you must sell your stock (if you have
sold a call option).

A call option, often simply labeled a call, is a nancial contract between two parties, the buyer and the seller
2. Expiry date: this is the date on which the option
of this type of option.[1] The buyer of the call option has
expires, or becomes worthless, if the buyer doesn't
the right, but not the obligation to buy an agreed quanexercise it.
tity of a particular commodity or nancial instrument (the
3. Premium: this is the price you pay when you buy
underlying) from the seller of the option at a certain time
an option and the price you receive when you sell an
(the expiration date) for a certain price (the strike price).
option.
The seller (or writer) is obligated to sell the commodity or nancial instrument to the buyer if the buyer so
decides. The buyer pays a fee (called a premium) for this The initial transaction in this context (buying/selling a call
right.
option) is not the supplying of a physical or nancial asset
When you buy a call option, you are buying the right to (the underlying instrument). Rather it is the granting of
buy a stock at the strike price, regardless of the stock price the right to buy the underlying asset, in exchange for a fee
in the future before the expiration date. Conversely, you the option price or premium.
can short or write the call option, giving the buyer the
right to buy that stock from you anytime before the option
expires. To compensate you for that risk taken, the buyer
pays you a premium, also known as the price of the call.
The seller of the call is said to have shorted the call option,
and keeps the premium (the amount the buyer pays to buy
the option) whether or not the buyer ever exercises the
option.
For example, if a stock trades at $50 right now and you
buy its call option with a $50 strike price, you have the
right to purchase that stock for $50 regardless of the current stock price as long as it has not expired. Even if the
stock rises to $100, you still have the right to buy that
stock for $50 as long as the call option has not expired.
Since the payo of purchased call options increases as the
stock price rises, buying call options is considered bullish.
When the price of the underlying instrument surpasses
the strike price, the option is said to be "in the money".
On the other hand, If the stock falls to below $50, the
buyer will never exercise the option, since he would have
to pay $50 per share when he can buy the same stock for
less. If this occurs, the option expires worthless and the
option seller keeps the premium as prot. Since the payo for sold (or written) call options increases as the stock
price falls, selling call options is considered bearish.
All call options have the following three characteristics:

Exact specications may dier depending on option style.

A European call option allows the holder to exercise the
option (i.e., to buy) only on the option expiration date. An
American call option allows exercise at any time during
the life of the option.
Call options can be purchased on many nancial instruments other than stock in a corporation. Options can be
purchased on futures or interest rates, for example (see
interest rate cap), and on commodities like gold or crude
oil. A tradeable call option should not be confused with
either Incentive stock options or with a warrant. An incentive stock option, the option to buy stock in a particular company, is a right granted by a corporation to a particular person (typically executives) to purchase treasury
stock. When an incentive stock option is exercised, new
shares are issued. Incentive options are not traded on the
open market. In contrast, when a call option is exercised,
the underlying asset is transferred from one owner to another.

22.1 Example of a call option on a

stock
An investor typically 'buys a call' when he expects the
price of the underlying instrument will go above the calls

117

CHAPTER 22. CALL OPTION

of
it
Pr

Pa

yo
ff

118

Profit

Premium

Share Price at Maturity

Long Call

Strike
Price

Prots from buying a call.

Profit

it
of

Pr
Payoff

Premium

Share Price at Maturity

Strike
Price

Short Call

Prots from writing a call.

'strike price,' hopefully signicantly so, before the call

expires. The investor pays a non-refundable premium
for the legal right to exercise the call at the strike price,
meaning he can purchase the underlying instrument at the
strike price. Typically, if the price of the underlying instrument has surpassed the strike price, the buyer pays
the strike price to actually purchase the underlying instrument, and then sells the instrument and pockets the
prot. Of course, the investor can also hold onto the underlying instrument, if he feels it will continue to climb
even higher.

of ABC Corp from 'Terence R.,' who is the call

writer/seller. The strike price for the contract is $50
per share, and Greg pays a premium up front of $5
per share, or $500 total. If ABC Corp does not go
up, and Greg does not exercise the contract, then
Greg has lost $500.
ABC Corp stock subsequently goes up to $60 per
share before the contract expires. Greg exercises the
call option by buying 100 shares of ABC from Terence for a total of $5,000. Greg then sells the stock
on the market at market price for a total of $6,000.
Greg has paid a $500 contract premium plus a stock
cost of $5,000, for a total of $5,500. He has earned
back $6,000, yielding a net prot of $500.
If, however, the ABC stock price drops to $40 per
share by the time the contract expires, Greg will not
exercise the option (i.e., Greg will not buy a stock at
$50 per share from Terence when he can buy it on
the open market at $40 per share). Greg loses his
premium, a total of $500. Terence, however, keeps
the premium with no other out-of-pocket expenses,
making a prot of $500.
The break-even stock price for Greg is $55 per
share, i.e., the $50 per share for the call option price
plus the $5 per share premium he paid for the option. If the stock reaches $55 per share when the
option expires, Greg can recover his investment by
exercising the option and buying 100 shares of ABC
Corp stock from Terence at $50 per share, and then
immediately selling those shares at the market price
of $55. His total costs are then the $5 per share premium for the call option, plus $50 per share to buy
the shares from Greg, for a total of $5,500. His total
earnings are $55 per share sold, or $5,500 for 100
shares, yielding him a net $0. (Note that this does
not take into account broker fees or other transaction
costs.)

An investor typically 'writes a call' when he expects the

price of the underlying instrument to stay below the calls
strike price. The writer (seller) receives the premium up
front as his or her prot. However, if the call buyer de- 22.2 Example of valuing a stock
cides to exercise his option to buy, then the writer has the
option
obligation to sell the underlying instrument at the strike
price. Often the writer of the call does not actually own
A company issues an option for the right to buy their
the underlying instrument, and must purchase it on the
stock. An investor buys this option and hopes the stock
open market in order to be able to sell it to the buyer of
goes higher so their option will increase in value.
the call. The seller of the call will lose the dierence between his purchase price of the underlying instrument and
the strike price. This risk can be huge if the underlying
Theoretical option price = (current price + theinstrument skyrockets unexpectedly in price.
oretical time/volatility premium) strike price
The current price of ABC Corp stock is $45 per Lets look at an actual example, PNC options for Janshare, and investor 'Greg R.' expects it will go up sig- uary 2012: http://finance.yahoo.com/q/op?s=PNC&m=
nicantly. Greg buys a call contract for 100 shares 2012-01.

22.3. VALUE OF A CALL

Strike price the price the investor can buy the stock
at through the option.

119

22.3 Value of a call

Symbol like a stock symbol but for options it in- This example leads to the following formal reasoning. Fix
O an underlying nancial instrument. Let be a call
corporates the date.
option for this instrument, purchased at time 0 , expiring
Last like the last stock price, it is the last price at time T R+ , with exercise (strike) price K R ;
traded between two parties.
and let S : [0, T ] R be the price of the underlying
instrument.
Change how much it went up and down today.
Assume the owner of the option , wants to make no
Bid what a person is bidding for the option.
loss, and does not want to actually possess the underlying
instrument, O . Then either (i) the person will exercise
Ask what someone wants to sell the option for.
the option and purchase O , and then immediately sell it;
Vol how many options traded today.
or (ii) the person will not exercise the option (which subsequently becomes worthless). In (i), the pay-o would
Open Int how many options are available, i.e. the
be K + ST ; in (ii) the pay-o would be 0 . So if
option oat.
ST K 0 (i) or (ii) occurs; if ST K < 0 then (ii)
occurs.
Notes:
Hence the pay-o, i.e. the value of the call option at ex1. The bid/ask price is more relevant in ascertaining piry, is
the value of the option than the last price since options are not frequently traded. Meaning the value
is usually the Ask/Bid Price.
+
2. An option usually covers 100 shares. So the bid/ask which is also written (ST K) 0 or (ST K) .
price is multiplied by 100 to get the total cost.

Lets say we bought 3 PNC strike $45, January 2012 call 22.4 Price of options
options in August for $11.75. That means we paid $3,525
(11.75 * 3 options for 100 shares each) for the right to buy Option values vary with the value of the underlying in300 (3*100) PNC shares for $45 per share between now strument over time. The price of the call contract must
and January 2012.
reect the likelihood or chance of the call nishing
The stock at that time traded at $50.65 meaning the the- in-the-money. The call contract price generally will be
oretical call premium was $6.1 as shown by our formula: higher when the contract has more time to expire (except
(current price + theoretical time/volatility premium) in cases when a signicant dividend is present) and when
the underlying nancial instrument shows more volatility.
strike price, (50.65 + 6.1 45 = 11.75).
Determining this value is one of the central functions of
Today the stock is trading at $64 making the call option
nancial mathematics. The most common method used
worth $19.45 with a theoretical call premium now of 45
is the BlackScholes formula. Importantly, the Blackcents above its in-the-money intrinsic value $19 (the $64
Scholes formula provides an estimate of the price of
market price minus the call option $45 strike price). The
European-style options.[2]
call premium tends to go down as the option gets closer
to the call date. And it goes down as the option price rises Whatever the formula used, the buyer and seller must
relative to the stock price, i.e. the 19.45 the option is now agree on the initial value (the premium or price of the
worth is 30% (19.45/ $64) of the price per PNC shares. call contract), otherwise the exchange (buy/sell) of the
In August it was 23% (11.75/$50.65). The lower percent- call will not take place.
age of the options price is based on the stocks price, the Adjustment to Call Option: When a call option is in-themore upside the investor has, therefore the investor will money i.e. when the buyer is making prot, she has many
pay a premium for it.
options. Some of them are as follows:
This option could be used to buy 300 PNC shares today at
$45, it can be sold on the option market for $19.45 or for
$5,835 (19.45 * 3 options for 100 shares each). Or it can
be held as the investor bets that the price will continue to
increase. The investor must make a decision by January
2012: he will either have to sell the option or buy the 300
shares. If the stock price drops below the strike price on
this date the investor will not exercise his right since it
will be worthless.

1. She can sell the call and book her prot

2. If she still feels that there is scope of making more
money she can continue to hold the position.
3. If she is interested in holding the position but at the
same time would like to have some protection,she
can buy a protective put of the strike that suits her.

120
4. She can sell a call of higher strike price and convert
the position into call spread and thus limiting her
loss if the market reverses.
Similarly if the buyer is making loss on her position i.e.
the call is out-of-the-money, she can make several adjustments to limit her loss or even make some prot.

22.5 Options
Binary option
Bond option
Credit default option
Exotic option
Foreign exchange option
Interest rate cap and oor
Options on futures
Stock option
Swaption

22.6 See also

CHAPTER 22. CALL OPTION

Chapter 23

Exotic option
In nance, an exotic option is an option which has features making it more complex than commonly traded
vanilla options. Like the more general exotic derivatives they may have several triggers relating to determination of payo. An exotic option may also include nonstandard underlying instrument, developed for a particular client or for a particular market. Exotic options are
more complex than options that trade on an exchange,
and are generally traded over the counter (OTC).

23.3 Features
A straight call or put option, either American or
European, would be considered non-exotic or vanilla option. An exotic option could have one or more of the
following features:
The payo at maturity depends not just on the value
of the underlying instrument at maturity, but at its
value at several times during the contracts life (it
could be an Asian option depending on some average, a lookback option depending on the maximum
or minimum, a barrier option which ceases to exist if a certain level is reached or not reached by the
underlying, a digital option, peroni options, range
options, spread options, etc.)

23.1 Etymology
The term exotic option was popularized by Mark Rubinstein's 1990 working paper (published 1992, with Eric
Reiner) Exotic Options, with the term based either on
exotic wagers in horse racing, or due to the use of international terms such as Asian option, suggesting the
exotic Orient.[1][2]

It could depend on more than one index such as in

basket options, outperformance options, Himalaya
options, peroni options, or other mountain range options

Journalist Brian Palmer used the successful $1 bet on

the superfecta in the 2010 Kentucky Derby that paid
The manner of settlement may vary depending on
a whopping $101,284.60 as an example of the controthe moneyness of the option at expiry, such as a cash
versial high-risk, high-payout exotic bets that were obor share option.
served by track-watchers since the 1970s in his article
about why we use the term exotic for certain types of There could be callability and putability rights.
nancial instrument. Palmer compared these horse racing
bets to the controversial emerging exotic nancial instru It could involve foreign exchange rates in various
ments that concerned then-chairman of the Federal Reways, such as a quanto or composite option.
serve Paul Volcker in 1980. He argued that just as the
exotic wagers survived the media controversy so will the
Even products traded actively in the market can have
exotic options[1]
the characteristics of exotic options, such as convertible
In 1987, Bankers Trust Mark Standish and David bonds, whose valuation can depend on the price and
Spaughton, were in Tokyo on business when they de- volatility of the underlying equity, the credit rating, the
veloped the rst commercially used pricing formula for level and volatility of interest rates, and the correlations
options linked to the average price of crude oil. They between these factors.
called this exotic option, the Asian option, because they
were in Asia.[3]

23.4 Barriers
23.2 Development

Barriers in exotic option are determined by the underlying price and ability of the stock to be active or inactive
Exotic options are often created by nancial engineers during the trade period, for instance up-and out option
and rely on complex models to price them.
has a high chance of being inactive should the underlying
121

122
price go beyond the marked barrier. Down-and-in-option
is very likely to be active should the underlying prices of
the stock go below the marked barrier. Up-and-in option
is very likely to be active should the underlying price go
beyond the marked barrier.[4]

23.5 Examples
Barrier
Cash or Share
Cliquet
Compound option
Constant proportion portfolio insurance
Digital/Binary option

CHAPTER 23. EXOTIC OPTION

Banks, Erik; Paul Siegel (2007). The Options Applications Handbook: Hedging and Speculating Techniques for Professional Investors. New York: Wiley.
ISBN 0-07-145315-6.
Kuznetsov, Alex (2006). The Complete Guide to
Capital Markets for Quantitative Professionals. New
York: McGraw-Hill. ISBN 0-07-146829-3.
Kyprianou, Andreas E.; Wim Schoutens; Paul
Wilmott (2005). Exotic Option Pricing and Advanced Levy Models. Hoboken, NJ: John Wiley &
Sons. ISBN 0-470-01684-1.
Rebonato, Riccardo (1998). Interest-rate Option
Models: Understanding, Analysing and Using Models for Exotic Interest-rate Options. New York:
McGraw-Hill. ISBN 0-471-97958-9.

23.8 External links

Lookback
Rainbow option
Timer call
Unit Contingent Options
Variance swap
Bermudan options

23.6 References
[1] Brian Palmer (14 July 2010). Why Do We Call Financial
Instruments Exotic"? Because some of them are from
Japan. Slate. Retrieved 9 September 2013. The article
quotes then-chairman of the Federal Reserve Paul Volcker
in 1908 when he argued, This is hardly the time to search
out for new exotic lending areas or to nance speculative
or purely nancial activities that have little to do with the
performance of the American economy.
[2] Rubinstein, Mark; Reiner, Eric (1995). Exotic Options.
Working Paper, University of California at Berkeley.
[3] William Falloon; David Turner, eds. (1999). The evolution of a market. Managing Energy Price Risk. London:
Risk Books.
[4] Exotic And Double Digital Options. BOB. May 18,
2013. Retrieved 11 July 2013.

23.7 Further reading

Haug, Espen Gaarder (2007). The Complete Guide
to Option Pricing Formulas. New York: McGrawHill. ISBN 0-07-147734-9.

A paper on exotic options

Overview of exotic options

Chapter 24

Put option
In nance, a put or put option is a stock market device
which gives the owner of the put, the right, but not the
obligation, to sell an asset (the underlying), at a specied price (the strike), by a predetermined date (the expiry or maturity) to a given party (the seller of the put).
Put options are most commonly used in the stock market
to protect against the decline of the price of a stock below
a specied price. If the price of the stock declines below
the specied price of the put option, the owner/buyer of
the put has the right, but not the obligation, to sell the asset at the specied price, while the seller of the put, has
the obligation to purchase the asset at the strike price if
the owner uses the right to do so (the owner/buyer is said
to exercise the put or put option). In this way the buyer of
the put will receive at least the strike price specied, even
if the asset is currently worthless.
If the strike is K, and at time t the value of the underlying
is S(t), then in an American option the buyer can exercise
the put for a payout of K-S(t) any time up until the options
maturity time T. The put yields a positive return only if
the security price falls below the strike when the option
is exercised. A European option can only be exercised at
time T rather than any time up until T, and a Bermudan
option can be exercised only on specic dates listed in the
terms of the contract. If the option is not exercised by
maturity, it expires worthless. (Note that the buyer will
not exercise the option at an allowable date if the price of
the underlying is greater than K.)

24.1 Instrument models

The terms for exercising the options right to sell it dier
depending on option style. A European put option allows
the holder to exercise the put option for a short period
of time right before expiration, while an American put
option allows exercise at any time before expiration.
The most widely-traded put options are on
stocks/equities, but they are traded on many other
instruments such as interest rates (see interest rate oor)
or commodities.
The put buyer either believes that the underlying assets
price will fall by the exercise date or hopes to protect a
long position in it. The advantage of buying a put over
short selling the asset is that the option owners risk of
loss is limited to the premium paid for it, whereas the
asset short sellers risk of loss is unlimited (its price can
rise greatly, in fact, in theory it can rise innitely, and such
a rise is the short sellers loss). The put buyers prospect
(risk) of gain is limited to the options strike price less the
underlyings spot price and the premium/fee paid for it.

The put writer believes that the underlying securitys price

will rise, not fall. The writer sells the put to collect the
premium. The put writers total potential loss is limited
to the puts strike price less the spot and premium already
received. Puts can be used also to limit the writers portThe most obvious use of a put is as a type of insurance. In folio risk and may be part of an option spread.
the protective put strategy, the investor buys enough puts The put buyer/owner is short on the underlying asset of
to cover his holdings of the underlying so that if a drastic the put, but long on the put option itself. That is, the buyer
downward movement of the underlyings price occurs, he wants the value of the put option to increase by a decline
has the option to sell the holdings at the strike price. An- in the price of the underlying asset below the strike price.
other use is for speculation: an investor can take a short The writer (seller) of a put is long on the underlying asset
position in the underlying stock without trading in it di- and short on the put option itself. That is, the seller wants
rectly.
the option to become worthless by an increase in the price
Puts may also be combined with other derivatives as part of the underlying asset above the strike price. Generally,
of more complex investment strategies, and in particular, a put option that is purchased is referred to as a long put
may be useful for hedging. Note that by put-call parity, a and a put option that is sold is referred to as a short put.
European put can be replaced by buying the appropriate A naked put, also called an uncovered put, is a put option
call option and selling an appropriate forward contract.
whose writer (the seller) does not have a position in the
The put was invented by Wall Street Guru, Stephen A. underlying stock or other instrument. This strategy is best
used by investors who want to accumulate a position in
Markowitz at an unknown date.
the underlying stock, but only if the price is low enough.
123

124

CHAPTER 24. PUT OPTION

The sellers potential loss on a naked put can be substantial. If the stock falls all the way to zero (bankruptcy), his
loss is equal to the strike price (at which he must buy the
stock to cover the option) minus the premium received.
The potential upside is the premium received when selling the option: if the stock price is above the strike price
at expiration, the option seller keeps the premium, and
the option expires worthless. During the options lifetime, if the stock moves lower, the options premium may
increase (depending on how far the stock falls and how
much time passes). If it does, it becomes more costly to
close the position (repurchase the put, sold earlier), resulting in a loss. If the stock price completely collapses
before the put position is closed, the put writer potentially can face catastrophic loss. In order to protect the
put buyer from default, the put writer is required to post
margin. The put buyer does not need to post margin because the buyer would not exercise the option if it had a
negative payo.

24.2 Example of a put option on a

stock

of

ff

yo

Pa
Pr
it

Profit

Premium

Share Price at Maturity

Payo from buying a put.

Buying a put

Strike
Price

Long Put

Premium

Payoff

Profit

If the underlying stocks market price is below the options strike price when expiration arrives, the option
owner (buyer) can exercise the put option, forcing the
writer to buy the underlying stock at the strike price. That
allows the exerciser (buyer) to prot from the dierence
between the stocks market price and the options strike
price. But if the stocks market price is above the options strike price at the end of expiration day, the option
expires worthless, and the owners loss is limited to the
premium (fee) paid for it (the writers prot).

Pr
of
it

If the buyer fails to exercise the options, then the writer

keeps the option premium as a gift for playing the game.

Share Price at Maturity

Strike
Price

Short Put

Payo from writing a put.

before it expires. The buyer has the right to sell the stock
at the strike price.
Writing a put
The writer receives a premium from the buyer. If the
buyer exercises his option, the writer will buy the stock at
the strike price. If the buyer does not exercise his option,
the writers prot is the premium.
Trader A (Put Buyer) purchases a put contract to
sell 100 shares of XYZ Corp. to Trader B (Put
Writer) for $50 per share. The current price is
$50 per share, and Trader A pays a premium of $5
per share. If the price of XYZ stock falls to $40 a
share right before expiration, then Trader A can exercise the put by buying 100 shares for $4,000 from
the stock market, then selling them to Trader B for
$5,000.
Trader As total earnings (S) can be calculated
at $500. The sale of the 100 shares of stock at
a strike price of $50 to Trader B = $5,000 (P).
The purchase of 100 shares of stock at $40 =
$4,000 (Q). The put option premium paid to
trader B for buying the contract of 100 shares
at $5 per share, excluding commissions = $500
(R). Thus S = ( P - Q ) - R = ($5,000 - $4,000
) - $500 = $500.
If, however, the share price never drops below the
strike price (in this case, $50), then Trader A would
not exercise the option (because selling a stock to
Trader B at $50 would cost Trader A more than that
to buy it). Trader As option would be worthless
and he would have lost the whole investment, the
fee (premium) for the option contract, $500 ($5 per
share, 100 shares per contract). Trader As total loss
is limited to the cost of the put premium plus the
sales commission to buy it.

A buyer thinks the price of a stock will decrease. He pays A put option is said to have intrinsic value when the una premium which he will never get back, unless it is sold derlying instrument has a spot price (S) below the options

24.5. EXTERNAL LINKS

strike price (K). Upon exercise, a put option is valued at
K-S if it is "in-the-money", otherwise its value is zero.
Prior to exercise, an option has time value apart from
its intrinsic value. The following factors reduce the time
value of a put option: shortening of the time to expire,
decrease in the volatility of the underlying, and increase
of interest rates. Option pricing is a central problem of
nancial mathematics.

24.3 Payo of a put

These examples lead to the following formal reasoning.
Fix O an underlying nancial instrument. Let be a put
option for this instrument, purchased at time 0 , expiring
at time T R+ , with exercise (strike) price of K R
; and let S : [0, T ] R be the price of the underlying
instrument.
Assume the owner of the option , wants to not take a
loss, and does not want to actually possess the underlying
instrument, O . Then either (i) the person will purchase
O at expiry, and then immediately exercise the selling option; or (ii) the person will not exercise the option (which
subsequently becomes worthless).
In (i), the pay-o would be ST + K ; in (ii) the payo would be 0 . So if K ST 0 (i) or (ii) occurs; if
K ST < 0 then (ii) occurs.
Hence the pay-o, i.e. the value of the put option at expiry, is

which is alternatively written (K ST )0 or (K ST )+

.

24.4 See also

Call option
CBOE S&P 500 PutWrite Index (PUT)
Married put
Naked put

24.4.1

Options

Credit default option

Interest rate cap and oor
Options on futures
Real option

125

24.5 External links

Basic Options Concepts: Put Options at Yahoo! Finance
Put Writing Strategy Example

Chapter 25

Security (nance)
Degree of liquidity

This article is about the negotiable instrument. For the

legal right given to a creditor by a debtor, see Security
interest.

Income payments
Tax treatment

A security is a tradable nancial asset of any kind.[1] Securities are broadly categorized into:

Credit rating
Industrial sector or "industry". (Sector often
refers to a higher level or broader category, such as
Consumer Discretionary, whereas industry often
refers to a lower level classication, such as Consumer Appliances. See Industry for a discussion of
some classication systems.)

debt securities, (e.g., banknotes, bonds and

debentures)
equity securities, (e.g., common stocks)
derivative securities, (e.g., forwards, futures, options
and swaps).

Region or country (such as country of incorporation,

country of principal sales/market of its products or
services, or country in which the principal securities
exchange where it trades is located)

The company or other entity issuing the security is called

the issuer. A countrys regulatory structure determines
what qualies as a security. For example, private investment pools may have some features of securities, but they
may not be registered or regulated as such if they meet
various restrictions.
Securities may be represented by a certicate or, more
typically, non-certicated, that is in electronic or book
entry only form. Certicates may be bearer, meaning
they entitle the holder to rights under the security merely
by holding the security, or registered, meaning they entitle
the holder to rights only if he or she appears on a security register maintained by the issuer or an intermediary.
They include shares of corporate stock or mutual funds,
bonds issued by corporations or governmental agencies,
stock options or other options, limited partnership units,
and various other formal investment instruments that are
negotiable and fungible.

25.1 Classication

Market capitalization
State (typically for municipal or tax-free bonds in
the US)

25.1.1 New capital

Securities are the traditional way that commercial enterprises raise new capital. These may be an attractive alternative to bank loans depending on their pricing and market demand for particular characteristics. Another disadvantage of bank loans as a source of nancing is that the
bank may seek a measure of protection against default by
the borrower via extensive nancial covenants. Through
securities, capital is provided by investors who purchase
the securities upon their initial issuance. In a similar way,
a government may issue securities too when it needs to increase government debt

Securities may be classied according to many categories 25.1.2

or classication systems:
Currency of denomination
Ownership rights
Terms to maturity

Type of holder

Investors in securities may be retail, i.e. members of the

public investing other than by way of business. The greatest part of investment, in terms of volume, is wholesale,
i.e. by nancial institutions acting on their own account,
or on behalf of clients. Important institutional investors
126

25.2. DEBT AND EQUITY

include investment banks, insurance companies, pension
funds and other managed funds.
Investment
The traditional economic function of the purchase of securities is investment, with the view to receiving income
and/or achieving capital gain. Debt securities generally
oer a higher rate of interest than bank deposits, and equities may oer the prospect of capital growth. Equity
investment may also oer control of the business of the
issuer. Debt holdings may also oer some measure of
control to the investor if the company is a edgling startup or an old giant undergoing 'restructuring'. In these
cases, if interest payments are missed, the creditors may
take control of the company and liquidate it to recover
some of their investment.
Collateral
The last decade has seen an enormous growth in the use
of securities as collateral. Purchasing securities with borrowed money secured by other securities or cash itself is
called "buying on margin". Where A is owed a debt or
other obligation by B, A may require B to deliver property
rights in securities to A, either at inception (transfer of title) or only in default (non-transfer-of-title institutional).
For institutional loans, property rights are not transferred
but nevertheless enable A to satisfy its claims in the event
that B fails to make good on its obligations to A or otherwise becomes insolvent. Collateral arrangements are divided into two broad categories, namely security interests
and outright collateral transfers. Commonly, commercial
banks, investment banks, government agencies and other
institutional investors such as mutual funds are signicant
collateral takers as well as providers. In addition, private
parties may utilize stocks or other securities as collateral
for portfolio loans in securities lending scenarios.

127

25.2 Debt and equity

Securities are traditionally divided into debt securities and
equities (see also derivatives).

25.2.1 Debt
Debt securities may be called debentures, bonds,
deposits, notes or commercial paper depending on their
maturity and certain other characteristics. The holder of
a debt security is typically entitled to the payment of principal and interest, together with other contractual rights
under the terms of the issue, such as the right to receive
certain information. Debt securities are generally issued
for a xed term and redeemable by the issuer at the end of
that term. Debt securities may be protected by collateral
or may be unsecured, and, if they are unsecured, may be
contractually senior to other unsecured debt meaning
their holders would have a priority in a bankruptcy of the
issuer. Debt that is not senior is subordinated.
Corporate bonds represent the debt of commercial or
industrial entities. Debentures have a long maturity, typically at least ten years, whereas notes have a shorter maturity. Commercial paper is a simple form of debt security that essentially represents a post-dated cheque with a
maturity of not more than 270 days.
Money market instruments are short term debt instruments that may have characteristics of deposit accounts,
such as certicates of deposit, Accelerated Return Notes
(ARN), and certain bills of exchange. They are highly liquid and are sometimes referred to as near cash. Commercial paper is also often highly liquid.

Euro debt securities are securities issued internationally

outside their domestic market in a denomination dierent from that of the issuers domicile. They include eurobonds and euronotes. Eurobonds are characteristically
underwritten, and not secured, and interest is paid gross.
On the consumer level, loans against securities have A euronote may take the form of euro-commercial paper
grown into three distinct groups over the last decade: (ECP) or euro-certicates of deposit.
1) Standard Institutional Loans, generally oering low Government bonds are medium or long term debt seculoan-to-value with very strict call and coverage regimens, rities issued by sovereign governments or their agencies.
akin to standard margin loans; 2) Transfer-of-Title (ToT) Typically they carry a lower rate of interest than corpoLoans, typically provided by private parties where bor- rate bonds, and serve as a source of nance for governrower ownership is completely extinguished save for the ments. U.S. federal government bonds are called trearights provided in the loan contract; and 3) Non-Transfer- suries. Because of their liquidity and perceived low risk,
of-Title Credit Line facilities where shares are not sold treasuries are used to manage the money supply in the
and they serve as assets in a standard lien-type line of cash open market operations of non-US central banks.
credit. Of the three, transfer-of-title loans have fallen into
the very high-risk category as the number of providers has Sub-sovereign government bonds, known in the U.S. as
dwindled as regulators have launched an industry-wide municipal bonds, represent the debt of state, provincial,
crackdown on transfer-of-title structures where the pri- territorial, municipal or other governmental units other
vate lender may sell or sell short the securities to fund the than sovereign governments.
loan. See sell short. Institutionally managed consumer Supranational bonds represent the debt of international
securities-based loans, on the other hand, draw loan funds organizations such as the World Bank, the International
from the nancial resources of the lending institution, not Monetary Fund, regional multilateral development banks
and others.
from the sale of the securities.

128

25.2.2

CHAPTER 25. SECURITY (FINANCE)

Equity

An equity security is a share of equity interest in an entity

such as the capital stock of a company, trust or partnership. The most common form of equity interest is common stock, although preferred equity is also a form of
capital stock. The holder of an equity is a shareholder,
owning a share, or fractional part of the issuer. Unlike
debt securities, which typically require regular payments
(interest) to the holder, equity securities are not entitled to
any payment. In bankruptcy, they share only in the residual interest of the issuer after all obligations have been
paid out to creditors. However, equity generally entitles
the holder to a pro rata portion of control of the company, meaning that a holder of a majority of the equity
is usually entitled to control the issuer. Equity also enjoys the right to prots and capital gain, whereas holders
of debt securities receive only interest and repayment of
principal regardless of how well the issuer performs nancially. Furthermore, debt securities do not have voting rights outside of bankruptcy. In other words, equity
holders are entitled to the upside of the business and to
control the business.

exercised.

25.3 Markets
25.3.1 Primary and secondary market
Public securities markets are either primary or secondary
markets. In the primary market, the money for the securities is received by the issuer of the securities from investors, typically in an initial public oering (IPO). In the
secondary market, the securities are simply assets held
by one investor selling them to another investor, with the
money going from one investor to the other.

An initial public oering is when a company issues public stock newly to investors, called an IPO for short. A
company can later issue more new shares, or issue shares
that have been previously registered in a shelf registration. These later new issues are also sold in the primary
market, but they are not considered to be an IPO but are
often called a secondary oering. Issuers usually retain
investment banks to assist them in administering the IPO,
obtaining SEC (or other regulatory body) approval of the
oering ling, and selling the new issue. When the in25.2.3 Hybrid
vestment bank buys the entire new issue from the issuer
at a discount to resell it at a markup, it is called a rm
Hybrid securities combine some of the characteristics of
commitment underwriting. However, if the investment
both debt and equity securities.
bank considers the risk too great for an underwriting, it
Preference shares form an intermediate class of security may only assent to a best eort agreement, where the inbetween equities and debt. If the issuer is liquidated, they vestment bank will simply do its best to sell the new issue.
carry the right to receive interest and/or a return of cap- For the primary market to thrive, there must be a
ital in priority to ordinary shareholders. However, from secondary market, or aftermarket that provides liquidity
a legal perspective, they are capital stock and therefore for the investment securitywhere holders of securities
may entitle holders to some degree of control depending can sell them to other investors for cash. Otherwise, few
on whether they contain voting rights.
people would purchase primary issues, and, thus, compaConvertibles are bonds or preferred stock that can be
converted, at the election of the holder of the convertibles, into the common stock of the issuing company. The
convertibility, however, may be forced if the convertible
is a callable bond, and the issuer calls the bond. The bondholder has about 1 month to convert it, or the company
will call the bond by giving the holder the call price, which
may be less than the value of the converted stock. This is
referred to as a forced conversion.

nies and governments would be restricted in raising equity capital (money) for their operations. Organized exchanges constitute the main secondary markets. Many
smaller issues and most debt securities trade in the decentralized, dealer-based over-the-counter markets.

Equity warrants are options issued by the company that

allow the holder of the warrant to purchase a specic
number of shares at a specied price within a specied
time. They are often issued together with bonds or existing equities, and are, sometimes, detachable from them
and separately tradeable. When the holder of the warrant
exercises it, he pays the money directly to the company,
and the company issues new shares to the holder.

In Europe, the principal trade organization for securities

dealers is the International Capital Market Association.[2]
In the U.S., the principal trade organization for securities dealers is the Securities Industry and Financial Markets Association,[3] which is the result of the merger of
the Securities Industry Association and the Bond Market
Association. The Financial Information Services Division of the Software and Information Industry Association (FISD/SIIA)[4] represents a round-table of market
data industry rms, referring to them as Consumers, Exchanges, and Vendors. In India the equivalent organisation is the securities exchange board of India (SEBI).

Warrants, like other convertible securities, increases the

number of shares outstanding, and are always accounted
for in nancial reports as fully diluted earnings per share,
which assumes that all warrants and convertibles will be

Securities of all types, including debt and equities, are often identied by its ISIN number, which stands for international securities identication number. The ISIN code
is 12 digit code that uniquely identies a stock or a bond

25.4. PHYSICAL NATURE

and its share classes or tranches.[5]

25.3.2

Public oer and private placement

129

25.4 Physical nature

25.4.1 Certicated securities

Securities that are represented in paper (physical) form

In the primary markets, securities may be oered to the are called certicated securities. They may be bearer or
public in a public oer. Alternatively, they may be of- registered.
fered privately to a limited number of qualied persons
in a private placement. Sometimes a combination of the
two is used. The distinction between the two is impor- 25.4.2 DRS securities
tant to securities regulation and company law. Privately
placed securities are not publicly tradable and may only Securities may also be held in the Direct Registration Sysbe bought and sold by sophisticated qualied investors. tem (DRS), which is a method of recording shares of
As a result, the secondary market is not nearly as liquid stock in book-entry form. Book-entry means the companys transfer agent maintains the shares on the owners
as it is for public (registered) securities.
behalf without the need for physical share certicates.
Another category, sovereign bonds, is generally sold by
Shares held in un-certicated book-entry form have the
auction to a specialized class of dealers.
same rights and privileges as shares held in certicated
form.

25.3.3

Listing and over-the-counter dealBearer securities

ing

Securities are often listed in a stock exchange, an organized and ocially recognized market on which securities can be bought and sold. Issuers may seek listings for
their securities to attract investors, by ensuring there is
a liquid and regulated market that investors can buy and
sell securities in.
Growth in informal electronic trading systems has challenged the traditional business of stock exchanges. Large
volumes of securities are also bought and sold over the
counter (OTC). OTC dealing involves buyers and sellers dealing with each other by telephone or electronically
on the basis of prices that are displayed electronically,
usually by commercial information vendors such as SuperDerivatives, Reuters and Bloomberg.
There are also eurosecurities, which are securities that are
issued outside their domestic market into more than one
jurisdiction. They are generally listed on the Luxembourg
Stock Exchange or admitted to listing in London. The
reasons for listing eurobonds include regulatory and tax
considerations, as well as the investment restrictions.

25.3.4

Market

Bearer securities are completely negotiable and entitle the

holder to the rights under the security (e.g. to payment if
it is a debt security, and voting if it is an equity security).
They are transferred by delivering the instrument from
person to person. In some cases, transfer is by endorsement, or signing the back of the instrument, and delivery.
Regulatory and scal authorities sometimes regard bearer
securities negatively, as they may be used to facilitate the
evasion of regulatory restrictions and tax. In the United
Kingdom, for example, the issue of bearer securities was
heavily restricted rstly by the Exchange Control Act 1947
until 1953. Bearer securities are very rare in the United
States because of the negative tax implications they may
have to the issuer and holder.
Registered securities
In the case of registered securities, certicates bearing the
name of the holder are issued, but these merely represent
the securities. A person does not automatically acquire
legal ownership by having possession of the certicate.
Instead, the issuer (or its appointed agent) maintains a
register in which details of the holder of the securities are
entered and updated as appropriate. A transfer of registered securities is eected by amending the register.

London is the centre of the eurosecurities markets. There

was a huge rise in the eurosecurities market in London in
the early 1980s. Settlement of trades in eurosecurities 25.4.3 Non-certicated
securities and
is currently eected through two European computerized
global certicates
clearing/depositories called Euroclear (in Belgium) and
Clearstream (formerly Cedelbank) in Luxembourg.
Modern practice has developed to eliminate both the need
The main market for Eurobonds is the EuroMTS, owned for certicates and maintenance of a complete security
by Borsa Italiana and Euronext. There are ramp up mar- register by the issuer. There are two general ways this
ket in Emergent countries, but it is growing slowly.
has been accomplished.

130
Non-certicated securities

CHAPTER 25. SECURITY (FINANCE)

rities Clearing Corp. or NSCC, a subsidiary of DTCC.

In some jurisdictions, such as France, it is possible for

issuers of that jurisdiction to maintain a legal record of Other depositories
their securities electronically.
Besides DTC, two other large securities depositories exIn the United States, the current ocial version of Ar- ist, both in Europe: Euroclear and Clearstream.
ticle 8 of the Uniform Commercial Code permits noncerticated securities. However, the ocial UCC is
a mere draft that must be enacted individually by each 25.4.4 Divided and undivided security
U.S. state. Though all 50 states (as well as the District of
Columbia and the U.S. Virgin Islands) have enacted some The terms divided and undivided relate to the propriform of Article 8, many of them still appear to use older etary nature of a security.
versions of Article 8, including some that did not permit Each divided security constitutes a separate asset, which
non-certicated securities.[6]
is legally distinct from each other security in the same
Global certicates, book entry interests, depositories
To facilitate the electronic transfer of interests in securities without dealing with inconsistent versions of Article 8, a system has developed whereby issuers deposit
a single global certicate representing all the outstanding securities of a class or series with a universal depository. This depository is called The Depository Trust
Company, or DTC. DTCs parent, Depository Trust &
Clearing Corporation (DTCC), is a non-prot cooperative owned by approximately thirty of the largest Wall
Street players that typically act as brokers or dealers in
securities. These thirty banks are called the DTC participants. DTC, through a legal nominee, owns each of the
global securities on behalf of all the DTC participants.
All securities traded through DTC are in fact held, in electronic form, on the books of various intermediaries between the ultimate owner, e.g. a retail investor, and the
DTC participants. For example, Mr. Smith may hold 100
shares of Coca Cola, Inc. in his brokerage account at local
broker Jones & Co. brokers. In turn, Jones & Co. may
hold 1000 shares of Coca Cola on behalf of Mr. Smith
and nine other customers. These 1000 shares are held by
Jones & Co. in an account with Goldman Sachs, a DTC
participant, or in an account at another DTC participant.
Goldman Sachs in turn may hold millions of Coca Cola
shares on its books on behalf of hundreds of brokers similar to Jones & Co. Each day, the DTC participants settle
their accounts with the other DTC participants and adjust
the number of shares held on their books for the benet
of customers like Jones & Co. Ownership of securities
in this fashion is called benecial ownership. Each intermediary holds on behalf of someone beneath him in the
chain. The ultimate owner is called the benecial owner.
This is also referred to as owning in Street name.
Among brokerages and mutual fund companies, a large
amount of mutual fund share transactions take place
among intermediaries as opposed to shares being sold and
redeemed directly with the transfer agent of the fund.
Most of these intermediaries such as brokerage rms
clear the shares electronically through the National Secu-

issue. Pre-electronic bearer securities were divided. Each

instrument constitutes the separate covenant of the issuer
and is a separate debt.
With undivided securities, the entire issue makes up one
single asset, with each of the securities being a fractional
part of this undivided whole. Shares in the secondary
markets are always undivided. The issuer owes only one
set of obligations to shareholders under its memorandum,
articles of association and company law. A share represents an undivided fractional part of the issuing company.
Registered debt securities also have this undivided nature.

25.4.5 Fungible and non-fungible security

The terms fungible and non-fungible are a feature of
assets.
If an asset is fungible, this means that if such an asset is
lent, or placed with a custodian, it is customary for the
borrower or custodian to be obliged at the end of the loan
or custody arrangement to return assets equivalent to the
original asset, rather than the specic identical asset. In
other words, the redelivery of fungibles is equivalent and
not in specie. For example, if an owner of 100 shares of
IBM transfers custody of those shares to another party
to hold for a purpose, at the end of the arrangement, the
holder need simply provide the owner with 100 shares of
IBM identical to those received. Cash is also an example
of a fungible asset. The exact currency notes received
need not be segregated and returned to the owner.
Undivided securities are always fungible by logical necessity. Divided securities may or may not be fungible,
depending on market practice. The clear trend is towards
fungible arrangements.

25.5 Regulation
In the US, the public oer and sale of securities must
be either registered pursuant to a registration statement
that is led with the U.S. Securities and Exchange Commission (SEC) or are oered and sold pursuant to an

25.8. SEE ALSO

exemption therefrom. Dealing in securities is regulated
by both federal authorities (SEC) and state securities departments. In addition, the brokerage industry is supposedly self policed by Self Regulatory Organizations
(SROs), such as the Financial Industry Regulatory Authority (FINRA), formerly the National Association of
Securities Dealers (or NASD) or the MSRB.
With respect to investment schemes that do not fall within
the traditional categories of securities listed in the denition of a security (Sec. 2(a)(1) of the 33 act and Sec.
3(a)(10) of the 34 act) the US Courts have developed a
broad denition for securities that must then be registered
with the SEC. When determining if there is an investment contract that must be registered the courts look for
an investment of money, a common enterprise and expectation of prots to come primarily from the eorts of
others. See SEC v. W.J. Howey Co..

131

or based on the value thereof), or any put, call, straddle,

option, or privilege entered into on a national securities
exchange relating to foreign currency, or in general, any
instrument commonly known as a security"; or any certicate of interest or participation in, temporary or interim
certicate for, receipt for, or warrant or right to subscribe
to or purchase, any of the foregoing; but shall not include
currency or any note, draft, bill of exchange, or bankers
acceptance which has a maturity at the time of issuance
of not exceeding nine months, exclusive of days of grace,
or any renewal thereof the maturity of which is likewise
limited.
[2] icma-group.org. icma-group.org. Retrieved 2012-0518.
[3] sifma.org. sifma.org. 2012-05-10. Retrieved 2012-0518.
[4] sd.net. sd.net. Retrieved 2012-05-18.
[5] http://isin.org - International Securities Organization

25.6 See also

[6] LII: UCC - Locator. Law.cornell.edu. 2004-03-15. Retrieved 2012-04-24.

Commercial Law
Finance
Financial market
Financial regulation
History of private equity and venture capital
Interest in securities
List of nance topics
Securities lending
Securities regulation in the United States
Settlement (nance)
Single-stock futures
Stock market data systems
T2S
Toxic security
Trading account assets

25.7 Notes
[1] The United States Securities Exchange Act of 1934 denes a security as: Any note, stock, treasury stock, bond,
debenture, certicate of interest or participation in any
prot-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral trust certicate, preorganization certicate or subscription, transferable share,
investment contract, voting-trust certicate, certicate of
deposit, for a security, any put, call, straddle, option, or
group or index of securities (including any interest therein

25.8 See also

List of nance topics

Chapter 26

Stock
For capital stock in the sense of the xed input of a
production function, see Physical capital. For the goods
and materials that a business holds, see Inventory.
For other uses, see Stock (disambiguation).
The stock (also capital stock) of a corporation constitutes the equity stake of its owners. It represents the
residual assets of the company that would be due to
stockholders after discharge of all senior claims such as
secured and unsecured debt. Stockholders equity cannot
be withdrawn from the company in a way that is intended
to be detrimental to the companys creditors.[1]

mon stock typically carries voting rights that can be exercised in corporate decisions. Preferred stock diers
from common stock in that it typically does not carry
voting rights but is legally entitled to receive a certain
level of dividend payments before any dividends can be
issued to other shareholders.[3][4] Convertible preferred
stock is preferred stock that includes an option for the
holder to convert the preferred shares into a xed number of common shares, usually any time after a predetermined date. Shares of such stock are called convertible
preferred shares (or convertible preference shares in
the UK).

New equity issue may have specic legal clauses attached

that dierentiate them from previous issues of the issuer.
Some shares of common stock may be issued without the
26.1 Shares
typical voting rights, for instance, or some shares may
have special rights unique to them and issued only to cerThe stock of a corporation is partitioned into shares, the tain parties. Often, new issues that have not been registotal of which are stated at the time of business forma- tered with a securities governing body may be restricted
tion. Additional shares may subsequently be authorized from resale for certain periods of time.
by the existing shareholders and issued by the company.
In some jurisdictions, each share of stock has a certain Preferred stock may be hybrid by having the qualities of
declared par value, which is a nominal accounting value bonds of xed returns and common stock voting rights.
used to represent the equity on the balance sheet of the They also have preference in the payment of dividends
corporation. In other jurisdictions, however, shares of over common stock and also have been given preference
at the time of liquidation over common stock. They have
stock may be issued without associated par value.
other features of accumulation in dividend. In addition,
Shares represent a fraction of ownership in a business. A preferred stock usually comes with a letter designation at
business may declare dierent types (classes) of shares, the end of the security; for example, Berkshire-Hathaway
each having distinctive ownership rules, privileges, or Class B shares sell under stock ticker BRK.B, whereas
share values. Ownership of shares may be documented Class A shares of ORION DHC, Inc will sell under
by issuance of a stock certicate. A stock certicate is a ticker OODHA until the company drops the A creating
legal document that species the amount of shares owned ticker OODH for its Common shares only designation.
by the shareholder, and other specics of the shares, such This extra letter does not mean that any exclusive rights
as the par value, if any, or the class of the shares.
exist for the shareholders but it does let investors know
In the United Kingdom, Republic of Ireland, South that the shares are considered for such, however, these
Africa, and Australia, stock can also refer to completely rights or privileges may change based on the decisions
dierent nancial instruments such as government bonds made by the underlying company.
or, less commonly, to all kinds of marketable securities.[2]

26.2.1 Rule 144 stock

26.2 Types of stock

"Rule 144 Stock is a common name given to shares of

stock subject SEC Rule 144: Selling Restricted and ConStock typically takes the form of shares of either common trol Securities.[5] Under Rule 144, restricted and constock or preferred stock. As a unit of ownership, com- trolled securities are acquired in unregistered form. In132

26.4. HISTORY
vestors either purchase or take ownership of these securities through private sales (or other means such as via
ESOPs or in exchange for seed money) from the issuing company (as in the case with Restricted Securities)
or from an aliate of the issuer (as in the case with Control Securities). Investors wishing to sell these securities
are subject to dierent rules than those selling traditional
common or preferred stock. These individuals will only
be allowed to liquidate their securities after meeting the
specic conditions set forth by SEC Rule 144.

26.3 Stock derivatives

For more details on this topic, see equity derivative.
A stock derivative is any nancial instrument which has
a value that is dependent on the price of the underlying
stock. Futures and options are the main types of derivatives on stocks. The underlying security may be a stock
index or an individual rms stock, e.g. single-stock futures.

133
During the Roman Republic, the state contracted (leased)
out many of its services to private companies. These
government contractors were called publicani, or societas
publicanorum as individual company.[7] These companies were similar to modern corporations, or joint-stock
companies more specically, in couple of aspects. They
issued shares called partes (for large cooperatives) and
particulae which were small shares that acted like todays over-the-counter shares.[8] Polybius mentions that
almost every citizen participated in the government
leases.[9] There is also an evidence that the price of stocks
uctuated. The great Roman orator Cicero speaks of
partes illo tempore carissimae, which means share that
had a very high price at that time.[10] This implies a uctuation of price and stock market behavior in Rome.
Around 1250 in France at Toulouse, 96 shares of the Socit des Moulins du Bazacle, or Bazacle Milling Company were traded at a value that depended on the profitability of the mills the society owned.[11] As early as
1288, the Swedish mining and forestry products company Stora has documented a stock transfer, in which the
Bishop of Vsters acquired a 12.5% interest in the mine
(or more specically, the mountain in which the copper
resource was available, Great Copper Mountain) in exchange for an estate.

Stock futures are contracts where the buyer is long, i.e.,

takes on the obligation to buy on the contract maturity
date, and the seller is short, i.e., takes on the obligation The earliest recognized joint-stock company in modern
to sell. Stock index futures are generally not delivered in times was the English (later British) East India Company,
the usual manner, but by cash settlement.
one of the most famous joint-stock companies. It was
A stock option is a class of option. Specically, a call op- granted an English Royal Charter by Elizabeth I on Detion is the right (not obligation) to buy stock in the future cember 31, 1600, with the intention of favouring trade
at a xed price and a put option is the right (not obliga- privileges in India. The Royal Charter eectively gave the
tion) to sell stock in the future at a xed price. Thus, the newly created Honourable East India Company (HEIC) a
[12]
value of a stock option changes in reaction to the under- 15-year monopoly on all trade in the East Indies. The
lying stock of which it is a derivative. The most popu- Company transformed from a commercial trading venlar method of valuing stock options is the Black Scholes ture to one that virtually ruled India as it acquired auxilmodel.[6] Apart from call options granted to employees, iary governmental and military functions, until its dissolution.
most stock options are transferable.

26.4 History

The East India Companys ag initially had the ag of England,

St. Georges Cross, in the corner.

One of the earliest stock by VOC

Soon afterwards, in 1602,[13] the Dutch East India Company issued the rst shares that were made tradeable on
the Amsterdam Stock Exchange, an invention that enhanced the ability of joint-stock companies to attract cap-

134
ital from investors as they now easily could dispose of
their shares. The Dutch East India Company became the
rst multinational corporation and the rst megacorporation. Between 1602 and 1796 it traded 2.5 million tons
of cargo with Asia on 4,785 ships and sent a million Europeans to work in Asia, surpassing all other rivals.

CHAPTER 26. STOCK

Companies listed at the stock market are expected to
strive to enhance shareholder value.
Shareholders are granted special privileges depending on
the class of stock, including the right to vote on matters
such as elections to the board of directors, the right to
share in distributions of the companys income, the right
to purchase new shares issued by the company, and the
right to a companys assets during a liquidation of the
company. However, shareholders rights to a companys
assets are subordinate to the rights of the companys creditors.

The innovation of joint ownership made a great deal of

Europe's economic growth possible following the Middle
Ages. The technique of pooling capital to nance the
building of ships, for example, made the Netherlands a
maritime superpower. Before adoption of the joint-stock
corporation, an expensive venture such as the building of Shareholders are considered by some to be a partial
a merchant ship could be undertaken only by governments subset of stakeholders, which may include anyone who
or by very wealthy individuals or families.
has a direct or indirect equity interest in the business enEconomic historians nd the Dutch stock market of the tity or someone with even a non-pecuniary interest in a
17th century particularly interesting: there is clear docu- non-prot organization. Thus it might be common to
mentation of the use of stock futures, stock options, short call volunteer contributors to an association stakeholders,
selling, the use of credit to purchase shares, a specula- even though they are not shareholders.
tive bubble that crashed in 1695, and a change in fash- Although directors and ocers of a company are bound
ion that unfolded and reverted in time with the market by duciary duties to act in the best interest of the share(in this case it was headdresses instead of hemlines). Dr. holders, the shareholders themselves normally do not
Edward Stringham also noted that the uses of practices
have such duties towards each other.
such as short selling continued to occur during this time
despite the government passing laws against it. This is However, in a few unusual cases, some courts have been
unusual because it shows individual parties fullling con- willing to imply such a duty between shareholders. For
tracts that were not legally enforceable and where the par- example, in California, USA, majority shareholders of
ties involved could incur a loss. Stringham argues that this closely held corporations have a duty not to destroy the
[16][17]
shows that contracts can be created and enforced with- value of the shares held by minority shareholders.
out state sanction or, in this case, in spite of laws to the The largest shareholders (in terms of percentages of comcontrary.[14][15]
panies owned) are often mutual funds, and, especially,
passively managed exchange-traded funds.

26.5 Shareholder
26.6 Application
The owners of a private company may want additional
capital to invest in new projects within the company.
They may also simply wish to reduce their holding, freeing up capital for their own private use. They can achieve
these goals by selling shares in the company to the general
public, through a sale on a stock exchange. This process
is called an initial public oering, or IPO.
By selling shares they can sell part or all of the company
to many part-owners. The purchase of one share entitles
the owner of that share to literally share in the ownership
of the company, a fraction of the decision-making power,
Stock certicate for ten shares of the Baltimore and Ohio Rail- and potentially a fraction of the prots, which the company may issue as dividends.
road Company
In the common case of a publicly traded corporation,
where there may be thousands of shareholders, it is impractical to have all of them making the daily decisions
A shareholder (or stockholder) is an individual or required to run a company. Thus, the shareholders will
company (including a corporation) that legally owns one use their shares as votes in the election of members of the
or more shares of stock in a joint stock company. Both board of directors of the company.
private and public traded companies have shareholders. In a typical case, each share constitutes one vote. CorMain article: Shareholder

26.7. TRADING
porations may, however, issue dierent classes of shares,
which may have dierent voting rights. Owning the majority of the shares allows other shareholders to be outvoted eective control rests with the majority shareholder (or shareholders acting in concert). In this way the
original owners of the company often still have control of
the company.

135
itors have been paid (often the shareholders end up with
nothing).[19]

26.6.2 Means of nancing

Financing a company through the sale of stock in a company is known as equity nancing. Alternatively, debt nancing (for example issuing bonds) can be done to avoid
giving up shares of ownership of the company. Uno26.6.1 Shareholder rights
cial nancing known as trade nancing usually provides
Although ownership of 50% of shares does result in 50% the major part of a companys working capital (day-toownership of a company, it does not give the shareholder day operational needs).
the right to use a companys building, equipment, materials, or other property. This is because the company is
considered a legal person, thus it owns all its assets itself. 26.7 Trading
This is important in areas such as insurance, which must
be in the name of the company and not the main shareMain article: Stock trader
holder.
In general, the shares of a company may be transferred
In most countries, boards of directors and company
managers have a duciary responsibility to run the company in the interests of its stockholders. Nonetheless, as
Martin Whitman writes:
...it can safely be stated that there does not exist any publicly traded company where management works exclusively in the best interests
of OPMI [Outside Passive Minority Investor]
stockholders. Instead, there are both communities of interest and conicts of interest
between stockholders (principal) and management (agent). This conict is referred to as the
principalagent problem. It would be naive to
think that any management would forego management compensation, and management entrenchment, just because some of these management privileges might be perceived as giving rise to a conict of interest with OPMIs.[18]

A stockbroker using multiple screens to stay up to date on trading.

from shareholders to other parties by sale or other mechanisms, unless prohibited. Most jurisdictions have established laws and regulations governing such transfers, parEven though the board of directors runs the company, the ticularly if the issuer is a publicly traded entity.
shareholder has some impact on the companys policy, as The desire of stockholders to trade their shares has led
the shareholders elect the board of directors. Each share- to the establishment of stock exchanges, organizations
holder typically has a percentage of votes equal to the which provide marketplaces for trading shares and other
percentage of shares he or she owns. So as long as the derivatives and nancial products. Today, stock traders
shareholders agree that the management (agent) are per- are usually represented by a stockbroker who buys and
forming poorly they can select a new board of directors sells shares of a wide range of companies on such exwhich can then hire a new management team. In practice, changes. A company may list its shares on an exchange
however, genuinely contested board elections are rare. by meeting and maintaining the listing requirements of a
Board candidates are usually nominated by insiders or by particular stock exchange. In the United States, through
the board of the directors themselves, and a considerable the intermarket trading system, stocks listed on one exchange can often also be traded on other participating
amount of stock is held or voted by insiders.
networks
Owning shares does not mean responsibility for liabili- exchanges, including electronic communication
[20]
(ECNs),
such
as
Archipelago
or
Instinet.
ties. If a company goes broke and has to default on loans,
the shareholders are not liable in any way. However, all
money obtained by converting assets into cash will be
used to repay loans and other debts rst, so that shareholders cannot receive any money unless and until cred-

Many large non-U.S companies choose to list on a U.S.

exchange as well as an exchange in their home country
in order to broaden their investor base. These companies must maintain a block of shares at a bank in the US,

136

CHAPTER 26. STOCK

typically a certain percentage of their capital. On this

basis, the holding bank establishes American depositary
shares and issues an American depositary receipt (ADR)
for each share a trader acquires. Likewise, many large
U.S. companies list their shares at foreign exchanges to
raise capital abroad.
Small companies that do not qualify and cannot meet
the listing requirements of the major exchanges may be
traded over-the-counter (OTC) by an o-exchange mechanism in which trading occurs directly between parties.
The major OTC markets in the United States are the electronic quotation systems OTC Bulletin Board (OTCBB)
and OTC Markets Group (formerly known as Pink OTC
Markets Inc.)[21] where individual retail investors are also
represented by a brokerage rm and the quotation services requirements for a company to be listed are minimal. Shares of companies in bankruptcy proceeding are
usually listed by these quotation services after the stock
is delisted from an exchange.

26.7.1

Buying

There are various methods of buying and nancing

stocks, the most common being through a stockbroker.
Brokerage rms, whether they are a full-service or
discount broker, arrange the transfer of stock from a
seller to a buyer. Most trades are actually done through
brokers listed with a stock exchange.
There are many dierent brokerage rms from which to
choose, such as full service brokers or discount brokers.
The full service brokers usually charge more per trade,
but give investment advice or more personal service; the
discount brokers oer little or no investment advice but
charge less for trades. Another type of broker would be
a bank or credit union that may have a deal set up with
either a full-service or discount broker.

He can sell if the share price drops below the margin requirement, at least 50% of the value of the stocks in the
account. Buying on margin works the same way as borrowing money to buy a car or a house, using a car or house
as collateral. Moreover, borrowing is not free; the broker
usually charges 810% interest.

26.7.2 Selling
Selling stock is procedurally similar to buying stock.
Generally, the investor wants to buy low and sell high,
if not in that order (short selling); although a number of
reasons may induce an investor to sell at a loss, e.g., to
avoid further loss.
As with buying a stock, there is a transaction fee for the
brokers eorts in arranging the transfer of stock from a
seller to a buyer. This fee can be high or low depending on
which type of brokerage, full service or discount, handles
the transaction.
After the transaction has been made, the seller is then
entitled to all of the money. An important part of selling
is keeping track of the earnings. Importantly, on selling
the stock, in jurisdictions that have them, capital gains
taxes will have to be paid on the additional proceeds, if
any, that are in excess of the cost basis.

26.7.3 Stock price uctuations

The price of a stock uctuates fundamentally due to the
theory of supply and demand. Like all commodities in the
market, the price of a stock is sensitive to demand. However, there are many factors that inuence the demand
for a particular stock. The elds of fundamental analysis
and technical analysis attempt to understand market conditions that lead to price changes, or even predict future
price levels. A recent study shows that customer satisfaction, as measured by the American Customer Satisfaction Index (ACSI), is signicantly correlated to the market value of a stock.[22] Stock price may be inuenced by
analysts business forecast for the company and outlooks
for the companys general market segment. Stocks can
also uctuate greatly due to pump and dump scams.

There are other ways of buying stock besides through a

broker. One way is directly from the company itself. If
at least one share is owned, most companies will allow
the purchase of shares directly from the company through
their investor relations departments. However, the initial
share of stock in the company will have to be obtained
through a regular stock broker. Another way to buy stock
in companies is through Direct Public Oerings which
are usually sold by the company itself. A direct public
oering is an initial public oering in which the stock is 26.7.4 Share price determination
purchased directly from the company, usually without the
aid of brokers.
At any given moment, an equitys price is strictly a result
When it comes to nancing a purchase of stocks there are of supply and demand. The supply, commonly referred
two ways: purchasing stock with money that is currently to as the oat, is the number of shares oered for sale at
in the buyers ownership, or by buying stock on margin. any one moment. The demand is the number of shares
Buying stock on margin means buying stock with money investors wish to buy at exactly that same time. The
borrowed against the value of stocks in the same account. price of the stock moves in order to achieve and mainThese stocks, or collateral, guarantee that the buyer can tain equilibrium. The product of this instantaneous price
repay the loan; otherwise, the stockbroker has the right to and the oat at any one time is the market capitalization
sell the stock (collateral) to repay the borrowed money. of the entity oering the equity at that point in time.

26.8. SEE ALSO

When prospective buyers outnumber sellers, the price
rises. Eventually, sellers attracted to the high selling price
enter the market and/or buyers leave, achieving equilibrium between buyers and sellers. When sellers outnumber buyers, the price falls. Eventually buyers enter and/or
sellers leave, again achieving equilibrium.
Thus, the value of a share of a company at any given
moment is determined by all investors voting with their
money. If more investors want a stock and are willing to
pay more, the price will go up. If more investors are selling a stock and there aren't enough buyers, the price will
go down.
Note: For Nasdaq-listed stocks, the price quote includes information on the bid and ask prices for the
stock.[23]
Of course, that does not explain how people decide the
maximum price at which they are willing to buy or the
minimum at which they are willing to sell. In professional investment circles the ecient market hypothesis
(EMH) continues to be popular, although this theory is
widely discredited in academic and professional circles.
Briey, EMH says that investing is overall (weighted by
the standard deviation) rational; that the price of a stock
at any given moment represents a rational evaluation of
the known information that might bear on the future value
of the company; and that share prices of equities are
priced eciently, which is to say that they represent accurately the expected value of the stock, as best it can be
known at a given moment. In other words, prices are the
result of discounting expected future cash ows.
The EMH model, if true, has at least two interesting consequences. First, because nancial risk is presumed to
require at least a small premium on expected value, the
return on equity can be expected to be slightly greater
than that available from non-equity investments: if not,
the same rational calculations would lead equity investors
to shift to these safer non-equity investments that could be
expected to give the same or better return at lower risk.
Second, because the price of a share at every given moment is an ecient reection of expected value, then
relative to the curve of expected returnprices will tend
to follow a random walk, determined by the emergence
of information (randomly) over time. Professional equity
investors therefore immerse themselves in the ow of fundamental information, seeking to gain an advantage over
their competitors (mainly other professional investors) by
more intelligently interpreting the emerging ow of information (news).
The EMH model does not seem to give a complete description of the process of equity price determination.
For example, stock markets are more volatile than EMH
would imply. In recent years it has come to be accepted
that the share markets are not perfectly ecient, perhaps
especially in emerging markets or other markets that are
not dominated by well-informed professional investors.

137
Another theory of share price determination comes
from the eld of Behavioral Finance.
According
to Behavioral Finance, humans often make irrational
decisionsparticularly, related to the buying and selling
of securitiesbased upon fears and misperceptions of
outcomes. The irrational trading of securities can often
create securities prices which vary from rational, fundamental price valuations. For instance, during the technology bubble of the late 1990s (which was followed by
the dot-com bust of 20002002), technology companies
were often bid beyond any rational fundamental value because of what is commonly known as the "greater fool
theory". The greater fool theory holds that, because
the predominant method of realizing returns in equity is
from the sale to another investor, one should select securities that they believe that someone else will value at a
higher level at some point in the future, without regard to
the basis for that other partys willingness to pay a higher
price. Thus, even a rational investor may bank on others
irrationality.

26.7.5 Arbitrage trading

When companies raise capital by oering stock on more
than one exchange, the potential exists for discrepancies
in the valuation of shares on dierent exchanges. A keen
investor with access to information about such discrepancies may invest in expectation of their eventual convergence, known as arbitrage trading. Electronic trading has resulted in extensive price transparency (ecientmarket hypothesis) and these discrepancies, if they exist,
are short-lived and quickly equilibrated.

26.8 See also

26.9 References
[1] Stock Denition. Investopedia. Retrieved 25 February
2012.
[2] Cambridge Advanced Learners Dictionary.
nary.cambridge.org. Retrieved 2010-02-12.

Dictio-

[3] Common Stock vs. Preferred Stock, and Stock Classes.

InvestorGuide.com.
[4] Zvi Bodie, Alex Kane, Alan J. Marcus, Investments, 9th
Ed., ISBN 978-0078034695.
[5] Rule 144: Selling Restricted and Control Securities. US
Securities and Exchange Commission. Retrieved 18 May
2013.
[6] Black Scholes Calculator.
trieved 2010-02-12.

Tradingtoday.com.

[7] Livy, Ab Urbe Condita

[8] (Cic. pro Rabir. Post. 2; Val. Max. VI.9 7)

Re-

138

[9] (Polybius, 6, 17, 3)

[10] (Cicero, P. VAT. 12, 29.)
[11] http://www.euronext.com/editorial/wide/
editorial-1989-EN.html
[12] Irwin, Douglas A. (December 1991). Mercantilism as
Strategic Trade Policy: The Anglo-Dutch Rivalry for the
East India Trade. The Journal of Political Economy
(The University of Chicago Press) 99 (6): 12961314.
doi:10.1086/261801. JSTOR 2937731. at 1299.
[13] Stringham, Edward (2003). The Extralegal Development of Securities Trading in Seventeenth Century Amsterdam. The Quarterly Review of Economics and Finance. Retrieved 13 September 2011.
[14] Stringham, Edward (2002). The Origin of the London
Stock Exchange as a Self Policing Club. Journal of Private Enterprise. Retrieved 16 August 2010.
[15] Devil the Hindmost by Edward Chancellor.
[16] Jones v. H. F. Ahmanson & Co., 1 Cal. 3d)
[17] Jones v. H.F. Ahmanson & Co. (1969) 1 C3d 93. Online.ceb.com. Retrieved 2010-02-12.
[18] Whitman, 2004, 5
[19] Jackson, Thomas (2001). The Logic and Limits of
Bankruptcy Law. Oxford Oxfordshire: Oxford University
Press. p. 32. ISBN 1-58798-114-9.
[20] Stock Trading. ShareWorld. Retrieved 24 February
2012.
[21] Stock Trading. US Securities and Exchange Commission. Retrieved 18 May 2013.
[22] Mithas, Sunil (January 2006). Increased Customer Satisfaction Increases Stock Price. Research@Smith. University of Maryland. Retrieved 25 February 2012.
[23] Understanding Stock Prices: Bid, Ask, Spread. Youngmoney.com. Retrieved 2010-02-12.

26.10 External links

Stock exchanges at DMOZ
Stocks investing at DMOZ
The oldest share in the world, issued by the Dutch
East India Company (Vereenigde Oost-Indische
Compagnie or VOC), 1606.

CHAPTER 26. STOCK

Chapter 27

Time deposit
A time deposit (also known as a certicate of deposit in
the United States, a term deposit, particularly in Canada,
Australia and New Zealand; a bond in the United Kingdom; Fixed Deposits in India and in some other countries)
is a money deposit at a banking institution that cannot be
withdrawn for a certain term or period of time (unless
a penalty is paid). When the term is over it can be withdrawn or it can be held for another term. Generally speaking, the longer the term the better the yield on the money.
In its strict sense, certicate deposit is dierent from that
of time deposit in terms of its negotiability: CDs are negotiable and can be rediscounted when the holder needs
some liquidity, while time deposits must be kept until maturity.

27.1 See also

Certicate of deposit
Guaranteed Investment Certicate
Federal Deposit Insurance Corporation
Money supply

27.2 External links

The opposite, sometimes known as a sight deposit or on

call deposit, can be withdrawn at any time, without any
notice or penalty: e.g., money deposited in a checking
account in a bank.
The rate of return is higher than for savings accounts because the requirement that the deposit be held for a prespecied term gives the bank the ability to invest it in
a higher-gain nancial product class. However, the return on a time deposit is generally lower than the longterm average of that of investments in riskier products
like stocks or bonds. Some banks oer market-linked
time deposit accounts which oer potentially higher returns while guaranteeing principal.
A time deposit is an interest-bearing bank deposit that
has a specied date of maturity. A deposit of funds in a
savings institution is made under an agreement stipulating that (a) the funds must be kept on deposit for a stated
period of time, or (b) the institution may require a minimum period of notication before a withdrawal is made.
Small time deposits are dened in the U.S. as those under $100,000, while large ones are $100,000 or greater
in size. The term jumbo CD is commonly used in the
United States to refer to large time deposits.
In the U.S., banks are not subject to a reserve requirement
against their time deposit holdings.

139

FDIC: Your Insured Deposits

International Time Deposits

Chapter 28

Certicate of deposit
A certicate of deposit (CD) is a time deposit, a nan- 28.1 How CDs work
cial product commonly sold in the United States and elsewhere by banks, thrift institutions, and credit unions.
CDs typically require a minimum deposit, and may oer
CDs are similar to savings accounts in that they are in- higher rates for larger deposits. The best rates are genersured and thus virtually risk free; they are money in the ally oered on Jumbo CDs with minimum deposits of
bank. In the USA, CDs are insured by the Federal De- $100,000.
posit Insurance Corporation (FDIC) for banks and by the The consumer who opens a CD may receive a paper cerNational Credit Union Administration (NCUA) for credit ticate, but it is now common for a CD to consist simunions. They are dierent from savings accounts in that ply of a book entry and an item shown in the consumers
the CD has a specic, xed term (often monthly, three periodic bank statements; that is, there is often no cermonths, six months, or one to ve years) and, usually, a ticate as such. Consumers who wish to have a hard
xed interest rate. It is intended that the CD be held un- copy verifying their CD purchase may request a paper
til maturity, at which time the money may be withdrawn statement from the bank or print out their own from the
together with the accrued interest.
nancial institutions online banking service.
In exchange for keeping the money on deposit for the
agreed-on term, institutions usually grant higher interest
rates than they do on accounts from which money may be
withdrawn on demand, although this may not be the case
in an inverted yield curve situation. Fixed rates are common, but some institutions oer CDs with various forms
of variable rates. For example, in mid-2004, interest rates
were expected to rise, many banks and credit unions began to oer CDs with a bump-up feature. These allow
for a single readjustment of the interest rate, at a time
of the consumers choosing, during the term of the CD.
Sometimes, CDs that are indexed to the stock market, the
bond market, or other indices are introduced.

28.1.1 Closing a CD
Withdrawals before maturity are usually subject to a substantial penalty. For a ve-year CD, this is often the loss
of six months interest. These penalties ensure that it is
generally not in a holders best interest to withdraw the
money before maturityunless the holder has another investment with signicantly higher return or has a serious
need for the money.

Commonly, institutions mail a notice to the CD holder

shortly before the CD matures requesting directions. The
notice usually oers the choice of withdrawing the princiA few general guidelines for interest rates are:
pal and accumulated interest or rolling it over (depositing it into a new CD). Generally, a window is allowed
A larger principal should receive a higher interest
after maturity where the CD holder can cash in the CD
rate, but may not.
without penalty. In the absence of such directions, it is
A longer term will usually receive a higher interest common for the institution to roll over the CD automatirate, except in the case of an inverted yield curve cally, once again tying up the money for a period of time
(though the CD holder may be able to specify at the time
(i.e. preceding a recession)
the CD is opened not to roll over the CD).
Smaller institutions tend to oer higher interest rates
than larger ones.

28.1.2 CD renance

Personal CD accounts generally receive higher inInsured CDs are required by the Truth in Savings Regulaterest rates than business CD accounts.
tion DD to state at the time of account opening the penalty
Banks and credit unions that are not insured by the for early withdrawal. It has been generally accepted that
FDIC or NCUA generally oer higher interest rates. these penalties cannot be revised by the depository prior
140

28.3. TERMS AND CONDITIONS

to maturity. However, there have been cases in which
a credit union modied its early withdrawal penalty and
made it retroactive on existing accounts.[1] The second
occurrence happened when Main Street Bank of Texas
closed a group of CDs early without full payment of interest. The bank claimed the disclosures allowed them to
do so.[2]
The penalty for early withdrawal is the deterrent to allowing depositors to take advantage of subsequent enhanced investment opportunities during the term of the
CD. In rising interest rate environments the penalty may
be insucient to discourage depositors from redeeming
their deposit and reinvesting the proceeds after paying the
applicable early withdrawal penalty. The added interest
from the new higher yielding CD may more than oset
the cost of the early withdrawal penalty.

28.1.3

Ladders

While longer investment terms yield higher interest rates,

longer terms also may result in a loss of opportunity to
lock in higher interest rates in a rising-rate economy. A
common mitigation strategy for this opportunity cost is
the CD ladder strategy. In the ladder strategies, the
investor distributes the deposits over a period of several
years with the goal of having all ones money deposited at
the longest term (and therefore the higher rate), but in a
way that part of it matures annually. In this way, the depositor reaps the benets of the longest-term rates while
retaining the option to re-invest or withdraw the money
in shorter-term intervals.

141
complex FDIC and NCUA rules, available in FDIC and
NCUA booklets or online. The standard insurance coverage is currently $250,000 per owner or depositor for
single accounts or $250,000 per co-owner for joint accounts.
Some institutions use a private insurance company instead of, or in addition to, the Federally backed FDIC
or NCUA deposit insurance. Institutions often stop using
private supplemental insurance when they nd that few
customers have a high enough balance level to justify the
additional cost.
The Certicate of Deposit Account Registry Service program allows investors to keep up to $50 million invested in CDs managed through one bank with full FDIC
insurance.[3] However rates will likely not be the highest
available.

28.3 Terms and conditions

There are many variations in the terms and conditions for
CDs.

The federally required Truth in Savings booklet, or

other disclosure document that gives the terms of the CD,
must be made available before the purchase. Employees
of the institution are generally not familiar with this information; only the written document carries legal weight.
If the original issuing institution has merged with another
institution, or if the CD is closed early by the purchaser,
or there is some other issue, the purchaser will need to
refer to the terms and conditions document to ensure that
For example, an investor beginning a three-year lad- the withdrawal is processed following the original terms
der strategy would start by depositing equal amounts of of the contract.
money each into a 3-year CD, 2-year CD, and 1-year CD.
From this point on, a CD will reach maturity every year,
The terms and conditions may be changeable.
at which time the investor would re-invest at a 3-year
They may contain language such as We can add to,
term. After two years of this cycle, the investor would
delete or make any other changes (Changes) we
have all money deposited at a three-year rate, yet have
want to these Terms at any time.[4]
one-third of the deposits mature every year (which can
then be reinvested, augmented, or withdrawn).
The CD may be callable. The terms may state that
the bank or credit union can close the CD before the
The responsibility for maintaining the ladder falls on the
term ends.
depositor, not the nancial institution. Because the ladder does not depend on the nancial institution, depositors are free to distribute a ladder strategy across more
than one bank, which can be advantageous as smaller
banks may not oer the longer terms found at some larger
banks. Although laddering is most common with CDs,
this strategy may be employed on any time deposit account with similar terms.

28.2 Deposit insurance

The amount of insurance coverage varies depending on
how accounts for an individual or family are structured
at the institution. The level of insurance is governed by

Payment of interest. Interest may be paid out as it

is accrued or it may accumulate in the CD.
Interest calculation. The CD may start earning interest from the date of deposit or from the start of
the next month or quarter.
Right to delay withdrawals. Institutions generally
have the right to delay withdrawals for a specied
period to stop a bank run.
Withdrawal of principal. May be at the discretion
of the nancial institution. Withdrawal of principal
below a certain minimumor any withdrawal of
principal at allmay require closure of the entire

142

CHAPTER 28. CERTIFICATE OF DEPOSIT

CD. A US Individual Retirement Account CD may terest rate for a long term may be bad (if ination goes
allow withdrawal of IRA Required Minimum Dis- up) or good (if ination goes down). For example, in the
tributions without a withdrawal penalty.
1970s, ination increased higher than it had been, and
banks were slow to raise their interest rates. This does
Withdrawal of interest.
May be limited to not much aect a person with a short note, since they get
the most recent interest payment or allow for with- their money back, and they can go somewhere else (or
drawal of accumulated total interest since the CD the same place) that gives a higher rate. But longer notes
was opened. Interest may be calculated to date of are locked in their rate. This gave rise to amusing nickwithdrawal or through the end of the last month or names for CDs. A bit later, the opposite happened, where
last quarter.
ination was declining. This does not greatly help a perPenalty for early withdrawal. May be measured in son with a short note, since they shortly get their money
months of interest, may be calculated to be equal to back and they are forced to reinvest at a new, lower rate.
the institutions current cost of replacing the money, But longer notes become very valuable since they have a
[9]
or may use another formula. May or may not reduce higher interest rate.
the principalfor example, if principal is with- However, this applies only to average CD interest rates.
drawn three months after opening a CD with a six- In reality, some banks pay much lower than average rates,
month penalty.
while others pay much higher rates (two-fold dierences
[10]
In the United
Fees. A fee may be specied for withdrawal or clo- are not unusual, e.g., 2.5% vs 5%).
States,
depositors
can
take
advantage
of
the
best FDICsure or for providing a certied check.
insured rates without increasing their risk.[11]
Automatic renewal. The institution may or may
Investors should be suspicious of an unusually high innot commit to sending a notice before automatic
terest rate on a CD. Allen Stanford used fraudulent CDs
rollover at CD maturity. The institution may specwith high rates to lure people into his Ponzi scheme.
ify a grace period before automatically rolling over
the CD to a new CD at maturity. Some banks have Finally, the statement that CD interest rates closely track
been known to renew at rates lower than that of the ination is not necessarily true. For example, during a
credit crunch banks are in dire need of funds, and CD
original CD.[5]
interest rate increases may not track ination.[12]

28.4 Criticism

28.5 References
[6]

CD interest rates closely track ination. For example,

in one situation interest rates may be 15% and ination
may be 15%, and in another situation interest rates may
be 2% and ination may be 2%. Of course, these factors
cancel out, so the real interest rate is the same in both
cases.
In this situation, it is a misinterpretation that the interest
is an increase in value. However, to keep the same value,
the rate of withdrawal must be the same as the real rate
of return, in this case, zero. People may also think that
the higher-rate situation is better, when the real rate of
return is actually the same.
Also, the above does not include taxes.[7] When taxes are
considered, the higher-rate situation above is worse, with
a lower (more negative) real return, although the beforetax real rates of return are identical. The after-ination,
after-tax return is whats important.
Author Ric Edelman writes: You don't make any money
in bank accounts (in real economic terms), simply because you're not supposed to.[8] On the other hand, he
says, bank accounts and CDs are ne for holding cash for
a short amount of time.
Even if CD rates track ination, this can only be the expected ination at the time the CD is bought. The actual ination will be lower or higher. Locking in the in-

[1] Fort Knox FCU -- Early Withdrawal Penalty. DepositAccounts.

[2] Main Street Bank closes CDs early. JCDI.
[3] CDARS.
[4] ING Direct Account Disclosures. Retrieved 31 Jan
2012.: "Change to/Waiver of Terms: We can add to,
delete or make any other changes (Changes) we want
to these Terms at any time. You and your account will
be bound by the Changes as soon as we implement them.
If the Change isn't in your favor, before its implemented,
we'll let you know about it as required by law. However, if
applicable law requires us to make a Change, you may not
receive any prior notice. We can cancel, change or add
products, accounts or services whenever we want. Notice of any such changes, additions or terminations will
be provided as required by law. We can waive any of
our rights under these Terms whenever we want, but this
doesn't mean that we'll waive the same rights in the future.
[5] Major Bank Certicate of Deposit Renewal Rate Rip-O
"(Article no longer active)Rip O.
[6] Ric Edelman, The Truth About Money, 3rd ed., p. 31
[7] Ric Edelman, The Truth About Money, 3rd ed., p. 30

28.6. EXTERNAL LINKS

[8] Ric Edelman, The Truth About Money, 3rd ed., p. 61

[9] E.g., in 1981 the ination rate was 10.3%, which subsequently decreased US Department of Labors CPI.
while CDs where paying double digit rates Federal Reserves CD rates. Whoever purchased long-term CDs at
that time enjoyed high real interest rates during the following years.
[10] Compare a typical large-bank 1-year CD, e.g., Wells
Fargo. vs the highest 1-year CD available at a listing service, e.g., BankCD.com.
[11] FDIC: Insuring Your Deposits.
[12] Goldwasser, Joan (September 10, 2008). Upside of the
Credit Crunch. The Washington Post. Retrieved April
28, 2010.

28.6 External links

The US SEC on buying CDs
North American Securities Administrators Association on buying CDs.
2007 US Department of Justice ling "...a scheme to
defraud investors, many of them elderly, of approximately $3,661,248 by selling the investors fraudulent certicates of deposit.

143

Chapter 29

Accounting
Accountancy redirects here. For the functional constituency in Hong Kong, see Accountancy (constituency).
Accounting, or accountancy, is the measurement, processing and communication of nancial information
about economic entities.[1][2] Accounting, which has been
called the language of business,[3] measures the results of an organizations economic activities and conveys
this information to a variety of users including investors,
creditors, management, and regulators.[4] Practitioners of
accounting are known as accountants. The terms accounting and nancial reporting are often used as synonyms.
Accounting can be divided into several elds including
nancial accounting, management accounting, auditing,
and tax accounting.[5][6] Financial accounting focuses on
the reporting of an organizations nancial information,
including the preparation of nancial statements, to external users of the information, such as investors, regulators
and suppliers;[7] and management accounting focuses on
the measurement, analysis and reporting of information
for internal use by management.[1][7] The recording of
nancial transactions, so that summaries of the nancials may be presented in nancial reports, is known as
bookkeeping, of which double-entry bookkeeping is the
most common system.[8]

29.1 Etymology
Both the words accounting and accountancy were in use
in Great Britain by the mid-1800s, and are derived from
the words accompting and accountantship used in the 18th
century.[12] In Middle English (used roughly between the
12th and the late 15th century) the verb to account
had the form accounten, which was derived from the Old
French word aconter,[13] which is in turn related to the
Vulgar Latin word computare, meaning to reckon. The
base of computare is putare, which variously meant to
prune, to purify, to correct an account, hence, to count or
calculate, as well as to think.[13]
The word "accountant" is derived from the French word
compter, which is also derived from the Latin word computare. The word was formerly written in English as accomptant, but in process of time the word, which was
always pronounced by dropping the p, became gradually changed both in pronunciation and in orthography to
its present form.[14]

29.1.1 Accounting and accountancy

Accounting has variously been dened as the keeping or

preparation of the nancial records of an entity, the analAccounting is facilitated by accounting organiza- ysis, verication and reporting of such records and the
it also refers to
tions such as standard-setters, accounting rms and principles and procedures of accounting";
[15][16][17]
the
job
of
being
an
accountant.
professional bodies. Financial statements are usually
audited by accounting rms,[9] and are prepared in ac- Accountancy refers to the occupation or profession
cordance with generally accepted accounting principles of an accountant,[18][19][20] particularly in British En(GAAP).[7] GAAP is set by various standard-setting glish.[15][16]
organizations such as the Financial Accounting Standards
Board (FASB) in the United States[1] and the Financial
Reporting Council in the United Kingdom.[10] As of
2012, all major economies have plans to converge 29.2 History
towards or adopt the International Financial Reporting
Standards (IFRS).[11]
Main article: History of accounting
The history of accounting is thousands of years old
and can be traced to ancient civilizations.[21][22][23] The
early development of accounting dates back to ancient
Mesopotamia, and is closely related to developments in
writing, counting and money;[21] there is also evidence
for early forms of bookkeeping in ancient Iran,[24][25]
144

29.3. TOPICS

145

29.3.2 Management accounting

Main article: Management accounting

Early 19th-century ledger.

Management accounting focuses on the measurement,

analysis and reporting of information that can help managers in making decisions to full the goals of an organization. In management accounting, internal measures
and reports are based on cost-benet analysis, and are not
required to follow GAAP.[7]

Management accounting produces future-oriented

reportsfor example the budget for 2006 is prepared
in 2005and the time span of reports varies widely.
and early auditing systems by the ancient Egyptians and Such reports may include both nancial and nonnancial
Babylonians.[22] By the time of the Emperor Augustus, information, and may, for example, focus on specic
the Roman government had access to detailed nancial products and departments.[7]
information.[26]
Double-entry bookkeeping developed in medieval Europe,[27] and accounting split into nancial accounting
and management accounting with the development of
joint-stock companies.[28] Accounting began to transition
into an organized profession in the nineteenth century,[29]
with local professional bodies in England merging to form
the Institute of Chartered Accountants in England and
Wales in 1880.[30]

29.3.3 Auditing
Main articles: Financial audit and Internal audit
Auditing is the verication of assertions made by others
regarding a payo,[31] and in the context of accounting it
is the "unbiased examination and evaluation of the nancial statements of an organization.[32]

An audit of nancial statements aims to express or disclaim an opinion on the nancial statements. The auditor
expresses an opinion on the fairness with which the 29.3 Topics
nancial statements presents the nancial position, results
of operations, and cash ows of an entity, in accordance
Accounting has several subelds or subject areas, with GAAP and in all material respects. An auditor is
including nancial accounting, management account- also required to identify circumstances in which GAAP
ing, auditing, taxation and accounting information sys- has not been consistently observed.[33]
tems.[5][6]

29.3.4 Accounting information systems

29.3.1

Financial accounting

Main article: Financial accounting

Financial accounting focuses on the reporting of an organizations nancial information to external users of the
information, such as investors, regulators and suppliers.
It measures and records business transactions and prepares nancial statements for the external users in accordance with generally accepted accounting principles
(GAAP).[7] GAAP, in turn, arises from the wide agreement between accounting theory and practice, and change
over time to meet the needs of decision-makers.[1]

Main article: Accounting information system

An accounting information system is a part of an organisations information system that focuses almost exclusively on processing quantitative data.[34]

29.3.5 Tax accounting

Main article: Tax accounting

U.S. tax accounting concentrates on the preparation,

analysis and presentation of tax payments and tax returns. The United States tax system has a complicated set
Financial accounting produces past-oriented reportsfor of accounting method characteristic for tax accounting
example the nancial statements prepared in 2006 reports purposes. Although tax accounting largely applies under
on performance in 2005on an annual or quarterly basis, generally accepted accounting principles (GAAP), a difgenerally about the organization as a whole.[7]
ferent accounting method may cause a quite dierent.[35]

146

CHAPTER 29. ACCOUNTING

In the U.S.s organizational form and taxes: there are four

basic forms of business ownerships: the Sole proprietorship, the partnership, the corporation, and the limited liability company. Corporate income taxes structures include corporation and personal income taxes, which contains, sole proprietorship, partnership and limited liability Company. Corporate Income taxes include marginal,
which is taxed on each additional dollar of income, average corporate tax rates, which is basic on total tax as
a percentage of income, and basic corporate income tax
structure. The current corporate-tax rate is from 15 percent to 39 percent.[36] The current corporate income tax
rate is 15 percent on the rst $50,000 of income, 25 percent on the next $25,000, 34 percent on the next $25,000,
39 percent on the next $235,000, 34 percent on the next
$9,665,000, 5 percent on the next $5000,000, 38 percent
on the next $3,333,333, 35 percent on all income above
$18,333,333. [37] The personal- tax rate starts lower than
the corporate-tax rate in the lowest brackets to the higher
income levels. 15 percent for corporate income of less
than $50,000 and 10 percent in the lowest personal brackets for all ling statures for the lowest income, and the
highest personal rate of 35 percent never exceeds the
highest corporate rate of 35 percent. [38]

29.4 Organizations
29.4.1

Professional bodies

Main article: Professional accounting body

Professional accounting bodies include the American Institute of Certied Public Accountants (AICPA) and the
other 179 members of the International Federation of Accountants (IFAC),[39] including CPA Australia, Institute
of Chartered Accountants of India (ICAI) and Institute of
Chartered Accountants in England and Wales (ICAEW).
Professional bodies for subelds of the accounting professions also exist, for example the Chartered Institute
of Management Accountants (CIMA).[40] Many of these
professional bodies oer education and training including qualication and administration for various accounting designations, such as certied public accountant and
chartered accountant.[41][42]

29.4.2

Accounting rms

Main article: Accounting networks and associations

Depending on its size, a company may be legally required
to have their nancial statements audited by a qualied
auditor, and audits are usually carried out by accounting
rms.[9]
Accounting rms grew in the United States and Europe
in the late nineteenth and early twentieth century, and

through several mergers there were large international

accounting rms by the mid-twentieth century. Further
large mergers in the late twentieth century led to the dominance by the auditing market by the Big Five accounting rms: Arthur Andersen, Deloitte, Ernst & Young,
KPMG and PricewaterhouseCoopers.[43] The demise of
Arthur Andersen following the Enron scandal reduced
the Big Five to the Big Four.[44]

29.4.3 Standard-setters
See also: Accounting standards and Convergence of
accounting standards
Generally accepted accounting principles (GAAP) are
accounting standards issued by national regulatory bodies. In addition, the International Accounting Standards
Board (IASB) issues the International Financial Reporting Standards (IFRS) implemented by 147 countries.[1]
While standards for international audit and assurance,
ethics, education, and public sector accounting are all
set by independent standard settings boards supported by
IFAC. The International Auditing and Assurance Standards Board sets international standards for auditing,
assurance, and quality control; the International Ethics
Standards Board for Accountants (IESBA) [45] sets the internationally appropriate principles- based Code of Ethics
for Professional Accounts the International Accounting
Education Standards Board (IAESB) sets professional
accounting education standards;[46] International Public Sector Accounting Standards Board (IPSASB) sets
accrual-based international public sector accounting standards [47]
Organizations in individual countries may issue accounting standards unique to the countries. For example, in the
United States the Financial Accounting Standards Board
(FASB) issues the Statements of Financial Accounting
Standards, which form the basis of US GAAP,[1] and
in the United Kingdom the Financial Reporting Council
(FRC) sets accounting standards.[10] However,as of 2012
all major economies have plans to converge towards or
adopt the IFRS.[11]

29.5 Education and qualications

29.5.1 Accounting degrees
At least a bachelors degree in accounting or a related eld
is required for most accountant and auditor job positions,
and some employers prefer applicants with a masters degree.[48] A degree in accounting may also be required
for, or may be used to full the requirements for, membership to professional accounting bodies. For example, the education during an accounting degree can be
used to full the American Institute of CPAs (AICPA)

29.7. ACCOUNTING AND COMPUTER SOFTWARE

150 semester hour requirement,[49] and associate membership with the Certied Public Accountants Association of the UK is available after gaining a degree in nance or accounting.[50]
A doctorate is required in order to pursue a career in accounting academia, for example to work as a university
professor.[51][52] The Doctor of Philosophy (PhD) and the
Doctor of Business Administration (DBA) are the most
popular degrees. The PhD is the most common degree
for those wishing to pursue a career in academia, while
DBA programs generally focus on equipping business executives for business or public careers requiring research
skills and qualications.[51]

29.5.2

Professional qualications

147
a divide between academia and practice in accounting.[59]
Methodologies in academic accounting research can be
classied into archival research, which examines objective data collected from repositories"; experimental research, which examines data the researcher gathered
by administering treatments to subjects"; and analytical research, which is based on the act of formally
modeling theories or substantiating ideas in mathematical terms. This classication is not exhaustive; other
possible methodologies include the use of case studies,
computer simulations and eld research.[60]

29.7 Accounting
software

and

computer

See also: Chartered Accountant and Certied Public See also: Accounting information system
Accountant
Professional accounting qualications include the
Chartered Accountant designations and other qualications including certicates and diplomas.[53] In
the United Kingdom, chartered accountants of the
ICAEW undergo annual training, and are bound by the
ICAEWs code of ethics and subject to its disciplinary
procedures.[54] In the United States, the requirements
for joining the AICPA as a Certied Public Accountant
are set by the Board of Accountancy of each state,
and members agree to abide by the AICPAs Code of
Professional Conduct and Bylaws. In India the Apex
Accounting body constituted by parliament of India is
Institute of Chartered Accountants of India (ICAI) was
known for its rigorous training and study methodology
for granting the Qualication. [55]

29.6 Accounting research

Many laborious practices have been simplied with the

help of computer software. Enterprise resource planning
(ERP) software provides a comprehensive, centralized,
integrated source of information that companies can use
to manage all major business processes, from purchasing to manufacturing to human resources. This software
can replace up to 200 individual software programs that
were previously used. Computer integrated manufacturing allows products to be made and completely untouched
by human hands and can increase production by having
fewer errors in the manufacturing process.
Computers have reduced the cost of accumulating, storing, and reporting managerial accounting information and
have made it possible to produce a more detailed account
of all data that is entered into any given system. They have
also changed business to business interaction through ecommerce. Rather than dealing with multiple companies
to purchase products, a business can purchase a product
at a less expensive price and take out the third party and
vastly reduces expenses companies once accrued.

Additionally, Inter-organizational information system enable suppliers and businesses to be connected at all times.
When a company is low on a product the supplier will be
Accounting research is research on the eects of econotied and fulll an order immediately which eliminates
nomic events on the process of accounting, and the efthe need for someone to do inventory, ll out the proper
fects of reported information on economic events. It
documents, send them out and wait for their products.[61]
encompasses a broad range of research areas including
nancial accounting, management accounting, auditing
and taxation.[56]
Main article: Accounting research

Accounting research is carried out both by academic researchers and practicing accountants. Academic accounting research addresses all aspects of the accounting profession using the scientic method, while research by
practicing accountants focuses on solving problems for
a client or group of clients.[57] Academic accounting research can make signicant contribution to accounting
practice,[57][58] although changes in accounting education
and the accounting academia in recent decades has led to

29.8 Accounting aects the economy

Although nancial accounting produces past-oriented reports, it is based on generally accepted accounting principles and generally accepted accounting practices compliant with International Financial Reporting Standards/US
GAAP. In order to prepare the nancial accounts/reports
an entity has to comply with these GAAPs and gaaps.

148
Which of these accounting practices and principles the
board of directors choose at the start of the nancial period and whatever changes in these generally accepted accounting principles and practices are implemented during
the accounting period, aect the entitys economy and
aect the nancial accounts (nancial reports) prepared
at the end of the nancial period. When all entities implement the same change during the nancial year as required by IFRS/US GAAP, then that aects the entire
economy.

CHAPTER 29. ACCOUNTING

29.10 See also

Business
Finance
Economics

29.11 References
[1] Needles, Belverd E.; Powers, Marian (2013). Principles
of Financial Accounting. Financial Accounting Series (12
ed.). Cengage Learning.

29.9 Accounting scandals

[2] Accounting Research Bulletins No. 7 Reports of Committee on Terminology (Report). Committee on Accounting
Procedure, American Institute of Accountants. November 1940. Retrieved December 31, 2013.

Main article: Accounting scandals

See also: Accounting ethics

[3] Peggy Bishop Lane on Why Accounting Is the Language of

Business, Knowledge @ Wharton High School, September
23, 2013, retrieved December 25, 2013

The year 2001 witnessed a series of nancial information

frauds involving Enron, auditing rm Arthur Andersen,
the telecommunications company WorldCom, Qwest and
Sunbeam, among other well-known corporations. These
problems highlighted the need to review the eectiveness of accounting standards, auditing regulations and
corporate governance principles. In some cases, management manipulated the gures shown in nancial reports
to indicate a better economic performance. In others, tax
and regulatory incentives encouraged over-leveraging of
companies and decisions to bear extraordinary and unjustied risk.[62]

[4] Department of Accounting. Foster School of Business.

Foster School of Business. 2013. Retrieved 31 December
2013.
[5] Weber, Richard P., and W. C. Stevenson. 1981. Evaluations of Accounting Journal and Department Quality.
The Accounting Review 56 (3): 596612.
[6] Asian Review of Accounting Information. Emerald.
Emerald Group Publishing Limited. 2013. Retrieved 30
December 2013.
[7] Horngren, Charles T.; Datar, Srikant M.; Foster, George
(2006), Cost Accounting: A Managerial Emphasis (12th
ed.), New Jersey: Pearson Prentice Hall

The Enron scandal deeply inuenced the development of

new regulations to improve the reliability of nancial reporting, and increased public awareness about the importance of having accounting standards that show the nancial reality of companies and the objectivity and independence of auditing rms.[62]

[8] Lung, Henry (2009). Fundamentals of Financial Accounting. Elsevier.

In addition to being the largest bankruptcy reorganization

in American history, the Enron scandal undoubtedly is
the biggest audit failure.[63] It involved a nancial scandal
of Enron Corporation and their auditors Arthur Andersen, which was revealed in late 2001. The scandal caused
the dissolution of Arthur Andersen, which at the time was
one of the ve largest accounting rms in the world. After
a series of revelations involving irregular accounting procedures conducted throughout the 1990s, Enron led for
Chapter 11 bankruptcy protection in December 2001.[64]

[10] Knowledge guide to UK Accounting Standards, ICAEW,

2014, retrieved January 1, 2014

[9] Auditors: Market concentration and their role, CHAPTER 1: Introduction. UK Parliament. House of Lords.
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[11] IFRS Foundation, 2012. The move towards global standards. Retrieved on April 27, 2012.
[12] Labardin, Pierre, and Marc Nikitin. 2009. Accounting
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[13] Baladouni, Vah. 1984. Etymological Observations
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One consequence of these events was the passage of

SarbanesOxley Act in the United States 2002, as a re- [14] Pixley, Francis William: Accountancyconstructive and
recording accountancy (Sir Isaac Pitman & Sons, Ltd,
sult of the rst admissions of fraudulent behavior made
London, 1900), p4
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to defraud shareholders.[65]

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Universidad Francisco Marroqun, March 2006) p. 41,
UFM.edu.gt
[63] Bratton, William W. Enron and the Dark Side of Shareholder Value (Tulane Law Review, New Orleans, May
2002) p. 61
[64] Enron les for bankruptcy. BBC News. 2001-12-03.
Retrieved 2008-03-15.
[65] Aiyesha Dey, and Thomas Z. Lys: Trends in Earnings Management and Informativeness of Earnings Announcements in the Pre- and Post-Sarbanes Oxley Periods (Kellogg School of Management, Evanston, Illinois,
February, 2005) p. 5

CHAPTER 29. ACCOUNTING

Chapter 30

Audit
For other uses, see Audit (disambiguation).

Financial audits are performed to ascertain the validity

and reliability of information, as well as to provide an
assessment of a systems internal control. As a result of
this a third party can express an opinion of the person
/ organization / system (etc.) in question. The opinion
given on nancial statements will depends on the audit
evidence obtained.

Auditing refers to a systematic examination of books, accounts, documents and vouchers of an organization to ascertain how far the nancial statements present a true and
fair view of the concern. It also attempts to ensure that the
books of accounts are properly maintained by the concern
as required by law. Auditing has become such an ubiqui- Due to constraints, an audit seeks to provide only reasontous phenomenon in the corporate and the public sector able assurance that the statements are free from material
that academics started identifying an Audit Society.[1] error. Hence, statistical sampling is often adopted in auAuditing is dened as a systematic and independent ex- dits. In the case of nancial audits, a set of nancial stateamination of data, statements, records, operations and ments are said to be true and fair when they are free of
performances (nancial or otherwise) of an enterprise for material misstatements a concept inuenced by both
a stated purpose. In any auditing the auditor perceives and quantitative (numerical) and qualitative factors. But rego beyond just
recognizes the propositions before him/her for examina- cently, the argument that auditing should
[3]
true
and
fair
is
gaining
momentum.
And
the US Public
tion, collects evidence, evaluates the same and on this baCompany
Accounting
Oversight
Board
has
come
out with
sis formulates his/her judgment which is communicated
[4]
a
concept
release
on
the
same.
[2]
through his/her audit report.

Cost accounting is a process for verifying the cost of manufacturing or producing of any article, on the basis of accounts measuring the use of material, labor or other items
of cost. In simple words, the term, cost audit means a
systematic and accurate verication of the cost accounts
and records, and checking for adherence to the cost accounting objectives. According to the Institute of Cost
and Management Accountants of Pakistan, a cost audit
is an examination of cost accounting records and veriAs a result of an audit, stakeholders may eectively eval- cation of facts to ascertain that the cost of the product
uate and improve the eectiveness of risk management, has been arrived at, in accordance with principles of cost
control, and the governance process over the subject man- accounting.
ner.
In most nations, an audit must adhere to generally accepted standards established by governing bodies. These
standards assure third parties or external users that they
30.1 Accounting
can rely upon the auditors opinion on the fairness of nancial statements, or other subjects on which the auditor
Main article: Financial audit
expresses an opinion.
Any subject matter may be audited. Audits provide third
party assurance to various stakeholders that the subject
matter is free from material misstatement. The term is
most frequently applied to audits of the nancial information relating to a legal person. Other areas which are commonly audited include: internal controls, quality management, project management, water management, and energy conservation.

Due to strong incentives (including taxation, misselling

and other forms of fraud) to misstate nancial information, auditing has become a legal requirement for many
entities who have the power to exploit nancial information for personal gain. Traditionally, audits were mainly
associated with gaining information about nancial systems and the nancial records of a company or a business.

30.1.1 Integrated audits

In US audits of publicly traded companies are governed
by rules laid down by the Public Company Accounting
Oversight Board (PCAOB), which was established by
Section 404 of the SarbanesOxley Act of 2002. Such an

151

152

CHAPTER 30. AUDIT

audit is called an integrated audit, where auditors, in adManagement Accountants.

dition to an opinion on the nancial statements, must also
Further information: Cost auditing
express an opinion on the eectiveness of a companys internal control over nancial reporting, in accordance with
PCAOB Auditing Standard No. 5.
The most commonly used external audit standards are the
There are also new types of integrated auditing becom- US GAAS of the American Institute of Certied Public
ing available that use unied compliance material (see the Accountants; and the ISA International Standards on Auunied compliance section in Regulatory compliance). diting developed by the International Auditing and AssurDue to the increasing number of regulations and need ance Standards Board of the International Federation of
for operational transparency, organizations are adopting Accountants.
risk-based audits that can cover multiple regulations and
standards from a single audit event. This is a very new
Internal auditors are employed by the organizations
but necessary approach in some sectors to ensure that all
they audit. They work for government agencies (fedthe necessary governance requirements can be met witheral, state and local); for publicly traded compaout duplicating eort from both audit and audit hosting
nies; and for non-prot companies across all indusresources.
tries. The internationally recognised standard setting body for the profession is the Institute of Internal Auditors - IIA (www.theiia.org). The IIA has
30.1.2 Assessments
dened internal auditing as follows: Internal auditing is an independent, objective assurance and
The purpose of an assessment is to measure something
consulting activity designed to add value and imor calculate a value for it. Although the process of proprove an organizations operations. It helps an orducing an assessment may involve an audit by an indeganization accomplish its objectives by bringing a
pendent professional, its purpose is to provide a measuresystematic, disciplined approach to evaluate and imment rather than to express an opinion about the fairness
prove the eectiveness of risk management, control,
of statements or quality of performance.[5]
and governance processes.[6] Thus professional internal auditors provide independent and objective
audit and consulting services focused on evaluating
30.1.3 Auditors
whether the board of directors, shareholders, stakeholders, and corporate executives have reasonable
Auditors of nancial statements can be classied into two
assurance that the organizations governance, risk
categories:
management, and control processes are designed
adequately and function eectively. Internal audit
External auditor / Statutory auditor is an indepenprofessionals (Certied Internal Auditors - CIAs)
dent rm engaged by the client subject to the auare governed by the international professional standit, to express an opinion on whether the companys
dards and code of conduct of the Institute of Internal
nancial statements are free of material misstateAuditors.[7] While internal auditors are not indepenments, whether due to fraud or error. For publicly
dent of the companies that employ them, indepentraded companies, external auditors may also be redence and objectivity are a cornerstone of the IIA
quired to express an opinion over the eectiveness
professional standards; and are discussed at length
of internal controls over nancial reporting. Exterin the standards and the supporting practice guides
nal auditors may also be engaged to perform other
and practice advisories. Professional internal audiagreed-upon procedures, related or unrelated to tors are mandated by the IIA standards to be indenancial statements. Most importantly, external audipendent of the business activities they audit. This
tors, though engaged and paid by the company being
independence and objectivity are achieved through
audited, should be regarded as independent.
the organizational placement and reporting lines of
the internal audit department. Internal auditors of
Cost auditor / Statutory Cost auditor is an indepublicly traded companies in the United States are
pendent rm engaged by the client subject to the
required to report functionally to the board of diCost audit, to express an opinion on whether the
rectors directly, or a sub-committee of the board of
companys Cost statements and Cost Sheet are free
directors (typically the audit committee), and not to
of material misstatements, whether due to fraud
management except for administrative purposes. As
or error. For publicly traded companies, external
described often in the professional literature for the
auditors may also be required to express an opinion
practice of internal auditing (such as Internal Auover the eectiveness of internal controls over Cost
ditor, the journal of the IIA) -,[8] or other similar
reporting. These are Specialized Persons called
and generally recognized frameworks for manageCost Accountants in India & CMA globally either
ment control when evaluating an entitys governance
Cost & Management Accountants or Certied
and control practices; and apply COSOs Enter-

30.4. PROJECT MANAGEMENT

153

prise Risk Management-Integrated Framework or 30.4 Project management

other similar and generally recognized frameworks
for entity-wide risk management when evaluating Projects can undergo 2 types of Project audits:[9]
an organizations entity-wide risk management practices. Professional internal auditors also use Control
Regular Health Check Audits: The aim of a regSelf-Assessment (CSA) as an eective process for
ular health check audit is to understand the current
performing their work.
state of a project in order to increase project success.
Consultant auditors are external personnel con Regulatory Audits: The aim of a regulatory audit is
tracted by the rm to perform an audit following
to verify that a project is compliant with regulations
the rms auditing standards. This diers from
and standards. Best practices of NEMEA Complithe external auditor, who follows their own auditance Center describe that, the regulatory audit must
ing standards. The level of independence is therebe accurate, objective, and independent while profore somewhere between the internal auditor and
viding oversight and assurance to the organization.
the external auditor. The consultant auditor may
work independently, or as part of the audit team that
includes internal auditors. Consultant auditors are 30.5 Energy audits
used when the rm lacks sucient expertise to audit certain areas, or simply for sta augmentation
Main article: Energy audit
when sta are not available.

[9]

30.2 Performance audits

An energy audit is an inspection, survey and analysis of

energy ows for energy conservation in a building, process or system to reduce the amount of energy input into
the system without negatively aecting the output(s).

Safety, security, information systems performance, and

environmental concerns are increasingly the subject of
audits. There are now audit professionals who specialize
in security audits and information systems audits. With 30.6 Operations audit
nonprot organizations and government agencies, there
has been an increasing need for performance audits, ex- Further information: Operational audit
amining their success in satisfying mission objectives.

30.3 Quality audits

Main article: Quality audit

An operations audit is an examination of the operations

of the clients business. In this audit the auditor thoroughly examines the eciency, eectiveness and economy of the operations with which the management of the
entity (client) is achieving its objective. The operational
audit goes beyond the internal controls issues since management does not achieve its objectives merely by compliance of satisfactory system of internal controls. Operational audits cover any matters which may be commercially unsound. The objective of operational audit is to
examine Three Es, namely: Eectiveness doing the
right things with least wastage of resources. Eciency
performing work in least possible time. Economy balance between benets and costs to run the operations

Quality audits are performed to verify conformance to

standards through review of objective evidence. A system of quality audits may verify the eectiveness of a
quality management system. This is part of certications
such as ISO 9001. Quality audits are essential to verify the existence of objective evidence showing conformance to required processes, to assess how successfully
processes have been implemented, and to judge the effectiveness of achieving any dened target levels. Quality A control self-assessment is a commonly used tool for
[10]
audits are also necessary to provide evidence concerning completing an operations audit.
reduction and elimination of problem areas, and they are
a hands-on management tool for achieving continual improvement in an organization.
30.7 Forensic audits
To benet the organization, quality auditing should not
only report non-conformance and corrective actions but
also highlight areas of good practice and provide evidence of conformance. In this way, other departments
may share information and amend their working practices
as a result, also enhancing continual improvement.

Also refer to forensic accountancy, forensic accountant

or forensic accounting. It refers to an investigative audit
in which accountants with specialised on both accounting
and investigation seek to uncover frauds, missing money
and negligences

154

CHAPTER 30. AUDIT

30.8 See also

[5] Ladda, R.L. Basic Concepts Of Accounting. Solapur:

Laxmi Book Publication. p. 58. ISBN 978-1-312-161306.

Academic audit

[6] Pages - Denition of Internal Auditing. Na.theiia.org.

2000-01-01. Retrieved 2013-09-02.

Accounting
Big Four auditors
Comptroller,
Comptroller
General,
Comptroller General of the United States

and

Continuous auditing
COSO framework, Risk management
EarthCheck
Financial audit, External auditor, Certied Public
Accountant (CPA), and Audit risk
Independent review
Information technology audit, Information technology audit process, History of information technology auditing, and Auditing information security
Internal audit
Audit Plan
INTOSAI (International Organization of Supreme
Audit Institutions)
Lead Auditor, under the Chief Audit Executive, or
Director of Audit
Quality audit
Cost audit
Technical audit
Management audit
Operational audit
Risk based audit

30.9 References
[1] Power, Michael. 1999. The Audit Society: Rituals of
Verication. Oxford: Oxford University Press.
[2] Audit assurance.
[3] McKenna, Francine. Auditors and Audit Reports: Is The
Firms John Hancock Enough?". Forbes. Retrieved 22
July 2011.
[4] CONCEPT RELEASE ON POSSIBLE REVISIONS
TO PCAOB STANDARDS RELATED TO REPORTS
ON AUDITED FINANCIAL STATEMENTS. Retrieved 22 July 2011.

[7] Pages - International Professional Practices Framework

(IPPF)". Na.theiia.org. 2000-01-01. Retrieved 2013-0902.
[8] Professional internal auditors, in carrying out their
responsibilities, apply COSOs Integrated FrameworkInternal Control. Theiia.org.
[9] Dierent Types of Audits (June 2013) Auditronix Guidance Note
[10] Gilbert W. Joseph and Terry J. Engle (December 2005).
The Use of Control Self-Assessment by Independent Auditors. The CPA Journal. Retrieved 10 March 2012.

Chapter 31

Capital budgeting
Capital budgeting, or investment appraisal, is the
planning process used to determine whether an organizations long term investments such as new machinery, replacement machinery, new plants, new products,
and research development projects are worth the funding of cash through the rms capitalization structure
(debt, equity or retained earnings). It is the process
of allocating resources for major capital, or investment,
expenditures.[1] One of the primary goals of capital budgeting investments is to increase the value of the rm to
the shareholders.

31.2 Capital Budgeting Denition

Capital budgeting is the planning of long-term corporate

nancial projects relating to investments funded through
and aecting the rms capital structure. Management
must allocate the rms limited resources between competing opportunities (projects), which is one of the main
focuses of capital budgeting. [2] Capital budgeting is
also concerned with the setting of criteria about which
projects should receive investment funding to increase the
value of the rm, and whether to nance that investment
Many formal methods are used in capital budgeting, in- with equity or debt capital. Investments should be made
cluding the techniques such as
on the basis of value-added to the future of the corporation. Capital budgeting projects may include a wide
variety of dierent types of investments, including but
Accounting rate of return
not limited to, expansion policies, or mergers and acquisitions. When no such value can be added through the cap Payback period
ital budgeting process and excess cash surplus exists and
is not needed, then management is expected to pay out
Net present value
some or all of those surplus earnings in the form of cash
dividends or to repurchase the companys stock through
Protability index
a share buyback program.
Internal rate of return
Choosing between capital budgeting projects may be
based upon several inter-related criteria. (1) Corporate
Modied internal rate of return
management seeks to maximize the value of the rm by
investing in projects which yield a positive net present
Equivalent annual cost
value when valued using an appropriate discount rate in
consideration of risk. (2) These projects must also be Real options valuation
nanced appropriately. (3) If no positive NPV projects exist and excess cash surplus is not needed to the rm, then
These methods use the incremental cash ows from each nancial theory suggests that management should return
potential investment, or project. Techniques based on some or all of the excess cash to shareholders (i.e., distriaccounting earnings and accounting rules are sometimes bution via dividends).
used - though economists consider this to be improper
- such as the accounting rate of return, and "return on Capital budgeting involves allocating the rms capital
investment. Simplied and hybrid methods are used as resources between competing project and investments.
well, such as payback period and discounted payback pe- Each potential projects value should be estimated using
a discounted cash ow (DCF) valuation, to nd its net
riod.
present value (NPV). (First applied to Corporate Finance
by Joel Dean in 1951.) This valuation requires estimating
the size and timing of all the incremental cash ows from
31.1 Net present value
the project. (These future cash highest NPV(GE).) The
NPV is greatly aected by the discount rate, so selectMain article: Net present value
ing the proper ratesometimes called the hurdle rate
is critical to making the right decision. The hurdle rate is
155

156
the Minimum acceptable rate of return on an investment.
This should reect the riskiness of the investment, typically measured by the volatility of cash ows, and must
take into account the nancing mix. Managers may use
models such as the CAPM or the APT to estimate a discount rate appropriate for each particular project, and use
the weighted average cost of capital (WACC) to reect the
nancing mix selected. A common practice in choosing
a discount rate for a project is to apply a WACC that applies to the entire rm, but a higher discount rate may be
more appropriate when a projects risk is higher than the
risk of the rm as a whole.
Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. However, because
the amount of capital available at any given time for new
projects is limited, management needs to use capital budgeting techniques to determine which projects will yield
the most return over an applicable period of time.

CHAPTER 31. CAPITAL BUDGETING

31.3 Internal rate of return

Main article: Internal rate of return
The internal rate of return (IRR) is dened as the
discount rate that gives a net present value (NPV) of zero.
It is a commonly used measure of investment eciency.
The IRR method will result in the same decision as the
NPV method for (non-mutually exclusive) projects in an
unconstrained environment, in the usual cases where a
negative cash ow occurs at the start of the project, followed by all positive cash ows. In most realistic cases,
all independent projects that have an IRR higher than the
hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the
project with the highest IRR - which is often used - may
select a project with a lower NPV.

Popular methods of capital budgeting include net present In some cases, several zero NPV discount rates may exist,
value (NPV), internal rate of return (IRR), discounted so there is no unique IRR. The IRR exists and is unique if
one or more years of net investment (negative cash ow)
cash ow (DCF) and payback period.
are followed by years of net revenues. But if the signs of
the cash ows change more than once, there may be sev31.2.1 Factors Inuencing Capital Bud- eral IRRs. The IRR equation generally cannot be solved
analytically but only via iterations.
geting
Availability of funds
Structure of capital
Taxation Policy
Government Policy
Lending Policies of Financial Institutions
Immediate need of the Project
Earnings
Capital Return
Economic Value of the Project
Working Capital
Accounting Practice
Trend of Earning
Size of Business
Risk of the business
Forecast of the market
Political unrest
Geographical Condition
Exchange Rate of Currency

One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case
because intermediate cash ows are almost never reinvested at the projects IRR; and, therefore, the actual rate
of return is almost certainly going to be lower. Accordingly, a measure called Modied Internal Rate of Return
(MIRR) is often used.
Despite a strong academic preference for NPV, surveys
indicate that executives prefer IRR over NPV, although
they should be used in concert. In a budget-constrained
environment, eciency measures should be used to maximize the overall NPV of the rm. Some managers nd
it intuitively more appealing to evaluate investments in
terms of percentage rates of return than dollars of NPV.

31.4 Equivalent annuity method

Main article: Equivalent annual cost
The equivalent annuity method expresses the NPV as an
annualized cash ow by dividing it by the present value
of the annuity factor. It is often used when assessing only
the costs of specic projects that have the same cash inows. In this form it is known as the equivalent annual
cost (EAC) method and is the cost per year of owning and
operating an asset over its entire lifespan.
It is often used when comparing investment projects of
unequal lifespans. For example if project A has an ex-

31.8. NEED FOR CAPITAL BUDGETING

157

pected lifetime of 7 years, and project B has an expected

lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects,
unless the projects could not be repeated.

of bank loans, or bonds issued to creditors. Equity capital are investments made by shareholders, who purchase
shares in the companys stock. Retained earnings are excess cash surplus from the companys present and past
The use of the EAC method implies that the project will earnings.
be replaced by an identical project.
Alternatively the chain method can be used with the NPV
method under the assumption that the projects will be replaced with the same cash ows each time. To compare
projects of unequal length, say 3 years and 4 years, the
projects are chained together, i.e. four repetitions of the
3 year project are compare to three repetitions of the 4
year project. The chain method and the EAC method
give mathematically equivalent answers.
The assumption of the same cash ows for each link in
the chain is essentially an assumption of zero ination, so
a real interest rate rather than a nominal interest rate is
commonly used in the calculations.

31.5 Real options

Main article: Real options analysis
Real options analysis has become important since the
1970s as option pricing models have gotten more sophisticated. The discounted cash ow methods essentially value projects as if they were risky bonds, with
the promised cash ows known. But managers will have
many choices of how to increase future cash inows, or to
decrease future cash outows. In other words, managers
get to manage the projects - not simply accept or reject
them. Real options analysis try to value the choices - the
option value - that the managers will have in the future
and adds these values to the NPV.

31.6 Ranked Projects

The real value of capital budgeting is to rank projects.
Most organizations have many projects that could potentially be nancially rewarding. Once it has been determined that a particular project has exceeded its hurdle,
then it should be ranked against peer projects (e.g. - highest Protability index to lowest Protability index). The
highest ranking projects should be implemented until the
budgeted capital has been expended.

31.7 Funding Sources

Capital budgeting investments and projects must be
funded through excess cash provided through the raising
of debt capital, equity capital, or the use of retained earnings. Debt capital is borrowed cash, usually in the form

31.8 Need For Capital Budgeting

1. As large sum of money is involved which inuences
the protability of the rm making capital budgeting
an important task.
2. Long term investment once made can not be reversed without signicance loss of invested capital.
The investment becomes sunk and mistakes, rather
than being readily rectied,must often be borne until the rm can be withdrawn through depreciation
charges or liquidation. It inuences the whole conduct of the business for the years to come.
3. Investment decision are the base on which the prot
will be earned and probably measured through the
return on the capital. A proper mix of capital investment is quite important to ensure adequate rate
of return on investment, calling for the need of capital budgeting.
4. The implication of long term investment decisions
are more extensive than those of short run decisions
because of time factor involved, capital budgeting
decisions are subject to the higher degree of risk and
uncertainty than short run decision.[3]

31.9 External links and references

[1] Sullivan, arthur; Steven M. Sherin (2005). Economics:
Principles in action. Upper Saddle River, New Jersey
07458: Pearson Prentice Hall. p. 375. ISBN 0-13063085-3.
[2] See: Investment Decisions and Capital Budgeting, Prof.
Campbell R. Harvey; The Investment Decision of the Corporation, Prof. Don M. Chance
[3] Varshney, R.L.; K.L. Maheshwari (2010). Manegerial
Economics. 23 Daryaganj, New Delhi 110002: Sultan
Chand & Sons. p. 881. ISBN 978-81-8054-784-3.

Capital Budgeting
International Good Practice:
Guidance on
Project Appraisal Using Discounted Cash Flow,
International Federation of Accountants, June
2008, ISBN 978-1-934779-39-2
Prospective Analysis: Guidelines for Forecasting
Financial Statements, Ignacio Velez-Pareja, Joseph
Tham, 2008

158
To Plug or Not to Plug, that is the Question: No
Plugs, No Circularity: A Better Way to Forecast Financial Statements, Ignacio Velez-Pareja, 2008
A Step by Step Guide to Construct a Financial
Model Without Plugs and Without Circularity for
Valuation Purposes, Ignacio Velez-Pareja, 2008
Long-Term Financial Statements Forecasting:
Reinvesting Retained Earnings, Sergei Cheremushkin, 2008
Using Monte Carlo simulation to teach capital budgeting risk analysis
Resource Person:
Tanvir Hossain, Management
Counsellor, Bangladesh Institute of Management
(BIM),tanvir.fm@gmail.com 01726134400

CHAPTER 31. CAPITAL BUDGETING

Chapter 32

Credit rating agency

A credit rating agency (CRA, also called a ratings service) is a company that assigns credit ratings, which rate a
debtors ability to pay back debt by making timely interest
payments and the likelihood of default. An agency may
rate the creditworthiness of issuers of debt obligations, of
debt instruments,[1] and in some cases, of the servicers of
the underlying debt,[2] but not of individual consumers.

to those who purchased goods or services from them, it

was easy for the merchants to extend credit to them, due
to their proximity and the fact that merchants knew their
customers personally and knew whether or not they would
be able to pay them back. As trading distances increased,
merchants no longer personally knew their customers and
became leery of extending credit to people who they did
The debt instruments rated by CRAs include government not know in fear of them not being able to pay them back.
Business owners hesitation to extend credit to new cusbonds, corporate bonds, CDs, municipal bonds, preferred
[7]
stock, and collateralized securities, such as mortgage- tomers led to the birth of the credit reporting industry.
backed securities and collateralized debt obligations.[3]
Mercantile credit agenciesthe precursors of todays
The issuers of the obligations or securities may be compa- rating agencieswere established in the wake of the
nies, special purpose entities, state or local governments, nancial crisis of 1837. These agencies rated the abiland consolidated
non-prot organizations, or sovereign nations.[3] A credit ity of merchants to pay their debts
[8]
these
ratings
in
published
guides.
The
rst such agency
rating facilitates the trading of securities on a secondary
was
established
in
1841
by
Lewis
Tappan
in New York
market. It aects the interest rate that a security pays out,
[8][9]
City.
It
was
subsequently
acquired
by
Robert Dun,
with higher ratings leading to lower interest rates. Indiwho
published
its
rst
ratings
guide
in
1859.
Another
vidual consumers are rated for creditworthiness not by
early
agency,
John
Bradstreet,
formed
in
1849
and
pubcredit rating agencies but by credit bureaus (also called
[8]
lished
a
ratings
guide
in
1857.
consumer reporting agencies or credit reference agencies), which issue credit scores.
The value of credit ratings for securities has been widely
questioned. Hundreds of billions of securities that were
given the agencies highest ratings were downgraded to
junk during the nancial crisis of 200708.[4][5][6] Rating
downgrades during the European sovereign debt crisis of
201012 were blamed by EU ocials for accelerating the
crisis.[3]
Credit rating is a highly concentrated industry, with
the two largest CRAsMoodys Investors Service and
Standard & Poors (S&P)controlling 80% of the global
market share, and the Big Three credit rating agenciesMoodys, S&P, and Fitch Ratingscontrolling approximately 95% of the ratings business.[3]

32.1 History
32.1.1

Early history

Credit rating agencies originated in the United States in

the early 1900s, when ratings began to be applied to securities, specically those related to the railroad bond
market.[8] In the United States, the construction of extensive railroad systems had led to the development of corporate bond issues to nance them, and therefore a bond
market several times larger than in other countries. The
bond markets in the Netherlands and Britain had been
established longer but tended to be small, and revolved
around sovereign governments that were trusted to honor
their debts.[10] Companies were founded to provide investors with nancial information on the growing railroad industry, including Henry Varnum Poor's publishing company, which produced a publication compiling nancial data about the railroad and canal industries.[11]
Following the 1907 nancial crisis, demand rose for such
independent market information, in particular for independent analyses of bond creditworthiness.[12] In 1909,
nancial analyst John Moody issued a publication focused solely on railroad bonds.[12][13][14] His ratings became the rst to be published widely in an accessible
format,[10][12][15] and his company was the rst to charge
subscription fees to investors.[14]

When the United States began to expand to the west and

other parts of the country, so did the distance of businesses to their customers. When businesses were close In 1913, the ratings publication by Moodys underwent
159

160

CHAPTER 32. CREDIT RATING AGENCY

two signicant changes: it expanded its focus to include industrial rms and utilities, and it began to use a
letter-rating system. For the rst time, public securities
were rated using a system borrowed from the mercantile credit rating agencies, using letters to indicate their
creditworthiness.[16] In the next few years, antecedents
of the "Big Three" credit rating agencies were established. Poors Publishing Company began issuing ratings
in 1916, Standard Statistics Company in 1922,[12] and the
Fitch Publishing Company in 1924.[13]

32.1.2

Post-Depression era

In the United States, the rating industry grew and consolidated rapidly following the passage of the Glass-Steagall
act of 1933 and the separation of the securities business
from banking.[17] As the market grew beyond that of traditional investment banking institutions, new investors
again called for increased transparency, leading to the
passage of new, mandatory disclosure laws for issuers,
and the creation of the Securities and Exchange Commission (SEC).[10] In 1936, regulation was introduced to prohibit banks from investing in bonds determined by recognized rating manuals (the forerunners of credit rating
agencies) to be speculative investment securities (junk
bonds, in modern terminology). US banks were permitted to hold only investment grade bonds, and it was
the ratings of Fitch, Moodys, Poors, and Standard that
legally determined which bonds were which. State insurance regulators approved similar requirements in the following decades.[13]
From 1930 to 1980, the bonds and ratings of them
were primarily relegated to American municipalities
and American blue chip industrial rms.[18] International sovereign bond rating shrivelled during the
Great Depression to a handful of the most creditworthy
countries,[19] after a number of defaults of bonds issued
by governments such as Germanys.[18]
In the late 1960s and 1970s, ratings were extended to
commercial paper and bank deposits. Also during that
time, major agencies changed their business model by
beginning to charge bond issuers as well as investors.[12]
The reasons for this change included a growing free rider
problem related to the increasing availability of inexpensive photocopy machines[20] and the increased complexity of the nancial markets.[21]
The rating agencies added levels of gradation to their rating systems. In 1973, Fitch added plus and minus symbols to its existing letter-rating system. The following
year, Standard and Poors did the same, and Moodys began using numbers for the same purpose in 1982.[8]

32.1.3 Growth of bond market

The end of the Bretton Woods system in 1971 led to the
liberalization of nancial regulations and the global expansion of capital markets in the 1970s and 1980s.[12]
In 1975, SEC rules began explicitly referencing credit
ratings.[22] For example, the commission changed its
minimum capital requirements for broker-dealers, allowing smaller reserves for higher-rated bonds; the rating
would be done by nationally recognized statistical ratings organizations (NRSROs). This referred to the Big
Three,[23] but in time ten agencies (later six, due to consolidation) were identied by the SEC as NRSROs.[13][24]
Rating agencies also grew in size and protability as the
number of issuers accessing the debt markets grew exponentially, both in the United States and abroad.[25] By
2009 the worldwide bond market (total debt outstanding)
reached an estimated $82.2 trillion, in 2009 dollars.[26]

32.1.4 1980spresent
Two economic trends of the 1980s and 90s that brought
signicant expansion for the global capital market
were[12]
the move away from intermediated nancing
(bank loans) toward cheaper and longer-term disintermediated nancing (tradable bonds and other
xed income securities),[27] and
the global move away from state intervention and
state-led industrial adjustment toward economic liberalism based on (among other things) global capital
markets and arms-length relations between government and industry.[28]
More debt securities meant more business for the Big
Three agencies, which many investors depended on to
judge the securities of the capital market.[14] US government regulators also depended on the rating agencies;
they allowed pension funds and money market funds to
purchase only securities rated above certain levels.[29]
A market for low-rated, high-yield junk bonds blossomed in the late 1970s, expanding securities nancing
to rms other than a few large, established blue chip
corporations.[30] Rating agencies also began to apply their
ratings beyond bonds to counterparty risks, the performance risk of mortgage servicers, and the price volatility
of mutual funds and mortgage-backed securities.[8] Ratings were increasingly used in most developed countries
nancial markets and in the "emerging markets" of the
developing world. Moodys and S&P opened oces Europe, Japan, and particularly emerging markets.[12] NonAmerican agencies also developed outside of the United
States. Along with the largest US raters, one British, two
Canadian, and three Japanese rms were listed among
the worlds most inuential rating agencies in the early

32.2. ROLE IN CAPITAL MARKETS

161

1990s by the Financial Times publication Credit Ratings mote liquid markets.[52][53][54] These functions may inInternational.[31]
crease the supply of available risk capital in the market
[49][54]
Structured nance was another growth area of growth. and promote economic growth.
The nancial engineering of the new private-label
asset-backed securitiessuch as subprime mortgagebacked securities (MBS), collateralized debt obligations (CDO), CDOs squared, and "synthetic CDOs"
made them harder to understand and to price and became a prot center for rating agencies.[32] By 2006,
Moodys earned $881 million in revenue from structured
nance.[33] By December 2008, there were over $11 trillion structured nance debt securities outstanding in the
US bond market.[34]

32.2.1 Ratings use in bond market

Further information: Credit rating

Credit rating agencies provide assessments about the

creditworthiness of bonds issued by corporations,
governments, and packagers of asset-backed securities.[55][56] In market practice, a signicant bond
a rating from one or two of the
The Big Three issued 97%98% of all credit ratings in issuance generally has
[57]
Big
Three
agencies.
[35]
[36]
the United States and roughly 95% worldwide, giving them considerable pricing power.[37] This and credit CRAs theoretically provide investors with an indemarket expansion brought them prot margins of around pendent evaluation and assessment of debt securities'
50% from 2004 through 2009.[38][39]
creditworthiness.[52] However, in recent decades the payAs the inuence and protability of CRAs expanded, ing customers of CRAs have primarily been not issuers
raising the issue of conict of
so did scrutiny and concern about their performance of securities but buyers,
[58]
interest
(see
below).
and alleged illegal practices.[40] In 1996 the US Department of Justice launched an investigation into possible improper pressuring of issuers by Moodys in order to win business.[41][42] Agencies were subjected to
dozens of lawsuits by investors complaining of inaccurate
ratings[43][44] following the collapse of Enron,[12] and especially after the US subprime mortgage crisis and subsequent late-2000s nancial crisis.[45][46] During that debacle, 73%over $800 billion worth[47] of all mortgagebacked securities that one credit rating agency (Moodys)
had rated triple-A in 2006 were downgraded to junk status two years later.[47][48]
Downgrades of European and US sovereign debt were
also criticized. In August 2011, S&P downgraded the
long-held triple-A rating of US securities.[3] Since the
spring of 2010,
one or more of the Big Three relegated Greece, Portugal, and Ireland to "junk"
statusa move that many EU ocials say has
accelerated a burgeoning European sovereigndebt crisis. In January 2012, amid continued
eurozone instability, S&P downgraded nine eurozone countries, stripping France and Austria
of their triple-A ratings.[3]

32.2 Role in capital markets

Credit rating agencies assess the relative credit risk
of specic debt securities or structured nance instruments and borrowing entities (issuers of debt),[49]
and in some cases the creditworthiness of governments
and their securities.[50][51] By serving as information
intermediaries, CRAs theoretically reduce information
costs, increase the pool of potential borrowers, and pro-

In addition, rating agencies have been liableat least in

US courtsfor any losses incurred by the inaccuracy of
their ratings only if it is proven that they knew the ratings were false or exhibited reckless disregard for the
truth.[12][59][60] Otherwise, ratings are simply an expression of the agencies informed opinions,[61] protected as
free speech under the First Amendment.[62][63] As one
rating agency disclaimer read:
The ratings ... are and must be construed
solely as, statements of opinion and not statements of fact or recommendations to purchase,
sell, or hold any securities.[64]
Under an amendment to the 2010 Dodd-Frank Act, this
protection has been removed, but how the law will be implemented remains to be determined by rules made by the
SEC and decisions by courts.[65][66][67][68]
To determine a bonds rating, a credit rating agency analyzes the accounts of the issuer and the legal agreements
attached to the bond[69][70] to produce what is eectively
a forecast of the bonds chance of default, expected loss,
or a similar metric.[69] The metrics vary somewhat between the agencies. S&Ps ratings reect default probability, while ratings by Moodys reect expected investor
losses in the case of default.[71][72] For corporate obligations, Fitchs ratings incorporate a measure of investor
loss in the event of default, but its ratings on structured,
project, and public nance obligations narrowly measure
default risk.[73] The process and criteria for rating a convertible bond are similar, although dierent enough that
bonds and convertible bonds issued by the same entity
may still receive dierent ratings.[74] Some bank loans
may receive ratings to assist in wider syndication and attract institutional investors.[70]

162
The relative risksthe rating gradesare usually expressed through some variation of an alphabetical combination of lower- and uppercase letters, with either plus
or minus signs or numbers added to further ne-tune the
rating.[75][76]

CHAPTER 32. CREDIT RATING AGENCY

ties after their initial rating) and may change a securitys

rating if they feel its creditworthiness has changed. CRAs
typically signal in advance their intention to consider rating changes.[75][85] Fitch, Moodys, and S&P all use negative outlook notications to indicate the potential for
Further information: Bond credit rating Credit rating a downgrade within the next two years (one year in the
case of speculative-grade credits). Negative watch notiers
tications are used to indicate that a downgrade is likely
within the next 90 days.[75][85]
Fitch and S&P use (from the most creditworthy to the
least) AAA, AA, A, and BBB for investment-grade longterm credit risk and BB, CCC, CC, C, and D for spec- 32.2.2 Accuracy and responsiveness
ulative long-term credit risk. Moodys long-term designators are Aaa, Aa, A, and Baa for investment grade and
Further information: Credit rating agencies and the
Ba, B, Caa, Ca, and C for speculative grade.[75][76] Fitch
subprime crisis
and S&P use pluses and minuses (e.g., AA+ and AA-),
and Moodys uses numbers (e.g., Aa1 and Aa3) to add
Critics maintain that this rating, outlooking, and watchfurther gradations.[75][76]
ing of securities has not worked nearly as smoothly as
Agencies do not attach a hard number of probability of
agencies suggest. They point to near-defaults, defaults,
default to each grade, preferring descriptive denitions,
and nancial disasters not detected by the rating agencies
such as the obligors capacity to meet its nancial compost-issuance surveillance, or ratings of troubled debt semitment on the obligation is extremely strong, (from a
curities not downgraded until just before (or even afStandard and Poors denition of a AAA-rated bond) or
ter) bankruptcy.[86] These include the 1970 Penn Cenless vulnerable to non-payment than other speculative istral bankruptcy, the 1976 New York City scal crisues (for a BB-rated bond).[81] However, some studies
sis, the 1994 Orange County default, the Asian and
have estimated the average risk and reward of bonds by
Russian nancial crises, the 1998 collapse of the Longrating. One study by Moodys[79][80] claimed that over
Term Capital Management hedge fund, the 2001 Enron
a 5-year time horizon, bonds that were given its highand WorldCom bankruptcies, and especially the 20078
est rating (Aaa) had a cumulative default rate of just
subprime mortgage crisis.[86][87][88][89][90]
0.18%, the next highest (Aa2) 0.28%, the next (Baa2)
2.11%, 8.82% for the next (Ba2), and 31.24% for the In the 2001 Enron accounting scandal, the companys ratlowest it studied (B2). (See Default rate in Estimated ings remained at investment grade until four days before
spreads and default rates by rating grade table to right.) bankruptcythough Enrons stock had been in sharp de[91][92]
when the outlines of its
Over a longer time horizon, it stated, the order is by and cline for several months
[82]
fraudulent practices were rst revealed.[93] Critics comlarge, but not exactly, preserved.
plained that not a single analyst at either Moodys of S&P
Another study in the Journal of Finance calculated the
lost his job as a result of missing the Enron fraud and
additional interest rate or spread that corporate bonds
management stayed the same.[94] During the subprime
pay over that of riskless US Treasury bonds, according
crisis, when hundreds of billion of dollars worth[47] of
to the bonds rating. (See Basis point spread in the tatriple-A-rated mortgage-backed securities were abruptly
ble to right.) Looking at rated bonds from 1973 through
downgraded from triple-A to junk status within two
1989, the authors found a AAA-rated bond paid only 43
years of issue,[48] the CRAs ratings were characterized
"basis points" (or 43/100ths of a percentage point) more
by critics as catastrophically misleading[95] and prothan a Treasury bond (so that it would yield 3.43% if the
vided little or no value.[66][96] Ratings of preferred stocks
Treasury bond yielded 3.00%). A CCC-rated junk (or
also fared poorly. Despite over a year of rising mortgage
speculative) bond, on the other hand, paid over 4% more
deliquencies,[97] Moodys continued to rate Freddie Mac's
than a Treasury bond on average (7.04% if the Treasury
preferred stock triple-A until mid-2008, when it was
bond yielded 3.00%) over that period.[23][77]
downgraded to one tick above the junk bond level.[98][99]
The market also follows the benets from ratings that Some empirical studies have also found that rather than a
result from government regulations (see below), which downgrade lowering the market price and raising the inoften prohibit nancial institutions from purchasing se- terest rates of corporate bonds, the cause and eect are
curities rated below a certain level. For example, in reversed. Expanding yield spreads (i.e., declining value
the United States, in accordance with two 1989 regu- and quality) of corporate bonds precedes downgrades by
lations, pension funds are prohibited from investing in agencies, suggesting it is the market that alerts the CRAs
asset-backed securities rated below A,[83] and savings and of trouble and not vice versa.[100][101]
loan associations from investing in securities rated below
In response, defenders of credit rating agencies comBBB.[84]
plain of the markets lack of appreciation. Argues Robert
CRAs provide surveillance (ongoing review of securi- Clow, When a company or sovereign nation pays its debt

32.2. ROLE IN CAPITAL MARKETS

on time, the market barely takes momentary notice ... but
let a country or corporation unexpectedly miss a payment
or threaten default, and bondholders, lawyers and even
regulators are quick to rush the eld to protest the credit
analysts lapse.[81] Others say that bonds assigned a low
credit rating by rating agencies have been shown to default
more frequently than bonds that receive a high credit rating, suggesting that ratings still serve as a useful indicator
of credit risk.[65]
Explanations of aws
A number of explanations of the rating agencies inaccurate ratings and forecasts have been oered, especially in
the wake of the subprime crisis:[88][90]

163
rates on securities rise, but other contracts with nancial
institutions may also be aected adversely, causing an increase in nancing costs and an ensuing decrease in creditworthiness. Large loans to companies often contain a
clause that makes the loan due in full if the companys
credit rating is lowered beyond a certain point (usually
from investment grade to speculative). The purpose of
these ratings triggers is to ensure that the loan-making
bank is able to lay claim to a weak companys assets before the company declares bankruptcy and a receiver is
appointed to divide up the claims against the company.
The eect of such ratings triggers, however, can be devastating: under a worst-case scenario, once the companys
debt is downgraded by a CRA, the companys loans become due in full; if the company is incapable of paying all
of these loans in full at once, it is forced into bankruptcy
(a so-called death spiral). These ratings triggers were
instrumental in the collapse of Enron. Since that time,
major agencies have put extra eort into detecting them
and discouraging their use, and the US SEC requires that
public companies in the United States disclose their existence.

The methodologies employed by agencies to rate and

monitor securities may be inherently awed.[102] For
instance, a 2008 report by the Financial Stability
Forum singled out methodological shortcomings
especially inadequate historical dataas a contributing cause in the underestimating of the risk in
structured nance products by the CRAs before the
Reform laws
subprime mortgage crisis.[103]
The rating agencies interest in pleasing the issuers
of securities, who are their paying customers and
benet from high ratings, creates a conict with
their interest in providing accurate ratings of securities for investors buying the securities.[104] Issuers of securities benet from higher ratings in
that many of their customersretail banks, pension
funds, money market funds, insurance companies
are prohibited by law or otherwise restrained from
buying securities below a certain rating.[84]
The rating agencies may have been signicantly understaed during the subprime boom and thus unable to properly assess every debt instrument.[105]

The 2010 DoddFrank Wall Street Reform and Consumer Protection Act[107] mandated improvements to
the regulation of credit rating agencies and addressed
several issues relating to the accuracy of credit ratings specically.[65][68] Under Dodd-Frank rules, agencies must publicly disclose how their ratings have performed over time and must provide additional information in their analyses so investors can make better
decisions.[65][68] An amendment to the act also species
that ratings are not protected by the First Amendment as
free speech but are fundamentally commercial in character and should be subject to the same standards of liability and oversight as apply to auditors, securities analysts
and investment bankers.[66][65] Implementation of this
amendment has proven dicult due to conict between
the SEC and the rating agencies.[68][67] The Economist
magazine credits the free speech defence at least in part
for the fact that 41 legal actions targeting S&P have been
dropped or dismissed since the crisis.[108]

Agency analysts may be underpaid relative to similar

positions at investment banks and Wall Street rms,
resulting in a migration of credit rating analysts and
the analysts inside knowledge of rating procedures
to higher-paying jobs at the banks and rms that issue the securities being rated, and thereby facilitat- In the European Union, there is no specic legislation
ing the manipulation of ratings by issuers.[99]
governing contracts between issuers and credit rating
agencies.[67] General rules of contract law apply in full,
The functional use of ratings as regulatory mecha- although it is dicult to hold agencies liable for breach
nisms may inate their reputation for accuracy.[106] of contract.[67] In 2012, an Australian federal court held
Standard & Poors liable for inaccurate ratings.[67]
Excessive power

32.2.3 Ratings use in structured nance

Conversely, the complaint has been made that agencies

have too much power over issuers and that downgrades
can even force troubled companies into bankruptcy. The Further information: Structured nance
lowering of a credit score by a CRA can create a vicious
cycle and a self-fullling prophecy: not only do interest Credit rating agencies play a key role in structured -

164

CHAPTER 32. CREDIT RATING AGENCY

nancial transactions, a term that may refer to assetbacked securities (ABS), residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), collateralized debt obligations (CDOs),
"synthetic CDOs", or derivatives.[109]

to ratings-based constraints in buying securitiessome

investors simply prefer that a structured nance product be rated by a credit rating agency.[116] And not all
structured nance products receive a credit rating agency
rating.[116] Ratings for complicated or risky CDOs are unrelying
Credit ratings for structured nance instruments may be usual and some issuers create structured products
[116]
solely
on
internal
analytics
to
assess
credit
risk.
distinguished from ratings for other debt securities in several important ways.[110]
These securities are more complex and an accurate prognoses of repayment more dicult than with
other debt ratings.[110][111] This is because they are
formed by pooling debt usually consumer credit
assets, such as mortgages, credit card or auto loans
and structured by slicing the pool into multiple "tranches", each with a dierent priority of payment. Tranches are often likened to buckets capturing cascading water, where the water of monthly or
quarterly repayment ows down to the next bucket
(tranche) only if the one above has been lled with
its full share and is overowing. The higher-up
the bucket in the income stream, the lower its risk,
the higher its credit rating, and lower its interest
payment.[112] This means the higher-level tranches
have more credit worthiness than would a conventional unstructured, untranched bond with the same
repayment income stream, and allows rating agencies to rate the tranches triple A or other high grades.
Such securities are then eligible for purchase by
pension funds and money market funds restricted to
higher-rated debt, and for use by banks wanting to
reduce costly capital requirements.[113][114][115]

Subprime mortgage boom and crisis

Further information: Credit rating agencies and the
subprime crisis
The Financial Crisis Inquiry Commission[120] has described the Big Three rating agencies as key players
in the process of mortgage securitization,[32] providing reassurance of the soundness of the securities to
money manager investors with no history in the mortgage business.[121]
Credit rating agencies began issuing ratings for mortgagebacked securities (MBS) in the mid-1970s. In subsequent years, the ratings were applied to securities backed
by other types of assets.[116] During the rst years of
the twenty-rst century, demand for highly rated xed
income securities was high.[122] Growth was particularly strong and protable in the structured nance industry during the 2001-2006 subprime mortgage boom,
and business with nance industry accounted for almost
all of the revenue growth at at least one of the CRAs
(Moodys).[123]

From 2000 to 2007, Moodys rated nearly 45,000

CRAs are not only paid for giving ratings to struc- mortgage-related securities as triple-A. In contrast only
in the United States were
tured securities, but may be paid for advice on six (private sector) companies
[124]
[110][116]
given
that
top
rating.
how to structure tranches
and sometimes
the underlying assets that secure the debt[116][117] to Rating agencies were even more important in rating
achieve ratings the issuer desires. This involves back collateralized debt obligations (CDOs). These securities
and forth interaction and analysis between the spon- mortgage/asset backed security tranches lower in the wasor of the trust that issues the security and the rat- terfall of repayment that could not be rated triple-A, but
ing agency.[110][116] During this process, the sponsor for whom buyers had to found or the rest of the pool
may submit proposed structures to the agency for of mortgages and other assets could not be securitized.
analysis and feedback until the sponsor is satised Rating agencies solved the problem by rating 70%[125] to
with the ratings of the dierent tranches.[116][117]
80%[126] of the CDO tranches triple-A. Still another innovative structured product most of whose tranches were
Credit rating agencies employ varying methodolo- also given high ratings was the "synthetic CDO". Cheaper
gies to rate structured nance products, but gener- and easier to create than ordinary cash CDOs, they
ally focus on the type of pool of nancial assets un- paid insurance premium-like payments from credit dederlying the security and the proposed capital struc- fault swap insurance, instead of interest and principal
ture of the trust.[116] This approach often involves a payments from house mortgages. If the insured or refquantitative assessment in accordance with mathe- erenced CDOs defaulted, investors lost their investment,
matical models, and may thus introduce a degree of which was paid out much like an insurance claim.[127]
model risk.[110][118] However, bank models of risk
assessment have proven less reliable than credit rating agency models, even in the base of large banks Conict of interest
with sophisticated risk management procedures.[119]
However when it was discovered that the mortgages had
Aside from investors mentioned abovewho are subject been sold to buyers who could not pay them, massive

32.2. ROLE IN CAPITAL MARKETS

165

numbers of securities were downgraded, the securitiza- Sovereign credit ratings represent an assessment by a rattion seized up and the Great Recession ensued.[128][129] ing agency of a sovereigns ability and willingness to re[144]
The rating methodologies used to asCritics blamed this underestimation of the risk of the se- pay its debt.
sess
sovereign
credit
ratings are broadly similar to those
curities on the conict between two interests the CRAs
used
for
corporate
credit
ratings, although the borrowers
haverating securities accurately, and serving their cuswillingness
to
repay
receives
extra emphasis since na[130]
tomers, the security issuers
who need high ratings to
tional
governments
may
be
eligible
for debt immunity
sell to investors subject to ratings-based constraints, such
under
international
law,
thus
complicating
repayment
[114][115]
as pension funds and life insurance companies.
obligations.[142][143] In addition, credit assessments reWhile this conict had existed for years, the combination
of CRA focus on market share and earnings growth,[131] ect not only the long-term perceived default risk, but
also short or immediate term political and economic
the importance of structured nance to CRA prots,[132]
[145]
Dierences in sovereign ratings beand pressure from issuers who began to `shop around` for developments.
tween agencies may reect varying qualitative evaluations
the best ratings brought the conict to a head between
of the investment environment.[146]
2000 and 2007.[133][134][135][136]
National governments may solicit credit ratings to generate investor interest and improve access to the international capital markets.[145][146] Developing countries often depend on strong sovereign credit ratings to access
funding in international bond markets.[145] Once ratings
for a sovereign have been initiated, the rating agency will
A 2013 Swiss Finance Institute study of structured debt continue to monitor for relevant developments and adjust
ratings from S&P, Moodys, and Fitch found that agen- its credit opinion accordingly.[145]
cies provide better ratings for the structured products of
issuers that provide them with more overall bilateral rat- A 2010 International Monetary Fund study concluded
that ratings were a reasonably good indicator of
ing business.[138][139] This eect was found to be partic[52][147]
However, credit rating
ularly pronounced in the run-up to the subprime mort- sovereign-default risk.
agencies
were
criticized
for
failing
to predict the 1997
gage crisis.[138][139] Alternative accounts of the agencies
Asian
nancial
crisis
and
for
downgrading
countries in
inaccurate ratings before the crisis downplay the conict
the midst of that turmoil.[144] Similar criticisms emerged
of interest factor and focus instead on the agencies overdowngrades to Greece, Ireland, Portucondence in rating securities, which stemmed from faith after recent credit
[144]
gal,
and
Spain,
although credit ratings agencies had
in their methodologies and past successes with subprime
begun
to
downgrade
peripheral Eurozone countries well
[140][141]
securitizations.
before the Eurozone crisis began.[147]
In the wake of the global nancial crisis, various legal requirements were introduced to increase the transparency
of structured nance ratings. The European Union now Conict of interest in assigning sovereign ratings
requires credit rating agencies to use an additional symbol
with ratings for structured nance instruments in order to It has also been suggested that the credit agencies are condistinguish them from other rating categories.[110]
icted in assigning sovereign credit ratings since they have
a political incentive to show they do not need stricter regulation by being overly critical in their assessment of governments they regulate.[148]
32.2.4 Ratings use in sovereign debt
A small number of arrangers of structured nance
productsprimarily investment banksdrive a large
amount of business to the ratings agencies, and thus have
a much greater potential to exert undue inuence on a
rating agency than a single corporate debt issuer.[137]

Further information: Sovereign credit rating

Further information: List of countries by credit rating
Credit rating agencies also issue credit ratings for
sovereign borrowers, including national governments,
states, municipalities, and sovereign-supported international entities.[142] Sovereign borrowers are the largest
debt borrowers in many nancial markets.[142] Governments from both advanced economies and emerging
markets borrow money by issuing government bonds
and selling them to private investors, either overseas or
domestically.[143] Governments from emerging and developing markets may also choose to borrow from other
governments and international organizations, such as the
World Bank and the International Monetary Fund.[143]

As part of the SarbanesOxley Act of 2002, Congress ordered the U.S. SEC to develop a report, titled Report on
the Role and Function of Credit Rating Agencies in the
Operation of the Securities Markets[149] detailing how
credit ratings are used in U.S. regulation and the policy
issues this use raises. Partly as a result of this report, in
June 2003, the SEC published a concept release called
Rating Agencies and the Use of Credit Ratings under the
Federal Securities Laws[150] that sought public comment
on many of the issues raised in its report. Public comments on this concept release have also been published
on the SECs website.
In December 2004, the International Organization of
Securities Commissions (IOSCO) published a Code of
Conduct[151] for CRAs that, among other things, is designed to address the types of conicts of interest that

166
CRAs face. All of the major CRAs have agreed to sign
on to this Code of Conduct and it has been praised by
regulators ranging from the European Commission to the
US SEC.

CHAPTER 32. CREDIT RATING AGENCY

opinions.[152][159]

Against this background and in the wake of criticism of

credit rating agencies following the subprime mortgage
crisis, legislators in the United States and other jurisdictions have commenced to reduce rating reliance in laws
and regulations.[88][160] The 2010 DoddFrank Act re32.2.5 Use by government regulators
moves statutory references to credit rating agencies, and
calls for federal regulators to review and modify existing
Further information: Nationally recognized statistical
regulations to avoid relying on credit ratings as the sole
rating organization
assessment of creditworthiness.[161][162][163]
Further information: Basel III
Regulatory authorities and legislative bodies in the
United States and other jurisdictions rely on credit rating agencies assessments of a broad range of debt issuers, and thereby attach a regulatory function to their
ratings.[152][153] This regulatory role is a derivative function in that the agencies do not publish ratings for that
purpose.[152] Governing bodies at both the national and
international level have woven credit ratings into minimum capital requirements for banks, allowable investment alternatives for many institutional investors, and
similar restrictive regulations for insurance companies
and other nancial market participants.[154][155]

32.3 Industry structure

32.3.1 The Agencies

The three largest credit rating agenciesStandard &

Poors, Moodys Investors Service, and Fitch Ratings
are collectively referred to as the Big Three due to their
substantial market share.[73] In a 2012 report, the US
SEC calculated that the three agencies together accounted
for approximately 96% of all credit ratings.[164] In 2011,
Deutsche Welle reckoned their collective market share
The use of credit ratings by regulatory agencies is not at roughly 95%".[3][36]
a new phenomenon.[152] In the 1930s, regulators in the
United States used credit rating agency ratings to prohibit As of December 2012, S&P is the largest of the three,
outstanding ratings and 1,416 analysts
banks from investing in bonds that were deemed to be be- with 1.2 million[164][165]
and
supervisors;
Moodys has 1 million outstand[88]
low investment grade.
In the following decades, state
ing
ratings
and
1,252
analysts
and supervisors;[164][165]
regulators outlined a similar role for agency ratings in
restricting insurance company investments.[88][152] From and Fitch is the smallest, with approximately 350,000
used as an alter1975 to 2006, the U.S. Securities and Exchange Com- outstanding ratings, and is sometimes
[164][166]
native
to
S&P
and
Moodys.
mission (SEC) recognized the largest and most credible
agencies as Nationally Recognized Statistical Rating Or- The three largest agencies are not the only sources of
ganizations, and relied on such agencies exclusively for credit information.[55] Many smaller rating agencies also
distinguishing between grades of creditworthiness in vari- exist, mostly serving non-US markets.[167] All of the large
ous regulations under federal securities laws.[152][156] The securities rms have internal xed income analysts who
Credit Rating Agency Reform Act of 2006 created a vol- oer information about the risk and volatility of securiuntary registration system for CRAs that met a certain ties to their clients.[55] And specialized risk consultants
minimum criteria, and provided the SEC with broader working in a variety of elds oer credit models and deoversight authority.[157]
fault estimates.[55]
The practice of using credit rating agency ratings for regulatory purposes has since expanded globally.[152] Today,
nancial market regulations in many countries contain extensive references to ratings.[152][158] The Basel III accord, a global bank capital standardization eort, relies
on credit ratings to calculate minimum capital standards
and minimum liquidity ratios.[152]

Market share concentration is not a new development in

the credit rating industry. Since the establishment of the
rst agency in 1909, there have never been more than four
credit rating agencies with signicant market share.[168]
Even the Financial crisis of 200708where the performance of the three rating agencies was dubbed horrendous by The Economist magazine[169] led to a drop in
of the three by just one percentfrom 98 to
The extensive use of credit ratings for regulatory pur- the share
[170]
97%.
[152]
poses can have a number of unintended eects.
Because regulated market participants must follow mini- The reason for the concentrated market structure is dismum investment grade provisions, ratings changes across puted. One widely cited opinion is that the Big Threes
the investment/non-investment grade boundary may lead historical reputation within the nancial industry creates
to strong market price uctuations and potentially cause a high barrier of entry for new entrants.[168] Following
systemic reactions.[152] The regulatory function granted the enactment of the Credit Rating Agency Reform Act
to credit rating agencies may also adversely aect their of 2006 in the US, seven additional rating agencies atoriginal market information function of providing credit tained recognition from the SEC as nationally recognized

32.3. INDUSTRY STRUCTURE

statistical rating organization (NRSROs).[171][172] While
these other agencies remain niche players,[173] some have
gained market share following the Financial crisis of
200708,[174] and in October 2012 several announced
plans to join together and create a new organization called
the Universal Credit Rating Group.[175] The European
Union has considered setting up a state-supported EUbased agency.[176]

32.3.2

Business models

Credit rating agencies generate revenue from a variety

of activities related to the production and distribution of
credit ratings.[177] The sources of the revenue are generally the issuer of the securities or the investor. Most agencies operate under one or a combination of business models: the subscription model and the issuer-pays model.[50]
However, agencies may oer additional services using a
combination of business models.[177][178]
Under the subscription model, the credit rating agency
does not make its ratings freely available to the market, so investors pay a subscription fee for access to
ratings.[50][179] This revenue provides the main source of
agency income, although agencies may also provide other
types of services.[50][180] Under the issuer-pays model,
agencies charge issuers a fee for providing credit rating
assessments.[50] This revenue stream allows issuer-pays
credit rating agencies to make their ratings freely available
to the broader market, especially via the Internet.[181][182]

167
ing investors.[181][182] Issuer-pays CRAs have argued that
subscription-models can also be subject to conicts of interest due to pressures from investors with strong preferences on product ratings.[188] In 2010 Lace Financials,
a subscriber-pays agency later acquired by Kroll Ratings,
was ned by the SEC for violating securities rules to the
benet of its largest subscriber.[189]
A 2009 World Bank report proposed a hybrid approach
in which issuers who pay for ratings are required to seek
additional scores from subscriber-based third parties.[190]
Other proposed alternatives include a public-sector
model in which national governments fund the rating
costs, and an exchange-pays model, in which stock
and bond exchanges pay for the ratings.[188][191] Crowdsourced, collaborative models such as Wikirating have
been suggested as an alternative to both the subscription
and issuer-pays models, although it is a recent development as of the 2010, and not yet widely used.[192][193]

Oligopoly produced by regulation

Agencies are sometimes accused of being

oligopolists,[194] because barriers to market entry
are high and rating agency business is itself reputationbased (and the nance industry pays little attention to
a rating that is not widely recognized). In 2003, the
US SEC submitted a report to Congress detailing plans
to launch an investigation into the anti-competitive
practices of credit rating agencies and issues including
[195]
The subscription approach was the prevailing business conicts of interest.
model until the early 1970s, when Moodys, Fitch, Think tanks such as the World Pensions Council (WPC)
and nally Standard & Poors adopted the issuer-pays have argued that the Basel II/III capital adequacy norms
model.[50][179] Several factors contributed to this tran- favored at rst essentially by the central banks of France,
sition, including increased investor demand for credit Germany and Switzerland (while the US and the UK
ratings, and widespread use of information sharing were rather lukewarm) have unduly encouraged the use
technologysuch as fax machines and photocopiers of ready-made opinions produced by oligopolistic rating
which allowed investors to freely share agencies re- agencies [196][197]
ports and undermined demand for subscriptions.[183] Today, eight of the nine nationally recognized statisti- Of the large agencies, only Moodys is a separate, publicly
held corporation that discloses its nancial results without
cal rating organizations (NRSRO) use the issuer-pays
model, only Egan-Jones maintains an investor subscrip- dilution by non-ratings businesses, and its high prot margins (which at times have been greater than 50 percent of
tion service.[181] Smaller, regional credit rating agencies may use either model. For example, Chinas oldest gross margin) can be construed as consistent with the type
expect in an industry which has high
rating agency, Chengxin Credit Management Co., uses of returns one might
[198]
Celebrated investor Warren Buett
barriers
to
entry.
the issuer-pays model. The Universal Credit Ratings
described
the
company
as a natural duopoly, with inGroup, formed by Beijing-based Dagong Global Credit
credible
pricing
power,
when asked by the Financial CriRating, Egan-Jones of the U.S. and Russias RusRatsis
Inquiry
Commission
about his ownership of 15% of
ings claimed they are going to uses the investor-pays
[199][200]
the
company.
[184][185][186]
model.
While Dagong Europe Credit Rating,
the other joint-venture of Dagong Global Credit Rating According to professor Frank Partnoy, the regulation of
sticks with the issuer-pays model.
CRAs by the SEC and Federal Reserve Bank has elimiCritics argue that the issuer-pays model creates a po- nated competition between CRAs and practically forced
big
tential conict of interest because the agencies are paid market participants to use the services of the three
[201]
agencies,
Standard
and
Poors,
Moodys
and
Fitch.
[187]
by the organizations whose debt they rate.
However, the subscription model is also seen to have disad- SEC Commissioner Kathleen Casey has said that these
vantages, as it restricts the ratings availability to pay- CRAs have acted much like Fannie Mae, Freddie Mac

168
and other companies that dominate the market because
of government actions. When the CRAs gave ratings that
were catastrophically misleading, the large rating agencies enjoyed their most protable years ever during the
past decade.[201]
To solve this problem, Ms. Casey (and others such
as NYU professor Lawrence White[202] ) have proposed
removing the NRSRO rules completely.[201] Professor
Frank Partnoy suggests that the regulators use the results
of the credit risk swap markets rather than the ratings of
NRSROs.[201]

CHAPTER 32. CREDIT RATING AGENCY

market were caused by a combination of poorly constructed CDOs, irresponsible underwriting practices, and
awed credit rating procedures.
[7] http://www.buynowpaylatersites.net/
buy-now-pay-later-sites-the-history-of-personal-credit/
[8] Cantor, Richard; Packer, Frank (SummerFall 1994).
The credit rating industry. Federal Reserve Bank of New
York Quarterly Review (Federal Reserve Bank of New
York). pp. 126. ISSN 0147-6580.
[9] Langohr, Herwig M.; Patricia T., Langohr (2009). The
rating agencies and their credit ratings. Wiley, John &
Sons, Incorporated. ISBN 9780470018002.

The CRAs have made competing suggestions that would,

instead, add further regulations that would make market
[10] Richard Sylla (12 March 2000). A Historical Primer on
entrance even more expensive than it is now.[202]

32.4 See also

ICRA Limited
Lehman Brothers
Securities Industry and Financial Markets Association
List of countries by credit rating

32.5 References

the Business of Credit Ratings. The Role of Credit Reporting Systems in the International Economy. Washington,
D.C.: The World Bank. Retrieved 21 September 2013.
[11] Karp, Gregory (14 August 2011). Ratings game: Power
of S&P, other top credit agencies, grew from government
action. Chicago Tribune. Retrieved 21 September 2013.
[12] Sinclair, Timothy J. (2005). The New Masters of Capital:
American Bond Rating Agencies and the Politics of Creditworthiness. Ithaca, New York: Cornell University Press.
ISBN 978-0801474910. Retrieved 21 September 2013.
[13] White, Lawrence J. (Spring 2010).
The Credit
Rating Agencies. Journal of Economic Perspectives
(American Economic Association) 24 (2): 211226.
doi:10.1257/jep.24.2.211.
Retrieved 22 September
2013.

[1] A debt instrument is any type of documented nancial

obligation. A debt instrument makes it possible to transfer the ownership of debt so it can be traded. (source:
wisegeek.com)

[14] Yasuyuki, Fuchita; Robert E. Litan (2006). Financial

Gatekeepers: Can They Protect Investors?. Washington, D.C.: Brookings Institution Press. ISBN 9780815729815. Retrieved 21 September 2013.

[2] For example, in the US, a state government which shares

the credit responsibility for a Municipal bond issued by
a municipal government entities but under the control of
that state government entity. (source:Campbell R. Harveys Hypertextual Finance Glossary)

[15] Richard S. Wilson (1987). Corporate Senior Securities:

Analysis and Evaluation of Bonds, Convertibles, and Preferreds. Chicago: Probus.

[3] Alessi, Christopher. The Credit Rating Controversy.

Campaign 2012. Council on Foreign Relations. Retrieved 29 May 2013.
[4] $300 billion collateralized debt obligations (CDOs) issued
in 2005-2007 (over half of the CDOs by value during time
period) that rating agencies gave their highest triple-A
rating to, were written-down to junk by the end of 2009.
(source: The Financial Crisis Inquiry Report. National
Commission on the Causes of the Financial and Economic
Crisis in the United States. 2011. pp. 2289.)
[5] McLean, Bethany and Joe Nocera. All the Devils Are Here:
The Hidden History of the Financial Crisis, Portfolio, Penguin, 2010 (p.111)
[6] Barnett-Hart, Anna Katherine. The Story of the CDO
Market Meltdown: An Empirical Analysis. March 19,
2009. Harvard Kennedy School. Retrieved 28 May 2013.
Overall, my ndings suggest that the problems in the CDO

[16] Moodys History: A Century of Market Leadership.

moodys.com. Retrieved 17 September 2013.
[17] Sinclair, Timothy J. (2005). The New Masters of Capital:
American Bond Rating Agencies and the Politics of Creditworthiness. Ithaca, New York: Cornell University Press.
p. 26. ISBN 978-0801474910. Retrieved 21 September
2013. Rating entered a period of rapid growth and consolidation with this legally enforced separation and institutionalization of the securities business after 1929. Rating
became a standard requirement for selling any issue in the
United States, after many state governments incorporated
rating standards into their prudential rules for investment
by pension funds in the early 1930s.
[18] Alvin Toer, Powershift: Knowledge, wealth, Violence at
the Edge of the 21st Century, NY, Bantam, 1990, pages
43-57
[19] Sinclair, Timothy J. (2005). The New Masters of Capital:
American Bond Rating Agencies and the Politics of Creditworthiness. Ithaca, New York: Cornell University Press.

32.5. REFERENCES

p. 26. ISBN 978-0801474910. Retrieved 21 September

2013. In this era of rating conservatism, sovereign rating
coverage was reduced to a handful of the most creditworthy countries.
[20] White, Ben (31 January 2002). Do Rating Agencies
Make the Grade?; Enron Case Revives Some Old Issues.
The Washington Post.
[21] White, Lawrence J. (24 January 2009).
Agency
ProblemsAnd Their Solution. The American. American Enterprise Institute. Retrieved 21 September 2013.
[22] Christopher Cox (26 September 2007). The Role and
Impact of Credit Rating Agencies on the Subprime Credit
Markets. sec.gov. Securities and Exchange Commission.
Retrieved 20 September 2013.
[23] Cantor, Richard; Packer, Frank (SummerFall 1994).
The credit rating industry. Federal Reserve Bank of New
York Quarterly Review (Federal Reserve Bank of New
York). p. 8. ISSN 0147-6580. When the phrase NRSRO
was rst used, the SEC was referring to the three agencies that had a national presence at that time, Moodys,
Standard and Poors and Fitch.
[24] Oversight of Credit Rating Agencies Registered as
Nationally Recognized Statistical Rating Organization.
sec.gov. Securities and Exchange Commission. 2 February 2007. Retrieved 19 September 2013.
[25] Clarke, Thomas (2009). European corporate governance:
readings and perspectives. Taylor & Francis. p. 15. ISBN
9780415405331. Retrieved 21 September 2013.
[26] Outstanding World Bond Market Debt from the Bank for
International Settlements via Asset Allocation Advisor.
Original BIS data as of March 31, 2009; Asset Allocation
Advisor compilation as of November 15, 2009. Accessed
January 7, 2010.
[27] Sinclair, Timothy J. (2005). The New Masters of Capital: American Bond Rating Agencies and the Politics of
Creditworthiness. Ithaca, New York: Cornell University
Press. pp. 5456. ISBN 978-0801474910. Retrieved 21
September 2013. Changes in the nancial markets have
made people think the agencies are increasingly important. ... What is disintermediation? Banks acted as nancial intermediaries in that they brought together suppliers
and users of funds. ... Disintermediation has occurred on
both sides of the balance sheet. Mutual funds ... now contain $2 trillion in assets not much less than the $2.7 trillion held in U.S. bank deposits. ... In 1970, commercial
lending by banks made up 65% of the borrowing needs of
corporate America. By 1992, the banks share had fallen
to 36%
[28] Sinclair, Timothy J. (2005). The New Masters of Capital: American Bond Rating Agencies and the Politics of
Creditworthiness. Ithaca, New York: Cornell University
Press. pp. 5759. ISBN 978-0801474910. Retrieved 21
September 2013.
[29] Financial Crisis Inquiry Report. GPO. 2011. p. 119.
Credit ratings also determined whether investors could
buy certain investments at all. The SEC restricts money

169

market funds to purchasing securities that have received

credit ratings from any two NRSROs ... in one of the
two highest short-term rating categories or comparable
unrated securities. The Department of Labor restricts
pension fund investments to securities rated A or higher.
Credit ratings aect even private transactions: contracts
may contain triggers that require the posting of collateral
or immediate repayment, should a security or entity be
downgraded. Triggers played an important role in the nancial crisis and helped cripple AIG.
[30] Sinclair, Timothy J. (2005). The New Masters of Capital: American Bond Rating Agencies and the Politics of
Creditworthiness. Ithaca, New York: Cornell University
Press. pp. 5759. ISBN 978-0801474910. Retrieved 21
September 2013. The third period of rating development
began in the 1980s, as a market in low-rated, high-yield
(junk) bonds developed. This market a feature of the
newly released energies of nancial globalization saw
many new entrants into capital markets.
[31] Cantor, Richard; Packer, Frank (SummerFall 1994).
The credit rating industry. Federal Reserve Bank of New
York Quarterly Review (Federal Reserve Bank of New
York). p. 2. ISSN 0147-6580. Table 1. Selected Bond
Rating Agencies
[32] The Financial Crisis Inquiry Report. National Commission on the Causes of the Financial and Economic Crisis
in the United States. 2011. pp. 4344. Purchasers of
the safer tranches got a higher rate of return than ultrasafe Treasury notes without much extra riskat least in
theory. However, the nancial engineering behind these
investments made them harder to understand and to price
than individual loans. To determine likely returns, investors had to calculate the statistical probabilities that
certain kinds of mortgages might default, and to estimate
the revenues that would be lost because of those defaults.
Then investors had to determine the eect of the losses on
the payments to dierent tranches. This complexity transformed the three leading credit rating agenciesMoodys,
Standard & Poors (S&P), and Fitchinto key players in
the process, positioned between the issuers and the investors of securities.
[33] Alessi, Christopher. The Credit Rating Controversy.
Campaign 2012. Council on Foreign Relations. Retrieved 29 May 2013. By 2006, Moodys had earned more
revenue from structured nance $881 million than all
its business revenues combined for 2001
[34] Benmelech, Efraim; Jennifer Dlugosz (2009). The
Credit Rating Crisis. NBER Macroeconomics Annual
2009, (in Volume 24). National Bureau of Economic Research, NBER Macroeconomics Annual.
[35] Status quo for rating agencies (chart of percentage of
outstanding credit ratings reported to the SEC 2007 and
2011; and Moodys revenue and income 1996, 2000,
2010, 2012)| mcclatchydc.com
[36] Alessi, Christopher. The Credit Rating Controversy.
Campaign 2012. Council on Foreign Relations. `The
three major rating agencies hold a collective market share
of roughly 95%. Their special status has been cemented

170

CHAPTER 32. CREDIT RATING AGENCY

by law at rst only in the United States, but then in Europe as well,` explains an analysis by DeutscheWelle.
[37] Evans, David; Caroline Salas (April 29, 2009). Flawed
Credit Ratings Reap Prots as Regulators Fail (Update1)". Bloomberg. S&P, Moodys and Fitch control
98 percent of the market for debt ratings in the U.S., according to the SEC. The noncompetitive market leads to
high fees, says SEC Commissioner Casey, 43, appointed
by President George W. Bush in July 2006 to a ve-year
term. S&P, a unit of McGraw-Hill Cos., has prot margins similar to those at Moodys, she says. `Theyve beneted from the monopoly status that theyve achieved with a
tremendous amount of assistance from regulators,` Casey
says.
[38] Evans, David; Caroline Salas (April 29, 2009). Flawed
Credit Ratings Reap Prots as Regulators Fail (Update1)". Bloomberg. Moodys, the only one of the three
that stands alone as a publicly traded company, has averaged pretax prot margins of 52 percent over the past
ve years. It reported revenue of $1.76 billion earning a pretax margin of 41 percent even during the economic collapse in 2008. S&P, Moodys and Fitch control
98 percent of the market for debt ratings in the U.S., according to the SEC. The noncompetitive market leads to
high fees, says SEC Commissioner Casey, 43, appointed
by President George W. Bush in July 2006 to a ve-year
term. S&P, a unit of McGraw-Hill Cos., has prot margins similar to those at Moodys, she says.
[39] Younglai, Rachelle; daCosta, Ana (2 August 2011).
Insight: When ratings agencies judge the world. Reuters.
Retrieved 20 September 2013. Critics say this created
perverse incentives such that at the height of the credit
boom in 2005 to 2007, the agencies recklessly awarded
Triple A ratings to complex exotic structured instruments
that they scarcely understood. They have proted handsomely. In the three-year period ending in 2007, the
height of the credit boom, S&Ps operating prot rose 73
percent to $3.58 billion compared to the three-year period ending in 2004. The comparable gain for Moodys
over the same period was 68 percent to $3.33 billion.
[40] Sinclair, Timothy J. (2005). The New Masters of Capital:
American Bond Rating Agencies and the Politics of Creditworthiness. Ithaca, New York: Cornell University Press.
p. 154. ISBN 978-0801474910. Retrieved 21 September
2013. Today [2008] expressions of concern about rating
performance how good the rating agencies are at their
business have become the norm. Newspapers, magazines, and online sites talk continuously about the agencies
and their failings.

pressure` issuers in order to win business. ... If they come

to be viewed as `shakedown artists,` using ratings to generate business, this will undermine credit markets.
[43] S&P Lawsuit First Amendment Defense May Fare
Poorly, Experts Say. 4 February 2013 (Hu Post). 4
February 2013. Retrieved 4 September 2013. Investors,
including public pension funds and foreign banks, lost
hundreds of billions of dollars, and have since led dozens
of lawsuits against the agencies.
[44] Utley, Michael (12 June 1996). Orange County widens
lawsuit to include S&P, Morgan Stanley. The Bond
Buyer.
[45] Ratings in structured nance: what went wrong and what
can be done to address shortcomings?". CGFS Papers
(Committee on the Global Financial System) 32. July
2008.
[46] Gallu, Joshua; Faux, Zeke (27 September 2011). SECs
Notice to S&P May Signal Enforcement Cases Against
Raters. Bloomberg Businessweek. Retrieved 19 September 2013.
[47] Alessi, Christopher. The Credit Rating Controversy.
Campaign 2012. Council on Foreign Relations. Retrieved 29 May 2013. In 2007, as housing prices began
to tumble, Moodys downgraded 83% of the $869 billion
in mortgage securities it had rated at the AAA level in
2006
[48] The Financial Crisis Inquiry Report. National Commission on the Causes of the Financial and Economic Crisis
in the United States. 2011. p. 122. Retrieved 5 November 2013. In October 2007, the M4-M11 tranches [on one
subprime mortgage backed deal the FCIC followed] were
downgraded and by 2008, all the tranches were downgraded. Of all mortgage-backed securities it rated tripleA in 2006, Moodys downgraded 73% to junk.
[49] Essvale Corporation (2006). Business Knowledge for IT in
Investment Banking. Essvale Corporation Limited. p. 31.
ISBN 0955412404.
[50] Gerard Caprio (2012). Handbook of Key Global Financial
Markets, Institutions, and Infrastructure. Academic Press.
ISBN 0123978734.
[51] Andrew Crockett; Trevor Harris; Frederic S. Mishkin;
Eugene N. White (2003). Conicts of Interest in the Financial Services Industry: What Should We Do about Them?.
Centre for Economic Policy Research.

[41] Watching the Watchers: Justice Department Launches

Probe of Moodys Ratings. Tulsa World. 28 March
1996.

[52] Global Financial Stability Report Chapter 3: The Uses and

Abuses of Sovereign Credit Ratings (pdf). International
Monetary Fund. October 2010.

[42] Sinclair, Timothy J. (2005). The New Masters of Capital:

American Bond Rating Agencies and the Politics of Creditworthiness. Ithaca, New York: Cornell University Press.
ISBN 978-0801474910. Retrieved 21 September 2013.
The concern of the Justice Departments antitrust division
was that unsolicited ratings were, in eect, anticompetitive. Rating rms could use the practice to `improperly

[53] Gerard Caprio (2002). Adrienne Heritier, ed. Common

Goods: Reinventing European Integration Governance.
Rowman & Littleeld. p. 296. ISBN 0742517012.
[54] Ahmed Naciri (2009). Internal and External Aspects of
Corporate Governance. Routledge. pp. 206207. ISBN
0415776414.

32.5. REFERENCES

171

[55] Edward Altman; Sabri Oncu; Anjolein Schmeits;

Lawrence White (6 April 2010). What Should be Done
About the Credit Rating Agencies. Regulating Wall
Street. New York University. Retrieved 11 October 2013.

[68] Jia Lynn Yang; Dina ElBoghdady (6 February 2013).

Overhaul of rating agencies bogs down four years after
nancial crisis. The Washington Post. Retrieved 11 October 2007.

[56] David Stowell (2012). Investment Banks, Hedge Funds,

and Private Equity. Academic Press. pp. 143145. ISBN
012415820X.

[69] Patrick J. Brown (2006). An Introduction to the Bond Markets. Wiley. pp. 2930. ISBN 0470015837.

[57] McLean, Bethany; Joe Nocera (2010). All the Devils Are
Here: The Hidden History of the Financial Crisis. Portfolio Penguin. pp. 112117. ISBN 1591843634.
[58] Sinclair, Timothy J. (2005). The New Masters of Capital:
American Bond Rating Agencies and the Politics of Creditworthiness. Ithaca, New York: Cornell University Press.
p. 29. ISBN 978-0801474910. Retrieved 21 September
2013. In the late 1960s and early 1970s, raters began to
charge fees to bond issuers to pay for ratings. Today, at
least 75% of the agencies income is obtained from such
fees.
[59] CREDIT AGENCY REFORM ACT of 2006. October 27, 2006. CAHILL GORDON & REINDEL LLP.
Retrieved 30 November 2013. These courts have held,
among other things, that rating agencies are protected by
the actual malice standard, which insulates them from
liability for their ratings unless the publications are made
with knowledge of falsity or reckless disregard for the
truth.
[60] Credit and blame. The Economist. 6 September 2007.
It is very hard to see how this combination can be justied. Imagine if patients were forced to use doctors whose
incomes depended on the pharmaceutical companies, but
who were immune from lawsuits if they prescribed a toxic
drug.
[61] John B Caouette; Edward Altman; Paul Narayanan;
Robert Nimmo (2008). 6: The Rating Agencies.
Managing Credit Risk: The Great Challenge for Global Financial Markets. Wiley Finance. ISBN 0470118725.
[62] Ashby Jones (21 April 2009). A First Amendment Defense for the Rating Agencies?". The Wall Street Journal.
Retrieved 11 October 2013.
[63] Free speech or knowing misrepresentation.
The
Economist. 5 February 2013. Retrieved 11 October 2013.
[64] The Financial Crisis Inquiry Commission (January 2011).
The Financial Crisis Inquiry Report (pdf). US Government Printing Oce. p. 120.
[65] Je Madura (2011). Financial Markets and Institutions. South-Western Cengage Learning. p. 49. ISBN
0538482133.

[70] E.R. Yescombe (2007). Public-Private Partnerships: Principles of Policy and Finance. Butterworth-Heinemann.
pp. 135137. ISBN 0750680547.
[71] Felix Salmon (9 August 2011). The dierence between
S&P and Moodys. Reuters.
[72] Kristin Samuelson (8 January 2012). Why do S&P,
Moodys and Fitch matter?". The Chicago Tribune.
[73] H. Kent Baker; Gerald S. Martin (2011). Capital Structure
and Corporate Financing Decisions: Theory, Evidence,
and Practice. Wiley. ISBN 0470569522.
[74] Jan De Spiegeleer; Wim Schoutens (2011). The Handbook of Convertible Bonds: Pricing, Strategies and Risk
Management. Wiley. pp. 5556. ISBN 0470689684.
[75] Global Financial Stability Report Chapter 3: The Uses and
Abuses of Sovereign Credit Ratings (pdf). International
Monetary Fund. October 2010. pp. 8889.
[76] Permanent Subcommittee on Investigations (13 April
2011). Wall Street & the Financial Crisis - Anatomy of
a Financial Collapse (pdf). United States Senate. p. 27.
[77] from Altman, Edward I Measuring Corporate Bond Mortality and Performance Journal of Finance, (September
1989) p.909-22
[78] Note: Based on equally weighted averages of monthly
spreads per rating category. Spreads for BB and B represent data from 1979-87 only, spreads for CCC, data for
1982-87 only.
[79] Cantor, R., Hamilton, D.T., Kim, F., and Ou, S., 2007
Corporate default and recovery rates. 1920-2006, Special Comment: Moodys investor Service, June Report
102071, 1-48 page 24
[80] cited by authors Herwig Langohr and Patricia Langohr
[81] Sinclair, Timothy J. (2005). The New Masters of Capital:
American Bond Rating Agencies and the Politics of Creditworthiness. Ithaca, New York: Cornell University Press.
p. 36, Bond Rating Symbols and Denitions, Table 2,.
ISBN 978-0801474910. Retrieved 21 September 2013.
[82] Langohr, Herwig; Patricia Langohr (2010). The Rating
Agencies and Their Credit Ratings: What They Are, How
They Work. Wiley. p. 48. ISBN 9780470714355.

[66] John Lippert (7 December 2010). Credit Ratings

Can't Claim Free Speech in Law Giving New Risks.
Bloomberg Markets Magazine. Retrieved 11 October
2013.

[83] Sicilia, David. Roots of Credit Rating Agency Shortcomings. May 24th, 2011. Center for Financial Policy. Retrieved 17 December 2013. A more recent example is the
1989 regulation allowing pension funds to invest in assetbacked securities rated A or higher.

[67] Brigitte Haar (2013). Civil Liability of Credit Rating

Agencies (pdf). Center of Excellence SAFE. Retrieved
27 August 2013.

[84] Sinclair, Timothy J. (2005). The New Masters of Capital. Cornell University. p. 43,. table 3, Ratings in U.S.
regulation

172

[85] Rabah Arezki; Bertrand Candelon; Amadou N.R. Sy

(2011). Sovereign Rating News and Financial Markets spillovers: Evidence from the European Debt Crisis
(pdf). International Monetary Fund. p. 5.

CHAPTER 32. CREDIT RATING AGENCY

[98] The downgrade was precipitated by Warren Buett's

telling CNBC that he had passed on an opportunity to
help the troubled mortgage giant.Associated Press (August 22, 2008). Freddie Mac courts investors, Buffett passes. International Herald Tribune via Internet
Archive. Retrieved August 6, 2011.

[86] McLean, Bethany; Joe Nocera (2010). All the Devils Are
Here. Portfolio Penguin. pp. 113114. The agencies had
charts and studies showing that their ratings were accu- [99] Michael Lewis (2010). The Big Short : Inside the Doomsday Machine. WW Norton and Co. p. 156. ISBN
rate a very high percentage of the time. But anyone who
0393338827.
dig more deeply could nd many instances when they got
it wrong, usually when something unexpected happened.
The rating agencies had missed the near default of New [100] Kliger, D. and O. Sarig (2000), The Information Value
of Bond Ratings, Journal of Finance, December: 2879York City, the bankruptcy of Orange County, and the
2902
Asian and Russian meltdowns. They failed to catch Penn
Central in the 1970s and Long-Term Capital Management
in the 1990s. They often downgraded companies just days [101] Galil, Koresh (2003). The quality of corporate credit rating: An empirical investigation. EFMA 2003 Helsinki
before bankruptcy too late to help investors. Nor was
Meetings. European Financial Management Association.
this anything new: one study showed that 78% of the municipal bonds rated double A or triple-A in 1929 defaulted
[102] Siegfried Utzig (2010). The nancial crisis and the reguduring the Great Depression.
lation of credit rating agencies: A European banking perspective (pdf). Asian Development Bank Institute. Re[87] Bethany McLean; Joe Nocera (2010). All the Devils Are
trieved 11 October 2013.
Here, the Hidden History of the Financial Crisis. Portfolio
Penguin. pp. 113114. ISBN 1591843634.
[103] Report of the Financial Stability Form on Enhancing
[88] Lawrence J. White (2010). Markets: The Credit Rating
Agencies (pdf). Journal of Economic Perspectives.
[89] David Stowell (2012). Investment Banks, Hedge Funds,
and Private Equity. Academic Press. pp. 146147. ISBN
012415820X.

Market and Institutional Resilience (pdf). Financial Stability Forum. 7 April 2008. Retrieved 11 October 2013.
[104] Muhamed Ali Khanzada (2010). The Role and Criticisms of Credit Rating Agencies in the Financial Crisis
(pdf). The Financial Crisis of 2008: French and American Responses. University of Maine. p. 567. Retrieved
11 October 2013.

[90] Permanent Subcommittee on Investigations (13 April

2011). Wall Street & the Financial Crisis - Anatomy of [105] Bethany McLean; Joe Nocera (2010). All the Devils Are
a Financial Collapse (pdf). United States Senate.
Here: The Hidden History of the Financial Crisis. Portfolio Penguin. p. 123. ISBN 1591843634.
[91] Borrus, Amy (8 April 2002). The Credit-Raters: How
They Work and How They Might Work Better. Busi- [106] Frank Partnoy (1999). The Siskel and Ebert of FinannessWeek.
cial Markets?: Two Thumbs Down for the Credit Rating
Agencies. Washington University Law Review (Univer[92] Wyatt, Edward (8 February 2002). Credit Agencies
sity of Washington) 77 (3). Retrieved 11 October 2013.
Waited Months to Voice Doubt About Enron. New York
Times.
[107] Bill Summary & Status 111th Congress (20092010)
H.R.4173 All Information THOMAS (Library of
[93] McLean and Nocera, All the Devils Are Here, 2010, p.119
Congress)". Library of Congress. Retrieved 11 October
2013.
[94] Bethany McLean; Joe Nocera (2010). All the Devils Are
Here: The Hidden History of the Financial Crisis. Portfo- [108] Free speech or knowing misrepresentation?". The
lio Penguin. p. 120. ISBN 1591843634. Not a single
Economist. 5 February 2013.
analyst at either Moodys of S&P lost his job as a result of
missing the Enron fraud. Management stayed the same. [109] Frank J. Fabozzi; Henry A. Davis; Moorad Choudhry
Moodys stock price, after a brief tumble, began rising
(2006). Introduction to Structured Finance. Wiley. pp.
again .... `Enron taught them how small the consequences
910. ISBN 0470045353.
of a bad reputation were.`
[110] Gerard Caprio (2012). Handbook of Key Global Financial
[95] (according to the head of the SEC), Casey, Kathleen. ""In
Markets, Institutions, and Infrastructure. Academic Press.
Search of Transparency, Accountability, and Competipp. 383383. ISBN 0123978734.
tion: The Regulation of Credit Rating Agencies, remarks
at The SEC Speaks in 2009"". February 6, 2009. US [111] Qiao Liu; Paul Lejot; Douglas W Arner (2013). Finance
in Asia: Institutions, Regulation and Policy. Routledge. p.
SEC. Retrieved 21 August 2013.
280. ISBN 0415423201.
[96] (Chairman of the Financial Crisis Inquiry Commission
[112] Whats a C.D.O.?". Upstart Business Journal (American
Chairman, Phil Angelides)
City Business Journals). 5 December 2007. Retrieved 19
[97] Financial Crisis Inquiry Report, gure 11.2, p.217
November 2013.

32.5. REFERENCES

173

[113] McLean, and Nocera. All the Devils Are Here, 2010 [123] In the case of the one CRA that was a separate public
(p.111)
company Moodys Between the time it was spun o
into a public company and February 2007, its stock had
[114] Joshua D. Coval; Jakub Jurek; Erik Staord (2008). The
risen 340%. Structured nance was approaching 50% of
Economics of Structured Finance. Harvard Business ReMoodys revenue up from 28% in 1998. It accounted for
view. Retrieved 11 October 2013.
pretty much all of Moodys growth."|McLean and Nocera,
All the Devils Are Here, 2010 (p.124)
[115] Joel Telpner (2003). A securitisation primer for rst time
issuers (pdf). Global Securitisation and Structured Fi- [124] The Financial Crisis Inquiry Report. National Commisnance 2003. Greenberg Traurig. Retrieved 11 October
sion on the Causes of the Financial and Economic Crisis
2013.
in the United States. 2011. p. xxv.
[116] The Role of Credit Rating Agencies in Structured Fi- [125] 70%. Firms bought mortgage-backed bonds with the
very highest yields they could nd and reassembled them
nance Markets (pdf). International Organization of Seinto new CDOs. The original bonds ... could be lowercurities Commissions. May 2008. Retrieved 11 October
rated securities that once reassembled into a new CDO
2013.
would wind up with as much as 70% of the tranches rated
[117] David Stowell (2012). 7: Credit Rating Agencies, Extriple-A. Ratings arbitrage, Wall Street called this pracchanges, and Clearing and Settlement. Investment Banks,
tice. A more accurate term would have been ratings launHedge Funds, and Private Equity. Academic Press. ISBN
dering. (source: McLean and Nocera, All the Devils Are
012415820X.
Here, 2010 p.122)
[118] Walter V. Haslett Jr. (2010). Risk Management: Foun- [126] 80%. In a CDO you gathered a 100 dierent mortgage
bonds usually the riskiest lower oors of the original
dations For a Changing Financial World. Wiley. p. 434.
tower ...... They bear a lower credit rating triple B. ... if
ISBN 0470903392.
you could somehow get them rerated as triple A, thereby
[119] World Bank (2012). Global Financial Development Relowering their perceived risk, however dishonestly and arport 2013: Rethinking the Role of the State in Finance.
ticially. This is what Goldman Sachs had cleverly done.
World Bank Publications. p. 60. ISBN 0821395033.
it was absurd. The 100 buildings occupied the same ood[B]ank models of risk assessment have proved to be even
plain; in the event of ood, the ground oors of all of them
less reliable than credit ratings, including in the largest
were equally exposed. But never mind: the rating agenbanks where risk management was widely believed to
cies, who were paid fat fees by Goldman Sachs and other
most advanced.
Wall Street rms for each deal they rated, pronounced
80% of the new tower of debt triple-A. (source: Michael
[120] set up by the US Congress and President to investigate the
Lewis, The Big Short : Inside the Doomsday Machine WW
causes of the crisis, and publisher of the Financial Crisis
Norton and Co, 2010, p.73)
Inquiry Report (FCIR)
[127] Unlike the traditional cash CDO, synthetic CDOs con[121] The Financial Crisis Inquiry Report. National Commistained no actual tranches of mortgage-backed securities
sion on the Causes of the Financial and Economic Crisis
... in the place of real mortgage assets, these CDOs conin the United States. 2011. p. 44. Participants in the secutained credit default swaps and did not nance a single
ritization industry realized that they needed to secure fahome purchase. (source: The Financial Crisis Inquiry Revorable credit ratings in order to sell structured products to
port, 2011, p.142)
investors. Investment banks therefore paid handsome fees
to the rating agencies to obtain the desired ratings. The [128] Gelinas, Nicole (2009). Can the Feds Uncrunch
Credit?". City-journal.org. Retrieved 2009-02-27.
rating agencies were important tools to do that because
you know the people that we were selling these bonds to
had never really had any history in the mortgage business. [129] Brookings Institute U.S. Financial and Economic Crisis
June 2009 PDF Page 14
... They were looking for an independent party to develop
an opinion, Jim Callahan told the FCIC; Callahan is CEO [130] Buttonwood Credit and blame. The Economist. 6
of PentAlpha, which services the securitization industry,
September 2007. Retrieved 11 October 2013.
and years ago he worked on some of the earliest securitizations
[131] McLean, Bethany; Nocera, Joe (2010). All the Devils
Are Here. Portfolio, Penguin. pp. 1145. What caused
[122] Giant Pool of Money (transcript)". Originally aired
Moodys to change were three things. ... the inexorable
05.09.2008. This American Life (radio program) from
rise of structured nance, and the concomitant rise of
WBEZ. Retrieved 3 September 2013. Adam Davidson:
Moodys structured products business. ... the 2000 spinAnd by the way, before you nance enthusiasts start writo, which resulted in many Moodys executives getting
ing any letters, we do know that $70 trillion technically
stock options and gave them a new appreciation for genrefers to that subset of global savings called xed income
erating revenues and prots.
securities. ... Ceyla Pazarbasioglu: This number doubled
since 2000. In 2000 this was about $36 trillion. Adam [132] McLean, Bethany; Nocera, Joe (2010). All the Devils Are
Here. Portfolio, Penguin. p. 124. Between the time it
Davidson: So it took several hundred years for the world
was spun o into a public company and February 2007,
to get to $36 trillion. And then it took six years to get
[Moodys] stock had risen 340%. Structured nance was
another $36 trillion.

174

CHAPTER 32. CREDIT RATING AGENCY

approaching 50% of Moodys revenue up from 28% in [144] Jakob de Haan; Fabian Amtenbrink (January 2011).
1998. It accounted for pretty much all of Moodys growth.
Credit Rating Agencies (pdf). DNB Working Paper
(278). De Nederlandsche Bank. Retrieved 11 October
[133] The Financial Crisis Inquiry Report. National Commis2013.
sion on the Causes of the Financial and Economic Crisis
in the United States. 2011. pp. xxv. The three credit rat- [145] Suk-Joong Kim; Eliza Wu (2011). 38: Can Sovereign
Credit Ratings Promote Financial Sector Development
ing agencies were key enableers of the nancial meltdown
and Capital Inows to Emerging Markets?". In Robert
... forces at work ... includ[e] awed computer models,
Kolb. Sovereign Debt: From Safety to Default. Wiley. pp.
the pressure from nancial rms that paid for that ratings,
345347. ISBN 0470922397.
the relentless drive for market share, ...)
[146] Shreekant Iyengar (2012). The Credit Rating Agencies
[134] McLean, Bethany; Nocera, Joe (2010). All the Devils Are
Are They Reliable? A Study of Sovereign Ratings.
Here. Penguin. p. 118. ISBN 9781101551059. ReVikalpa (Indian Institute of Management) 37 (1): 6982.
trieved June 5, 2014. [Example from page 118] UBS
Retrieved 11 October 2013.
banker Robert Morelli, upon hearing that S&P might be
revising its RMSBS ratings, sent an e-mail to an S&P ana- [147] Credit-rating agencies: Judges with tenure. The
lyst. 'Heard your ratings could be 5 notches back of modEconomist. 13 August 2011. Retrieved 11 October 2013.
dys [sic] equivalent, Gonna kill you resi biz. May force us
[148] Will Financial Reform Negatively Bias U.S. Sovereign
to do moddytch only ...'"
Credit Ratings?". Thoughtsworththinking.net. May 21,
[135] Credit and blame. The Economist. 2007-09-06.
2010.
[136] The Financial Crisis Inquiry Report. National Commission on the Causes of the Financial and Economic Crisis in the United States. 2011. p. 210. [When asked if
the investment banks frequently threatened to withdraw
their business if they didnt get their desired rating, former Moody team managing director Gary Witt told the
FCIC] Oh God, are you kidding? All the time. I mean,
thats routine. I mean, they would threaten you all of the
time... Its like, Well, next time, were just going to go
with Fitch and S&P.

[149] SEC.gov
[150] SEC.gov
[151] IOSCO.org
[152] Gerard Caprio (2012). Handbook of Key Global Financial
Markets, Institutions, and Infrastructure. Academic Press.
pp. 385386. ISBN 0123978734.

[153] Howell E. Jackson (2001). The Role of Credit Rating

Agencies in the Establishment of Capital Standards for Financial Institutions in a Global Economy. In Eilis Ferran;
[137] Gerard Caprio (2012). Handbook of Key Global Financial
A E GoodHart. Regulating Financial Services and Markets
Markets, Institutions, and Infrastructure. Academic Press.
in the 21st Century. Hart Publishing. ISBN 1841132799.
pp. 383385. ISBN 0123978734.
[154]
[138] Matthias Eng; Harald Hau (29 May 2013). Structured
Debt Ratings: Evidence on Conicts of Interest. Swiss
Finance Institute Research Paper No. 13-21. Retrieved 11
October 2013.
[155]

World Bank (2012). Global Financial Development Report 2013: Rethinking the Role of the State in Finance. The
World Bank. p. 60. ISBN 0821395033.
Herwig Langohr; Patricia Langohr (2009). The Rating
Agencies and Their Credit Ratings. Wiley. p. ix. ISBN
0470018003.

[139] Matthias Eng; Harald Hau (18 June 2013). Corrupted

credit ratings: Standard & Poors lawsuit and the evi[156] Herwig Langohr; Patricia Langohr (2009). The Rating
dence. Vox. Retrieved 11 October 2013.
Agencies and Their Credit Ratings. Wiley. p. 409. ISBN
0470018003.
[140] Claire A. Hill (2009). Why did rating agencies do such
a bad job rating subprime securities. University of Pittsburgh Law Review (University of Pittsburgh) 71: 585 [157] Raquel Garca Alcubilla; Javier Ruiz del Pozo (2012).
Credit Rating Agencies on the Watch List: Analysis of Euro608. Retrieved 11 October 2013.
pean Regulation. Oxford University Press. pp. 272273.
ISBN 0199608865.
[141] Jonathan Katz; Emanuel Salinas; Constantinos Stephanou
(October 2009). Credit Rating Agencies: No Easy Reg[158] Yasuyuki Fuchita; Richard J. Herring; Robert E. Litan,
ulatory Solutions (pdf). Crisis Response: Public Policy
eds. (2009). Prudent Lending Restored: Securitization AfFor the Private Sector. World Bank. Retrieved 11 Octoter the Mortgage Meltdown. Brookings. p. 282. ISBN
ber 2013.
0815703368.
[142] Gerard Caprio (2012). Handbook of Key Global Financial [159] Langohr, Herwig; Langohr, Patricia (2009). The Rating
Markets, Institutions, and Infrastructure. Academic Press.
Agencies and Their Credit Ratings. Wiley. p. 384. ISBN
p. 383. ISBN 0123978734.
0470018003.
[143] Rebecca M. Nelson (31 January 2013). Sovereign [160] Raquel Garca Alcubilla; Javier Ruiz del Pozo (2012).
Debt in Advanced Economies: Overview and Issues for
Credit Rating Agencies on the Watch List: Analysis of EuCongress (pdf). Congressional Research Service. Reropean Regulation. Oxford University Press. pp. 4246.
trieved 11 October 2013.
ISBN 0199608865.

32.5. REFERENCES

175

[161] David A. Skeel (2010). The New Financial Deal: Under- [177] Securities and Exchange Commission: Action Needed
standing the Dodd-Frank Act and Its (Unintended) Conseto Improve Rating Agency Registration Program and
quences. Wiley. pp. 68. ISBN 0470942754.
Performance-related Disclosures (pdf). United States
Government Accountability Oce. 2010. pp. 6061.
[162] James P. Hawley; Shyam J. Kamath; Andrew T. Williams,
eds. (2010). Corporate Governance Failures: The Role [178] Lianna Brinded (28 November 2007). Moodys to boost
investor condence with new data feed. Financial News.
of Institutional Investors in the Global Financial Crisis. University of Pennsylvania Press. p. 216. ISBN
[179] Pragyan Deb; Gareth Murphy (2009). Credit Rating
0812204646.
Agencies: An Alternative Model (PDF). London School
of Economics.
[163] Credit Rating Agencies. U.S. Securities and Exchange
Commission. Retrieved 11 October 2013.

[180] General Principles for Credit Reporting (PDF). World

Bank. September 2011. In some countries, credit rating
[164] Annual Report on Nationally Recognized Statistical Ratagencies are starting to provide other types of services,
ing Organizations (pdf). U.S. Securities and Exchange
including credit reporting serv-ices.
Commission. December 2012.
[181] Stephen Foley (14 January 2013). Issuer payment:
[165] Jeannette Neumann (16 November 2012). SEC says
model resistant to reform. Financial Times.
credit rating industry remains plagued by weak oversight.
Financial News.
[182] Issuer-pays model ensures ratings are available to the entire market. The Economic Times. 6 May 2010.
[166] Klein, Alec (23 November 2004). Smoothing the Way
for Debt Markets. The Washington Post.
[183] John (Xuefeng) Jiang; Mary Harris Stanford; Yuan Xie
(2012). Does it matter who pays for bond ratings? His[167] Herwig Langohr; Patricia Langohr (2009). The Rating
torical evidence (PDF). Journal of Financial Economics.
Agencies and Their Credit Ratings. Wiley. p. 384. ISBN
[184] John Morgan (26 October 2012). Credit Ratings Agen0470018003.
cies from China, Russia and the US Join Forces. Mon[168] Gerard Caprio (2012). Handbook of Key Global Financial
eynews.com.
Markets, Institutions, and Infrastructure. Academic Press.
[185] Katie Hunt (31 October 2012). China ratings rms chalp. 386. ISBN 0123978734.
lenge US dominance. BBC.
[169] TE (5 February 2013). Free speech or knowing misrep[186] Norbert Gaillard (2011). A Century of Sovereign Ratings.
resentation?". The Economist.
Springer. p. 90. ISBN 146140522X.
[170] In the 12 months that ended in June 2011, the SEC re[187] Gwynneth Anderson (April 2011). New raters enter the
ported that the big three issued 97% of all credit ratings,
Fray. Treasury & Risk.
down only 1% from 98% in 2007. (sources: Gordon,
Greg (August 7, 2013). Industry wrote provision that [188] Damien Fennell; Andrei Medvedev (November 2011).
undercuts credit-rating overhaul. McClatchy. Retrieved
An economic analysis of credit rating agency business
4 September 2013. ; Status quo for rating agencies (chart
models and ratings accuracy (PDF). Financial Services
of percentage of outstanding credit ratings reported to the
Authority. p. 19.
SEC 2007 and 2011; and Moodys revenue and income
[189] Jeannette Neumann; Aaron Lucchetti (6 September
1996, 2000, 2010, 2012)| mcclatchydc.com
2010). Ratings Firm is Fined in Misstate Case. The
[171] Marie Leone (2 October 2006). Bush Signs Rating
Wall Street Journal.
Agency Reform Act. CFO.com. Retrieved 13 May
[190] Jonathan Katz; Emanuel Salinas; Constantinos Stephanou
2013.
(October 2009). Credit Rating Agencies: No Easy Regulatory Solutions (pdf). The World Bank Group.
[172] Credit Rating AgenciesNRSROs. U.S. Securities and
Exchange Commission. 12 May 2011. Retrieved 13 May
[191] Report of the Committee on Comprehensive Regulation
2013.
for Credit Rating Agencies (pdf). Securities and Exchange Board of India. December 2009.
[173] Arturo Cifuentes (4 March 2013). Get technical to x
rating agencies. Financial Times. Retrieved 13 May [192] John Greenwood (28 January 2012). Wiki joins rating
2013.
game. Financial Post.
[174] Yali N'diaye (26 February 2013). Analysis: Can The US [193] Yali N'Diaye (26 November 2012). Crowd Sourced RatRating Landscape Really Change?". Market News Intering Firms Join Forces;Target SEC Registration. MNI.
national.
Deutsche Boerse Group.
[175] Simon Rabinovitch (24 October 2012). New credit rat- [194] Measuring the measurers. The Economist. 31 May
ing agency to align with common interests of human soci2007.
ety. Financial Times. Retrieved 13 May 2013.
[195] Teather, David (28 January 2003). SEC seeks rating sec[176] The Times, 3 June 2010, Europe launches credit ratings
tor clean-up | Business. The Guardian (London). Reoensive
trieved 10 May 2009.

176

[196] Barr, David G. (November 23, 2013). What We Thought

We Knew: The Financial System and Its Vulnerabilities
(pdf). Bank of England.
[197] M. Nicolas J. Firzli, A Critique of the Basel Committee on Banking Supervision Revue Analyse Financire,
November 10, 2011 & Q2 2012
[198] Dagong, the new Chinese bad guy or a fair player ? ,
SACR, 21 mars 2012.
[199] The Financial Crisis Inquiry Report. National Commission on the Causes of the Financial and Economic Crisis
in the United States. 2011. p. 207.
[200] Buett explained that pricing power was what was important in his purchase of Moodys stock. `... he knew nothing about the management of Moodys. I had no idea.
I'd never been at Moodys, I dont know where they are
located.` (source: The Financial Crisis Inquiry Report)
[201] A Triple-A IdeaEnding the rating oligopoly, Wall Street
Journal, April 15, 2009
[202] AAA Oligopoly, The Wall Street Journal, FEBRUARY
26, 2008

32.6 Further reading

On the history and origins of credit agencies, see
Born Losers: A History of Failure in America, by
Scott A. Sandage (Harvard University Press, 2005),
chapters 46.
On contemporary dynamics, see Timothy J. Sinclair,
The New Masters of Capital: American Bond Rating
Agencies and the Politics of Creditworthiness (Ithaca,
NY: Cornell University Press, 2005).
For a description of what CRAs do in the corporate context, see IOSCO Report on the Activities
of Credit Rating Agencies and IOSCO Statement of
Principles Regarding the Activities of Credit Rating
Agencies.
On the limits of the current 'Issuer-pays business
model, see Kenneth C. Kettering, Securization and
its discontents: The Dynamics of Financial Product
Development, 29 CDZLR 1553, 60 (2008).
For a renewed approach of CRAs business model,
see Vincent Fabi, A Rescue Plan for rating Agencies, Blue SkyNew Ideas for the Obama Administration ideas.berkeleylawblogs.org.
Frank J. Fabozzi and Dennis Vink (2009). On
securitization and over-reliance on credit ratings.
Yale International Center for Finance.
For a theoretical analysis of the impact of regulation
on rating agencies business model, see Rating Agencies in the Face of RegulationRating Ination and
Regulatory Arbitrage, by Opp, Christian C., Opp,
Marcus M. and Harris, Milton (2010).

CHAPTER 32. CREDIT RATING AGENCY

Analysts and ratings = chapter 14 in Stocks and Exchange the only Book you need, Ladis Konecny,
2013, ISBN 9783848220656

32.7 External links

Securities Exchange Commission Oce of Credit
Ratings
SEC: Risky Ratings

Chapter 33

Financial risk management

Financial risk management is the practice of economic
value in a rm by using nancial instruments to manage
exposure to risk, particularly credit risk and market risk.
Other types include Foreign exchange, Shape, Volatility,
Sector, Liquidity, Ination risks, etc. Similar to general risk management, nancial risk management requires
identifying its sources, measuring it, and plans to address
them.

result in unique risks for the rm are the best candidates

for nancial risk management.

The concepts of nancial risk management change dramatically in the international realm. Multinational Corporations are faced with many dierent obstacles in
overcoming these challenges. There has been some research on the risks rms must consider when operating in many countries, such as the three kinds of forFinancial risk management can be qualitative and quanti- eign exchange exposure for various future time horizons:
tative. As a specialization of risk management, nancial transactions exposure,[1] accounting exposure,[2] and ecorisk management focuses on when and how to hedge us- nomic exposure.[3]
ing nancial instruments to manage costly exposures to
risk.
In the banking sector worldwide, the Basel Accords
are generally adopted by internationally active banks for
tracking, reporting and exposing operational, credit and
market risks.

33.2 See also

33.3 Bibliography

33.1 When to use nancial risk

management
Finance theory (i.e., nancial economics) prescribes
that a rm should take on a project when it increases
shareholder value. Finance theory also shows that rm
managers cannot create value for shareholders, also called
its investors, by taking on projects that shareholders could
do for themselves at the same cost.
When applied to nancial risk management, this implies
that rm managers should not hedge risks that investors
can hedge for themselves at the same cost. This notion
was captured by the hedging irrelevance proposition: In
a perfect market, the rm cannot create value by hedging
a risk when the price of bearing that risk within the rm
is the same as the price of bearing it outside of the rm.
In practice, nancial markets are not likely to be perfect
markets.
This suggests that rm managers likely have many opportunities to create value for shareholders using nancial
risk management. The trick is to determine which risks
are cheaper for the rm to manage than the shareholders.
A general rule of thumb, however, is that market risks that
177

Crockford, Neil (1986). An Introduction to Risk

Management (2nd ed.). Woodhead-Faulkner. ISBN
0-85941-332-2.
Charles, Tapiero (2004). Risk and Financial Management: Mathematical and Computational Methods. John Wiley & Son. ISBN 0-470-84908-8.
Conti, Cesare & Mauri, Arnaldo (2008). Corporate Financial Risk Management: Governance and
Disclosure post IFRS 7, Icfai Journal of Financial
Risk Management, ISSN 0972-916X, Vol. V, n. 2,
pp.20-27.
Lam, James (2003). Enterprise Risk Management:
From Incentives to Controls. John Wiley. ISBN 9780-471-43000-1.
McNeil, Alexander J.; Frey, Rdiger; Embrechts,
Paul (2005), Quantitative Risk Management. Concepts, Techniques and Tools, Princeton Series
in Finance, Princeton, NJ: Princeton University
Press, ISBN 0-691-12255-5, MR 2175089, Zbl
1089.91037
van Deventer, Donald R., Kenji Imai and Mark
Mesler (2004). Advanced Financial Risk Management: Tools and Techniques for Integrated Credit

178

CHAPTER 33. FINANCIAL RISK MANAGEMENT

Risk and Interest Rate Risk Management. John Wiley. ISBN 978-0-470-82126-8.

33.4 References
[1] http://www.emeraldinsight.com/Insight/
viewContentItem.do;jsessionid=
EFA8D4FB63329F2C94F48279646551BF?
(concontentType=Article&contentId=1649008
trary to conventional wisdom it may be rational to hedge
translation exposure. Empirical evidence of agency
costs and the managerial tendency to report higher levels
of translated income, based on the early adoption of
Financial Accounting Standard No. 52).
[2] Aggarwal, Raj, The Translation Problem in International
Accounting: Insights for Financial Management. Management International Review 15 (Nos. 2-3, 1975): 6779. (Proposed accounting framework for evaluating and
developing translation procedures for multinational corporations).
[3] http://www.iijournals.com/doi/abs/10.3905/jpm.1997.
409611 (Discusses the benets for hedging in foreign
currencies for MNCs).

33.5 External links

CERA - The Chartered Enterprise Risk Analyst
Credential - Society of Actuaries (SOA)
Financial Risk Manager Certication Program Global Association of Risk Professional (GARP)
Professional Risk Manager Certication Program Professional Risk Managers International Association (PRMIA)
Managing a portfolio of stock and risk-free investments: a tutorial for risk-sensitive investors

Chapter 34

Financial statement
34.1 Purpose of nancial statements by business entities
The objective of nancial statements is to provide information about the nancial position, performance and
changes in nancial position of an enterprise that is
useful to a wide range of users in making economic
decisions.[2] Financial statements should be understandable, relevant, reliable and comparable. Reported assets,
liabilities, equity, income and expenses are directly related to an organizations nancial position.

Historical nancial statement

Financial statements are intended to be understandable

A nancial statement (or nancial report) is a formal by readers who have a reasonable knowledge of busirecord of the nancial activities of a business, person, or ness and economic activities and accounting and who are
other entity.
willing to study the information diligently.[2] Financial
Relevant nancial information is presented in a structured statements may be used by users for dierent purposes:
manner and in a form easy to understand. They typically include basic nancial statements, accompanied by
a management discussion and analysis:[1]
1. A balance sheet, also referred to as a statement of
nancial position, reports on a companys assets,
liabilities, and ownership equity at a given point in
time.
2. An income statement, also known as a statement
of comprehensive income, statement of revenue
& expense, P&L or prot and loss report, reports on a companys income, expenses, and prots
over a period of time. A prot and loss statement
provides information on the operation of the enterprise. These include sales and the various expenses
incurred during the stated period.
3. A statement of cash ows reports on a companys cash ow activities, particularly its operating,
investing and nancing activities.
For large corporations, these statements may be complex
and may include an extensive set of footnotes to the nancial statements and management discussion and
analysis. The notes typically describe each item on the
balance sheet, income statement and cash ow statement
in further detail. Notes to nancial statements are considered an integral part of the nancial statements.
179

Owners and managers require nancial statements

to make important business decisions that aect its
continued operations. Financial analysis is then performed on these statements to provide management
with a more detailed understanding of the gures.
These statements are also used as part of managements annual report to the stockholders.
Employees also need these reports in making
collective bargaining agreements (CBA) with the
management, in the case of labor unions or for individuals in discussing their compensation, promotion
and rankings.
Prospective investors make use of nancial statements to assess the viability of investing in a business. Financial analyses are often used by investors
and are prepared by professionals (nancial analysts), thus providing them with the basis for making
investment decisions.
Financial institutions (banks and other lending companies) use them to decide whether to grant a
company with fresh working capital or extend
debt securities (such as a long-term bank loan or
debentures) to nance expansion and other significant expenditures.

180

34.2 Consolidated nancial statements

Main article: Consolidated nancial statement

CHAPTER 34. FINANCIAL STATEMENT

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

Consolidated nancial statements are dened as

"Financial statements of a group in which the assets,
liabilities, equity, income, expenses and cash ows of
the parent (company) and its subsidiaries are presented
as those of a single economic entity", according to
International Accounting Standard 27 Consolidated
and separate nancial statements, and International
Financial Reporting Standard 10 Consolidated nancial
statements.[3][4]
In the United States, especially in the post-Enron era there
has been substantial concern about the accuracy of nancial statements. Corporate ocers (the chief executive
34.3 Government nancial state- ocer (CEO) and chief nancial ocer (CFO)) are personally responsible for fair nancial reporting allowing
ments
those reading the report to have a good sense of the organization.
See also: Fund accounting
The rules for the recording, measurement and presentation of government nancial statements may be dierent
from those required for business and even for non-prot
organizations. They may use either of two accounting
methods: accrual accounting, or cost accounting, or a
combination of the two (OCBOA). A complete set of
chart of accounts is also used that is substantially dierent from the chart of a prot-oriented business.

34.4 Personal nancial statements

Personal nancial statements may be required from persons applying for a personal loan or nancial aid. Typically, a personal nancial statement consists of a single
form for reporting personally held assets and liabilities
(debts), or personal sources of income and expenses, or
both. The form to be lled out is determined by the organization supplying the loan or aid.

34.6 Standards and regulations

Dierent countries have developed their own accounting
principles over time, making international comparisons
of companies dicult. To ensure uniformity and comparability between nancial statements prepared by different companies, a set of guidelines and rules are used.
Commonly referred to as Generally Accepted Accounting Principles (GAAP), these set of guidelines provide
the basis in the preparation of nancial statements, although many companies voluntarily disclose information
beyond the scope of such requirements.[5]
Recently there has been a push towards standardizing
accounting rules made by the International Accounting
Standards Board (IASB). IASB develops International
Financial Reporting Standards that have been adopted by
Australia, Canada and the European Union (for publicly
quoted companies only), are under consideration in South
Africa and other countries. The United States Financial
Accounting Standards Board has made a commitment to
converge the U.S. GAAP and IFRS over time.

34.5 Audit and legal implications

Although laws dier from country to country, an audit
of the nancial statements of a public company is usually required for investment, nancing, and tax purposes.
These are usually performed by independent accountants
or auditing rms. Results of the audit are summarized
in an audit report that either provide an unqualied opinion on the nancial statements or qualications as to its
fairness and accuracy. The audit opinion on the nancial
statements is usually included in the annual report.

34.7 Inclusion in annual reports

To entice new investors, public companies assemble their

nancial statements on ne paper with pleasing graphics
and photos in an annual report to shareholders, attempting to capture the excitement and culture of the organization in a marketing brochure" of sorts. Usually the
companys chief executive will write a letter to shareholders, describing managements performance and the comThere has been much legal debate over who an auditor panys nancial highlights.

34.10. MOVING TO ELECTRONIC FINANCIAL STATEMENTS

181

In the United States, prior to the advent of the internet,

the annual report was considered the most eective way
for corporations to communicate with individual shareholders. Blue chip companies went to great expense to
produce and mail out attractive annual reports to every
shareholder. The annual report was often prepared in the
style of a coee table book.

sition, capital resources,[7] results of its operations, underlying causes of material changes in nancial statement items (such as asset impairment and restructuring
charges), events of unusual or infrequent nature (such as
mergers and acquisitions or share buybacks), positive and
negative trends, eects of ination, domestic and international market risks,[8] and signicant uncertainties.

34.8 Notes to nancial statements

34.10 Moving to electronic nancial statements

Notes to nancial statements (notes) are additional information added to the end of nancial statements that help
explain specic items in the statements as well as provide
a more comprehensive assessment of a companys nancial condition. Notes to nancial statements can include
information on debt, going concern criteria, accounts,
contingent liabilities or contextual information explaining the nancial numbers (e.g. to indicate a lawsuit).

Financial statements have been created on paper for hundreds of years. The growth of the Web has seen more and
more nancial statements created in an electronic form
which is exchangeable over the Web. Common forms
of electronic nancial statements are PDF and HTML.
These types of electronic nancial statements have their
drawbacks in that it still takes a human to read the inforThe notes clarify individual statement line-items. For ex- mation in order to reuse the information contained in a
ample, if a company lists a loss on a xed asset impair- nancial statement.
ment line in their income statement, notes could corrobo- More recently a market driven global standard, XBRL
rate the reason for the impairment by describing how the (Extensible Business Reporting Language), which can be
asset became impaired. Notes are also used to explain used for creating nancial statements in a structured and
the accounting methods used to prepare the statements computer readable format, has become more popular as
and they support valuations for how particular accounts a format for creating nancial statements. Many regulahave been computed.
tors around the world such as the U.S. Securities and ExIn consolidated nancial statements, all subsidiaries are
listed as well as the amount of ownership (controlling interest) that the parent company has in the subsidiaries.
Any items within the nancial statements that are valuated by estimation are part of the notes if a substantial
dierence exists between the amount of the estimate previously reported and the actual result. Full disclosure of
the eects of the dierences between the estimate and
actual results should be included.

change Commission have mandated XBRL for the submission of nancial information.
The UN/CEFACT created, with respect to Generally Accepted Accounting Principles, (GAAP), internal or external nancial reporting XML messages to be used between
enterprises and their partners, such as private interested
parties (e.g. bank) and public collecting bodies (e.g. taxation authorities). Many regulators use such messages to
collect nancial and economic information.

34.9 Management discussion and 34.11 See also

analysis

Accountable Fundraising

Management discussion and analysis or MD&A is an integrated part of a companys annual nancial statements.
The purpose of the MD&A is to provide a narrative explanation, through the eyes of management, of how an entity has performed in the past, its nancial condition, and
its future prospects. In so doing, the MD&A attempt to
provide investors with complete, fair, and balanced information to help them decide whether to invest or continue
to invest in an entity.[6]
The section contains a description of the year gone by
and some of the key factors that inuenced the business
of the company in that year, as well as a fair and unbiased
overview of the companys past, present, and future.
MD&A typically describes the corporations liquidity po-

Center for Audit Quality (CAQ)

Corporate nance
Financial statement analysis
Comprehensive annual nancial report
Model audit

34.12 References
[1] Presentation of Financial Statements Standard IAS 1,
International Accounting Standards Board. Accessed 24
June 2007.

182

[2] The Framework for the Preparation and Presentation of

Financial Statements International Accounting Standards
Board. Accessed 24 June 2007.
[3] IAS 27 Separate Financial Statements (2011)". www.
iasplus.com. IAS Plus (This material is provided by Deloitte Touche Tohmatsu Limited (DTTL), or a member
rm of DTTL, or one of their related entities. This material is provided AS IS and without warranty of any kind,
express or implied. Without limiting the foregoing, neither Deloitte Touche Tohmatsu Limited (DTTL), nor
any member rm of DTTL (a DTTL Member Firm),
nor any of their related entities (collectively, the Deloitte
Network) warrants that this material will be error-free or
will meet any particular criteria of performance or quality, and each entity of the Deloitte Network expressly disclaims all implied warranties, including without limitation
warranties of merchantability, title, tness for a particular
purpose, non-infringement, compatibility and accuracy.).
Retrieved 2013-11-29.
[4] IFRS 10 Consolidated Financial Statements. www.
iasplus.com. IAS Plus (This material is provided by Deloitte Touche Tohmatsu Limited (DTTL), or a member
rm of DTTL, or one of their related entities. This material is provided AS IS and without warranty of any kind,
express or implied. Without limiting the foregoing, neither Deloitte Touche Tohmatsu Limited (DTTL), nor
any member rm of DTTL (a DTTL Member Firm),
nor any of their related entities (collectively, the Deloitte
Network) warrants that this material will be error-free or
will meet any particular criteria of performance or quality, and each entity of the Deloitte Network expressly disclaims all implied warranties, including without limitation
warranties of merchantability, title, tness for a particular
purpose, non-infringement, compatibility and accuracy.).
Retrieved 2013-11-29.
[5] FASB, 2001. Improving Business Reporting: Insights into
Enhancing Voluntary Disclosures. Retrieved on April 20,
2012.
[6] MD&A & Other Performance Reporting
[7] Nico Resources Managements Discussion and Analysis
[8] PepsiCo Managements Discussion and Analysis

34.13 Further reading

Alexander, D., Britton, A., Jorissen, A., International Financial Reporting and Analysis, Second
Edition, 2005, ISBN 978-1-84480-201-2

34.14 External links

IFRS Foundation & International Accounting Standards Board
Financial Accounting Standards Board (U.S.)
UN/CEFACT

CHAPTER 34. FINANCIAL STATEMENT

UN/CEFACT Trade And Business Group Accounting And Audit
Mako, Rafa. New legal framework for nancial
statements. Library Brieng. Library of the European Parliament. Retrieved 6 June 2013.
Fundamental Analysis: Notes To The Financial
Statements by Investopedia.com
The Notes to the Financial Statements May Be
Worth Noting by Googobits.com

Chapter 35

Leveraged buyout
A leveraged buyout (LBO) is a transaction when a
company or single asset (e.g., a real estate property)
is purchased with a combination of equity and significant amounts of borrowed money, structured in such
a way that the targets cash ows or assets are used as
the collateral (or leverage) to secure and repay the
money borrowed to purchase the target. Since the debt
(be it senior or mezzanine) has a lower cost of capital (until bankruptcy risk reaches a level threatening to
the lender[s]) than the equity, the returns on the equity
increase as the amount of borrowed money does until
the perfect capital structure is reached. As a result, the
debt eectively serves as a lever to increase returns-on- Diagram of the basic structure of a generic leveraged buyout
investment.
transaction
LBOs are a very common occurrence in a "Mergers and
Acquisitions" (M&A) environment. The term LBO is
usually employed when a nancial sponsor acquires a
company. However, many corporate transactions are partially funded by bank debt, thus eectively also representing an LBO. LBOs can have many dierent forms
such as Management Buyout (MBO), Management Buyin (MBI), secondary buyout and tertiary buyout, among
others, and can occur in growth situations, restructuring
situations and insolvencies. LBOs mostly occur in private
companies, but can also be employed with public companies (in a so-called PtP transaction Public to Private).

their equity by employing the leverage; banks can make

substantially higher margins when supporting the nancing of LBOs as compared to usual corporate lending, because the interest chargeable is that much higher.
The amount of debt banks are willing to provide to support an LBO varies greatly and depends, among other
things, on:
The quality of the asset to be acquired (stability of
cash ows, history, growth prospects, hard assets,
)

As nancial sponsors increase their returns by employing

The amount of equity supplied by the nancial spona very high leverage (i.e., a high ratio of debt to equity),
sor
they have an incentive to employ as much debt as possible to nance an acquisition. This has in many cases
The history and experience of the nancial sponsor
led to situations, in which companies were overlevered,
The economic environment
meaning that they did not generate sucient cash ows
to service their debt, which in turn led to insolvency or
to debt-to-equity swaps in which the equity owners lose For companies with very stable and secured cash ows
control over the business and the debt providers assume (e.g., real estate portfolios with rental income secured
the equity.
with long term rental agreements), debt volumes of up
to 100% of the purchase price have been provided. In
situations of normal companies with normal business
risks, debt of 4060% of the purchase price are normal
35.1 Characteristics
gures. The debt ratios that are possible vary also significantly between the regions and between the industries of
LBOs have become very attractive as they usually repre- the target.
sent a win-win situation for the nancial sponsor and the Depending on the size and purchase price of the acquisibanks: The nancial sponsor can increase the returns on tion, the debt is provided in dierent tranches.
183

184

CHAPTER 35. LEVERAGED BUYOUT

Senior debt: This debt is secured with the assets of in corporate assets was a relatively new trend in the 1960s,
the target company and has the lowest interest mar- popularized by the likes of Warren Buett (Berkshire
gins
Hathaway) and Victor Posner (DWG Corporation), and
later adopted by Nelson Peltz (Triarc), Saul Steinberg
Junior debt (usually mezzanine): This debt usually (Reliance Insurance) and Gerry Schwartz (Onex Corpohas no securities and bears thus a higher interest ration). These investment vehicles would utilize a nummargins
ber of the same tactics and target the same type of companies as more traditional leveraged buyouts and in many
In larger transactions, sometimes all or part of these two ways could be considered a forerunner of the later private
debt types is replaced by high yield bonds. Depending on equity rms. In fact, it is Posner who is often credited
the size of the acquisition, debt as well as equity can be with coining the term leveraged buyout or LBO.[3]
provided by more than one party. In larger transactions,
The leveraged buyout boom of the 1980s was conceived
debt is often syndicated, meaning that the bank who arin the 1960s by a number of corporate nanciers, most
ranges the credit sells all or part of the debt in pieces to
notably Jerome Kohlberg, Jr. and later his protg Henry
other banks in an attempt to diversify and hence reduce
Kravis. Working for Bear Stearns at the time, Kohlberg
its risk. Another form of debt that is used in LBOs are
and Kravis, along with Kravis cousin George Roberts,
seller notes (or vendor loans) in which the seller eecbegan a series of what they described as bootstrap intively uses parts of the proceeds of the sale to grant a loan
vestments. Many of the target companies lacked a vito the purchaser. Such seller notes are often employed in
able or attractive exit for their founders, as they were too
management buyouts or in situations with very restrictive
small to be taken public and the founders were reluctant
bank nancing environments. Note that in close to all
to sell out to competitors. Thus a sale to a nancial buyer
cases of LBOs, the only collateralization available for the
might prove attractive. Their acquisition of Orkin Exdebt are the assets and cash ows of the company. The
terminating Company in 1964 is among the rst signinancial sponsor can treat their investment as common
cant leveraged buyout transactions. In the following years
equity or preferred equity among other types of securithe three Bear Stearns bankers would complete a series
ties. Preferred equity can pay a dividend and has payment
of buyouts including Stern Metals (1965), Incom (a divipreferences to common equity.
sion of Rockwood International, 1971), Cobblers IndusAs a rule of thumb, senior debt usually has interest mar- tries (1971), and Boren Clay (1973) as well as Thompson
gins of 35% (on top of Libor or Euribor) and needs to be Wire, Eagle Motors and Barrows through their investpaid back over a period of 57 years, junior debt has mar- ment in Stern Metals.[4] By 1976, tensions had built up
gins of 716%, and needs to be paid back in one payment between Bear Stearns and Kohlberg, Kravis and Roberts
(as bullet) after 710 years. Junior debt often addition- leading to their departure and the formation of Kohlberg
ally has warrants and its interest is often all or partly of Kravis Roberts in that year.
PIK nature.

35.2 History

35.2.2 1980s
Main article: Private equity in the 1980s

Main article: History of private equity and venture capital

35.2.1

Origins

Main article: Early history of private equity

In January 1982, former U.S. Secretary of the Treasury

William E. Simon and a group of investors acquired Gibson Greetings, a producer of greeting cards, for $80 million, of which only $1 million was rumored to have been
contributed by the investors. By mid-1983, just sixteen months after the original deal, Gibson completed a
$290 million IPO and Simon made approximately $66
million.[5] The success of the Gibson Greetings investment attracted the attention of the wider media to the
nascent boom in leveraged buyouts.[6] Between 1979 and
1989, it was estimated that there were over 2,000 leveraged buyouts valued in excess of $250 billion[7]

The rst leveraged buyout may have been the purchase by

McLean Industries, Inc. of Pan-Atlantic Steamship Company in January 1955 and Waterman Steamship Corporation in May 1955.[1] Under the terms of that transaction,
McLean borrowed $42 million and raised an additional
$7 million through an issue of preferred stock. When In the summer of 1984 the LBO was a target for viruthe deal closed, $20 million of Waterman cash and as- lent criticism by Paul Volcker, then chairman of the Fedsets were used to retire $20 million of the loan debt.[2]
eral Reserve, by John S.R. Shad, chairman of the U.S.
Similar to the approach employed in the McLean trans- Securities and Exchange Commission, and other senior
action, the use of publicly traded holding companies as nanciers. The gist of all the denunciations was that topinvestment vehicles to acquire portfolios of investments heavy reversed pyramids of debt were being created and

35.2. HISTORY
that they would soon crash, destroying assets and jobs.

185
[8]

During the 1980s, constituencies within acquired companies and the media ascribed the "corporate raid" label to many private equity investments, particularly those
that featured a hostile takeover of the company, perceived
asset stripping, major layos or other signicant corporate restructuring activities. Among the most notable investors to be labeled corporate raiders in the 1980s included Carl Icahn, Victor Posner, Nelson Peltz, Robert
M. Bass, T. Boone Pickens, Harold Clark Simmons,
Kirk Kerkorian, Sir James Goldsmith, Saul Steinberg
and Asher Edelman. Carl Icahn developed a reputation
as a ruthless corporate raider after his hostile takeover
of TWA in 1985.[9][10] Many of the corporate raiders
were onetime clients of Michael Milken, whose investment banking rm, Drexel Burnham Lambert helped
raise blind pools of capital with which corporate raiders
could make a legitimate attempt to take over a company
and provided high-yield debt nancing of the buyouts.[11]

of Federated Department Stores, the 1986 buyout of the

Revco drug stores, Walter Industries, FEB Trucking and
Eaton Leonard. Additionally, the RJR Nabisco deal was
showing signs of strain, leading to a recapitalization in
1990 that involved the contribution of $1.7 billion of new
equity from KKR.[13]

Drexel Burnham Lambert was the investment bank most

responsible for the boom in private equity during the
1980s due to its leadership in the issuance of high-yield
debt. Drexel reached an agreement with the government
in which it pleaded nolo contendere (no contest) to six
felonies three counts of stock parking and three counts
of stock manipulation.[14] It also agreed to pay a ne of
$650 million at the time, the largest ne ever levied
under securities laws. Milken left the rm after his own
indictment in March 1989.[15] On February 13, 1990, after being advised by United States Secretary of the Treasury Nicholas F. Brady, the U.S. Securities and Exchange
Commission (SEC), the New York Stock Exchange, and
ocially
One of the nal major buyouts of the 1980s proved to be the Federal Reserve, Drexel Burnham Lambert
[15]
led
for
Chapter
11
bankruptcy
protection.
its most ambitious and marked both a high-water mark
and a sign of the beginning of the end of the boom that
had begun nearly a decade earlier. In 1989, KKR closed
35.2.3 Age of the mega-buyout
in on a $31.1 billion takeover of RJR Nabisco. It was,
at that time and for over 17 years following, the largest
Main article: Private equity in the 21st century
leverage buyout in history. The event was chronicled in
the book (and later the movie), Barbarians at the Gate:
The Fall of RJR Nabisco. KKR would eventually prevail The combination of decreasing interest rates, loosening
in acquiring RJR Nabisco at $109 per share marking a lending standards, and regulatory changes for publicly
dramatic increase from the original announcement that traded companies (specically the SarbanesOxley Act)
Shearson Lehman Hutton would take RJR Nabisco pri- would set the stage for the largest boom the private eqvate at $75 per share. A erce series of negotiations and uity industry had seen. Marked by the buyout of Dex
horse-trading ensued which pitted KKR against Shearson Media in 2002, large multi-billion dollar U.S. buyouts
Lehman Hutton and later Forstmann Little & Co. Many could once again obtain signicant high yield debt nancof the major banking players of the day, including ing from various banks and larger transactions could be
Morgan Stanley, Goldman Sachs, Salomon Brothers, and completed. By 2004 and 2005, major buyouts were once
Merrill Lynch were actively involved in advising and - again becoming common, including the acquisitions of
[16]
The Hertz Corporation,[17][18] Metronancing the parties. After Shearson Lehman's original Toys R Us,
[19]
[20]
bid, KKR quickly introduced a tender oer to obtain RJR Goldwyn-Mayer and SunGard in 2005.
Nabisco for $90 per share a price that enabled it to As 2005 ended and 2006 began, new largest buyout
proceed without the approval of RJR Nabiscos manage- records were set and surpassed several times with nine
ment. RJRs management team, working with Shearson of the top ten buyouts at the end of 2007 having been anLehman and Salomon Brothers, submitted a bid of $112, nounced in an 18-month window from the beginning of
a gure they felt certain would enable them to outank 2006 through the middle of 2007. In 2006, private eqany response by Kraviss team. KKRs nal bid of $109, uity rms bought 654 U.S. companies for $375 billion,
while a lower dollar gure, was ultimately accepted by the representing 18 times the level of transactions closed in
board of directors of RJR Nabisco.[12] At $31.1 billion 2003.[21] Additionally, U.S. based private equity rms
of transaction value, RJR Nabisco was by far the largest raised $215.4 billion in investor commitments to 322
leveraged buyout in history. In 2006 and 2007, a number funds, surpassing the previous record set in 2000 by 22%
of leveraged buyout transactions were completed that for and 33% higher than the 2005 fundraising total[22] The
the rst time surpassed the RJR Nabisco leveraged buyout following year, despite the onset of turmoil in the credit
in terms of nominal purchase price. However, adjusted markets in the summer, saw yet another record year of
for ination, none of the leveraged buyouts of the 2006 fundraising with $302 billion of investor commitments to
2007 period would surpass RJR Nabisco.
415 funds[23] Among the mega-buyouts completed during
By the end of the 1980s the excesses of the buyout market the 2006 to 2007 boom were: Equity Oce Properties,
[24]
[25]
[26]
were beginning to show, with the bankruptcy of several HCA, Alliance Boots and TXU.
large buyouts including Robert Campeau's 1988 buyout In July 2007, turmoil that had been aecting the

186
mortgage markets spilled over into the leveraged nance
and high-yield debt markets.[27][28] The markets had been
highly robust during the rst six months of 2007, with
highly issuer friendly developments including PIK and
PIK Toggle (interest is "Payable In Kind) and covenant
light debt widely available to nance large leveraged buyouts. July and August saw a notable slowdown in issuance
levels in the high yield and leveraged loan markets with
only few issuers accessing the market. Uncertain market
conditions led to a signicant widening of yield spreads,
which coupled with the typical summer slowdown led
many companies and investment banks to put their plans
to issue debt on hold until the autumn. However, the expected rebound in the market after Labor Day 2007 did
not materialize and the lack of market condence prevented deals from pricing. By the end of September, the
full extent of the credit situation became obvious as major lenders including Citigroup and UBS AG announced
major writedowns due to credit losses. The leveraged
nance markets came to a near standstill.[29] As 2007
ended and 2008 began, it was clear that lending standards
had tightened and the era of mega-buyouts had come
to an end. Nevertheless, private equity continues to be a
large and active asset class and the private equity rms,
with hundreds of billions of dollars of committed capital
from investors are looking to deploy capital in new and
dierent transactions.

35.3 Management buyouts

Main article: Management buyout

CHAPTER 35. LEVERAGED BUYOUT

For the management team, the negotiation of the deal
with the nancial sponsor (i.e., who gets how many shares
of the company) is a key value creation lever. Financial
sponsors are often sympathetic to MBOs as in these cases
they are assured that management believes in the future of
the company and has an interest in value creation (as opposed to being solely employed by the company). There
are no clear guidelines as to how big a share the management team must own after the acquisition in order to qualify as an MBO, as opposed to a normal leveraged buy-out
in which the management invests together with the nancial sponsor. However, in the usual use of the term, an
MBO is a situation in which the management team initiates and actively pushes the acquisition.
MBO situations lead management teams often into a
dilemma as they face a conict of interest, being interested in a low purchase price personally while at the same
time being employed by the owners who obviously have
an interest in a high purchase price. Owners usually react
to this situation by oering a deal fee to the management
team if a certain price threshold is reached. Financial
sponsors usually react to this again by oering to compensate the management team for a lost deal fee if the
purchase price is low. Another mechanisms to handle this
problem are earn-outs (purchase price being contingent
on reaching certain future protabilities).
There probably are just as many successful MBOs as
there unsuccessful ones. Crucial for the management
team at the beginning of the process is the negotiation of
the purchase price and the deal structure (including the
envy ratio) and the selection of the nancial sponsor.

A special case of a leveraged acquisition is a management 35.4 Secondary and tertiary buybuyout (MBO). In an MBO, the incumbent management
outs
team (that usually has no or close to no shares in the company) acquires a sizeable portion of the shares of the company. Similar to an MBO is an MBI (Management Buy A secondary buyout is a form of leveraged buyout where
In) in which an external management team acquires the both the buyer and the seller are private equity rms or
shares. An MBO can occur for a number of reasons; e.g., nancial sponsors (i.e., a leveraged buyout of a company
that was acquired through a leveraged buyout). A sec1. The owners of the business want to retire and want ondary buyout will often provide a clean break for the
to sell the company to the management team they selling private equity rms and its limited partner investors. Historically, given that secondary buyouts were
trust (and with whom they have worked for years)
perceived as distressed sales by both seller and buyer, lim2. The owners of the business have lost faith in the ited partner investors considered them unattractive and
business and are willing to sell it to the management largely avoided them.
(who believes in the future of the business) in order
The increase in secondary buyout activity in 2000s was
to get some value for the business
driven in large part by an increase in capital available for
3. The managers see a value in the business that the the leveraged buyouts. Often, selling private equity rms
current owners do not see and do not want to pursue pursue a secondary buyout for a number of reasons:
In most situations, the management team does not have
enough money to fund the equity needed for the acquisition (to be combined with bank debt to constitute the
purchase price) so that management teams work together
with nancial sponsors to part-nance the acquisition.

Sales to strategic buyers and IPOs may not be possible for niche or undersized businesses.
Secondary buyouts may generate liquidity more
quickly than other routes (i.e., IPOs).

35.6. POPULAR REFERENCES

187

Some kinds of businesses e.g., those with relatively

slow growth but which generate high cash ows
may be most appealing to private equity rms than
they are to public stock investors or other corporations.

at the time of the LBO, or whether subsequent unforeseeable events led to the failure. The analysis historically
depended on dueling expert witnesses and was notoriously subjective, expensive, and unpredictable. However, courts are increasingly turning toward more objective, market-based measures.[32]

Often, secondary buyouts have been successful if the investment has reached an age where it is necessary or desirable to sell rather than hold the investment further or
where the investment had already generated signicant
value for the selling rm.[30]

In addition, the Bankruptcy Code includes a so-called

safe harbor provision, preventing bankruptcy trustees
from recovering settlement payments to the bought-out
shareholders.[33] In 2009, the U.S. Court of Appeals for
the Sixth Circuit held that such settlement payments could
not be avoided, irrespective of whether they occurred in
an LBO of a public or private company.[34] To the extent that public shareholders are protected, insiders and
secured lenders become the primary targets of fraudulent
transfer actions.

Secondary buyouts dier from secondaries or secondary

market purchases which typically involve the acquisition
of portfolios of private equity assets including limited
partnership stakes and direct investments in corporate securities.

Banks have reacted to failed LBOs by requiring a lower

If a company that was acquired in a secondary buyout gets
debt-to-equity ratio, thus increasing the skin in the
sold to another nancial sponsor, the resulting transaction
game for the nancial sponsor and reducing the debt buris called a tertiary buyout.
den.

35.5 Failures

35.6 Popular references

Some LBOs pre 2000 have resulted in corporate

bankruptcy, such as Robert Campeau's 1988 buyout of
Federated Department Stores and the 1986 buyout of
the Revco drug stores. Many LBOs of the boom period
20052007 were also nanced with too high a debt burden. The failure of the Federated buyout was a result of
excessive debt nancing, comprising about 97% of the
total consideration, which led to large interest payments
that exceeded the companys operating cash ow.

LBOs form the basis of several cultural works. As mentioned previously, Barbarians at the Gate: The Fall of RJR
Nabisco[35] and the lm adaptation, are based on actual
events. A ctional LBO is the basis of the 1963 Japanese
lm High and Low. The process was covered during the
2012 United States presidential election, as Mitt Romney had previously worked in the business for Bain Capital.[35]

Often, instead of declaring insolvency, the company negotiates a debt restructuring with its lenders. The nancial restructuring might entail that the equity owners inject some more money in the company and the lenders
waive parts of their claims. In other situations, the lenders
inject new money and assume the equity of the company,
with the present equity owners losing their shares and investment. The operations of the company are not aected
by the nancial restructuring. Nonetheless, the nancial
restructuring requires signicant management attention
and may lead to customers losing faith in the company.
The inability to repay debt in an LBO can be caused
by initial overpricing of the target rm and/or its assets.
Over-optimistic forecasts of the revenues of the target
company may also lead to nancial distress after acquisition. Some courts have found that in certain situations,
LBO debt constitutes a fraudulent transfer under U.S. insolvency law if it is determined to be the cause of the
acquired rms failure.[31]
The outcome of litigation attacking a leveraged buyout as
a fraudulent transfer will generally turn on the nancial
condition of the target at the time of the transaction that
is, whether the risk of failure was substantial and known

35.7 See also

Bootstrap funding
Divisional buyout
Envy ratio
History of private equity and venture capital
List of private equity rms
Vulture capitalist

35.8 Notes
[1] On January 21, 1955, McLean Industries, Inc. purchased
the capital stock of Pan Atlantic Steamship Corporation
and Gulf Florida Terminal Company, Inc. from Waterman Steamship Corporation. In May McLean Industries,
Inc. completed the acquisition of the common stock of
Waterman Steamship Corporation from its founders and
other stockholders.

188

CHAPTER 35. LEVERAGED BUYOUT

[2] Marc Levinson, The Box: How the Shipping Container

Made the World Smaller and the World Economy Bigger,
pp. 4447 (Princeton Univ. Press 2006). The details of
this transaction are set out in ICC Case No. MC-F-5976,
McLean Trucking Company and Pan-Atlantic American
Steamship Corporation Investigation of Control, July 8,
1957.

[22] Dow Jones Private Equity Analyst as referenced in U.S.

private-equity funds break record Associated Press, January 11, 2007.

[3] Trehan, R. (2006). The History Of Leveraged Buyouts.

December 4, 2006. Accessed May 22, 2008

[24] SORKIN, ANDREW ROSS. "HCA Buyout Highlights

Era of Going Private. New York Times, July 25, 2006.

[4] Burrough, Bryan. Barbarians at the Gate. New York :

Harper & Row, 1990, pp. 133136

[25] WERDIGIER, JULIA. "Equity Firm Wins Bidding for

a Retailer, Alliance Boots. New York Times, April 25,
2007

[5] Taylor, Alexander L. "Buyout Binge". TIME magazine,

Jul. 16, 1984.
[6] David Carey and John E. Morris, King of Capital: The Remarkable Rise, Fall and Rise Again of Steve Schwarzman
and Blackstone (Crown 2010), pp. 1516.
[7] Opler, T. and Titman, S. The determinants of leveraged
buyout activity: Free cash ow vs. nancial distress costs.
Journal of Finance, 1993.
[8] Thackray, John "Leveraged buyouts: The LBO craze
ourishes amid warnings of disaster". Euromoney, February 1986.
[9] 10 Questions for Carl Icahn by Barbara Kiviat, TIME
magazine, Feb. 15, 2007
[10] TWA Death Of A Legend by Elaine X. Grant, St Louis
Magazine, Oct 2005
[11] King of Capital, pp. 3144.
[12] Game of Greed (TIME magazine, 1988)
[13] Wallace, Anise C. "Nabisco Renance Plan Set. The
New York Times, July 16, 1990.
[14] Stone, Dan G. (1990). April Fools: An Insiders Account
of the Rise and Collapse of Drexel Burnham. New York
City: Donald I. Fine. ISBN 1-55611-228-9.
[15] Den of Thieves. Stewart, J. B. New York: Simon & Schuster, 1991. ISBN 0-671-63802-5.
[16] SORKIN, ANDREW ROSS and ROZHON, TRACIE.
"Three Firms Are Said to Buy Toys 'R' Us for $6 Billion.
New York Times, March 17, 2005.
[17] ANDREW ROSS SORKIN and DANNY HAKIM. "Ford
Said to Be Ready to Pursue a Hertz Sale. New York
Times, September 8, 2005
[18] PETERS, JEREMY W. "Ford Completes Sale of Hertz to
3 Firms. New York Times, September 13, 2005
[19] SORKIN, ANDREW ROSS. "Sony-Led Group Makes a
Late Bid to Wrest MGM From Time Warner. New York
Times, September 14, 2004
[20] "Capital Firms Agree to Buy SunGard Data in Cash Deal.
Bloomberg, March 29, 2005
[21] Samuelson, Robert J. "The Private Equity Boom". The
Washington Post, March 15, 2007.

[23] Dow Jones Private Equity Analyst as referenced in Private

equity fund raising up in 2007: report, Reuters, January
8, 2008.

[26] Lonkevich, Dan and Klump, Edward. KKR, Texas Pacic

Will Acquire TXU for $45 Billion Bloomberg, February
26, 2007.
[27] SORKIN, ANDREW ROSS and de la MERCED,
MICHAEL J. "Private Equity Investors Hint at Cool
Down. New York Times, June 26, 2007
[28] SORKIN, ANDREW ROSS. "Sorting Through the Buyout Freezeout. New York Times, August 12, 2007.
[29] id=9566005 Turmoil in the markets The Economist July
27, 2007
[30] See King of Capital, pp. 21112.
[31] U.S. Bankruptcy Code, 11 U.S.C. 548(2); Uniform
Fraudulent Transfer Act, 4. The justication given for
this verdict is that the company gets no benet from the
transaction but incurs the debt for it nevertheless.
[32] Amicus Brief, In re Lyondell Chemical Company
bankruptcy. Ssrn.com. Retrieved 2013-02-11.
[33] U.S. Bankruptcy Code, 11 U.S.C. 546(e).
[34] QSI Holdings, Inc. v. Alford, --- F.3d ---, Case No. 081176 (6th Cir. July 6, 2009).
[35] Matt Taibbi (2012-08-29). Greed and Debt: The True
Story of Mitt Romney and Bain Capital | Politics News.
Rolling Stone. Retrieved 2013-02-11.

35.9 External links

Jarrell, Gregg A. (2002). Takeovers and Leveraged
Buyouts. In David R. Henderson (ed.). Concise Encyclopedia of Economics (1st ed.). Library of Economics and Liberty. OCLC 317650570, 50016270
and 163149563
LCD Loan Market Primer: LBOs What are leveraged loans used for?
Investopedia denition Leveraged Buyout

Chapter 36

Mergers and acquisitions

Merger redirects here.
(disambiguation).

For other uses, see Merge ness or company by another company or other business
entity. Such purchase may be of 100%, or nearly 100%,
of the assets or ownership equity of the acquired entity.
Mergers and acquisitions (M&A) are both as- Consolidation occurs when two companies combine together to form a new enterprise altogether, and neither of
pects of strategic management, corporate nance and
management dealing with the buying, selling, dividing the previous companies remains independently. Acquisitions are divided into private and public acquisitions,
and combining of dierent companies and similar entities
that can help an enterprise grow rapidly in its sector or lo- depending on whether the acquiree or merging company
(also termed a target) is or is not listed on a public stock
cation of origin, or a new eld or new location, without
on acquisitions as
creating a subsidiary, other child entity or using a joint market. Some public companies rely
[1]
an
important
value
creation
strategy.
An additional diventure.
mension or categorization consists of whether an acquisiM&A can be dened as a type of restructuring in that tion is friendly or hostile.
they result in some entity reorganization with the aim to
provide growth or positive value. Consolidation of an in- Achieving acquisition success has proven to be very difshown that 50% of acdustry or sector occurs when widespread M&A activity cult, while various studies have
[2]
quisitions
were
unsuccessful.
The
acquisition process
concentrates the resources of many small companies into
is
very
complex,
with
many
dimensions
inuencing its
a few larger ones, such as occurred with the automotive
[3]
outcome.
Serial
acquirers
appear
to
be
more successindustry between 1910 and 1940.
ful with M&A than companies who only make an acThe distinction between a merger and an acquisition quisition occasionally (see Douma & Schreuder, 2013,
has become increasingly blurred in various respects (par- chapter 13).[4] The new forms of buy out created since
ticularly in terms of the ultimate economic outcome), al- the crisis are based on serial type acquisitions known as
though it has not completely disappeared in all situations. an ECO Buyout which is a co-community ownership buy
From a legal point of view, a merger is a legal consolida- out and the new generation buy outs of the MIBO (Mantion of two companies into one entity, whereas an acqui- agement Involved or Management & Institution Buy Out)
sition occurs when one company takes over another and and MEIBO (Management & Employee Involved Buy
completely establishes itself as the new owner (in which Out).
case the target company still exists as an independent legal entity controlled by the acquirer). Either structure can Whether a purchase is perceived as being a friendly one
result in the economic and nancial consolidation of the or a hostile depends signicantly on how the proposed
two entities. In practice, a deal that is an acquisition for acquisition is communicated to and perceived by the tarlegal purposes may be euphemistically called a "merger get companys board of directors, employees and shareof equals" if both CEOs agree that joining together is in holders. It is normal for M&A deal communications to
the best interest of both of their companies, while when take place in a so-called condentiality bubble wherein
is restricted pursuant to condenthe deal is unfriendly (that is, when the target company the ow of information
[5]
In
the case of a friendly transaction,
tiality
agreements.
does not want to be purchased) it is almost always rethe
companies
cooperate
in negotiations; in the case of
garded as an acquisition.
a hostile deal, the board and/or management of the target is unwilling to be bought or the targets board has no
prior knowledge of the oer. Hostile acquisitions can,
36.1 Acquisition
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
Main article: Takeover
improvement in the terms of the oer and/or through negotiation.
An acquisition or takeover is the purchase of one busi189

190
Acquisition usually refers to a purchase of a smaller
rm by a larger one. Sometimes, however, a smaller
rm 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 nancing) buys a publicly listed shell company, usually one with no business and limited assets.[6]

CHAPTER 36. MERGERS AND ACQUISITIONS

The terms "demerger", "spin-o" and spin-out are
sometimes used to indicate a situation where one company splits into two, generating a second company which
may or may not become separately listed on a stock exchange.

As per knowledge-based views, rms can generate

greater values through the retention of knowledge-based
resources which they generate and integrate.[7] Extracting
technological benets during and after acquisition is ever
challenging issue because of organizational dierences.
Based on the content analysis of seven interviews authors
concluded ve following components for their grounded
The combined evidence suggests that the shareholders of model of acquisition:
acquired rms realize signicant positive abnormal returns while shareholders of the acquiring company are
1. Improper documentation and changing implicit
most likely to experience a negative wealth eect. The
knowledge makes it dicult to share information
overall net eect of M&A transactions appears to be posduring acquisition.
itive: almost all studies report positive returns for the
2. For acquired rm symbolic and cultural indepeninvestors in the combined buyer and target rms. This
dence which is the base of technology and capabilimplies that M&A creates economic value, presumably
ities are more important than administrative indeby transferring assets to management teams that operate
pendence.
them more eciently (see Douma & Schreuder, 2013,
chapter 13).
3. Detailed knowledge exchange and integrations are
There are also a variety of structures used in securing condicult when the acquired rm is large and high
trol over the assets of a company, which have dierent tax
performing.
and regulatory implications:
4. Management of executives from acquired rm is
critical in terms of promotions and pay incentives
The buyer buys the shares, and therefore control,
to utilize their talent and value their expertise.
of the target company being purchased. Owner5. Transfer of technologies and capabilities are most
ship control of the company in turn conveys eecdicult task to manage because of complications of
tive control over the assets of the company, but since
acquisition implementation. The risk of losing imthe company is acquired intact as a going concern,
plicit knowledge is always associated with the fast
this form of transaction carries with it all of the lipace acquisition.
abilities accrued by that business over its past and
all of the risks that company faces in its commercial
environment.
Preservation of tacit knowledge, employees and documentation are often dicult to achieve during and after
The buyer buys the assets of the target company. acquisition. Strategic management of all these resources
The cash the target receives from the sell-o is paid is a very important factor for a successful acquisition. In
back to its shareholders by dividend or through liq- order to preserve employees post-acquisition, rms often
uidation. This type of transaction leaves the target use retention agreements to retain key sta and talent.[8]
company as an empty shell, if the buyer buys out
An increase in acquisitions in the global business environthe entire assets. A buyer often structures the transment requires enterprises to evaluate the key stake holders
action as an asset purchase to cherry-pick the asof acquisition very carefully before implementation. It is
sets that it wants and leave out the assets and liabilimperative for the acquirer to understand this relationship
ities that it does not. This can be particularly imand apply it to its advantage. Retention is only possible
portant where foreseeable liabilities may include fuwhen resources are exchanged and managed without afture, unquantied damage awards such as those that
fecting their independence.[9]
could arise from litigation over defective products,
employee benets or terminations, or environmental damage. A disadvantage of this structure is the
tax that many jurisdictions, particularly outside the 36.2 Legal structures
United States, impose on transfers of the individual
assets, whereas stock transactions can frequently be Corporate acquisitions can be characterized for legal purstructured as like-kind exchanges or other arrange- poses as either asset purchases in which the seller sells
ments that are tax-free or tax-neutral, both to the business assets to the buyer, or equity purchases in
which the buyer purchases equity interests in a target
buyer and to the sellers shareholders.

36.4. BUSINESS VALUATION

191

company from one or more selling shareholders. Asset

purchases are common in technology transactions where
the buyer is most interested in particular intellectual property rights but does not want to acquire liabilities or other
contractual relationships.[10] An asset purchase structure
may also be used when the buyer wishes to buy a particular division or unit of a company which is not a separate
legal entity. There are numerous challenges particular to
this type of transaction, including isolating the specic
assets and liabilities that pertain to the unit, determining whether the unit utilizes services from other units of
the selling company, transferring employees, transferring
permits and licenses, and ensuring that the seller does not
compete with the buyer in the same business area in the
future.[11]

at both the time of signing and the time of closing.

Sellers often attempt to craft their representations
and warranties with knowledge qualiers, dictating
the level of knowledge applicable and which seller
parties knowledge is relevant.[14] Some agreements
provide that if the representations and warranties by
the seller prove to be false, the buyer may claim
a refund of part of the purchase price, as is common in transactions involving privately held companies (although in most acquisition agreements involving public company targets, the representations
and warranties of the seller do not survive the closing). Representations regarding a target companys
net working capital are a common source of postclosing disputes.[15]

Mergers, asset purchases and equity purchases are each

taxed dierently, and the most benecial structure for tax
purposes is highly situation-dependent. One hybrid form
often employed for tax purposes is a triangular merger,
where the target company merges with a shell company
wholly owned by the buyer, thus becoming a subsidiary
of the buyer. In a forward triangular merger, the buyer
causes the target company to merge into the subsidiary; a
reverse triangular merger is similar except that the subsidiary merges into the target company. Under the U.S.
Internal Revenue Code, a forward triangular merger is
taxed as if the target company sold its assets to the shell
company and then liquidated, whereas a reverse triangular merger is taxed as if the target companys shareholders
sold their stock in the target company to the buyer.[12]

Covenants, which govern the conduct of the parties,

both before the closing (such as covenants that restrict the operations of the business between signing
and closing) and after the closing (such as covenants
regarding future income tax lings and tax liability
or post-closing restrictions agreed to by the buyer
and seller parties).

36.3 Documentation
The documentation of an M&A transaction often begins
with a letter of intent. The letter of intent generally does
not bind the parties to commit to a transaction, but may
bind the parties to condentiality and exclusivity obligations so that the transaction can be considered through a
due diligence process involving lawyers, accountants, tax
advisors, and other professionals, as well as business people from both sides.[11]

Termination rights, which may be triggered by a

breach of contract, a failure to satisfy certain conditions or the passage of a certain period of time
without consummating the transaction, and fees and
damages payable in case of a termination for certain
events (also known as breakup fees). In 2013, termination fees ranged from 1.0% to 9.4% of the total
transaction value.[16]
Provisions relating to obtaining required shareholder
approvals under state law and related SEC lings required under federal law, if applicable, and terms
related to the mechanics of the legal transactions to
be consummated at closing (such as the determination and allocation of the purchase price and postclosing adjustments (such as adjustments after the
nal determination of working capital at closing or
earnout payments payable to the sellers), repayment
of outstanding debt, and the treatment of outstanding shares, options and other equity interests).

After due diligence is completed, the parties may proceed

to draw up a denitive agreement, known as a merger
agreement, share purchase agreement or asset pur- 36.4 Business valuation
chase agreement depending on the structure of the transaction. Such contracts are typically 80 to 100 pages long The ve most common ways to value a business are
and focus on ve key types of terms:[13]
Conditions, which must be satised before there is
an obligation to complete the transaction. Conditions typically include matters such as regulatory approvals and the lack of any material adverse change
in the targets business.
Representations and warranties by the seller with regard to the company, which are claimed to be true

asset valuation,
historical earnings valuation,
future maintainable earnings valuation,
relative valuation (comparable company and
comparable transactions),
discounted cash ow (DCF) valuation

192

CHAPTER 36. MERGERS AND ACQUISITIONS

Professionals who value businesses generally do not use

just one of these methods but a combination of some of
them, as well as possibly others that are not mentioned
above, in order to obtain a more accurate value. The information in the balance sheet or income statement is obtained by one of three accounting measures: a Notice to
Reader, a Review Engagement or an Audit.
Accurate business valuation is one of the most important
aspects of M&A as valuations like these will have a major impact on the price that a business will be sold for.
Most often this information is expressed in a Letter of
Opinion of Value (LOV) when the business is being valuated for interests sake. There are other, more detailed
ways of expressing the value of a business. While these
reports generally get more detailed and expensive as the
size of a company increases, this is not always the case
as there are many complicated industries which require
more attention to detail, regardless of size.
As synergy plays a large role in the valuation of acquisitions, it is paramount to get the value of synergies right.
Synergies are dierent from the sales price valuation
of the rm, as they will accrue to the buyer. Hence, the
analysis should be done from the acquiring rms point
of view. Synergy-creating investments are started by the
choice of the acquirer, and therefore they are not obligatory, making them essentially real options. To include
this real options aspect into analysis of acquisition targets
is one interesting issue that has been studied lately.[17]

36.5 Financing
Mergers are generally dierentiated from acquisitions
partly by the way in which they are nanced and partly
by the relative size of the companies. Various methods
of nancing an M&A deal exist:

36.5.1

Cash

quiring rm should consider other potential bidders and

think strategically. The form of payment might be decisive for the seller. With pure cash deals, there is no doubt
on the real value of the bid (without considering an eventual earnout). The contingency of the share payment is
indeed removed. Thus, a cash oer preempts competitors better than securities. Taxes are a second element
to consider and should be evaluated with the counsel of
competent tax and accounting advisers. Third, with a
share deal the buyers capital structure might be aected
and the control of the buyer modied. If the issuance of
shares is necessary, shareholders of the acquiring company might prevent such capital increase at the general
meeting of shareholders. The risk is removed with a cash
transaction. Then, the balance sheet of the buyer will
be modied and the decision maker should take into account the eects on the reported nancial results. For
example, in a pure cash deal (nanced from the companys current account), liquidity ratios might decrease.
On the other hand, in a pure stock for stock transaction
(nanced from the issuance of new shares), the company
might show lower protability ratios (e.g. ROA). However, economic dilution must prevail towards accounting
dilution when making the choice. The form of payment
and nancing options are tightly linked. If the buyer pays
cash, there are three main nancing options:
Cash on hand: it consumes nancial slack (excess
cash or unused debt capacity) and may decrease debt
rating. There are no major transaction costs.
Issue of debt: It consumes nancial slack, may decrease debt rating and increase cost of debt. Transaction costs include underwriting or closing costs of
1% to 3% of the face value.
Issue of stock: it increases nancial slack, may improve debt rating and reduce cost of debt. Transaction costs include fees for preparation of a proxy
statement, an extraordinary shareholder meeting
and registration.

Payment by cash. Such transactions are usually termed

If the buyer pays with stock, the nancing possibilities
acquisitions rather than mergers because the shareholdare:
ers of the target company are removed from the picture
and the target comes under the (indirect) control of the
Issue of stock (same eects and transaction costs as
bidders shareholders.
described above).

36.5.2

Stock

Payment in the form of the acquiring companys stock,

issued to the shareholders of the acquired company at a
given ratio proportional to the valuation of the latter.

36.5.3

Financing options

Shares in treasury: it increases nancial slack (if

they dont have to be repurchased on the market),
may improve debt rating and reduce cost of debt.
Transaction costs include brokerage fees if shares
are repurchased in the market otherwise there are
no major costs.

In general, stock will create nancial exibility. Transaction costs must also be considered but tend to have a
There are some elements to think about when choosing greater impact on the payment decision for larger transthe form of payment. When submitting an oer, the ac- actions. Finally, paying cash or with shares is a way to

36.7. MOTIVATION
signal value to the other party, e.g.: buyers tend to oer
stock when they believe their shares are overvalued and
cash when undervalued.[18]

36.6 Specialist advisory rms

Although at present the majority of M&A advice is provided by full-service investment banks, recent years have
seen a rise in the prominence of specialist M&A advisers, who only provide M&A advice (and not nancing).
These companies are sometimes referred to as Merchant
Capital Advisors or Advisors, assisting businesses often
referred to as companies in selling. To perform these
services in the US, an advisor must be a licensed broker
dealer, and subject to SEC (FINRA) regulation.
M&A advisers can assist dealmakers in eliminating administrative ineciencies in their transaction, such as
slow payments or poorly invested escrows. These ineciencies cost merger parties over ve billion annually.[19]

36.7 Motivation
36.7.1

Improving nancial performance or

reducing risk

The dominant rationale used to explain M&A activity is

that acquiring rms seek improved nancial performance
or reduce risk. The following motives are considered to
improve nancial performance or reduce risk:
Economy of scale: This refers to the fact that the
combined company can often reduce its xed costs
by removing duplicate departments or operations,
lowering the costs of the company relative to the
same revenue stream, thus increasing prot margins.
Economy of scope: This refers to the eciencies primarily associated with demand-side changes,
such as increasing or decreasing the scope of marketing and distribution, of dierent types of products.
Increased revenue or market share: This assumes
that the buyer will be absorbing a major competitor and thus increase its market power (by capturing
increased market share) to set prices.
Cross-selling: For example, a bank buying a stock
broker could then sell its banking products to the
stock brokers customers, while the broker can sign
up the banks customers for brokerage accounts. Or,
a manufacturer can acquire and sell complementary
products.
Synergy: For example, managerial economies such
as the increased opportunity of managerial specialization. Another example is purchasing economies

193
due to increased order size and associated bulkbuying discounts.
Taxation: A protable company can buy a loss
maker to use the targets loss as their advantage by
reducing their tax liability. In the United States and
many other countries, rules are in place to limit the
ability of protable companies to shop for loss
making companies, limiting the tax motive of an acquiring company.
Geographical or other diversication: This is designed to smooth the earnings results of a company,
which over the long term smoothens the stock price
of a company, giving conservative investors more
condence in investing in the company. However,
this does not always deliver value to shareholders
(see below).
Resource transfer: resources are unevenly distributed across rms (Barney, 1991) and the interaction of target and acquiring rm resources can create
value through either overcoming information asymmetry or by combining scarce resources.[20]
Vertical integration: Vertical integration occurs
when an upstream and downstream rm merge (or
one acquires the other). There are several reasons for this to occur. One reason is to internalise an externality problem. A common example of such an externality is double marginalization.
Double marginalization occurs when both the upstream and downstream rms have monopoly power
and each rm reduces output from the competitive level to the monopoly level, creating two deadweight losses. Following a merger, the vertically integrated rm can collect one deadweight loss by setting the downstream rms output to the competitive
level. This increases prots and consumer surplus.
A merger that creates a vertically integrated rm can
be protable.[21]
Hiring: some companies use acquisitions as an alternative to the normal hiring process. This is especially common when the target is a small private
company or is in the startup phase. In this case, the
acquiring company simply hires (acquhires) the
sta of the target private company, thereby acquiring its talent (if that is its main asset and appeal).
The target private company simply dissolves and little legal issues are involved.
Absorption of similar businesses under single management: similar portfolio invested by two dierent
mutual funds namely united money market fund and
united growth and income fund, caused the management to absorb united money market fund into
united growth and income fund.
Access to hidden or nonperforming assets (land, real
estate).

194

36.7.2

CHAPTER 36. MERGERS AND ACQUISITIONS

Other types

However, on average and across the most commonly studied variables, acquiring rms nancial performance does
not positively change as a function of their acquisition
activity.[22] Therefore, additional motives for merger and
acquisition that may not add shareholder value include:

their service suppliers is an example of vertical buying. The vertical buying is aimed at reducing overhead cost of operations and economy of scale.
Conglomerate M&A is the third form of M&A process which deals the merger between two irrelevant
companies. The example of conglomerate M&A
with relevance to above scenario would be if health
care system buys a restaurant chain. The objective
may be diversication of capital investment.[24]

Diversication: While this may hedge a company

against a downturn in an individual industry it fails
to deliver value, since it is possible for individual
shareholders to achieve the same hedge by diversifying their portfolios at a much lower cost than those 36.8.2 Arms length mergers
associated with a merger. (In his book One Up on
Wall Street, Peter Lynch termed this diworseica- An arms length merger is a merger:
tion.)
1. approved by disinterested directors and
Managers hubris: managers overcondence about
2. approved by disinterested stockholders:
expected synergies from M&A which results in
overpayment for the target company.
The two elements are complementary and not substi Empire-building: Managers have larger companies
tutes. The rst element is important because the dito manage and hence more power.
rectors have the capability to act as eective and ac Managers compensation: In the past, certain exec- tive bargaining agents, which disaggregated stockholders
utive management teams had their payout based on do not. But, because bargaining agents are not always
the total amount of prot of the company, instead eective or faithful, the second element is critical, beof the prot per share, which would give the team cause it gives the minority stockholders the opportunity
a perverse incentive to buy companies to increase to reject their agents work. Therefore, when a merger
the total prot while decreasing the prot per share with a controlling stockholder was: 1) negotiated and
(which hurts the owners of the company, the share- approved by a special committee of independent directors; and 2) conditioned on an armative vote of a maholders).
jority of the minority stockholders, the business judgment standard of review should presumptively apply, and
Interestingly, a twenty year study of over twenty-ve
any plainti ought to have to plead particularized facts
thousand rms found that rms that were inactive in anthat, if true, support an inference that, despite the facially
nouncing their M&A activity underperformed the market
fair process, the merger was tainted because of duciary
while rms that more frequently announced their acquiwrongdoing.[25]
[23]
sitions outperformed the market.

36.8 Dierent types

36.8.3 Strategic mergers

A Strategic merger usually refers to long term strategic

holding of target (Acquired) rm. This type of M&A
36.8.1 By functional roles in market
process aims at creating synergies in the long run by inThe M&A process itself is a multifaceted which depends creased market share, broad customer base, and corporate strength of business. A strategic acquirer may also
upon the type of merging companies.
be willing to pay a premium oer to target rm in the
outlook of the synergy value created after M&A process.
A horizontal merger is usually between two companies in the same business sector. The example of
horizontal merger would be if a health care system 36.8.4 Acqui-hire
buys another health care system. This means that
synergy can obtained through many forms including The term acqui-hire is used to refer to acquisitions
such as; increased market share, cost savings and ex- where the acquiring company seeks to obtain the target
ploring new market opportunities.
companys talent, rather than their products (which are
often discontinued as part of the acquisition so the team
A vertical merger represents the buying of supplier can focus on projects for their new employer). In recent
of a business. In the same example as above if a years, these types of acquisitions have become common
health care system buys the ambulance services from in the technology industry, where major web companies

36.11. HISTORY
such as Facebook, Twitter, and Yahoo! have frequently
used talent acquisitions to add expertise in particular areas to their workforces.[26][27]

36.9 Research and statistics for acquired organizations

Given that the cost of replacing an executive can run
over 100% of his or her annual salary, any investment
of time and energy in re-recruitment will likely pay for
itself many times over if it helps a business retain just a
handful of key players that would have otherwise left.[28]

195
company lost the considerable value of both Yellow
Freight and Roadway Corp.
The factors inuencing brand decisions in a merger or acquisition transaction can range from political to tactical.
Ego can drive choice just as well as rational factors such as
brand value and costs involved with changing brands.[31]
Beyond the bigger issue of what to call the company after
the transaction comes the ongoing detailed choices about
what divisional, product and service brands to keep. The
detailed decisions about the brand portfolio are covered
under the topic brand architecture.

Organizations should move rapidly to re-recruit key managers. Its much easier to succeed with a team of quality 36.11 History
players that one selects deliberately rather than try to win
Most histories of M&A begin in the late 19th century
a game with those who randomly show up to play.[29]
U.S. However, mergers coincide historically with the existence of companies. In 1708, for example, the East India Company merged with an erstwhile competitor to re36.10 Brand considerations
store its monopoly over Indian trade. In 1784, the Italian
Monte dei Paschi and Monte Pio banks were united as the
Mergers and acquisitions often create brand problems, Monti Reuniti.[32] In 1821, the Hudsons Bay Company
beginning with what to call the company after the trans- merged with the rival North West Company.
action and going down into detail about what to do about
overlapping and competing product brands. Decisions
about what brand equity to write o are not inconsequen- 36.11.1 The Great Merger Movement:
tial. And, given the ability for the right brand choices to
18951905
drive preference and earn a price premium, the future
success of a merger or acquisition depends on making
The Great Merger Movement was a predominantly U.S.
wise brand choices. Brand decision-makers essentially
business phenomenon that happened from 1895 to 1905.
can choose from four dierent approaches to dealing with
During this time, small rms with little market share connaming issues, each with specic pros and cons:[30]
solidated with similar rms to form large, powerful institutions that dominated their markets. It is estimated that
1. Keep one name and discontinue the other. The more than 1,800 of these rms disappeared into consolistrongest legacy brand with the best prospects for the dations, many of which acquired substantial shares of the
future lives on. In the merger of United Airlines and markets in which they operated. The vehicle used were
Continental Airlines, the United brand will continue so-called trusts. In 1900 the value of rms acquired in
forward, while Continental is retired.
mergers was 20% of GDP. In 1990 the value was only
3% and from 1998 to 2000 it was around 1011% of
2. Keep one name and demote the other. The strongest
GDP. Companies such as DuPont, US Steel, and General
name becomes the company name and the weaker
Electric that merged during the Great Merger Movement
one is demoted to a divisional brand or product
were able to keep their dominance in their respective secbrand. An example is Caterpillar Inc. keeping the
tors through 1929, and in some cases today, due to growBucyrus International name.[31]
ing technological advances of their products, patents, and
3. Keep both names and use them together. Some brand recognition by their customers. There were also
companies try to please everyone and keep the other companies that held the greatest market share in
value of both brands by using them together. This 1905 but at the same time did not have the competitive
can create an unwieldy name, as in the case of advantages of the companies like DuPont and General
PricewaterhouseCoopers, which has since changed Electric. These companies such as International Paper
and American Chicle saw their market share decrease sigits brand name to PwC.
nicantly by 1929 as smaller competitors joined forces
4. Discard both legacy names and adopt a totally new with each other and provided much more competition.
one. The classic example is the merger of Bell At- The companies that merged were mass producers of holantic with GTE, which became Verizon Communi- mogeneous goods that could exploit the eciencies of
cations. Not every merger with a new name is suc- large volume production. In addition, many of these
cessful. By consolidating into YRC Worldwide, the mergers were capital-intensive. Due to high xed costs,

196
when demand fell, these newly merged companies had
an incentive to maintain output and reduce prices. However more often than not mergers were quick mergers.
These quick mergers involved mergers of companies
with unrelated technology and dierent management. As
a result, the eciency gains associated with mergers were
not present. The new and bigger company would actually
face higher costs than competitors because of these technological and managerial dierences. Thus, the mergers
were not done to see large eciency gains, they were in
fact done because that was the trend at the time. Companies which had specic ne products, like ne writing
paper, earned their prots on high margin rather than volume and took no part in Great Merger Movement.

Short-run factors
One of the major short run factors that sparked The Great
Merger Movement was the desire to keep prices high.
However, high prices attracted the entry of new rms into
the industry.
A major catalyst behind the Great Merger Movement was
the Panic of 1893, which led to a major decline in demand for many homogeneous goods. For producers of
homogeneous goods, when demand falls, these producers have more of an incentive to maintain output and cut
prices, in order to spread out the high xed costs these
producers faced (i.e. lowering cost per unit) and the desire to exploit eciencies of maximum volume production. However, during the Panic of 1893, the fall in demand led to a steep fall in prices.
Another economic model proposed by Naomi R. Lamoreaux for explaining the steep price falls is to view
the involved rms acting as monopolies in their respective markets. As quasi-monopolists, rms set quantity
where marginal cost equals marginal revenue and price
where this quantity intersects demand. When the Panic of
1893 hit, demand fell and along with demand, the rms
marginal revenue fell as well. Given high xed costs,
the new price was below average total cost, resulting in
a loss. However, also being in a high xed costs industry,
these costs can be spread out through greater production
(i.e. Higher quantity produced). To return to the quasimonopoly model, in order for a rm to earn prot, rms
would steal part of another rms market share by dropping their price slightly and producing to the point where
higher quantity and lower price exceeded their average total cost. As other rms joined this practice, prices began
falling everywhere and a price war ensued.[33]
One strategy to keep prices high and to maintain profitability was for producers of the same good to collude
with each other and form associations, also known as
cartels. These cartels were thus able to raise prices right
away, sometimes more than doubling prices. However,
these prices set by cartels only provided a short-term solution because cartel members would cheat on each other

CHAPTER 36. MERGERS AND ACQUISITIONS

by setting a lower price than the price set by the cartel.
Also, the high price set by the cartel would encourage new
rms to enter the industry and oer competitive pricing,
causing prices to fall once again. As a result, these cartels
did not succeed in maintaining high prices for a period
of more than a few years. The most viable solution to
this problem was for rms to merge, through horizontal
integration, with other top rms in the market in order to
control a large market share and thus successfully set a
higher price.
Long-run factors
In the long run, due to desire to keep costs low, it was advantageous for rms to merge and reduce their transportation costs thus producing and transporting from one location rather than various sites of dierent companies as in
the past. Low transport costs, coupled with economies
of scale also increased rm size by two- to fourfold during the second half of the nineteenth century. In addition, technological changes prior to the merger movement within companies increased the ecient size of
plants with capital intensive assembly lines allowing for
economies of scale. Thus improved technology and transportation were forerunners to the Great Merger Movement. In part due to competitors as mentioned above, and
in part due to the government, however, many of these
initially successful mergers were eventually dismantled.
The U.S. government passed the Sherman Act in 1890,
setting rules against price xing and monopolies. Starting in the 1890s with such cases as Addyston Pipe and
Steel Company v. United States, the courts attacked large
companies for strategizing with others or within their own
companies to maximize prots. Price xing with competitors created a greater incentive for companies to unite
and merge under one name so that they were not competitors anymore and technically not price xing.
The economic history has been divided into Merger
Waves based on the merger activities in the business world
as:[34]
Objectives in more recent merger waves
During the third merger wave (19651989), corporate
marriages involved more diverse companies. Acquirers
more frequently bought into dierent industries. Sometimes this was done to smooth out cyclical bumps, to diversify, the hope being that it would hedge an investment
portfolio.
Starting in the fth merger wave (19921998) and continuing today, companies are more likely to acquire in the
same business, or close to it, rms that complement and
strengthen an acquirers capacity to serve customers.
Buyers arent necessarily hungry for the target companies hard assets. Some are more interested in acquiring thoughts, methodologies, people and relationships.

36.13. FAILURE
Paul Graham recognized this in his 2005 essay Hiring
is Obsolete, in which he theorizes that the free market
is better at identifying talent, and that traditional hiring
practices do not follow the principles of free market because they depend a lot upon credentials and university
degrees. Graham was probably the rst to identify the
trend in which large companies such as Google, Yahoo!
or Microsoft were choosing to acquire startups instead of
hiring new recruits.[35]
Many companies are being bought for their patents, licenses, market share, name brand, research sta, methods, customer base, or culture. Soft capital, like this, is
very perishable, fragile, and uid. Integrating it usually
takes more nesse and expertise than integrating machinery, real estate, inventory and other tangibles.[36]

36.12 Cross-border
In a study conducted in 2000 by Lehman Brothers, it was
found that, on average, large M&A deals cause the domestic currency of the target corporation to appreciate
by 1% relative to the acquirers local currency.

197

36.13 Failure
Despite the goal of performance improvement, results
from mergers and acquisitions (M&A) are often disappointing compared with results predicted or expected.
Numerous empirical studies show high failure rates of
M&A deals. Studies are mostly focused on individual determinants. A book by Thomas Straub (2007) Reasons
for frequent failure in Mergers and Acquisitions[42] develops a comprehensive research framework that bridges
dierent perspectives and promotes an understanding of
factors underlying M&A performance in business research and scholarship. The study should help managers in the decision making process. The rst important
step towards this objective is the development of a common frame of reference that spans conicting theoretical assumptions from dierent perspectives. On this basis, a comprehensive framework is proposed with which
to understand the origins of M&A performance better
and address the problem of fragmentation by integrating the most important competing perspectives in respect
of studies on M&A. Furthermore, according to the existing literature, relevant determinants of rm performance are derived from each dimension of the model.
For the dimension strategic management, the six strategic variables: market similarity, market complementarities, production operation similarity, production operation complementarities, market power, and purchasing
power were identied as having an important impact on
M&A performance. For the dimension organizational
behavior, the variables acquisition experience, relative
size, and cultural dierences were found to be important. Finally, relevant determinants of M&A performance from the nancial eld were acquisition premium,
bidding process, and due diligence. Three dierent ways
in order to best measure post M&A performance are recognized: synergy realization, absolute performance, and
nally relative performance.

The rise of globalization has exponentially increased

the necessity for agencies such as the Mergers and Acquisitions International Clearing (MAIC), trust accounts
and securities clearing services for Like-Kind Exchanges
for cross-border M&A. In 1997 alone, there were over
2,333 cross-border transactions, worth a total of approximately $298 billion. Due to the complicated nature of cross-border M&A and the additional burden
of complying with the unique laws and regulations of a
sellers jurisdiction,[37] the vast majority of cross-border
actions are unsuccessful as companies seek to expand
their global footprint and become more agile at creating high-performing businesses and cultures across national boundaries.[38] Nonetheless, the current surge in Employee turnover contributes to M&A failures. The
global cross-border M&A has been called the New Era turnover in target companies is double the turnover experienced in non-merged rms for the ten years followof Global Economic Discovery.[39]
ing the merger.[43] Modern M&A deals require ecient
Even mergers of companies with headquarters in the information technology (IT) integration in order to avoid
same country can often be considered international in failure.[44]
scale and require MAIC custodial services. For example, when Boeing acquired McDonnell Douglas, the
two American companies had to integrate operations in
dozens of countries around the world (1997). This is
just as true for other apparently single-country mergers, such as the 29 billion-dollar merger of Swiss drug
36.14 Major
makers Sandoz and Ciba-Geigy (now Novartis).
Cross-border transactions often present unique challenges. For instance, multinational buyers may face 36.14.1 1990s
workplace issues when taking over the sellers sta.[40]
Further, cross-border mergers are often expensive and
time-consuming due to a growing number of countries Top 10 M&A deals worldwide by value from 1990 to
1999:[45]
requiring pre-merger ling requirements.[41]

198

36.14.2

CHAPTER 36. MERGERS AND ACQUISITIONS

2000s

Top 10 M&A deals worldwide by value from 2000 to

2010:[45]

36.14.3

20102014

Other notable M&A deals from 2010 to 2014 include:[57]

[17] Collan, Mikael; Kinnunen Jani (2011). A Procedure for

the Rapid Pre-acquisition Screening of Target Companies
Using the Pay-o Method for Real Option Valuation.
Journal of Real Options and Strategy 4 (1): 117141.

[19] Koenig, Paul. Solving for the Administrative Ineciencies in M&A. Transaction Advisors. ISSN 2329-9134.

36.16 References
[1] Derek van der Plaat (9 September 2013). Four Companies That Know How to Acquire. Private Company
Mergers and Acquisitions. Retrieved 18 February 2015.
[2] Investment banking explained pp. 223-224
[3] Mergers and acquisitions explained. Retrieved 200906-30.
[4] Hansell, Gerry; Kengelbach, Jens; Walker, Decker.
Lessons from Successful Serial Acquirers. Transaction
Advisors. ISSN 2329-9134.
[5] Harwood, 2005
in

[16] Houlihan Lokey. 2013 Transaction Termination Fee

Study. Transaction Advisors. ISSN 2329-9134.

[18] mergers.acquisitions.ch. Retrieved 18 February 2015.

36.15 See also

[6] Reverse Merger

acquisitions.org

[15] McKee, Monte. Purchase Agreement Clauses Leading

to Post-Closing Conict. Transaction Advisors. ISSN
2329-9134.

the

glossary

of

mergers-

[7] Rumyantseva, Maria, Grzegorz Gurgul, and Ellen Enkel.

Knowledge Integration after Mergers & Acquisitions.
University of Mississippi Business Department. University of Mississippi, July 2002.
[8] Cianni, Mary. Global M&A Retention Survey. Transaction Advisors. ISSN 2329-9134.
[9] Ranft, Annette L., and Michael D. Lord. Acquiring
new technologies and capabilities: A grounded model of
acquisition implementation. Organization science 13.4
(2002): 420-441.
[10] Moore, Jim. Get acquired! An idiots guide to technology M&A. Retrieved 19 August 2013.
[11] Mergers & Acquisitions Quick Reference Guide.
McKenna Long & Aldridge LLP. Retrieved 19 August
2013.
[12] Grin, William F. Tax Aspects of Corporate Mergers
and Acquisitions. Davis Malm & D'Agostine, P.C. Retrieved 19 August 2013.
[13] Barusch, Ronald. WSJ M&A 101: A Guide to Merger
Agreements. WSJ Deal Journal. Retrieved 19 August
2013.
[14] Avery, Daniel; Crossley, Kyle. Use of Knowledge Qualiers for Representations and Warranties. Transaction
Advisors. ISSN 2329-9134.

[20] King, D. R.; Slotegraaf, R.; Kesner, I. (2008). Performance implications of rm resource interactions in the acquisition of R&D-intensive rms. Organization Science
19 (2): 327340. doi:10.1287/orsc.1070.0313.
[21] Maddigan, Ruth; Zaima, Janis (1985). The Protability
of Vertical Integration. Managerial and Decision Economics 6 (3): 178179. doi:10.1002/mde.4090060310.
[22] King, D. R.; Dalton, D. R.; Daily, C. M.; Covin, J. G.
(2004). Meta-analyses of Post-acquisition Performance:
Indications of Unidentied Moderators. Strategic Management Journal 25 (2): 187200. doi:10.1002/smj.371.
[23] Moeller, Scott; Faelten, Anna; Whitchelo, Philip. Which
M&A Activities Drive the Most Shareholder Value.
Transaction Advisors. ISSN 2329-9134.
[24] An Overview of the Dierent Types of Mergers and Acquisitions. Johnsons Corporate.
[25] In re Cox Communications, Inc. Shareholders Litig., 879
A.2d 604, 606 (Del. Ch. 2005).
[26] Hof, Robert. Attention Startups: Heres How To Get
Acqui-Hired By Google, Yahoo Or Twitter. Forbes. Retrieved 9 January 2014.
[27] Start-Ups Get Snapped Up for Their Talent. Wall Street
Journal. Retrieved 9 January 2014.
[28] M&A Research and Statistics for Acquired Organizations MergerIntegration.com
[29] The Right Human Resources Approach to M&A
Turnover MergerIntegration.com
[30] NewsBeast And Other Merger Name Options Merriam Associates, Inc. Brand Strategies. Merriamassociates.com. Retrieved 2012-12-18.
[31] Caterpillars New LegsAcquiring the Bucyrus International Brand Merriam Associates, Inc. Brand Strategies. Merriamassociates.com. Retrieved 2012-12-18.
[32] Monte dei Paschi di Siena Bank | About us | History | The
Lorraine reform. 2009-03-17. Retrieved 2012-12-18.
[33] Lamoreaux, Naomi R. The great merger movement in
American business, 1895-1904. Cambridge University
Press, 1985.

36.17. FURTHER READING

199

[34]

[55] AT&T- News Room

[35] Hiring is Obsolete. Retrieved 18 February 2015.

[56] J. P. Morgan to buy Bank One for $58 billion. CNNMoney.com. 2004-01-15.

[36] Mergers:
tion.com

New Game, New Goals MergerIntegra-

[37] Christie, Alec. Privacy and M&A Transactions. Transaction Advisors. ISSN 2329-9134.
[38] Towers Watson: Employee Benets, HR Consulting,
Risk Management Insurance. Towers Watson. Retrieved
18 February 2015.
[39] Ayisi-Cromwell, M. The New Era of Global Economic
Discovery: Opportunities and Challenges. Thomson
Reuters Emerging Markets Investment Forum. New
York, NY. 19 Sep. 2012. Chairmans Opening Remarks.
[40] Dowling, Donald. Employment Law Toolkit for CrossBorder M&A Deals. Transaction Advisors. ISSN 23299134.
[41] Jalabert Doury, Nathalie; Perlman, Scott; Steel, Adrian;
Fourquet, Josephine. Multijurisdictional Merger Filings. Transaction Advisors. ISSN 2329-9134.
[42] [Straub, Thomas (2007). Reasons for frequent failure
in Mergers and Acquisitions: A comprehensive analysis. Wiesbaden: Deutscher Universitts-Verlag (DUV),
Gabler Edition Wissenschaft. ISBN 978-3-8350-08441.]
[43] Acquired Companies Prior to Close MergerIntegration.com
[44] Shah, Sachin; Linoi, Marc; Padmanabhan, Vishy. IT in
M&A: Increasing the odds of a successful integration.
Transaction Advisors. ISSN 2329-9134.
[45] Statistics on Mergers & Acquisitions (M&A) - M&A
Courses | Company Valuation Courses | Mergers & Acquisitions Courses. Imaa-institute.org. Retrieved 201212-18.
[46] Mannesmann to accept bid - February 3, 2000. CNN.
February 3, 2000.
[47] Pzer and Warner-Lambert agree to $90 billion merger
creating the worlds fastest-growing major pharmaceutical
company
[48] Exxon, Mobil mate for $80B - December 1, 1998. CNN.
December 1, 1998.
[49] Finance: Exxon-Mobil Merger Could Poison The Well
[50] Fool.com: Bell Atlantic and GTE Agree to Merge (Feature) July 28, 1998
[51] http://www.eia.doe.gov/emeu/finance/fdi/ad2000.html
[52] Online NewsHour: AOL/Time Warner Merger
[53] AOL and Time Warner to merge - January 10, 2000.
CNN. January 10, 2000.
[54] AT&T To Buy BellSouth For $67 Billion. CBS News.
March 5, 2006.

[57] The Biggest M&A Deals of 2011 - A running tally - Businessweek. Images.businessweek.com. Retrieved 201308-01.

36.17 Further reading

Denison, Daniel, Hooijberg, Robert, Lane, Nancy,
Lief, Colleen, (2012). Leading Culture Change in
Global Organizations. Creating One Culture Out
of Many, chapter 4. San Francisco: Jossey-Bass.
ISBN 9780470908846
Aharon, D.Y., I. Gavious and R. Yosef, 2010. Stock
market bubble eects on mergers and acquisitions.
The Quarterly Review of Economics and Finance,
50(4): p. 456470.
Cartwright, Susan; Schoenberg, Richard (2006).
Thirty Years of Mergers and Acquisitions Research: Recent Advances and Future Opportunities. British Journal of Management 17 (S1): S1
S5. doi:10.1111/j.1467-8551.2006.00475.x.
Bartram, Shnke M.; Burns, Natasha; Helwege,
Jean (September 2013). Foreign Currency Exposure and Hedging: Evidence from Foreign Acquisitions. Quarterly Journal of Finance. forthcoming.
Close, John Weir. A Giant Cow-tipping by Savages:
The Boom, Bust, and Boom Culture of M&A. New
York: Palgrave Macmilla. ISBN 9780230341814.
OCLC 828246072.
"8 Stages for an Optimal Outcome: The Tech M&A
Process". Corum Group Ltd.
M&A insights: Up front a ne balance. Deloitte.
DePamphilis, Donald (2008). Mergers, Acquisitions, and Other Restructuring Activities. New York:
Elsevier, Academic Press. p. 740. ISBN 978-0-12374012-0.
Douma, Sytse & Hein Schreuder (2013). Economic Approaches to Organizations, chapter 13.
5th edition. London: Pearson. ISBN 0273735292
ISBN 9780273735298
Fleuriet, Michel (2008). Investment Banking explained: An insiders guide to the industry. New
York, NY: McGraw Hill. ISBN 978-0-07-1497336.
Harwood, I. A. (2006). Condentiality constraints
within mergers and acquisitions: gaining insights
through a 'bubble' metaphor. British Journal of
Management 17 (4): 347359. doi:10.1111/j.14678551.2005.00440.x.

200
Popp, Karl Michael (2013). Mergers and Acquisitions in the Software Industry - foundations of due
diligence. Norderstedt: Books on demand. ISBN
978-3-7322-4381-5.
Reddy, K.S., Nangia, V.K., & Agrawal, R. (2014).
The 2007-2008 global nancial crisis, and crossborder mergers and acquisitions: A 26-nation exploratory study. Global Journal of Emerging Market Economies, 6(3), 257-281. http://eme.sagepub.
com/content/6/3/257.short
Reddy, K.S., Nangia, V.K., & Agrawal, R. (2013).
Indian economic-policy reforms, bank mergers, and
lawful proposals: The ex-ante and ex-post lookup.
Journal of Policy Modeling, 35(4), 601-622. http:
//dx.doi.org/10.1016/j.jpolmod.2012.12.001.
Reddy, K.S., Agrawal, R., & Nangia, V.K.
(2013). Reengineering, crafting and comparing
business valuation models-the advisory exemplar.
International Journal of Commerce and Management, 23(3), 216-241. http://dx.doi.org/10.1108/
IJCoMA-07-2011-0018.
Reifenberger, Sabine (28 December 2012). M&A
Market: The New Normal. CFO Insight
Rosenbaum, Joshua; Joshua Pearl (2009). Investment Banking: Valuation, Leveraged Buyouts, and
Mergers & Acquisitions. Hoboken, NJ: John Wiley
& Sons. ISBN 0-470-44220-4.
Scott, Andy (2008). China Brieng: Mergers and
Acquisitions in China (2nd ed.).
Straub, Thomas (2007). Reasons for frequent failure in Mergers and Acquisitions: A comprehensive analysis. Wiesbaden: Deutscher UniversittsVerlag (DUV), Gabler Edition Wissenschaft. ISBN
978-3-8350-0844-1.

CHAPTER 36. MERGERS AND ACQUISITIONS

Chapter 37

Structured nance
Structured nance is a broad term used to describe a
sector of nance that was created to help transfer risk using complex legal and corporate entities. This transfer
of risk, as applied to the securitization of various nancial assets (mortgages, credit card receivables, auto loans,
etc.), has helped provide increased liquidity or funding
sources to markets like housing and to transfer risk to
buyers of structured products; it also permits nancial
institutions to remove certain assets from their balance
sheets as well as provides a means for investors to gain
access to diversied asset classes.[1] However, it arguably
contributed to the degradation in underwriting standards
for these nancial assets, which helped give rise to both
the inationary credit bubble of the mid-2000s and the
credit crash and nancial crisis of 20079.[2]

37.1.2 Tranching
Main article: Tranche

Tranching, which refers to the creation of dierent

classes of securities (typically with dierent credit ratings) from the same pool of assets, is an important concept in structured nance because it is the system used to
create dierent investment classes for the securities created. Tranching allows the cash ow from the underlying
asset to be diverted to various investor groups. The Committee on the Global Financial System explains tranching
as follows: A key goal of the tranching process is to create at least one class of securities whose rating is higher
than the average rating of the underlying collateral pool
Common examples of instruments created through secu- or to create rated securities from a pool of unrated assets.
ritization include collateralized debt obligations (CDOs) This is accomplished through the use of credit support
(enhancement), such as prioritization of payments to
and asset-backed securities (ABS).
the dierent tranches.[5]

37.1 Structure
37.1.1

37.1.3 Credit enhancement

Securitization

Main article: Credit enhancement

Main article: Securitization

Securitization is the method utilized by participants of
structured nance to create the pools of assets that are
used in the creation of the end product nancial instruments.
Reasons for securitization
Better utilization of available capital
Alternative funding
Cheaper source of funding, especially for lowerrated originators
Reducing credit concentration
Risk management interest rates and liquidity
Risk transfer[3][4]

Credit enhancement is key in creating a security that has

a higher rating than the underlying asset pool. Credit enhancement can be created, for example, by issuing subordinate bonds. The subordinate bonds are allocated any
losses from the collateral before losses are allocated to the
senior bonds, thus giving senior bonds a credit enhancement. As a result, it is possible for defaults to occur in
repayment of the underlying assets without aecting payments to holders of the senior bonds. Also, many deals,
typically those involving riskier collateral, such as subprime and Alt-A mortgages, use over-collateralization as
well as subordination. In over-collateralization, the balance of the underlying assets (e.g., loans) is greater than
the balance of the bonds, thus creating excess interest in
the deal which acts as a cushion against reduction in
value of the underlying assets. Excess interest can be used
to oset collateral losses before losses are allocated to
bondholders, thus providing another credit enhancement.
A further credit enhancement involves the use of derivatives such as swap transactions, which eectively provide

201

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CHAPTER 37. STRUCTURED FINANCE

insurance, for a set fee, against a decrease in value.

Monoline insurers play a critical role in modern day
Credit Enhancements; they are more eective in (a) obalance-sheet models creating synthetic collateral, (b)
sovereign ratings enhancement with built-in asset derivatives and (c) cross border loans with receivables and counterparties in the domain and jurisdiction of the monoline
insurer. The decision whether to use a monoline insurer
or not often depends upon the cost of such cover vis-a-vis
the improvement in pricing for the loan or bond issue by
virtue of such credit enhancement.

37.1.4

Credit ratings

Main article: Credit rating agency

Ratings play an important role in structured nance for
instruments that are meant to be sold to investors. Many
mutual funds, governments, and private investors only
buy instruments that have been rated by a known agency,
like Moodys or Standard & Poors. New rules in the
U.S. and Europe have tightened the requirements for ratings agencies (perhaps in light of previous credit crises).
These are reected in Europe by a body of regulations
relating to the use of credit agencies.[6]

37.2 Structure
37.2.1

Other structures

There are numerous structures which may involve mezzanine risk participation, options, and futures within structured nance, as well as multiple stripping of interest rate
strips. There is no laid-out xed structure, unlike in securitization, which is only a subset of the overall structured
transactions. Esoteric transactions often have multiple
lenders and borrowers distributed by distribution agents
where the structuring entity may not be involved in the
transaction at all.

37.3 Types
There are several main types of structured nance instruments.
Asset-backed securities are bonds or notes based on
pools of assets or collateralized by the cash ows
from a specic pool of underlying assets.
Mortgage-backed securities are asset-backed securities, the cash ows from which are backed by the
principal and interest payments of a set of mortgage
loans.

Residential mortgage-backed securities deal

with residential homes, usually single family.
Commercial mortgage-backed securities are
for commercial real estate, such as malls or ofce complexes.
Collateralized mortgage obligations are securitizations of mortgage-backed securities, typically involving multiple classes with diering
levels of seniority.[7]
Collateralized debt obligations consolidate a group
of xed-income assets, such as high-yield debt or
asset-backed securities, into a pool, which is then
divided into various tranches. Many CDOs are collateralized by various types of mortgage-backed securities and other mortgage-related assets.[8] An extension of these CDOs are synthetic CDOs which
are collateralized by credit default swaps and other
derivatives.[9]
Collateralized bond obligations are collateralized debt obligations backed primarily by corporate bonds.
Collateralized loan obligations are collateralized debt obligations backed primarily by
leveraged bank loans.
Collateralized
debt
obligations
are
**Commercial real estate collateralized
debt obligations are collateralized debt obligations backed primarily by commercial real
estate loans and bonds.
Credit derivatives are contracts to transfer the risk
of the total return on a credit asset falling below an
agreed level, without transfer of the underlying asset.
Collateralized fund obligations are securitizations of
private equity and hedge fund assets.
Partial guaranteed structures
Future ow transactions
Loan sell os
Revolving Credit Financing (property or traded
goods)[10]

37.4 See also

Pooled investment
Securitization
Thomson Financial League Tables
Structuring

37.6. EXTERNAL LINKS

37.5 References
[1] Lemke, Lins, Hoenig and Rube, Hedge Funds and Other
Private Funds: Regulation and Compliance, Chapter 15
(Thomson West, 2014-2015 ed.).
[2] Lowenstein, Roger (April 27, 2008). Triple A failure.
New York Times. Retrieved June 5, 2009.
[3] http://www.principalliquiditygroup.com/
[4] http://www.artemis.bm/deal_directory/
[5] The role of ratings in structured nance: issues and implications. Bank for International Settlements. January
2005. Retrieved November 5, 2008.
[6] http://ec.europa.eu/internal_market/rating-agencies/
index_en.htm
[7] Lemke, Lins and Picard, Mortgage-Backed Securities,
4:14 - 4:20 (Thomson West, 2014 ed.).
[8] Lemke, Lins and Picard, Mortgage-Backed Securities,
5:16 (Thomson West, 2014 ed.).
[9] Lemke, Lins and Picard, Mortgage-Backed Securities,
5:17 (Thomson West, 2014 ed.).
[10] http://www.principalliquiditygroup.com

37.6 External links

Jobst, Andreas A. (2007). A Primer on Structured
Finance Journal of Derivatives and Hedge Funds
Tergesen, Anne (2006). Structured Notes: Quirkiest Vehicle on the Street, Business Week
Goldstein, Matthew (2004).
Post-Enron,
Structured Finance Addiction Hasn't Ebbed
TheStreet.com
The Economics of Structured Finance

203

Chapter 38

Venture capital
For the process of nancing by venture capital, see in their domain.[4]
Venture capital nancing.
Venture capital (VC) is nancial capital provided to
early-stage, high-potential, growth startup companies.
The venture capital fund earns money by owning equity
in the companies it invests in, which usually have a novel
technology or business model in high technology industries, such as biotechnology and IT. The typical venture
capital investment occurs after the seed funding round as
the rst round of institutional capital to fund growth (also
referred to as Series A round) in the interest of generating a return through an eventual realization event, such as
an IPO or trade sale of the company. Venture capital is a
type of private equity.[1]

38.1 History
A venture may be dened as a project prospective converted into a process with an adequate assumed risk and
investment. With few exceptions, private equity in the
rst half of the 20th century was the domain of wealthy
individuals and families. The Wallenbergs, Vanderbilts,
Whitneys, Rockefellers, and Warburgs were notable investors in private companies in the rst half of the century. In 1938, Laurance S. Rockefeller helped nance the
creation of both Eastern Air Lines and Douglas Aircraft,
and the Rockefeller family had vast holdings in a variety
of companies. Eric M. Warburg founded E.M. Warburg
& Co. in 1938, which would ultimately become Warburg
Pincus, with investments in both leveraged buyouts and
venture capital. The Wallenberg family started Investor
AB in 1916 in Sweden and were early investors in several
Swedish companies such as ABB, Atlas Copco, Ericsson,
etc. in the rst half of the 20th century.

In addition to angel investing, equity crowdfunding and

other seed funding options, venture capital is attractive
for new companies with limited operating history that are
too small to raise capital in the public markets and have
not reached the point where they are able to secure a bank
loan or complete a debt oering. In exchange for the high
risk that venture capitalists assume by investing in smaller
and less mature companies, venture capitalists usually get
signicant control over company decisions, in addition
to a signicant portion of the companys ownership (and 38.1.1 Origins of modern private equity
consequently value).
Venture capital is also associated with job creation (ac- Before World War II (19391945), money orders (origicounting for 2% of US GDP),[2] the knowledge econ- nally known as development capital) remained primaromy, and used as a proxy measure of innovation within ily the domain of wealthy individuals and families. Only
an economic sector or geography. Every year, there after 1945 did true private equity investments begin to
are nearly 2 million businesses created in the USA, and emerge, notably with the founding of the rst two venture
600800 get venture capital funding. According to the capital rms in 1946: American Research and DevelopCorporation (ARDC) and J.H. Whitney & ComNational Venture Capital Association, 11% of private ment [5][6]
pany.
sector jobs come from venture-backed companies and
venture-backed revenue accounts for 21% of US GDP.[3]
It is also a way in which the private and the public sector can construct an institution that systematically creates
networks for the new rms and industries, so that they
can progress. This institution helps identify and combine
pieces of companies, such as nance, technical expertise,
marketing know-how, and business models. Once integrated, these enterprises succeed by becoming nodes in
the search networks for designing and building products

Georges Doriot, the father of venture capitalism[7]

(and former assistant dean of Harvard Business School),
founded INSEAD in 1957. Along with Ralph Flanders and Karl Compton (former president of MIT),
Doriot founded ARDC in 1946 to encourage privatesector investment in businesses run by soldiers returning from World War II. ARDC became the rst institutional private-equity investment rm to raise capital from
sources other than wealthy families, although it had several notable investment successes as well.[8] ARDC is

204

38.1. HISTORY

205

credited with the rst trick when its 1957 investment of

$70,000 in Digital Equipment Corporation (DEC) would
be valued at over $355 million after the companys initial public oering in 1968 (representing a return of over
1200 times on its investment and an annualized rate of
return of 101%).[9]
Former employees of ARDC went on to establish several
prominent venture-capital rms including Greylock Partners (founded in 1965 by Charlie Waite and Bill Elfers)
and Morgan, Holland Ventures, the predecessor of Flagship Ventures (founded in 1982 by James Morgan).[10]
ARDC continued investing until 1971, when Doriot retired. In 1972 Doriot merged ARDC with Textron after
having invested in over 150 companies.
John Hay Whitney (19041982) and his partner Benno
Schmidt (19131999) founded J.H. Whitney & Company in 1946. Whitney had been investing since the
1930s, founding Pioneer Pictures in 1933 and acquiring a
15% interest in Technicolor Corporation with his cousin
Cornelius Vanderbilt Whitney. Florida Foods Corporation proved Whitneys most famous investment. The
company developed an innovative method for delivering
nutrition to American soldiers, later known as Minute
Maid orange juice and was sold to The Coca-Cola Com- A highway exit for Sand Hill Road in Menlo Park, California,
pany in 1960. J.H. Whitney & Company continued to where many Bay Area venture capital rms are based
make investments in leveraged buyout transactions and
raised $750 million for its sixth institutional private equity fund in 2005.
1959 by what would later become Venrock Associates.[13]
Venrock was founded in 1969 by Laurance S. Rocke38.1.2 Early venture capital and the feller, the fourth of John D. Rockefellers six children as
a way to allow other Rockefeller children to develop exgrowth of Silicon Valley
posure to venture capital investments.
It was also in the 1960s that the common form of private
equity fund, still in use today, emerged. Private equity
rms organized limited partnerships to hold investments
in which the investment professionals served as general
partner and the investors, who were passive limited partners, put up the capital. The compensation structure, still
in use today, also emerged with limited partners paying
an annual management fee of 1.02.5% and a carried inDuring the 1960s and 1970s, venture capital rms focused their investment activity primarily on starting and terest typically representing up to 20% of the prots of
the partnership.
expanding companies. More often than not, these companies were exploiting breakthroughs in electronic, med- The growth of the venture capital industry was fueled by
ical, or data-processing technology. As a result, venture the emergence of the independent investment rms on
capital came to be almost synonymous with technology Sand Hill Road, beginning with Kleiner, Perkins, Caunance. An early West Coast venture capital company eld & Byers and Sequoia Capital in 1972. Located
was Draper and Johnson Investment Company, formed in Menlo Park, CA, Kleiner Perkins, Sequoia and later
in 1962[12] by William Henry Draper III and Franklin venture capital rms would have access to the many
P. Johnson, Jr. In 1965, Sutter Hill Ventures acquired semiconductor companies based in the Santa Clara Valthe portfolio of Draper and Johnson as a founding ac- ley as well as early computer rms using their devices and
tion. Bill Draper and Paul Wythes were the founders, programming and service companies.[14]
and Pitch Johnson formed Asset Management Company Throughout the 1970s, a group of private equity rms,
at that time.
focused primarily on venture capital investments, would
One of the rst steps toward a professionally managed
venture capital industry was the passage of the Small
Business Investment Act of 1958. The 1958 Act ocially
allowed the U.S. Small Business Administration (SBA) to
license private Small Business Investment Companies
(SBICs) to help the nancing and management of the
small entrepreneurial businesses in the United States.[11]

It is commonly noted that the rst venture-backed startup be founded that would become the model for later leveris Fairchild Semiconductor (which produced the rst aged buyout and venture capital investment rms. In
commercially practical integrated circuit), funded in 1973, with the number of new venture capital rms in-

206

CHAPTER 38. VENTURE CAPITAL

creasing, leading venture capitalists formed the National

Venture Capital Association (NVCA). The NVCA was to
serve as the industry trade group for the venture capital
industry.[15] Venture capital rms suered a temporary
downturn in 1974, when the stock market crashed and
investors were naturally wary of this new kind of investment fund.
It was not until 1978 that venture capital experienced
its rst major fundraising year, as the industry raised
approximately $750 million. With the passage of the
Employee Retirement Income Security Act (ERISA) in
1974, corporate pension funds were prohibited from
holding certain risky investments including many investments in privately held companies. In 1978, the US Labor
Department relaxed certain of the ERISA restrictions,
under the "prudent man rule,[16] thus allowing corporate
pension funds to invest in the asset class and providing a
major source of capital available to venture capitalists.

38.1.4 Venture capital boom and the Internet Bubble

By the end of the 1980s, venture capital returns were relatively low, particularly in comparison with their emerging
leveraged buyout cousins, due in part to the competition
for hot startups, excess supply of IPOs and the inexperience of many venture capital fund managers. Growth
in the venture capital industry remained limited throughout the 1980s and the rst half of the 1990s, increasing
from $3 billion in 1983 to just over $4 billion more than
a decade later in 1994.
After a shakeout of venture capital managers, the more
successful rms retrenched, focusing increasingly on improving operations at their portfolio companies rather
than continuously making new investments. Results
would begin to turn very attractive, successful and would
ultimately generate the venture capital boom of the
1990s. Yale School of Management Professor Andrew
Metrick refers to these rst 15 years of the modern venture capital industry beginning in 1980 as the pre-boom
period in anticipation of the boom that would begin in
1995 and last through the bursting of the Internet bubble
in 2000.[20]

The late 1990s were a boom time for venture capital, as

rms on Sand Hill Road in Menlo Park and Silicon Valley beneted from a huge surge of interest in the nascent
Internet and other computer technologies. Initial public
The public successes of the venture capital industry in the oerings of stock for technology and other growth com1970s and early 1980s (e.g., Digital Equipment Corpora- panies were in abundance, and venture rms were reaping
tion, Apple Inc., Genentech) gave rise to a major prolif- large returns.
eration of venture capital investment rms. From just a
few dozen rms at the start of the decade, there were over
650 rms by the end of the 1980s, each searching for the 38.1.5 Private equity crash
next major home run. The number of rms multiplied,
and the capital managed by these rms increased from $3
billion to $31 billion over the course of the decade.[17]

38.1.3

1980s

The growth of the industry was hampered by sharply declining returns, and certain venture rms began posting
losses for the rst time. In addition to the increased
competition among rms, several other factors aected
returns. The market for initial public oerings cooled
in the mid-1980s before collapsing after the stock market crash in 1987, and foreign corporations, particularly
from Japan and Korea, ooded early-stage companies
with capital.[17]
In response to the changing conditions, corporations that
had sponsored in-house venture investment arms, including General Electric and Paine Webber either sold o or
closed these venture capital units. Additionally, venture
capital units within Chemical Bank and Continental Illinois National Bank, among others, began shifting their
focus from funding early stage companies toward investments in more mature companies. Even industry
founders J.H. Whitney & Company and Warburg Pincus
began to transition toward leveraged buyouts and growth
capital investments.[17][18][19]

The technology-heavy NASDAQ Composite index peaked at

5,048 in March 2000 reecting the high point of the dot-com
bubble.

The Nasdaq crash and technology slump that started in

March 2000 shook virtually the entire venture capital industry as valuations for startup technology companies collapsed. Over the next two years, many venture rms

38.2. FUNDING
had been forced to write-o large proportions of their
investments, and many funds were signicantly "under
water" (the values of the funds investments were below
the amount of capital invested). Venture capital investors
sought to reduce size of commitments they had made
to venture capital funds, and, in numerous instances, investors sought to unload existing commitments for cents
on the dollar in the secondary market. By mid-2003, the
venture capital industry had shriveled to about half its
2001 capacity. Nevertheless, PricewaterhouseCoopers
MoneyTree Survey[21] shows that total venture capital investments held steady at 2003 levels through the second
quarter of 2005.
Although the post-boom years represent just a small fraction of the peak levels of venture investment reached
in 2000, they still represent an increase over the levels
of investment from 1980 through 1995. As a percentage of GDP, venture investment was 0.058% in 1994,
peaked at 1.087% (nearly 19 times the 1994 level) in
2000 and ranged from 0.164% to 0.182% in 2003 and
2004. The revival of an Internet-driven environment in
2004 through 2007 helped to revive the venture capital
environment. However, as a percentage of the overall private equity market, venture capital has still not reached its
mid-1990s level, let alone its peak in 2000.

207
carry out detailed due diligence prior to investment. Venture capitalists also are expected to nurture the companies
in which they invest, in order to increase the likelihood
of reaching an IPO stage when valuations are favourable.
Venture capitalists typically assist at four stages in the
companys development:[23]
Idea generation;
Start-up;
Ramp up; and
Exit

Because there are no public exchanges listing their securities, private companies meet venture capital rms and
other private equity investors in several ways, including
warm referrals from the investors trusted sources and
other business contacts; investor conferences and symposia; and summits where companies pitch directly to investor groups in face-to-face meetings, including a variant known as Speed Venturing, which is akin to speeddating for capital, where the investor decides within 10
minutes whether he wants a follow-up meeting. In addition, some new private online networks are emerging to
Venture capital funds, which were responsible for much provide additional opportunities for meeting investors.[24]
of the fundraising volume in 2000 (the height of the This need for high returns makes venture funding an exdot-com bubble), raised only $25.1 billion in 2006, a pensive capital source for companies, and most suitable
2% decline from 2005 and a signicant decline from its for businesses having large up-front capital requirements,
peak.[22]
which cannot be nanced by cheaper alternatives such

38.2 Funding
Obtaining venture capital is substantially dierent from
raising debt or a loan. Lenders have a legal right to interest on a loan and repayment of the capital irrespective
of the success or failure of a business. Venture capital
is invested in exchange for an equity stake in the business. The return of the venture capitalist as a shareholder
depends on the growth and protability of the business.
This return is generally earned when the venture capitalist exits by selling its shareholdings when the business
is sold to another owner.

as debt. That is most commonly the case for intangible assets such as software, and other intellectual property, whose value is unproven. In turn, this explains
why venture capital is most prevalent in the fast-growing
technology and life sciences or biotechnology elds.
If a company does have the qualities venture capitalists
seek including a solid business plan, a good management
team, investment and passion from the founders, a good
potential to exit the investment before the end of their
funding cycle, and target minimum returns in excess of
40% per year, it will nd it easier to raise venture capital.

38.2.1 Financing stages

Venture capitalists are typically very selective in deciding There are typically six stages of venture round nancwhat to invest in; as a result, rms are looking for the ex- ing oered in Venture Capital, that roughly correspond
tremely rare yet sought-after qualities such as innovative to these stages of a companys development.[25]
technology, potential for rapid growth, a well-developed
business model, and an impressive management team. Of
Seed funding: The earliest round of nancing
these qualities, funds are most interested in ventures with
needed to prove a new idea, often provided by angel
exceptionally high growth potential, as only such opporinvestors. Equity crowdfunding is also emerging as
tunities are likely capable of providing nancial returns
an option for seed funding.
and a successful exit within the required time frame (typically 37 years) that venture capitalists expect.
Start-up: Early stage rms that need funding for expenses associated with marketing and product deBecause investments are illiquid and require the extended
time frame to harvest, venture capitalists are expected to
velopment

208

CHAPTER 38. VENTURE CAPITAL

Growth (Series A round): Early sales and manufacturing funds

Second-Round: Working capital for early stage
companies that are selling product, but not yet turning a prot
Expansion: Also called Mezzanine nancing, this is
expansion money for a newly protable company
Exit of venture capitalist: Also called bridge nancing, 4th round is intended to nance the going public process

Diagram of the structure of a generic venture capital fund

Between the rst round and the fourth round, venturebacked companies may also seek to take venture debt.[26] the managers of the rm and will serve as investment
advisors to the venture capital funds raised. Venture
capital rms in the United States may also be structured
as limited liability companies, in which case the rms
38.3 Firms and funds
managers are known as managing members. Investors in
venture capital funds are known as limited partners. This
38.3.1 Venture capitalists
constituency comprises both high-net-worth individuals
and institutions with large amounts of available capital,
A venture capitalist is a person who makes venture in- such as state and private pension funds, university
vestments, and these venture capitalists are expected to nancial endowments, foundations, insurance compabring managerial and technical expertise as well as capi- nies, and pooled investment vehicles, called funds of
tal to their investments. A venture capital fund refers to a funds.
pooled investment vehicle (in the United States, often an
LP or LLC) that primarily invests the nancial capital of
third-party investors in enterprises that are too risky for 38.3.3 Types
the standard capital markets or bank loans. These funds
are typically managed by a venture capital rm, which Venture Capitalist rms dier in their approaches. There
often employs individuals with technology backgrounds are multiple factors, and each rm is dierent.
(scientists, researchers), business training and/or deep inSome of the factors that inuence VC decisions include:
dustry experience.
A core skill within VC is the ability to identify novel or
Business situation: Some VCs tend to invest in new,
disruptive technologies that have the potential to generate
disruptive ideas, or edgling companies. Others prehigh commercial returns at an early stage. By denition,
fer investing in established companies that need supVCs also take a role in managing entrepreneurial compaport to go public or grow.
nies at an early stage, thus adding skills as well as capital,
Some invest solely in certain industries.
thereby dierentiating VC from buy-out private equity,
which typically invest in companies with proven revenue,
Some prefer operating locally while others will opand thereby potentially realizing much higher rates of reerate nationwide or even globally.
turns. Inherent in realizing abnormally high rates of returns is the risk of losing all of ones investment in a given
VC expectations can often vary. Some may want
startup company. As a consequence, most venture capia quicker public sale of the company or expect fast
tal investments are done in a pool format, where several
growth. The amount of help a VC provides can vary
investors combine their investments into one large fund
from one rm to the next.
that invests in many dierent startup companies. By investing in the pool format, the investors are spreading out
their risk to many dierent investments instead of taking 38.3.4 Roles
the chance of putting all of their money in one start up
Within the venture capital industry, the general partners
rm.
and other investment professionals of the venture capital rm are often referred to as venture capitalists or
VCs. Typical career backgrounds vary, but, broadly
38.3.2 Structure
speaking, venture capitalists come from either an operaVenture capital rms are typically structured as tional or a nance background. Venture capitalists with
partnerships, the general partners of which serve as an operational background (operating partner) tend to be

38.3. FIRMS AND FUNDS

209

former founders or executives of companies similar to

those which the partnership nances or will have served
as management consultants. Venture capitalists with nance backgrounds tend to have investment banking or
other corporate nance experience.

eral overlapping funds at the same time; doing so lets the

larger rm keep specialists in all stages of the development of rms almost constantly engaged. Smaller rms
tend to thrive or fail with their initial industry contacts;
by the time the fund cashes out, an entirely new generaAlthough the titles are not entirely uniform from rm to tion of technologies and people is ascending, whom the
general partners may not know well, and so it is prudent
rm, other positions at venture capital rms include:
to reassess and shift industries or personnel rather than
attempt to simply invest more in the industry or people
the partners already know.

38.3.5

Structure of the funds

Most venture capital funds have a xed life of 10 years,

with the possibility of a few years of extensions to allow
for private companies still seeking liquidity. The investing cycle for most funds is generally three to ve years,
after which the focus is managing and making follow-on
investments in an existing portfolio. This model was pioneered by successful funds in Silicon Valley through the
1980s to invest in technological trends broadly but only
during their period of ascendance, and to cut exposure to
management and marketing risks of any individual rm
or its product.
In such a fund, the investors have a xed commitment
to the fund that is initially unfunded and subsequently
called down by the venture capital fund over time as the
fund makes its investments. There are substantial penalties for a limited partner (or investor) that fails to participate in a capital call.
It can take anywhere from a month or so to several years
for venture capitalists to raise money from limited partners for their fund. At the time when all of the money has
been raised, the fund is said to be closed, and the 10-year
lifetime begins. Some funds have partial closes when one
half (or some other amount) of the fund has been raised.
The vintage year generally refers to the year in which the
fund was closed and may serve as a means to stratify VC
funds for comparison. This[27] shows the dierence between a venture capital fund management company and
the venture capital funds managed by them.
From investors point of view, funds can be: (1)
traditionalwhere all the investors invest with equal
terms; or (2) asymmetricwhere dierent investors have
dierent terms. Typically the asymmetry is seen in cases
where theres an investor that has other interests such as
tax income in case of public investors.[28]

38.3.6

Compensation

Main article: Carried interest

Venture capitalists are compensated through a combination of management fees and carried interest (often referred to as a two and 20 arrangement):
Because a fund may run out of capital prior to the end
of its life, larger venture capital rms usually have sev-

38.3.7 Alternatives
Because of the strict requirements venture capitalists have
for potential investments, many entrepreneurs seek seed
funding from angel investors, who may be more willing
to invest in highly speculative opportunities, or may have
a prior relationship with the entrepreneur.
Furthermore, many venture capital rms will only seriously evaluate an investment in a start-up company otherwise unknown to them if the company can prove at least
some of its claims about the technology and/or market
potential for its product or services. To achieve this, or
even just to avoid the dilutive eects of receiving funding before such claims are proven, many start-ups seek to
self-nance sweat equity until they reach a point where
they can credibly approach outside capital providers such
as venture capitalists or angel investors. This practice is
called "bootstrapping".
There has been some debate since the dot com boom
that a funding gap has developed between the friends
and family investments typically in the $0 to $250,000
range and the amounts that most VC funds prefer to invest between $1 million to $2 million. This funding gap
may be accentuated by the fact that some successful VC
funds have been drawn to raise ever-larger funds, requiring them to search for correspondingly larger investment
opportunities. This gap is often lled by sweat equity and
seed funding via angel investors as well as equity investment companies who specialize in investments in startup
companies from the range of $250,000 to $1 million. The
National Venture Capital Association estimates that the
latter now invest more than $30 billion a year in the USA,
in contrast to the $20 billion a year invested by organized
venture capital funds.
Equity crowdfunding is emerging as an alternative to traditional venture capital. Traditional crowdfunding is an
approach to raising the capital required for a new project
or enterprise by appealing to large numbers of ordinary
people for small donations. While such an approach has
long precedents in the sphere of charity, it is receiving renewed attention from entrepreneurs, now that social media and online communities make it possible to reach
out to a group of potentially interested supporters at very
low cost. Some equity crowdfunding models are also being applied specically for startup funding, such as those

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CHAPTER 38. VENTURE CAPITAL

listed at Comparison of crowd funding services. One of

the reasons to look for alternatives to venture capital is
the problem of the traditional VC model. The traditional
VCs are shifting their focus to later-stage investments,
and return on investment of many VC funds have been
low or negative.[24][30]

2550 deals in 2008), compared to international fund investments ($13.4 billion invested elsewhere), there has
been an average 5% growth in the venture capital deals
outside the USA, mainly in China and Europe.[34] Geographical dierences can be signicant. For instance, in
the UK, 4% of British investment goes to venture capital,
[35]
In Europe and India, Media for equity is a partial alterna- compared to about 33% in the U.S.
tive to venture capital funding. Media for equity investors
are able to supply start-ups with often signicant advertising campaigns in return for equity. In Europe, an in- 38.4.1 United States
vestment advisory rm oers young ventures the option
to exchange equity for services investment; they're aim is Venture capitalists invested some $29.1 billion in 3,752
to guide ventures through the development stage to arrive deals in the U.S. through the fourth quarter of 2011, acat a signicant funding, mergers and acquisition, or other cording to a report by the National Venture Capital Association. The same numbers for all of 2010 were $23.4
exit strategy. [31]
billion in 3,496 deals.[36] A National Venture Capital AsIn industries where assets can be securitized eectively sociation survey found that a majority (69%) of venture
because they reliably generate future revenue streams or capitalists predicted that venture investments in the U.S.
have a good potential for resale in case of foreclosure, would have leveled between $2029 billion in 2007.
businesses may more cheaply be able to raise debt to nance their growth. Good examples would include asset- According to a report by Dow Jones VentureSource, venintensive extractive industries such as mining, or man- ture capital funding fell to $6.4 billion in the USA in the
ufacturing industries. Oshore funding is provided via rst quarter of 2013, an 11.8% drop from the rst quarter
specialist venture capital trusts, which seek to utilise secu- of 2012, and a 20.8% decline from 2011. Venture rms
ritization in structuring hybrid multi-market transactions have added $4.2 billion into their funds this year, down
but up from
via an SPV (special purpose vehicle): a corporate entity from $6.3 billion in the rst quarter of 2013,
[37]
$2.6
billion
in
the
fourth
quarter
of
2012.
that is designed solely for the purpose of the nancing.
In addition to traditional venture capital and angel networks, groups have emerged, which allow groups of small 38.4.2 Mexico
investors or entrepreneurs themselves to compete in a privatized business plan competition where the group itself The Venture Capital industry in Mexico is a fast-growing
serves as the investor through a democratic process.[32]
sector in the country that, with the support of institutions
Law rms are also increasingly acting as an intermedi- and private funds, is estimated to reach US$100 billion
ary between clients seeking venture capital and the rms invested by 2018.[38]
providing it.[33]
Other forms include Venture Resources, that seek to provide non-monitary support to launch a new venture.

38.4 Geographical dierences

Venture capital, as an industry, originated in the United
States, and American rms have traditionally been the
largest participants in venture deals with the bulk of
venture capital being deployed in American companies.
However, increasingly, non-US venture investment is
growing, and the number and size of non-US venture capitalists have been expanding.
Venture capital has been used as a tool for economic de- Technology in Israel
velopment in a variety of developing regions. In many of
these regions, with less developed nancial sectors, venture capital plays a role in facilitating access to nance 38.4.3 Israel
for small and medium enterprises (SMEs), which in most
cases would not qualify for receiving bank loans.
In Israel, high-tech entrepreneurship and venture capital
In the year of 2008, while VC funding were still majorly have ourished well beyond the countrys relative size.
dominated by U.S. money ($28.8 billion invested in over As it has very little natural resources and, historically has

38.4. GEOGRAPHICAL DIFFERENCES

been forced to build its economy on knowledge-based industries, its VC industry has rapidly developed, and nowadays has about 70 active venture capital funds, of which
14 international VCs with Israeli oces, and additional
220 international funds which actively invest in Israel. In
addition, as of 2010, Israel led the world in venture capital invested per capita. Israel attracted $170 per person
compared to $75 in the USA.[39] About two thirds of the
funds invested were from foreign sources, and the rest domestic. In 2013, Wix.com joined 62 other Israeli rms
on the Nasdaq.[40] Read more about Venture capital in
Israel.

38.4.4

Canada

Canadian technology companies have attracted interest

from the global venture capital community partially as
a result of generous tax incentive through the Scientic
Research and Experimental Development (SR&ED) investment tax credit program. The basic incentive available to any Canadian corporation performing R&D is
a refundable tax credit that is equal to 20% of qualifying R&D expenditures (labour, material, R&D contracts, and R&D equipment). An enhanced 35% refundable tax credit of available to certain (i.e. small)
Canadian-controlled private corporations (CCPCs). Because the CCPC rules require a minimum of 50% Canadian ownership in the company performing R&D, foreign
investors who would like to benet from the larger 35%
tax credit must accept minority position in the company,
which might not be desirable. The SR&ED program does
not restrict the export of any technology or intellectual
property that may have been developed with the benet
of SR&ED tax incentives.

211

38.4.6 Europe
Europe has a large and growing number of active venture
rms. Capital raised in the region in 2005, including buyout funds, exceeded 60 billion, of which 12.6 billion
was specically allocated to venture investment. The European Venture Capital Association[43] includes a list of
active rms and other statistics. In 2006, the top three
countries receiving the most venture capital investments
were the United Kingdom (515 minority stakes sold for
1.78 billion), France (195 deals worth 875 million),
and Germany (207 deals worth 428 million) according
to data gathered by Library House.[44]
European venture capital investment in the second quarter of 2007 rose 5% to 1.14 billion from the rst
quarter. However, due to bigger sized deals in early
stage investments, the number of deals was down 20%
to 213. The second quarter venture capital investment
results were signicant in terms of early-round investment, where as much as 600 million (about 42.8% of
the total capital) were invested in 126 early round deals
(which comprised more than half of the total number of
deals).[45]
In 2007, private equity in Italy was 4.2B. Notable VC
rms in Italy include the milan based rm United Ventures and dPixel.
In 2012, in France, according to a study [46] by AFIC (the
French Association of VC rms), 6.1B have been invested through 1,548 deals (39% in new companies, 61%
in new rounds).

A study published in early 2013 showed that contrary to

popular belief, European startups backed by venture capital do not perform worse than US counterparts.[47] European venture-backed rms have an equal chance of listCanada also has a fairly unique form of venture capital ing on the stock exchange, and a slightly lower chance of
generation in its Labour Sponsored Venture Capital Cor- a trade sale (acquisition by other company).
porations (LSVCC). These funds, also known as Retail
Venture Capital or Labour Sponsored Investment Funds In contrast to the US, European media companies and
(LSIF), are generally sponsored by labor unions and of- also funds have been pursuing a media for equity business
fer tax breaks from government to encourage retail in- model as a form of venture capital investment.
vestors to purchase the funds. Generally, these Retail Leading early-stage venture capital investors in Europe
Venture Capital funds only invest in companies where the include Mark Tluszcz of Mangrove Capital Partners and
majority of employees are in Canada. However, innova- Danny Rimer of Index Ventures, both of which were
tive structures have been developed to permit LSVCCs to named on Forbes Magazines Midas List of the worlds
direct in Canadian subsidiaries of corporations incorpo- top dealmakers in technology venture capital in 2007.[48]
rated in jurisdictions outside of Canada.

38.4.5

Switzerland

Many Swiss start-ups are university spin-os, in particular from its federal institutes of technology in Lausanne
and Zurich.[41] According to a study by the London
School of Economics analysing 130 ETH Zurich spin-os
over 10 years, about 90% of these start-ups survived the
rst ve critical years, resulting in an average annual IRR
of more than 43%.[42]

38.4.7 Asia
India is fast catching up with the West in the eld of
venture capital and a number of venture capital funds
have a presence in the country (IVCA). In 2006, the total amount of private equity and venture capital in India reached $7.5 billion across 299 deals.[49] In the Indian context, venture capital consists of investing in equity, quasi-equity, or conditional loans in order to promote unlisted, high-risk, or high-tech rms driven by

212

CHAPTER 38. VENTURE CAPITAL

technically or professionally qualied entrepreneurs. It

is also dened as providing seed, start-up and rststage nancing.[50] It is also seen as nancing companies that have demonstrated extraordinary business potential. Venture capital refers to capital investment; equity and debt ;both of which carry indubitable risk. The
risk anticipated is very high. The venture capital industry follows the concept of high risk, high return, innovative entrepreneurship, knowledge-based ideas and human capital intensive enterprises have taken the front seat
as venture capitalists invest in risky nance to encourage
innovation.[51]

38.5 Condential information

Unlike public companies, information regarding an entrepreneurs business is typically condential and proprietary. As part of the due diligence process, most venture
capitalists will require signicant detail with respect to
a companys business plan. Entrepreneurs must remain
vigilant about sharing information with venture capitalists that are investors in their competitors. Most venture
capitalists treat information condentially, but as a matter
of business practice, they do not typically enter into Non
Disclosure Agreements because of the potential liability
China is also starting to develop a venture capital industry issues those agreements entail. Entrepreneurs are typically well advised to protect truly proprietary intellectual
(CVCA).
property.
Vietnam is experiencing its rst foreign venture capitals,
including IDG Venture Vietnam ($100 million) and DFJ Limited partners of venture capital rms typically have
access only to limited amounts of information with reVinacapital ($35 million)[52]
spect to the individual portfolio companies in which they
are invested and are typically bound by condentiality
provisions in the funds limited partnership agreement.

38.4.8

Middle East and North Africa

The Middle East and North Africa (MENA) venture capital industry is an early stage of development but growing. The MENA Private Equity Association Guide to
Venture Capital for entrepreneurs lists VC rms in the
region, and other resources available in the MENA VC
ecosystem. Diaspora organization TechWadi aims to give
MENA companies access to VC investors based in the
US.

38.4.9

Southern Africa

38.6 Governmental Regulations

There are several strict guidelines regulating those that
deal in venture capital. Namely, they are not allowed to
advertise or solicit business in any form as per the U.S.
Securities and Exchange Commission guidelines.[53]

38.7 In popular culture

The Southern African venture capital industry is devel- 38.7.1 In books

oping.
Mark Coggins' novel Vulture Capital (2002) feaSouth Africa, with the help of the South African Governtures a venture capitalist protagonist who investiment and Revenue Service, has realized the necessity to
gates the disappearance of the chief scientist in a
follow the international trend of using tax ecient vehibiotech rm in which he has invested. Coggins also
cles to propel economic growth and job creation through
worked in the industry and was co-founder of a dotventure capital. Section 12 J of the Income Tax Act was
com startup.[54]
updated to include Venture Capital Companies allowing
a tax ecient structure similar to VCTs in the UK. Sec Drawing on his experience as reporter covering
tion 12 J provides investors the opportunity to invest in
technology for the New York Times, Matt Richtel
Venture Capital through a tax ecient structure.
produced the novel Hooked (2007), in which the actions of the main characters deceased girlfriend, a
Despite the above structure Government needs to adjust
Silicon Valley venture capitalist, play a key role in
regulation around intellectual property, exchange control
the plot.[55]
and other legislation to ensure that Venture Capital succeeds in South Africa.
Currently, there are not many Venture Capital Funds in 38.7.2 In comics
operation and it is a small community however funds are
available. Funds are dicult to come by and very few
In the Dilbert comic strip, a character named Vijay,
rms have managed to get funding despite demonstrating
the Worlds Most Desperate Venture Capitalist fretremendous growth potential.
quently makes appearances, oering bags of cash to
anyone with even a hint of potential. In one strip,
The majority of the venture capital in Southern Africa is
he oers two small children with good math grades
centered around South Africa and Kenya.

38.9. REFERENCES
money based on the fact that if they marry and produce an engineer baby he can invest in the infants
rst idea. The children respond that they are already
looking for mezzanine funding.
Robert von Goeben and Kathryn Siegler produced a
comic strip called The VC between the years 1997
and 2000 that parodied the industry, often by showing humorous exchanges between venture capitalists
and entrepreneurs.[56] Von Goeben was a partner in
Redleaf Venture Management when he began writing the strip.[57]

213
IPO
M&A
National Venture Capital Association
Private equity
Private equity secondary market
Revenue-based nancing
Seed funding
Sweat equity

38.7.3

In lm

In Wedding Crashers (2005), Jeremy Grey (Vince

Vaughn) and John Beckwith (Owen Wilson) are
bachelors who create appearances to play at dierent weddings of complete strangers, and a large part
of the movie follows them posing as venture capitalists from New Hampshire.
The documentary, Something Ventured (2011),
chronicled the recent history of American technology venture capitalists.

38.7.4

In television

In the TV series Dragons Den, various startup companies pitch their business plans to a panel of venture
capitalists.
In the ABC reality television show Shark Tank, venture capitalists (Sharks) invest in entrepreneurs.
The short lived Bravo reality show Start-Ups: Silicon
Valley had participation from venture capitalists in
Silicon Valley
The sitcom Silicon Valley (TV series) parodies
startup companies and venture capital culture.

Social Venture Capital

Vulture capitalist

38.9 References
[1] Private Company Knowledge Bank.
[2] Venture Impact: The Economic Importance of VentureBacked Companies to the U.S. Economy. National Venture Capital Association. Retrieved 2012-05-18.
[3] Venture Impact (5 ed.). IHS Global Insight. 2009. p. 2.
ISBN 0-9785015-7-8.
[4] Article: The New Argonauts, Global Search And Local
Institution Building. Author : Saxeninan and Sabel
[5] Wilson, John. The New Ventures, Inside the High Stakes
World of Venture Capital.
[6] Ante, Spencer E. (2008). Creative Capital: Georges Doriot and the Birth of Venture Capital. Cambridge, MA:
Harvard Business School Press. ISBN 1-4221-0122-3.
[7] They Made America - Georges Doriot
[8] The New Kings of Capitalism, Survey on the Private Equity industry The Economist, November 25, 2004
[9] Joseph W. Bartlett, What Is Venture Capital?"". Vcexperts.com. Retrieved 2012-05-18.

38.8 See also

Venture capital nancing
Corporate Venture Capital

[10] Kirsner, Scott. Venture capitals grandfather. The

Boston Globe, April 6, 2008.
[11]

Small Business Administration Investment Division

(SBIC)

History of private equity and venture capital

[12] Web site history

List of venture capital rms

[13] The Future of Securities Regulation speech by Brian

G. Cartwright, General Counsel U.S. Securities and Exchange Commission. University of Pennsylvania Law
School Institute for Law and Economics Philadelphia,
Pennsylvania. October 24, 2007.

Adventure capital
Angel investor
Equity Crowdfunding
Enterprise Capital Fund a type of Venture Capital
fund in the UK

[14] In 1971, a series of articles entitled Silicon Valley USA

were published in the Electronic News, a weekly trade
publication, giving rise to the use of the term Silicon Valley.

214

CHAPTER 38. VENTURE CAPITAL

[15] Ocial website of the National Venture Capital Association, the largest trade association for the venture capital
industry.
[16] The prudent man rule is a duciary responsibility of investment managers under ERISA. Under the original application, each investment was expected to adhere to risk
standards on its own merits, limiting the ability of investment managers to make any investments deemed potentially risky. Under the revised 1978 interpretation, the
concept of portfolio diversication of risk, measuring risk
at the aggregate portfolio level rather than the investment
level to satisfy duciary standards would also be accepted.
[17] POLLACK, ANDREW. "Venture Capital Loses Its
Vigor. New York Times, October 8, 1989.
[18] Kurtzman, Joel. " PROSPECTS; Venture Capital. New
York Times, March 27, 1988.
[19] LUECK, THOMAS J. " High Techs Glamour fades for
some venture capitalists. New York Times, February 6,
1987.
[20] Metrick, Andrew. Venture Capital and the Finance of Innovation. John Wiley & Sons, 2007. p.12
[21] MoneyTree Survey. Pwcmoneytree.com. 2006-02-21.
Retrieved 2012-05-18.
[22] Dow Jones Private Equity Analyst as referenced in Taub,
Stephen. Record Year for Private Equity Fundraising.
CFO.com, January 11, 2007.
[23] Investment philosophy of VCs.
[24] Cash-strapped entrepreneurs get creative, BBC News.
[25] Corporate Finance, 8th Edition. Ross, Westereld, Jae.
McGraw-Hill publishing, 2008.]
[26] Bootlaw Essential law for startups and emerging tech
businesses Up, Up and Away. Should You be Thinking
About Venture Debt?". Bootlaw.com. Retrieved 201205-18.
[27] Free database of venture capital funds.
ator.zoho.com. Retrieved 2012-05-18.

[34] International venture funding rose 5 percent in 2008.

VentureBeat. 2009-02-18. Retrieved 2012-05-18.
[35] Mandelson, Peter. There is no Google, or Amazon, or
Microsoft or Apple in the UK, Mandelson tells BVCA.
BriskFox Financial News, March 11, 2009. Briskfox.com. Retrieved 2012-05-18.
[36] Recent Stats & Studies. Nvca.org. 2012-03-31. Retrieved 2012-05-18.
[37] Hamilton, Walter (2013-04-18). Venture-capital funding drops sharply in Southern California. latimes.com.
Retrieved 2013-06-14.
[38] Se aanza en Mxico industria de venture capital | EL
EMPRESARIO (in Spanish). Elempresario.mx. 201208-16. Retrieved 2013-06-14.
[39] What next for the start-up nation?, The Economist, Jan
21st 2012
[40] Israels Wix Reveals IPO Plans, Forbes, Oct 23rd 2013
[41] Wagner, Steen (20 June 2011). Bright sparks! A portrait of entrepreneurial Switzerland (PDF). Swiss Business. Retrieved 24 April 2013.
[42] Oskarsson, Ingvi; Schlpfer, Alexander (September
2008). The performance of Spin-o companies at the
Swiss Federal Institute of Technology Zurich (PDF).
ETH transfer. Retrieved 29 January 2014.
[43] European Venture Capital Association.
2012-03-01. Retrieved 2012-05-18.

Evca.com.

[44] Financial Times Article based on data published by Library House.

[45] European Venture Capital, by Sethi, Arjun Sep 2007, accessed December 30, 2007.
[46] French Study on 2012 Private Equity Investment in French
[47] ^Startup Success in Europe vs. US, Whiteboard, Feb.
2013

Cre[48] Technologys Top Dealmakers, Feb. 2007

[28] Fund - Buttery Ventures. Buttery Ventures. Retrieved 2012-05-18.

[49] Venture Capital & Private Equity in India (October

2007)" (PDF). Retrieved 2012-05-18.

[29] Private equity industry dictionary. CalPERS Alternative

Investment Program

[50] Venture Capital And Private Equity in India.

[30] Monday, February 15th, 2010 (2010-02-15). Grow VC

launches, aiming to become the Kiva for tech startups.
Eu.techcrunch.com. Retrieved 2012-05-18.
[31] http://www.sollertis-strategy.com/index.html
[32] Grow Venture Community. Growvc.com. Retrieved
2012-05-18.
[33] Austin, Scott (2010-09-09). ""Law Firms Oer Discounts, Play Matchmaker, The Wall Street Journal, Sept.
9, 2010. Online.wsj.com. Retrieved 2012-05-18.

[51] Venture Capital:An Impetus to Indian Economy.

[52] Lets Open the 100 Million Dollar Door | IDG Ventures
Vietnam Ocial Website. IDG Venture Vietnam. Retrieved 2012-05-18.
[53] Eliminating the Prohibition Against General Solicitation
and General Advertising in Rule 506 and Rule 144A Offerings. U.S. Securities and Exchange Commission. Retrieved 20 August 2014.
[54] Liedtke, Michael. Salon.com, How Greedy Was My
Valley?"". Dir.salon.com. Retrieved 2012-05-18.

38.9. REFERENCES

[55] Richtel, Matt. National Public Radio, Love, Loss and

Digital-Age Deception in Hooke"". Npr.org. Retrieved
2012-05-18.
[56] The VC Comic Strip. Thevc.com. Retrieved 2012-0518.
[57] Comic Book Pokes Fun at Venture Capitalists. San
Francisco Chronicle. 1999-12-20. Retrieved 2012-05-18.

215

Chapter 39

Credit (nance)
39.1 Types of credit
There are many types of credit, including but not limited
to bank credit, commerce, consumer credit, investment
credit, international credit, public credit and real estate.

39.2 Trade credit

Domestic credit to private sector in 2005

Credit (from Latin credere translation. to believe) is

the trust which allows one party to provide resources to
another party where that second party does not reimburse
the rst party immediately (thereby generating a debt),
but instead arranges either to repay or return those resources (or other materials of equal value) at a later date.
The resources provided may be nancial (e.g. granting a
loan), or they may consist of goods or services (e.g. consumer credit). Credit encompasses any form of deferred
payment.[1] Credit is extended by a creditor, also known
as a lender, to a debtor, also known as a borrower.
Credit does not necessarily require money. The credit
concept can be applied in barter economies as well, based
on the direct exchange of goods and services.[2] However,
in modern societies, credit is usually denominated by a
unit of account. Unlike money, credit itself cannot act as
a unit of account.
Movements of nancial capital are normally dependent
on either credit or equity transfers. Credit is in turn dependent on the reputation or creditworthiness of the entity which takes responsibility for the funds. Credit is also
traded in nancial markets. The purest form is the credit
default swap market, which is essentially a traded market in credit insurance. A credit default swap represents
the price at which two parties exchange this risk the
protection seller takes the risk of default of the credit in
return for a payment, commonly denoted in basis points
(one basis point is 1/100 of a percent) of the notional
amount to be referenced, while the protection buyer pays
this premium and in the case of default of the underlying
(a loan, bond or other receivable), delivers this receivable
to the protection seller and receives from the seller the par
amount (that is, is made whole).

The word credit is used in commercial trade in the term

"trade credit" to refer to the approval for delayed payments for purchased goods. Credit is sometimes not
granted to a person who has nancial instability or difculty. Companies frequently oer credit to their customers as part of the terms of a purchase agreement. Organizations that oer credit to their customers frequently
employ a credit manager.

39.3 Consumer credit

Consumer debt can be dened as money, goods or services provided to an individual in lieu of payment. Common forms of consumer credit include credit cards, store
cards, motor (auto) nance, personal loans (installment
loans), consumer lines of credit, retail loans (retail installment loans) and mortgages. This is a broad denition of
consumer credit and corresponds with the Bank of Englands denition of Lending to individuals. Given the
size and nature of the mortgage market, many observers
classify mortgage lending as a separate category of personal borrowing, and consequently residential mortgages
are excluded from some denitions of consumer credit such as the one adopted by the Federal Reserve in the US.
The cost of credit is the additional amount, over and
above the amount borrowed, that the borrower has to
pay. It includes interest, arrangement fees and any other
charges. Some costs are mandatory, required by the
lender as an integral part of the credit agreement. Other
costs, such as those for credit insurance, may be optional.
The borrower chooses whether or not they are included
as part of the agreement.
Interest and other charges are presented in a variety

216

39.6. REFERENCES
of dierent ways, but under many legislative regimes
lenders are required to quote all mandatory charges in
the form of an annual percentage rate (APR). The goal
of the APR calculation is to promote truth in lending,
to give potential borrowers a clear measure of the true
cost of borrowing and to allow a comparison to be made
between competing products. The APR is derived from
the pattern of advances and repayments made during the
agreement. Optional charges are not included in the APR
calculation. So if there is a tick box on an application
form asking if the consumer would like to take out payment insurance, then insurance costs will not be included
in the APR calculation.[3]

217
Financial literacy
Installment credit
Line of credit
Payday loan
Person-to-person lending
Predatory lending
Revolving credit
Risk-return spectrum
Settlement (nance)

39.4 The Six Cs of Credit

Lenders, especially bankers, use a formula known as the
six Cs of credit when evaluating a credit application. Understanding them will help you make your applications as
attractive as possible.

Sub prime lending

Social Credit

39.6 References

Character. This is essentially a summary of the individual. Creditors look for people who appear to be trustworthy and reliable, and who are willing and able to meet
their nancial obligations.

[1] Sullivan, Arthur; Steven M. Sherin (2003). Economics:

Principles in action. Upper Saddle River, New Jersey
07458: Pearson Prentice Hall. p. 512. ISBN 0-13063085-3.

Capacity. This is the individuals ability to repay the loan;

it is based on present and anticipated earnings balanced
against existing debts.

[2] Ingham, G. (2004). The Nature of Money. Polity Press.

pp. 1219.

Collateral. The item pledged by the borrower as security

for the loan, which may be real estate, stocks, savings, a
mortgage, etc.
Conditions. Both regulatory and economic conditions are
considered. Regulatory conditions apply to the lenders
individual circumstances; for example, when banks are
not lending in specic areas. Economic conditions determine the lenders general policy towards loan. Both are
aected by the current economic cycle.
Credit. This is the individuals credit history.
Capital. This is the net worth on an individual as indicated
by a personal nancial statement.[4]

39.5 See also

Commercial credit reporting
Credit bureau
Credit history
Credit risk
Credit score
Debt
Default (nance)

[3] Finlay, S. (2009). Consumer Credit Fundamentals (2nd

ed.). Palgrave Macmillan.
[4] Whitney, Russ (2006) [1994]. Building Wealth (Completely Revised and Updated): Achieving Personal and Financial Success in Real State and Business Without Money,
Credit, or Luck. pp. 215216.

Logemann, Jan, ed., The Development of Consumer Credit in Global Perspective: Business, Regulation, and Culture (New York: Palgrave Macmillan,
2012), ISBN 978-0-230-34105-0.

39.7 External links

Quotations related to Credit at Wikiquote

Chapter 40

Consumer debt
For information about loans to consumers, see Consumer what exactly constitutes predatory lending.
lending.
Long-term consumer debt is often considered scally
suboptimal. While some consumer items may be useful
In economics, consumer debt is outstanding debt of con- investments that justify debt (such as automobiles, which
sumers, as opposed to that of businesses or governments. are usually but not always exempted in discussions of conIn macroeconomic terms, it is debt which is used to fund sumer debt), most consumer goods are not. For example,
consumption rather than investment. It includes debts in- incurring high-interest consumer debt through buying a
curred on purchase of goods that are consumable and/or big-screen television now, rather than saving for it, can
do not appreciate.[1]
not usually be nancially justied by the subjective benIn recent years, an alternative analysis might view con- ets of having the television early. On the other hand,
sumer debt as a way to increase domestic production, on personal nance advisers like Robert Kiyosaki encourage
the grounds that if credit is easily available, the increased a more liberal attitude towards taking on debt if it can be
demand for consumer goods should cause an increase of leveraged into a small business or real estate.
overall domestic production. The permanent income hypothesis suggests that consumers take debt to smooth consumption throughout their lives, borrowing to nance expenditures (particularly housing and schooling) earlier in
their lives and paying down debt during higher-earning
periods.
Both domestic and international economists have supported a recent upsurge in South Korean consumer debt,
which has helped fuel economic expansion. On the other
hand, credit card debt is almost unknown just across the
sea in Japan and China, because of long-standing cultural taboos against personal debt. Theoretical underpinnings aside, personal debt is on the rise, particularly
in the United States and the United Kingdom. However,
according to the US Federal Reserve, the US household
debt service ratio is at the lowest level since its peak in
the Fall of 2007.[2]
The most common forms of consumer debt are credit
card debt, payday loans, and other consumer nance,
which are often at higher interest rates than long-term
secured loans, such as mortgages. The amount of debt
outstanding versus the consumers disposable income is
expressed as the consumer leverage ratio. The interest
rate charged depends on a range of factors, including the
economic climate, perceived ability of the customer to repay, competitive pressures from other lenders, and the inherent structure and security of the credit product. Rates
generally range from 0.25 percent above base-rate, to well
into double gures. Consumer debt is also associated with
Predatory lending, although there is much debate as to

In many countries, the ease with which individuals can

accumulate consumer debt beyond their means to repay
has precipitated a growth industry in debt consolidation
and credit counseling.

40.1 See also

Consumerism
Consumer Leverage Ratio
Predatory lending
Consumer credit risk

40.2 References
[1] Consumer Debt Denition. Investopedia. Retrieved
August 24, 2011.
[2] US Federal Reserve. Household Debt Service and Financial Obligations Ratios. Household Debt Service and Financial Obligations Ratios. Retrieved December 4, 2012.

40.3 External links

218

U.S. consumer credit outstanding

In depth reports on debt and borrowing in the United
Kingdom

40.3. EXTERNAL LINKS

CBC Digital Archives Personal Debt in Canada

219

Chapter 41

Employment contract
A contract of employment is a category of contract used
in labour law to attribute right and responsibilities between parties to a bargain. The contract is between an
employee and an employer. It has arisen out of the
old master-servant law, used before the 20th century. But
generally, the contract of employment denotes a relationship of economic dependence and social subordination.
In the words of the controversial labour lawyer Sir Otto
Kahn-Freund,
the relation between an employer and an
isolated employee or worker is typically a relation between a bearer of power and one who
is not a bearer of power. In its inception it
is an act of submission, in its operation it is a
condition of subordination, however much the
submission and the subordination may be concealed by the indispensable gment of the legal
mind known as the 'contract of employment'.
The main object of labour law has been, and...
will always be a countervailing force to counteract the inequality of bargaining power which
is inherent and must be inherent in the employment relationship.[1]

locatio conductio operis (contract for services).[4][5]

The terminology is complicated by the use of many other
sorts of contracts involving one person doing work for
another. Instead of being considered an employee, the
individual could be considered a "worker" (which could
mean less employment legislation protection) or as having
an employment relationship (which could mean protection somewhere in between) or a professional or a
dependent entrepreneur, and so on. Dierent countries
will take more or less sophisticated, or complicated approaches to the question.

41.2 Criticism
Main articles: Labour economics and Contemporary slavery

41.1 Terminology
A contract of employment usually dened to mean the
same as a contract of service.[2] A contract of service
has historically been distinguished from a contract for the
supply of services, the expression altered to imply the
dividing line between a person who is employed and
someone who is self-employed. The purpose of the dividing line is to attribute rights to some kinds of people
who work for others. This could be the right to a minimum wage, holiday pay, sick leave, fair dismissal,[3] a
written statement of the contract, the right to organize in
a union, and so on. The assumption is that genuinely selfemployed people should be able to look after their own
aairs, and therefore work they do for others should not
carry with it an obligation to look after these rights.

Anarcho-syndicalists and other socialists who criticise

wage slavery, e.g. David Ellerman and Carole Pateman,
posit that the employment contract is a legal ction in that
it recognises human beings juridically as mere tools or inputs by abdicating responsibility and self-determination,
which the critics argue are inalienable. As Ellerman
points out, "[t]he employee is legally transformed from
being a co-responsible partner to being only an input supplier sharing no legal responsibility for either the input liabilities [costs] or the produced outputs [revenue, prots]
of the employers business.[6] Such contracts are inherently invalid since the person remain[s] a de facto fully
capacitated adult person with only the contractual role
of a non-person as it is impossible to physically transfer self-determination.[7] As Pateman argues:

In Roman law the equivalent dichotomy was that between

locatio conductio operarum (employment contract) and
220

The contractarian argument is unassailable

all the time it is accepted that abilities can 'acquire' an external relation to an individual, and
can be treated as if they were property. To
treat abilities in this manner is also implicitly
to accept that the 'exchange' between employer
and worker is like any other exchange of material property . . . The answer to the question of how property in the person can be contracted out is that no such procedure is possible. Labour power, capacities or services, can-

41.5. REFERENCES
not be separated from the person of the worker
like pieces of property.[8]

41.3 See also

Employment#Employment contract
Collective bargaining
Job description
Labour law
Labor union
Work for hire
First Employment Contract and New Employment
Contract in France
Master and Servant Act
Adair v. United States, 209 U.S. 161, 175 (1908)
the employer and the employee have equality of
right and any legislation that disturbs that equality
is an arbitrary interference with the liberty of contract which no government can legally justify in our
free land.

41.4 Notes
[1] Labour and the Law, Hamlyn Lectures, 1972, 7
[2] in the UK, s.230 Employment Rights Act 1996
[3] Employment Contract FAQs
[4] see, Sir John MacDonell, Classication of Forms and Contracts of Labour (1904) Journal of the Society of Comparative Legislation, New Series, Vol. 5, No. 2, pp. 253-261,
at 255-256
[5] "locatio conductio operarum is a contract whereby one
party agrees to supply the other with a certain quantum
of labour. locatio conductio operis is a contract whereby
one party agrees, in consideration of money payment, to
supply the other not with labour, but with the result of
labour. Sohm, Institutes of Roman Law, 311 (1892)
[6] Ellerman 2005, p. 16.
[7] Ellerman 2005, p. 14.
[8] Ellerman 2005, p. 32.

41.5 References
Mark Freedland, The Personal Employment Contract (2003) Oxford University Press, ISBN 0-19924926-1

221

Chapter 42

Financial planner
A nancial planner or personal nancial planner is
a professional who prepares nancial plans for people.
These nancial plans often cover cash ow management,
retirement planning, investment planning, nancial risk
management, insurance planning, tax planning, estate
planning and business succession planning (for business
owners).

Step 1: Setting goals with the client This step (that is

usually performed in conjunction with Step 2) is meant
to identify where the client wants to go in terms of their
nances and life.
Step 2: Gathering relevant information on the client
This would include the qualitative and quantitative aspects of the clients nancial and relevant non-nancial
situation.

Step 3: Analyzing the information The information

gathered is analysed so that the clients situation is properly understood. This includes determining whether there
Financial planning should cover all areas of the clients are sucient resources to reach the clients goals and what
nancial needs and should result in the achievement of those resources are.
each of the clients goals as required. The scope of planStep 4: Constructing a nancial plan Based on the unning would usually include the following:
derstanding of what the client wants in the future and their
current nancial status, a road map to the client goals is
Risk Management and Insurance Planning
Managing cash ow risks through sound risk drawn to facilitate the achievements of those goals.

42.1 Scope

management and insurance techniques

Step 5: Implementing the strategies in the plan

Guided by the nancial plan, the strategies outlined in
Investment and Planning Issues Planning, creating the plan are implemented using the resources allocated
and managing capital accumulation to generate for the purpose.
future capital and cash ows for reinvestment and
spending, including managing for risk-adjusted Step 6: Monitoring implementation and reviewing
the plan The implementation process is closely monireturns and to deal with ination
tored to ensure it stays in alignment to the clients goals.
Retirement Planning Planning to ensure nancial in- Periodic reviews are undertaken to check for misaligndependence at retirement including 401Ks, IRAs ment and changes in the clients situation. If there is any
etc.
signicant change to the clients situation, the strategies
and goals in the nancial plan are revised accordingly.
Tax Planning Planning for the reduction of tax liabilities and the freeing-up of cash ows for other purposes
Estate Planning Planning for the creation, accumulation, conservation and distribution of assets

42.3 Licensing, regulations and

self-regulation

Cash Flow and Liability Management Maintaining

In many countries, there are no requirements regarding
and enhancing personal cash ows through debt and
use of the title of 'nancial planner'.[2][3]
lifestyle management

42.3.1 Australia

42.2 Process
The personal nancial planning process is according to
ISO 22222:2005 a six-step process[1] as follows:

In Australia, a company providing nancial services must

be obtain a licence from ASIC.[4] However, there are no
requirements for the individuals providing the nancial

222

42.5. REFERENCES
advice and the ASIC website states Holding an AFS licence does not provide a guarantee of the probity or quality of the licensees services.

42.3.2

Malaysia

The Securities Commission Malaysia introduced legislation through amendments made to the Securities Industry
Act in 2003 to regulate nancial planning and the use of
the title or related-title of 'nancial planner' or to conduct
activities related to nancial planning.[5]
In 2005, amendments to the Malaysian Insurance Act require those who carry out nancial advisory business (including nancial planning activities related to insurance)
and/or use the title of nancial adviser under their rm
(which, like in Singapore, must be a corporate structure)
to obtain a license from Bank Negara Malaysia (BNM).[6]
Some persons who oer nancial advisory services, e.g.,
licensed life insurance agents, are exempted from licensing as a practising requirement.

42.4 See also

Registered Investment Advisor
Certied Financial Planner
Family planning
Financial adviser
Financial plan
Financial planning (business)
Life planning
Stockbroker
Brokerage rm

42.5 References
[1] http://www.iso.org/iso/home/store/catalogue_tc/
catalogue_detail.htm?csnumber=43033
[2] http://theconversation.com/
the-unregulated-business-of-property-investment-advice-18792
[3] http://www.professionaladviser.com/ifaonline/feature/
2221263/is-the-future-of-financial-advice-unregulated
[4] http://www.asic.gov.au/asic/ASIC.NSF/byHeadline/
Licensing
[5] Financial Planning Association - Financial Planning History Made in Malaysia
[6] Bank Negara Malaysia - Introduction of Financial Advisers

223

Chapter 43

Retirement
For other uses, see Retirement (disambiguation).

table below shows the variation in eligibility ages for public old-age benets in the United States and many European countries, according to the OECD.

Retirement is the point where a person stops

employment completely.[1][2] A person may also Notes: Parentheses indicate eligibility age for women
semi-retire by reducing work hours.
when dierent. Sources: Cols. 12: OECD Pensions
Many people choose to retire when they are eligible for at a Glance (2005), Cols. 36: Tabulations from HRS,
private or public pension benets, although some are ELSA and SHARE. Square brackets indicate early retireforced to retire when physical conditions no longer allow ment for some public employees.
the person to work any longer (by illness or accident) or as
a result of legislation concerning their position.[3] In most
countries, the idea of retirement is of recent origin, being
introduced during the late 19th and early 20th centuries.
Previously, low life expectancy and the absence of pension arrangements meant that most workers continued to
work until death. Germany was the rst country to introduce retirement, in 1889.[4]
Nowadays most developed countries have systems to provide pensions on retirement in old age, which may be
sponsored by employers and/or the state. In many poorer
countries, support for the old is still mainly provided
through the family. Today, retirement with a pension is
considered a right of the worker in many societies, and
hard ideological, social, cultural and political battles have
been fought over whether this is a right. In many western
countries this right is mentioned in national constitutions.

43.1 Retirement in specic countries

Main article: Retirement age
A person may retire at whatever age they please. However, a countrys tax laws and/or state old-age pension
rules usually mean that in a given country a certain age
is thought of as the standard retirement age.

* In France, the retirement age has been extended to 62

and 67 respectively, over the next eight years.[7]
** In Spain, the retirement age will be extended to 63 and
67 respectively, this increase will be progressively done
from 2013 to 2027 at a rate of 1 month during the rst 6
years and 2 months during the other 9.[8]
In the United States, while the normal retirement age for
Social Security, or Old Age Survivors Insurance (OASI),
historically has been age 65 to receive unreduced benets, it is gradually increasing to age 67. For those turning 65 in 2008, full benets will be payable beginning at
age 66.[9] Public servants are often not covered by Social
Security but have their own pension programs. Police ofcers in the United States are typically allowed to retire
at half pay after only 20 years of service or three-quarter
pay after 30 years, allowing people to retire in their early
forties or fties.[10] Military members of the US Armed
Forces may elect to retire after 20 years of active duty.
Their retirement pay (not a pension since they can be involuntarily called back to active duty at any time) is calculated on total number of years on active duty, their nal
pay grade and the retirement system in place when they
entered service. Allowances such as housing and subsistence are not used to calculate a members retired pay.
Members awarded the Medal of Honor qualify for a separate stipend, regardless of the years of service. Military
members in the reserve and US National Guard have their
retirement based on a point system.

The standard retirement age varies from country to

country but it is generally between 50 and 70 (accord- 43.2 Data sets
ing to latest statistics, 2011). In some countries this age is
dierent for males and females, although this has recently Recent advances in data collection have vastly improved
been challenged in some countries (e.g., Austria), and in our ability to understand important relationships between
some countries the ages are being brought into line.[5] The retirement and factors such as health, wealth, employ224

43.3. FACTORS AFFECTING RETIREMENT DECISIONS

ment characteristics and family dynamics, among others.
The most prominent study for examining retirement behavior in the United States is the ongoing Health and Retirement Study (HRS), rst elded in 1992. The HRS is a
nationally representative longitudinal survey of adults in
the U.S. ages 51+, conducted every two years, and contains a wealth of information on such topics as labor force
participation (e.g., current employment, job history, retirement plans, industry/occupation, pensions, disability),
health (e.g., health status and history, health and life insurance, cognition), nancial variables (e.g., assets and
income, housing, net worth, wills, consumption and savings), family characteristics (e.g., family structure, transfers, parent/child/grandchild/sibling information) and a
host of other topics (e.g., expectations, expenses, internet use, risk taking, psychosocial, time use).[11]
2002 and 2004 saw the introductions of the English Longitudinal Study of Ageing (ELSA) and the Survey of
Health, Ageing and Retirement in Europe (SHARE),
which includes respondents from 14 continental European countries plus Israel. These surveys were closely
modeled after the HRS in sample frame, design and content. A number of other countries (e.g., Japan, South
Korea) also now eld HRS-like surveys, and others (e.g.,
China, India) are currently elding pilot studies. These
data sets have expanded the ability of researchers to examine questions about retirement behavior by adding a
cross-national perspective.
Notes: MHAS discontinued in 2003; ELSA numbers exclude institutionalized (nursing homes). Source: BorschSupan et al., eds. (November 2008). Health, Ageing and
Retirement in Europe (20042007): Starting the Longitudinal Dimension.

43.3 Factors aecting retirement

decisions
Many factors aect peoples retirement decisions. Social Security clearly plays an important role. In countries
around the world, people are much more likely to retire
at the early and normal retirement ages of the public pension system (e.g., ages 62 and 65 in the U.S.).[12] This
pattern cannot be explained by dierent nancial incentives to retire at these ages since typically retirement benets at these ages are approximately actuarially fair; that
is, the present value of lifetime pension benets (pension
wealth) conditional on retiring at age a is approximately
the same as pension wealth conditional on retiring one
year later at age a+1.[13] Nevertheless a large literature
has found that individuals respond signicantly to nancial incentives relating to retirement (e.g., to discontinuities stemming from the Social Security earnings test or
the tax system).[14][15][16]
Greater wealth tends to lead to earlier retirement, since
wealthier individuals can essentially purchase addi-

225
tional leisure. Generally the eect of wealth on retirement is dicult to estimate empirically since observing
greater wealth at older ages may be the result of increased
saving over the working life in anticipation of earlier retirement. However, a number of economists have found
creative ways to estimate wealth eects on retirement and
typically nd that they are small. For example, one paper
exploits the receipt of an inheritance to measure the effect of wealth shocks on retirement using data from the
HRS.[17] The authors nd that receiving an inheritance increases the probability of retiring earlier than expected by
4.4 percentage points, or 12 percent relative to the baseline retirement rate, over an eight-year period.
A great deal of attention has surrounded how the nancial crisis (2007 - ?) is aecting retirement decisions,
with the conventional wisdom saying that fewer people
will retire since their savings have been depleted; however recent research suggests that the opposite may happen. Using data from the HRS, researchers examined
trends in dened benet (DB) vs. dened contribution
(DC) pension plans and found that those nearing retirement had only limited exposure to the recent stock market decline and thus are not likely to substantially delay
their retirement.[18] At the same time, using data from
the Current Population Survey (CPS), another study estimates that mass layos are likely to lead to an increase in
retirement almost 50% larger than the decrease brought
about by the stock market crash, so that on net retirements
are likely to increase in response to the crisis.[19]
More information tells of how many who retire will continue to work, but not in the career they have had for the
majority of their life. Job openings will increase in the
next 5 years due to retirements of the baby boomer generation. The Over 50 population is actually the fastest
growing labor groups in the US.
A great deal of research has examined the eects of
health status and health shocks on retirement. It is
widely found that individuals in poor health generally retire earlier than those in better health. This does not necessarily imply that poor health status leads people to retire
earlier, since in surveys retirees may be more likely to exaggerate their poor health status to justify their earlier decision to retire. This justication bias, however, is likely
to be small.[20] In general, declining health over time, as
well as the onset of new health conditions, have been
found to be positively related to earlier retirement.[21]
Most people are married when they reach retirement age;
thus, spouses employment status may aect ones decision to retire. On average, husbands are three years older
than their wives in the U.S., and spouses often coordinate
their retirement decisions. Thus, men are more likely to
retire if their wives are also retired than if they are still in
the labor force, and vice versa.[22][23]

226

43.3.1

CHAPTER 43. RETIREMENT

EU Member States

Researchers analyzed factors aecting retirement decisions in EU Member States:

Rashad Mehbaliyev (2011)[24] analyzed how dierent factors related with health, demographics, behavior, nancial status, and macroeconomics can affect retirement status in European Union countries
for data collected from the SHARE Wave 2 dataset
(Survey of Health, Ageing and Retirement in Europe)[25] and UN sources. He found that males are
less likely to be retired compared with females in
New Member States, which is the opposite result
than he found for Old Member States.[26] He explained that:[27] The reasons for these results can
be the facts that signicant gender wage gap exists
in New Member States,[28] household sizes are bigger in these countries than in Old Member States[29]
and males play important role in household income
which make them retire less than females.[30]
Alba-Ramirez (1997) uses micro data from the
Active Population Survey of Spain and logit model
for analyzing determinants of retirement decision
and nds that having more members in the household, and as well as children, has a negative eect
on the probability of retirement among older males.
This is an intuitive result as males in bigger household with children have to earn more and pension
benets will be less than needed for household.[31]
Antolin and Scarpetta (1998) using German SocioEconomic Panel and hazard model nd that Sociodemographic factors such as health and gender have
a strong impact on the retirement decision: women
tend to retire earlier than men, and poor health
makes people go into retirement, particularly in the
case of disability retirement. The relationship between health status and retirement is signicant for
both self-assessed and objective indicators of health
status.[32] This is similar nding to the previous research of Blau and Riphahn (1997); using individual data from the German Socio-Economic Panel
as well, but controlling for dierent variables they
found that if individual has chronic health condition,
then he tends to retire.[33] Antolin and Scarpetta
(1998) use better measure for health status than Blau
and Riphahn (1997), because self-assessed and objective indicators of health status are better measures than chronic health condition.[34]
Blndal and Scarpetta (1999) nd signicant effect of socio-demographic factors on the retirement
decision. Men tend to retire later than women as
women try to benet from special early retirement
schemes in Germany and the Netherlands. Another
reason is that they get access to pensions earlier than

men as standard age of entitlement to pension is

lower for women compared with men in Italy and
the United Kingdom. The other interesting nding
is that retirement depends on household size: heads
of large households prefer not to retire. They think
that this can be because of the signicance of wages
in large households compared with smaller ones and
insuciency of pension benets. Another nding
is that health status is signicant factor in all early
retirements; poor health conditions are especially
signicant if respondents join to disability benet
scheme. This result is true for both indicators used
to express health status (self assessment and objective indicators).[35] This research is similar to Antolin and Scarpetta (1998) and shows similar results
extending sample and implications from Germany
to OECD.

43.3.2 United States

Quinn et al. (1998) nd signicant correlation between health status and retirement status. They
transform answers for question about health status
from ve levels (excellent, very good, good,
fair and poor) into three levels and report results
for three groups of people. 85% of respondents who
answered excellent or very good to the question about their health in 1992 were still working
two years after this interview, compared to 82% of
those who answered good, and 70% of those answered fair or poor. This fact is also true for
year 1996: 73% of people from the rst group were
still on the job market, while this is 66% and 55%
for other groups of people.[36] However, Dhaval,
Rashad and Spasojevic (2006) using data from six
waves of Health and Retirement Survey (HRS) show
that relationship between retirement and health status can imply the opposite eect in reality: physical
and mental health decline after retirement.[37]

Benitez-Silva (2000) analyzes determinants of labor force status and retirement process among elderly US citizens and possibility of decision returning to work using logit and probit models. He uses
Health and Retirement Survey (HRS) for this purpose and nds that physical and mental health has
signicant eect on becoming employed. Male respondents are more likely to change their status from
being not-employed to employed, but being insured
has a negative eect on switching job status from
not-employed to employed for people aged 60
62 and insignicant eect for 55-59 and aged over
63.[38]

43.4. SAVING FOR RETIREMENT

43.4 Saving for retirement

Retired workers support themselves either through
pensions or savings. In most cases the money is provided by the government, but sometimes granted only
by private subscriptions to mutual funds. In this latter
case, subscriptions might be compulsory or voluntary. In
some countries an additional bonus is granted una tantum (once only) in proportion to the years of work and the
average wages; this is usually provided by the employer.
The nancial weight of provision of pensions on a governments budget is often heavy and is the reason for political
debates about the retirement age. The state might be interested in a later retirement age for economic reasons.

227
Retirement calculators generally accumulate a proportion
of salary up to retirement age. This shows a straightforward case which nonetheless could be practically useful
for optimistic people hoping to work for only as long as
they are likely to be retired. References relevant to the
zero real interest assumption are listed here
For more complicated situations, there are several online
retirement calculators on the Internet. Many retirement
calculators project how much an investor needs to save,
and for how long, to provide a certain level of retirement
expenditures. Some retirement calculators, appropriate
for safe investments, assume a constant, unvarying rate of
return. Monte Carlo retirement calculators take volatility
into account, and project the probability that a particular
plan of retirement savings, investments and expenditures
will outlast the retiree. Retirement calculators vary in the
extent to which they take taxes, social security, pensions,
and other sources of retirement income and expenditures
into account.

The cost of health care in retirement is large, because

people tend to be ill more frequently in later life. Most
countries provide universal health insurance coverage for
seniors, although in the United States many people retire
before they become eligible for Medicare at age 65. In
2006, Medicare Part D went into eect, expanding ben- The assumptions keyed into a retirement calculator are
critical. One of the most important assumptions, is the
ets to include prescription drug coverage.
assumed rate of real (after ination) investment return.
A poll made in Washington said many people were un- A conservative return estimate could be based on the
aware that medicare doesn't pay for the most common real yield of Ination-indexed bonds oered by some
types of long-term care (Neergaard); 37 percent of governments, including the United States, Canada, and
Americans who took the survey believe that it does cover the United Kingdom. The TIP$TER retirement calcuit. Medicaid is a federal-state program for the needy lator projects the retirement expenditures that a portfoand the main source seniors use to pay their long-term lio of ination-linked bonds, coupled with other income
care.[39]
sources like Social Security, would be able to sustain.
Overall, income after retirement can come from state Current real yields on United States Treasury Ination
pensions, occupational pensions, private savings and in- Protected Securities (TIPS) are available at the US Treavestments (private pension funds, owned housing), dona- sury site. Current real yields on Canadian 'Real Return
tions (e.g. by children), and social benets.[40] On a per- Bonds are available at the Bank of Canadas site. As
sonal level, the rising cost of living during retirement is a of December, 2011, US Treasury ination-linked bonds
serious concern to many older adults. Health care costs (TIPS) were yielding about 0.8% real per annum for the
30 year maturity and a noteworthy slightly negative real
play an important role.
return for the 7 year maturity.

43.4.1

Retirement calculators

A useful and straightforward calculation can be done if

we assume that interest, after expenses, taxes and ination
is zero. Assume that in real (after-ination) terms, your
salary never changes during your w years of working life.
During your p years of pension, you have a living standard
which costs a replacement ratio R times as much as your
living standard in your working life. Your working life
living standard is your salary less the proportion of salary
Z that you need to save. Calculations are per unit salary,
e.g. assume salary = 1.
Then after w years work, retirement age accumulated savings = wZ. To pay for pension for p years, necessary savings at retirement = Rp(1-Z)
Many individuals use 'retirement calculators on the InterEquate these: wZ = Rp(1-Z) and solve to give Z = Rp / net to determine the proportion of their pay which they
(w + Rp). For example, if w = 35, p = 30 and R = 0.65 should be saving in a tax advantaged-plan (e.g. IRA or
we nd that we need to save a proportion Z = 35.78% of 401-K in the US, RRSP in Canada, personal pension in
the UK, superannuation in Australia). After expenses
our salary.

228

CHAPTER 43. RETIREMENT

and any taxes, a reasonable (though arguably pessimistic)

long-term assumption for a safe real rate of return is zero.
So in real terms, interest does not help the savings grow.
Each year of work must pay its share of a year of retirement. For someone planning to work for 40 years and to
be retired for 20 years, each year of work pays for itself
and for half a year of retirement. Hence 33.33% of pay
must be saved and 66.67% can be spent when earned.
After 40 years of saving 33.33% of pay we have accumulated assets of 13.33 years of pay, as in the graph. In
the graph to the right, the lines are straight, which is appropriate given the assumption of a zero real investment
return.
The graph above can be compared with those generated by many retirement calculators. However, most retirement calculators use nominal (not 'real' dollars), and
therefore require a projection of both the expected ination rate and the expected nominal rate of return. One
way to work around this limitation is to, for example, enter '0% return, 0% ination' inputs into the calculator.
The Bloomberg retirement calculator gives the exibility
to specify, for example, zero ination and zero investment return and to reproduce the graph above. The MSN
retirement calculator in 2011 has as the defaults a realistic 3% per annum ination rate and optimistic 8% return
assumptions; consistency with the December 2011 US
nominal bond and ination-protected bond market rates
requires a change to about 3% ination and 4% investment return before and after retirement.
Ignoring tax, someone wishing to work for a year and to
then relax for a year on the same living standard needs
to save 50% of pay. Similarly, someone wishing to work
from age 25 to 55 and to be retired for 30 years till 85
needs to save 50% of pay if government and employment
pensions are not a factor, and if it is considered appropriate to assume a zero real investment return. The problem that the lifespan is not known in advance can be reduced in some countries by the purchase at retirement of
an ination-indexed life annuity.

43.4.2

Retirement calculations

power is (1-zprop ) of pay while you are working. You need

a pension for p years. Lets say that at retirement you are
earning S per year and require to replace a ratio Rrepl of
your pre-retirement living standard. So you need a pension of (1 zprop ) Rrepl S, indexed to price ination.
Lets assume that the investments, after price ination
fprice , earn a real rate ireal in real terms where
(1+ ireal ) = ((1+inominal ))/((1+fprice ) ) (Ret-01)
Lets assume that the investments, after wage ination
fpay , earn a real rate i rel to pay where
(1+ i rel to pay ) = ((1+inominal ))/((1+fpay ) ) (Ret-02)

43.4.3 Size of lump sum required

To pay for your pension, assumed for simplicity to be received at the end of each year, and taking discounted values in the manner of a net present value calculation, you
need a lump sum available at retirement of:
(1 zprop ) R repl S {(1+ ireal ) 1 +(1+ ireal ) 2 + .+
(1+ ireal ) -p } = (1-zprop ) R repl S {(1 (1+ireal )-p )/ireal }
Above we have used the standard mathematical formula
for the sum of a geometric series. (Or if ireal =0 then
the series in braces sums to p since it then has p equal
terms). As an example, assume that S=60,000 per year
and that it is desired to replace Rrepl =0.80, or 80%, of
pre-retirement living standard for p=30 years. Assume
for current purposes that a proportion z prop =0.25 (25%)
of pay was being saved. Using ireal =0.02, or 2% per year
real return on investments, the necessary lump sum is
given by the formula as (1-0.25)*0.80*60,000*annuityseries-sum(30)=36,000*22.396=806,272 in the nations
currency in 20082010 terms. To allow for ination in
a straighforward way, it is best to talk of the 806,272 as
being '13.43 years of retirement age salary'. It may be appropriate to regard this as being the necessary lump sum
to fund 36,000 of annual supplements to any employer or
government pensions that are available. It is common to
not include any house value in the calculation of this necessary lump sum, so for a homeowner the lump sum pays
primarily for non-housing living costs.

For most people, employer pensions, government pensions and the tax situation in their country are important factors, typically taken account of in calculations
by actuaries. Ignoring those signicant nation-specic
factors but not necessarily assuming zero real interest
rates, a 'not to be relied upon' calculation of required
43.4.4 Size of lump sum saved
personal savings rate zprop can be made using a little
mathematics.[41] It helps to have a dimly-remembered acWill you have saved enough at retirement? Use our necquaintance with geometric series, maybe in the form
essary but unrealistic assumption of a constant after-payrises rate of interest. At retirement you have accumulated
2
3
n1
n
1 + r + r + r + ... + r = (1 r )/(1 r)
zprop S {(1+ i rel to pay )w-1 +(1+ i rel to pay )w-2 + .+ (1+
rel to pay
)+ 1 }
You work for w years, saving a proportion zprop of pay i
at the end of each year. So the after-savings purchasing = zprop S ((1+i rel to pay )w - 1)/i rel to pay

43.5. EARLY RETIREMENT

43.4.5

Equate and derive necessary saving 43.5

proportion

229

Early retirement

Early retirement can be at any age, but is generally beTo make the accumulation match with the lump sum fore the age (or tenure) needed for eligibility for support and funds from government or employer-provided
needed to pay your pension:
sources. Thus, early-retirees rely on their own savings
prop
rel to pay
w
rel to pay
prop
repl
z
S (((1+i
)) - 1)/i
= (1-z
)R
S
and investments to be initially self-supporting, until they
real -p
real
(1 ((1+i )) )/i
start receiving such external support. Early retirement is
Bring zprop to the left hand side to give our answer, under also a euphemistic term for accepting termination of emthis rough and unguaranteed method, for the proportion ployment before retirement age as part of the employers
of pay that we should be saving:
labor force rationalization. In this case, a monetary inprop
repl
real
-p
real
rel to pay
w ducement may be involved.
z
=R
(1 ((1+i
)) )/i
/ [(((1+i
))
- 1)/i rel to pay + R repl (1 ((1+i real )) -p )/i real ] (Ret-03)
You are encouraged to download the use-at-your-own- 43.5.1 Savings needed for early retirement
nancial-risk spreadsheet. The results in the spreadsheet
can be seen to make sense. For example, working for 5 Further information: Withdrawal rate
years and drawing a pension for 5 years requires you to
save almost half your pay, with interest helping only a litWhile conventional wisdom has it that one can retire
tle.
and take 7% or more out of a portfolio year after year,
Note that the special case i rel to pay =0 = i real means that this would not have worked very often in the past.[45][46]
we instead sum the geometric series by noting that we When making periodic ination-adjusted withdrawals
have p or w identical terms and hence z prop = p/(w+p). from retirement savings,[47] can make meaningless many
This corresponds to our graph above with the straight line assumptions that are based on long term average investreal-terms accumulation.
ment returns.

43.4.6

Sample results

The result for the necessary zprop given by (Ret-03) depends critically on the assumptions that you make. As
an example, you might assume that price ination will
be 3.5% per year forever and that your pay will increase
only at that same rate of 3.5%. If you assume a 4.5% per
year nominal rate of interest, then (using 1.045/1.035 in
real terms ) your pre-retirement and post-retirement net
interest rates will remain the same, irel to pay = 0.966 percent per year and ireal = 0.966 percent per year. These
assumptions may be reasonable in view of the market returns available on ination-indexed bonds, after expenses
and any tax. Equation (Ret-03) is readily coded in Excel and with these assumptions gives the required savings The chart at the right shows the year-to-year portfolio balrates in the accompanying picture.
ances after taking $35,000 (and adjusting for ination)
from a $750,000 portfolio every year for 30 years, starting in 1973 (red line), 1974 (blue line), or 1975 (green
[48]
43.4.7 Monte Carlo: better allowance for line). While the overall market conditions and ination aected all three about the same (since all three exrandomness
perienced exactly the same conditions between 1975 and
2003), the chance of making the funds last for 30 years
Finally, a newer method for determining the adequacy depended heavily on what happened to the stock market
of a retirement plan is Monte Carlo simulation. This in the rst few years.
method has been gaining popularity and is now employed
by many nancial planners.[42] Monte Carlo retirement Those contemplating early retirement will want to know
calculators[43][44] allow users to enter savings, income and if they have enough to survive possible bear markets such
expense information and run simulations of retirement as the one that would cause the hypothetical 1973 retirees
scenarios. The simulation results show the probability fund to be exhausted after only 20 years.
that the retirement plan will be successful.
The history of the US stock market shows that one would

230

CHAPTER 43. RETIREMENT

need to live on about 4% of the initial portfolio per year

to ensure that the portfolio is not depleted before the end
of the retirement;[49] this rule of thumb is a summary
of one conclusion of the Trinity study, though the report
is more nuanced and the conclusions and very approach
have been heavily criticized (see Trinity study for details).
This allows for increasing the withdrawals with ination
to maintain a consistent spending ability throughout the
retirement, and to continue making withdrawals even in
dramatic and prolonged bear markets.[50] (The 4% gure
does not assume any pension or change in spending levels
throughout the retirement.)
When retiring prior to age 59, there is a 10% IRS
penalty on withdrawals from a retirement plan such as a
401(k) plan or a Traditional IRA. Exceptions apply under certain circumstances. At age 59 and six months, the
penalty-free status is achieved and the 10% IRS penalty
no longer applies.
To avoid the 10% penalty prior to age 59 a person
should consult a lawyer about the use of IRS rule 72 T.
This rule must be applied for with the IRS. It allows the
distribution of an IRA account prior to age 59 in equal
amounts of a period of either 5 years or until the age of
59 which ever is the longest time period without a 10%
penalty. Taxes still must be paid on the distributions.

43.5.2

Calculations using actual numbers

Although the 4% initial portfolio withdrawal rate described above can be used as a rough gauge, it is often
desirable to use a retirement planning tool that accepts
detailed input and can render a result that has more precision. Some of these tools model only the retirement
phase of the plan while others can model both the savings
or accumulation phase as well as the retirement phase of
the plan.

such as for so-called grey nomads. Some retired people

even choose to go and live in warmer climates in what is
known as retirement migration.
It has been found that Americans have six lifestyle choices
as they age: continuing to work full-time, continuing to
work part-time, retiring from work and becoming engaged in a variety of leisure activities, retiring from work
and becoming involved in a variety of recreational and
leisure activities, retiring from work and later returning to
work part-time, and retiring from work and later returning to work full-time.[53] An important note to make from
these lifestyle denitions are that four of the six involve
working. America is facing an important demographic
change in that the Baby Boomer generation is now reaching retirement age. This poses two challenges: whether
there will be a sucient number of skilled workers in the
work force, and whether the current pension programs
will be sucient to support the growing number of retired
people.[54] The reasons that some people choose to never
retire, or to return to work after retiring include not only
the diculty of planning for retirement but also wages
and fringe benets, expenditure of physical and mental
energy, production of goods and services, social interaction, and social status may interact to inuence an individuals work force participation decision.[55]
Often retirees are called upon to care for grandchildren
and occasionally aged parents. For many it gives them
more time to devote to a hobby or sport such as golf or
sailing. On the other hand, many retirees feel restless
and suer from depression as a result of their new situation. Although it is not scientically possible to directly show that retirement either causes or contributes
to depression, the newly retired are one of the most vulnerable societal groups when it comes to depression most
likely due to conuence of increasing age and deteriorating health status.[56] Retirement coincides with deterioration of ones health that correlates with increasing age and
this likely plays a major role in increased rates of depression in retirees. Longitudinal and cross-sectional studies
have shown that healthy elderly and retired people are as
happy or happier and have an equal quality of life as they
age as compared to younger employed adults, therefore
retirement in and of itself is not likely to contribute to
development of depression.

The eects of making ination-adjusted withdrawals

from a given starting portfolio can be modeled with a
downloadable spreadsheet[51] that uses historical stock
market data to estimate likely portfolio returns. Another approach is to employ a retirement calculator[52]
that also uses historical stock market modeling, but adds
provisions for incorporating pensions, other retirement
income, and changes in spending that may occur during Many people in the later years of their lives, due to failing
the course of the retirement.
health, require assistance, sometimes in extremely expensive treatments in some countries being provided in a
nursing home. Those who need care, but are not in need
of constant assistance, may choose to live in a retirement
43.6 Life after retirement
home.
Retirement might coincide with important life changes; a
retired worker might move to a new location, for example a retirement community, thereby having less frequent
contact with their previous social context and adopting a
new lifestyle. Often retirees volunteer for charities and
other community organizations. Tourism is a common
marker of retirement and for some becomes a way of life,

43.7 See also

Simple living
Downshifting

43.8. REFERENCES
Pension
Ageing
Mandatory retirement
Gerontology
Social security
Retirement spend down
Asset/liability modeling
Best places in the US to retire

43.8 References
[1] Retire: To withdraw from ones occupation, business, or
oce; stop working. American Heritage Dictionary
[2] Retire: Leave ones job and cease to work, especially because one has reached a particular age. Compact Oxford
Dictionary
[3] For example, in the United States, a person holding the
rank of general or admiral must retire after 40 years of
service unless he or she is reappointed to serve longer. (10
USC 636 Retirement for years of service: regular ocers
in grades above brigadier general and rear admiral (lower
half))
[4] The German Precedent Social Security History, US Social Security Administration

231

[14] Feldstein, Martin and Jerey B. Liebman (2002). Social Security, in Handbook of Public Economics, Vol. 4,
Elsevier Press
[15] Friedberg, Leora (2000). The Labor Supply Eects of
the Social Security Earnings Test. Review of Economics
and Statistics, Vol. 82, No. 1, pp. 4863
[16] Liebman, Jerey B., Erzo F.P. Luttmer and David G. Seif
(2008). Labor Supply Responses to Marginal Social Security Benets: Evidence from Discontinuities. NBER
Working Paper No. 14540
[17] Brown, Jerey R., Courtney Coile and Scott J. Weisbenner (2006). The Eect of Inheritance Receipt on Retirement. NBER Working Paper No. 12386
[18] Gustman, Alan, Thomas Steinmeier and Jahid Tabatabai
(2009). How Do Pension Changes Aect Retirement
Preparedness? The Trend to Dened Contribution Plans
and the Vulnerability of the Retirement Age Population
to the Stock Market Decline of 20082009. Presented
at 11th Annual Joint Conference of the Retirement Research Consortium, August 1011, 2009, National Press
Club, Washington, DC
[19] Coile, Courtney B. and Phillip B. Levine (2009). The
Market Crash and Mass Layos: How the Current
Economic Crisis May Aect Retirement, presented at
NBER Summer Institute Workshop on Aging, July 21
25, 2009.
[20] Dwyer, Debra and Olivia Mitchell (1999). Health problems as determinants of retirement: Are self-rated measures endogenous?" Journal of Health Economics, Vol.
18, No. 2, pp. 173193

[5] OECD (2005). Ageing and Employment Policies: Austria.

[6] http://www.bbc.com/news/world-europe-20293058
[7] Pension rallies hit French cities. BBC News. September
7, 2010.
[8] Minder, Raphael (January 27, 2011). Spain to Raise Retirement Age to 67. The New York Times.
[9] Normal retirement age (NRA)

[21] Dwyer, Debra and Jianting Hu (2000). Retirement Expectations and Realizations: the Role of Health Shocks
and Economic Factors, in Forecasting Retirement Needs
and Retirement Wealth, Mitchell, Olivia, P. Brett Hammond and Anna Rappaport, eds.
[22] Blau, David M. (1998). Labor Force Dynamics of Older
Married Couples. Journal of Labor Economics, Vol. 16,
No. 3, pp. 595629

[10] Michael Bucci (November 1992). Police and reghter

pension plans. Monthly Labor Review 115 (11). Retrieved 2007-08-03.

[23] Gustman, Alan and Thomas Steinmeier (2000). Retirement in Dual Career Families: A Structural Model. Journal of Labor Economics, Vol. 18, No. 3, pp. 503545

[11] Juster, F. Thomas; Suzman, Richard (1995). An

Overview of the Health and Retirement Study. The Journal of Human Resources 30 (Special Issue on the Health
and Retirement Study: Data Quality and Early Results):
S7S56. doi:10.2307/146277. JSTOR 146277.

[24] Rashad Mehbaliyev (2009), Determinants of retirement

status: Comparative evidence from old and new EU member states. Masters Thesis. Central European University,
Budapest.

[12] Gruber, Jonathan and David Wise, eds. (1999). Social

Security and Retirement around the World. University of
Chicago Press.
[13] Gustman, Alan and Thomas Steinmeier (2003). Retirement Eects of Proposals by the Presidents Commission
to Strengthen Social Security. NBER Working Paper No.
10030

[25] SHARE-project.org: Publications - Other

[26] Morebooks.de: Determinants of Retirement Status: Comparative Evidence from Old and New EU Member States
by Rashad Mehbaliyev
[27] Buecher.de: Rashad Mehbaliyev - Determinants of Retirement Status: Comparative Evidence from Old and New EU
Member States

232

CHAPTER 43. RETIREMENT

[28] Librerianuniversitaria.it: Determinants of Retirement

Status: Comparative Evidence from Old and New EU
Member States, di Mehbaliyev Rashad

[46] SC:Lynch #2

[29] Lawbooks.com.au: Lawbooks.com.au: Determinants of

Retirement Status, Author: Rashad Mehbaliyev

[48] FIRECalc: Why another retirement calculator?

[30] Amazon.com: Determinants of Retirement Status: Comparative Evidence from Old and New EU Member States
[Paperback], Rashad Mehbaliyev
[31] Alba-Ramirez, A. 1997, Labor Force Participation and
Transitions of Older Workers in Spain, Universidad Carlos III de Madrid, Working Paper 97-39, Economic series
17, May.
[32] Antoln, P. and S. Scarpetta. 1998. Microeconometric Analysis of the Retirement Decision: Germany,
OECD Economics Department Working Papers, No.
204, OECD Publishing
[33] Blau, D. and R. Riphahn. 1997. Labor Force Transitions
of Older Married Couples in Germany. Paper presented
at International Health and Retirement Surveys Conference, Amsterdam, August.
[34] Antoln, P. and S. Scarpetta. 1998. Microeconometric Analysis of the Retirement Decision: Germany,
OECD Economics Department Working Papers, No.
204, OECD Publishing
[35] Blndal, S. and S. Scarpetta. 1997. Early retirement in
OECD countries: The Role of Social Security Systems,
OECD Economic Studies, issue 29, pages 7-54
[36] Quinn, J., R. Burkhauser, K. Cahill and R. Weather.
1998. Microeconometric Analysis of the Retirement
Decision: The United States, OECD Economics Department Working Paper No. 203
[37] Dhaval, D., I. Rashad, and J. Spasojevic. 2006. The Effects of Retirement on Physical and Mental Health Outcomes, NBER Working Paper w12123
[38] Benitez-Silva, H. 2000. Micro Determinants of Labor Force Status Among Older Americans, SUNY-Stony
Brook Department of Economics Working Papers 00-07
[39] Neergaard, Lauran, and Jennifer Agiesta. Long-Term
Care in Aging US: Not for Me, Poll Says. Washington
Times. 24 Apr. 2013: n.p. SIRS Issues Researcher. Web.
21 Jan. 2015.
[40] Eurofound, Income from work after retirement in the EU
(2012) http://www.eurofound.europa.eu/pubdocs/2012/
59/en/2/EF1259EN.pdf
[41] Broverman, Samuel A., Mathematics of Investment and
Credit, 3rd. Edition, Section 2.3.1 Actex Publications,
Inc, Winsted CT, (2004)
[42] A SURE BET? (Wealth Manager).
[43] Retirement Calculator by VestingPoint.com
[44] Online Monte Carlo Retirement Planner.
[45] Clements, Jonathan (May 21, 2006). Make Sure Your
Money Lasts as Long as You. The Wall Street Journal.

[47] http://firecalc.com/intro.php volatility

[49] Dallas Morning News | News for Dallas, Texas | Scott

Burns: Columns 2006
[50] Retire Earlys Safe Withdrawal Rates in Retirement
[51] http://retireearlyhomepage.com/re60.html downloadable
spreadsheet
[52] FIRECalc: A dierent kind of retirement calculator.
[53] Cox, H. (2012). Work/retirement choices and lifestyle
patterns of older Americans. In L. Loeppke (Ed.), Annual editions: Aging (24th ed., pp. 74-83). New York,
NY: McGraw-Hill
[54] Hardy, M. (2006). Older workers. In R. Binstock & L.
George (Eds.), Handbook of aging and the social sciences
(6th ed., pp. 201-218). Boston, MA: Academic Press
[55] Cox, H. (2012). Work/retirement choices and lifestyle
patterns of older Americans. In L. Loeppke (Ed.), Annual editions: Aging (24th ed., pp. 74-83). New York,
NY: McGraw-Hill
[56] http://www.retirementjoy.com/ avoiding depression after
retirement

43.9 Further reading

Schultz, Ellen E., RETIREMENT HEIST: How Companies Plunder and Prot from the Nest Eggs of
American Workers, Penguin Publishing, 2011

43.10 External links

Historical Development, Social Security Administration
Ultimate Guide to Retirement
Short, Joanna, Economic History of Retirement in
the U.S., 2010-02-01, Augustana College, Rock Island, Illinois
Retirement Calculator

Chapter 44

Student loan
A student loan is designed to help students pay for university tuition, books, and living expenses. It may dier
from other types of loans in that the interest rate may be
substantially lower and the repayment schedule may be
deferred while the student is still in school. It also diers
in many countries in the strict laws regulating renegotiating and bankruptcy.

44.2.2 Main Loan Programs

Income Contingent Loan (ICL)

44.2 Korea

For undergraduate students of all grades from lowincome households in the 1st through 7th income bracket
levels; also, for students (irrespective of income level)
from households with three or more childrenbeginning
with the third child. Strong academic performance is
part of the eligibility criteria. Loans are not subject to
credit approval. Loan applicants must be enrolled for undergraduate study in a postsecondary institution in Korea. Students do not qualify for this loan program if they
are in a graduate school, a continuing education program
through an academic credit bank system, or a school outside of Korea. Loan must be used for tuition, qualifying
school fees, and other specic education-related costs, including living expenses during study. Loan payments may
not exceed the students nancial need; there is no other
upper limit on the amount borrowed (loan program permits full coverage of tuition and expenses). In the case
of applying loan towards both tuition/school fees and instudy living expenses, the lower limit is KRW 600,000 (at
least KRW 100,000 for tuition/school fees plus at least
KRW 500,000 for living expenses). Under the income
contingent repayment system, a borrower does not have
to pay the loan principal amount or interest until he or
she has income above a certain minimum threshold level
for repayment. Once the borrowers annual income is
greater than the repayment minimum threshold level, the
borrower is under obligation to begin repayment.

44.2.1

Direct Loan (DL)

44.1 Australia
Tertiary student places in Australia are usually funded
through the HECS-HELP scheme. This funding is in the
form of loans that are not normal debts. They are repaid over time via a supplementary tax, using a sliding
scale based on taxable income. As a consequence, loan
repayments are only made when the former student has
income to support the repayments. Discounts are available for early repayment. The scheme is available to citizens and permanent humanitarian visa holders. Meanstested scholarships for living expenses are also available.
Special assistance is available to indigenous students.[1]
There has been criticism that the HECS-HELP scheme
creates an incentive for people to leave the country after
graduation, because those who do not le an Australian
tax return do not make any repayments.[2]

Koreas Student Loan

Koreas student loans are managed by the Korea Student

Aid Foundation](KOSAF) which was established in May
2009. According to the governmental philosophy that
Koreas future depends on talent development and no student should quit studying due to nancial reasons, they
help students grow into talents that serve the nation and
society as members of Korea. Through the management
of Koreas national scholarship programs, student loan
programs, and talent development programs, KOSAF offers customized student aid services and student loan program is one of the their major tasks.[3]

Reduced-interest loans that come from and are guaranteed by the government. Qualifying borrowers, on certain conditions, may be eligible for interest relief oered
by the government. For undergraduate and graduate students of any grade level*, from households of any income
level. Loan applicants must be enrolled for undergraduate study in a postsecondary institution in Korea. Students do not qualify for this loan program if they are
in a continuing education program through an academic
credit bank system or a school outside of Korea. Satisfactory academic performance is part of the eligibility crite-

233

234

CHAPTER 44. STUDENT LOAN

ria. Loans are subject to credit approval. Loan must be

used for tuition, qualifying school fees, and other specic
education-related costs, including living expenses during
study. Loan payments may not exceed the students nancial need. Depending on the type of school (i.e. undergraduate, graduate), the upper limit on the amount borrowed ranges from KRW 40 million to KRW 90 million.
If applying loan towards both tuition/school fees and instudy living expenses, the lower limit is KRW 600,000
(at least KRW 100,000 for tuition/school fees plus at least
KRW 500,000 for living expenses). The repayment system oers a borrower grace period of 10 years or less
during which payments only need to be made towards
the interest on the loan. This maximum period of time
is determined by the borrowers year in school and the remaining number of years within the standard period of
the borrowers program. After the grace period, the borrower is given up to 10 years in which to repay the loan
principal amount and interest. The repayment period is
dependent upon the borrower.

for graduate students (through the SL). For 1st- or 2ndyear undergraduates, the same academic and income level
qualications for the ICL apply; for 3rd- or 4th-year undergraduates, the academic and income level qualications for the ICL and the SL apply. Loan must be used
for necessary non-tuition, living expenses during the academic year that may include room and board, books and
supplies, and transportation costs. The student may determine the amount to borrow in increments of KRW
100,000from KRW 500,000 to KRW 1 million per
semester (or up to KRW 2 million per school year). May
receive loan on its own or in combination with a student
loan (for school tuition and fees).
KOSAF Loan Conversion Program

For undergraduate and graduate students whose academic and income levels qualify them for the Income
Contingent Loan (ICL). Students receiving the Direct
Loan (DL) who qualify for the ICL may be eligible to
shift from the DL to the ICL. The transition only applies
For undergraduate students in the 1st semester of
from the school semester during which the loan approval
the 1st year who apply for this loan, only credit is
is made. For all previous semesters during which the borconsidered when making approvals for loans.
rower received the DL, the terms and conditions of the
DL fully apply (e.g. the interest accrued on the loan principal each month while the borrower was receiving the
Loan for Rural Students (LRS)
DL must be repaid).
No-interest loans that come from and are guaranteed by
the government. Highlights the customized aspect of the
student loans provided through KOSAF. For undergraduate students of all grades and any income level whose
parents and guardians have lived at a permanent address
in an agriculture and sheries community area for more
than 6 months (180 days) and/or students who have been
making a living in the agriculture and sheries industry
for more than 6 months. Students from households with
more than three children may be given priority. Loan
applicants must be enrolled for undergraduate study in a
postsecondary institution in Korea. Students do not qualify for this loan program if they are in a graduate school,
a remote (o-campus)/distance learning program, a continuing education program through an academic credit
bank system, or a school utside of Korea. Satisfactory
academic performance is part of the eligibility criteria.
Loan must be used for tuition and qualifying school fees
(not including living expenses). Oers full coverage of
tuition and qualifying school fees. Loan payments may
not exceed the students nancial need.

44.2.3

Variations

44.2.4 Current situation

About 700,000 students borrowed about 2.7 trillion
KRW in 2011. KOSAF seeks lower interest rates by
issuing direct loans. Since KOSAF issue governmentguaranteed bonds, students can borrow directly from the
foundation, which reduces their burden on tuition payment

44.3 United Kingdom

Main article: Student loans in the United Kingdom
Student loans in the United Kingdom are primarily provided by the state-owned Student Loans Company. Interest begins to accumulate on each loan payment as soon as
the student receives it, but repayment is not required until
the start of the next tax year after the student completes
(or abandons) their education.

Since 1998, repayments have been collected by HMRC

via the tax system, and are calculated based on the borLiving Expenses Loan
rowers current level of income. If the borrowers income
is below a certain threshold (15,000 per tax year for
For undergraduate students whose income level qualies 2011/2012, 21,000 per tax year for 2012/2013), no rethem for the Income Contingent (Deun-Deun) Student payments are required, though interest continues to accuLoan (ICL) and/or the Standard Student Loan (SL) and mulate.

44.4. UNITED STATES

Loans are cancelled if the borrower dies or becomes permanently unable to work. Depending on when the loan
was taken out and which part of the UK the borrower is
from, they may also be cancelled after a certain period of
time usually after 30 years, or when the borrower reaches
a certain age.
Student loans taken out between 1990 and 1998, in the
introductory phase of the UK governments phasing in
of student loans, were not subsequently collected through
the tax system in following years. The onus was (and still
is) on the loan holder to prove their income falls below
an annually calculated threshold set by the government
if they wish to defer payment of their loan. A portfolio
of early student loans from the 1990s was sold, by The
Department for Business, Innovation and Skills in 2013.
Erudio, a company nancially backed by CarVal and Arrow Global was established to process applications for deferment and to manage accounts, following its successful
purchasing bid of the loan portfolio in 2013.

44.4 United States

Main article: Student loans in the United States

235
changed so that private educational loans also could not
be readily discharged. Supporters of this change claimed
that it would reduce student loan interest rates.

44.4.1 Income-Based Repayment

The Income-Based Repayment plan is an alternative to
paying back student loans, which allow the borrowers to
pay back loans based on how much they make, and not
based how much money is actually owed.[9] However, income based repayment does not apply to private loans.[10]
IBR plans generally cap loan payments at 10 percent of
the student borrowers income. Interest accrues and the
balance continues to build. However, after a certain number of years, the balance of the loan is forgiven. This period is 10 years if the student borrower works in the public
sector (government or a nonprot) and 25 years if the student works at a for-prot. Debt forgiveness is treated as
taxable income, but can be excluded as taxable under certain circumstances, like bankruptcy and insolvency.[11]
Scholars have criticized IBR plans on the grounds that
they create moral hazard and suer from adverse selection. That is, IBR may encourage student borrowers who
could have obtained high-wage jobs to take low wage jobs
with good benets and minimal work hours to reduce
their loan payments, thereby driving up the cost of the
IBR program. And, if IBR programs are optional, only
students who expect to have low wages will opt into the
program. Historically, a number of IBR programs have
collapsed because of these problems.[4][12]

In the United States, there are two types of student loans:

federal loans sponsored by the federal government and
private student loans,[4][5] which broadly includes statealiated nonprots and institutional loans provided by
schools.[6] The overwhelming majority of student loans
are federal loans.[4] Federal loans can be subsidized or
unsubsidized. Interest does not accrue on subsidized
loans while the students are in school. Student loans may 44.4.2 Qualication
be oered as part of a total nancial aid package that may
also include grants, scholarships, and/or work study op- Most college students in the United States qualify for
portunities.
federal student loans.[13] Students can borrow the same
Prior to 2010, federal loans were also divided between amount of money, at the same price, regardless of their
own income or their parents incomes, regardless of their
direct loans (which are originated and funded by the federal government) and guaranteed loans, originated and expected future income, and regardless of their credit history. Only students who have defaulted on federal stuheld by private lenders but guaranteed by the government. The guaranteed lending program was eliminated dent loans or have been convicted of drug oenses are
excluded.
in 2010 because of a widespread perception that the government guarantees boosted student lending companies The amount students can borrow each year depends on
prots but did not benet students by reducing student their education level (undergraduate or graduate), and
loan costs.[4][7]
their status as dependent or independent. UndergraduFederal Student loans are generally less expensive than ates may receive lower interest rates than graduate stugraduate students can typically borrow more
private student loans. However, the federal student lend- dents, but
[4][7]
per
year.
ing program still generates billions of dollars in prot
for the government each year, because the interest payments exceed the governments own borrowing costs,
loan losses, and administrative costs. Losses on student loans are extremely low, even when students default, in part because these loans cannot be discharged
in bankruptcy unless repaying the loan would create an
undue hardship for the student borrower and his or
her dependents.[4][8] In 2005, the bankruptcy laws were

Private lenders may use dierent underwriting criteria,

including income level, parents income level, and other
nancial considerations. Students will generally only borrow from private lenders when they exhaust the maximum borrowing limit under federal loans. Several scholars have advocated eliminating the borrowing limit on
federal loans and enabling students to borrow according
to their needs (tuition plus living expenses) and thereby

236

CHAPTER 44. STUDENT LOAN

eliminating high-cost private loans.[4][7]

44.4.3

Repayment

Federal student loan interest rates are established by

Congress and listed in 20 U.S.C. 1087E(b). Because the interest rates are established by Congress, interest rates are a political decision. The federal student
loan program currently runs a multibillion dollar negative subsidy, or prot, for the federal government. Some
scholars have suggested that federal student loan interest
rates should be tailored to particular courses of study and
reect the riskiness of those dierent courses of study.
They have also suggested that the program should be run
at cost, or below cost, because of the benets an educated workforce provides to societylower burdens on
public services, lower health costs, higher wages and tax
revenues, lower unemployment.[4][14][15]
Repayment typically begins anywhere from six to twelve
months after a student leaves school, regardless of
whether or not they complete their degree program. In
some cases, repayment begins if course load drops to half
time or less, so it is important to check the exact terms and
conditions of any student loan.
The student may have multiple options for extending the
repayment period, although an extension of the loan term
will likely reduce the monthly payment, it will also increase the amount of total interest paid on the principle
balance during the life of the loan. Extension options
include extended payment periods oered by the original lender and federal loan consolidation. There are also
other extension options including income sensitive repayment plans and hardship deferments. Extensions and consolidation will also add to the principal, many times unpaid interest and penalties become capitalized.

Occupy Boston activist Nelson Terry at the Occupy Wall Street

event in New York protesting student loan debt, September 19,
2011

There are many documented cases of Americans committing extreme actions because of large student loan balances. This seems particularly true in the case of private
loan balances.[22] After the passage of the bankruptcy reform bill of 2005, even private student loans are not disThe Master Promissory Note is an agreement between the charged during bankruptcy. This provided a credit risk
lender and the borrower that promises to repay the loan. free loan for the lender, averaging 7 percent a year.[23]
It is a binding legal contract.
Increasing student loans have also been blamed for driving tuition costs up. As Cato Institute economist Neal
McCluskey explained in an April 2012 article for U.S.
44.4.4 Criticism
World & News Report: The basic problem is simple:
In coverage through established media outlets, many bor- Give everyone $100 to pay for higher education and colrowers have expressed feelings of victimization by the leges will raise their prices by $100, negating the value of
student loan corporations.[16][17][18] There is a compari- the aid. And ination-adjusted aid--most of it federal-per underson between these accounts and the college credit card has certainly gone up, ballooning from $4,602 [24]
graduate
in
1990-91
to
$12,455
in
2010-11.
trend in America during the 2000s, though the amounts
owed by students on their student loans are almost always
higher than the amount owed on credit cards.[19] Many
anecdotal accounts of the hardships caused by excessive
student loan debt levels are chronicled by the organization Student Loan Justice which is founded and led by
consumer rights advocate and author Alan Collinge.[20]
Student loans cannot be discharged in a bankruptcy
proceeding unless the debtor can demonstrate undue
hardship.[21]

In 2007, the Attorney General of New York State,

Andrew Cuomo, led an investigation into lending practices and anti-competitive relationships between student
lenders and universities. Specically, many universities
steered student borrowers to preferred lenders which
resulted in those borrowers incurring higher interest rates.
Some of these preferred lenders allegedly rewarded
university nancial aid sta with kick backs. This has
led to changes in lending policy at many major American

44.6. REFERENCES

237

universities. Many universities have also rebated millions

of dollars in fees back to aected borrowers.[25][26]
The biggest lenders, Sallie Mae and Nelnet, are frequently
criticized by borrowers. These lenders often nd themselves embroiled in lawsuits, the most serious of which
was led in 2007. The false claims suit was led on behalf
of the federal government by former Department of Education researcher Jon Oberg against Sallie Mae, Nelnet,
and other lenders. Oberg argued that the lenders overcharged the U.S. government and defrauded taxpayers of
millions and millions of dollars. In August 2010, Nelnet
settled the lawsuit and paid $55 million.[27]
The New York Times published an editorial in August
2011 endorsing the return of bankruptcy protections for
private student loans in response to the economic downturn and universally increasing tuition at all colleges and
graduate institutions.[28]

[3] ko:
[4] Michael Simkovic, Risk-Based Student Loans (2012)
[5] Kantrowitz, Mark (2010-03-26). Student Loans - The
New York Times. Nytimes.com. Retrieved 2010-09-07.
[6] Consumer Financial Protection Bureau. (2012) Private
Student Loans. See also: Report Details Woes of Student
Loan Debt. NYT.
[7] Jonathan Glater, The Other Big Test: Why Congress
Should Allow College Students to Borrow More Through
Federal Aid Programs, 14 N.Y.U. J. LEGIS. & PUB.
POLY 11, 37 (2011)
[8] John A. E. Pottow, The Nondischargeability of Student
Loans in Personal Bankruptcy Proceedings: The Search
for a Theory, 44 CAN. BUS. L.J. 245, 249-250 (2006)
[9] Student Aid on the Web. Studentaid.ed.gov. Retrieved
2012-04-24.

As of 2013, many economists are predicting a new economic crisis will emerge as a result of an estimated $1 [10] Loans | Repayment Plans | Income-Based Repayment.
FinAid. Retrieved 2012-04-24.
trillion of student loan debt currently impacting two thirds
[29]
of graduating college students in America.
[11] Philip G. Schrag & Charles W. Pruett, Coordinating Loan
Repayment Assistance Programs with New Federal Legislation, 60 J. LEGAL EDUC. 583, 590-597 (2010)

44.5 See also

[12] Robert J. Shiller, THE NEW FINANCIAL ORDER:

RISK IN THE 21ST CENTURY (2003).

College tuition in the United States

[13] StudentLoans.gov. Retrieved 3 January 2014.

EdFund

[14] OECD, Education at a Glance (2011)

Free education

[15] DEBORAH KALCEVIC & JUSTIN HUMPHREY,

CONGRESSIONAL BUDGET OFFICE, CBO MARCH
2012 BASELINE PROJECTIONS FOR THE STUDENT LOAN AND PELL GRANT PROGRAMS, Tables 2, 3

Higher Education Bubble

Higher Education Price Index
Post-secondary education

[16] Student Loan Stories . NOW on PBS. Pbs.org. Retrieved 2010-09-07.

Private university
Student benet

[17] Anderson Cooper 360: Blog Archive - Student

Loan Nightmare: Help Wanted - CNN.com Blogs.
Ac360.blogs.cnn.com. 2009-03-30. Retrieved 2010-0907.

Student debt
Student loans in the United States

[18] Fetterman, Mindy (2006-11-22). Young people struggle to deal with kiss of debt. Usatoday.Com. Retrieved
2010-09-07.

Tuition agency
Tuition center

[19] Kurt SollerFebruary 17, 2009 (2009-02-17). Credit

Card Issuers Still Target College Students. Newsweek.
Retrieved 2010-09-07.

Tuition fees
Tuition freeze

[20] StudentLoanJustice.Org. StudentLoanJustice.Org. Retrieved 2012-04-24.

44.6 References
Going-

[21] Liz Pulliam Weston: Good and bad student loan debt
- MSN Money. Articles.moneycentral.msn.com. Retrieved 2010-09-07.

[2] Free Uni for Artful Dodgers Incentives for Australians to

leave the country after graduation (Retrieved 2014-08-22)

[22] College grads take extreme measures to repay student

loans. http://www.walletpop.com. Retrieved 2011-0415.

[1] Paying for your studies (HELP loans)".

touni.gov.au. Retrieved 2010-09-07.

238

[23] Collinge, Alan. The student loan scam : the most oppressive debt in U.S. history, and how we can ght back.
Boston, MA : Beacon Press, c2009. ISBN 978-0-80704229-8 http://lccn.loc.gov/2008012230
[24] http://mercatus.org/expert_commentary/
subsidized-loans-drive-college-tuition-student-debt-record-levels
[25] Cuomo: School loan corruption widespread. U.S.A. Today. April 10, 2007. Retrieved 2008-04-08.
[26] Lederman, Doug (May 15, 2007). The First Casualty.
Inside Higher Education. Retrieved 2008-04-08.
[27] Field, Kelly (August 15, 2010). Nelnet to Pay $55 Million to Resolve Whistle Blower Lawsuit. The Chronicle
of Higher Education. Retrieved 2011-07-14.
[28] Relief for Student Debtors. The New York Times. 201108-26.
[29] Denhart, Chris. How The $1.2 Trillion College Debt
Crisis Is Crippling Students, Parents And The Economy.
Forbes.

44.7 Further reading

Manning, Robert D. (1999). Credit Cards on Campus: The Social Costs and Consequences of Student
Debt. Washington, D.C.: Consumer Federation of
America.
Schemo, Diana Jean, Private Loans Deepen a Crisis in Student Debt, The New York Times, June 10,
2007
New Default Rate Data for Federal Student Loans:
44% of Defaulters Attended For-Prot Institutions,
The Pew Charitable Trusts, Project on Student Debt,
Berkeley, California, December 15, 2009
Studentaid.ed.gov on Federal Perkins Loan Teacher
Cancellation

44.8 External links

UNITED NATIONS: Education Policy and Reform
Big Money On Campus. U.S. News & World Report. October 19, 2003.
College, Inc., PBS FRONTLINE documentary,
May 4, 2010

CHAPTER 44. STUDENT LOAN

Chapter 45

Government spending
Public Purse redirects here. For the term used in
relation to the British monarchy, see Privy Purse.

45.2 Current use: nal consumption expenditure

Government spending or expenditure includes all

government consumption, investment, and transfer
payments.[1][2] In national income accounting the acquisition by governments, of goods and services for current
use, to directly satisfy the individual or collective needs
of the community, is classed as government nal consumption expenditure. Government acquisition of goods
and services intended to create future benets, such as
infrastructure investment or research spending, is classed
as government investment (government gross capital formation). These two types of government spending, on nal consumption and on gross capital formation, together
constitute one of the major components of gross domestic product.

Main article: Government nal consumption expenditure

Government acquisition of goods and services for current use to directly satisfy individual or collective needs
of the members of the community is called government
nal consumption expenditure (GFCE.) It is a purchase
from the national accounts use of income account for
goods and services directly satisfying of individual needs
(individual consumption) or collective needs of members
of the community (collective consumption). GFCE consists of the value of the goods and services produced by
the government itself other than own-account capital formation and sales and of purchases by the government of
goods and services produced by market producers that are
Government spending can be nanced by government supplied to households - without any transformation as
borrowing, seigniorage, or taxes. Changes in government social transfers in kind.[3]
spending is a major component of scal policy used to
stabilize the macroeconomic business cycle.

45.3 Infrastructure and investment: gross xed capital

formation

45.1 Macroeconomic scal policy

Main article: Gross xed capital formation

Further information: Investment In economics or
macroeconomics

Main article: scal policy

For scal policy, increases in government spending are
expansionary, while decreases are contractionary. John
Maynard Keynes was one of the rst economists to advocate government decit spending (increased government spending nanced by borrowing) as part of the scal
policy response to an economic contraction. According
to Keynesian economics, increased government spending raises aggregate demand and increases consumption,
which leads to increased production and faster recovery
from recessions. Classical economists, on the other hand,
believe that increased government spending exacerbates
an economic contraction by shifting resources from the
private sector, which they consider productive, to the
public sector, which they consider unproductive.

Government acquisition intended to create future benets, such as infrastructure investment or research spending, is called gross xed capital formation, or government investment, which usually is the largest part of the
government.[4] Acquisition of goods and services is made
through production by the government (using the governments labour force, xed assets and purchased goods and
services for intermediate consumption) or through purchases of goods and services from market producers. In
economic theory or in macroeconomics, investment is the
amount purchased per unit time of goods which are not
consumed but are to be used for future production (i.e.
capital). Examples include railroad or factory construc-

239

240

CHAPTER 45. GOVERNMENT SPENDING

tion.
Infrastructure spending is considered government
investment because it will usually save money in the
long run, and thereby reduce the net present value of
government liabilities.
Spending on physical infrastructure in the U.S. returns
an average of about $1.92 for each $1.00 spent on nonresidential construction because it is almost always less
expensive to maintain than repair or replace once it has
become unusable.[5]
Likewise, government spending on social infrastructure,
such as preventative health care, can save several hundreds of billions of dollars per year in the U.S., because
for example cancer patients are more likely to be diagnosed at Stage I where curative treatment is typically a
few outpatient visits, instead of at Stage III or later in
an emergency room where treatment can involve years of Public spending / GDP in Europe.
hospitalization and is often terminal.[6]
Legend: maroon > 55%, red 5055%, orange 4550%, yellow
4045%, green 3540%, blue 3035%

45.4 Transfer payments

Main article: Transfer payment
Government expenditures that are not acquisition of
goods and services, and instead just represent transfers of
money, such as social security payments, are called transfer payments. These payments are considered to be exhaustive because they do not directly absorb resources or
create output. In other words, the transfer is made with- Government Expenditure as a Percentage of GDP (2014 Index
[9]
out any exchange of goods or services.[7] Examples of of Economic Freedom).
certain transfer payments include welfare (nancial aid),
social security, and government giving subsidies to certain businesses (rms).

45.5 International
spending
45.5.1

government

Per capita

In 2010 the average national government spent $2,376

per citizen, whilst the average for the worlds 20 largest
economies (in terms of GDP) was $16,110 per citizen. Norway and Sweden topped the list with per citizen spending of $40,908 and $26,760 respectively. The
federal government of the USA spent an average of
$11,041 per citizen (per capita), ahead of only South
Korea ($4,557), Brazil ($2,813), Russia ($2,458), China
($1,010), and India ($226) in the twenty largest world
economies.[8]

Tax Burden as a Percentage of GDP (2014 Index of Economic

Freedom).[9]

45.5.2 As a percentage of GDP

This is a list of countries by government spending as a
percentage of gross domestic product (GDP) for the listed
countries, according to the 2014 Index of Economic Freedom[9] by The Heritage Foundation and The Wall Street
Journal. Tax revenue is included for comparison.

45.5. INTERNATIONAL GOVERNMENT SPENDING

45.5.3

United States of America

Government spending in the United States of America occurs at several levels of government, including primarily
federal, state, and local governments. The Organisation
for Economic Co-operation and Development (OECD)
reports that total federal, state and local spending in the
United States was $6.134 trillion in 2010.[10] This is
tracked in National Income and Product Accounts.
Federal spending

241
mines how much to spend on these programs on an annual
basis in annual appropriations bills.
Mandatory spending accounts for two-thirds of all federal
spending. This kind of spending is authorized by permanent laws, and includes insurance programs like Social Security, Medicare/Medicaid, the Supplemental Nutrition Assistance Program, and federal retirement and
disability programs that provide benets to federal civilian employees, members of the military, and veterans.
Spending levels in these areas are mostly determined by
the number of people who request and qualify for the program benets as determined by the agencies. In some
cases, mandatory spending is inuenced by earmarks in
multi-year spending bills like highway bills and farm bills.
All government agencies face congressional oversight and
most programs are updated and amended by congressional legislation, as well as internal agency rules and regulations. U.S. Congress members who seek to inuence
agencies with direct control have at times been prosecuted
or disciplined by the respective House and Senate Ethics
Committees.

State and local spending

The United States Census Bureau conducts a Census of
Governments every ve years for scal years ending in
2 or 7. The latest scal year covered by the Census of
Governments is 2012.

History
The United States Census Bureau publishes historical
data on government spending in the United States in its
Chart showing how the United States Congress has spent the fed- Statistical Abstract of the United States[12] and in its speeral tax revenue, 2010-2014.[11]
cial release of historical statistics in 1976 at the time of
the US Bicentennial.[13]
For more details on this topic, see United States federal
Over the last century, overall government spending in
budget.
the United States has increased substantially from about
seven percent of GDP in 1902 to about 35 percent of
As of September 2001 the U.S. Congressional Budget GDP in 2010. Major spikes in spending occurred in
Oce reported that federal government spending for World War I and World War II.
2004 was projected to be $2.293 trillion, or slightly less When broken down by major function, the history of US
than 20% of the GDP. Of that, $646.7 billion was for net government spending as a percent of GDP shows a slow
interest, $486 billion for defense, $492 billion for Social and consistent increase in education spending; it shows
Security, $473 billion for Medicare and Medicaid, $191 the spikes in defense spending during World War I and
billion for various welfare programs, $136 billion for re- World War II, and the sustained high level maintained
tirement and disability benets, and $64 billion was pro- during the Cold War. Spending on welfare shows a clear
jected to be spent elsewhere.
takeo during the Great Depression and a modest decline
There are two types of government spending discretionary and mandatory. Discretionary spending, which
accounts for roughly one-third of all Federal spending,
includes money for things like the Army, FBI, the Coast
Guard, and highway projects. Congress explicitly deter-

following reform in 1996. Spending on pensions (primarily Social Security) begins to show up in the 1950s.
Health care spending takes o after the birth of Medicare
and Medicaid in the 1960s and shows sustained growth
ever since.

242

45.6 See also

Concepts:
Rahn curve
Government operations

CHAPTER 45. GOVERNMENT SPENDING

[8] CIA World Factbook, population data from 2010, Spending and GDP data from 2011. These numbers fail however to account for State and Local Government Spending which when included bring the per Capital Spending
to $16,755
[9] 2014 Index of Economic Freedom

Public nance

[10] 11. Government expenditure by function (COFOG)".

OECD.Stats. Retrieved 18 April 2012.

Government budget

[11] Federal Budget Spending and the National Debt

Government waste

[12] Statistical Abstract of the United States

Fiscal policy

[13] Bicentennial Edition: Historical Statistics of the United

States, Colonial Times to 1970, Part 2

Tax
Mandatory spending
Taxpayers unions
Specic:
Government spending in the United Kingdom

45.7 References
[1] Frequently Asked Questions: BEA seems to have several dierent measures of government spending. What
are they for and what do they measure?". Bureau of Economic Analysis. May 28, 2010. Retrieved 12 July 2014.
[2] Robert Barro and Vittorio Grilli (1994), European
Macroeconomics, Ch. 1516. Macmillan, ISBN 0-33357764-7.
[3] F. Lequiller, D. Blades: Understanding National Accounts, Paris: OECD 2006, pp. 12730
[4] Gross capital formation Statistics Explained European
Union Statistics Directorate, European Commission
[5] Cohen, Isabelle; Freiling, Thomas; Robinson, Eric (January 2012). The Economic Impact and Financing of Infrastructure Spending (report). Williamsburg, Virginia:
Thomas Jeerson Program in Public Policy, College of
William & Mary. p. 5. Retrieved October 1, 2012.
[6] Hogg, W.; Baskerville, N.; Lemelin, J. (2005). Cost
savings associated with improving appropriate and reducing inappropriate preventive care: Cost-consequences
BMC Health Services Research 5: 20.
analysis.
doi:10.1186/1472-6963-5-20. PMC 1079830. PMID
15755330.
[7] Bishop, Matthew (2012). Economics A-Z terms beginning with T;transfer. The Economist. Retrieved 11 July
2012. Payments that are made without any good or service being received in return. Much PUBLIC SPENDING goes on transfers, such as pensions and WELFARE
benets. Private-sector transfers include charitable donations and prizes to lottery winners.

45.8 External links

Higgs, Robert (2008). Government Growth. In
David R. Henderson (ed.). Concise Encyclopedia
of Economics (2nd ed.). Indianapolis: Library of
Economics and Liberty. ISBN 978-0865976658.
OCLC 237794267.
Seater, John J. (2008). Government Debt and
Decits. In David R. Henderson (ed.). Concise
Encyclopedia of Economics (2nd ed.). Indianapolis: Library of Economics and Liberty. ISBN 9780865976658. OCLC 237794267.
Tullock, Gordon (2002). Government Spending.
In David R. Henderson (ed.). Concise Encyclopedia of Economics (1st ed.). Indianapolis: Library
of Economics and Liberty. OCLC 317650570,
50016270 and 163149563
OECD Government spending statistics
Canadian Governments Compared

Chapter 46

Government nal consumption

expenditure
These ndings mirror the importance of social transfers in kind in European countries, where the share
of household nal consumption expenditure in actual nal consumption of the households is often less
than 80%.

Government nal consumption expenditure (GFCE)

is a transaction of the national accounts use of income account representing government expenditure on goods and
services that are used for the direct satisfaction of individual needs (individual consumption) or collective needs
of members of the community (collective consumption).
It consists of the value of the goods and services produced
by the government itself other than own-account capital
formation and sales and of purchases by the government
of goods and services produced by market producers that
are supplied to households - without any transformation as social transfers in kind (for more detail see for example
[1]
)

46.1 Data

46.2 See also

Final consumption expenditure
Household nal consumption expenditure
Government spending

46.3 Notes

Data on government nal consumption expenditure shed

light on the involvement of governments in providing
goods and services for the direct needs of the population.
A high government share in the provision of individual
consumption goods and services is often found in countries known as welfare states. This may be illustrated by
looking at data for the European Union (downloadable
from Eurostats database providing gures on government
expenditure):

[1] F. Lequiller, D. Blades: Understanding National Accounts, Paris: OECD 2006, p. 127-130

46.4 References
Databases
Eurostat: National accounts data (including
government nal consumption expenditure),
member states of the European Union and
other countries

Approximately one quarter of the economy-wide nal consumption expenditure in the European Union
of 27 member states is made by governments; countries with relatively large government shares in nal consumption expenditure are Denmark, Luxembourg, the Netherlands, Finland and Sweden
(around one-third of their nal consumption expenditure).
60% of the governments nal consumption expenditure in the European Union of 27 member states
is individual consumption; the largest shares of individual consumption in government nal consumption expenditure are observed for Sweden (more
than 70%).

Further information:
Eurostat: National accounts website
F. Malherbe: Le site de la comptabilit nationale (in French language)

46.5 External links

243

Government nal consumption expenditure

Chapter 47

Government operations
Law enforcement

This article aims to describe the extent of operations and

processes of governments around the world at all levels.

Police
Defence and armed forces

47.1 Size of economic footprint

Postal service
Transport (e.g. government transportation)

Main articles: Government ownership and Government

spending

Counterintelligence and anti-terrorism services

The scale to which government should exist and operate

in the world is a matter of debate. Government spend47.3 Goods
ing in developed countries varies considerably but generally makes up between about 30% and 70% of their
GDP. One major exception is the United States, where Government agencies may produce goods like:
central government spending takes up less than 20% of
Coal
GDP, although the combined spending of all administrations reach 36%.
Electrical infrastructure
Oil (e.g. Pemex)

47.2 Services

Roads, bridges, tunnels

Sewers

Government agencies may produce services like:

Steel

Communications

Water infrastructure

Education (e.g. community college)

Emergency services

47.4 Local government

Entertainment (e.g. Canadian Broadcasting Corporation)

At the level of local government, territorial or other authorities may set up government corporations such as
Entitlements
"Local Authority Trading Enterprises" (LATEs).
Financial services
Financing
Fire ghting
Healthcare

47.5 Commonwealth of Nations

See also: crown corporation, state-owned enterprises of
New Zealand

In monarchical commonwealth countries country-wide

government corporations often use the style "crown cor Law (e.g. legislative, judicial, and regulatory activi- poration". Notable exceptions include both the stateties)
owned enterprises and the crown entities in New Zealand.
Insurance

244

47.10. EXTERNAL LINKS

245

Examples of crown corporations include the Canadian 47.10

Broadcasting Corporation (CBC) in Canada and Air
Canada before it underwent privatisation. Cabinet min47.10.1
isters (ministers of the crown) often control the shares in
such public corporations.
All levels

47.6 United Kingdom

External links
United States

Current Report: Financial Report of the United

States: Publications & Guidance: Financial Management Service

Main article: United Kingdom budget

Federal level
For partial government employment statistics, see List of
largest United Kingdom employers.

47.7 United States

Main article: United States federal budget
In the United States, businesses that are government
owned include Amtrak and the United States Postal Service. Many states have government owned businesses for
operations as well. Generally speaking, a statute passed
by a legislature specically sets up a government owned
company in order to undertake a specic public purpose
with public funds or public property.
For employment statistics, see List of largest employers
in the United States.

47.8 Privatization
Main article: privatization
Privatization is the transfer of ownership from the public
sector (government) to the private sector (business).

47.9 See also

Government
Government debt
Government ownership
Government spending
Government-sponsored enterprise
Public sector
State-owned enterprise

Current Report: Combined Statement of Receipts,

Outlays, and Balances of the United States Government (Combined Statement): Publications & Guidance: Financial Management Service

Chapter 48

Redistribution of income and wealth

fewer or no taxes. While the persons receiving transfers from such programs may prefer to be directly given
cash, these programs may be more palatable to society
than cash assistance, as they give society some measure
of control over how the funds are spent.[4]
The dierence between the Gini index for the income distribution before taxation and the Gini index after taxation
is an indicator for the eects of such taxation.
Wealth redistribution can be implemented through land
reform that transfers ownership of land from one category of people to another, or through inheritance taxes
or direct wealth taxes. Before-and-after Gini coecients
for the distribution of wealth can be compared.

U.S. mean family net worth by percentile of net worth (1989)

Redistribution of income and redistribution of wealth

are respectively the transfer of income and of wealth
(including physical property) from some individuals
to others by means of a social mechanism such as
taxation, monetary policies, welfare, land reform, charity,
conscation, divorce or tort law.[1] The term typically
refers to redistribution on an economy-wide basis rather
than between selected individuals, and it typically refers
to redistributions from those who have more to those who
have less.

The objectives of income redistribution are varied and almost always include the funding of public services. Supporters of redistributive policies argue that less stratied
economies are more socially just.[5]

Today, income redistribution occurs in some form in

most democratic countries. In a progressive income
tax system, a high income earner will pay a higher tax
rate than a low income earner. Another taxation-based
method of redistributing income is the negative income
tax.

Some proponents of redistribution argue that capitalism

results in an externality that creates unequal wealth
distribution.[6] Studies show that a lower rate of redistribution in a given society increases the inequality found
among future incomes, due to restraints on wealth investments in both human and physical capital.[7]

Two other common types of governmental redistribution of income are subsidies and vouchers (such as food
stamps). These transfer payment programs are funded
through general taxation, but benet the poor, who pay

Some argue that wealth and income inequality are a cause

of economic crises, and that reducing these inequalities
is one way to prevent or ameliorate economic crises,
with redistribution thus beneting the economy overall.

48.2 Objectives

One basis for redistribution is the concept of distributive

justice, whose premise is that money and resources ought
to be distributed in such a way as to lead to a socially just,
The desirability and eects of redistribution are actively and possibly more nancially egalitarian, society. Andebated on ethical and economic grounds. The subject other argument is that a larger middle class benets an
includes analysis of its rationales, objectives, means, and economy by enabling more people to be consumers, while
providing equal opportunities for individuals to reach a
policy eectiveness.[2][3]
better standard of living. Seen for example in the work
of John Rawls, another argument is that a truly fair society would be organized in a manner beneting the least
advantaged, and any inequality would be permissible only
48.1 Types of redistribution
to the extent that it benets the least advantaged.

246

48.4. SEE ALSO

247

This view was associated with the underconsumptionism

school in the 19th century, now considered an aspect
of some schools of Keynesian economics; it has also
been advanced, for dierent reasons, by Marxian economics. It was particularly advanced in the US in the
1920s by Waddill Catchings and William Trufant Foster.[8][9] There is currently a great debate concerning the
extent to which the worlds extremely rich have become
richer over recent decades. Thomas Piketty Capital in the
Twenty-First Century is at the forefront, critiqued in certain publications such as The Economist. [10]

48.2.1

A Moral Obligation

Thomas Pogge argues that the distribution of wealth is

not natural, it is a manmade concept.The design in the
distribution of wealth global via institutional design and
decisions that have eects on how much inequality there
will be, on how much poverty there will be. [11] He also
states the uneven distribution of wealth leads to world
poverty.[12] Peter Singer argument contrasts to Thomas
Pogges in that he states we have an individual moral obligation to help the poor.[13][14]

Number of high-net-worth individuals in the world in 2011[15]

rates of social goods (life expectancy, educational performance, trust among strangers, womens status, social
mobility, even numbers of patents issued per capita), on
the other.[16] The authors argue inequality leads to the social ills through the psychosocial stress, status anxiety it
creates.[17]

Pogge argues that the redistribution of wealth is an institutional moral obligation while Singer believes it is a A 2011 report by the International Monetary Fund by Andrew G. Berg and Jonathan D. Ostry found a strong assopersonal moral obligation.
ciation between lower levels of inequality and sustained
periods of economic growth. Developing countries (such
48.2.2 'Min-max criterion' for social wel- as Brazil, Cameroon, Jordan) with high inequality have
succeeded in initiating growth at high rates for a few
fare
years but longer growth spells are robustly associated
with more equality in the income distribution.[18][19]
One way of measuring societal well-being is the social
welfare function, or the concept that societys utility is
made up in some way through the utilities of its individuals. At one polar extreme of the possible social welfare 48.4 See also
functions is the 'min-max' or 'minimax' function:
Economic policy
W = min(Y1 , Y2 , , Yn )

Poverty reduction

This states that the welfare (utility) W of society is dependent solely on the welfare YI of the lowest-welfare
individual (Yi), or in terms of income, the income of the
lowest-income individual.

Social inequality
Wealth concentration
Lists:

48.3 Economic eects of inequality

List of countries by income equality

See also: Economic inequality Inequality and economic

List of countries by inequality-adjusted HDI
growth
Using statistics from 23 developed countries and the 50
states of the US, British researchers Richard G. Wilkin- Opposite tendencies:
son and Kate Pickett show a correlation between income inequality and higher rates of health and social
Accumulation by dispossession
problems (obesity, mental illness, homicides, teenage
births, incarceration, child conict, drug use), and lower
Primitive accumulation of capital

248

CHAPTER 48. REDISTRIBUTION OF INCOME AND WEALTH

48.5 References

48.6 External links

[1] Redistribution. Stanford Encyclopedia of Philosophy.

Stanford University. 2 July 2004. Retrieved 13 August
2010. The social mechanism, such as a change in tax laws,
monetary policies, or tort law, that engenders the redistribution of goods among these subjects

Levy, Frank (2008). Distribution of Income. In

David R. Henderson (ed.). Concise Encyclopedia
of Economics (2nd ed.). Indianapolis: Library of
Economics and Liberty. ISBN 978-0865976658.
OCLC 237794267.

[2] F.A. Cowell ([1987] 2008). redistribution of income and

wealth,The New Palgrave Dictionary of Economics, 2nd
Edition, TOC.

Small calculus of inequality measures

[3] Rugaber, Christopher S.; Boak, Josh (January 27, 2014).

Wealth gap: A guide to what it is, why it matters. AP
News. Retrieved January 27, 2014.
[4] Harvey S. Rosen & Ted Gayer, Public Finance pp. 271
72 (2010).
[5] Redistribution (Stanford Encyclopedia of Philosophy)
[6] Marx, K. A Contribution to the Critique of Political Economy. Progress Publishers, Moscow, 1977
[7] http://www.jstor.org/stable/117283 Unequal Societies:
Income Distribution and the Social Contract.
[8] (Dorfman 1959)
[9] Allgoewer, Elisabeth (May 2002). Underconsumption
theories and Keynesian economics. Interpretations of the
Great Depression. Discussion paper no. 2002-14.
[10] Forget the 1%; Free Exchange, The Economist, 8 November 2014, p79.
[11] Thomas Pogge on the Past, Present and Future of Global
Poverty
[12] Thomas Pogge on Global Poverty
[13] Famine, Auence, and Morality
[14] Fighting Poverty
[15] http://www.taxjustice.net/cms/upload/pdf/Price_of_
Offshore_Revisited_120722.pdf
[16] Statistics and graphs from Wilkinson and Pickett research.
[17] The Spirit Level: how 'ideas wreckers turned book into
political punchbag| Robert Booth| The Guardian| 13 August 2010
[18] Inequality and Unsustainable Growth: Two Sides of the
Same Coin? Andrew G. Berg and Jonathan D. Ostry| IMF
STAFF DISCUSSION NOTE | April 8, 2011
[19] Berg, Andrew G.; Ostry, Jonathan D. (2011). Equality
and Eciency. Finance and Development (International
Monetary Fund) 48 (3). Retrieved September 10, 2012.

Chapter 49

Transfer payment
In economics, a transfer payment (or government
transfer or simply transfer) is a redistribution of income
in the market system. These payments are considered
to be non-exhaustive because they do not directly absorb
resources or create output. In other words, the transfer
is made without any exchange of goods or services.[1]
Examples of certain transfer payments include welfare
(nancial aid), social security, and government making
subsidies for certain businesses (rms).

2012. Payments that are made without any good or service being received in return. Much PUBLIC SPENDING goes on transfers, such as pensions and WELFARE
benets. Private-sector transfers include charitable donations and prizes to lottery winners.

49.3 External links

Use for administrative: In some federal systems the term

can be also used to refer to payments from one order of
a government to another; for example in Canada, transfer payments usually refer to a system of payments from
the federal government to the provinces. Major Canadian transfer payments include equalization payments,
the Canada Health Transfer and the Canada Social Transfer (formerly the Canada Health and Social Transfer) and
Territorial Formula Financing. Transfer payments are not
a part of the national income so they are cut from national
income to get n.n.p in order to arrive national income such
payments are bad debts incurred by banks, payments of
pensions, charity, scholarships etc. In the UK they have
several transfer payments such as EMA and a job seekers
allowance.

49.1 See also

Public nance
Government budget
Transfer payments multiplier
Workfare
Welfare state
Barnett formula

49.2 References
[1] Bishop, Matthew (2012). Economics A-Z terms beginning with T;transfer. The Economist. Retrieved 11 July

249

Department of Finance (Canada): Federal Transfers

to Provinces and Territories

Chapter 50

Government revenue
Government revenue is money received by a
government. It is an important tool of the scal
policy of the government and is the opposite factor of
government spending. Revenues earned by the government are received from sources such as taxes levied on
the incomes and wealth accumulation of individuals
and corporations and on the goods and services produced, exports and imports, non-taxable sources such as
government-owned corporations' incomes, central bank
revenue and capital receipts in the form of external loans
and debts from international nancial institutions.

50.1 Sources
Governments across the world earn public revenue from
the following main sources:
Tax revenue
Non-tax revenue
Capital receipts

50.2 See also

Government budget
Government budget by country

50.3 References
Chisholm, Hugh, ed.
(1911).
"Revenue".
Encyclopdia Britannica (11th ed.). Cambridge
University Press.

250

Chapter 51

Tax
A tax (from the Latin taxo; rate) is a nancial charge or
other levy imposed upon a taxpayer (an individual or legal
entity) by a state or the functional equivalent of a state to
fund various public expenditures.[1] A failure to pay, or
evasion of or resistance to taxation, is usually punishable
by law. Taxes are also imposed by many administrative
divisions. Taxes consist of direct or indirect taxes and
may be paid in money or as its labour equivalent. Few
countries impose no taxation at all, such as the United
Arab Emirates.[2]

money; but in-kind and corve taxation are characteristic

of traditional or pre-capitalist states and their functional
equivalents. The method of taxation and the government
expenditure of taxes raised is often highly debated in
politics and economics. Tax collection is performed by a
government agency such as the Canada Revenue Agency,
the Internal Revenue Service (IRS) in the United States,
or Her Majestys Revenue and Customs (HMRC) in the
United Kingdom. When taxes are not fully paid, the state
may impose civil penalties (such as nes or forfeiture) or
criminal penalties (such as incarceration)[3] on the nonpaying entity or individual.

51.1 Overview
51.2 Purposes and eects

Pieter Brueghel the Younger, The tax collectors oce, 1640

The legal denition and the economic denition of taxes

dier in that economists do not regard many transfers to
governments as taxes. For example, some transfers to the
public sector are comparable to prices. Examples include
tuition at public universities and fees for utilities provided
by local governments. Governments also obtain resources
by creating money and coins (for example, by printing bills and by minting coins), through voluntary gifts
(for example, contributions to public universities and museums), by imposing penalties (such as trac nes), by
borrowing, and by conscating wealth. From the view of
economists, a tax is a non-penal, yet compulsory transfer
of resources from the private to the public sector levied
on a basis of predetermined criteria and without reference to specic benet received.

Money provided by taxation has been used by states

and their functional equivalents throughout history to
carry out many functions. Some of these include expenditures on war, the enforcement of law and public
order, protection of property, economic infrastructure
(roads, legal tender, enforcement of contracts, etc.),
public works, social engineering, subsidies, and the operation of government itself. A portion of taxes also
go to pay o the states debt and the interest this
debt accumulates. Governments also use taxes to fund
welfare and public services. These services can include
education systems, health care systems, pensions for the
elderly, unemployment benets, and public transportation. Energy, water and waste management systems are
also common public utilities. Colonial and modernizing
states have also used cash taxes to draw or force reluctant
subsistence producers into cash economies.

Most economists, especially neo-classical economists, argue that all taxation creates market distortion and results
in economic ineciency. They have therefore sought
to identify the kind of tax system that would minimize
this distortion. [4] Recent scholarship suggests that in the
United States, the federal government eectively taxes investments in higher education more heavily than it subsidizes higher education, thereby contributing to a shortage
of skilled workers and unusually high dierences in pretax earnings between highly educated and less educated
In modern taxation systems, governments levy taxes in workers.[4]
251

252
Governments use dierent kinds of taxes and vary the tax
rates. This is done to distribute the tax burden among individuals or classes of the population involved in taxable
activities, such as business, or to redistribute resources
between individuals or classes in the population. Historically, the nobility were supported by taxes on the poor;
modern social security systems are intended to support
the poor, the disabled, or the retired by taxes on those
who are still working. In addition, taxes are applied to
fund foreign aid and military ventures, to inuence the
macroeconomic performance of the economy (the governments strategy for doing this is called its scal policy;
see also tax exemption), or to modify patterns of consumption or employment within an economy, by making
some classes of transaction more or less attractive.
A nations tax system is often a reection of its communal values and/or the values of those in power. To create a system of taxation, a nation must make choices regarding the distribution of the tax burdenwho will pay
taxes and how much they will payand how the taxes collected will be spent. In democratic nations where the public elects those in charge of establishing the tax system,
these choices reect the type of community that the public wishes to create. In countries where the public does
not have a signicant amount of inuence over the system of taxation, that system may be more of a reection
on the values of those in power.
All large businesses incur administrative costs in the process of delivering revenue collected from customers to the
suppliers of the goods or services being purchased. Taxation is no dierent, the resource collected from the public
through taxation is always greater than the amount which
can be used by the government. The dierence is called
the compliance cost and includes for example the labour
cost and other expenses incurred in complying with tax
laws and rules. The collection of a tax in order to spend it
on a specied purpose, for example collecting a tax on alcohol to pay directly for alcoholism rehabilitation centres,
is called hypothecation. This practice is often disliked by
nance ministers, since it reduces their freedom of action.
Some economic theorists consider the concept to be intellectually dishonest since, in reality, money is fungible.
Furthermore, it often happens that taxes or excises initially levied to fund some specic government programs
are then later diverted to the government general fund.
In some cases, such taxes are collected in fundamentally
inecient ways, for example highway tolls.
Since governments also resolve commercial disputes, especially in countries with common law, similar arguments
are sometimes used to justify a sales tax or value added
tax. Others (e.g., libertarians) argue that most or all
forms of taxes are immoral due to their involuntary (and
therefore eventually coercive/violent) nature. The most
extreme anti-tax view is anarcho-capitalism, in which
the provision of all social services should be voluntarily
bought by the person(s) using them.

CHAPTER 51. TAX

51.3 Kinds of taxes

The Organisation for Economic Co-operation and Development (OECD) publishes an analysis of tax systems of
member countries. As part of such analysis, OECD developed a denition and system of classication of internal taxes,[5] generally followed below. In addition, many
countries impose taxes (taris) on the import of goods.

51.3.1 Taxes on income

Income tax
Main article: Income tax
Many jurisdictions tax the income of individuals and
business entities, including corporations. Generally the
tax is imposed on net prots from business, net gains, and
other income. Computation of income subject to tax may
be determined under accounting principles used in the jurisdiction, which may be modied or replaced by tax law
principles in the jurisdiction. The incidence of taxation
varies by system, and some systems may be viewed as
progressive or regressive. Rates of tax may vary or be
constant (at) by income level. Many systems allow individuals certain personal allowances and other nonbusiness
reductions to taxable income, although business deductions tend to be favored over personal deductions.[4]
Personal income tax is often collected on a pay-as-youearn basis, with small corrections made soon after the end
of the tax year. These corrections take one of two forms:
payments to the government, for taxpayers who have not
paid enough during the tax year; and tax refunds from the
government for those who have overpaid. Income tax systems will often have deductions available that lessen the
total tax liability by reducing total taxable income. They
may allow losses from one type of income to be counted
against another. For example, a loss on the stock market
may be deducted against taxes paid on wages. Other tax
systems may isolate the loss, such that business losses can
only be deducted against business tax by carrying forward
the loss to later tax years.

Negative income tax

Main article: Negative income tax
In economics, a negative income tax (abbreviated NIT)
is a progressive income tax system where people earning
below a certain amount receive supplemental pay from the
government instead of paying taxes to the government.

51.3. KINDS OF TAXES

253

Capital gains tax

51.3.3 Taxes on payroll or workforce

Main article: Capital gains tax

Unemployment and similar taxes are often imposed on

employers based on total payroll. These taxes may be
imposed in both the country and sub-country levels.[9]

Most jurisdictions imposing an income tax treat capital

gains as part of income subject to tax. Capital gain is
generally a gain on sale of capital assets that is those assets not held for sale in the ordinary course of business.
Capital assets include personal assets in many jurisdictions. Some jurisdictions provide preferential rates of tax
or only partial taxation for capital gains. Some jurisdictions impose dierent rates or levels of capital gains taxation based on the length of time the asset was held. Because tax rates are often much lower for capital gains than
for ordinary income, there is widespread controversy and
dispute about the proper denition of capital. Some tax
scholars have argued that dierences in the ways dierent kinds of capital and investment are taxed contribute
to economic distortions.[4]

51.3.4 Taxes on property

Recurrent property taxes may be imposed on immovable property (real property) and some classes of movable
property. In addition, recurrent taxes may be imposed on
net wealth of individuals or corporations.[10] Many jurisdictions impose estate tax, gift tax or other inheritance
taxes on property at death or gift transfer. Some jurisdictions impose taxes on nancial or capital transactions.
Property tax
Main articles: Property tax and Land value tax

Corporate tax

A property tax (or millage tax) is an ad valorem tax levy

on the value of property that the owner of the property is
Main article: Corporate tax
required to pay to a government in which the property is
situated. Multiple jurisdictions may tax the same propCorporate tax refers to income, capital, net worth, or erty. There are three general varieties of property: land,
other taxes imposed on corporations. Rates of tax and improvements to land (immovable man-made things, e.g.
the taxable base for corporations may dier from those buildings) and personal property (movable things). Real
for individuals or other taxable persons.
estate or realty is the combination of land and improvements to land.

51.3.2

Social security contributions

Many countries provide publicly funded retirement or

health care systems.[6] In connection with these systems,
the country typically requires employers and/or employees to make compulsory payments.[7] These payments
are often computed by reference to wages or earnings
from self-employment. Tax rates are generally xed,
but a dierent rate may be imposed on employers than
on employees.[8] Some systems provide an upper limit
on earnings subject to the tax. A few systems provide
that the tax is payable only on wages above a particular amount. Such upper or lower limits may apply for
retirement but not health care components of the tax.
Some have argued that such taxes on wages are a form of
forced savings and not really a tax, while others point to
redistribution through such systems between generations
(from newer cohorts to older cohorts) and across income
levels (from higher income levels to lower income levels) which suggest that such programs are really tax and
spending programs.[4] Some tax scholars argue that supporting social security programs exclusively through taxes
on wages, rather than through broader taxes that include
capital, creates distortions and underinvestment in human
capital, since the returns to such investments will be taxes
as wages.[4]

Property taxes are usually charged on a recurrent basis

(e.g., yearly). A common type of property tax is an annual charge on the ownership of real estate, where the tax
base is the estimated value of the property. For a period
of over 150 years from 1695 a window tax was levied in
England, with the result that one can still see listed buildings with windows bricked up in order to save their owners money. A similar tax on hearths existed in France
and elsewhere, with similar results. The two most common type of event driven property taxes are stamp duty,
charged upon change of ownership, and inheritance tax,
which is imposed in many countries on the estates of the
deceased.
In contrast with a tax on real estate (land and buildings),
a Land Value Tax (or LVT) is levied only on the unimproved value of the land (land in this instance may mean
either the economic term, i.e., all natural resources, or
the natural resources associated with specic areas of the
Earths surface: lots or land parcels). Proponents of
land value tax argue that it is economically justied, as
it will not deter production, distort market mechanisms
or otherwise create deadweight losses the way other taxes
do.[11]
When real estate is held by a higher government unit or
some other entity not subject to taxation by the local government, the taxing authority may receive a payment in

254

CHAPTER 51. TAX

lieu of taxes to compensate it for some or all of the fore- of the transaction. In most countries the stamp has been
gone tax revenues.
abolished but stamp duty remains. Stamp duty is levied in
the
UK on the purchase of shares and securities, the issue
In many jurisdictions (including many American states),
of
bearer
instruments, and certain partnership transacthere is a general tax levied periodically on residents who
tions.
Its
modern
derivatives, stamp duty reserve tax and
own personal property (personalty) within the jurisdicstamp
duty
land
tax,
are respectively charged on transaction. Vehicle and boat registration fees are subsets of this
tions
involving
securities
and land. Stamp duty has the
kind of tax. The tax is often designed with blanket covereect
of
discouraging
speculative
purchases of assets by
age and large exceptions for things like food and clothing.
decreasing liquidity. In the United States, transfer tax is
Household goods are often exempt when kept or used
within the household.[12] Any otherwise non-exempt ob- often charged by the state or local government and (in the
case of real property transfers) can be tied to the recordject can lose its exemption if regularly kept outside the
[12]
household. Thus, tax collectors often monitor newspa- ing of the deed or other transfer documents.
per articles for stories about wealthy people who have lent
art to museums for public display, because the artworks
Wealth (net worth) tax
have then become subject to personal property tax.[12] If
an artwork had to be sent to another state for some touchups, it may have become subject to personal property tax Main article: Wealth tax
in that state as well.[12]
Some countries governments will require declaration of
the tax payers balance sheet (assets and liabilities), and
Inheritance tax
from that exact a tax on net worth (assets minus liabilities), as a percentage of the net worth, or a percentage
Main article: Inheritance tax
of the net worth exceeding a certain level. The tax may
be levied on "natural" or legal persons. An example is
Inheritance tax, estate tax, and death tax or duty are the Frances ISF.
names given to various taxes which arise on the death of
an individual. In United States tax law, there is a distinction between an estate tax and an inheritance tax: the 51.3.5 Taxes on goods and services
former taxes the personal representatives of the deceased,
while the latter taxes the beneciaries of the estate. How- Value added tax (Goods and Services Tax)
ever, this distinction does not apply in other jurisdictions;
for example, if using this terminology UK inheritance tax Main article: Value added tax
would be an estate tax.
Expatriation tax
Main article: Expatriation tax
An expatriation tax is a tax on individuals who renounce
their citizenship or residence. The tax is often imposed
based on a deemed disposition of all the individuals
property. One example is the United States under the
American Jobs Creation Act, where any individual who
has a net worth of $2 million or an average income-tax
liability of $127,000 who renounces his or her citizenship and leaves the country is automatically assumed to
have done so for tax avoidance reasons and is subject to
a higher tax rate.[13]
Transfer tax
Main article: Transfer tax

A value added tax (VAT), also known as Goods and Services Tax (G.S.T), Single Business Tax, or Turnover Tax
in some countries, applies the equivalent of a sales tax to
every operation that creates value. To give an example,
sheet steel is imported by a machine manufacturer. That
manufacturer will pay the VAT on the purchase price, remitting that amount to the government. The manufacturer will then transform the steel into a machine, selling
the machine for a higher price to a wholesale distributor. The manufacturer will collect the VAT on the higher
price, but will remit to the government only the excess
related to the value added (the price over the cost of
the sheet steel). The wholesale distributor will then continue the process, charging the retail distributor the VAT
on the entire price to the retailer, but remitting only the
amount related to the distribution mark-up to the government. The last VAT amount is paid by the eventual retail
customer who cannot recover any of the previously paid
VAT. For a VAT and sales tax of identical rates, the total
tax paid is the same, but it is paid at diering points in
the process.

Historically, in many countries, a contract needed to have VAT is usually administrated by requiring the company
a stamp axed to make it valid. The charge for the stamp to complete a VAT return, giving details of VAT it has
was either a xed amount or a percentage of the value been charged (referred to as input tax) and VAT it has

51.3. KINDS OF TAXES

255

charged to others (referred to as output tax). The dier- Excises

ence between output tax and input tax is payable to the
Local Tax Authority. If input tax is greater than output Main article: Excise
tax the company can claim back money from the Local
Tax Authority.
Unlike an ad valorem, an excise is not a function of the
value of the product being taxed. Excise taxes are based
on the quantity, not the value, of product purchased.
Sales taxes
For example, in the United States, the Federal government imposes an excise tax of 18.4 cents per U.S. galMain article: Sales tax
lon (4.86/L) of gasoline, while state governments levy
an additional 8 to 28 cents per U.S. gallon. Excises on
Sales taxes are levied when a commodity is sold to its nal particular commodities are frequently hypothecated. For
consumer. Retail organizations contend that such taxes example, a fuel excise (use tax) is often used to pay for
discourage retail sales. The question of whether they are public transportation, especially roads and bridges and for
generally progressive or regressive is a subject of much the protection of the environment. A special form of hycurrent debate. People with higher incomes spend a lower pothecation arises where an excise is used to compensate
proportion of them, so a at-rate sales tax will tend to be a party to a transaction for alleged uncontrollable abuse;
regressive. It is therefore common to exempt food, utili- for example, a blank media tax is a tax on recordable
ties and other necessities from sales taxes, since poor peo- media such as CD-Rs, whose proceeds are typically allople spend a higher proportion of their incomes on these cated to copyright holders. Critics charge that such taxes
commodities, so such exemptions make the tax more pro- blindly tax those who make legitimate and illegitimate usgressive. This is the classic You pay for what you spend ages of the products; for instance, a person or corporation
tax, as only those who spend money on non-exempt (i.e. using CD-Rs for data archival should not have to subsidize the producers of popular music.
luxury) items pay the tax.
A small number of U.S. states rely entirely on sales taxes Excises (or exemptions from them) are also used to modfor state revenue, as those states do not levy a state in- ify consumption patterns (social engineering). For excome tax. Such states tend to have a moderate to large ample, a high excise is used to discourage alcohol conamount of tourism or inter-state travel that occurs within sumption, relative to other goods. This may be combined
their borders, allowing the state to benet from taxes with hypothecation if the proceeds are then used to pay
from people the state would otherwise not tax. In this for the costs of treating illness caused by alcohol abuse.
way, the state is able to reduce the tax burden on its citi- Similar taxes may exist on tobacco, pornography, etc.,
zens. The U.S. states that do not levy a state income tax and they may be collectively referred to as "sin taxes". A
are Alaska, Tennessee, Florida, Nevada, South Dakota, carbon tax is a tax on the consumption of carbon-based
Texas,[14] Washington state, and Wyoming. Addition- non-renewable fuels, such as petrol, diesel-fuel, jet fuels,
ally, New Hampshire and Tennessee levy state income and natural gas. The object is to reduce the release of cartaxes only on dividends and interest income. Of the above bon into the atmosphere. In the United Kingdom, vehicle
states, only Alaska and New Hampshire do not levy a state excise duty is an annual tax on vehicle ownership.
sales tax. Additional information can be obtained at the
Federation of Tax Administrators website.
In the United States, there is a growing movement[15]
for the replacement of all federal payroll and income
taxes (both corporate and personal) with a national retail sales tax and monthly tax rebate to households of
citizens and legal resident aliens. The tax proposal is
named FairTax. In Canada, the federal sales tax is called
the Goods and Services tax (GST) and now stands at
5%. The provinces of British Columbia, Saskatchewan,
Manitoba, and Prince Edward Island also have a provincial sales tax [PST]. The provinces of Nova Scotia, New
Brunswick, Newfoundland & Labrador, and Ontario have
harmonized their provincial sales taxes with the GST
Harmonized Sales Tax [HST], and thus is a full VAT. The
province of Quebec collects the Quebec Sales Tax [QST]
which is based on the GST with certain dierences. Most
businesses can claim back the GST, HST and QST they
pay, and so eectively it is the nal consumer who pays
the tax.

51.3.6 Tari

Main article: Tari

An import or export tari (also called customs duty or
impost) is a charge for the movement of goods through a
political border. Taris discourage trade, and they may
be used by governments to protect domestic industries.
A proportion of tari revenues is often hypothecated to
pay government to maintain a navy or border police. The
classic ways of cheating a tari are smuggling or declaring a false value of goods. Tax, tari and trade rules in
modern times are usually set together because of their
common impact on industrial policy, investment policy,
and agricultural policy. A trade bloc is a group of allied
countries agreeing to minimize or eliminate taris against
trade with each other, and possibly to impose protective
taris on imports from outside the bloc. A customs union

256

CHAPTER 51. TAX

has a common external tari, and the participating coun- 51.3.8 Descriptive labels given some taxes
tries share the revenues from taris on goods entering the
Ad valorem and per unit
customs union.
In some societies, taris also could be imposed by local
Main articles: Ad valorem tax and Per unit tax
authorities on the movement of goods between regions
(or via specic internal gateways). A notable example is
the likin, which became an important revenue source for An ad valorem tax is one where the tax base is the value
of a good, service, or property. Sales taxes, taris, proplocal governments in the late Qing China.
erty taxes, inheritance taxes, and value added taxes are
dierent types of ad valorem tax. An ad valorem tax is
51.3.7 Other taxes
typically imposed at the time of a transaction (sales tax
or value added tax (VAT)) but it may be imposed on an
License fees
annual basis (property tax) or in connection with another
signicant event (inheritance tax or taris).
Occupational taxes or license fees may be imposed on
businesses or individuals engaged in certain businesses. In contrast to ad valorem taxation is a per unit tax, where
the tax base is the quantity of something, regardless of its
Many jurisdictions impose a tax on vehicles.
price. An excise tax is an example.
Poll tax
Main article: Poll tax
A poll tax, also called a per capita tax, or capitation tax,
is a tax that levies a set amount per individual. It is an
example of the concept of xed tax. One of the earliest
taxes mentioned in the Bible of a half-shekel per annum
from each adult Jew (Ex. 30:1116) was a form of poll
tax. Poll taxes are administratively cheap because they
are easy to compute and collect and dicult to cheat.
Economists have considered poll taxes economically efcient because people are presumed to be in xed supply
and poll taxes therefore do not lead to economic distortions. However, poll taxes are very unpopular because
poorer people pay a higher proportion of their income
than richer people.[4] In addition, the supply of people
is in fact not xed over time: on average, couples will
choose to have fewer children if a poll tax is imposed.[16]
The introduction of a poll tax in medieval England was
the primary cause of the 1381 Peasants Revolt. Scotland was the rst to be used to test the new poll tax in
1989 with England and Wales in 1990. The change from
a progressive local taxation based on property values to
a single-rate form of taxation regardless of ability to pay
(the Community Charge, but more popularly referred to
as the Poll Tax), led to widespread refusal to pay and to
incidents of civil unrest, known colloquially as the 'Poll
Tax Riots'.
Other
Some types of taxes have been proposed but not actually
adopted in any major jurisdiction. These include:
Bank tax
Financial transaction taxes including currency transaction taxes

Consumption tax
Main article: Consumption tax
Consumption tax refers to any tax on non-investment
spending, and can be implemented by means of a sales
tax, consumer value added tax, or by modifying an income tax to allow for unlimited deductions for investment
or savings.
Environmental tax
See also: Ecotax, Gas Guzzler Tax and Polluter pays
principle
This includes natural resources consumption tax, greenhouse gas tax (Carbon tax), sulfuric tax, and others.
The stated purpose is to reduce the environmental impact
by repricing.
Proportional, progressive, regressive, and lump-sum
An important feature of tax systems is the percentage of
the tax burden as it relates to income or consumption. The
terms progressive, regressive, and proportional are used
to describe the way the rate progresses from low to high,
from high to low, or proportionally. The terms describe a
distribution eect, which can be applied to any type of tax
system (income or consumption) that meets the denition.
A progressive tax is a tax imposed so that the
eective tax rate increases as the amount to which
the rate is applied increases.
The opposite of a progressive tax is a regressive tax,
where the eective tax rate decreases as the amount
to which the rate is applied increases. This eect is

51.4. HISTORY

257

commonly produced where means testing is used to

withdraw tax allowances or state benets.

possibly graduated for vehicle type, or for distance

on long routes.

In between is a proportional tax, where the eective

tax rate is xed, while the amount to which the rate
is applied increases.

User fees, such as those charged for use of parks or

other government owned facilities.

Ruling fees charged by governmental agencies to

A lump-sum tax is a tax that is a xed amount, no
make determinations in particular situations.
matter the change in circumstance of the taxed entity. This in actuality is a regressive tax as those with
lower income must use higher percentage of their in- Some scholars refer to certain economic eects as taxes,
come than those with higher income and therefore though they are not levies imposed by governments.
the eect of the tax reduces as a function of income. These include:
The terms can also be used to apply meaning to the taxation of select consumption, such as a tax on luxury goods
and the exemption of basic necessities may be described
as having progressive eects as it increases a tax burden
on high end consumption and decreases a tax burden on
low end consumption.[17][18][19]
Direct and indirect

Ination tax: the economic disadvantage suered by

holders of cash and cash equivalents in one denomination of currency due to the eects of expansionary
monetary policy[23]
Financial repression: Government policies such as
interest rate caps on government debt, nancial regulations such as reserve requirements and capital
controls, and barriers to entry in markets where the
government owns or controls businesses.[24]

Main articles: Direct tax and Indirect tax

Taxes are sometimes referred to as direct taxes or indirect taxes. The meaning of these terms can vary in
dierent contexts, which can sometimes lead to confusion. An economic denition, by Atkinson, states that
"...direct taxes may be adjusted to the individual characteristics of the taxpayer, whereas indirect taxes are levied
on transactions irrespective of the circumstances of buyer
or seller.[20] According to this denition, for example,
income tax is direct, and sales tax is indirect. In law,
the terms may have dierent meanings. In U.S. constitutional law, for instance, direct taxes refer to poll taxes and
property taxes, which are based on simple existence or
ownership. Indirect taxes are imposed on events, rights,
privileges, and activities.[21] Thus, a tax on the sale of
property would be considered an indirect tax, whereas the
tax on simply owning the property itself would be a direct
tax.

51.3.9

Fees and eective taxes

Governments may charge user fees, tolls, or other types

of assessments in exchange of particular goods, services,
or use of property. These are generally not considered
taxes, as long as they are levied as payment for a direct
benet to the individual paying.[22] Such fees include:
Tolls: a fee charged to travel via a road, bridge,
tunnel, canal, waterway or other transportation facilities. Historically tolls have been used to pay
for public bridge, road and tunnel projects. They
have also been used in privately constructed transport links. The toll is likely to be a xed charge,

51.4 History

Egyptian peasants seized for non-payment of taxes. (Pyramid

Age)

The rst known system of taxation was in Ancient Egypt

around 30002800 BC in the rst dynasty of the Old
Kingdom.[25] The earliest and most widespread form of
taxation was the corve and tithe. The corve was forced
labour provided to the state by peasants too poor to pay
other forms of taxation (labour in ancient Egyptian is a
synonym for taxes).[26] Records from the time document
that the pharaoh would conduct a biennial tour of the
kingdom, collecting tithes from the people. Other records
are granary receipts on limestone akes and papyrus.[27]
Early taxation is also described in the Bible. In Genesis
(chapter 47, verse 24 the New International Version),
it states But when the crop comes in, give a fth of it
to Pharaoh. The other four-fths you may keep as seed
for the elds and as food for yourselves and your households and your children. Joseph was telling the people
of Egypt how to divide their crop, providing a portion to
the Pharaoh. A share (20%) of the crop was the tax (in
this case, a special rather than an ordinary tax, as it was
gathered against an expected famine).[28]

258

CHAPTER 51. TAX

In the Persian Empire, a regulated and sustainable tax

system was introduced by Darius I the Great in 500
BC;[29] the Persian system of taxation was tailored to each
Satrapy (the area ruled by a Satrap or provincial governor). At diering times, there were between 20 and 30
Satrapies in the Empire and each was assessed according
to its supposed productivity. It was the responsibility of
the Satrap to collect the due amount and to send it to the
treasury, after deducting his expenses (the expenses and
the power of deciding precisely how and from whom to
raise the money in the province, oer maximum opportunity for rich pickings). The quantities demanded from
the various provinces gave a vivid picture of their economic potential. For instance, Babylon was assessed for
the highest amount and for a startling mixture of commodities; 1,000 silver talents and four months supply of
food for the army. India, a province fabled for its gold,
was to supply gold dust equal in value to the very large
amount of 4,680 silver talents. Egypt was known for the
wealth of its crops; it was to be the granary of the Persian
Empire (and, later, of the Roman Empire) and was required to provide 120,000 measures of grain in addition
to 700 talents of silver.[30] This tax was exclusively levied
on Satrapies based on their lands, productive capacity and
tribute levels.[31]
The Rosetta Stone, a tax concession issued by Ptolemy
V in 196 BC and written in three languages led to the
most famous decipherment in historythe cracking of
hieroglyphics.[32]
In India, Islamic rulers imposed jizya (a poll tax on nonMuslims) starting in the 11th century.

51.4.1

Taxation levels

Numerous records of government tax collection in Europe since at least the 17th century are still available today. But taxation levels are hard to compare to the size
and ow of the economy since production numbers are
not as readily available. Government expenditures and
revenue in France during the 17th century went from
about 24.30 million livres in 160010 to about 126.86
million livres in 165059 to about 117.99 million livres in
170010 when government debt had reached 1.6 billion
livres. In 178089, it reached 421.50 million livres.[33]
Taxation as a percentage of production of nal goods may
have reached 15%20% during the 17th century in places
such as France, the Netherlands, and Scandinavia. During the war-lled years of the eighteenth and early nineteenth century, tax rates in Europe increased dramatically
as war became more expensive and governments became
more centralized and adept at gathering taxes. This increase was greatest in England, Peter Mathias and Patrick
O'Brien found that the tax burden increased by 85% over
this period. Another study conrmed this number, nding that per capita tax revenues had grown almost sixfold over the eighteenth century, but that steady economic
growth had made the real burden on each individual only

double over this period before the industrial revolution.

Eective tax rates were higher in Britain than France the
years before the French Revolution, twice in per capita
income comparison, but they were mostly placed on international trade. In France, taxes were lower but the burden was mainly on landowners, individuals, and internal
trade and thus created far more resentment.[34]
Taxation as a percentage of GDP in 2003 was 56.1%
in Denmark, 54.5% in France, 49.0% in the Euro area,
42.6% in the United Kingdom, 35.7% in the United
States, 35.2% in Ireland, and among all OECD members
an average of 40.7%.[35][36]

51.4.2 Forms of taxation

In monetary economies prior to at banking, a critical
form of taxation was seigniorage, the tax on the creation
of money.
Other obsolete forms of taxation include:
Scutage, which is paid in lieu of military service;
strictly speaking, it is a commutation of a non-tax
obligation rather than a tax as such but functioning
as a tax in practice.
Tallage, a tax on feudal dependents.
Tithe, a tax-like payment (one tenth of ones earnings or agricultural produce), paid to the Church
(and thus too specic to be a tax in strict technical
terms). This should not be confused with the modern practice of the same name which is normally voluntary.
(Feudal) aids, a type of tax or due that was paid by
a vassal to his lord during feudal times.
Danegeld, a medieval land tax originally raised to
pay o raiding Danes and later used to fund military
expenditures.
Carucage, a tax which replaced the danegeld in England.
Tax farming, the principle of assigning the responsibility for tax revenue collection to private citizens
or groups.
Socage, a feudal tax system based on land rent.
Burgage, a feudal tax system based on land rent.
Some principalities taxed windows, doors, or cabinets to
reduce consumption of imported glass and hardware. Armoires, hutches, and wardrobes were employed to evade
taxes on doors and cabinets. In some circumstances, taxes
are also used to enforce public policy like congestion
charge (to cut road trac and encourage public transport) in London. In Tsarist Russia, taxes were clamped

51.5. ECONOMIC EFFECTS

on beards. Today, one of the most-complicated taxation
systems worldwide is in Germany. Three quarters of the
worlds taxation literature refers to the German system.
Under the German system, there are 118 laws, 185 forms,
and 96,000 regulations, spending 3.7 billion to collect
the income tax. In the United States, the IRS has about
1,177 forms and instructions,[37] 28.4111 megabytes of
Internal Revenue Code[38] which contained 3.8 million
words as of 1 February 2010,[39] numerous tax regulations in the Code of Federal Regulations,[40] and suppmentary material in the Internal Revenue Bulletin.[41] Today, governments in more advanced economies (i.e. Europe and North America) tend to rely more on direct
taxes, while developing economies (i.e. India and several
African countries) rely more on indirect taxes.

259
distributed over the factors of production depending on
the elasticities thereof; this includes workers (in the form
of lower wages), capital investors (in the form of loss to
shareholders), landowners (in the form of lower rents),
entrepreneurs (in the form of lower wages of superintendence) and customers (in the form of higher prices).

To show this relationship, suppose that the market price

of a product is $1.00, and that a $0.50 tax is imposed on
the product that, by law, is to be collected from the seller.
If the product has an elastic demand, a greater portion
of the tax will be absorbed by the seller. This is because
goods with elastic demand cause a large decline in quantity demanded for a small increase in price. Therefore in
order to stabilize sales, the seller absorbs more of the additional tax burden. For example, the seller might drop
the price of the product to $0.70 so that, after adding in
the tax, the buyer pays a total of $1.20, or $0.20 more
51.5 Economic eects
than he did before the $0.50 tax was imposed. In this
example, the buyer has paid $0.20 of the $0.50 tax (in
the
In economic terms, taxation transfers wealth from house- the form of a post-tax price) and the seller has paid [42]
remaining
$0.30
(in
the
form
of
a
lower
pre-tax
price).
holds or businesses to the government of a nation. The
side-eects of taxation (such as economic distortions) and
theories about how best to tax are an important subject
in microeconomics.[4] Taxation is almost never a simple 51.5.2 Increased economic welfare
transfer of wealth. Economic theories of taxation approach the question of how to maximize economic wel- Government spending
fare through taxation.
The purpose of taxation is to provide for government
spending without ination. The provision of public goods
such as roads and other infrastructure, schools, a social
51.5.1 Tax incidence
safety net, health care for the indigent, national defense,
law enforcement, and a courts system increases the ecoMain article: Tax incidence
nomic welfare of society if the benet outweighs the costs
See also: Eect of taxes and subsidies on price
involved.
Law establishes from whom a tax is collected. In
many countries, taxes are imposed on business (such as
corporate taxes or portions of payroll taxes). However,
who ultimately pays the tax (the tax burden) is determined by the marketplace as taxes become embedded
into production costs. Economic theory suggests that the
economic eect of tax does not necessarily fall at the
point where it is legally levied. For instance, a tax on employment paid by employers will impact on the employee,
at least in the long run. The greatest share of the tax burden tends to fall on the most inelastic factor involvedthe
part of the transaction which is aected least by a change
in price. So, for instance, a tax on wages in a town will (at
least in the long run) aect property-owners in that area.

Pigovian taxes
The existence of a tax can increase economic eciency
in some cases. If there is a negative externality associated with a good, meaning that it has negative eects not
felt by the consumer, then a free market will trade too
much of that good. By taxing the good, the government
can increase overall welfare as well as raising revenue.
This type of tax is called a Pigovian tax, after economist
Arthur Pigou.

Possible Pigovian taxes include those on polluting fuels

(like petrol), taxes on goods which incur public healthcare costs (such as alcohol or tobacco), and charges for
Depending on how quantities supplied and demanded existing 'free' public goods (like congestion charging) are
vary with price (the elasticities of supply and demand), another possibility.
a tax can be absorbed by the seller (in the form of lower
pre-tax prices), or by the buyer (in the form of higher
post-tax prices).[4] If the elasticity of supply is low, more Reduced inequality
of the tax will be paid by the supplier. If the elasticity
of demand is low, more will be paid by the customer; Progressive taxation may reduce economic inequality.
and, contrariwise for the cases where those elasticities are This eect occurs even when the tax revenue isn't
high. If the seller is a competitive rm, the tax burden is redistributed. [citation needed]

260

51.5.3

CHAPTER 51. TAX

Reduced economic welfare

tax is on a good in completely inelastic supply, a lump

sum tax such as a poll tax (head tax) which is paid by
Most taxes (see below) have side eects that reduce all adults regardless of their choices. Arguably a windfall
economic welfare, either by mandating unproductive la- prots tax which is entirely unanticipated can also fall
bor (compliance costs) or by creating distortions to eco- into this category.
nomic incentives (deadweight loss and perverse incenDeadweight loss does not account for the eect taxes have
tives).
in leveling the business playing eld. Business that have
more money are better suited to fend o competition. It
is common that an industry having a few but very large
Cost of compliance
corporations have a very high barrier of entry of new enAlthough governments must spend money on tax collec- trants in the marketplace. This is due to the fact that
tion activities, some of the costs, particularly for keeping the larger the corporation the better the position of it to
records and lling out forms, are borne by businesses and negotiate with suppliers. Also the nancial position can
by private individuals. These are collectively called costs provide the means for the company to be able to operate
of compliance. More complex tax systems tend to have for extended periods of time with very low or negative
higher compliance costs. This fact can be used as the ba- prots, in order to push the competition out of business.
sis for practical or moral arguments in favor of tax sim- The taxation of prots in a progressive manner would replication (such as the FairTax or OneTax, and some at duce the barriers for entry in a specic market for new
entrants thereby increasing competition. This would ultitax proposals).
mately benet the consumers since increased competition
benets consumers.[44]
Deadweight costs of taxation
Perverse incentives
Complexity of the tax code in developed economies offer perverse tax incentives. The more details of tax policy
there are, the more opportunities for legal tax avoidance
and illegal tax evasion. These not only result in lost revenue, but involve additional costs: for instance, payments
made for tax advice are essentially deadweight costs because they add no wealth to the economy. Perverse incentives also occur because of non-taxable 'hidden' transactions; for instance, a sale from one company to another
might be liable for sales tax, but if the same goods were
shipped from one branch of a corporation to another, no
tax would be payable.
To address these issues, economists often suggest simple and transparent tax structures which avoid providing
loopholes. Sales tax, for instance, can be replaced with
In the absence of negative externalities, the introduction a value added tax which disregards intermediate transacof taxes into a market reduces economic eciency by tions.
causing deadweight loss. In a competitive market the
price of a particular economic good adjusts to ensure that
all trades which benet both the buyer and the seller of Reduced production
a good occur. The introduction of a tax causes the price
received by the seller to be less than the cost to the buyer If a tax is paid on outsourced services that is not also
by the amount of the tax. This causes fewer transactions charged on services performed for oneself, then it may
to occur, which reduces economic welfare; the individu- be cheaper to perform the services oneself than to
als or businesses involved are less well o than before the pay someone elseeven considering losses in economic
tax. The tax burden and the amount of deadweight cost eciency.[45][46]
is dependent on the elasticity of supply and demand for For example, suppose jobs A and B are both valued at $1
the good taxed.
on the market. And suppose that because of your unique
Diagram illustrating deadweight costs of taxes

Most taxesincluding income tax and sales taxcan

have signicant deadweight costs. The only way to avoid
deadweight costs in an economy that is generally competitive is to refrain from taxes that change economic incentives. Such taxes include the land value tax,[43] where the

abilities, you can do job A twice over (100% extra output)

in the same eort as it would take you to do job B. But job
B is the one that you need done right now. Under perfect
division of labor, you would do job A and somebody else
would do job B. Your unique abilities would always be

51.6. TAXATION IN DEVELOPING COUNTRIES

rewarded.
Income taxation has the worst eect on division of labor in the form of barter. Suppose that the person doing
job B is actually interested in having job A done for him.
Now suppose you could amazingly do job A four times
over, selling half your work on the market for cash just to
pay your tax bill. The other half of the work you do for
somebody who does job B twice over but he has to sell
o half to pay his tax bill. You're left with one unit of job
B, but only if you were 400% as productive doing job A!
In this case of 50% tax on barter income, anything less
than 400% productivity will cause the division of labor
to fail.
In summary, depending on the situation a 50% tax rate
can cause the division of labor to fail even where productivity gains of up to 300% would have resulted. Even a
mere 30% tax rate can negate the advantage of a 100%
productivity gain.[47]

51.6 Taxation in developing countries

Researchers for EPS PEAKS [48] stated that the core
purpose of taxation is revenue mobilisation, providing
resources for National Budgets, and forming an important part of macroeconomic management. They said
economic theory has focused on the need to 'optimise'
the system through balancing eciency and equity, understanding the impacts on production, and consumption
as well as distribution, redistribution, and welfare.

261
GDP varying greatly around a global average of 19%.[50]
This data also indicates countries with higher GDP tend
to have higher tax to GDP ratios, demonstrating that
higher income is associated with more than proportionately higher tax revenue. On average, high-income countries have tax revenue as a percentage of GDP of around
22%, compared to 18% in middle-income countries and
14% in low-income countries.
In high-income countries, the highest tax-to-GDP ratio is in Denmark at 47% and the lowest is in Kuwait
at 0.8%, reecting low taxes from strong oil revenues.
Long-term average performance of tax revenue as a share
of GDP in low-income countries has been largely stagnant, although most have shown some improvement in
more recent years. On average, resource-rich countries
have made the most progress, rising from 10% in the mid
90s to around 17% in 2008. Non resource rich countries
made some progress, with average tax revenues increasing from 10% to 15% over the same period.[51]
Many low-income countries have a tax-to-GDP ratio of
less than 15% which could be due to low tax potential,
such as a limited taxable economic activity, or low tax
eort due to policy choice, non-compliance, or administrative constraints.
Some low-income countries have relatively high tax-toGDP ratios due to resource tax revenues (e.g. Angola) or
relatively ecient tax administration (e.g. Kenya, Brazil)
whereas some middle-income countries have lower taxto-GDP ratios (e.g. Malaysia) which reect a more taxfriendly policy choice.
While overall tax revenues have remained broadly constant, the global trend shows trade taxes have been declining as a proportion of total revenues(IMF, 2011), with
the share of revenue shifting away from border trade taxes
towards domestically levied sales taxes on goods and services. Low-income countries tend to have a higher dependence on trade taxes, and a smaller proportion of from
income and consumption taxes, when compared to high
income countries.[52]

They state that taxes and tax reliefs have also been used
as a tool for behavioural change, to inuence investment
decisions, labour supply, consumption patterns, and positive and negative economic spill-overs (externalities), and
ultimately, the promotion of economic growth and development. The tax system and its administration also play
an important role in state-building and governance, as a
principle form of 'social contract' between the state and
citizens who can, as taxpayers, exert accountability on the One indicator of the taxpaying experience was captured
in the 'Doing Business survey,[53] which compares the
state as a consequence.
total tax rate, time spent complying with tax procedures
The researchers wrote that domestic revenue forms an and the number of payments required through the year,
important part of a developing countrys public nancing across 176 countries. The 'easiest' countries in which to
as it is more stable and predictable than Overseas Devel- pay taxes are located in the Middle East with the UAE
opment Assistance and necessary for a country to be self- ranking rst, followed by Qatar and Saudi Arabia, most
sucient. They found that domestic revenue ows are, on likely reecting low tax regimes in those countries. Counaverage, already much larger than ODA, with aid worth tries in Sub-Saharan Africa are among the 'hardest' to pay
less than 10% of collected taxes in Africa as a whole.
with the Central African Republic, Republic of Congo,
However, in a quarter of African countries Overseas De- Guinea and Chad in the bottom 5, reecting higher total
velopment Assistance does exceed tax collection,[49] with tax rates and a greater administrative burden to comply.
these more likely to be non-resource-rich countries. This
suggests countries making most progress replacing aid
with tax revenue tend to be those beneting disproportionately from rising prices of energy and commodities.
The author

[48]

found tax revenue as a percentage of

262

51.6.1

CHAPTER 51. TAX

Key facts

The below facts were compiled by EPS PEAKS researchers [48]

Trade liberalisation has led to a decline in trade taxes
as a share of total revenues and GDP.[48][54]
Resource-rich countries tend to collect more revenue as a share of GDP, but this is more volatile.
Sub-Saharan African countries that are resource
rich have performed better tax collecting than
non-resource-rich countries, but revenues are more
volatile from year to year.[55] By strengthening revenue management, there are huge opportunities for
investment for development and growth [48][56]
Developing countries have an informal sector representing an average of around 40%, perhaps up
to 60% in some.[57] Informal sectors feature many
small informal traders who may not be ecient in
bringing into the tax net, since the cost of collection is high and revenue potential limited (although
there are broader governance benets). There is also
an issue of non-compliant companies who are 'hard
to tax', evading taxes and should be brought into the
tax net.[48][58]
In many low-income countries, the majority of revenue is collected from a narrow tax base, sometimes
because of a limited range of taxable economic activities. There is therefore dependence on few taxpayers, often multinationals, that can exacerbate the
revenue challenge by minimising their tax liability,
in some cases abusing a lack of capacity in revenue authorities, sometimes through transfer pricing
abuse [48][58]
Developing and developed countries face huge challenges in taxing multinationals and international citizens. Estimates of tax revenue losses from evasion
and avoidance in developing countries are limited by
a lack of data and methodological shortcomings, but
some estimates are signicant [48][59]
Countries use incentives to attract investment but
doing this may be unnecessarily giving up revenue as
evidence suggests that investors are inuenced more
by economic fundamentals like market size, infrastructure, and skills, and only marginally by tax incentives (IFC investor surveys) [48]

which is especially important for VAT. Weak administration, governance and corruption tend to
be associated with low revenue collections (IMF,
2011)[48]
Evidence on the eect of aid on tax revenues is inconclusive. Tax revenue is more stable and sustainable than aid. While a disincentive eect of aid
on revenue may be expected and was supported by
some early studies, recent evidence does not support that conclusion, and in some cases, points towards higher tax revenue following support for revenue mobilisation.[48]
Of all regions, Africa has the highest total tax rates
borne by business at 57.4% of prot on average, but
has reduced the most since 2004, from 70%, partly
due to introducing VAT and this is likely to have a
benecial eect on attracting investment.[48][61]
Fragile states are less able to expand tax revenue as a
percentage of GDP and any gains are more dicult
to sustain.[62] Tax administration tends to collapse if
conict reduces state controlled territory or reduces
productivity.[63] As economies are rebuilt after conicts, there can be good progress in developing effective tax systems. Liberia expanded from 10.6%
of GDP in 2003 to 21.3% in 2011. Mozambique
increased from 10.5% of GDP in 1994 to around
17.7% in 2011.[48][64]

51.6.2 Summary
Aid interventions in revenue can support revenue mobilisation for growth, improve tax system design and
administrative eectiveness, and strengthen governance
and compliance.[48] The author of the Economics Topic
Guide found that the best aid modalities for revenue depend on country circumstances, but should aim to align
with government interests and facilitate eective planning and implementation of activities under an evidencebased tax reform. Lastly, she found that identifying areas
for further reform requires country-specic diagnostic assessment: broad areas for developing countries identied
internationally (e.g. IMF) include, for example property taxation for local revenues, strengthening expenditure management, and eective taxation of extractive industries and multinationals.[48]

51.7 Views on taxation

In low-income countries, compliance costs are high,

they are lengthy processes, frequent tax payments, 51.7.1
bribes and corruption [48][58][60]

Support for taxation

Administrations are often under-resourced, re- Main article: Social contract

sources aren't eectively targeted on areas of greatest impact, and mid-level management is weak. Co- Every tax, however, is, to the person who pays it, a badge,
ordination between domestic and customs is weak, not of slavery, but of liberty.

51.7. VIEWS ON TAXATION

Adam Smith (1776), Wealth of Nations[65]
According to most political philosophies, taxes are justied as they fund activities that are necessary and benecial to society. Additionally, progressive taxation can be
used to reduce economic inequality in a society. According to this view, taxation in modern nation-states benet
the majority of the population and social development.[66]
A common presentation of this view, paraphrasing various statements by Oliver Wendell Holmes, Jr. is Taxes
are the price of civilization.[67]
It can also be argued that in a democracy, because the
government is the party performing the act of imposing taxes, society as a whole decides how the tax system should be organized.[68] The American Revolution's
"No taxation without representation" slogan implied this
view. For traditional conservatives, the payment of taxation is justied as part of the general obligations of citizens to obey the law and support established institutions.
The conservative position is encapsulated in perhaps the
most famous adage of public nance, An old tax is a
good tax.[69] Conservatives advocate the fundamental
conservative premise that no one should be excused from
paying for government, lest they come to believe that government is costless to them with the certain consequence
that they will demand more government 'services.[70]
Social democrats generally favor higher levels of taxation to fund public provision of a wide range of services
such as universal health care and education, as well as
the provision of a range of welfare benets.[71] As argued
by Tony Crosland and others, the capacity to tax income
from capital is a central element of the social democratic
case for a mixed economy as against Marxist arguments
for comprehensive public ownership of capital.[72] Many
libertarians recommend a minimal level of taxation in order to maximize the protection of liberty.

263
Because payment of tax is compulsory and enforced
by the legal system, some political philosophies view
taxation as theft, extortion, (or as slavery, or as
a violation of property rights), or tyranny, accusing the government of levying taxes via force and
coercive means.[74] Voluntaryists, individualist anarchists, Objectivists, anarcho-capitalists, and libertarians
see taxation as government aggression (see zero aggression principle). The view that democracy legitimizes taxation is rejected by those who argue that all forms of
government, including laws chosen by democratic means,
are fundamentally oppressive. According to Ludwig von
Mises, society as a whole should not make such decisions, due to methodological individualism.[75] Libertarian opponents of taxation claim that governmental protection, such as police and defense forces might
be replaced by market alternatives such as private defense agencies, arbitration agencies or voluntary contributions.[76] Walter E. Williams, professor of economics
at George Mason University, stated Government income redistribution programs produce the same result as
theft. In fact, thats what a thief does; he redistributes income. The dierence between government and thievery
is mostly a matter of legality.[77]

51.7.3 Socialist view

Karl Marx assumed that taxation would be unnecessary

after the advent of communism and looked forward to
the "withering away of the state". In socialist economies
such as that of China, taxation played a minor role, since
most government income was derived from the ownership
of enterprises, and it was argued by some that monetary
taxation was not necessary.[78] While the morality of taxCompulsory taxation of individuals, such as income ation is sometimes questioned, most arguments about taxtax, is often justied on grounds including territorial ation revolve around the degree and method of taxation
sovereignty, and the social contract. Defenders of busi- and associated government spending, not taxation itself.
ness taxation argue that it is an ecient method of taxing income that ultimately ows to individuals, or that
separate taxation of business is justied on the grounds
that commercial activity necessarily involves use of publicly established and maintained economic infrastructure, 51.7.4 Tax choice
and that businesses are in eect charged for this use.[73]
Georgist economists argue that all of the economic rent Main article: Tax choice
collected from natural resources (land, mineral extraction, shing quotas, etc.) is unearned income, and be- Tax choice is the theory that taxpayers should have more
longs to the community rather than any individual. They control with how their individual taxes are allocated. If
advocate a high tax (the Single Tax) on land and other taxpayers could choose which government organizations
natural resources to return this unearned income to the received their taxes, opportunity cost decisions would instate, but no other taxes.
tegrate their partial knowledge.[79] For example, a tax-

51.7.2

Opposition to taxation

Main articles: Tax noncompliance and Taxation as theft

payer who allocated more of his taxes on public education would have less to allocate on public healthcare. Supporters argue that allowing taxpayers to demonstrate their
preferences would help ensure that the government succeeds at eciently producing the public goods that taxpayers truly value.[80]

264

CHAPTER 51. TAX

51.8 Theories on taxation

Main article: Theory of taxation

51.8.1

Laer curve

Main article: Laer curve

In economics, the Laer curve is a theoretical representation of the relationship between government revenue
raised by taxation and all possible rates of taxation. It
is used to illustrate the concept of taxable income elasticity (that taxable income will change in response to
changes in the rate of taxation). The curve is constructed
by thought experiment. First, the amount of tax revenue
raised at the extreme tax rates of 0% and 100% is considered. It is clear that a 0% tax rate raises no revenue, but
the Laer curve hypothesis is that a 100% tax rate will
also generate no revenue because at such a rate there is no
longer any incentive for a rational taxpayer to earn any income, thus the revenue raised will be 100% of nothing.
If both a 0% rate and 100% rate of taxation generate no
revenue, it follows from the extreme value theorem that
there must exist at least one rate in between where tax
revenue would be a maximum. The Laer curve is typically represented as a graph which starts at 0% tax, zero
revenue, rises to a maximum rate of revenue raised at an
intermediate rate of taxation and then falls again to zero
revenue at a 100% tax rate.

tegrate optimal tax theory with the social welfare function, which is the economic expression of the idea that
equality is valuable to a greater or lesser extent. If individuals experience diminishing returns from income,
then the optimum distribution of income for society involves a progressive income tax. Mirrlees optimal income tax is a detailed theoretical model of the optimum
progressive income tax along these lines. Over the last
years the validity of the theory of optimal taxation was
discussed by many political economists.[82]

51.8.3 Tax rates

Main article: Tax rate
Taxes are most often levied as a percentage, called the
tax rate. An important distinction when talking about tax
rates is to distinguish between the marginal rate and the
eective tax rate. The eective rate is the total tax paid
divided by the total amount the tax is paid on, while the
marginal rate is the rate paid on the next dollar of income
earned. For example, if income is taxed on a formula
of 5% from $0 up to $50,000, 10% from $50,000 to
$100,000, and 15% over $100,000, a taxpayer with income of $175,000 would pay a total of $18,750 in taxes.
Tax calculation
(0.05*50,000) + (0.10*50,000) +
(0.15*75,000) = 18,750

One potential result of the Laer curve is that increasing tax rates beyond a certain point will become counterproductive for raising further tax revenue. A hypothetical Laer curve for any given economy can only be
estimated and such estimates are sometimes controversial. The New Palgrave Dictionary of Economics reports
that estimates of revenue-maximizing tax rates have varied widely, with a mid-range of around 70%.[81]

51.9 See also

51.8.2

51.9.1 By country or region

Optimal tax

Main article: Optimal tax

Most governments take revenue which exceeds that which
can be provided by non-distortionary taxes or through
taxes which give a double dividend. Optimal taxation
theory is the branch of economics that considers how
taxes can be structured to give the least deadweight costs,
or to give the best outcomes in terms of social welfare.[4] The Ramsey problem deals with minimizing deadweight costs. Because deadweight costs are related to the
elasticity of supply and demand for a good, it follows that
putting the highest tax rates on the goods for which there
is most inelastic supply and demand will result in the least
overall deadweight costs. Some economists sought to in-

The eective rate would be 10.7%:

18,750/175,000 = 0.107
The marginal rate would be 15%.

List of countries by tax rates

List of countries by tax revenue as percentage of
GDP
Category:Taxation by country

51.10 Notes
[1] Charles E. McLure, Jr. Taxation. Britannica. Retrieved
3 March 2015.
[2] 2013-2014 The worldwide personal tax guide United
Arab Emirates. Ernst & Young. Retrieved 3 March
2015.

51.10. NOTES

[3] See for example 26 U.S.C. 7203 in the case of U.S.

Federal taxes.
[4] Simkovic, Michael. Distortionary Taxation of Human
Capital Acquisition Costs. Social Science Research Network.
[5] Denition of Taxes (Note by the Chairman), 1996
(PDF). Retrieved 2013-01-22.
[6] Social Security Programs Throughout the World on the
U.S. Social Security website for links to individual country
program descriptions. Ssa.gov. Retrieved 2013-01-22.
[7] By contrast, some countries, such as New Zealand, nance
the programs through other taxes.
[8] See, e.g., India Social Security overview
[9] See, e.g., United States Federal Unemployment Tax Act.
[10] Taxes on the net wealth of corporations are often referred
to as corporate tax.
[11] McCluskey, William J.; Franzsen, Ril C. D. (2005).
Land Value Taxation: An Applied Analysis. Ashgate Publishing, Ltd. p. 4. ISBN 0-7546-1490-5.
[12] TPC Tax Topics | Federal Budget. Taxpolicycenter.org.
Retrieved 2009-03-27.
[13] 26 USC 877. Law.cornell.edu. Retrieved 2013-01-22.
[14] Although Texas has no individual income tax, the state
does impose a franchise taxsoon to be replaced by a
margin taxon business activity that, while not denominated as an income tax, is in substance a kind of income
tax.
[15] Economist.com. Economist.com. 2009-02-12. Retrieved 2009-03-27.
[16] Tax Facts | Tax Facts Listing. Taxpolicycenter.org. Retrieved 2009-03-27.
[17] Internal
Revenue
Service.
webcache.googleusercontent.com. Retrieved 2009-03-27.
[18] luxury tax Britannica Online Encyclopedia. Concise.britannica.com. Retrieved 2009-03-27.
[19] http://links.jstor.org/sici?sici=0002-8282(196909)59%
3A4%3C596%3ACEASTR%3E2.0.CO%3B2-3
[20] A. B. Atkinson, Optimal Taxation and the Direct Versus
Indirect Tax Controversy, 10 Can. J. Econ. 590, 592
(1977)
[21] What is Dierence Between Direct and Indirect Tax?".
Investor Guide. Retrieved 2011-10-28.
[22] Taxes versus fees. Ncsu.edu. 2007-05-02. Retrieved
2013-01-22.
[23] Some economists hold that the ination tax aects the
lower and middle classes more than the rich, as they hold
a larger fraction of their income in cash, they are much
less likely to receive the newly created monies before the
market has adjusted with inated prices, and more often

265

have xed incomes, wages or pensions. Some argue that

ination is a regressive consumption tax. Also see Andrs
Erosa and Gustavo Ventura, "On ination as a regressive
consumption tax". Some claim there are systemic eects
of an expansionary monetary policy, which are also denitively taxing, imposing a nancial charge on some as a
result of the policy. Because the eects of monetary expansion or counterfeiting are never uniform over an entire economy, the policy inuences capital transfers in the
market, creating economic bubbles where the new monies
are rst introduced. Economic bubbles increase market
instability, and therefore increase investment risk, creating the conditions common to a recession. This particular
tax can be understood to be levied on future generations
that would have beneted from economic growth, and it
has a 100% transfer cost (so long as people are not acting
against their interests, increased uncertainty benets noone). One example of a strong supporter of this tax was
the former Federal Reserve chair Beardsley Ruml.
[24] See, e.g., Reinhart, Carmen M. and Rogo, Kenneth S.,
This Time is Dierent. Princeton and Oxford: Princeton University Press, 2008 (p. 143), The Liquidation
of Government Debt, Reinhart, Carmen M. & Sbrancia, M. Belen, p. 19, Giovannini, Alberto and de Melo,
Martha, Government Revenue from Financial Repression.
The American Economic Review, Vol. 83, No. 4 Sep.
1993 (pp. 953963).
[25] Taxes in the Ancient World, University of Pennsylvania
Almanac, Vol. 48, No. 28, April 2, 2002
[26] David F. Burg (2004). A World History of Tax Rebellions.
pp. viviii. ISBN 9780415924986.
[27] Olmert, Michael (1996). Miltons Teeth and Ovids Umbrella: Curiouser & Curiouser Adventures in History, p.41.
Simon & Schuster, New York. ISBN 0-684-80164-7.
[28] The Bible.
[29] Darius I (Darius the Great), King of Persia (from 521
BC)". 1902encyclopedia.com. Retrieved 2013-01-22.
[30] History Of Iran (Persia)". Historyworld.net. Retrieved
2013-01-22.
[31] The Theocratic Ideology of the Chronicler by Jonathan
E. Dyck p. 96 BRILL, 1998
[32] British Museum. History of the World in 100 Objects:
Rosetta Stone. BBC.
[33] Homan, Phillipe and Kathryn Norberg (1994), Fiscal
Crises, Liberty, and Representative Government, 1450
1789, p. 238.
[34] Homan, Phillipe and Kathryn Norberg (1994), Fiscal
Crises, Liberty, and Representative Government, 1450
1789, p. 300 .
[35] OECD national accounts. Retrieved 2007-03-01.
[36] Tax/Spending Burden, Forbes magazine, 05-24-04
[37] IRS pick list. IRS. Retrieved 21 January 2013.

266

CHAPTER 51. TAX

[38] title 26 US Code. US House of Reperesentitives. Retrieved 21 January 2013.

[58] IMF, 2011, Revenue Mobilization in Developing Countries, Fiscal Aairs Department

[39] Caron, Paul L. (October 28, 2011). How Many Words

Are in the Internal Revenue Code?". Retrieved 21 January 2013.

[59] See Section 3 'International Taxation' e.g. Torvik, 2009

in Commission on Capital Flight from Developing Countries, 2009: Tax Havens and Development

[40] 26 CFR Table Of Contents. Gpo.gov. 2012-04-01.

Retrieved 2013-01-22.

[60] 'Doing Business 2013', World Bank/IFC 2013

[41] Internal Revenue Bulletin: 2012-23. Internal Revenue

Service. 4 June 2012. Retrieved 7 June 2012.
[42] Parkin, Michael (2006), Principles of Microeconomics, p.
134.
[43] McCluskey, William J; Franzsen, Ril C. D (2005). Land
Value Taxation: An Applied Analysis, William J. McCluskey, Ril C. D. Franzsen. Books.google.com. ISBN
978-0-7546-1490-6. Retrieved 2009-03-27.
[44] Avi-Yonah, Reuven S.; Slemrod, Joel B. (April 2002).
Why Tax the Rich? Eciency, Equity, and Progressive
Taxation. The Yale Law Journal 111 (6): 13911416.
doi:10.2307/797614. JSTOR 797614.
[45] Johnsson, Richard. Taxation and Domestic Free Trade.
Ideas.repec.org. Retrieved 2009-03-27.
[46] Corsi, Jerome, 2007. The VAT: Menace to Free Trade,
WorldNetDaily Exclusive Commentary, WorldNetDaily,
February 3, 2007
[47] Johnsson, Richard, 2004. Taxation and Domestic Free
Trade, Ratio Working Papers 40, The Ratio Institute, revised June 7, 2004.
[48] Hazel Granger (2013). Economics Topic Guide Taxation
and Revenue. EPS PEAKS.

[61] Paying Taxes 2013: Total tax rate is a composite measure

including corporate income tax, employment taxes, social
contributions, indirect taxes, property taxes and smaller
taxes e.g. environmental tax.
[62] IMF Working Paper 108/12 (2012), Mobilizing Revenue
in Sub-Saharan Africa: Empirical Norms and Key Determinants
[63] African Economic Outlook (2010)
[64] IMF Revenue Data,2011: Total Tax Revenue as a percentage of GDP
[65] Smith, Adam (1776), Wealth of Nations, Penn State Electronic Classics edition, republished 2005, p.704
[66] Population and Social Integration Section (PSIS), United
Nations Social and Economic Commission for Asia and
the Pacic
[67] Gerhart, Eugene C (September 1998). Quote it Completely!. Books.google.com.au. ISBN 978-1-57588-4004. Retrieved 2009-03-27.
[68] Logue, Danielle. 2009. Moving policy forward: 'brain
drain' as a wicked problem. Globalisation, Societies &
Education 7, no. 1: 4150. Academic Search Premier,
EBSCOhost. Retrieved February 18, 2009.

[49] Africa Economic Outlook 2010, Part 2: Public Resource

Mobilisation and Aid in Africa, AfDB/OECD (2010)

[69] Tax History Project: The Depression and Reform: FDRs

Search for Tax Revision in N.Y. (Copyright, 2003, Tax
Analysts)".

[50] According to IMF data for 2010, from Revenue Data for
IMF Member Countries, as of 2011, (unpublished)

[70] Do Conservatives Have a Conservative Tax Agenda?".

Heritage.org. Retrieved 2013-01-22.

[51] IMF FAD (2011), Revenue Mobilization in Developing

Countries

[71] Ruiz del Portal, X. 2009. A general principalagent

setting with non-dierentiable mechanisms: Some examples. Mathematical Social Sciences 57, no. 2: 262278.
Academic Search Premier, EBSCOhost.

[52] IMF WP/05/112, Tax Revenue and (or?) Trade Liberalization, Thomas Baunsgaard and Michael Keen
[53] 'Doing Business 2013', World Bank/IFC (2013)
[54] Keen & Mansour, 2010-09-01, Development Policy Review, Vol. 28 No.5, pp.553-555
[55] Keen & Mansour 2010, Revenue Mobilisation in SubSaharan Africa: Challenges from Globalisation I Trade
Reform, Development Policy Review, Vol. 28, No. 5, pp.
553571, September 2010
[56] See for example Paul Collier (2010), The Political Economy of Natural Resources, social research Vol 77 : No 4
: Winter 2010.
[57] Schneider, Buehn, and Montenegro (2010), Shadow
Economies all over the World: New Estimates for 162
Countries from 1999 to 2007.

[72] Chaturvedi, Skand (2009). Financial Management: Entailing Planning for the Future. Page 77: Global India
Publications. Retrieved December 5, 2013.
[73] Van Der Graaf, Rieke, and Johannes J. M. Van Delden.
2009. Clarifying appeals to dignity in medical ethics from
an historical perspective. Bioethics 23, no. 3: 151160.
Academic Search Premier, EBSCOhost.
[74] For an overview of the classical liberal perspective on taxation see www.irefeurope.org
[75] Human Action Chapter II. Sec. 4. The Principle of
Methodological Individualism by Ludwig von Mises
[76] Spencer Heath MacCallum (2007-09-12). The Rule of
Law Without the State,. Ludwig Von Mises Institute.
Retrieved 2008-08-16.

51.12. EXTERNAL LINKS

[77] Williams, Walter E. (2008-08-06). Government theft,

American-style. WorldNetDaily. Retrieved 2008-0911.
[78] Li, Jinyan (1991). Taxation in the Peoples Republic of
China. New York: Praeger. ISBN 0-275-93688-0.
[79] Tax morale and conditional cooperation. ScienceDirect.com. Retrieved 3 January 2013.
[80] Do Earmarks Increase Giving to Government?".
Cbees.utdallas.edu. Retrieved 3 January 2013.
[81] Fullerton, Don (2008). Laer curve. The New Palgrave Dictionary of Economics, Second Edition (Palgrave
Macmillan). Retrieved 5 July 2011. The mid-range for
this elasticity is around 0.4, with a revenue peak around
70 per cent.
[82] Libertarian & Conservative News. Words Of Liberty.
Retrieved 2013-01-22.

51.11 Further reading

My taxes go where? How countries spend your
money (17 February 2015), The BBC
Minarik, Joseph J. (2008). Taxation. In David
R. Henderson (ed.). Concise Encyclopedia of Economics (2nd ed.). Library of Economics and Liberty. ISBN 978-0865976658. OCLC 237794267.

51.12 External links

OECD tax statistics

267

Chapter 52

Decit spending
Decit spending is the amount by which spending exceeds revenue over a particular period of time, also called
simply decit, or budget decit; the opposite of budget
surplus. The term may be applied to the budget of a government, private company, or individual.

which money can be saved decline and at the same time

a higher level of debt is enforced from the collapsing revenues. The states decit enables a correspondend buildup
of money assets for the private sector and prevents the
break down of economy, by which otherwise the private
Government decit spending is a central point of contro- money savings would have been made congruent with the
private debt. The monetary mechanism how as the case
versy in economics, as discussed below.
may be revenue surpluses enforce the corresponding expense surpluses and why thereby it comes to an economic
breakdown did Wolfgang Sttzel explain much later by
the means of his Balances Mechanics.
52.1 Controversy
William Vickrey, awarded the 1996 Nobel Memorial
Government decit spending is a central point of contro- Prize in Economic Sciences, commented:
versy in economics, with prominent economists holding
Decits are considered to represent sinful
diering views.[1]
proigate spending at the expense of future
The mainstream economics position is that decit spendgenerations who will be left with a smaller ening is desirable and necessary as part of countercyclical
dowment of invested capital.
scal policy, but that there should not be a structural
This fallacy seems to stem from a false
decit (i.e., permanent decit): The government should
analogy to borrowing by individuals. Current
run decits during recessions to compensate for the shortreality is almost the exact opposite. Decits
fall in aggregate demand, but should run surpluses in
add to the net disposable income of individboom times so that there is no net decit over an economic
uals, to the extent that government disbursecycle (i.e., only run cyclical decits and not structural
ments that constitute income to recipients exdecits). This is derived from Keynesian economics, and
ceed that abstracted from disposable income in
gained acceptance (especially in the Anglo-Saxon world)
taxes, fees, and other charges. This added purduring the period between the Great Depression in the
chasing power, when spent, provides markets
1930s and post-WWII in the 1950s.
for private production, inducing producers to
invest in additional plant capacity, which will
This position is attacked from both sides: Advoform part of the real heritage left to the future.
cates of scal conservatism argue that decit spendThis is in addition to whatever public investing is always bad policy, while some post-Keynesian
ment takes place in infrastructure, education,
economistsparticularly post-Keynesian Chartalists
research, and the like. Larger decits, suargue that decit spending is necessary, and not only for
cient to recycle savings out of a growing gross
scal stimulus.
domestic product (GDP) in excess of what can
According to most economists, during recessions, the
be recycled by prot-seeking private investgovernment can stimulate the economy by intentionally
ment, are not an economic sin but an economic
running a decit.
necessity. Decits in excess of a gap growing as
The decit spending requested by John Meynard Keynes
a result of the maximum feasible growth in real
for overcoming crisis is the monetary side of his economy
output might indeed cause problems, but we
theory. Like the investment is identical to the real saving,
are nowhere near that level. Even the analogy
money assets buildup is to debt. Therefore the excess savitself is faulty. If General Motors, AT&T, and
ings of money in time of crisis has to enforce a corresponindividual households had been required to baldend borrowing and the mechanism for that again is the
ance their budgets in the manner being applied
intensication of the crisis, by what the revenues from
to the Federal government, there would be no
268

52.1. CONTROVERSY

269

corporate bonds, no mortgages, no bank loans,

and many fewer automobiles, telephones, and
houses.
15 Fatal Fallacies of
Fundamentalism-William
1996

52.1.1

Financial
Vickrey

Fiscal conservatism

Advocates of scal conservatism reject Keynesianism by

arguing that government should always run a balanced
budget (and a surplus to pay down any outstanding debt),
and that decit spending is always bad policy.
Fiscal conservatism has academic support, predominantly
associated with the neoclassical-inclined Chicago school
of economics, and has signicant political and institutional support, with all of the United States except
Vermont having a balanced budget amendment to their
state constitution, and the Stability and Growth Pact
of the European Monetary Union punishing government
decits of 3% of GDP or greater. Proponents of scal
conservatism date back to Adam Smith, founder of modern economics. Fiscal conservatism was the dominant
position until the Great Depression, associated with the
gold standard and expressed in the now outdated Treasury
View that government scal policy is ineective.
The usual argument against decit spending, dating to
Adam Smith, is that households should not run decits
one should have money before one spends it, from
prudenceand that what is correct for a household is
correct for a nation and its government. A further argument is that debts must be repaid, and thus it is burdening future generations to run decits today, for little or no
gain.
A similar argument is that decit spending today will require increased taxation in the future, thus burdening future generations. (See generational accounting for discussion.) Others argue that because debt is both owed
by and owed to private individuals, there is no net debt
burden of government debt, just wealth transfer (redistribution) from those who owe debt (government, backed
by tax payers) to those who hold debt (holders of government bonds).[2]

52.1.2 Post-Keynesian economics

Some Post-Keynesian economists argue that decit
spending is necessary, either to create the money supply
(Chartalism) or to satisfy demand for savings in excess of
what can be satised by private investment.
Chartalists argue that decit spending is logically necessary because, in their view, at money is created by decit
spending: at money cannot be collected in taxes before
it is issued and spent; the amount of at money in circulation is exactly the government debtmoney spent
but not collected in taxes. In a quip, at money governments are 'spend and tax', not 'tax and spend'"decit
spending comes rst. Chartalists argue that nations are
fundamentally dierent from households. Governments
in a at money system which only have debt in their own
currency can issue other liabilities, their at money, to
pay o their interest bearing bond debt. They cannot go
bankrupt involuntarily because this at money is what is
used in their economy to settle debts, while household liabilities are not so used. This view is summarized as:
But it is hard to understand how the concept
of budget busting applies to a government
which, as a sovereign issuer of its own currency,
can always create dollars to spend. There is,
in other words, no budget to bust. A national budget is merely an account of national
spending priorities, and does not represent an
external constraint in the manner of a household budget.[3]
Continuing in this vein, Chartalists argue that a structural
decit is necessary for monetary expansion in an expanding economy: if the economy grows, the money supply
should as well, which should be accomplished by government decit spending. Private sector savings are equal to
government sector decits, to the penny. In the absence
of sucient decit spending, money supply can increase
by increasing nancial leverage in the economythe
amount of bank money grows, while the base money supply remains unchanged or grows at a slower rate, and thus
the ratio (leverage = credit/base) increaseswhich can
lead to a credit bubble and a nancial crisis.
Chartalism is a small minority view in economics; while
it has had advocates over the years, and inuenced
Keynes, who specically credited it,[4] it is categorically
rejected or ignored by virtually all contemporary mainstream economists. A notable proponent was UkrainianAmerican economist Abba P. Lerner, who founded the
school of Neo-Chartalism, and advocated decit spending in his theory of functional nance. A contemporary
center of Neo-Chartalism is the Kansas City School of
economics.

A related line of argument, associated with the Austrian

school of economics, is that government decits are
inationary. Anything other than mild or moderate ination is generally accepted in economics to be a bad thing.
In practice this is argued to be because governments pay
o debts by printing money, increasing the money supply
and creating ination, and is taken further by some as an Chartalists, like other Keynesians, accept the paradox
argument against at money and in favor of hard money, of thrift, which argues that identifying behavior of inespecially the gold standard.
dividual households and the nation as a whole commits

270

CHAPTER 52. DEFICIT SPENDING

the fallacy of composition; while the paradox of thrift domestic product (GDP) and the employment of labour,
(and thus decit spending for scal stimulus) is widely and if all else is constant, lowers the unemployment rate.
accepted in economics, the Chartalist form is not.
(The connection between demand for GDP and unemAn alternative argument for the necessity of decits was ployment is called Okuns law.)
given by U.S. economist William Vickrey, who argued The increased size of the market, due to government
that decits were necessary to satisfy demand for savings decits, can further stimulate the economy by raising
in excess of what can be satised by private investment. business protability and spurring optimism, which encourages private xed investment in factories, machines,
and the like to rise. This accelerator eect stimulates
Larger decits, sucient to recycle savings out
demand further and encourages rising employment. Inof a growing gross domestic product (GDP)
crease in government payroll has been shown to depress
in excess of what can be recycled by protthe economy in the long run.
seeking private investment, are not an economic sin but an economic necessity.[5]

52.2 Government decits

When the outlay of a government (i.e., the total of its
purchases of goods and services, transfers in grants to individuals and corporations, and its net interest payments)
exceeds its tax revenues, the government budget is said
to be in decit; government spending in excess of tax receipts is known as decit spending. Governments usually issue bonds to match their decits. They can be
bought by its Central Bank through open market operations. Otherwise the debt issuance can increase the level
of (i) public debt, (ii) private sector net worth, (iii) debt
service (interest payments), and (iv) interest rates. (See
Crowding out below.) Decit spending may, however, be
consistent with public debt remaining stable as a proportion of GDP, depending on the level of GDP growth.
The opposite of a budget decit is a budget surplus; in
this case, tax revenues exceed government purchases and
transfer payments.
For the public sector to be in decit implies that the private sector (domestic and foreign) is in surplus. An increase in public indebtedness must necessarily therefore
correspond to an equal decrease in private sector net indebtedness. In other words, decit spending permits the
private sector to accumulate net worth.

Similarly, running a government surplus or reducing its

decit reduces consumer and business spending and raises
unemployment. This can lower the ination rate. Any use
of the government decit to steer the macro-economy is
called scal policy.
A decit does not simply stimulate demand. If private
investment is stimulated, that increases the ability of the
economy to supply output in the long run. Also, if the
governments decit is spent on such things as infrastructure, basic research, public health, and education, that can
also increase potential output in the long run. Finally, the
high demand that a government decit provides may actually allow greater growth of potential supply, following
Verdoorns law.
Decit spending may create ination, or encourage existing ination to persist. For example, in the United States
Vietnam-war era decits encouraged ination. This is especially true at low unemployment rates. But government
decits are not the only cause of ination: It can arise due
to such supply-side shocks as the oil crises of the 1970s
and ination left over from the past (e.g., inationary expectations and the price/wage spiral). If equilibrium is
located on the classical range of the supply graph, an increase in government spending will lead to ination without aecting unemployment. There must also be enough
money circulating in the system to allow ination to persist, so that ination depends on monetary policy.

On average, through the economic cycle, most govern- 52.2.2 Loanable funds
ments have tended to run budget decits, as can be seen
from the large debt balances accumulated by governments Many economists believe government decits inuence
the economy through the loanable funds market, whose
across the world.
existence Chartalists and other Post-Keynesians dispute. Government borrowing in this market increases
52.2.1 Keynesian eect
the demand for loanable funds and thus (ignoring other
changes) pushes up interest rates. Rising interest rates
Following John Maynard Keynes, many economists rec- can crowd out, or discourage, xed private investment
ommend decit spending to moderate or end a recession, spending, canceling out some or even all of the demand
especially a severe one. When the economy has high un- stimulus arising from the decitand perhaps hurting
employment, an increase in government purchases cre- long-term supply-side growth. But increased decits also
ates a market for business output, creating income and raise the amount of total income received, which raises
encouraging increases in consumer spending, which cre- the amount of saving done by individuals and corporaates further increases in the demand for business output. tions and thus the supply of loanable funds, lowering in(This is the multiplier eect.) This raises the real gross terest rates. Thus, crowding out is a problem only when

52.3. SEE ALSO

271

the economy is already close to full employment (say, couraged ination, reinforcing the eect of Vietnam war
at about 4% unemployment) and the scope for increas- decit spending.
ing income and saving is blocked by resource constraints
(potential output). Despite a government debt that exceeded GDP in 1945, the U.S. saw the long prosperity of 52.3 See also
the 1950s and 1960s. The growth of the supply side, it
seems, was not hurt by the large decits and debts.
Functional nance
A government decit increases government debt. In many
Decit (disambiguation)
countries the government borrows by selling bonds rather
Public debt
than borrowing from banks. The most important burden of this debt is the interest that must be paid to bond Balanced Budget Amendment
holders, which restricts a governments ability to raise its
Keynesian economics
outlays or cut taxes to attain other goals.
Fiscal policy

52.2.3

Crowding out

Main article: Crowding out (economics)

Usually when economists use the term crowding out
they are referring to the government spending using up nancial and other resources that would otherwise be used
by private enterprise. However, some commentators use
crowding out to refer to government providing a service
or good that would otherwise be a business opportunity
for private industry.

52.4 References
[1] In "Britains Decit", February 16, 2010, Paul Krugman
cites two opposing groups of economists, one arguing that
Britain should cut its decit immediately, the other arguing
that the decit provides useful or necessary scal stimulus.
[2] Mankiw Promulgates Confusion on the Debt at the NYT,
Dean Baker
[3] Spain and the EU: Decit Terrorism in Action, 01/8/2010,
New Deal 2.0, Marshall Auerback
[4] See references at Chartalism for the inuence on Keynes.

52.2.4

Unintentional decits

National government decits may be intentional, a result

of policy decisions, or unintentional. When an economy
goes into a recession, decits usually rise in the more afuent countries. Revenue from progressive taxes based
on economic activity (income, expenditure, or transactions) falls. Other sources of tax revenue such as wealth
taxes, notably property taxes, are not subject to recessions, though they are subject to asset price bubbles.
Transfer payments due to increased unemployment and
reduced household income rise.

52.2.5

Automatic vs. active decit policies

Further information: Automatic stabilizer

Most economists favor the use of automatic stabilization
over active or discretionary use of decits to ght mild recessions (or surpluses to combat ination). Active policymaking takes too long for politicians to institute and too
long to aect the economy. Often, the medicine ends
up aecting the economy only after its disease has been
cured, leaving the economy with side-eects such as ination. For example, President John F. Kennedy proposed
tax cuts in response to the high unemployment of 1960,
but these were instituted only in 1964 and impacted the
economy only in 1965 or 1966 and the increased debt en-

[5] (Vickrey 1996, Fallacy 1)

William J. Baumol, Alan S. Blinder (2005). Economics: Principles and Policy. Thomson SouthWestern. ISBN 0-324-22113-4.
Mitchell, Bill: Decit spending 101 Part 1, Part 2,
Part 3; Neo-Chartalist (Modern Monetary Theory)
perspective on decit spending
Vickrey, William (October 5, 1996). Fifteen Fatal Fallacies of Financial Fundamentalism: A Disquisition on Demand Side Economics. Paper was
written one week before the authors death, three
days before he received the Nobel Memorial Prize
in Economics.
McGregor, Michael A., Driscoll, Paul D., McDowell, Walter (2010) Heads Broadcasting in America: A Survey of Electronic Media. Boston, Massachusetts: Allyn & Bacon p. 180

52.5 Further reading

Seater, John J. (2008). Government Debt and
Decits. In David R. Henderson (ed.). Concise
Encyclopedia of Economics (2nd ed.). Indianapolis: Library of Economics and Liberty. ISBN 9780865976658. OCLC 237794267.

Chapter 53

Government budget
public budget redirects here. For the academic study, Thirteen years later, Walpole announced his scal plans
see public budgeting.
to bring in an excise tax on the consumption of a variety of goods, such as wine and tobacco, and to lessen
A government budget is a government document pre- the taxation burden on the landed gentry. This provoked
a wave of public outrage, including erce denunciations
senting the governments proposed revenues and spending
for a nancial year that is often passed by the legislature, from the Whig peer William Pulteney, who wrote a pamphlet entitled The budget opened, Or an answer to a pamapproved by the chief executive or president and presented by the Finance Minister to the nation. The budget phlet. Concerning the duties on wine and tobacco - the
rst time the word 'budget' was used in connection with
is also known as the Annual Financial Statement of the
scal policies. The scheme was eventucountry. This document estimates the anticipated gov- the governments
[3]
ally
rescinded.
ernment revenues and government expenditures for the
ensuing (current) nancial year.[1] For example, only certain types of revenue may be imposed and collected.
Property tax is frequently the basis for municipal and
county revenues, while sales tax and/or income tax are
the basis for state revenues, and income tax and corporate
tax are the basis for national revenues.

The institution of the annual account of the budget

evolved into practice during the rst half of the 18th
century and had become well established by the 1760s;
George Grenville introduced the Stamp Act in his 1764
budget speech to the House of Commons of Great
Britain. [4]

53.1 History

53.2 Types
Government budgets are of three types:
Balanced Budget: when government revenue and
expenditure are equal.
Surplus Budget: when anticipated revenues exceed
expenditure.
Decit Budget: when anticipated expenditure is
greater than revenues.

The nancial crisis caused by the South Sea Bubble led to the
presentation of the government budget under Sir Robert Walpole.
Painting by Edward Matthew Ward.

The practice of presenting budgets and scal policy to

parliament was initiated by Sir Robert Walpole in his
position as Chancellor of the Exchequer, in an attempt
to restore the condence of the public after the chaos
unleashed by the collapse of the South Sea Bubble in
1720.[2]

53.3 Elements
The two basic elements of any budget are the revenues
and expenses. In the case of the government, revenues
are derived primarily from taxes. Government expenses
include spending on current goods and services, which
economists call government consumption; government
investment expenditures such as infrastructure investment or research expenditure; and transfer payments like
unemployment or retirement benets.

272

53.7. EXTERNAL LINKS

273
Seater, John J. (2008). Government Debt and
Decits. In David R. Henderson (ed.). Concise
Encyclopedia of Economics (2nd ed.). Indianapolis: Library of Economics and Liberty. ISBN 9780865976658. OCLC 237794267.

53.7 External links

Budgeted revenues of governments in 2006

53.4 Special consideration

Government budgets have economic, political and technical basis. Unlike a pure economic budget, they are not
entirely designed to allocate scarce resources for the best
economic use. They also have a political basis wherein
dierent interests push and pull in an attempt to obtain
benets and avoid burdens. The technical element is the
forecast of the likely levels of revenues and expenses.

53.5 References
[1] Public Budgeting and Financial Management, Florida International University, Retrieved November 21, 2013
[2] History, Origins and Traditions of the Budget. Retrieved 2012-12-17.
[3] A history of the Budget. Retrieved 2012-12-17.
[4] The rst budget? Walpoles bag of tricks and the origins
of the chancellors great secret. Retrieved 2012-12-17.

Professor L. Randall Wray:Why The Federal Budget Is Not Like a Household Budget
Budget Decits and Net Private Saving
Sectoral Balances in State Budget. By Fred Bethune
Performance Budgeting: Linking Funding and Results, Marc Robinson (ed.), IMF, 2007
Fiscal Policy in a Stock-Flow Consistent Model by
Wynne Godley and Marc Lavoie
From Line-item to Program Budgeting, John Kim,
Seoul, 2007

53.6 Further reading

Higgs, Robert (2008). "http://www.econlib.org/
library/Enc/GovernmentGrowth.html". In David
R. Henderson (ed.). Concise Encyclopedia of
Economics (2nd ed.). Indianapolis: Library of
Economics and Liberty. ISBN 978-0865976658.
OCLC 237794267.

List of countries by budget; its reference is the CIAs

World factbook, in alphabetic order.

Chapter 54

Government budget balance

This article is about government budget decits. For interest payments on the debt.[2]
trade balances, see Balance of trade. For payment Therefore, if t is a timeframe, G is government spending
t
balances, see Balance of payments.
and Tt is tax revenue for the respective timeframe, then
Budget decit redirects here; not to be confused
with Government debt.

decit Primary = Gt Tt

A government budget is a government document presenting the governments proposed revenues and spending
for a nancial year. The government budget balance,
also alternatively referred to as general government balance,[1] public budget balance, or public scal balance, is the overall dierence between government revenues and spending. A positive balance is called a government budget surplus, and a negative balance is a government budget decit. A budget is prepared for each level
of government (from national to local) and takes into account public social security obligations.
The government budget balance is further dierentiated
by closely related terms such as primary balance and
structural balance (also known as cyclically-adjusted balance) of the general government. The primary budget
balance equals the government budget balance before interest payments. The structural budget balances attempts
to adjust for the impacts of the real GDP changes in the
national economy.

54.1 Primary decit, total decit,

and debt

If Dt1 is last years debt, and r is the interest rate, then

the total decit is

decit Total = r Dt1 + Gt Tt

Finally, this years debt can be calculated from last years
debt and this years total decit, as follows:

Dt = (1 + r)Dt1 + Gt Tt
Economic trends can inuence the growth or shrinkage
of scal decits in several ways. Increased levels of economic activity generally lead to higher tax revenues, while
government expenditures often increase during economic
downturns because of higher outlays for social insurance
programs such as unemployment benets. Changes in
tax rates, tax enforcement policies, levels of social benets, and other government policy decisions can also have
major eects on public debt. For some countries, such
as Norway, Russia, and members of the Organization of
Petroleum Exporting Countries (OPEC), oil and gas receipts play a major role in public nances.

Ination reduces the real value of accumulated debt. If

The meaning of decit diers from that of debt, investors anticipate future ination, however, they will
which is an accumulation of yearly decits. Decits oc- demand higher interest rates on government debt, makcur when a governments expenditures exceed the rev- ing public borrowing more expensive.
enue that it generates. The decit can be measured with
or without including the interest payments on the debt as
expenditures.[2]
54.2 Sectoral balances description
The primary decit is dened as the dierence between
current government spending on goods and services and
total current revenue from all types of taxes net of transfer
payments. The total decit (which is often called the scal decit or just the 'decit') is the primary decit plus

The sectoral balances (also called sectoral nancial

balances) are a sectoral analysis framework for macroeconomic analysis of national economies developed by
British economist Wynne Godley.[3]

274

54.2. SECTORAL BALANCES DESCRIPTION

275
resent the net savings of non-residents.
Another way of saying this is that total private savings (S)
is equal to private investment (I) plus the public decit
(spending, G minus taxes, T) plus net exports (exports
(X) minus imports (M)), where net exports represent the
net savings of non-residents.
All these relationships (equations) hold as a matter of accounting and not matters of opinion.

Sectoral nancial balances in U.S. economy 1990-2012. By definition, the three balances must net to zero. Since 2009, the U.S.
capital surplus and private sector surplus have driven a government budget decit.

GDP (Gross Domestic Product) is the value of all goods

and services sold within a country during one year. GDP
measures ows rather than stocks (example: the public
decit is a ow, the government debt is a stock). Flows
are derived from the National Accounting relationship
between aggregate spending and income. Ergo:
(1) Y = C + I + G + (X M)
where Y is GDP (income), C is consumption spending,
I is private investment spending, G is government spending, X is exports and M is imports (so X M = net exports).
Another perspective on the national income accounting is
to note that households can use total income (Y) for the
following uses:
(2) Y = C + S + T

Thus, when an external decit (X M < 0) and public surplus (G - T < 0) coincide, there must be a private decit.
While private spending can persist for a time under these
conditions using the net savings of the external sector, the
private sector becomes increasingly indebted in the process.
In macroeconomics, the Modern Money Theory uses sectoral balances to dene any transactions between the government sector and the non-government sector as a vertical transaction.
The government sector is considered to include the treasury and the central bank, whereas the non-government
sector includes private individuals and rms (including
the private banking system) and the external sector that
is, foreign buyers and sellers.[4]
In any given time period, the governments budget can be
either in decit or in surplus. A decit occurs when the
government spends more than it taxes; and a surplus occurs when a government taxes more than it spends. Sectoral balances analysis states that as a matter of accounting, it follows that government budget decits add net nancial assets to the private sector. This is because a budget decit means that a government has deposited more
money into private bank accounts than it has removed in
taxes. A budget surplus means the opposite: in total, the
government has removed more money from private bank
accounts via taxes than it has put back in via spending.

where S is total saving and T is total taxation (the other

variables are as previously dened).
Therefore, budget decits, by denition, are equivalent to
You than then bring the two perspectives together (be- adding net nancial assets to the private sector; whereas
budget surpluses remove nancial assets from the private
cause they are both just views of Y) to write:
sector.
(3) C + S + T = Y = C + I + G + (X M)
This is represented by the identity:
You can then drop the C (common on both sides) and you
(G-T) = (S-I) NX
get:
(4) S + T = I + G + (X M)
Then you can convert this into the following sectoral balances accounting relations, which allow us to understand
the inuence of scal policy over private sector indebtedness. Hence, equation (4) can be rearranged to get the
accounting identity for the three sectoral balances private domestic, government budget and external:

where G is government spending, T is taxes, S is savings,

I is investment and NX is net exports.
The conclusion drawn from this is that private net saving
is only possible if the government runs budget decits;
alternately, the private sector is forced to dis-save when
the government runs a budget surplus.

According to the sectoral balances framework, budget

surpluses remove net savings; in a time of high eec(S I) = (G T) + (X M)
tive demand, this may lead to a private sector reliance on
The sectoral balances equation says that total private savcredit to nance consumption patterns. Hence, continual
ings (S) minus private investment (I) has to equal the pubbudget decits are necessary for a growing economy that
lic decit (spending, G minus taxes, T) plus net exports
wants to avoid deation. Therefore budget surpluses are
(exports (X) minus imports (M)), where net exports rep-

276

CHAPTER 54. GOVERNMENT BUDGET BALANCE

required only when the economy has excessive aggregate

demand, and is in danger of ination.Because the government can issue its own currency at will, MMT maintains
that the level of taxation relative to government spending
(the governments decit spending or budget surplus) is
in reality a policy tool that regulates ination and unemployment, and not a means of funding the governments
activities per se.

54.3 Overview
Economist Martin Wolf explained in July 2012 that government scal balance is one of three major nancial sectoral balances in the national economy, the others being
the foreign nancial sector and the private nancial sector. The sum of the surpluses or decits across these three
sectors must be zero by denition. Hence, a foreign nancial surplus (or capital surplus) exists because capital is
imported (net) to fund the trade decit. Further, there is
a private sector nancial surplus due to household savings
exceeding business investment. By denition, there must
therefore exist a government budget decit so all three net
to zero. The government sector includes federal, state and
local. For example, the U.S. government budget decit in
2011 was approximately 10% GDP (8.6% GDP of which
was federal), osetting a capital surplus of 4% GDP and
a private sector surplus of 6% GDP.[5]

French government borrowing (budget decits) as a percentage

of GNP, 19602009.

Wolf argued that sudden shifts in the private sector from

decit to surplus forced the government balance into
decit, and cited as example the U.S.: The nancial
balance of the private sector shifted towards surplus by
the almost unbelievable cumulative total of 11.2 per cent
of gross domestic product between the third quarter of
2007 and the second quarter of 2009, which was when
the nancial decit of US government (federal and state)
reached its peak...No scal policy changes explain the
collapse into massive scal decit between 2007 and
2009, because there was none of any importance. The
collapse is explained by the massive shift of the private sector from nancial decit into surplus or, in other
words, from boom to bust.[5]

The structural decit is the decit that remains across the

business cycle, because the general level of government
spending exceeds prevailing tax levels. The observed total
budget decit is equal to the sum of the structural decit
with the cyclical decit or surplus.

Economist Paul Krugman also explained in December

2011 the causes of the sizable shift from private decit
to surplus: This huge move into surplus reects the end
of the housing bubble, a sharp rise in household saving, and a slump in business investment due to lack of
customers.[6]

est point in the business cycle, there is a high level of

unemployment. This means that tax revenues are low and
expenditure (e.g., on social security) high. Conversely, at
the peak of the cycle, unemployment is low, increasing
tax revenue and decreasing social security spending. The
additional borrowing required at the low point of the cycle is the cyclical decit. By denition, the cyclical decit
will be entirely repaid by a cyclical surplus at the peak of
the cycle.

Some economists have criticized the distinction between

cyclical and structural decits, contending that the business cycle is too dicult to measure to make cyclical analysis worthwhile.[7]
The scal gap, a measure proposed by economists Alan
Auerbach and Laurence Kotliko, measures the dierence between government spending and revenues over the
very long term, typically as a percentage of Gross Domestic Product. The scal gap can be interpreted as the
percentage increase in revenues or reduction of expenditures necessary to balance spending and revenues in the
long run. For example, a scal gap of 5% could be eliminated by an immediate and permanent 5% increase in
taxes or cut in spending or some combination of both.[8]

It includes not only the structural decit at a given point

in time, but also the dierence between promised fu54.4 Structural decits, cyclical ture government commitments, such as health and retirement spending, and planned future tax revenues. Since
decits, and the scal gap
the elderly population is growing much faster than the
young population in many developed countries, many
Main article: Structural and cyclical decit
economists argue that these countries have important sA government decit can be thought of as consisting cal gaps, beyond what can be seen from their decits
of two elements, structural and cyclical. At the low- alone.

54.6. DEFICIT SPENDING

54.4.1

National government budgets

Data are for 2010:[9]

54.5 Early decits

United States decit or surplus percentage 1901 to 2006.

Before the invention of bonds, the decit could only be

nanced with loans from private investors or other countries. A prominent example of this was the Rothschild
dynasty in the late 18th and 19th century, though there
were many earlier examples.

277
fallacy seems to stem from a false analogy to borrowing by
individuals.Current reality is almost the exact opposite.
Decits add to the net disposable income of individuals,
to the extent that government disbursements that constitute income to recipients exceed that abstracted from disposable income in taxes, fees, and other charges. This
added purchasing power, when spent, provides markets
for private production, inducing producers to invest in
additional plant capacity, which will form part of the real
heritage left to the future. This is in addition to whatever
public investment takes place in infrastructure, education,
research, and the like. Larger decits, sucient to recycle
savings out of a growing gross domestic product (GDP) in
excess of what can be recycled by prot-seeking private
investment, are not an economic sin but an economic necessity. Decits in excess of a gap growing as a result of
the maximum feasible growth in real output might indeed
cause problems, but we are nowhere near that level. Even
the analogy itself is faulty. If General Motors, AT&T,
and individual households had been required to balance
their budgets in the manner being applied to the Federal
government, there would be no corporate bonds, no mortgages, no bank loans, and many fewer automobiles, telephones, and houses.
15 Fatal Fallacies of Financial FundamentalismWilliam Vickrey 1996

These loans became popular when private nanciers had 54.6.1 Ricardian equivalence
amassed enough capital to provide them, and when governments were no longer able to simply print money, with The Ricardian equivalence hypothesis, named after the
English political economist and Member of Parliament
consequent ination, to nance their spending.
David Ricardo, states that because households anticipate
However, large, long-term loans had a high element of that current public decit will be paid through future
risk for the lender and consequently gave high interest taxes, those households will accumulate savings now to
rates. Governments later began to issue bonds that were oset those future taxes. If households acted in this way,
payable to the bearer, rather than the original purchaser. a government would not be able to use tax cuts to stimuThis meant that someone who lent the state money could late the economy. The Ricardian equivalence result resell on the debt to someone else, reducing the risks in- quires several assumptions. These include households
volved and reducing the overall interest rates. Examples acting as if they were innite-lived dynasties as well as asof this are British Consols and American Treasury bill sumptions of no uncertainty and no liquidity constraints.
bonds.
Also, for Ricardian equivalence to apply, the decit
spending would have to be permanent. In contrast, a onetime stimulus through decit spending would suggest a
54.6 Decit spending
lesser tax burden annually than the one-time decit expenditure. Thus temporary decit spending is still expansionary. Empirical evidence on Ricardian equivalence efMain article: Decit spending
fects has been mixed.
According to most economists, during recessions, the
government can stimulate the economy by intention- 54.6.2 Crowding-out hypothesis
ally running a decit. As Professor William Vickrey ,
awarded with the 1996 Nobel Memorial Prize in Eco- The crowding-out hypothesis is the assumption that when
nomic Sciences put it :
a government experiences a decit, the choice to borrow
Decits are considered to represent sinful proigate to oset that decit draws on the pool of resources availspending at the expense of future generations who will be able for investment and private investment gets crowded
left with a smaller endowment of invested capital. This out. This crowding-out eect is induced by changes in

278

CHAPTER 54. GOVERNMENT BUDGET BALANCE

the interest rate. When the government wishes to borrow, with their electorate, or popularity with their donors.
their demand for credit increases and the interest rate, or
price of credit, increases. This increase in the interest rate
makes private investment more expensive as well and less 54.7.2 Changes in tax code
of it is used.[11]
Similar to increasing taxes, changes can be made to the
tax code that increases tax revenue. Closing tax loopholes
and allowing fewer deductions are dierent from the act
54.7 Potential policy solutions for of
increasing taxes but essentially have the same eect.

unintended decits

54.7.1

54.7.3 Reduce debt service liability

Increase taxes or reduce government spending
Every year, the government must pay debt service payments on their overall public debt. These payments include principal and interest payments. Occasionally, the
government has the opportunity to renance some of their
public debt to aord them lower debt service payments.
Doing this would allow the government to cut expenditures without cutting government spending.[12]

54.8 See also

Current account
Fiscal policy
Generational accounting
Government budget
List of countries by current account balance
Public nance
Sectoral balances
U.S.-specic
Decit hawk
Fiscal policy of the United States
The government surplus/decit of struggling European countries according to European sovereign debt crisis: Italy, Cyprus,
Portugal, Spain, Greece, United Kingdom and Ireland against the
Eurozone and the United States (20002013).

National debt by U.S. presidential terms

If a reduction in a structural decit is desired, either revenue must increase, spending must decrease, or both.
Taxes may be increased for everyone/every entity across
the board or lawmakers may decide to assign that tax burden to specic groups of people (higher-income individuals, businesses, etc.) Lawmakers may also decide to cut
government spending.

United States federal budget

Like with taxes, they could decide to cut the budgets of

every government agency/entity by the same percentage
or they may decide to give a greater budget cut to specic agencies. Many, if not all, of these decisions made
by lawmakers are based on political ideology, popularity

Starve-the-beast
Taxation in the United States

United States public debt

54.9 References
[1] IMF database. Imf.org. 2006-09-14. Retrieved 201302-01.
[2] Michael Burda and Charles Wyplosz (1995), European
Macroeconomics, 2nd ed., Ch. 3.5.1, p. 56. Oxford University Press, ISBN 0-19-877468-0.

54.10. EXTERNAL LINKS

279

[3] Goldmans Top Economist Explains The Worlds Most

Important Chart, And His Big Call For The US Economy

National accounting identities and the sectoral balance approach

[4] Decit Spending 101 - Part 1 : Vertical Transactions

Bill Mitchell, 21 February 2009

Sectoral Balances in a National Budget- part 1 by

Professor William Mitchell University of Newcastle

[5] Financial Times-Martin Wolf-The Balance Sheet Recession in the U.S.- July 2012

Sectoral Balances in a National Budget- part 2 by

Professor William Mitchell University of Newcastle

[6] NYT-Paul Krugman-The Problem-December 2011

Sectoral Balances in a National Budget- part 3 by

Professor William Mitchell University of Newcastle

[7] Dillow, Chris (15 February 2010). The myth of the

structural decit. Investors Chronicle. The Financial
Times Limited. Retrieved 19 May 2013.
[8] AARP article on the scal gap
[9] Data on the United States federal debt can be found at
U.S. Treasury website. Data on U.S. state government nances can be found at the National Association of State
Budget Ocers website. Data for most advanced countries can be obtained from the Organization for Economic
Cooperation and Development (OECD) website. Data
for most other countries can be found at the International
Monetary Fund (IMF) website.
[10] In this column, a negative number represents a decit, and
a positive number represents a surplus.
[11] Harvey S. Rosen (2005), Public Finance, 7th Ed., Ch. 18
p. 464. McGraw-Hill Irwin, ISBN 0-07-287648-4
[12] Steven A. Finkler (2005), Financial Management For
Public, Health And Not-For-Prot Organizations, 2nd Ed.,
Ch. 11, pp. 44243. Pearson Education, Inc, ISBN 0-13147198-8.

54.10 External links

United States
The Basics of Macro Accounting By Professor L.
Randall Wray University of Kansas City Missouri
Higgs, Robert (2008). "http://www.econlib.org/
library/Enc/GovernmentGrowth.html". In David
R. Henderson (ed.). Concise Encyclopedia of
Economics (2nd ed.). Indianapolis: Library of
Economics and Liberty. ISBN 978-0865976658.
OCLC 237794267.
Seater, John J. (2008). Government Debt and
Decits. In David R. Henderson (ed.). Concise
Encyclopedia of Economics (2nd ed.). Indianapolis: Library of Economics and Liberty. ISBN 9780865976658. OCLC 237794267.
Decit spending by Professor William Mitchell University of Newcastle part 1
Decit spending by Professor William Mitchell University of Newcastle part 2

Death and Taxes: 2009 A graphical representation

of the 2009 United States federal discretionary budget, including the public debt.
United States Decit versus Savings rate from
1981 Historical graphical representation of the 12
month rolling Fiscal decit versus the Savings rate
of the United States. (since 1981)
Government decit calculator from AARP
Hong Kong
Hong Kong Government Budget
Finland
Statistics Finland General government decit and
gross debt according to EMU criteria

Chapter 55

Government debt
See also: List of countries by public debt
Government debt (also known as public debt, national
debt and sovereign debt)[1][2] is the debt owed by a
central government. (In the U.S. and other federal states,
government debt may also refer to the debt of a state or
provincial government, municipal or local government.)
By contrast, the annual "government decit" refers to the
dierence between government receipts and spending in
a single year, that is, the increase of debt over a particular
year.
Government debt is one method of nancing government
operations, but it is not the only method. Governments
can also create money to monetize their debts, thereby removing the need to pay interest. But this practice simply The sealing of the Bank of England Charter (1694)
reduces government interest costs rather than truly canceling government debt,[3] and can result in hyperination
if used unsparingly.
ing to the king and the nances of countries that were
Governments usually borrow by issuing securities, often at war remained extremely volatile.
government bonds and bills. Less creditworthy countries
The creation of the rst central bank in England - an instisometimes borrow directly from a supranational organitution designed to lend to the government - was initially an
zation (e.g. the World Bank) or international nancial
expedient by William III of England for the nancing of
institutions.
his war against France. He engaged a syndicate of City
As the government draws its income from much of the traders and merchants to oer for sale an issue of govpopulation, government debt is an indirect debt of the tax- ernment debt. This syndicate soon evolved into the Bank
payers. Government debt can be categorized as internal of England, eventually nancing the wars of the Duke of
debt (owed to lenders within the country) and external Marlborough and later Imperial conquests.
debt (owed to foreign lenders). Another common diviThe establishment of the bank was devised by Charles
sion of government debt is by duration until repayment
Montagu, 1st Earl of Halifax, in 1694, to the plan which
is due. Short term debt is generally considered to be for
had been proposed by William Paterson three years beone year or less, long term is for more than ten years.
fore, but had not been acted upon.[4] He proposed a loan
Medium term debt falls between these two boundaries.
of 1.2m to the government; in return the subscribers
A broader denition of government debt may consider all
would be incorporated as The Governor and Company
government liabilities, including future pension payments
of the Bank of England with long-term banking priviand payments for goods and services the government has
leges including the issue of notes. The Royal Charter was
contracted but not yet paid.
granted on 27 July through the passage of the Tonnage
Act 1694.[5]
The founding of the Bank of England revolutionised public nance and put an end to defaults such as the Great
Stop of the Exchequer of 1672, when Charles II had susDuring the Early Modern era, European monarchs would pended payments on his bills. From then on, the British
often default on their loans or arbitrarily refuse to pay Government would never fail to repay its creditors.[6] In
them back. This generally made nanciers wary of lend- the following centuries, other countries in Europe and late

55.1 History

280

55.3. BY COUNTRY

281

Public debt as a percent of GDP by CIA

A new way to pay the National Debt, James Gillray, 1786. King
George III, with William Pitt handing him another moneybag.

around the world adopted similar nancial institutions to

manage their government debt.
Government debt as a percent of GDP by IMF
In 1815, at the end of the Napoleonic Wars, British government debt reached a peak of more than 200% of
ments are prohibited by law from printing money directly,
GDP.[7]
that function having been relegated to their central banks.
However, central banks may buy government bonds in order to nance government spending, thereby monetizing
55.2 Government and sovereign the debt.

bonds

Government debt, synonymous to sovereign debt,[9] can

be issued either in domestic or foreign currencies. Investors in sovereign bonds denominated in foreign curMain article: government bond
A government bond is a bond issued by a national gov- rency have exchange rate risk: the foreign currency
might depreciate against the investors local currency.
Sovereigns issuing debt denominated in a foreign curDebt
General government consolidated gross debt, percentage of GDP (source: EUROSTAT)
rency may furthermore be unable to obtain that foreign
250%
currency to service debt. In the 2010 Greek debt crisis,
D
UK
for example, the debt is held by Greece in Euros, and one
E
200%
F
I
proposed solution (advanced notably by World Pensions
USA
J
Council (WPC) nancial economists) is for Greece to
150%
go back to issuing its own drachma.[10][11] This proposal
would only address future debt issuance, leaving substan100%
tial existing debts denominated in what would then be a
foreign currency, potentially doubling their cost[12]
50%
0%
1995

2000

Year

2005

2010

Public debt as a percent of GDP, evolution for USA, Japan and

the main EU economies.

ernment. Such bonds are most often denominated in the

countrys domestic currency. Sovereigns can also issue
debt in foreign currencies: almost 70% of all debt in 2000
was denominated in US dollars.[8] Government bonds are
sometimes regarded as risk-free bonds, because national
governments can raise taxes or reduce spending, and in
extreme cases they can print more money to redeem
the bond at maturity. Most developed country govern-

55.3 By country
Further information: List of countries by public debt and
List of countries by future gross government debt
Public Debt is the total of all government borrowings
less repayments that are denominated in a countrys home
currency. CIAs World Factbook list only percentage of
GDP, the debt amount and per capita is calculated with
GDP (PPP) and population gures of same report.
Using a debt to GDP ratio is one of the most accepted
measures of assessing the signicance of a nations debt.

282

CHAPTER 55. GOVERNMENT DEBT

Outdated Tables

55.4 Municipal, provincial, or state

bonds
Further information: Municipal bond

General government debt as percent of GDP, USA, Japan,

Germany.

Municipal bonds, munis in the United States, are debt

securities issued by local governments (municipalities).

55.5 Denominated in reserve currencies

Governments often borrow money in a currency in which
the demand for debt securities is strong. An advantage
of issuing bonds in a currency such as the US dollar, the
pound sterling, or the euro is that many investors wish to
invest in such bonds. Countries such as the United States,
Germany, Italy and France have only issued in their domestic currency (or in the Euro in the case of Euro members).
Interest burden of public debt with respect to GDP.

Relatively few investors are willing to invest in currencies that do not have a long track record of stability. A
disadvantage for a government issuing bonds in a foreign
currency is that there is a risk that it will not be able to
obtain the foreign currency to pay the interest or redeem
the bonds. In 1997 and 1998, during the Asian nancial
crisis, this became a serious problem when many countries were unable to keep their exchange rate xed due to
speculative attacks.

55.6 Risk
Main article: Credit risk
National Debt Clock outside the IRS oce in NYC, April 20, 2012

Although there is always default risk, lending to a national

government in the countrys own sovereign currency is ofFor example, one of the criteria of admission to the ten considered risk free and is done at a so-called "riskEuropean Union's euro currency is that an applicant coun- free interest rate. This is because, up to a point, the debt
trys debt should not exceed 60% of that countrys GDP. and interest can be repaid by raising tax receipts (either by
* US data exclude debt issued by individual US states, as well economic growth or raising tax revenue), a reduction in
as intra-governmental debt; intra-governmental debt consists of spending, or failing that by simply printing more money.
Treasury borrowings from surpluses in the trusts for Federal So- It is widely considered that this would increase ination
cial Security, Federal Employees, Hospital Insurance (Medicare and thus reduce the value of the invested capital (at least
and Medicaid), Disability and Unemployment, and several other for debt not linked to ination). This has happened many
smaller trusts; if data for intra-government debt were added, times throughout history, and a typical example of this
Gross Debt would increase by about one-third of GDP. The is provided by Weimar Germany of the 1920s which sufdebt of the United States over time is documented online at the fered from hyperination due to its governments inability
Department of the Treasurys website TreasuryDirect.Gov[14] as to pay the national debt deriving from the costs of World
well as current totals.[15]
War I.

55.7. CLEARING AND DEFAULTS

In practice, the market interest rate tends to be dierent
for debts of dierent countries. An example is in borrowing by dierent European Union countries denominated
in euros. Even though the currency is the same in each
case, the yield required by the market is higher for some
countries debt than for others. This reects the views of
the market on the relative solvency of the various countries and the likelihood that the debt will be repaid. Further, there are historical examples where countries defaulted, i.e., refused to pay their debts, even when they
had the ability of paying it with printed money. This is
because printing money has other eects that the government may see as more problematic than defaulting.
A politically unstable state is anything but risk-free as it
maybeing sovereigncease its payments. Examples
of this phenomenon include Spain in the 16th and 17th
centuries, which nullied its government debt seven times
during a century, and revolutionary Russia of 1917 which
refused to accept the responsibility for Imperial Russia's
foreign debt.[17] Another political risk is caused by external threats. It is mostly uncommon for invaders to accept responsibility for the national debt of the annexed
state or that of an organization it considered as rebels.
For example, all borrowings by the Confederate States of
America were left unpaid after the American Civil War.
On the other hand, in the modern era, the transition from
dictatorship and illegitimate governments to democracy
does not automatically free the country of the debt contracted by the former government. Todays highly developed global credit markets would be less likely to lend to
a country that negated its previous debt, or might require
punishing levels of interest rates that would be unacceptable to the borrower.

283
just as a national one could. Further, local government
loans are sometimes guaranteed by the national government, and this reduces the risk. In some jurisdictions,
interest earned on local or municipal bonds is tax-exempt
income, which can be an important consideration for the
wealthy.

55.7 Clearing and defaults

Main articles: sovereign default, clearing (nance) and
default (nance)
Public debt clearing standards are set by the Bank for International Settlements, but defaults are governed by extremely complex laws which vary from jurisdiction to jurisdiction. Globally, the International Monetary Fund can
take certain steps to intervene to prevent anticipated defaults. It is sometimes criticized for the measures it advises nations to take, which often involve cutting back
on government spending as part of an economic austerity
regime. In triple bottom line analysis, this can be seen
as degrading capital on which the nations economy ultimately depends.

Those considerations do not apply to private debts, by

contrast: credit risk (or the consumer credit rating) determines the interest rate, more or less, and entities go
bankrupt if they fail to repay. Governments need a far
more complex way of managing defaults because they
cannot really go bankrupt (and suddenly stop providing
services to citizens), albeit in some cases a government
may disappear as it happened in Somalia or as it may
U.S. Treasury bonds denominated in U.S. dollars are of- happen in cases of occupied countries where the occuten considered risk free in the U.S. This disregards the pier doesn't recognize the occupied countrys debts.
risk to foreign purchasers of depreciation in the dollar Smaller jurisdictions, such as cities, are usually guaranrelative to the lenders currency. In addition, a risk-free teed by their regional or national levels of government.
status implicitly assumes the stability of the US govern- When New York City declined into what would have been
ment and its ability to continue repayments during any a bankrupt status during the 1970s (had it been a private
nancial crisis.
entity), by the mid-1970s a "bailout" was required from
Lending to a national government in a currency other than New York State and the United States. In general, such
its own does not give the same condence in the ability measures amount to merging the smaller entitys debt into
to repay, but this may be oset by reducing the exchange that of the larger entity and thereby giving it access to the
rate risk to foreign lenders. On the other hand, national lower interest rates the larger entity enjoys. The larger
debt in foreign currency cannot be disposed of by start- entity may then assume some agreed-upon oversight in
ing a hyperination; and this increases the credibility of order to prevent recurrence of the problem.
the debtor. Usually small states with volatile economies
have most of their national debt in foreign currency. For
countries in the Eurozone, the euro is the local currency, 55.8 Economic policy basis
although no single state can trigger ination by creating
more currency.
According to Modern Monetary Theory, public debt is
Lending to a local or municipal government can be just seen as private wealth and interest payments on the debt
as risky as a loan to a private company, unless the local as private income. The outstanding public debt is an
or municipal government has sucient power to tax. In expression of the accumulated previous budget decits
this case, the local government could to a certain extent which have added nancial assets to the private sector,
pay its debts by increasing the taxes, or reduce spending, providing demand for goods and services. Adherents
of this school of economic thought argue that the scale

284
of the problem is much less severe than is popularly
supposed.[18]

CHAPTER 55. GOVERNMENT DEBT

55.9 Structure and risk of a public

debt

Wolfgang Sttzel showed with his Saldenmechanik

(Balances Mechanics) how a comprehensive debt re- Understanding the structure of public debt and analyzing
demption would compulsorily force a corresponding in- its risk requires one to:
debtedness of the private sector, due to a negative
Keynes-multiplier leading to crisis and deation. [19]
Assess the expected value of any public asset being
In the dominant economic policy generally ascribed to
constructed, at least in future tax terms if not in ditheories of John Maynard Keynes, sometimes called
rect revenues. A choice must be made about its staKeynesian economics, there is tolerance for fairly high
tus as a public goodsome public assets end up as
levels of public debt to pay for public investment in lean
public bads, such as nuclear power plants which are
times, which, if boom times follow, can then be paid
extremely expensive to decommissionthese costs
back from rising tax revenues. Empirically, however,
must also be worked into asset values.
sovereign borrowing in developing countries is procyclical, since developing countries have more diculty ac Determine whether any public debt is being used to
cessing capital markets in lean times.[20]
nance consumption, which includes all social assistance and all military spending.
As this theory gained global popularity in the 1930s,
many nations took on public debt to nance large
infrastructural capital projectssuch as highways or
large hydroelectric dams. It was thought that this could
start a virtuous cycle and a rising business condence
since there would be more workers with money to spend.
Some have argued that the greatly increased military
spending of World War II really ended the Great Depression. Of course, military expenditures are based upon
the same tax (or debt) and spend fundamentals as the rest
of the national budget, so this argument does little to undermine Keynesian theory. Indeed, some have suggested
that signicantly higher national spending necessitated by
war essentially conrms the basic Keynesian analysis (see
Military Keynesianism).

Determine whether triple bottom line issues are

likely to lead to failure or defaults of governments
say due to being overthrown.

for trade disputes, the World Trade Organization also has

immense power to aect foreign exchange relations, as
many nations are dependent on specic commodity markets for the balance of payments they require to repay
debt.

Not all developing countries have been aected to the

same extent. For example Yugoslavia had low government debt (perhaps because it was unable to borrow
on world markets) until its breakup and the coming of
democracy, when the new national governments started to
borrow money from the IMF. Croatia has a government
debt of $47 billion today while the whole of Yugoslavia
(six times as many people as Croatia) in 1980 had debt
of $14 billion.

Determine whether any of the debt being undertaken may be held to be odious debt, which might
permit it to be disavowed without any eect on a
countrys credit status. This includes any loans to
purchase assets such as leaders palaces, or the
peoples suppression or extermination. International
law does not permit people to be held responsible for
such debtsas they did not benet in any way from
the spending and had no control over it.

Determine if any future entitlements are being creNonetheless, the Keynesian scheme remained dominant,
ated by expendituresnancing a public swimming
thanks in part to Keynes own pamphlet How to Pay for
pool for instance may create some right to recreation
the War, published in the United Kingdom in 1940. Since
where it did not previously exist, by precedent and
the war was being paid for, and being won, Keynes and
expectations.
Harry Dexter White, Assistant Secretary of the United
States Department of the Treasury, were, according to
John Kenneth Galbraith, the dominating inuences on the
Bretton Woods agreements. These agreements set the 55.10 Problems
policies for the Bank for International Settlements (BIS),
International Monetary Fund (IMF), and World Bank, the Sovereign debt problems have been a major public policy
so-called Bretton Woods Institutions, launched in the late issue since World War II, including the treatment of debt
1940s for the last two (the BIS was founded in 1930).
related to that war, the developing country debt crisis in
These are the dominant economic entities setting policies the 1980s, and the shocks of the 1998 Russian nancial
regarding public debt. Due to its role in setting policies crisis and Argentinas default in 2001.

Global debt is of great concern since interest payments

can often place great demands on governments and indi-

55.13. REFERENCES
viduals. This has led to calls for universal debt relief for
poorer countries.

55.11 Implicit debt

285
Government spending
Generational accounting
Financial repression
Fiscal policy

Government implicit debt is the promise by a govern Public nance

ment of future payments from the state. Usually this
Sovereign default
refers to long term promises of social payments such as
pensions and health expenditure; not promises of other
Tax
expenditure such as education or defense (which are
largely paid on a "quid pro quo" basis to government emSpecic:
ployees and contractors).
A problem with these implicit government insurance li 2010 European sovereign debt crisis
abilities is that it is hard to cost them accurately, since
United States public debt
the amounts of future payments depend on so many factors. First of all, the social security claims are not open
bonds or debt papers with a stated time frame, "time to General:
maturity", "nominal value", or "net present value".
In the United States, as in most other countries, there is
no money earmarked in the governments coers for future social insurance payments. This insurance system is
called PAYGO (pay-as-you-go). Alternative social insurance strategies might have included a system that involved
save and invest.

Bond (nance)

Furthermore, population projections predict that when

the "baby boomers" start to retire, the working population in the United States, and in many other countries,
will be a smaller percentage of the population than it is
now, for many years to come. This will increase the burden on the country of these promised pension and other
paymentslarger than the 65 percent[21] of GDP that it
is now. The burden of the government is what it spends,
since it can only pay its bills through taxes, debt, and increasing the money supply (government spending = tax
revenues + change in government debt held by public +
change in monetary base held by the public). Government social benets paid by the United States government during 2003 totaled $1.3 trillion.[22]

List of countries by external debt

In 2010 the European Commission required EU Member

Countries to publish their debt information in standardized methodology, explicitly including debts that were
previously hidden in a number of ways to satisfy minimum requirements on local (national) and European
(Stability and Growth Pact) level.[23]

55.12 See also

Government nance:
Debt crisis
Government bond
Government budget decit

Credit default swap

Warrant (of Payment)
List of countries by credit rating

List of countries by net international investment position

List of countries by public debt

55.13 References
[1] Bureau of the Public Debt Homepage. United State Department of the Treasury. Retrieved October 12, 2010.
[2] FAQs: National Debt. United State Department of the
Treasury. Retrieved October 12, 2010.
[3] The Economics of Money, Banking, and the Financial
Markets 7ed, Frederic S. Mishkin
[4] Committee of Finance and Industry 1931 (Macmillan Report) description of the founding of Bank of England.
Books.google.ca. Retrieved 10 May 2010. Its foundation in 1694 arose out the diculties of the Government
of the day in securing subscriptions to State loans. Its primary purpose was to raise and lend money to the State
and in consideration of this service it received under its
Charter and various Act of Parliament, certain privileges
of issuing bank notes. The corporation commenced, with
an assured life of twelve years after which the Government had the right to annul its Charter on giving one years
notice. '''Subsequent extensions of this period coincided
generally with the grant of additional loans to the State'''"
[5] H. Roseveare, /The Financial Revolution 16601760/
(1991, Longman), pp. 34

286

CHAPTER 55. GOVERNMENT DEBT

[6] Ferguson, Niall (2008). The Ascent of Money: A Financial

History of the World. Penguin Books, London. p. 76.
[7] UK public spending Retrieved September 2011
[8] Empirical Research on Sovereign Debt and Default.
Federal Reserve Board of Chicago. Retrieved 2014-0618.

[10] M. Nicolas J. Firzli, Greece and the Roots the EU Debt

Crisis The Vienna Review, March 2010
[11] EU accused of 'head in sand' attitude to Greek debt crisis. Telegraph.co.uk. Retrieved 2012-09-11.
[12] Why leaving the euro would still be bad for both Greece
and the currency area The Economist, 2015-01-17
[13] Country Comparison :: Public debt. cia.gov. Retrieved
May 16, 2013.
[14] Government Historical Debt Outstanding Annual.
Treasurydirect.gov. 2010-10-01. Retrieved 2011-11-08.
[15] Debt to the Penny (Daily History Search Application)".
Treasurydirect.gov. Retrieved 2014-02-03.
[16] Country Comparison :: Public debt. cia.gov. Retrieved
November 8, 2011.
[17] Hedlund, Stefan (2004). Foreign Debt. Encyclopedia
of Russian History (reprinted in Encyclopedia.com). Retrieved 3 March 2010.
Debts,

[19] Wolfgang Sttzel: Volkswirtschaftliche Saldenmechanik

Tbingen : Mohr Siebeck, 2011, Nachdr. der 2. Au.,
Tbingen, Mohr, 1978, S. 86
[20] The Economics and Law of Sovereign Debt and Default.
Journal of Economic Literature. 2009. Retrieved 201406-18.
[21] Report for Selected Countries and Subjects.
International Monetary Fund.
Retrieved 2010-1012.(General government gross debt 2008 estimates
rounded to one decimal place)
[22] Government Social Benets Table.
[23] COUNCIL REGULATION (EC) No 479/2009. Retrieved 2011-11-08.

55.14 External links

US-National-Debt-Clock (Live-Counter)
The IMF Public Financial Management Blog
OECD government debt statistics
Canadian Taxpayers Federation debt clock

French public debt clock

UK national debt clock
Germanys taxpayers union and debt clock (at the
top of the page)
Japans Central Government Debt

[9] FT Lexicon The Financial Times

[18] http://hir.harvard.edu/
debt-deficits-and-modern-monetary-theory
Decits and MMT

European national debt clocks

Riksgldskontoret Swedish national debt oce

United States Treasury, Bureau of Public Debt The
Debt to the Penny and Who Holds It
The US National Debt Clock by Ed Hall
Slaying the Dragon of Debt, Regional Oral History
Oce, The Bancroft Library, University of California, Berkeley
A historical collection of documents on or referring
to government spending and scal policy, available
on FRASER
Eisner, Robert (1993). Federal Debt. In David
R. Henderson (ed.). Concise Encyclopedia of Economics (1st ed.). Library of Economics and Liberty.
OCLC 317650570, 50016270 and 163149563

55.14.1 Databases
CLYPS dataset on public debt level and composition
in Latin America

Chapter 56

Non-tax revenue
Fees for the granting or issuance of permits or licenses. Examples include vehicle registration plate
permits, vehicle registration fees, watercraft registration fees, building fees, drivers licenses, hunting
and shing licenses, fees for professional licensing, fees for visas or passports, fees for demolition,
rezoning, and land grading (which causes silt), and
sometimes for increasing stormwater runo, destroying native vegetation, and cutting-down healthy
trees.

Non-tax revenue or non-tax receipts are government

revenue not generated from taxes.

56.1 Sources of non-tax revenue

Examples include:
Aid from another level of government (intragovernmental aid) - for example, in the United States,
federal grants may be considered non-tax revenue to
the receiving states, and equalization payments

User fees collected in exchange for the use of many

public services and facilities. Tolls charged for the
use of toll roads are an example

Aid from abroad (foreign aid)

Tribute or indemnities paid by a weaker state to a
stronger one, often as a condition of peace after suffering military defeat. The war reparations paid by
the defeated Central Powers after the First World
War oer a well-known example.

Donations and voluntary contributions to the state

56.2 References

Loans, or other borrowing, from monetary funds

and/or other governments
Revenue from state-owned enterprises (for example,
revenue from Public Sector Unions)
Revenue (including interest or prot) from
investment funds (collective investment schemes),
sovereign wealth funds, or endowments
Revenues from sales of state assets
Rents, concessions, and royalties collected by the
state when it contracts out the right to prot from
some good or service to a private corporation.
An example are contracts for resource extraction
(for such natural resources as minerals, timber,
petroleum and natural gas, or marine resources)
collected privately under license from state-owned
lands
Fines collected and assets forfeitured as a penalty.
Examples include parking nes, court costs levied
on criminal oenders
287

Chapter 57

Warrant of payment
This article is about a payment method. For the nancial
instrument, see warrant (nance). For other uses, see
Warrant.
In nancial transactions, a warrant is a written order
from a rst person that instructs a second person to pay a
specied recipient a specic amount of money or goods
at a specic time.[1] The warrant may or may not be negotiable and may authorize payment to the warrant holder
on demand or after a maturity date. Governments may
choose to pay wages and other accounts payable by issuing warrants instead of checks.

57.1 History
In the 18th century, warrants were used by the military
to authorize payments to soldiers and suppliers. George
Washington, for example, signed warrants that ordered
quartermasters to deliver money or acquire supplies. [2]
These warrants were used by quartermasters to issue
vouchers to acquire food, supplies, munitions, clothing,
transportation, etc. for the use of the American military
and to maintain Washingtons headquarters. Warrants
could be redeemed by the army paymasters, but most often they were used like cash by the recipient. Warrants,
like bills of exchange and vouchers, were often heavily
discounted and depreciated in value. The fortunes of war
could be traced through the discount rates on warrants,
vouchers, and Continental dollars.
In the early days of the colony at Sydney Cove in Australia, the merchant Robert Campbell was one of the rst
merchants to attempt to trade, but lacked sucient currency. When he rst sailed into Sydney aboard his companys ship the Hunter in 1798,[3] Campbell was forced
to sell his rst consignment of goods to a syndicate of
military ocers in return for Paymasters Bills drawn on
London, which were like warrants.[4]

57.2 Modern warrants

Sample Registered Warrant

In government nance, a warrant is a written order to

pay that instructs a federal, state, or county government
treasurer to pay the warrant holder on demand or after a maturity date. Such warrants look like checks and
clear through the banking system like checks, but are
not drawn against cleared funds in a checking account
(demand deposit account). Instead they may be drawn
against available funds or out of fund 0027 so that
the issuer can collect interest on the oat or delay redemption. If the warrant is conditional on funds being
available, the warrant is not a negotiable debt instrument.
In the U.S., warrants are issued by government entities
such as the military and state and county governments.
Warrants are issued for payroll to individual employees,
accounts payable to vendors, to local governments, to taxpayers receiving tax refunds, to recipients of unemployment benets, and to owners of unclaimed money. A
warrant diers from a check in that the warrant is not
drawn on a checking account, is not necessarily payable
on demand, and may not be negotiable.[5][6]
Warrants deposited in a bank are routed (based on the
MICR routing number) to a collecting bank which processes them as collection items like maturing treasury
bills and presents the warrants to the government entitys
treasury department for payment to the bank each business day.

Regular warrants are redeemable by the government treasurer after they are issued. Registered Warrants bear
The term warrant may continue to be used broadly as an interest and need not be redeemed by the treasurer until
order to pay or an order to deliver goods.
the warrant maturity date.[7] If warrants cannot be imme288

57.7. EXTERNAL LINKS

diately redeemed by the issuing entity, the collecting bank
may accept the warrants as short term debt instruments
and collect interest when redeemed in accordance with
a prior agreement with the issuing entity. The collecting
bank may refuse to accept a warrant issue, in which case
other banks may also refuse to accept them. [8]
The warrants of a municipal corporation are not negotiable instruments. They do not constitute a new debt, or
evidence of a new debt, but are only the prescribed means
devised by law for drawing money from the treasury.[9]
The U.S. Securities and Exchange Commission said on
July 9, 2009 that Californias Registered Warrants are
securities under federal securities law and will be regulated as municipal securities by the Municipal Securities
Rulemaking Board.[10] Under these regulations anybody
who prots by buying and reselling warrants must be registered as a municipal securities broker-dealer.[11]

289

[3] Steven, Margaret (2006). Campbell, Robert senior

(1769 - 1846)". Australian Dictionary of Biography,
ANU. Retrieved 7 June 2010.
[4] Binney, Keith Robert (2005).
The Merchants.
Horsemen of the rst frontier (1788-1900) and the Serpents legacy. Volcanic Productions. p. 72. ISBN 0-64644865-X. Retrieved 2010-06-28.
[5] Check.
Glossary of Accounting terms.
A-ZDictionaries.com. 2005. Retrieved 26 May 2009. See
also Warrant
[6] Warrant.
Glossary of Accounting terms.
A-ZDictionaries.com. 2005. Retrieved 26 May 2009. See
also Check
[7] Frequently Asked Questions about Registered Warrants
[8] California IOU holders
[9] First National Bank v. Cook, 43 Neb. 318, 61 N.W. Rep.

Although Registered Warrants are evidence of a munici693. 12 B.L.J. 151.

palitys obligation to pay, because they demonstrate an intent to disburse funds when those funds become available, [10] SEC press release
the US Supreme Court has ruled that a holder of a valid
[11] California IOUs considered securities SEC says
warrant cannot obtain a writ of mandamus for specic
performance of the obligation to pay, enforced against a [12] Raton Waterworks Co. v. Raton, 174 U.S. 360 (1899).
treasurer or other employee of the municipality.[12]
Warrants can be replaced with substitute checks under the
Check 21 Act.[13] Such substitute checks show the MICR
routing numbers that identify them as warrants.

[13] Substitute Checks - Frequently Asked Questions - Section

B.8

57.7 External links

57.3 In the United Kingdom
In the UK, warrants are issued as payment by the NS&I
when a Premium Bond is chosen.
The dierence between a warrant and a cheque is that a
cheque usually places no explicit time frame on when the
amount is to be paid.

57.4 In Canada
Main article: Governor Generals Warrant

57.5 See also

Government debt

57.6 References
[1] Oxford English Dictionary, 1971.
[2] Revolutionary War Warrant Books of George Washington, 1775-1776

California law on Registered Warrants

Country regulations for Registered Warrants

Chapter 58

Central bank
A central bank, reserve bank, or monetary authority
is an institution that manages a states currency, money
supply, and interest rates. Central banks also usually oversee the commercial banking system of their respective
countries. In contrast to a commercial bank, a central
bank possesses a monopoly on increasing the monetary
base in the state, and usually also prints the national
currency,[1] which usually serves as the states legal tender.[2][3] Examples include the European Central Bank
(ECB), the Bank of England and the Federal Reserve of
the United States.[4]
The primary function of a central bank is to manage
the nations money supply (monetary policy), through active duties such as managing interest rates, setting the
reserve requirement, and acting as a lender of last resort
to the banking sector during times of bank insolvency or
nancial crisis. Central banks usually also have supervisory powers, intended to prevent bank runs and to reduce
the risk that commercial banks and other nancial institutions engage in reckless or fraudulent behavior. Central
banks in most developed nations are institutionally designed to be independent from political interference.[5][6]
Still, limited control by the executive and legislative bodies usually exists.[7][8]

The old town hall in Amsterdam where the Bank of Amsterdam

was founded in 1609, painting by Pieter Saenredam.

As the rst public bank to oer accounts not directly

convertible to coin, the Bank of Amsterdam established
in 1609 is considered to be the precursor to modern
central banks.[9] The central bank of Sweden ("Sveriges
Riksbank" or simply Riksbanken) was founded in
Stockholm from the remains of the failed bank Stockholms Banco in 1664 and answered to the parliament
The chief executive of a central bank is normally known
("Riksdag of the Estates").[10] One role of the Swedish
as the Governor, President or Chairman.
central bank was lending money to the government.[11]

58.1 History

58.1.1 Bank of England

Prior to the 17th century most money was commodity

money, typically gold or silver. However, promises to pay
were widely circulated and accepted as value at least ve
hundred years earlier in both Europe and Asia. The Song
Dynasty was the rst to issue generally circulating paper currency, while the Yuan Dynasty was the rst to use
notes as the predominant circulating medium. In 1455,
in an eort to control ination, the succeeding Ming Dynasty ended the use of paper money and closed much of
Chinese trade. The medieval European Knights Templar
ran an early prototype of a central banking system, as
their promises to pay were widely respected, and many
regard their activities as having laid the basis for the modern banking system.

In England in the 1690s, public funds were in short supply and were needed to nance the ongoing conict with
France. The credit of William III's government was so
low in London that it was impossible for it to borrow the
1,200,000 (at 8 percent) that the government wanted. In
order to induce subscription to the loan, the subscribers
were to be incorporated by the name of the Governor and
Company of the Bank of England. The bank was given
exclusive possession of the governments balances, and
was the only limited-liability corporation allowed to issue banknotes.[12] The lenders would give the government
cash (bullion) and also issue notes against the government
bonds, which can be lent again. The 1.2M was raised in
12 days; half of this was used to rebuild the Navy.

290

58.1. HISTORY

291
ing regarded as a public authority with civic responsibility toward the upkeep of a healthy nancial system.
The currency crisis of 1797, caused by panicked depositors withdrawing from the Bank led to the government
suspending convertibility of notes into specie payment.
The bank was soon accused by the bullionists of causing
the exchange rate to fall from over issuing banknotes, a
charge which the Bank denied. Nevertheless, it was clear
that the Bank was being treated as an organ of the state.

The sealing of the Bank of England Charter (1694).

The establishment of the Bank of England, the model on

which most modern central banks have been based, was
devised by Charles Montagu, 1st Earl of Halifax, in 1694,
to the plan which had been proposed by William Paterson three years before, but had not been acted upon.[13]
He proposed a loan of 1.2M to the government; in return the subscribers would be incorporated as The Governor and Company of the Bank of England with long-term
banking privileges including the issue of notes. The Royal
Charter was granted on 27 July through the passage of the
Tonnage Act 1694.[14]

Henry Thornton, a merchant banker and monetary theorist has been described as the father of the modern central
bank. An opponent of the real bills doctrine, he was a defender of the bullionist position and a signicant gure in
monetary theory. Thorntons process of monetary expansion anticipated the theories of Knut Wicksell regarding
the cumulative process which restates the Quantity Theory in a theoretically coherent form. As a response 1797
currency crisis, Thornton wrote in 1802 An Enquiry into
the Nature and Eects of the Paper Credit of Great Britain,
in which he argued that the increase in paper credit did
not cause the crisis. The book also gives a detailed account of the British monetary system as well as a detailed
examination of the ways in which the Bank of England
should act to counteract uctuations in the value of the
pound.[16]

The Bank of England, established in 1694.

Although some would point to the 1694 establishment

Bank of England as the origin of central banking, it did
not have the functions as a modern central bank, namely,
to regulate the value of the national currency, to nance
the government, to be the sole authorised distributor of
banknotes, and to function as a 'lender of last resort' to
banks suering a liquidity crisis. The modern central
bank evolved slowly through the 18th and 19th centuries
to reach its current form.[15]

Walter Bagehot, an inuential theorist on the economic role of

the central bank.

Until the mid-nineteenth century, commercial banks

were able to issue their own banknotes, and notes issued by provincial banking companies were commonly
in circulation.[17] Many consider the origins of the central bank to lie with the passage of the Bank Charter Act
Although the Bank was originally a private institution, of 1844.[15] Under this law, authorisation to issue new
by the end of the 18th century it was increasingly be- banknotes was restricted to the Bank of England. At the

292

CHAPTER 58. CENTRAL BANK

same time, the Bank of England was restricted to issue

new banknotes only if they were 100% backed by gold or
up to 14 million in government debt. The Act served to
restrict the supply of new notes reaching circulation, and
gave the Bank of England an eective monopoly on the
printing of new notes.[18]
The Bank accepted the role of 'lender of last resort' in
the 1870s after criticism of its lacklustre response to the
Overend-Gurney crisis. The journalist Walter Bagehot
wrote an inuential work on the subject Lombard Street:
A Description of the Money Market, in which he advocated for the Bank to ocially become a lender of last
resort during a credit crunch (sometimes referred to as
Bagehots dictum). Paul Tucker phrased the dictum as
follows:[19]
to avert panic, central banks should lend early
and freely (ie without limit), to solvent rms,
against good collateral, and at 'high rates".

58.1.2

Spread around the world

Central banks were established in many European countries during the 19th century. The War of the Second
Coalition led to the creation of the Banque de France in
1800, in an eort to improve the public nancing of the
war.

coordination of the European national banks, which continue to manage their respective economies separately in
all respects other than currency exchange and base interest rates.

58.1.3 Naming of central banks

There is no standard terminology for the name of a central bank, but many countries use the Bank of Country formfor example: Bank of England (which is in
fact the central bank of the United Kingdom as a whole),
Bank of Canada, Bank of Mexico. Some are styled national banks, such as the National Bank of Ukraine, although the term national bank is also used for private
commercial banks in some countries. In other cases, central banks may incorporate the word Central (for example, European Central Bank, Central Bank of Ireland,
Central Bank of Brazil). The word Reserve is also often included, such as the Reserve Bank of India, Reserve
Bank of Australia, Reserve Bank of New Zealand, the
South African Reserve Bank, and U.S. Federal Reserve
System. Other central banks are known as monetary authorities such as the Monetary Authority of Singapore,
Maldives Monetary Authority and Cayman Islands Monetary Authority. Many countries have state-owned banks
or other quasi-government entities that have entirely separate functions, such as nancing imports and exports.

In some countries, particularly in some Communist countries, the term national bank may be used to indicate both
the monetary authority and the leading banking entity,
such as the Soviet Union's Gosbank (state bank). In other
countries, the term national bank may be used to indicate that the central banks goals are broader than monetary stability, such as full employment, industrial development, or other goals. Some state-owned commercial
banks have names suggestive of central banks, even if
The US Federal Reserve was created by the U.S. they are not: examples are the Bank of India and the
Congress through the passing of The Federal Reserve Act Central Bank of India.
in the Senate and its signing by President Woodrow Wilson on the same day, December 23, 1913. Australia established its rst central bank in 1920, Colombia in 1923,
Mexico and Chile in 1925 and Canada and New Zealand 58.2 Activities and responsibilities
in the aftermath of the Great Depression in 1934. By
1935, the only signicant independent nation that did not
possess a central bank was Brazil, which subsequently
developed a precursor thereto in 1945 and the present
central bank twenty years later. Having gained independence, African and Asian countries also established central banks or monetary unions.
Although central banks today are generally associated
with at money, the 19th and early 20th centuries central banks in most of Europe and Japan developed under
the international gold standard, elsewhere free banking or
currency boards were more usual at this time. Problems
with collapses of banks during downturns, however, lead
to wider support for central banks in those nations which
did not as yet possess them, most notably in Australia.

The Peoples Bank of China evolved its role as a central

bank starting in about 1979 with the introduction of market reforms, which accelerated in 1989 when the country
adopted a generally capitalist approach to its export economy. Evolving further partly in response to the European
Central Bank, the Peoples Bank of China has by 2000 The Eccles Federal Reserve Board Building in Washington, D.C.
become a modern central bank. The most recent bank houses the main oces of the Board of Governors of the United
model, was introduced together with the euro, involves States Federal Reserve System

58.3. GOALS OF MONETARY POLICY

293

Functions of a central bank may include:

workers seeking employment. Macroeconomic policy

generally aims to reduce unintended unemployment.

implementing monetary policies.

Keynes labeled any jobs that would be created by a rise in

wage-goods (i.e., a decrease in real-wages) as involuntary
unemployment:

determining Interest rates

controlling the nations entire money supply
the Governments banker and the bankers bank
("lender of last resort")
managing the countrys foreign exchange and gold
reserves and the Governments stock register
regulating and supervising the banking industry
setting the ocial interest rate used to manage
both ination and the countrys exchange rate and
ensuring that this rate takes eect via a variety of
policy mechanisms

58.2.1

Monetary policy

Central banks implement a countrys chosen monetary

policy. At the most basic level, this involves establishing
what form of currency the country may have, whether a
at currency, gold-backed currency (disallowed for countries with membership of the International Monetary
Fund), currency board or a currency union. When a country has its own national currency, this involves the issue of
some form of standardized currency, which is essentially
a form of promissory note: a promise to exchange the
note for money under certain circumstances. Historically, this was often a promise to exchange the money for
precious metals in some xed amount. Now, when many
currencies are at money, the promise to pay consists
of the promise to accept that currency to pay for taxes.
A central bank may use another countrys currency either
directly (in a currency union), or indirectly (a currency
board). In the latter case, exemplied by Bulgaria, Hong
Kong and Latvia, the local currency is backed at a xed
rate by the central banks holdings of a foreign currency.

Men are involuntarily unemployed

if, in the event of a small rise in
the price of wage-goods relatively
to the money-wage, both the aggregate supply of labour willing to
work for the current money-wage
and the aggregate demand for it at
that wage would be greater than the
existing volume of employment.
John Maynard Keynes, The General Theory of Employment, Interest
and Money p11
Price stability:
Ination is dened either as the devaluation of a currency
or equivalently the rise of prices relative to a currency.
Since ination lowers real wages, Keynesians view ination as the solution to involuntary unemployment. However, unanticipated ination leads to lender losses as the
real interest rate will be lower than expected. Thus, Keynesian monetary policy aims for a steady rate of ination.
Economic growth:
Economic growth can be enhanced by investment in
capital, such as more or better machinery. A low interest
rate implies that rms can loan money to invest in their
capital stock and pay less interest for it. Lowering the
interest is therefore considered to encourage economic
growth and is often used to alleviate times of low economic growth. On the other hand, raising the interest
rate is often used in times of high economic growth as
a contra-cyclical device to keep the economy from overheating and avoid market bubbles.

The expression monetary policy may also refer more Interest rate stability
narrowly to the interest-rate targets and other active mea- Financial market stability
sures undertaken by the monetary authority.
Foreign exchange market stability

58.3 Goals of monetary policy

High employment:

Conicts among goals:

Goals frequently cannot be separated from each other and
often conict. Costs must therefore be carefully weighed
before policy implementation.

Frictional unemployment is the time period between jobs

when a worker is searching for, or transitioning from one
58.3.1 Currency issuance
job to another. Unemployment beyond frictional unemployment is classied as unintended unemployment.
Similar to commercial banks, central banks hold assets
For example, structural unemployment is a form of un- (government bonds, foreign exchange, gold, and other
employment resulting from a mismatch between demand nancial assets) and incur liabilities (currency outstandin the labour market and the skills and locations of the ing). Central banks create money by issuing interest-free

294

CHAPTER 58. CENTRAL BANK

cute its policies. In the case of the Federal Reserve, they
are the local Federal Reserve Banks; for the ECB they are
the national central banks.

58.3.3 Limits on policy eects

Although the perception by the public may be that the
central bank controls some or all interest rates and currency rates, economic theory (and substantial empirical
evidence) shows that it is impossible to do both at once in
an open economy. Robert Mundell's "impossible trinity"
is the most famous formulation of these limited powers,
and postulates that it is impossible to target monetary policy (broadly, interest rates), the exchange rate (through
a xed rate) and maintain free capital movement. Since
most Western economies are now considered open with
free capital movement, this essentially means that central banks may target interest rates or exchange rates with
credibility, but not both at once.
In the most famous case of policy failure, Black Wednesday, George Soros arbitraged the pound sterling's relationship to the ECU and (after making $2 billion himself and forcing the UK to spend over $8bn defending the
The European Central Bank building in Frankfurt
pound) forced it to abandon its policy. Since then he has
been a harsh critic of clumsy bank policies and argued
currency notes and selling them to the public (govern- that no one should be able to do what he did.
ment) in exchange for interest-bearing assets such as government bonds. When a central bank wishes to purchase The most complex relationships are those between the
more bonds than their respective national governments yuan and the US dollar, and between the euro and its
make available, they may purchase private bonds or as- neighbours. The situation in Cuba is so exceptional as to
require the Cuban peso to be dealt with simply as an exsets denominated in foreign currencies.
ception, since the United States forbids direct trade with
The European Central Bank remits its interest income to Cuba. US dollars were ubiquitous in Cubas economy afthe central banks of the member countries of the Euro- ter its legalization in 1991, but were ocially removed
pean Union. The US Federal Reserve remits all its prof- from circulation in 2004 and replaced by the convertible
its to the U.S. Treasury. This income, derived from the peso.
power to issue currency, is referred to as seigniorage, and
usually belongs to the national government. The statesanctioned power to create currency is called the Right of
Issuance. Throughout history there have been disagree- 58.4 Policy instruments
ments over this power, since whoever controls the creation of currency controls the seigniorage income.
The main monetary policy instruments available to central banks are open market operation, bank reserve requirement, interest rate policy, re-lending and re-discount
58.3.2 Interest rate interventions
(including using the term repurchase market), and credit
Typically a central bank controls certain types of short- policy (often coordinated with trade policy). While
term interest rates. These inuence the stock- and bond capital adequacy is important, it is dened and regulated
markets as well as mortgage and other interest rates. The by the Bank for International Settlements, and central
European Central Bank for example announces its inter- banks in practice generally do not apply stricter rules.
est rate at the meeting of its Governing Council; in the To enable open market operations, a central bank must
case of the U.S. Federal Reserve, the Federal Reserve hold foreign exchange reserves (usually in the form of
Board of Governors.
government bonds) and ocial gold reserves. It will ofBoth the Federal Reserve and the ECB are composed of
one or more central bodies that are responsible for the
main decisions about interest rates and the size and type
of open market operations, and several branches to exe-

ten have some inuence over any ocial or mandated

exchange rates: Some exchange rates are managed, some
are market based (free oat) and many are somewhere in
between (managed oat or dirty oat).

58.4. POLICY INSTRUMENTS

295
to and borrowing money from (taking deposits from) a
limited number of qualied banks, or by purchasing and
selling bonds. As an example of how this functions, the
Bank of Canada sets a target overnight rate, and a band of
plus or minus 0.25%. Qualied banks borrow from each
other within this band, but never above or below, because
the central bank will always lend to them at the top of the
band, and take deposits at the bottom of the band; in principle, the capacity to borrow and lend at the extremes of
the band are unlimited.[20] Other central banks use similar mechanisms.

The headquarters of the Bank for International Settlements, in

Basel (Switzerland).

The Bank of Japan.

It is also notable that the target rates are generally shortterm rates. The actual rate that borrowers and lenders
receive on the market will depend on (perceived) credit
risk, maturity and other factors. For example, a central
bank might set a target rate for overnight lending of 4.5%,
but rates for (equivalent risk) ve-year bonds might be
5%, 4.75%, or, in cases of inverted yield curves, even
below the short-term rate. Many central banks have one
primary headline rate that is quoted as the central bank
rate. In practice, they will have other tools and rates
that are used, but only one that is rigorously targeted and
enforced.
The rate at which the central bank lends money can indeed be chosen at will by the central bank; this is the rate
that makes the nancial headlines. Henry C.K. Liu.[21]
Liu explains further that the U.S. central-bank lending
rate is known as the Fed funds rate. The Fed sets a target
for the Fed funds rate, which its Open Market Committee
tries to match by lending or borrowing in the money market ... a at money system set by command of the central
bank. The Fed is the head of the central-bank because
the U.S. dollar is the key reserve currency for international trade. The global money market is a USA dollar
market. All other currencies markets revolve around the
U.S. dollar market. Accordingly the U.S. situation is not
typical of central banks in general.
A typical central bank has several interest rates or monetary policy tools it can set to inuence markets.

The BSP Complex, in the Philippines.

58.4.1

Interest rates

By far the most visible and obvious power of many modern central banks is to inuence market interest rates;
contrary to popular belief, they rarely set rates to a xed
number. Although the mechanism diers from country to country, most use a similar mechanism based on
a central banks ability to create as much at money as
required.

Marginal lending rate (currently 0.30% in the

Eurozone[22] ) a xed rate for institutions to borrow money from the central bank. (In the USA this
is called the discount rate).
Main renancing rate (0.05% in the Eurozone[22] )
the publicly visible interest rate the central bank
announces. It is also known as minimum bid rate
and serves as a bidding oor for renancing loans.
(In the USA this is called the federal funds rate).
Deposit rate, generally consisting of interest on reserves and sometimes also interest on excess reserves (0.20% in the Eurozone[22] ) the rates parties receive for deposits at the central bank.

The mechanism to move the market towards a 'target

rate' (whichever specic rate is used) is generally to lend
money or borrow money in theoretically unlimited quantities, until the targeted market rate is suciently close These rates directly aect the rates in the money market,
to the target. Central banks may do so by lending money the market for short term loans.

296

58.4.2

CHAPTER 58. CENTRAL BANK

Open market operations

bank runs. Over time this process has been regulated

and insured by central banks. Such legal reserve requirements were introduced in the 19th century as an attempt
to reduce the risk of banks overextending themselves and
suering from bank runs, as this could lead to knock-on
eects on other overextended banks. See also money multiplier.

Through open market operations, a central bank inuences the money supply in an economy. Each time it
buys securities (such as a government bond or treasury
bill), it in eect creates money. The central bank exchanges money for the security, increasing the money
supply while lowering the supply of the specic security.
As the early 20th century gold standard was undermined
Conversely, selling of securities by the central bank reby ination and the late 20th century at dollar hegemony
duces the money supply.
evolved, and as banks proliferated and engaged in more
Open market operations usually take the form of:
complex transactions and were able to prot from dealings globally on a moments notice, these practices be Buying or selling securities ("direct operations") to came mandatory, if only to ensure that there was some
achieve an interest rate target in the interbank mar- limit on the ballooning of money supply. Such limits have
become harder to enforce. The Peoples Bank of China
ket .
retains (and uses) more powers over reserves because the
Temporary lending of money for collateral secu- yuan that it manages is a non-convertible currency.
rities (Reverse Operations or "repurchase operations", otherwise known as the repo market). Loan activity by banks plays a fundamental role in deterThese operations are carried out on a regular ba- mining the money supply. The central-bank money after
sis, where xed maturity loans (of one week and one aggregate settlement nal money can take only one
of two forms:
month for the ECB) are auctioned o.
Foreign exchange operations such as foreign exchange swaps.

physical cash, which is rarely used in wholesale nancial markets,

All of these interventions can also inuence the foreign

central-bank money which is rarely used by the peoexchange market and thus the exchange rate. For example
ple the Peoples Bank of China and the Bank of Japan
have on occasion bought several hundred billions of U.S.
Treasuries, presumably in order to stop the decline of the
The currency component of the money supply is far
U.S. dollar versus the renminbi and the yen.
smaller than the deposit component. Currency, bank reserves and institutional loan agreements together make up
the monetary base, called M1, M2 and M3. The Federal
58.4.3 Capital requirements
Reserve Bank stopped publishing M3 and counting it as
[23]
All banks are required to hold a certain percentage of part of the money supply in 2006.
their assets as capital, a rate which may be established by
the central bank or the banking supervisor. For international banks, including the 55 member central banks of
the Bank for International Settlements, the threshold is
8% (see the Basel Capital Accords) of risk-adjusted assets, whereby certain assets (such as government bonds)
are considered to have lower risk and are either partially or fully excluded from total assets for the purposes of calculating capital adequacy. Partly due to concerns about asset ination and repurchase agreements,
capital requirements may be considered more eective
than reserve requirements in preventing indenite lending: when at the threshold, a bank cannot extend another
loan without acquiring further capital on its balance sheet.

58.4.4

Reserve requirements

Historically, bank reserves have formed only a small fraction of deposits, a system called fractional reserve banking. Banks would hold only a small percentage of their
assets in the form of cash reserves as insurance against

58.4.5 Exchange requirements

To inuence the money supply, some central banks may
require that some or all foreign exchange receipts (generally from exports) be exchanged for the local currency.
The rate that is used to purchase local currency may be
market-based or arbitrarily set by the bank. This tool is
generally used in countries with non-convertible currencies or partially convertible currencies. The recipient of
the local currency may be allowed to freely dispose of the
funds, required to hold the funds with the central bank for
some period of time, or allowed to use the funds subject
to certain restrictions. In other cases, the ability to hold
or use the foreign exchange may be otherwise limited.
In this method, money supply is increased by the central
bank when it purchases the foreign currency by issuing
(selling) the local currency. The central bank may subsequently reduce the money supply by various means, including selling bonds or foreign exchange interventions.

58.6. INDEPENDENCE

58.4.6

297

Margin requirements and other 58.6

tools

Independence

In the 2000s there has been a trend towards increasing

the independence of central banks as a way of improving long-term economic performance. However, while a
large volume of economic research has been done to dene the relationship between central bank independence
and economic performance, the results are ambiguous.

In some countries, central banks may have other tools that

work indirectly to limit lending practices and otherwise
restrict or regulate capital markets. For example, a central
bank may regulate margin lending, whereby individuals
or companies may borrow against pledged securities. The
margin requirement establishes a minimum ratio of the Advocates of central bank independence argue that a central bank which is too susceptible to political direction
value of the securities to the amount borrowed.
or pressure may encourage economic cycles ("boom and
Central banks often have requirements for the quality of bust"), as politicians may be tempted to boost economic
assets that may be held by nancial institutions; these re- activity in advance of an election, to the detriment of the
quirements may act as a limit on the amount of risk and long-term health of the economy and the country. In this
leverage created by the nancial system. These require- context, independence is usually dened as the central
ments may be direct, such as requiring certain assets to banks operational and management independence from
bear certain minimum credit ratings, or indirect, by the the government.
central bank lending to counterparties only when security
The literature on central bank independence has dened
of a certain quality is pledged as collateral.
a number of types of independence.
Legal independence

58.5 Banking supervision

other activities

and

In some countries a central bank, through its subsidiaries,

controls and monitors the banking sector. In other countries banking supervision is carried out by a government
department such as the UK Treasury, or by an independent government agency (for example, UKs Financial
Conduct Authority). It examines the banks balance
sheets and behaviour and policies toward consumers.
Apart from renancing, it also provides banks with services such as transfer of funds, bank notes and coins or
foreign currency. Thus it is often described as the bank
of banks.
Many countries such as the United States will monitor
and control the banking sector through dierent agencies and for dierent purposes, although there is usually
signicant cooperation between the agencies. For example, money center banks, deposit-taking institutions, and
other types of nancial institutions may be subject to different (and occasionally overlapping) regulation. Some
types of banking regulation may be delegated to other
levels of government, such as state or provincial governments.
Any cartel of banks is particularly closely watched and
controlled. Most countries control bank mergers and are
wary of concentration in this industry due to the danger
of groupthink and runaway lending bubbles based on a
single point of failure, the credit culture of the few large
banks.

The independence of the central bank is enshrined in law. This type of independence
is limited in a democratic state; in almost all
cases the central bank is accountable at some
level to government ocials, either through a
government minister or directly to a legislature. Even dening degrees of legal independence has proven to be a challenge since legislation typically provides only a framework
within which the government and the central
bank work out their relationship.
Goal independence
The central bank has the right to set its own policy goals, whether ination targeting, control of
the money supply, or maintaining a xed exchange rate. While this type of independence
is more common, many central banks prefer to
announce their policy goals in partnership with
the appropriate government departments. This
increases the transparency of the policy setting
process and thereby increases the credibility of
the goals chosen by providing assurance that
they will not be changed without notice. In
addition, the setting of common goals by the
central bank and the government helps to avoid
situations where monetary and scal policy are
in conict; a policy combination that is clearly
sub-optimal.
Operational independence
The central bank has the independence to determine the best way of achieving its policy

298

CHAPTER 58. CENTRAL BANK

goals, including the types of instruments used
and the timing of their use. This is the most
common form of central bank independence.
The granting of independence to the Bank of
England in 1997 was, in fact, the granting of
operational independence; the ination target
continued to be announced in the Chancellors
annual budget speech to Parliament.

Management independence
The central bank has the authority to run its
own operations (appointing sta, setting budgets, and so on.) without excessive involvement of the government. The other forms of
independence are not possible unless the central bank has a signicant degree of management independence. One of the most common
statistical indicators used in the literature as
a proxy for central bank independence is the
turn-over-rate of central bank governors. If
a government is in the habit of appointing and
replacing the governor frequently, it clearly has
the capacity to micro-manage the central bank
through its choice of governors.
It is argued that an independent central bank can run a
more credible monetary policy, making market expectations more responsive to signals from the central bank.
Recently, both the Bank of England (1997) and the European Central Bank have been made independent and
follow a set of published ination targets so that markets know what to expect. Even the Peoples Bank of
China has been accorded great latitude due to the difculty of problems it faces, though in the Peoples Republic of China the ocial role of the bank remains that
of a national bank rather than a central bank, underlined
by the ocial refusal to unpeg the yuan or to revalue
it under pressure. The Peoples Bank of Chinas independence can thus be read more as independence from
the USA which rules the nancial markets, than from
the Communist Party of China which rules the country.
The fact that the Communist Party is not elected also relieves the pressure to please people, increasing its independence.

a belief in the intrinsic merits of increased independence.

The support for independence from the international organizations also derives partly from the connection between increased independence for the central bank and
increased transparency in the policy-making process.
The IMFs Financial Services Action Plan (FSAP) review self-assessment, for example, includes a number of
questions about central bank independence in the transparency section. An independent central bank will score
higher in the review than one that is not independent.

58.7 See also

58.8 Notes and references
[1] http://www.bankofcanada.ca/2013/11/
5-and-10-bank-note-issue-2/.
Missing or empty
|title= (help)
[2] Sullivan, arthur; Steven M. Sherin (2003). Economics:
Principles in action. Upper Saddle River, New Jersey
07458: Pearson Prentice Hall. p. 254. ISBN 0-13063085-3.
[3] central bank Britannica Online Encyclopedia. britannica.com. Retrieved 2 November 2010.
[4] The Structure of the Federal Reserve System. federalreserveeducation.org. Retrieved 1 October 2010.
[5] Public governance of central banks: an approach from
new institutional economics. The Bulletin of the Faculty
of Commerce (Meiji University) 89 (4). March 2007.
[6] Apel, Emmanuel (November 2007). 1. Central Banking
Systems Compared: The ECB, The Pre-Euro Bundesbank
and the Federal Reserve System. Routledge. p. 14. ISBN
978-0415459228.
[7] Ownership and independence of FED. Retrieved 29
September 2013.
[8] Governance of Deutsche Bundesbank. Retrieved 29
September 2013.
[9] Quinn, Stephen; Roberds, William (2006), An Economic
Explanation of the Early Bank of Amsterdam, Debasement, Bills of Exchange, and the Emergence of the First
Central Bank, Federal Reserve Bank of Atlanta, Working Paper 200613

Governments generally have some degree of inuence

over even independent central banks; the aim of independence is primarily to prevent short-term interfer- [10] History of Sveriges Riksbank
ence. For example, the Board of Governors of the U.S.
Federal Reserve are nominated by the President of the [11] Bordo, M. (2007), A Brief History of Central Banks,
Federal Reserve Bank of Cleveland.
U.S. and conrmed by the Senate.[24] The Chairman and
other Federal Reserve ocials often testify before the [12] Bagehot, Walter (1873). Lombard Street: a description of
Congress.[25]
the money market. London: Henry S. King and Co.
International organizations such as the World Bank, [13] Committee of Finance and Industry 1931 (Macmillan Rethe Bank for International Settlements (BIS) and the
port) description of the founding of Bank of England.
International Monetary Fund (IMF) are strong supporters
Books.google.ca. Retrieved 10 May 2010. Its foundaof central bank independence. This results, in part, from
tion in 1694 arose out the diculties of the Government

58.10. EXTERNAL LINKS

of the day in securing subscriptions to State loans. Its primary purpose was to raise and lend money to the State
and in consideration of this service it received under its
Charter and various Act of Parliament, certain privileges
of issuing bank notes. The corporation commenced, with
an assured life of twelve years after which the Government had the right to annul its Charter on giving one years
notice. '''Subsequent extensions of this period coincided
generally with the grant of additional loans to the State'''
[14] H. Roseveare, /The Financial Revolution 16601760/
(1991, Longman), p. 34
[15] The development of central banking. Retrieved 201212-17.
[16] Philippe Beaugrand, Henry Thornton, un prcurseur de
J.M. Keynes, Paris: Presses Universitaires de France,
1981.
[17] "2 note issued by Evans, Jones, Davies & Co.. British
Museum. Retrieved 31 October 2011.
[18] Yesterday was a Historic Day Mises Economics Blog.
Blog.mises.org. Archived from the original on 18 September 2010. Retrieved 2010-09-17.
[19] Paul Tucker, Deputy Governor, Financial Stability, Bank
of England, The Repertoire of Ocial Sector Interventions in the Financial System: Last Resort Lending, MarketMaking, and Capital, Bank of Japan 2009 International
Conference, 2728 May 2009, p. 5
[20] Bank of Canada backgrounder: Target for the Overnight
Rate
[21] Asia Times article explaining modern central bank function in detail
[22] Key ECB Interest Rates
[23] Reserve, Federal. Fed stops publishing M3. press release. Federal Reserve Board. Retrieved 9 March 2006.
[24] Who are the members of the Federal Reserve Board, and
how are they selected?
[25] Is the Federal Reserve accountable to anyone?

58.9 Further reading

Acocella, N. and Di Bartolomeo, G. and Hughes
Hallett, A. [2012], Central banks and economic policy after the crisis: what have we learned?, ch. 5 in:
Baker, H.K. and Riddick, L.A. (eds.), Survey of International Finance, Oxford University Press.

58.10 External links

List of central bank websites at the Bank for International Settlements

299
Central Bank Rates: worldwide rates, monetary
meetings, central banks
Interactive map of all the central banks
International Journal of Central Banking
The Federal Reserve System: Purposes and Functions A publication of the U.S. Federal Reserve,
describing its role in the macroeconomy
The Eurosystem Website of the European Central
Bank describing the structure of the central banking
system in the Eurozone
A hundred ways to skin a cat: comparing monetary policy operating procedures in the United States,
Japan and the euro area PDF (176 KB) C E V
Borio, Bank for International Settlements, Basel
Chairman Ben Bernanke Lecture Series Part 1
Recorded live on March 20, 2012 10:35am MST at
a class at George Washington University

Chapter 59

Fractional-reserve banking
Fractional-reserve banking is the practice whereby a
bank creates credit or makes loans, and holds reserves
(to satisfy demands for withdrawals) that are less than the
amount of its customers deposits. Reserves are held at
the bank as currency, or as deposits in the banks accounts
at the central bank. Because bank deposits are usually
considered money in their own right, fractional-reserve
banking permits the money supply to grow beyond the
amount of the underlying reserves of base money originally created by the central bank.[1][2]

acceptance as a medium of exchange for commercial

transactions and thus became an early form of circulating
paper money.[7] As the notes were used directly in trade,
the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing
loans and bills. This generated income for the goldsmiths
but left them with more notes on issue than reserves
with which to pay them. A process was started that altered the role of the goldsmiths from passive guardians of
To mitigate the risks of bank runs (when a large pro- bullion, charging fees for safe storage, to interest-paying
portion of depositors seek withdrawal of their deposits and interest-earning banks. Thus fractional-reserve bankat the same time) or, when problems are extreme and ing was born.
widespread, systemic crises, the governments of most However, if creditors (note holders of gold originally decountries regulate and oversee commercial banks, pro- posited) lost faith in the ability of a bank to pay their
vide deposit insurance and act as lender of last resort notes, many would try to redeem their notes at the same
to commercial banks.[1][2] In most countries, the central time. If in response a bank could not raise enough funds
bank (or other monetary authority) regulates bank credit by calling in loans or selling bills, it either went into
creation, imposing reserve requirements and capital ade- insolvency or defaulted on its notes. Such a situation is
quacy ratios. This can limit the amount of money creation called a bank run and caused the demise of many early
that occurs in the commercial banking system, and helps banks.[7]
to ensure that banks are solvent and have enough funds Starting in the late 1600s nations began to establish
to meet demand for withdrawals.[2] Rather than directly central banks which were given the legal power to set
limiting the money supply, central banks may pursue an
the reserve requirement and to specify the form in which
interest rate target to control bank issuance of credit.[3]
such assets (called the monetary base) are required to be
Fractional-reserve banking is the current form of banking practiced in most countries worldwide.[4] Fractional
reserve banking has been said to violate Islamic principles of ownership.[5]

59.1 History
See also: Banknote

held.[8] In order to mitigate the impact of bank failures

and nancial crises, central banks were also granted the
authority to centralize banks storage of precious metal
reserves, thereby facilitating transfer of gold in the event
of bank runs, to regulate commercial banks, impose reserve requirements, and to act as lender-of-last-resort if
any bank faced a bank run. The emergence of central
banks reduced the risk of bank runs which is inherent in
fractional-reserve banking, and it allowed the practice to
continue as it does today.[2]

During the twentieth century, the role of the central bank

grew to include inuencing or managing various macroeconomic policy variables, including measures of ination, unemployment, and the international balance of
payments. In the course of enacting such policy, central
In the past, savers looking to keep their coins and valu- banks have from time to time attempted to manage interables in safekeeping depositories deposited gold and est rates, reserve requirements, and various measures of
silver at goldsmiths, receiving in exchange a note for their the money supply and monetary base.[9]
deposit (see Bank of Amsterdam). These notes gained
Fractional-reserve banking predates the existence of governmental monetary authorities and originated many centuries ago in bankers realization that generally not all depositors demand payment at the same time.[6]

300

59.4. MONEY CREATION PROCESS

59.2 How it works

In most legal systems, a bank deposit is not a bailment. In
other words, the funds deposited are no longer the property of the customer. The funds become the property of
the bank, and the customer in turn receives an asset called
a deposit account (a checking or savings account). That
deposit account is a liability on the balance sheet of the
bank. Each bank is legally authorized to issue credit up
to a specied multiple of its reserves, so reserves available to satisfy payment of deposit liabilities are less than
the total amount which the bank is obligated to pay in
satisfaction of demand deposits.

301
inuencing the money supply and interest rates. Many
economists believe that these should be adjusted by the
government to promote macroeconomic stability.[12]
The process of fractional-reserve banking expands the
money supply of the economy but also increases the risk
that a bank cannot meet its depositor withdrawals. Modern central banking allows banks to practice fractionalreserve banking with inter-bank business transactions
with a reduced risk of bankruptcy.[13][14]

59.4 Money creation process

Fractional-reserve banking ordinarily functions Main article: Money creation

smoothly.
Relatively few depositors demand payment at any given time, and banks maintain a buer of
reserves to cover depositors cash withdrawals and other There are two types of money in a fractional-reserve
[15][16][17]
demands for funds. However, during a bank run or a banking system operating with a central bank:
generalized nancial crisis, demands for withdrawal can
1. Central bank money: money created or adopted
exceed the banks funding buer, and the bank will be
by the central bank regardless of its form precious
forced to raise additional reserves to avoid defaulting on
metals, commodity certicates, banknotes, coins,
its obligations. A bank can raise funds from additional
electronic money loaned to commercial banks, or
borrowings (e.g., by borrowing in the interbank lending
anything else the central bank chooses as its form
market or from the central bank), by selling assets, or by
of money
calling in short-term loans. If creditors are afraid that the
bank is running out of reserves or is insolvent, they have
2. Commercial bank money: demand deposits in the
an incentive to redeem their deposits as soon as possible
commercial banking system; sometimes referred to
before other depositors access the remaining reserves.
as chequebook money
Thus the fear of a bank run can actually precipitate the
crisis.
When a deposit of central bank money is made at a comMany of the practices of contemporary bank regulation
mercial bank, the central bank money is removed from
and central banking, including centralized clearing of
circulation and added to the commercial banks reserves
payments, central bank lending to member banks, regu(it is no longer counted as part of M1 money supply). Silatory auditing, and government-administered deposit inmultaneously, an equal amount of new commercial bank
surance, are designed to prevent the occurrence of such
money is created in the form of bank deposits. When a
bank runs.
loan is made by the commercial bank (which keeps only
a fraction of the central bank money as reserves), using
the central bank money from the commercial banks reserves, the m1 money supply expands by the size of the
59.3 Economic function
loan.[2] This process is called deposit multiplication.
Fractional-reserve banking allows banks to create credit
in the form of bank deposits, which represent immediate
liquidity to depositors. The banks also provide longerterm loans to borrowers, and act as nancial intermediaries for those funds.[2][10] Less liquid forms of deposit
(such as time deposits) or riskier classes of nancial assets (such as equities or long-term bonds) may lock up a
depositors wealth for a period of time, making it unavailable for use on demand. This borrowing short, lending
long, or maturity transformation function of fractionalreserve banking is a role that many economists consider
to be an important function of the commercial banking
system.[11]

59.4.1 Example of deposit multiplication

The table below displays the relending model of how

loans are funded and how the money supply is aected.
It also shows how central bank money is used to create
commercial bank money from an initial deposit of $100
of central bank money. In the example, the initial deposit
is lent out 10 times (of course, they do not really pay out
loans from the money they receive as deposits)[18] with a
fractional-reserve rate of 20% to ultimately create $500
of commercial bank money (it is important to note that
the 20% reserve rate used here is for ease of illustration,
Additionally, according to macroeconomic theory, a well- actual reserve requirements are usually much lower, for
regulated fractional-reserve bank system also benets the example around 3% in the USA and UK). Each succeseconomy by providing regulators with powerful tools for sive bank involved in this process creates new commercial

302

CHAPTER 59. FRACTIONAL-RESERVE BANKING

bank money on a diminishing portion of the original deposit of central bank money. This is because banks only
lend out a portion of the central bank money deposited,
in order to fulll reserve requirements and to ensure that
they always have enough reserves on hand to meet normal
transaction demands.
The relending model begins when an initial $100 deposit
of central bank money is made into Bank A. Bank A takes
20 percent of it, or $20, and sets it aside as reserves, and
then can theoretically loan out the remaining 80 percent,
or $80. If the bank does in fact issue loan proceeds in
the form of $80 in central bank money, the money supply actually totals $180, not $100, because the bank has
loaned out $80 of the central bank money, kept $20 of
central bank money in reserve (not part of the money supply), and substituted a newly created $100 IOU claim for
the depositor that acts equivalently to and can be implicitly redeemed for central bank money (the depositor can
transfer it to another account, write a check on it, demand
his cash back, etc.). These claims by depositors on banks
are termed demand deposits or commercial bank money
and are simply recorded in a banks accounts as a liability
(specically, an IOU to the depositor). From a depositors perspective, commercial bank money is equivalent
to central bank money it is impossible to tell the two
forms of money apart unless a bank run occurs.[2]

dition to the initial $100 deposit, new commercial bank

money is created through loans. The boxes marked in red
show the location of the original $100 deposit throughout
the entire process. The total reserves will always equal the
original amount, which in this case is $100. As this process continues, more commercial bank money is created.
The amounts in each step decrease towards a limit. If a
graph is made showing the accumulation of deposits, one
can see that the graph is curved and approaches a limit.
This limit is the maximum amount of money that can be
created with a given reserve rate. When the reserve rate
is 20%, as in the example above, the maximum amount
of total deposits that can be created is $500 and the maximum increase in the money supply is $400.

For an individual bank, the deposit is considered a

liability whereas the loan it gives out and the reserves are
considered assets. Deposits will always be equal to loans
plus a banks reserves, since loans and reserves are created from deposits. This is the basis for a banks balance
sheet. Fractional-reserve banking allows the money supply to expand or contract. Generally the expansion or
contraction of the money supply is dictated by the balance between the rate of new loans being created and the
rate of existing loans being repaid or defaulted on. The
balance between these two rates can be inuenced to some
degree by actions of the central bank. However, the cenAt this point in the relending model, Bank A now only tral bank has no direct control over the amount of money
has $20 of central bank money on its books. The loan re- created by commercial (or high street) banks.
cipient is holding $80 in central bank money, but he soon
spends the $80. The receiver of that $80 then deposits it 59.4.2 Money multiplier
into Bank B. Bank B is now in the same situation as Bank
A started with, except it has a deposit of $80 of central Main article: Money multiplier
bank money instead of $100. Similar to Bank A, Bank B The most common mechanism used to measure this insets aside 20 percent of that $80, or $16, as reserves and
lends out the remaining $64, increasing money supply by
$64. As the process continues, more commercial bank
money is created. To simplify the table, a dierent bank
is used for each deposit. In the real world, the money a
bank lends may end up in the same bank so that it then
has more money to lend out.

Total Amount of Deposited Money

The Expanson of $100 Through Fractional-Resverve

Lending with a 20% Reserve Rate
$500
$400
$300

The expansion of $100 through fractional-reserve banking with

varying reserve requirements. Each curve approaches a limit.
This limit is the value that the money multiplier'" calculates.

$200
$100
$0
A B C D E F G H I

J K L M N O P Q R S T U V W X Y Z

crease in the money supply is typically called the money

multiplier. This concept involves calculating the maxThe expansion of $100 of central bank money through imum amount of money to which an initial deposit can
fractional-reserve lending with a 20% reserve rate. $400 of com- be expanded using a given reserve ratio. Rather than dimercial bank money is created virtually through loans.
rectly limiting the money supply however, central banks
typically pursue an interest rate target to control bank
Although no new money was physically created in ad- issuance of credit.[3] The central bank simply supplies
Individual Deposits

59.5. MONEY SUPPLIES AROUND THE WORLD

303

whatever amount of base money is demanded by the The American Bankers Association has also stated that
economy at the prevailing level of interest rates.[19]
most bank loans are made not by doling out paper currency and coin, but instead by creating or increasing deposit liabilities owed by the bank:
Formula
The money multiplier, m, is the inverse of the reserve
requirement, R:[20]

m=

1
R

Example

Typically, bank loans are made to

existing customers, or the proceeds
of a loan are used to open an account; thus, most bank loans increase total deposits. In the typical
credit situation, two balance sheet
items --loans and deposits -- are simultaneously increased.[24]

For example, with the reserve ratio of 20 percent, this

reserve ratio, R, can also be expressed as a fraction:
From Professor Paul Horvitz:
R=

1
5

So then the money multiplier, m, will be calculated as:

m=

1
=5
1/5

This number is multiplied by the initial deposit to show

the maximum amount of money it can be expanded to.
The money creation process is also aected by the currency drain ratio (the propensity of the public to hold banknotes rather than deposit them with a commercial bank),
and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold
usually a small amount). Data for excess reserves and
vault cash are published regularly by the Federal Reserve
in the United States.[21] In practice, the actual money multiplier varies over time, and may be substantially lower
than the theoretical maximum.[22]

59.4.3

Creation of deposit liabilities

through the lending process

The proceeds of most bank loans are not, however, in the

form of currency (central bank money). In the United
States, the Federal Reserve Bank of Chicago has stated:
Of course, they [commercial
banks] do not really make loans
out of the money they receive as
deposits. If they did this, they
would be acting just like nancial
intermediaries and no additional
money would be created. What
they do when they make loans is
to accept promissory notes in exchange for credits they make to the
borrowers deposit accounts. Loans
(assets) and deposits (liabilities)
both rise....[23]

Deposits may arise in a dierent

way, however. Let us suppose a
businessman comes into the bank
and wants to borrow $1000 to cover
the cost of some additional inventory he wants to purchase. The
bank may approve the loan, and the
businessman will tell the bank to
credit the $1000 to his deposit account.
Bank Assets
debit Loans $1000
Bank Liabilities
credit Deposits $1000
The businessman now has an additional $1000 demand deposit. No
one elses demand deposits have
been reduced. This is clearly an increase in the money supply, and it is
apparent that the bank created the
$1000.
These derivative deposits are important both quantitatively and theoretically -- it is in terms of derivative deposits that banks can be
thought of as creators of money. If
all deposits arose from primary deposits, banks could not be said to
create money.[25]
Allowing the issuance of loan proceeds in the form of
cash (that is, in the form of paper currency and current
coins) is considered to be a weakness in internal control
in a bank.[26]

304

CHAPTER 59. FRACTIONAL-RESERVE BANKING

of commercial bank money is based on the fact that
it can be exchanged freely at a bank for central bank
money.[15][16]

11,000
10,000

Billions of US dollars

9,000

M3
M2

8,000
7,000
6,000

M1
currency

5,000
4,000
3,000
2,000
1,000

Percentage of total

0
1960
100

1965

1970

1975

1980

1985

1990

1995

2000

2005

1965

1970

1975

1980

1985

1990

1995

2000

2005

80
60
40
20
0
1960

Components of US money supply (currency, M1, M2, and M3)

since 1959. In January 2007, the amount of central bank
money was $750.5 billion while the amount of commercial
bank money (in the M2 supply) was $6.33 trillion. M1 is currency plus demand deposits; M2 is M1 plus time deposits, savings
deposits, and some money-market funds; and M3 is M2 plus large
time deposits and other forms of money. The M3 data ends in
2006 because the federal reserve ceased reporting it.

The actual increase in the money supply through this process may be lower, as (at each step) banks may choose to
hold reserves in excess of the statutory minimum, borrowers may let some funds sit idle, and some members of
the public may choose to hold cash, and there also may be
delays or frictions in the lending process.[27] Government
regulations may also be used to limit the money creation
process by preventing banks from giving out loans even
though the reserve requirements have been fullled.[28]

59.6 Regulation
Because the nature of fractional-reserve banking involves the possibility of bank runs, central banks have
been created throughout the world to address these
problems.[9][29]

59.6.1 Central banks

Main article: Central bank
Government controls and bank regulations related to
fractional-reserve banking have generally been used to
impose restrictive requirements on note issue and deposit taking on the one hand, and to provide relief from
bankruptcy and creditor claims, and/or protect creditors
with government funds, when banks defaulted on the
other hand. Such measures have included:
Components of the euro money supply 19982007

59.5 Money supplies around the

world
See also: Money supply

1. Minimum required reserve ratios (RRRs)

2. Minimum capital ratios
3. Government bond deposit requirements for note issue
4. 100% Marginal Reserve requirements for note issue,
such as the Bank Charter Act 1844 (UK)
5. Sanction on bank defaults and protection from creditors for many months or even years, and

Fractional-reserve banking determines the relationship

6. Central bank support for distressed banks, and govbetween the amount of central bank money in the ofernment guarantee funds for notes and deposits,
cial money supply statistics and the total money supply.
both to counteract bank runs and to protect bank
Most of the money in these systems is commercial bank
creditors.
money.. The issue of money through the banking system
is a mechanism of monetary transmission, which a central
bank can inuence only indirectly by raising or lowering
59.6.2 Reserve requirements
interest rates (although banking regulations may also be
adjusted to inuence the money supply, depending on the
The currently prevailing view of reserve requirements is
circumstances).
that they are intended to prevent banks from:
This table gives an outline of the makeup of money sup1. generating too much money by making too many
plies worldwide. Most of the money in any given money
loans against the narrow money deposit base;
supply consists of commercial bank money.[15] The value

59.7. HYPOTHETICAL EXAMPLE OF A BANK BALANCE SHEET AND FINANCIAL RATIOS

305

2. having a shortage of cash when large deposits are

withdrawn (although the reserve is thought to be a
legal minimum, it is understood that in a crisis or
bank run, reserves may be made available on a temporary basis).

The ability of the bank to borrow money reliably and

economically is crucial, which is why condence in the
banks creditworthiness is important to its liquidity. This
means that the bank needs to maintain adequate capitalisation and to eectively control its exposures to risk in
order to continue its operations. If creditors doubt the
In some jurisdictions, (such as the United States and the banks assets are worth more than its liabilities, all deEuropean Union), the central bank does not require re- mand creditors have an incentive to demand payment imserves to be held during the day. Reserve requirements mediately, causing a bank run to occur.
are intended to ensure that the banks have sucient sup- Contemporary bank management methods for liquidity
plies of highly liquid assets, so that the system operates are based on maturity analysis of all the banks assets
in an orderly fashion and maintains public condence.
and liabilities (o balance sheet exposures may also be
In addition to reserve requirements, there are other re- included). Assets and liabilities are put into residual conquired nancial ratios that aect the amount of loans tractual maturity buckets such as 'on demand', 'less than 1
that a bank can fund. The capital requirement ratio is month', '23 months etc. These residual contractual maperhaps the most important of these other required ra- turities may be adjusted to account for expected counter
tios. When there are no mandatory reserve requirements, party behaviour such as early loan repayments due to borwhich are considered by some economists to restrict lend- rowers renancing and expected renewals of term deing, the capital requirement ratio acts to prevent an in- posits to give forecast cash ows. This analysis highlights
any large future net outows of cash and enables the bank
nite amount of bank lending.
to respond before they occur. Scenario analysis may also
be conducted, depicting scenarios including stress scenar59.6.3 Liquidity and capital management ios such as a bank-specic crisis.

for a bank
Main articles: Capital requirement and Market liquidity

59.7 Hypothetical example of a

bank balance sheet and nancial ratios

To avoid defaulting on its obligations, the bank must

maintain a minimal reserve ratio that it xes in accordance with, notably, regulations and its liabilities. In
practice this means that the bank sets a reserve ratio target An example of fractional-reserve banking, and the calcuand responds when the actual ratio falls below the target. lation of the reserve ratio is shown in the balance sheet
Such response can be, for instance:
below:
In this example the cash reserves held by the bank is
1. Selling or redeeming other assets, or securitization NZ$3,010m (NZ$201m Cash + NZ$2,809m Balance at
of illiquid assets,
Central Bank) and the Demand Deposits (liabilities) of
the bank are NZ$25,482m, for a cash reserve ratio of
2. Restricting investment in new loans,
11.81%.
3. Borrowing funds (whether repayable on demand or
at a xed maturity),
4. Issuing additional capital instruments, or

59.7.1 Other nancial ratios

The key nancial ratio used to analyze fractional-reserve

banks is the cash reserve ratio, which is the ratio of cash
reserves to demand deposits. However, other important
Because dierent funding options have dierent costs, nancial ratios are also used to analyze the banks liquidand dier in reliability, banks maintain a stock of low ity, nancial strength, protability etc.
cost and reliable sources of liquidity such as:
For example the ANZ National Bank Limited balance
sheet above gives the following nancial ratios:
1. Demand deposits with other banks
5. Reducing dividends.

2. High quality marketable debt securities

3. Committed lines of credit with other banks
As with reserves, other sources of liquidity are managed
with targets.

1. The cash reserve ratio is $3,010m/$25,482m, i.e.

11.81%.
2. The
liquid
assets
reserve
ratio
($201m+$2,809m+$1,797m)/$25,482m,
18.86%.

is
i.e.

306

CHAPTER 59. FRACTIONAL-RESERVE BANKING

3. The equity capital ratio is $8,703m/107,787m, i.e.

8.07%.

59.9 Criticisms of
reserve banking

fractional-

In 1935, economist Irving Fisher proposed a system of

100% reserve banking as a means of reversing the deation of the Great depression. He wrote: 100 per cent
banking [...] would give the Federal Reserve absolute
5. The
total
capital
ratio
is control over the money supply. Recall that under the
($8,703m+$2,062m)/$107,787m, i.e. 9.99%.
present fractional-reserve system of depository institutions, the money supply is determined in the short run
by such non-policy variables as the currency/deposit ratio
It is important how the term 'reserves is dened for calcu- of the public and the excess reserve ratio of depository
lating the reserve ratio, as dierent denitions give dif- institutions.[35]
ferent results. Other important nancial ratios may reAustrian School economists such as Jess Huerta de
quire analysis of disclosures in other parts of the banks
Soto and Murray Rothbard have also strongly criticized
nancial statements. In particular, for liquidity risk, disfractional-reserve banking, calling for it to be outlawed
closures are incorporated into a note to the nancial stateand criminalized. According to them, not only does
ments that provides maturity analysis of the banks assets
money creation cause macroeconomic instability (based
and liabilities and an explanation of how the bank manon the Austrian Business Cycle Theory), but it is a form
ages its liquidity.
of embezzlement or nancial fraud, legalized only due to
the inuence of powerful rich bankers on corrupt governments around the world.[36][37]
4. The tangible equity ratio
$3,297m)/107,787m, i.e. 5.02%

is

($8,703m-

59.8 Criticisms of textbook descriptions of the monetary

system

To quote Murray Rothbard:[36]:97

It should be clear that modern fractional reserve banking is a shell game, a Ponzi scheme,
a fraud in which fake warehouse receipts are
issued and circulate as equivalent to the cash
supposedly represented by the receipts.

Sir Mervyn King, former Governor of the Bank of England said Textbooks assume that money is exogenous...
In the United Kingdom, money is endogenous.[30]
Politician Ron Paul has also criticized fractional reserve
Glenn Stevens, governor of the Reserve Bank of Aus- banking.[38]
tralia, said of the money multiplier, most practitioners
nd it to be a pretty unsatisfactory description of how the
monetary and credit system actually works.[31]
59.10 See also
Lord Adair Turner, formally the UKs chief nancial regulator, said Banks do not, as too many textbooks still
suggest, take deposits of existing money from savers and
lend it out to borrowers: they create credit and money ex
nihilo extending a loan to the borrower and simultaneously crediting the borrowers money account.[32]
McLeay et al. said in the Bank of England Quarterly Bulletin: This description of the relationship between monetary policy and money diers from the description in
many introductory textbooks, where central banks determine the quantity of broad money via a money multiplier
by actively varying the quantity of reserves.[33]
Former Deputy Governor of the Bank of Canada William
White said Some decades ago, the academic literature
would have emphasised the importance of the reserves
supplied by the central bank to the banking system, and
the implications (via the money multiplier) for the growth
of money and credit. Today, it is more broadly understood that no industrial country conducts policy in this
way under normal circumstances. [34]

Austrian Business Cycle Theory

Endogenous money
Basel II
Basel III
Asset liability management
Full-reserve banking
Chicago plan
The Chicago Plan Revisited

59.11 References
[1] Abel, Andrew; Bernanke, Ben (2005). 14.1. Macroeconomics (5th ed.). Pearson. pp. 522532

59.11. REFERENCES

[2] Mankiw, N. Gregory (2002). Chapter 18: Money Supply

and Money Demand. Macroeconomics (5th ed.). Worth.
pp. 482489
[3] Hubbard and Obrien. Economics. Chapter 25: Monetary
Policy, p943.
[4] Frederic S. Mishkin, Economics of Money, Banking and
Financial Markets, 10th Edition. Prentice Hall 2012
[5] Ownership eects of FRB, 2009, Ahamed Kameel Mydin
Meera and Moussa Larbani
[6] Carl Menger (1950) Principles of Economics, Free Press,
Glencoe, IL OCLC 168839
[7] United States. Congress. House. Banking and Currency
Committee. (1964). Money facts; 169 questions and answers on money a supplement to A Primer on Money,
with index, Subcommittee on Domestic Finance ... 1964.
Washington D.C.
[8] Charles P. Kindleberger, A Financial History of Western
Europe. Routledge 2007
[9] The Federal Reserve in Plain English An easy-to-read
guide to the structure and functions of the Federal Reserve
System (See page 5 of the document for the purposes and
functions)
[10] Abel, Andrew; Bernanke, Ben (2005). 7. Macroeconomics (5th ed.). Pearson. pp. 266269.
[11] Maturity Transformation Brad DeLong
[12] Mankiw, N. Gregory (2002). 9. Macroeconomics (5th
ed.). Worth. pp. 238255.
[13] Page 57 of 'The FED today', a publication on an educational site aliated with the Federal Reserve Bank of
Kansas City, designed to educate people on the history
and purpose of the United States Federal Reserve system.
The FED today Lesson 6
[14] Mervyn King, Finance: A Return from Risk. Bank of
England. Banks are dangerous institutions. They borrow
short and lend long. They create liabilities which promise
to be liquid and hold few liquid assets themselves. That
though is hugely valuable for the rest of the economy.
Household savings can be channelled to nance illiquid
investment projects while providing access to liquidity for
those savers who may need it.... If a large number of depositors want liquidity at the same time, banks are forced
into early liquidation of assets lowering their value ...'
[15] Bank for International Settlements The Role of Central Bank Money in Payment Systems. See page 9, titled,
The coexistence of central and commercial bank monies:
multiple issuers, one currency": A quick quotation in reference to the 2 dierent types of money is listed on page
3. It is the rst sentence of the document:
Contemporary monetary systems are based
on the mutually reinforcing roles of central
bank money and commercial bank monies.
[16] European Central Bank Domestic payments in Euroland: commercial and central bank money: One quotation from the article referencing the two types of money:

307

At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time, this monopoly
came to be shared with commercial banks,
when deposits and their transfer via cheques
and giros became widely accepted. Banknotes and commercial bank money became
fully interchangeable payment media that
customers could use according to their needs.
While transaction costs in commercial bank
money were shrinking, cashless payment instruments became increasingly used, at the
expense of banknotes
[17] Macmillan report 1931 account of how fractional banking
works
[18] Federal Reserve Bank of Chicago, Modern Money Mechanics, pp. 3-13 (May 1961), reprinted in Money and
Banking: Theory, Analysis, and Policy, p. 59, ed. by S.
Mittra (Random House, New York 1970) OCLC 89880
[19] Managing the central banks balance sheet: where monetary policy meets nancial stability. Bank of England.
[20] McGraw Hill Higher Education
[21] Federal Reserve Board, Aggregate Reserves of Depository Institutions and the Monetary Base (Updated
weekly).
[22] Bruce Champ & Scott Freeman (2001) Modeling Monetary Economies, p. 170 (Figure 9.1), Cambridge University Press ISBN 978-0-52178-354-5
[23] Federal Reserve Bank of Chicago, Modern Money Mechanics, pp. 3-13 (May 1961), reprinted in Money and
Banking: Theory, Analysis, and Policy, p. 59, ed. by S.
Mittra (Random House, New York 1970).
[24] Eric N. Compton, Principles of Banking, p. 150, American Bankers Assn (1979).
[25] Paul M. Horvitz, Monetary Policy and the Financial System, pp. 56-57, Prentice-Hall, 3rd ed. (1974).
[26] See, generally, Industry Audit Guide: Audits of Banks, p.
56, Banking Committee, American Institute of Certied
Public Accountants (1983).
[27] William MacEachern (2014) Macroeconomics: A Contemporary Introduction, p. 295, University of Connecticut, ISBN 978-1-13318-923-7
[28] The Federal Reserve Purposes and Functions (See pages
13 and 14 of the pdf version for information on government regulations and supervision over banks)
[29] Reserve Bank of India Report on Currency and Finance
200405 (See page 71 of the full report or just download
the section Functional Evolution of Central Banking): The
monopoly power to issue currency is delegated to a central
bank in full or sometimes in part. The practice regarding
the currency issue is governed more by convention than by
any particular theory. It is well known that the basic concept of currency evolved in order to facilitate exchange.
The primitive currency note was in reality a promissory

308

CHAPTER 59. FRACTIONAL-RESERVE BANKING

note to pay back to its bearer the original precious metals. With greater acceptability of these promissory notes,
these began to move across the country and the banks that
issued the promissory notes soon learnt that they could
issue more receipts than the gold reserves held by them.
This led to the evolution of the fractional-reserve system.
It also led to repeated bank failures and brought forth the
need to have an independent authority to act as lenderof-the-last-resort. Even after the emergence of central
banks, the concerned governments continued to decide asset backing for issue of coins and notes. The asset backing
took various forms including gold coins, bullion, foreign
exchange reserves and foreign securities. With the emergence of a fractional-reserve system, this reserve backing
(gold, currency assets, etc.) came down to a fraction of
total currency put in circulation.
[30] King, Mervyn. The transmission mechanism of monetary policy. Bank of England.
[31] Stevens, Glen. The Australian Economy: Then and
Now. Reserve Bank of Australia.
[32] Turner, Adair. Credit Money and Leverage, what Wicksell, Hayek and Fisher knew and modern macroeconomics
forgot.
[33] McLeay. Money creation in the modern economy.
Bank of England.
[34] White, William. Changing views on how best to conduct
monetary policy: the last fty years. Bank for International Settlements.
[35] Fisher, Irving (1997). 100% Money. Pickering & Chatto
Ltd. ISBN 978-1-85196-236-5.
[36] Rothbard, Murray (1983). The Mystery of Banking. ISBN
9780943940045.
[37] Jess Huerta de Soto (2012). Money, Bank Credit, and
Economic Cycles (3d ed.). Auburn, AL: Ludwig von
Mises Institute. p. 881. ISBN 9781610161893. OCLC
807678778. (with Melinda A. Stroup, translator) Also
available as a PDF here
[38] Ron Paul (2009) End the Fed, Ch. 2, Grand Central Pub.,
New York ISBN 978-0-44654-919-6

59.12 Further reading

Crick, W.F. (1927), The genesis of bank deposits,
Economica, vol 7, 1927, pp 191202.
Friedman, Milton (1960), A Program for Monetary
Stability, New York, Fordham University Press.
Meigs, A.J. (1962), Free reserves and the money supply, Chicago, University of Chicago, 1962.
Paul, Ron (2009). 2 The Origin and Nature of the
Fed. End the Fed. New York: Grand Central Publishing. ISBN 978-0-446-54919-6.

Philips, C.A. (1921), Bank Credit, New York,

Macmillan, chapters 14, 1921,
Thomson, P. (1956), Variations on a theme by
Philips, American Economic Review vol 46, December 1956, pp. 965970.

59.13 External links

Money creation in the modern economy Bank of
England
Regulation D of the Federal Reserve Board of the
U.S.
Interactive Fractional-Reserve Calculator Calculator that details deposit multiplication for any reserve
requirement.
Bank for International Settlements The Role of
Central Bank Money in Payment Systems
Fractional Reserve Banking Denition

Chapter 60

Money supply
In economics, the money supply or money stock, is the
total amount of monetary assets available in an economy
at a specic time.[1] There are several ways to dene
money, but standard measures usually include currency
in circulation and demand deposits (depositors easily accessed assets on the books of nancial institutions).[2][3]

60.1 Empirical measures in the

United States Federal Reserve
System
See also European Central Bank for other approaches and a more global perspective.

Money supply data are recorded and published, usually by

the government or the central bank of the country. Public
and private sector analysts have long monitored changes Money is used as a medium of exchange, a unit of acin money supply because of its eects on the price level, count, and as a ready store of value. Its dierent funcination, the exchange rate and the business cycle.[4]
tions are associated with dierent empirical measures of
That relation between money and prices is historically the money supply. There is no single correct measure
associated with the quantity theory of money. There of the money supply. Instead, there are several measures,
is strong empirical evidence of a direct relation be- classied along a spectrum or continuum between nartween money-supply growth and long-term price in- row and broad monetary aggregates. Narrow measures
ation, at least for rapid increases in the amount of include only the most liquid assets, the ones most easily
money in the economy. For example, a country such used to spend (currency, checkable deposits). Broader
as Zimbabwe which saw extremely rapid increases in its measures add less liquid types of assets (certicates of
money supply also saw extremely rapid increases in prices deposit, etc.).
(hyperination). This is one reason for the reliance on This continuum corresponds to the way that dierent
monetary policy as a means of controlling ination.[5][6] types of money are more or less controlled by moneThe nature of this causal chain is the subject of con- tary policy. Narrow measures include those more directly
tention. Some heterodox economists argue that the aected and controlled by monetary policy, whereas
money supply is endogenous (determined by the work- broader measures are less closely related to monetary[6]
ings of the economy, not by the central bank) and that policy actions. It is a matter of perennial debate as to
whether
narrower
or broader versions of the money supthe sources of ination must be found in the distributional
[7]
ply
have
a
more
predictable
link to nominal GDP.
structure of the economy.
In addition, those economists seeing the central banks The dierent types of money are typically classied as
control over the money supply as feeble say that there are "Ms. The M"s usually range from M0 (narrowest) to
two weak links between the growth of the money supply M3 (broadest) but which M"s are actually focused on in
and the ination rate. First, in the aftermath of a reces- policy formulation depends on the countrys central bank.
sion, when many resources are underutilized, an increase The typical layout for each of the M"s is as follows:
in the money supply can cause a sustained increase in real
production instead of ination. Second, if the velocity of
M0: In some countries, such as the United Kingmoney, i.e., the ratio between nominal GDP and money
dom, M0 includes bank reserves, so M0 is referred
supply changes, an increase in the money supply could
to as the monetary base, or narrow money.[11]
have either no eect, an exaggerated eect, or an unpre MB: is referred to as the monetary base or total
dictable eect on the growth of nominal GDP.
currency.[8] This is the base from which other forms
of money (like checking deposits, listed below) are
created and is traditionally the most liquid measure
of the money supply.[12]
M1: Bank reserves are not included in M1.
309

310

CHAPTER 60. MONEY SUPPLY

M2: Represents M1 and close substitutes for out. The ratio that applies to bank lending is its capital
M1.[13] M2 is a broader classication of money than requirement.[24]
M1. M2 is a key economic indicator used to forecast
ination.[14]

60.2 Example

M3: M2 plus large and long-term deposits. Since

2006, M3 is no longer published by the US central
bank.[15] However, there are still estimates produced Note: The examples apply when read in sequential order.
by various private institutions.
M0
MZM: Money with zero maturity. It measures the
supply of nancial assets redeemable at par on demand. Velocity of MZM is historically a relatively
accurate predictor of ination.[16][17][18]

Laura has ten US $100 bills, representing $1000 in

the M0 supply for the United States. (MB = $1000,
M0 = $1000, M1 = $1000, M2 = $1000)

The ratio of a pair of these measures, most often M2 /

M0, is called an (actual, empirical) money multiplier.

Laura burns one of her $100 bills. The US M0, and

her personal net worth, just decreased by $100. (MB
= $900, M0 = $900, M1 = $900, M2 = $900)

60.1.1

Fractional-reserve banking

Main article: Fractional-reserve banking

The dierent forms of money in government money supply statistics arise from the practice of fractional-reserve
banking. Whenever a bank gives out a loan in a fractionalreserve banking system, a new sum of money is created.
This new type of money is what makes up the non-M0
components in the M1-M3 statistics. In short, there
are two types of money in a fractional-reserve banking
system:[19][20]

M1
Laura takes the remaining nine bills and deposits
them in her transactional account (checking account
or current account by country) at her bank. (MB =
$900, M0 = 0, M1 = $900, M2 = $900)
The bank then calculates its reserve using the minimum reserve percentage given by the Fed and loans
the extra money. If the minimum reserve is 10%,
this means $90 will remain in the banks reserve.
The remaining $810 can only be used by the bank
as credit, by lending money, but until that happens
it will be part of the banks excess reserves.

1. central bank money (obligations of a

central bank, including currency and central bank depository accounts)

The M1 money supply increases by $810 when the

loan is made. M1 money is created. ( MB = $900
M0 = 0, M1 = $1710, M2 = $1710)

2. commercial bank money (obligations

of commercial banks, including checking
accounts and savings accounts)

Laura writes a check for $400, check number 7771.

The total M1 money supply didn't change, it includes
the $400 check and the $500 left in her account.
(MB = $900, M0 = 0, M1 = $1710, M2 = $1710)

In the money supply statistics, central bank money is

MB while the commercial bank money is divided up
into the M1-M3 components. Generally, the types of
commercial bank money that tend to be valued at lower
amounts are classied in the narrow category of M1 while
the types of commercial bank money that tend to exist in
larger amounts are categorized in M2 and M3, with M3
having the largest.
In the US, reserves consist of money in Federal Reserve
accounts and US currency held by banks (also known as
vault cash).[21] Currency and money in Fed accounts are
interchangeable (both are obligations of the Fed.) Reserves may come from any source, including the federal
funds market, deposits by the public, and borrowing from
the Fed itself.[22]
A reserve requirement is a ratio a bank must maintain
between deposits and reserves.[23] Reserve requirements
do not apply to the amount of money a bank may lend

Lauras check number 7771 is accidentally destroyed in the laundry. M1 and her checking account
do not change, because the check is never cashed.
(MB = $900, M0 = 0, M1 = $1710, M2 = $1710)
Laura writes check number 7772 for $100 to her
friend Alice, and Alice deposits it into her checking
account. MB does not change, it still has $900 in it,
Alices $100 and Lauras $800. (MB = $900, M0 =
0, M1 = $1710, M2 = $1710)
The bank lends Mandy the $810 credit that it has
created. Mandy deposits the money in a checking
account at another bank. The other bank must keep
$81 as a reserve and has $729 available for loans.
This creates a promise-to-pay money from a previous promise-to-pay, thus the M1 money supply is
now inated by $729. (MB = $900, M0 = 0, M1 =
$2439, M2 = $2439)

60.3. MONEY SUPPLIES AROUND THE WORLD

311

Mandys bank now lends the money to someone else

who deposits it on a checking account on yet another
bank, who again stores 10% as reserve and has 90%
available for loans. This process repeats itself at the
next bank and at the next bank and so on, until the
money in the reserves backs up an M1 money supply
of $9000, which is 10 times the MB money. (MB =
$900, M0 = 0, M1 = $9000, M2 = $9000)
M2
Laura writes check number 7774 for $1000 and
brings it to the bank to start a Money Market account (these do not have a credit-creating charter),
M1 goes down by $1000, but M2 stays the same.
This is because M2 includes the Money Market account in addition to all money counted in M1.
Foreign Exchange
Laura writes check number 7776 for $200 and
brings it downtown to a foreign exchange bank teller
at Credit Suisse to convert it to British Pounds. On
this particular day, the exchange rate is exactly USD
2.00 = GBP 1.00. The bank Credit Suisse takes
her $200 check, and gives her two 50 notes (and
charges her a dollar for the service fee). Meanwhile,
at the Credit Suisse branch oce in Hong Kong, a
customer named Huang has 100 and wants $200,
and the bank does that trade (charging him an extra
.50 for the service fee). US M0 still has the $900,
although Huang now has $200 of it. The 100 notes
Laura walks o with are part of Britains M0 money
supply that came from Huang.
The next day, Credit Suisse nds they have an excess of GB Pounds and a shortage of US Dollars,
determined by adding up all the branch oces supplies. They sell some of their GBP on the open FX
market with Deutsche Bank, which has the opposite
problem. The exchange rate stays the same.
The day after, both Credit Suisse and Deutsche
Bank nd they have too many GBP and not enough
USD, along with other traders. Then, to move their
inventories, they have to sell GBP at USD 1.999,
that is, 1/10-cent less than $2 per pound, and the
exchange rate shifts. None of these banks has the
power to increase or decrease the British M0 or the
American M0 (unless they burn bills); they are independent systems.

60.3 Money supplies around the

world

MB, M1 and M2 from 1981 to 2012 Further Information:

Federal Reserve Bank of St. Louis[25]

60.3.1 United States

The Federal Reserve previously published data on three
monetary aggregates, but on November 10, 2005 announced that as of March 23, 2006, it would cease publication of M3.[15] Since the Spring of 2006, the Federal
Reserve only publishes data on two of these aggregates.
The rst, M1, is made up of types of money commonly
used for payment, basically currency (M0) and checking
account balances. The second, M2, includes M1 plus balances that generally are similar to transaction accounts
and that, for the most part, can be converted fairly readily
to M1 with little or no loss of principal. The M2 measure
is thought to be held primarily by households. As mentioned, the third aggregate, M3 is no longer published.
Prior to this discontinuation, M3 had included M2 plus
certain accounts that are held by entities other than individuals and are issued by banks and thrift institutions to
augment M2-type balances in meeting credit demands; it
had also included balances in money market mutual funds
held by institutional investors. The aggregates have had
dierent roles in monetary policy as their reliability as
guides has changed. The following details their principal
components:[26]
M0: The total of all physical currency including
coinage. M0 = Federal Reserve Notes + US Notes
+ Coins. It is not relevant whether the currency is
held inside or outside of the private banking system
as reserves.
MB: The total of all physical currency plus Federal
Reserve Deposits (special deposits that only banks
can have at the Fed). MB = Coins + US Notes +
Federal Reserve Notes + Federal Reserve Deposits
M1: The total amount of M0 (cash/coin) outside
of the private banking system plus the amount of
demand deposits, travelers checks and other checkable deposits
M2: M1 + most savings accounts, money market accounts, retail money market mutual funds, and small
denomination time deposits (certicates of deposit
of under $100,000).

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CHAPTER 60. MONEY SUPPLY

MZM: 'Money Zero Maturity' is one of the most As of April 2013, the monetary base was $3 trillion[29]
popular aggregates in use by the Fed because its and M2, the broadest measure of money supply, was
velocity has historically been the most accurate pre- $10.5 trillion.[30]
dictor of ination. It is M2 time deposits + money
market funds

60.3.2 United Kingdom

M3: M2 + all other CDs (large time deposits, institutional money market mutual fund balances), deposits of eurodollars and repurchase agreements.
M4-: M3 + Commercial Paper

1750
1500
1250
1000

M4: M4- + T-Bills (or M3 + Commercial Paper +

T-Bills)

750
500
250
0

1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
L: The broadest measure of liquidity that the Federal Reserve no longer tracks. Pretty much M4 +
Bankers Acceptance
M4 money supply of the United Kingdom 19842007. In thou-

Money Multiplier: M1 / MB. Currently as of June

14, 2012 it is .85. While a multiplier under one is
historically an oddity, this is a reection of the popularity of M2 over M1 and the massive amount of
MB the government has created since 2008.
It should be noted that while the treasury can and does
hold cash and a special deposit account at the Fed (fed
funds), these assets do not count in any of the aggregates. So in essence taxes paid to the Federal Government (Treasury) is excluded from the money supply. To
counter this, the government created the TT&L program
in which any receipts above a certain threshold are redeposited in private banks. The idea is that tax receipts
won't decrease the amount of reserves in the banking system. The TT&L accounts, while demand deposits, do not
count toward M1 or any other aggregate as well.
When the Federal Reserve announced in 2005 that they
would cease publishing M3 statistics in March 2006, they
explained that M3 did not convey any additional information about economic activity compared to M2, and thus,
has not played a role in the monetary policy process for
many years. Therefore, the costs to collect M3 data outweighed the benets the data provided.[15] Some politicians have spoken out against the Federal Reserves decision to cease publishing M3 statistics and have urged the
U.S. Congress to take steps requiring the Federal Reserve
to do so. Congressman Ron Paul (R-TX) claimed that
M3 is the best description of how quickly the Fed is creating new money and credit. Common sense tells us that a
government central bank creating new money out of thin
air depreciates the value of each dollar in circulation.[27]
Modern Monetary Theory disagrees. It holds that money
creation in a free-oating at currency regime such as
the U.S. will not lead to signicant ination unless the
economy is approaching full employment and full capacity. Some of the data used to calculate M3 are still collected and published on a regular basis.[15] Current alternate sources of M3 data are available from the private
sector.[28]

sand millions (billions) of pounds sterling.

There are just two ocial UK measures. M0 is referred

to as the wide monetary base" or narrow money and
M4 is referred to as "broad money" or simply the money
supply.
M0: Cash outside Bank of England + banks operational deposits with Bank of England. (No longer
published.)
M4: Cash outside banks (i.e. in circulation with
the public and non-bank rms) + private-sector retail bank and building society deposits + privatesector wholesale bank and building society deposits
and certicates of deposit.[31] In 2010, the total
money supply (M4) measure in the UK was 2.2
trillion while the actual notes and coins in circulation was only 47 billion, 2.1% of the actual money
supply.[32]
There are several dierent denitions of money supply
to reect the diering stores of money. Due to the
nature of bank deposits, especially time-restricted
savings account deposits, the M4 represents the most
illiquid measure of money. M0, by contrast, is the most
liquid measure of the money supply.

60.3.3 Eurozone
The European Central Bank's denition of euro area
monetary aggregates:[33]
M1: Currency in circulation + overnight deposits
M2: M1 + deposits with an agreed maturity up to 2
years + deposits redeemable at a period of notice up
to 3 months.
M3: M2 + repurchase agreements + money market
fund (MMF) shares/units + debt securities up to 2
years

60.3. MONEY SUPPLIES AROUND THE WORLD

313

The Euro money supply from 19982007.

60.3.4

Australia
New Zealand money supply 19882008

M2: M1 + all non-M1 call funding (call funding includes overnight money and funding on terms that
can of right be broken without break penalties) minus inter-institutional non-M1 call funding
M3: the broadest monetary aggregate. It represents
all New Zealand dollar funding of M3 institutions
and any Reserve Bank repos with non-M3 institutions. M3 consists of notes & coin held by the public
plus NZ dollar funding minus inter-M3 institutional
claims and minus central government deposits
The money supply of Australia 19842007

The Reserve Bank of Australia denes the monetary aggregates as:[34]

60.3.6 India

M1: currency bank + current deposits of the private

non-bank sector
M3: M1 + all other bank deposits of the private nonbank sector
Broad Money: M3 + borrowings from the private
sector by NBFIs, less the latters holdings of currency and bank deposits
Money Base: holdings of notes and coins by the private sector plus deposits of banks with the Reserve
Bank of Australia (RBA) and other RBA liabilities
to the private non-bank sector
Components of the money supply of India in billions of Rupee
for 19502011

60.3.5

New Zealand

The Reserve Bank of India denes the monetary aggreThe Reserve Bank of New Zealand denes the monetary gates as:[36]
aggregates as:[35]
Reserve Money (M0): Currency in circulation +
M1: notes and coins held by the public plus chequeBankers deposits with the RBI + Other deposits
able deposits, minus inter-institutional chequeable
with the RBI = Net RBI credit to the Government +
deposits, and minus central government deposits
RBI credit to the commercial sector + RBIs claims

314

CHAPTER 60. MONEY SUPPLY

on banks + RBIs net foreign assets + Governments deposits of US dollars, with ocial foreign currency recurrency liabilities to the public RBIs net non- serves of 331.3 billion USD as of September 2014.[37]
monetary liabilities.

M1: Currency with the public + Deposit money of 60.3.8

the public (Demand deposits with the banking system + Other deposits with the RBI).

Japan

M2: M1 + Savings deposits with Post oce savings

banks.
M3: M1+ Time deposits with the banking system =
Net bank credit to the Government + Bank credit to
the commercial sector + Net foreign exchange assets
of the banking sector + Governments currency liabilities to the public Net non-monetary liabilities
of the banking sector (Other than Time Deposits).
M4: M3 + All deposits with post oce savings
Japanese money supply (April 1998 April 2008)
banks (excluding National Savings Certicates).
The Bank of Japan denes the monetary aggregates as:[38]

60.3.7

Hong Kong

In 1967, when sterling was devalued, the dollars peg to

the pound was increased from 1 shilling 3 pence to 1
shilling 4 pence (14.5455 dollars = 1 pound) although
this did not entirely oset the devaluation. In 1972, the
Hong Kong dollar was pegged to the U.S. dollar at a rate
of 5.65 H.K. dollar = 1 U.S. dollar. This was revised to
5.085 H.K. dollar = 1 U.S. dollar in 1973. Between 1974
and 1983, the Hong Kong dollar was oated. On 17 October 1983, the currency was pegged at a rate of 7.8 H.K.
dollar = 1 U.S. dollar, through the currency board system.
As of 18 May 2005, in addition to the lower guaranteed
limit, a new upper guaranteed limit was set for the Hong
Kong dollar at 7.75 to the American dollar. The lower
limit has been lowered from 7.80 to 7.85 (by 100 pips
per week from 23 May to 20 June 2005). The Hong Kong
Monetary Authority indicated this move is to narrow the
gap between the interest rates in Hong Kong and those of
the United States. A further aim of allowing the Hong
Kong dollar to trade in a range is to avoid the HK dollar
being used as a proxy for speculative bets on a renminbi
revaluation.

M1: cash currency in circulation + deposit money

M2 + CDs: M1 + quasi-money + CDs
M3 + CDs: (M2 + CDs) + deposits of post oces +
other savings and deposits with nancial institutions
+ money trusts
Broadly dened liquidity: (M3 + CDs) + money
market + pecuniary trusts other than money trusts +
investment trusts + bank debentures + commercial
paper issued by nancial institutions + repurchase
agreements and securities lending with cash collateral + government bonds + foreign bonds

60.4 Link with ination

60.4.1 Monetary exchange equation
Money supply is important because it is linked to ination
by the equation of exchange in an equation proposed by
Irving Fisher in 1911:[39]

The Hong Kong Basic Law and the Sino-British Joint

Declaration provides that Hong Kong retains full autonomy with respect to currency issuance. Currency in Hong M V = P Q
Kong is issued by the government and three local banks
where
under the supervision of the territorys de facto central
bank, the Hong Kong Monetary Authority. Bank notes
M is the total dollars in the nations money supply,
are printed by Hong Kong Note Printing.
V is the number of times per year each dollar is
A bank can issue a Hong Kong dollar only if it has the
spent (velocity of money),
equivalent exchange in US dollars on deposit. The currency board system ensures that Hong Kongs entire mon P is the average price of all the goods and services
etary base is backed with US dollars at the linked exsold during the year,
change rate. The resources for the backing are kept in
Q is the quantity of assets, goods and services sold
Hong Kongs exchange fund, which is among the largest
during the year.
ocial reserves in the world. Hong Kong also has huge

60.5. BANK RESERVES AT CENTRAL BANK

315

In mathematical terms, this equation is really an identity

which is true by denition rather than describing economic behavior. That is, each term is dened by the values of the other three. Unlike the other terms, the velocity of money has no independent measure and can only
be estimated by dividing PQ by M. Some adherents of
the quantity theory of money assume that the velocity of
money is stable and predictable, being determined mostly
by nancial institutions. If that assumption is valid then
changes in M can be used to predict changes in PQ. If not,
then a model of V is required in order for the equation of
exchange to be useful as a macroeconomics model or as
a predictor of prices.
Most macroeconomists replace the equation of exchange
with equations for the demand for money which describe more regular and predictable economic behavior.
However, predictability (or the lack thereof) of the velocity of money is equivalent to predictability (or the
lack thereof) of the demand for money (since in equilibrium real money demand is simply Q/V). Either way,
this unpredictability made policy-makers at the Federal
Reserve rely less on the money supply in steering the
U.S.economy. Instead, the policy focus has shifted to
interest rates such as the fed funds rate.

supply may cause dierent kinds of ination at dierent

times. For example, rises in the U.S. money supplies between the 1970s and the present encouraged rst a rise in
the ination rate for newly produced goods and services
(ination as usually dened) in the seventies and then
asset-price ination in later decades: it may have encouraged a stock market boom in the '80s and '90s and then,
after 2001, a rise in home prices, i.e., the famous housing
bubble. This story, of course, assumes that the amounts
of money were the causes of these dierent types of ination rather than being endogenous results of the economys dynamics.
When home prices went down, the Federal Reserve kept
its loose monetary policy and lowered interest rates; the
attempt to slow price declines in one asset class, e.g. real
estate, may well have caused prices in other asset classes
to rise, e.g. commoditie.s

60.4.2 Rates of growth

In terms of percentage changes (to a close approximation
under small growth rates,[40] the percentage change in a
product, say XY, is equal to the sum of the percentage
changes %X + %Y). So:

In practice, macroeconomists almost always use real

GDP to measure Q, omitting the role of all transac%P + %Q = %M + %V
tions except for those involving newly produced goods
and services (i.e., consumption goods, investment goods,
government-purchased goods, and exports). That is, the That equation rearranged gives the basic ination idenonly assets counted as part of Q are newly produced tity":
investment goods. But the original quantity theory of
money did not follow this practice: PQ was the mone%P = %M + %V %Q
tary value of all new transactions, whether of real goods
and services or of paper assets.
Ination (%P) is equal to the rate of money growth
(%M), plus the change in velocity (%V), minus the
90 %
rate of output growth (%Q).[41] As before, this equa80 %
tion is only useful if %V follows regular behavior. It
also loses usefulness if the central bank lacks control over
70 %
%M.
60 %

50 %

60.5 Bank reserves at central bank

40 %
1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

U.S. M3 money supply as a proportion of gross domestic product.

When a central bank is easing, it triggers an increase in

money supply by purchasing government securities on the
open market thus increasing available funds for private
banks to loan through fractional-reserve banking (the issue of new money through loans) and thus the amount of
bank reserves and the monetary base rise. By purchasing
government bonds (e.g., U.S. Treasury bills), this bids up
their prices, so that interest rates fall at the same time that
the monetary base increases.

The monetary value of assets, goods, and service sold

during the year could be grossly estimated using nominal GDP back in the 1960s. This is not the case anymore
because of the dramatic rise of the number of nancial
transactions relative to that of real transactions up until
2008. That is, the total value of transactions (including
purchases of paper assets) rose relative to nominal GDP With easy money, the central bank creates new bank
(which excludes those purchases).
reserves (in the US known as "federal funds"), which alIgnoring the eects of monetary growth on real purchases low the banks lend more. These loans get spent, and the
and velocity, this suggests that the growth of the money proceeds get deposited at other banks. Whatever is not

316

CHAPTER 60. MONEY SUPPLY

required to be held as reserves is then lent out again, and

through the multiplying eect of the fractional-reserve
system, loans and bank deposits go up by many times the
initial injection of reserves.
In contrast, when the central bank is tightening, it slows
the process of private bank issue by selling securities on
the open market and pulling money (that could be loaned)
out of the private banking sector. By increasing the supply of bonds, this lowers their prices and raises interest
rates at the same time that the money supply is reduced.
This kind of policy reduces or increases the supply of
short term government debt in the hands of banks and
the non-bank public, lowering or raising interest rates.
In parallel, it increases or reduces the supply of loanable
funds (money) and thereby the ability of private banks to
issue new money through issuing debt.
The simple connection between monetary policy and
monetary aggregates such as M1 and M2 changed in the
1970s as the reserve requirements on deposits started to
fall with the emergence of money funds, which require
no reserves. Then in the early 1990s, reserve requirements, for example in Canada, were dropped to zero[42]
on savings deposits, CDs, and Eurodollar deposit. At
present, reserve requirements apply only to "transactions
deposits" essentially checking accounts. The vast majority of funding sources used by private banks to create
loans are not limited by bank reserves. Most commercial
and industrial loans are nanced by issuing large denomination CDs. Money market deposits are largely used to
lend to corporations who issue commercial paper. Consumer loans are also made using savings deposits, which
are not subject to reserve requirements. This means that
instead of the amount of loans supplied responding passively to monetary policy, we often see it rising and falling
with the demand for funds and the willingness of banks
to lend.
Some academics argue that the money multiplier is a
meaningless concept, because its relevance would require
that the money supply be exogenous, i.e. determined by
the monetary authorities via open market operations. If
central banks usually target the shortest-term interest rate
(as their policy instrument) then this leads to the money
supply being endogenous.[43]

Individual Consumer Loans at All Commercial Banks, 1990

2008

ple of ineectiveness of open market operations encountered in 2008 in the United States, when short-term interest rates went as low as they could go in nominal terms,
so that no more monetary stimulus could occur. This
zero bound problem has been called the liquidity trap or
"pushing on a string" (the pusher being the central bank
and the string being the real economy).

60.6 Arguments
The main functions of the central bank are to maintain low ination and a low level of unemployment, although these goals are sometimes in conict (according to
Phillips curve). A central bank may attempt to do this by
articially inuencing the demand for goods by increasing or decreasing the nations money supply (relative to
trend), which lowers or raises interest rates, which stimulates or restrains spending on goods and services.
An important debate among economists in the second half of the twentieth century concerned the central banks ability to predict how much money should be
in circulation, given current employment rates and ination rates. Economists such as Milton Friedman believed that the central bank would always get it wrong,
leading to wider swings in the economy than if it
were just left alone.[44] This is why they advocated a
non-interventionist approachone of targeting a prespecied path for the money supply independent of current economic conditions even though in practice this
might involve regular intervention with open market operations (or other monetary-policy tools) to keep the
money supply on target.

Neither commercial nor consumer loans are any longer

limited by bank reserves. Nor are they directly linked
proportional to reserves. Between 1995 and 2008, the
amount of consumer loans has steadily increased out of
proportion to bank reserves. Then, as part of the nanThe former Chairman of the U.S. Federal Reserve, Ben
cial crisis, bank reserves rose dramatically as new loans
Bernanke, suggested in 2004 that over the preceding 10 to
shrank.
15 years, many modern central banks became relatively
In recent years, some academic economists renowned for adept at manipulation of the money supply, leading to a
their work on the implications of rational expectations smoother business cycle, with recessions tending to be
have argued that open market operations are irrelevant. smaller and less frequent than in earlier decades, a pheThese include Robert Lucas, Jr., Thomas Sargent, Neil nomenon termed "The Great Moderation"[45] This theory
Wallace, Finn E. Kydland, Edward C. Prescott and Scott encountered criticism during the global nancial crisis of
Freeman. The Keynesian side points to a major exam- 20082009. Furthermore, it may be that the functions

60.8. REFERENCES

317

of the central bank may need to encompass more than [19] Bank for International Settlements The Role of Central Bank Money in Payment Systems. See page 9, titled,
the shifting up or down of interest rates or bank reserves:
The coexistence of central and commercial bank monies:
these tools, although valuable, may not in fact moderate
multiple issuers, one currency": http://www.bis.org/publ/
the volatility of money supply (or its velocity).

60.7 See also

60.8 References
[1] Paul M. Johnson. Money stock, A Glossary of Political
Economy Terms
[2] Alan Deardor. Money supply, Deardors Glossary of
International Economics
[3] Karl Brunner, money supply, The New Palgrave: A Dictionary of Economics, v. 3, p. 527.
[4] The Money Supply Federal Reserve Bank of New York.
Newyorkfed.org.
[5] Milton Friedman (1987). quantity theory of money,
The New Palgrave: A Dictionary of Economics, v. 4, pp.
1519.
[6] money supply Denition. Retrieved 2008-07-20.
[7] Lance Taylor: Reconstructing Macroeconomics, 2004
[8] Gold, Oil, Stocks, Investments, Currencies, and the Federal Reserve: Growth of Global Money Supply. DollarDaze Economic Commentary Blog by Mike Hewitt.
[9] M1 Money Stock (M1) FRED St. Louis Fed. Research.stlouisfed.org.
[10] M3 Denition. Investopedia (February 15, 2009).

cpss55.pdf A quick quote in reference to the 2 dierent

types of money is listed on page 3. It is the rst sentence
of the document:
Contemporary monetary systems are based
on the mutually reinforcing roles of central
bank money and commercial bank monies.

[20] European Central Bank Domestic payments in Euroland: commercial and central bank money: At the
beginning of the 20th almost the totality of retail payments were made in central bank money. Over time,
this monopoly came to be shared with commercial banks,
when deposits and their transfer via checks and giros became widely accepted. Banknotes and commercial bank
money became fully interchangeable payment media that
customers could use according to their needs. While
transaction costs in commercial bank money were shrinking, cashless payment instruments became increasingly
used, at the expense of banknotes
[21] What is vault cash? denition and meaning. Investorwords.com.
[22] Net Free or Borrowed Reserves of Depository Institutions (NFORBRES) FRED St. Louis Fed. Research.stlouisfed.org.
[23] FRB: Reserve Requirements. Federal Reserve Bank.
[24] Bank Capital Requirements. Wfhummel.cnchost.com.
[25] http://research.stlouisfed.org/fred2/categories/24
[26] "''The Federal Reserve Purposes and Functions'". Federalreserve.gov. 2013-04-24. Retrieved 2013-12-11.

[11] M0 (monetary base). Moneyterms.co.uk.

[27] What the Price of Gold Is Telling Us. Lewrockwell.com

(April 25, 2006).

[12] M0. Investopedia. Retrieved 2008-07-20.

[28] See, for example. Shadowstats.com.

[13] M2. Investopedia. Retrieved 2008-07-20.

[29] Aggregate Reserves of Depository Institutions and the

Monetary Base H.3. Federal Reserve. Archived from
the original on 16 June 2013.

[14] M2 Denition. InvestorWords.com. Retrieved 200807-20.

[15] Discontinuance of M3, Federal Reserve, November 10,
2005, revised March 9, 2006.

[30] H.6 Money Stock Measures. Federal Reserve Statistical

Release. Federal Reserve. Archived from the original on
16 June 2013.

[16] Aziz, John (March 10, 2013). Is Ination Always And

Everywhere a Monetary Phenomenon?". Azizonomics.
Retrieved 2 April 2013.

[31] www.bankofengland.co.uk Explanatory Notes M4 Retrieved August 13, 2007

[17] Thayer, Gary (January 16, 2013). Investors should assume that ination will exceed the Feds target. Macro
Strategy. Wells Fargo Advisors. Retrieved 2 April 2013.
[18] Carlson, John B.; Benjamin D. Keen (1996). MZM: A
monetary aggregate for the 1990s?". Economic Review
(Federal Reserve Bank of Cleveland) 32 (2): 1523. Retrieved 2 April 2013.

[32] Lipsey, R. G. and Chrystal, K. A. (2011). Economics,

12th Edition, Oxford University Press. p455
[33] The ECBs denition of euro area monetary aggregates
[34] RBA: Glossary Text Only Version
[35] Series description Monetary and nancial statistics.
Rbnz.govt.nz.

318

[36] Handbook of Statistics on Indian Economy. See the

document at the bottom of the page titled, Notes on Tables. The denitions are on the fourth page of the document
[37] Hong Kongs Latest Foreign Currency Reserve Assets Figures Released
[38] click on the link to the exms01.pdf le. They are dened
in Appendix 1 which on the 11th page of the pdf.
[39] The Purchasing Power of Money, its Determination and
Relation to Credit, Interest and Crises, Irving Fisher.
Online Library Of Liberty
[40]
[41] Breaking Monetary Policy into Pieces, May 24, 2004
[42] Implementation of Monetary Policy in a Regime with
Zero Reserve Requirements by Kevin Clinton, Bank of
Canada Working Paper 97-8, April 1997
[43] Boermans, Martijn; Moore, Basil (2009). Locked-in and
Sticky textbooks. Issuu.com.
[44] Milton Friedman (1962). Capitalism and Freedom.
[45] FRB: Speech, Bernanke-The Great Moderation-February
20, 2004. Federal Reserve Bank (February 20, 2004).

60.9 Further reading

Article in the New Palgrave on Money Supply by
Milton Friedman
Do all banks hold reserves, and, if so, where do they
hold them? (11/2001)
What eect does a change in the reserve requirement
have on the money supply? (08/2001)
St. Louis Fed: Monetary Aggregates
Hlsmann, Jrg (2008). The Ethics of Money Production. Auburn, Alabama: Ludwig von Mises Institute. p. 294. ISBN 9781933550091.
Schwartz, Anna J. (2008). Money Supply. In
David R. Henderson (ed.). Concise Encyclopedia
of Economics (2nd ed.). Indianapolis: Library of
Economics and Liberty. ISBN 978-0865976658.
OCLC 237794267.
Discontinuance of M3 Publication
Investopedia: Money Zero Maturity (MZM)
White, Lawrence H. (2008). Competing Money
Supplies. In David R. Henderson (ed.). Concise
Encyclopedia of Economics (2nd ed.). Library of
Economics and Liberty. ISBN 978-0865976658.
OCLC 237794267.

CHAPTER 60. MONEY SUPPLY

60.10 External links

Aggregate Reserves Of Depository Institutions And
The Monetary Base (H.3)
Historical H.3 releases
U.S. M1,M2 Money Supply Historical Table
Money Stock Measures (H.6)
U.S. MZM magnitude and velocity, used as a predictor of ination
Data on Monetary Aggregates in Australia
Monetary Statistics on Hong Kong Monetary Authority
Monetary Survey from Peoples Bank of China
Money Supply Process by Fiona Maclachlan,
Wolfram Demonstrations Project.

Chapter 61

Lists of banks
61.4 See Also

Lists of banks are contained in the following articles:

List of oldest banks in continuous operation

61.1 By continent
List of banks in Africa - Each country in Africa
has a list of banks operating in that country
List of banks in Asia - Each country in Asia has a
list of banks with operations in that country
List of banks in Europe - Each country in Europe
has a list of banks licensed to operate in that country
List of banks in Oceania - Each country in Oceania has a list of banks with operations in that country

61.2 By super continent or intercontinental region

List of banks in the Arab world - Each Arab country has a list of banks operating in that country
List of banks in the Americas - Each country in
the Americas has a list of banks with operations in
that country

61.3 Other lists

List of banks (alphabetically) - A list of all banks.
List of international banking institutions - A list
of International and multilateral nancial institutions
List of systemically important banks - List of
banks deemed systemically important by at least one
major regulator
List of largest banks - List of largest banks as measured by market capitalization and total assets on
balance sheet
319

Chapter 62

Professional certication in nancial

services
A professional certication, trade certication, or professional designation is a designation a person earns to
demonstrate qualication for a job or task.

62.3 Chartered Alternative Investment Analyst

Main article: Chartered Alternative Investment Analyst
The Chartered Alternative Investment Analyst (CAIA)
designation is a nancial certication for investment professionals conferred by the Chartered Alternative Investment Analyst. Candidates must complete two examinations in succession and pay an ongoing certication fee to
retain rights to use the nancial designation.

62.1 Certied Financial Planner

Main article: Certied Financial Planner
The Certied Financial Planner (CFP) designation is a
certication mark for nancial planners conferred by the
CFP Board of Standards. To receive authorization to use
the designation, the candidate must meet education, examination, experience and ethics requirements, and pay
an ongoing certication fee.

62.4 Certied International Investment Analyst

Main article: Certied International Investment Analyst

62.2 Certied Treasury Professional

Certied International Investment Analyst CIIA is an

internationally recognised advanced professional qualication for individuals working in the nance and investment industry.

Main article: Certied Treasury Professional

The Certied Treasury Professional (CTP) designation
is a certication for treasurers, cash managers, treasury
managers, and other treasury-related professionals administered by the Bethesda, Maryland-based Association
for Financial Professionals (AFP). The CTP was formerly
known as the Certied Cash Manager or CCM designation but was renamed due to treasurys increasing role
in managing the entire balance sheet and implementing
the strategic direction prescribed by Chief Financial Ofcers. The CTP certication is held by over 20,000 nance professionals and is considered the certication in
the treasury management profession.

62.5 Chartered Financial Analyst

Main article: Chartered Financial Analyst
Chartered Financial Analyst (CFA) is a professional designation oered by the CFA Institute (formerly known
as AIMR) to nancial analysts who complete a series of
three examinations and work for at least four years in the
investment decision making process. CFA charterholders are also obliged to adhere to a strict Code of Ethics
and Standards governing their professional conduct.

320

62.10. REGISTERED FINANCIAL PLANNER

321

62.6 Corporate Finance Founda- 62.10 Registered Financial Plantions

ner
Corporate Finance Foundations (CFF) is a professional
designation for employees in corporate nance in various
divisions (Financial analysis, ECM, DCM, M&A, LBO,
Private Equity, Project nance, etc.), delivered by First
Finance Institute. Its programm covers the essentials of
Financial Analysis (cash ow and earnings analysis, investments, etc...).

62.7 Fellow Chartered Financial

Practitioner
The
Fellow
Chartered
Financial
Practitioner(FChFP)designation is a nancial planning
designation issued by the Asia Pacic Financial Services
Association (APFinSA). The designation was developed
by the National Association of Malaysian Life Insurance
and Financial Adviors (NAMLIFA) in 1996 and later
on adopted by APFinSA (of which NAMLIFA is a
member) in 2001 as the agship designation for its 11
member associations.

62.8 Master Financial Professional

Main article: American Academy of Financial Management
The Master Financial Planner (MFP) designation is a certication mark for college educated wealth planners conferred by the AAFM Board of Standards. To receive
authorization to use the designation, the candidate must
meet education, AACSB or ACBSP accredited college
examinations, experience and ethics requirements, and
pay an ongoing good standing fee.[1]

62.9 Master Financial Controller

The Master Financial Controller (MFC) designation is
a certication mark for nancial professionals engaged at
the senior level of corporate nance, such as in the role of
a CFO, Financial Controller or Financial Director for industry. The qualication is conferred by the AAFM Certication Board. Candidates must sit an executive conversion program, have at least 7 years working experience
and pass a rigorous exam to qualify.[1]

In Malaysia, the Registered Financial Planner(RFP)designation is conferred by the Malaysian

Financial Planning Council(MFPC). It is one of the
recognised qualication by the Securities Commission
and Bank Negara Malaysia for those wishing to apply
for a nancial planner or nancial adviser licence.
Another RFP designation is oered by the Registered
Financial Planners Institute formed in the United States.
Then you have the Society of Registered Financial
Planners oering the HKRFP in Hong Kong and China.
There is currently no connection between the three
designations.

62.11 See also

Professional certication (business)
Professional certication

62.12 References
[1] AAFM Board of Standards

Chapter 63

Accounting scandals
Accounting scandals are political or business scandals
which arise with the disclosure of nancial misdeeds by
trusted executives of corporations or governments. Such
misdeeds typically involve complex methods for misusing
or misdirecting funds, overstating revenues, understating
expenses, overstating the value of corporate assets or underreporting the existence of liabilities, sometimes with
the cooperation of ocials in other corporations or aliates.

one or two years of work. (This is nevertheless an excellent bargain for the takeover artist, who will tend to benet from developing a reputation of being very generous
to parting top executives.)

It is fairly easy for a top executive to reduce the price

of his/her companys stock due to information asymmetry. The executive can accelerate accounting of expected expenses, delay accounting of expected revenue,
engage in o balance sheet transactions to make the companys protability appear temporarily poorer, or simply promote and report severely conservative (e.g. pessimistic) estimates of future earnings. Such seemingly
adverse earnings news will be likely to (at least temporarily) reduce share price. (This is again due to information
asymmetries since it is more common for top executives
to do everything they can to window dress their companys earnings forecasts). There are typically very few
legal risks to being 'too conservative' in ones accounting
and earnings estimates.

Not all accounting scandals are caused by top executives.

Often managers and employees are pressured or willingly
alter nancial statements for the personal benet of the
individuals over the company. Managerial opportunism
plays a large role in these scandals. For example, managers who would be compensated more for short-term
results would report inaccurate information, since shortterm benets outweigh the long-term ones such as pension
obligations.[1]

A reduced share price makes a company an easier

takeover target. When the company gets bought out
(or taken private) at a dramatically lower price the
takeover artist gains a windfall from the former top executives actions to surreptitiously reduce share price. This
can represent tens of billions of dollars (questionably)
transferred from previous shareholders to the takeover
artist. The former top executive is then rewarded with a
golden handshake for presiding over the resale that can
sometimes be in the hundreds of millions of dollars for

63.3 Notable outcomes

Similar issues occur when a publicly held asset or nonprot organization undergoes privatization. Top executives often reap tremendous monetary benets when a
government-owned or non-prot entity is sold to private
hands. Just as in the example above, they can facilitate
In public companies, this type of "creative account- this process by making the entity appear to be in naning" can amount to fraud, and investigations are typi- cial crisis this reduces the sale price (to the prot of the
cally launched by government oversight agencies, such as purchaser), and makes non-prots and governments more
the Securities and Exchange Commission (SEC) in the likely to sell. It can also contribute to a public perception
that private entities are more eciently run, thereby reUnited States.
inforcing the political will to sell o public assets. Again,
due to asymmetric information, policy makers and the
general public see a government-owned rm that was a
63.1 Causes
nancial 'disaster' miraculously turned around by the
private sector (and typically resold) within a few years.

63.2 List of reported accounting

scandals

The Enron scandal turned in the indictment and criminal

conviction of one of the Big Five auditor Arthur Andersen on June 15, 2002. Although the conviction was overturned on May 31, 2005, by the Supreme Court of the
United States, the rm ceased performing audits and is
currently unwinding its business operations. The Enron
scandal was dened as being one of the biggest audit fail-

322

63.4. SEE ALSO

323

ures. The scandal included utilizing loopholes that were

found within the GAAP (General Accepted Accounting
Principles). For auditing a big sized company such as Enron, the auditors were criticized for having brief meetings
a few times a year that covered large amounts of material.
By January 17, 2002, Enron decided to discontinue its
business with Arthur Andersen claiming they had failed
in accounting advice and related documents. Arthur Andersen was judged guilty of obstruction of justice for getting rid of many emails and documents that were related
to auditing Enron. Since the SEC is not allowed to accept
audits from convicted felons, the rm was forced to give
up its CPA licenses later in 2002, costing over 113,000
employees their jobs. Although later the ruling was overturned by the U.S. Supreme Court, the once-proud rms
image was tarnished beyond repair, and it has not returned as a viable business even on a limited scale.

works executives say the men defrauded the shareholders of Nortel of more than $5 million. According to
the prosecutor this was accomplished by engineering a
nancial loss in 2002, and a prot in 2003 thereby triggering Return to Prot bonuses of $70 million for top
executives.[53][54][55][56][57]

On July 9, 2002 George W. Bush gave a speech about

recent accounting scandals that had been uncovered. In
spite of its stern tone, the speech did not focus on establishing new policy, but instead focused on actually enforcing current laws, which include holding CEOs and directors personally responsible for accountancy fraud.

Well before Bernard Mado's massive Ponzi scheme

came to light, observers doubted whether his listed accounting rman unknown two-person rm in a rural
area north of New York Citywas competent to service
a multi-million dollar operation, especially since it had
only one active accountant.[61] Ultimately, Mados accountant, David G. Friehling, admitted to simply rubberstamping 18 years worth of Mados lings with the
SEC. He also revealed that he continued to audit Mado even though he had invested a substantial amount of
money with him. Accountants aren't allowed to audit
broker-dealers with whom they're investing. He agreed to
forfeit $3.18 million in accounting fees and withdrawals
from his account with Mado. His involvement makes
the Mado scheme the largest accounting fraud in world
history.[62]

In July, 2002, WorldCom led for bankruptcy protection,

in what was considered the largest corporate insolvency
ever at the time.
These scandals reignited the debate over the relative merits of US GAAP, which takes a rules-based approach
to accounting, versus International Accounting Standards
and UK GAAP, which takes a principles-based approach. The Financial Accounting Standards Board announced that it intends to introduce more principlesbased standards. More radical means of accounting reform have been proposed, but so far have very little support. The debate itself, however, overlooks the diculties of classifying any system of knowledge, including accounting, as rules-based or principles-based.This also led
to the establishment of Sarbanes-Oxley.

In 2005, after a scandal on insurance and mutual funds

the year before, AIG was investigated for accounting
fraud. The company already lost over 45 billion US dollars worth of market capitalisation because of the scandal. Investigations also discovered over a billion US dollars worth of errors in accounting transactions. The New
York Attorney Generals investigation led to a $1.6 billion ne for AIG and criminal charges for some of its
executives.[58] CEO Maurice R. Hank Greenberg was
forced to step down and is still ghting civil charges being pursued by New York state.[59][60]

63.4 See also

Accounting ethics

On a lighter note, the 2002 Ig Nobel Prize in Economics

went to the CEOs of those companies involved in the corporate accounting scandals of that year for adapting the
mathematical concept of imaginary numbers for use in
the business world.

Corporate abuse

In 2003, Nortel made a big contribution to this list of

scandals by incorrectly reporting a one cent per share
earnings directly after their massive layo period. They
used this money to pay the top 43 managers of the company. The SEC and the Ontario securities commission
eventually settled civil action with Nortel. However, a
separate civil action will be taken up against top Nortel executives including former CEO Frank A. Dunn,
Douglas C. Beatty, Michael J. Gollogly and MaryAnne
E. Pahapill and Hamilton. These proceedings have
been postponed pending criminal proceedings in Canada,
which opened in Toronto on January 12, 2012.[52] Crown
lawyers at this fraud trial of three former Nortel Net-

Financial crisis of 2007-2010

Corporate scandal
Dotcom bubble

Philosophy of accounting
Forensic accounting
Penny stock scam
Sarbanes-Oxley Act
Savings and loan crisis
Securities fraud
Tobashi scheme

324
Vivien v. Worldcom
White-collar crime

CHAPTER 63. ACCOUNTING SCANDALS

[20] Ex-CA chief Kumar pleads guilty. CNN. April 24,

2006.
[21] Patsuris, Penelope (August 26, 2002). The Corporate
Scandal Sheet. Forbes.

63.5 References
[1] Cunningham, Lawrence (September 12, 2003). The Appeal and Limits of Internal Controls to Fight Fraud, Terrorism, Other Ills. p. 18.
[2] Owen, J. Sleight of Hand : The $25 million Nugan Hand
Bank Scandal; Balmain, Sydney, Australia: Colporteur
Press, 1983. ISBN 0-86399-023-1
[3] Minkow, Barry, Clean Sweep:The Inside Story of the Zzzz
Best Scam... One of Wall Streets Biggest Frauds, ISBN
0-7852-7916-4
[4] Frank, Partnoy, Infectous Greed, ISBN 9781846682933
[5] Reece, Damian (January 13, 2004). Deloittes John Connolly faces call to resign over Barlow Clowes link. The
Independent (London). Retrieved April 23, 2010.
[6] Fraud Is Cited at Miniscribe. New York Times. Associated Press. September 13, 1989. Retrieved October 12,
2007.
[7] Cases in Corporate Governance by Robert Wearing, Pages
41 to 53. Google Books. Retrieved November 1, 2011.
[8] Cellan-Jones, Rory (November 2, 2005). The end of an
epic. BBC News (BBC). Retrieved September 28, 2007.

[22] One.Tel auditor was linked to Packer.

Morning Herald. October 26, 2005.

The Sydney

[23] Amir Mansour (2010). The Big corruption in nancial

system. IGAO News (Iranian General Inspectors Oce
(IGAO)).
[24] Salami (2011). The Big corruption in nancial system.
IGAO News (Iranian General Inspectors Oce (IGAO)).
[25] Robert Bryce, Pipe Dreams: Greed, Ego, and the Death of
Enron (Public Aairs, 2002) ISBN 1-58648-138-X
[26] Adelphia founder John Rigas found guilty Business
Corporate scandals. MSNBC. Retrieved November 1,
2011.
[27] http://www.sec.gov/news/digest/dig080904.txt
[28] Today In Business: Utility Settles Lawsuit. The New
York Times. January 6, 2007. Retrieved April 23, 2010.
[29] Weinberg, Ari (December 11, 2003). Shaking Steady
Freddie. Forbes.
[30] Palmeri, Chris (July 6, 2006). How Stuart Wol Got
Himself Caught In A Trap. BusinessWeek. Retrieved
November 1, 2011.

[9] FRONTLINE: how to Steal $500 Million. Pbs.org.

June 23, 1994. Retrieved November 1, 2011.

[31] Ex-ImClone boss admits fraud. BBC News. October

15, 2002. Retrieved November 1, 2011.

[10] A nancial history of modern U.S. corporate scandals, p.

228

[32] SEC Charges KMarts Former CEO and CFO With Financial Fraud. Sec.gov. Retrieved November 1, 2011.

[11] Inside Informixs Demise. Revrec.

[33] Khan, Kim (May 21, 2002). Merrill settles charges.

CNN.

[12] Masters, Steve (January 28, 1998). Accounting scandal

rocks Sybase Japan. Computing News. Retrieved February 3, 2011.
[13] Kawamoto, Dawn (January 22, 1998). Sybase reeling
from snafu. CNET. Retrieved February 3, 2011.
[14] Jon Swartz (January 23, 1998). SYBASE TURNS SPIN
DOCTOR / CEO and executive team show how they managed Japan crisis. San Francisco Chronicle. Retrieved
February 3, 2011.
[15] Fischer, Lawrence (January 22, 1998). Sybase Loss to
Grow as Sales Are Disputed. New York Times. Retrieved
February 3, 2011.
[16] Cendant closes fraud case. CNN. August 27, 1998.
[17] Waste Management settles. CNN. November 7, 2001.

[34] SEC Settles With Ex-Andersen Partner In Sunbeam

Probe. Securities.stanford.edu. February 18, 2003. Retrieved November 1, 2011.
[35] Lohr, Steve (2013-06-21). Technology, Day 2: I Learn
the Books Are Cooked. New York Times.
[36] Lohr, Steve (2004-06-04). Ex-Executives at Symbol Are
Indicted. New York Times.
[37] Starkman, Dean (November 29, 2005). Ahold Settles
Lawsuit for $1.1 Billion. The Washington Post. Retrieved
April 23, 2010.
[38] Italian dairy boss gets 10 years. BBC News. December
18, 2008. Retrieved April 23, 2010.

[18] The BI Verdict: Analyses. Olapreport.com. Retrieved

November 1, 2011.

[39] Inside the Parmalat Scandal: What You Need to Know?

Our Paesani. Italiansrus.com. December 28, 2003.
Retrieved November 1, 2011.

[19] SEC Brings Financial Fraud Charges Against Executives at Three Northern California Software Companies.
Sec.gov. May 20, 2002. Retrieved November 1, 2011.

[40] HealthSouth Corporation and Richard M. Scrushy: Lit.

Rel. No. 18044 / March 20, 2003. Sec.gov. Retrieved
November 1, 2011.

63.6. FURTHER READING

325

[41] Bagnall, James (November 2, 2009). The beginning of

the end. Ottawa Citizen. Retrieved November 1, 2011.

[60] Zuill, Lilla (March 3, 2009). Reuters. Reuters. Retrieved November 1, 2011.

[42]

[61] Fitzgerald, Jim. Mados nancial empire audited by tiny

rm: one guy. Associated Press via Seattle Times, December 18, 2008.

[43] AIG Forks Up $126 Million to SEC on PNC Deals.

Insurancejournal.com. November 24, 2004. Retrieved
November 1, 2011.
[44] Hurst, Greg (December 12, 2008). Wall Street legend
Bernard Mado arrested over '$50 billion Ponzi scheme'".
The Times (London: Times Newspapers Ltd). Retrieved
December 13, 2008.
[45] Efrati, Amir (March 19, 2009). Accountant Arrested for
Sham Audits. The Wall Street Journal.
[46] Sharrock, David (December 20, 2008). Anglo Irish
Bank bosses quit after hiding loans of 87m. The Times
(London). Retrieved April 23, 2010.
[47] Satyam scandal rattles condence in accounting Big
Four. Reuters. January 8, 2009.
[48] Examiners Report Lehman Brothers Holdings Inc.
Chapter 11 Proceedings. Lehmanreport.jenner.com.
Retrieved November 1, 2011.

[62] Hamblett, Mark. Mados Accountant Acknowledges

Guilt, Casts Himself as Victim. New York Law Journal,
November 4, 2009.

63.6 Further reading

John R. Emshwiller and Rebecca Smith, 24 Days:
How Two Wall Street Journal Reporters Uncovered
the Lies that Destroyed Faith in Corporate America
or Infectious Greed, HarperInformation, 2003, ISBN
0-06-052073-6
Lawrence A. Cunningham, The Sarbanes-Oxley
Yawn: Heavy Rhetoric, Light Reform (And It Might
Just Work)
Zabihollah Rezaee, Financial Statement Fraud: Prevention and Detection, Wiley 2002.

[49] Homan, Andy (Jul. 15, 2011) ". The Globe And Mail
(Canada)
[50] Soble, Jonathan (Nov. 8, 2011). Olympus used takeover
fees to hide losses. Financial Times (London). Archived
from the original on Nov 11, 2011. Retrieved Nov 11,
2011.
[51] Fisher, Daniel (November 20, 2012). With Autonomy, H-P Bought An Old-Fashioned Accounting Scandal.
Heres How It Worked.. Forbes. Retrieved 20 November
2012.
[52] http://www.canada.com/business/Nortel+trial+execs+
raided+cookie+trigger+profit+driven+bonuses+court+
told/6005109/story.html#ixzz1jx1lhaFw
[53] Nortel trial hears fraud allegations. CBC News. January
17, 2012.

63.7 External links

U.S. Securities and Exchange Commission website
U.S. President Bushs speech, 2002-07-09 NPR report (audio recording)
Why didn't our auditors nd the fraud?", Wisconsin
Law Journal, January 25, 2006
GMI Warns of Accounting Risks at 40 Companies, Accounting Today, November 27, 2012
The Impact of Fraud on Shareholder Value,
Business Insider, June 18, 2013

[54] http://news.businessweek.com/
article.asp?documentKey=
1376-LXR6J607SXKX01-6EE8N6QJ3AUEFIHKAV9DABRAOV
[55] Lewis, Michael (January 17, 2012). Nortel auditors
pushed back against executives scheme, prosecutor says.
The Star (Toronto).
[56] Lewis, Michael (January 20, 2012). Nortel trial: Former
nancial director saw disconnect between stated earnings
and his understanding of Nortels circumstances. The
Star (Toronto).
[57] No business reason to release Nortel reserves, court told.
Globe and Mail (Canada). September 6, 2012.
[58] Yahoo
[59] MSNBC. MSNBC. Retrieved November 1, 2011.

Chapter 64

International Financial Reporting

Standards
International Financial Reporting Standards (IFRS)
are designed as a common global language for business
aairs so that company accounts are understandable and
comparable across international boundaries. They are a
consequence of growing international shareholding and
trade and are particularly important for companies that
have dealings in several countries. They are progressively
replacing the many dierent national accounting standards. The rules to be followed by accountants to maintain books of accounts which is comparable, understandable, reliable and relevant as per the users internal or external.

recognition criteria, and measurement concepts

for assets, liabilities, income, and expenses in
the Framework.

IFRS began as an attempt to harmonize accounting across

the European Union but the value of harmonization
quickly made the concept attractive around the world.
However, it has been debated whether or not the harmonization has been successful.[1] IFRS are sometimes still
called by the original name of International Accounting Standards (IAS). IAS were issued between 1973
and 2001 by the Board of the International Accounting
Standards Committee (IASC). On 1 April 2001, the new
International Accounting Standards Board (IASB) took
over from the IASC the responsibility for setting International Accounting Standards. During its rst meeting
the new Board adopted existing IAS and Standing Interpretations Committee standards (SICs). The IASB has
continued to develop standards calling the new standards
International Financial Reporting Standards.

Financial statements are a structured representation of

the nancial positions and nancial performance of an
entity. The objective of nancial statements is to provide
information about the nancial position, nancial performance and cash ows of an entity that is useful to a wide
range of users in making economic decisions. Financial statements also show the results of the managements
stewardship of the resources entrusted to it.[2]

Criticisms of IFRS are (1) that they are not being adopted
in the US (see GAAP), (2) a number of criticisms from
France and (3) that IAS 29 Financial Reporting in Hyperinationary Economies had no positive eect at all during
6 years in Zimbabwes hyperinationary economy. The
IASB oered responses to the rst two criticisms, but has
oered no response to the last criticism while IAS 29 is
currently (March 2014) being implemented in its original
IFRS, with the exception of IAS 29 Financial Report- ineective form in Venezuela and Belarus.
ing in Hyperinationary Economies and IFRIC 7 Applying the Restatement Approach under IAS 29, are authorized in terms of the historical cost paradigm. IAS 29 64.1 Objective of nancial stateand IFRIC 7 are authorized in terms of the constant purments
chasing power paradigm.

In the absence of a Standard or an Interpretation that specically applies to a transaction, management must use its judgement in developing and applying an accounting policy that
results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the denitions,

To meet this objective, nancial statements provide information about an entitys: (a) assets; (b) liabilities; (c) equity; (d) income and expenses, including gains and losses;
(e) contributions by and distributions to owners in their
capacity as owners; and (f) cash ows. This information,
along with other information in the notes, assists users of
nancial statements in predicting the entitys future cash
ows and, in particular, their timing and certainty.[2]
The following are the general features in IFRS:
Fair presentation and compliance with IFRS:
Fair presentation requires the faithful representation of
the eects of the transactions, other events and conditions
in accordance with the denitions and recognition criteria

326

64.2. QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS

327

for assets, liabilities, income and expenses set out in the occurred with the adoption of the revised standard IAS
Framework of IFRS.[3]
19 (as of 1 January 2013) or when the new consolidation
standards IFRS 10-11-12 were adopted (as of 1 January
2013 or 2014 for companies in the European Union).[12]
Going concern:
Consistency of presentation:
Financial statements are present on a going concern basis
unless management either intends to liquidate the entity
or to cease trading, or has no realistic alternative but to IFRS requires that the presentation and classication of
do so.[4]
items in the nancial statements is retained from one period to the next unless: (a) it is apparent, following a signicant change in the nature of the entitys operations or
Accrual basis of accounting:
a review of its nancial statements, that another presenAn entity shall recognise items as assets, liabilities, eq- tation or classication would be more appropriate having
uity, income and expenses when they satisfy the de- regard to the criteria for the selection and application of
(b) an IFRS standard renition and recognition criteria for those elements in the accounting policies in IAS 8; or[13]
quires
a
change
in
presentation.
[5]
Framework of IFRS.
Materiality and aggregation:

64.2 Qualitative characteristics of

nancial statements

Every material class of similar items has to be presented separately. Items that are of a dissimilar nature
or function shall be presented separately unless they are Qualitative characteristics of nancial statements include:
immaterial.[6]
Relevance (Materiality)

Osetting

Faithful representation
[7]

Osetting is generally forbidden in IFRS. However certain standards require osetting when specic conditions Enhancing qualitative characteristics include:
are satised (such as in case of the accounting for dened
benet liabilities in IAS 19 [8] and the net presentation of
Comparability
deferred tax liabilities and deferred tax assets in IAS 12[9]
Veriability
).
Frequency of reporting:
IFRS requires that at least annually a complete set of nancial statements is presented.[10] However listed companies generally also publish interim nancial statements
(for which the accounting is fully IFRS compliant)for
which the presentation is in accordance with IAS 34 Interim Financing Reporting.
Comparative information:
IFRS requires entities to present comparative information in respect of the preceding period for all amounts
reported in the current periods nancial statements.
In addition comparative information shall also be provided for narrative and descriptive information if it is
relevant to understanding the current periods nancial
statements.[11] The standard IAS 1 also requires an additional statement of nancial position (also called a third
balance sheet) when an entity applies an accounting policy retrospectively or makes a retrospective restatement
of items in its nancial statements, or when it reclassies items in its nancial statements. This for example

Timeliness
Understandability

64.3 Elements of nancial statements

The elements directly related to the measurement of the
statement of nancial position include:
Asset: An asset is a resource controlled by the entity as a result of past events and from which future
economic benets are expected to ow to the entity.
Liability: A liability is a present obligation of the
entity arising from the past events, the settlement of
which is expected to result in an outow from the entity of resources embodying economic benets, i.e.
assets.
Equity: Nominal equity is the nominal residual interest in the nominal assets of the entity after deducting all its liabilities in nominal value.[14]

328

CHAPTER 64. INTERNATIONAL FINANCIAL REPORTING STANDARDS

The nancial performance of an entity is presented in the

statement of comprehensive income, which consists of
the income statement and the statement of other comprehensive income [15] (usually presented in two separate
statements). Financial performance includes the following elements (which are recognised in the income statement or other comprehensive income as required by the
applicable IFRS standard):

for each component of equity, a reconciliation between the carrying amount at the beginning and the
end of the period, separately disclosing changes resulting from:
prot or loss;
other comprehensive income; and
transactions with owners in their capacity as
owners, showing separately contributions by
and distributions to owners and changes in
ownership interests in subsidiaries that do not
result in a loss of control.[25]

Revenues: increases in economic benet during an

accounting period in the form of inows or enhancements of assets, or decrease of liabilities that result
in increases in equity. However, it does not include
the contributions made by the equity participants
Statement of Cash Flows
(for example owners, partners or shareholders).
Expenses: decreases in economic benets during an
accounting period in the form of outows, or depletions of assets or incurrences of liabilities that result
in decreases in equity. However, these don't include
the distributions made to the equity participants.[16]
Results recognised in other comprehensive income are
limited to the following specic circumstances:
Remeasurements of dened benet assets or liabilities (as dened in the standard IAS 19) [17]
Increases or decreases in the fair value of nancial
assets classied as available for sale (with the exception of impairment losses)(as dened in the standard
IAS 39) [18]
Increases or decreases resulting from the application
of a revaluation of property, plant and equipment [19]
or intangible assets [20]

Operating cash ows: the principal revenueproducing activities of the entity and are generally
calculated by applying the indirect method, whereby
prot or loss is adjusted for the eects of transaction
of a non-cash nature, any deferrals or accruals of
past or future cash receipts or payments, and items
of income or expense associated with investing or
nancing cash ows.[26]
Investing cash ows: the acquisition and disposal
of long-term assets and other investments not included in cash equivalents. These represent the extent to which expenditures have been made for resources intended to generate future income and cash
ows. Only expenditures that result in a recognised
asset in the statement of nancial position are eligible for classication as investing activities.[26]
Financing cash ows: activities that result in
changes in the size and composition of the contributed equity and borrowings of the entity. These
are important because they are useful in predicting
claims on future cash ows by providers of capital
to the entity.[26]

Exchange dierences resulting from the translation

of foreign operations (subsidiary, associate, joint arrangement or branch of a reporting entity, the activities of which are conducted in a country or currency
other than those of the reporting entity[21] ) accordNotes to the Financial Statements: These shall (a)
ing to the standard IAS 21 [22]
present information about the basis of preparation of the
the portion of the gain or loss on the hedging instru- nancial statements and the specic accounting policies
ment in a cash ow hedge (or a hedge of a net in- used;(b) disclose the information required by IFRSs that
vestment in a foreign operation, as this is accounted is not presented elsewhere in the nancial statements; and
similarly [23] ) that is determined to be an eective (c) provide information that is not presented elsewhere in
hedge [24]
the nancial statements, but is relevant to an understanding of any of them.[27]
The statement of changes in equity consists of a reconciliation of the changes in equity in which the following
information is provided:

64.4 Recognition of elements of nancial statements

total comprehensive income for the period, showing

separately the total amounts attributable to owners
of the parent and to non-controlling interests;
An item is recognized in the nancial statements when:[28]
for each component of equity, the eects of ret it is probable future economic benet will ow to or
rospective application or retrospective restatement
from an entity.
recognised in accordance with IAS 8; and

64.6. CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE

the resource can be reliably measured
In some cases specic standards add additional conditions
before recognition is possible or prohibit recognition altogether.
An example is the recognition of internally generated
brands, mastheads, publishing titles, customer lists and
items similar in substance, for which recognition is prohibited by IAS 38.[29] In addition research and development expenses can only be recognised as an intangible
asset if they cross the threshold of being classied as 'development cost'.[30]

329

Par. 101. The measurement basis most commonly

adopted by entities in preparing their nancial statements
is historical cost. This is usually combined with other
measurement bases. For example, inventories are usually carried at the lower of cost and net realisable value,
marketable securities may be carried at market value and
pension liabilities are carried at their present value. Furthermore, some entities use the current cost basis as a
response to the inability of the historical cost accounting
model to deal with the eects of changing prices of nonmonetary assets.

Whilst the standard on provisions, IAS 37, prohibits the 64.6 Concepts of capital and capirecognition of a provision for contingent liabilities,[31]
tal maintenance
this prohibition is not applicable to the accounting for
contingent liabilities in a business combination. In that
case the acquirer shall recognise a contingent liability 64.6.1 Concepts of capital
even if it is not probable that an outow of resources embodying economic benets will be required.[32]
Par. 102. A nancial concept of capital is adopted by
most entities in preparing their nancial statements. Under a nancial concept of capital, such as invested money
64.5 Measurement of the elements or invested purchasing power, capital is synonymous with
the net assets or equity of the entity. Under a physical
of nancial statements
concept of capital, such as operating capability, capital
is regarded as the productive capacity of the entity based
Par. 99. Measurement is the process of determining the on, for example, units of output per day.
monetary amounts at which the elements of the nancial
statements are to be recognized and carried in the balance Par. 103. The selection of the appropriate concept of
sheet and income statement. This involves the selection capital by an entity should be based on the needs of the
users of its nancial statements. Thus, a nancial concept
of the particular basis of measurement.
of capital should be adopted if the users of nancial statePar. 100. A number of dierent measurement bases are ments are primarily concerned with the maintenance of
employed to dierent degrees and in varying combina- nominal invested capital or the purchasing power of intions in nancial statements. They include the following: vested capital. If, however, the main concern of users
(a) Historical cost. Assets are recorded at the amount of is with the operating capability of the entity, a physical
cash or cash equivalents paid or the fair value of the con- concept of capital should be used. The concept chosen
sideration given to acquire them at the time of their acqui- indicates the goal to be attained in determining prot,
sition. Liabilities are recorded at the amount of proceeds even though there may be some measurement diculties
received in exchange for the obligation, or in some cir- in making the concept operational.
cumstances (for example, income taxes), at the amounts
of cash or cash equivalents expected to be paid to satisfy
64.6.2 Concepts of capital maintenance
the liability in the normal course of business.
(b) Current cost. Assets are carried at the amount of cash
or cash equivalents that would have to be paid if the same
or an equivalent asset was acquired currently. Liabilities
are carried at the undiscounted amount of cash or cash
equivalents that would be required to settle the obligation
currently.

and the determination of prot

Par. 104. The concepts of capital in paragraph 102 give
rise to the following two concepts of capital maintenance:
(a) Financial capital maintenance. Under this concept a
prot is earned only if the nancial (or money) amount
of the net assets at the end of the period exceeds the nancial (or money) amount of net assets at the beginning
of the period, after excluding any distributions to, and
contributions from, owners during the period. Financial
capital maintenance can be measured in either nominal
monetary units or units of constant purchasing power.

(c) Realisable (settlement) value. Assets are carried at the

amount of cash or cash equivalents that could currently be
obtained by selling the asset in an orderly disposal. Assets
are carried at the present discounted value of the future
net cash inows that the item is expected to generate in the
normal course of business. Liabilities are carried at the
present discounted value of the future net cash outows (b) Physical capital maintenance. Under this concept a
that are expected to be required to settle the liabilities in prot is earned only if the physical productive capacity
(or operating capability) of the entity (or the resources
the normal course of business.

330

CHAPTER 64. INTERNATIONAL FINANCIAL REPORTING STANDARDS

or funds needed to achieve that capacity) at the end of

the period exceeds the physical productive capacity at the
beginning of the period, after excluding any distributions
to, and contributions from, owners during the period.
The concepts of capital in paragraph 102 give rise to the
following three concepts of capital during low ination
and deation:
(A) Physical capital.[33] See paragraph 102&103
(B) Nominal nancial capital.[33] See paragraph
104.[34]
(C) Constant item purchasing power nancial
capital.[33] See paragraph 104.[35]
The concepts of capital in paragraph 102 give rise to the
following three concepts of capital maintenance during
low ination and deation:

of constant purchasing power requires the calculation and accounting of net monetary losses and gains
from holding monetary items during low ination
and deation. The calculation and accounting of net
monetary losses and gains during low ination and
deation have thus been authorized in IFRS since
1989.
Par. 105. The concept of capital maintenance is concerned with how an entity denes the capital that it seeks
to maintain. It provides the linkage between the concepts
of capital and the concepts of prot because it provides
the point of reference by which prot is measured; it is a
prerequisite for distinguishing between an entitys return
on capital and its return of capital; only inows of assets in excess of amounts needed to maintain capital may
be regarded as prot and therefore as a return on capital. Hence, prot is the residual amount that remains after expenses (including capital maintenance adjustments,
where appropriate) have been deducted from income. If
expenses exceed income the residual amount is a loss.

(1) Physical capital maintenance:[33] optional dur- Par. 106. The physical capital maintenance concept reing low ination and deation. Current Cost Ac- quires the adoption of the current cost basis of measurecounting model prescribed by IFRS. See Par 106.
ment. The nancial capital maintenance concept, however, does not require the use of a particular basis of mea (2) Financial capital maintenance in nominal
surement. Selection of the basis under this concept is de[33]
monetary units (Historical cost accounting): aupendent on the type of nancial capital that the entity is
thorized by IFRS but not prescribedoptional durseeking to maintain.
ing low ination and deation. See Par 104 (a)
Historical cost accounting. Financial capital main- Par. 107. The principal dierence between the two contenance in nominal monetary units per se during in- cepts of capital maintenance is the treatment of the efation and deation is a fallacy: it is impossible to fects of changes in the prices of assets and liabilities of
maintain the real value of nancial capital constant the entity. In general terms, an entity has maintained its
with measurement in nominal monetary units per se capital if it has as much capital at the end of the period
as it had at the beginning of the period. Any amount over
during ination and deation.
and above that required to maintain the capital at the be (3) Financial capital maintenance in units of ginning of the period is prot.
constant purchasing power[33] (Capital Maintenance in Units of Constant Purchasing Power):[36] Par. 108. Under the concept of nancial capital mainteauthorized by IFRS but not prescribedoptional nance where capital is dened in terms of nominal moneduring low ination and deation. See Par 104(a). tary units, prot represents the increase in nominal money
Capital Maintenance in Units of Constant Purchas- capital over the period. Thus, increases in the prices of
ing Power is prescribed during hyperination in IAS assets held over the period, conventionally referred to as
29:[37] i.e. the restatement of Historical Cost or Cur- holding gains, are, conceptually, prots. They may not be
rent Cost period-end nancial statements in terms of recognised as such, however, until the assets are disposed
the period-end monthly published Consumer Price of in an exchange transaction. When the concept of nanIndex.[38] Only nancial capital maintenance in units cial capital maintenance is dened in terms of constant
of constant purchasing power (Capital Maintenance purchasing power units, prot represents the increase in
in Units of Constant Purchasing Power) in terms of invested purchasing power over the period. Thus, only
a daily index per se can automatically maintain the that part of the increase in the prices of assets that exreal value of nancial capital constant at all levels ceeds the increase in the general level of prices is regarded
of ination and deation in all entities that at least as prot. The rest of the increase is treated as a capital
break even in real valueceteris paribusfor an in- maintenance adjustment and, hence, as part of equity.
denite period of time. This would happen whether Par. 109. Under the concept of physical capital mainthese entities own revaluable xed assets or not and tenance when capital is dened in terms of the physical
without the requirement of more capital or addi- productive capacity, prot represents the increase in that
tional retained prots to simply maintain the exist- capital over the period. All price changes aecting the
ing constant real value of existing shareholders eq- assets and liabilities of the entity are viewed as changes
uity constant. Financial capital maintenance in units in the measurement of the physical productive capacity of

64.8. CRITICISMS OF IFRS

the entity; hence, they are treated as capital maintenance
adjustments that are part of equity and not as prot.

331
present a statement of nancial position (balance
sheet) as at the beginning of the earliest comparative period in a complete set of nancial statements
when the entity applies the new standard.

Par. 110. The selection of the measurement bases and

concept of capital maintenance will determine the accounting model used in the preparation of the nancial
present a statement of cash ow.
statements. Dierent accounting models exhibit dierent degrees of relevance and reliability and, as in other ar make necessary disclosure by the way of a note.
eas, management must seek a balance between relevance
and reliability. This Framework is applicable to a range
The revised IAS 1 is eective for annual periods beginof accounting models and provides guidance on preparing
ning on or after 1 January 2009. Early adoption is perand presenting the nancial statements constructed under
mitted.
the chosen model. At the present time, it is not the intention of the Board of IASC to prescribe a particular model
other than in exceptional circumstances, such as for those
entities reporting in the currency of a hyperinationary 64.8 Criticisms of IFRS
economy. This intention will, however, be reviewed in
the light of world developments.[39]
1. The US Securities and Exchange Commission Sta
issued a 127-page report stating reasons why not to
adopt IFRS in the United States.[40]

64.7 Requirements
Main article: Requirements of IFRS
IFRS nancial statements consist of (IAS1.8)
a Statement of Financial Position
a Statement of Comprehensive Income separate
statements comprising an Income Statement and
separately a Statement of Comprehensive Income,
which reconciles Prot or Loss on the Income statement to total comprehensive income
a Statement of Changes in Equity (SOCE)
a Cash Flow Statement or Statement of Cash Flows
notes, including a summary of the signicant accounting policies
Comparative information is required for the prior reporting period (IAS 1.36). An entity preparing IFRS accounts
for the rst time must apply IFRS in full for the current
and comparative period although there are transitional exemptions (IFRS1.7).
On 6 September 2007, the IASB issued a revised IAS 1
Presentation of Financial Statements. The main changes
from the previous version are to require that an entity
must:
present all non-owner changes in equity (that is,
'comprehensive income' ) either in one Statement
of comprehensive income or in two statements (a
separate income statement and a statement of comprehensive income). Components of comprehensive
income may not be presented in the Statement of
changes in equity.

The sta of the IFRS Foundation provided a detailed answer on the main criticisms in the SEC report.[41]
1. A number of criticisms were voiced in the beginning of 2013 in the French media to which the
IASB Board member Philippe DANJOU responded
in his document 'AN UPDATE ON INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRSs).[42]
2. It is widely acknowledged that IAS 29 Financial Reporting in Hyperinationary Economies had no positive eect during the six years it was implemented
during hyperination in Zimbabwe.
This leads
people to ask what the purpose of IAS 29 is when
it had no positive eect during hyperination in
Zimbabwe. IAS 29 is currently (March 2014) being implemented in its original ineective form in
Venezuela and Belarus. It was suggested to the IASB
in 2012 that IAS 29 should be corrected to require
daily indexation which would result in eective
Capital Maintenance in Units of Constant Purchasing Power (CMUCPP) and would stabilize the nonmonetary economy during hyperination.[43] The
IASB has oered no response to date (March 2014)
to this criticism and has not yet corrected IAS 29 to
require daily indexation.

64.9 Adoption
IFRS are used in many parts of the world, including the
European Union, India, Hong Kong, Australia, Malaysia,
Pakistan, GCC countries, Russia, Chile, South Africa,
Singapore and Turkey, but not in the United States. As of
August 2008, more than 113 countries around the world,
including all of Europe, currently require or permit IFRS

332

CHAPTER 64. INTERNATIONAL FINANCIAL REPORTING STANDARDS

reporting and 85 require IFRS reporting for all domes- The AASB has made certain amendments to the IASB
tic, listed companies, according to the U.S. Securities and pronouncements in making A-IFRS, however these genExchange Commission.[44]
erally have the eect of eliminating an option under
It is generally expected that IFRS adoption worldwide IFRS, introducing additional disclosures or implementing
will be benecial to investors and other users of - requirements for not-for-prot entities, rather than denancial statements, by reducing the costs of compar- parting from IFRS for Australian entities. Accordingly,
ing alternative investments and increasing the quality of for-prot entities that prepare nancial statements in acinformation.[45] Companies are also expected to benet, cordance with A-IFRS are able to make an unreserved
statement of compliance with IFRS.
as investors will be more willing to provide nancing.[45]
Companies that have high levels of international activi- The AASB continues to mirror changes made by the
ties are among the group that would benet from a switch IASB as local pronouncements. In addition, over recent
to IFRS. Companies that are involved in foreign activities years, the AASB has issued so-called 'Amending Stanand investing benet from the switch due to the increased dards to reverse some of the initial changes made to
comparability of a set accounting standard.[46] However, the IFRS text for local terminology dierences, to reinRay J. Ball has expressed some skepticism of the overall state options and eliminate some Australian-specic discost of the international standard; he argues that the en- closure. There are some calls for Australia to simply
forcement of the standards could be lax, and the regional adopt IFRS without 'Australianising' them and this has
dierences in accounting could become obscured behind resulted in the AASB itself looking at alternative ways of
a label. He also expressed concerns about the fair value adopting IFRS in Australia.
emphasis of IFRS and the inuence of accountants from
non-common-law regions, where losses have been recog64.9.2 Canada
nized in a less timely manner.[45]
To assess progress towards the goal of a single set global
accounting standards, the IFRS Foundation has developed and posted proles about the use of IFRSs in individual jurisdictions. These were based on information from various sources. The starting point was the responses provided by standard-setting and other relevant
bodies to a survey that the IFRS Foundation conducted.
Currently, proles are completed for 124 jurisdictions,
including all of the G20 jurisdictions plus 104 others.
Eventually, the plan is to have a prole for every jurisdiction that has adopted IFRSs, or is on a programme toward
adoption of IFRSs.[47]

64.9.1

Australia

The Australian Accounting Standards Board (AASB) has

issued 'Australian equivalents to IFRS' (A-IFRS), numbering IFRS standards as AASB 18 and IAS standards
as AASB 101141. Australian equivalents to SIC and
IFRIC Interpretations have also been issued, along with
a number of 'domestic' standards and interpretations.
These pronouncements replaced previous Australian generally accepted accounting principles with eect from annual reporting periods beginning on or after 1 January
2005 (i.e. 30 June 2006 was the rst report prepared under IFRS-equivalent standards for June year ends). To
this end, Australia, along with Europe and a few other
countries, was one of the initial adopters of IFRS for domestic purposes (in the developed world). It must be acknowledged, however, that IFRS and primarily IAS have
been part and parcel of accounting standard package in
the developing world for many years since the relevant
accounting bodies were more open to adoption of international standards for many reasons including that of capability.

The use of IFRS became a requirement for Canadian publicly accountable prot-oriented enterprises for nancial
periods beginning on or after 1 January 2011. This includes public companies and other prot-oriented enterprises that are responsible to large or diverse groups of
shareholders.[48]

64.9.3 European Union

In 2002 the European Union agreed that from 1 January
2005 International Accounting Standards / International
Financial Reporting Standards would apply for the consolidated accounts of the EU listed companies.[49]
In order to be approved for use in the EU, standards must
be endorsed by the Accounting Regulatory Committee
(ARC), which includes representatives of member state
governments and is advised by a group of accounting experts known as the European Financial Reporting Advisory Group. As a result IFRS as applied in the EU may
dier from that used elsewhere.
Parts of the standard IAS 39: Financial Instruments:
Recognition and Measurement were not originally approved by the ARC. IAS 39 was subsequently amended,
removing the option to record nancial liabilities at fair
value, and the ARC approved the amended version. The
IASB is working with the EU to nd an acceptable way
to remove a remaining anomaly in respect of hedge accounting. The World Bank Centre for Financial Reporting Reform is working with countries in the ECA region
to facilitate the adoption of IFRS and IFRS for SMEs.
Whilst the IASB set the eective dates for the new
consolidation standards IFRS 10 Consolidated Financial
Statements, IFRS 11 Joint Arrangements and IFRS 12 Dis-

64.9. ADOPTION
closure of Interests in Other Entities at 1 January 2013,
the ARC decided to delay the mandatory eective date
for the companies listed in the European Union by one
year. The standards therefore only became eective on 1
January 2014.[50]
The European Commission has launched a general analysis of the impacts of 8 years of use of international nancial reporting standards (IFRSs) in the EU for preparers and users of nancial statements from the private sector. The study will include an overall assessment
of whether the Regulation 1606/2002 of the European
Parliament and the Council ('IAS Regulation') has met
the two-fold initial objectives of ensuring a high degree
of transparency and comparability of the nancial statements of European companies and an ecient functioning of the market, in comparison with the situation before IFRS implementation in 2005. It will also include
a cost-benet analysis and an assessment and analysis of
the benets and drawbacks brought by the IAS Regulation for dierent stakeholder groups.[51]

64.9.4

India

The Institute of Chartered Accountants of India (ICAI)

has announced that IFRS will be mandatory in India for
nancial statements for the periods beginning on or after
1 April 2012, but this plan has been failed and IFRS/INDAS (Converged IFRS) are still not applicable. There was
a roadmap as given below but still Indian companies are
following old Indian GAAP. There is no clear new date
of adoption of IFRS.
Reserve Bank of India has stated that nancial statements
of banks need to be IFRS-compliant for periods beginning on or after 1 April 2011.
The ICAI has also stated that IFRS will be applied to
companies above INR 1000 crore (INR 10 billion) from
April 2011. Phase wise applicability details for dierent
companies in India:
Phase 1: Opening balance sheet as at 1 April 2011*
i. Companies which are part of NSE Index Nifty 50
ii. Companies which are part of BSE Index Sensex 30
a. Companies whose shares or other securities are listed
on a stock exchange outside India
b. Companies, whether listed or not, having net worth of
more than INR 1000 crore (INR 10 billion)
Phase 2: Opening balance sheet as at 1 April 2012*
Companies not covered in phase 1 and having net worth
exceeding INR 500 crore (INR 5 billion)
Phase 3: Opening balance sheet as at 1 April 2014*
Listed companies not covered in the earlier phases * If the
nancial year of a company commences at a date other
than 1 April, then it shall prepare its opening balance
sheet at the commencement of immediately following -

333
nancial year.
On 22 January 2010, the Ministry of Corporate Aairs
issued the road map for transition to IFRS. It is clear that
India has deferred transition to IFRS by a year. In the rst
phase, companies included in Nifty 50 or BSE Sensex,
and companies whose securities are listed on stock exchanges outside India and all other companies having net
worth of INR 10 billion will prepare and present nancial
statements using Indian Accounting Standards converged
with IFRS. According to the press note issued by the government, those companies will convert their rst balance
sheet as at 1 April 2011, applying accounting standards
convergent with IFRS if the accounting year ends on 31
March. This implies that the transition date will be 1
April 2011. According to the earlier plan, the transition
date was xed at 1 April 2010.
The press note does not clarify whether the full set of
nancial statements for the year 201112 will be prepared by applying accounting standards convergent with
IFRS. The deferment of the transition may make companies happy, but it will undermine Indias position. Presumably, lack of preparedness of Indian companies has
led to the decision to defer the adoption of IFRS for a
year. This is unfortunate that India, which boasts for its
IT and accounting skills, could not prepare itself for the
transition to IFRS over last four years. But that might be
the ground reality.
Transition in phases
Companies, whether listed or not, having net worth of
more than INR 5 billion will convert their opening balance sheet as at 1 April 2013. Listed companies having
net worth of INR 5 billion or less will convert their opening balance sheet as at 1 April 2014. Un-listed companies having net worth of Rs5 billion or less will continue
to apply existing accounting standards, which might be
modied from time to time. Transition to IFRS in phases
is a smart move.
The transition cost for smaller companies will be much
lower because large companies will bear the initial cost
of learning and smaller companies will not be required
to reinvent the wheel. However, this will happen only if
a signicant number of large companies engage Indian
accounting rms to provide them support in their transition to IFRS. If, most large companies, which will comply
with Indian accounting standards convergent with IFRS
in the rst phase, choose one of the international rms,
Indian accounting rms and smaller companies will not
benet from the learning in the rst phase of the transition to IFRS.
It is likely that international rms will protect their learning to retain their competitive advantage. Therefore,
it is for the benet of the country that each company
makes judicious choice of the accounting rm as its partner without limiting its choice to international accounting
rms. Public sector companies should take the lead and
the Institute of Chartered Accountants of India (ICAI)
should develop a clear strategy to diuse the learning.

334

CHAPTER 64. INTERNATIONAL FINANCIAL REPORTING STANDARDS

Size of companies
The government has decided to measure the size of companies in terms of net worth. This is not the ideal unit to
measure the size of a company. Net worth in the balance
sheet is determined by accounting principles and methods. Therefore, it does not include the value of intangible
assets. Moreover, as most assets and liabilities are measured at historical cost, the net worth does not reect the
current value of those assets and liabilities. Market capitalisation is a better measure of the size of a company.
But it is dicult to estimate market capitalisation or fundamental value of unlisted companies. This might be the
reason that the government has decided to use 'net worth'
to measure size of companies. Some companies, which
are large in terms of fundamental value or which intend to
attract foreign capital, might prefer to use Indian accounting standards convergent with IFRS earlier than required
under the road map presented by the government. The
government should provide that choice.[52]

64.9.5

Japan

The minister for Financial Services in Japan announced

in late June 2011 that mandatory application of the IFRS
should not take place from scal year-ending March
2015; ve to seven years should be required for preparation if mandatory application is decided; and to permit
the use of U.S. GAAP beyond the scal year ending 31
March 2016.[53]

64.9.6

Montenegro

Montenegro gained independence from Serbia in 2006.

Its accounting standard setter is the Institute of Accountants and Auditors of Montenegro (IAAM).[54]:2 In 2005,
IAAM adopted a revised version of the 2002 Law on
Accounting and Auditing which authorized the use of
IFRS for all entities.[54]:18 IFRS is currently required for
all consolidated and standalone nancial statements, however, enforcement is not eective except in the banking
sector.[54]:18 Financial statements for banks in Montenegro are, generally, of high quality and can be compared
to those of the European Union.[54]:3 Foreign companies
listed on Montenegros two stock exchanges (Montenegro
Stock Exchange and NEX Stock Exchange) are also required to apply IFRS in their nancial statements.[55]
Montenegro does not have a national GAAP.[54]:18 Currently, no Montenegrin translation of IFRS exists, and because of this Montenegro applies the Serbian translation
from 2010.[56]:20 IFRS for SMEs is not currently applied
in Montenegro.[56]:20

64.9.7

Nepal

In Nepal the Accounting Standards Board (ASB) is in

charge of standard setting. Nepal closely models its

Financial Reporting Standards (FRS) according to the

IFRS, with appropriate changes made to suit the Nepalese
context. It has issued Nepal Financial Reporting Standards in 2013. The 2013 version of standards is almost
resemble IFRS with slight modication.

64.9.8 Pakistan
All listed companies must follow all issued IAS/IFRS except the following:
IAS 39 and IAS 42: Implementation of these standards
has been held in abeyance by State Bank of Pakistan for
Banks and DFIs
IFRS-1: Eective for the annual periods beginning on or
after 1 January 2004. This IFRS is being considered for
adoption for all companies other than banks and DFIs.
IFRS-9: Under consideration of the relevant Committee
of the Institutes (ICAP & ICMAP). This IFRS will be
eective for the annual periods beginning on or after 1
January 2013.

64.9.9 Russia
The government of Russia has been implementing a program to harmonize its national accounting standards with
IFRS since 1998. Since then twenty new accounting standards were issued by the Ministry of Finance of the Russian Federation aiming to align accounting practices with
IFRS. Despite these eorts essential dierences between
Russian accounting standards and IFRS remain. Since
2004 all commercial banks have been obliged to prepare
nancial statements in accordance with both Russian accounting standards and IFRS. Full transition to IFRS is
delayed but starting 2012 new modications making Russian GAAP converging to IFRS have been made. They
notably include the booking of reserves for bad debts and
contingent liabilities and the devaluation of inventory and
nancial assets.
Still, several dierences between the two sets of account
still remain. Major reasons for deviation between Russian
GAAP and IFRS / US-GAAP (e.g. when the Russian
aliate of a larger group need to be consolidated to the
mother company) are the following:
1. Booking of payables in the General Ledger according to national accounting standards can only be
made upon receipt of the actual acceptance protocol (goods receipt). Indeed in Russia, in contrast
to IFRS and US-GAAP, the invoice (outgoing or
incoming) is not an ocial tax or accounting document and does not trigger any booking. There is
also no provision to book in the General Ledger any
expense for goods and services that according to a
contract are eectively received but for whom documents are still not exchanged.

64.9. ADOPTION
2. There is no possibility under Russian GAAP to
recognise the good-will as an intangible asset in the
balance sheet of a company. This has a major consequence when a company is sold. Indeed, if a company (or part of it) is sold at a higher value than its
book value (i.e. to account for the good-will value),
the selling party need to pay tax at the relevant prot
tax rate (20% in 2013) on the dierence in value
between selling and accounting value and the buyer
has no possibility to ammortize the cost and deduct
it from present and future revenues.
3. There is no equivalent of IAS 37 in the Russian
GAAP. Loans and monetary securities are not discounted, so the present value of such nancial assets
is not discounted for the relevant interest rates at the
dierent maturities of the loans.

64.9.10

Singapore

In Singapore the Accounting Standards Committee

(ASC) is in charge of standard setting. Singapore closely
models its Financial Reporting Standards (FRS) according to the IFRS, with appropriate changes made to suit
the Singapore context. Before a standard is enacted, consultations with the IASB are made to ensure consistency
of core principles.[57]

64.9.11

335
A. They will be required to prepare nancial
statements in accordance with Taiwan-IFRS
starting from 1 January 2013.
B. Early optional adoption: Firms that have already issued securities overseas, or have registered an overseas securities issuance with
the FSC, or have a market capitalization of
greater than NT$10 billion, will be permitted to prepare additional consolidated nancial statements[TW-original 1] in accordance with
Taiwan-IFRS starting from 1 January 2012. If
a company without subsidiaries is not required
to prepare consolidated nancial statements, it
will be permitted to prepare additional individual nancial statements on the above conditions.
(2) Phase II companies: unlisted public companies, credit
cooperatives and credit card companies:
A. They will be required to prepare nancial
statements in accordance with Taiwan-IFRS
starting from 1 January 2019
B. They will be permitted to apply TaiwanIFRS starting from 1 January 2013.
(3) Pre-disclosure about the IFRS adoption plan, and the
impact of adoption

South Africa

To prepare properly for IFRS adoption, domestic companies should propose an IFRS adoption plan and establish
All companies listed on the Johannesburg Stock Ex- a specic taskforce. They should also disclose the related
change have been required to comply with the require- information from 2 years prior to adoption, as follows:
ments of International Financial Reporting Standards
since 1 January 2005.
A. Phase I companies:
The IFRS for SMEs may be applied by 'limited interest companies, as dened in the South African Corporate Laws Amendment Act of 2006 (that is, they are not
'widely held'), if they do not have public accountability
(that is, not listed and not a nancial institution). Alternatively, the company may choose to apply full South
African Statements of GAAP or IFRS.
South African Statements of GAAP are entirely consistent with IFRS, although there may be a delay between
issuance of an IFRS and the equivalent SA Statement of
GAAP (can aect voluntary early adoption).

64.9.12

Taiwan

Adoption scope and timetable

(1) Phase I companies: listed companies and nancial institutions supervised by the Financial Supervisory Commission (FSC), except for credit cooperatives, credit card
companies and insurance intermediaries:

(A) They will be required to disclose the adoption plan, and the impact of adoption, in 2011 annual
nancial statements, and in 2012
interim and annual nancial statements.
(B) Early optional adoption:
a. Companies adopting
IFRS early will be required to disclose the
adoption plan, and the
impact of adoption, in
2010 annual nancial
statements, and in 2011
interim
and
annual
nancial statements.
b. If a company opts for
early adoption of TaiwanIFRS after 1 January
2011, it will be required
to disclose the adoption

336

CHAPTER 64. INTERNATIONAL FINANCIAL REPORTING STANDARDS

plan, and the impact of
adoption, in 2011 interim
and annual nancial
statements commencing
on the decision date.
B. Phase II companies will be required to disclose the related information from 2 years prior
to adoption, as stated above.

[1] To maintain the consistency of information declaration

and supervision with other companies, the early adopted
companies should still prepare individual and consolidated nancial statements in accordance with domestic
accounting standards.

Year Work Plan

2008
Establishment of IFRS Taskforce
2009~2011
Acquisition of authorization to translate IFRS
Translation, review, and issuance of IFRS

Follow-up analysis of the status of IFRS adoption,

and of the impact
2015
Applications of IFRS required for Phase II companies
Expected benets
(1) More ecient formulation of domestic accounting
standards, improvement of their international image, and
enhancement of the global rankings and international
competitiveness of our local capital markets;
(2) Better comparability between the nancial statements
of local and foreign companies;
(3) No need for restatement of nancial statements when
local companies wish to issue overseas securities, resulting in reduction in the cost of raising capital overseas;
(4) For local companies with investments overseas, use of
a single set of accounting standards will reduce the cost
of account conversions and improve corporate eciency.
Above is quoted from Accounting Research and Development Foundation, with the original here PDF (18.9 KB)
.

Analysis of possible IFRS implementation problems, and resolution thereof

64.9.13

Turkey

Proposal for modication of the related regulations

The Banking Regulation and Supervision Agency and
and supervisory mechanisms
Capital Markets Board of Turkey translated IFRS into
Enhancement of related publicity and training activ- Turkish in 2002. Banks and Turkish companies listed
on the Istanbul Stock Exchange are required to prepare
ities
IFRS reports since then. The Turkish Accounting Standards Board (called the Public Oversight Authority after
2012
2011) also translated IFRS in 2005. The new Commercial Code came into force in 2012. The Public Oversight
IFRS application permitted for Phase I companies Authority is the only authorized board regarding auditing
Study on possible IFRS implementation problems, and nancial reporting standards. Most businesses authorized by the Council of Ministers in addition to banks and
and resolution thereof
Turkish companies listed on the Istanbul Stock Exchange
Completion of amendments to the related regula- are required to prepare IFRS reports since 2012.
tions and supervisory mechanisms
Enhancement of the related publicity and training
activities
2013
Application of IFRS required for Phase I companies, and permitted for Phase II companies
Follow-up analysis of the status of IFRS adoption,
and of the impact
2014

64.10 See also

List of International Financial Reporting Standards
Nepal Financial Reporting Standards
Chinese accounting standards
Philosophy of Accounting
International Public Sector Accounting Standards
Indian Accounting Standards

64.11. REFERENCES
Generally
(Canada)

Accepted

337
Accounting

Principles

Generally Accepted Accounting Principles (France)

Generally Accepted Accounting Principles (UK)
Generally Accepted Accounting Principles (United
States)
Philosophy of accounting
Capital (economics)
Center for Audit Quality (CAQ)
Constant Purchasing Power Accounting

[26] http://eifrs.ifrs.org/eifrs/bnstandards/en/2013/ias7.pdf
[27] http://eifrs.ifrs.org/eifrs/bnstandards/en/2013/ias1.pdf
[28] Paragraph 4.38 of the Conceptual Framework of IFRS
[29] Paragraph 63 of the IFRS standard IAS 38
[30] Paragraphs 54 and 57 of the IFRS standard IAS 38
[31] Paragraph 27 of the IFRS standard IAS 37
[32] Paragraph 23 of the IFRS standard IFRS 3
[33] Smith, N.J. (2012) CONSTANT ITEM PURCHASING
POWER ACCOUNTING per IFRS, Ch. 1.22.2 Three
Concepts of Capital Maintenance
[34] Historical cost accounting

64.11 References

[35] Constant Purchasing Power Accounting

[1] http://hdl.handle.net/2077/36018

[36] http://www.amazon.com/dp/B008LAC0FE?keywords=
constant+item+purchasing+power+accounting+per+ifrs

[2] Paragraph 9 of the standard IAS 1

[37] http://www.iasb.org/IFRSs/IFRs.htm

[3] Paragraph 15 of the standard IAS 1

[38] Framework for the Preparation and Presentation of Financial Statements, Par 104

[4] Paragraph 25 of the standard IAS 1

[39] Full text of the Framework
[5] Paragraph 28 of the standard IAS 1
[6] Paragraph 29 of the standard IAS 1
[7] Paragraph 32 of the standard IAS 1
[8] Paragraph 57, 63 of the standard IAS 19
[9] Paragraph 71 of the standard IAS 12
[10] Paragraph 36 of the standard IAS 1
[11] Paragraph 38 of the standard IAS 1

[40] http://blogs.wsj.com/cfo/2012/07/13/
sec-staff-offers-127-pages-of-reasons-not-to-adopt-ifrs/
[41] http://www.ifrs.org/Alerts/PressRelease/Pages/
IFRS-Foundation-Staff-Analysis-of-SEC-Final-Staff-Report-on-IFRS.
aspx
[42] http://www.ifrs.org/Features/Documents/
Mise-au-point-concernant-les-normes-IFRS-19-eng-February-2013.
pdf
[43]

[12] Paragraph 10f of the standard IAS 1

[13] Paragraph 45 of the standard IAS 1
[14] Paragraph 4.4 of the Framework of IFRS
[15] Paragraph 10A of the standard IAS 1
[16] Paragraph 4.25 of the Framework of IFRS
[17] Paragraph 120 of the standard IAS 19
[18] Paragraph 55b of the standard IAS 39
[19] Paragraph 39 of the standard IAS 16
[20] Paragraph 85 of the standard IAS 38
[21] Paragraph 8 of the standard IAS 21
[22] Paragraph 39 of the standard IAS 21
[23] Paragraph 102 of the standard IAS 39
[24] Paragraph 95 of the standard IAS 39
[25] Paragraph 106 of the standard IAS 1

[44] SEC Proposes Roadmap Toward Global Accounting

Standards to Help Investors Compare Financial Information More Easily (Press release). U.S. Securities and Exchange Commission. 28 August 2008. Retrieved 27 August 2008.
[45] Ball R. (2006). International Financial Reporting Standards (IFRS): pros and cons for investors. Accounting and
Business Research
[46] Bradshaw, M., et al (2010). Response to the SECs Proposed Rule- Roadmap for the Potential Use of Financial
Statements Prepared in Accordance with International Financial Reporting Standards (IFRS) by U.S. Issuers. Accounting Horizons(24)1
[47] Proles of the IFRS Foundation
[48] AcSB Conrms Changeover Date to IFRSs. Canadian
Institute of Chartered Accountants. 13 February 2008.
Retrieved 8 August 2009.
[49] http://ec.europa.eu/internal_market/accounting/legal_
framework/ias_regulation/index_en.htm

338

CHAPTER 64. INTERNATIONAL FINANCIAL REPORTING STANDARDS

The latest IFRS news and resources from the Institute of Chartered Accountants in England and Wales
(ICAEW)

[50] http://www.efrag.org/Front/c1-306/
Endorsement-Status-Report_EN.aspx
[51] http://ted.europa.eu/udl?uri=TED:NOTICE:
202159-2013:DATA:EN:HTML&tabId=3
[52] Ashish K Bhattacharyya (8 February 2010). IFRS: transition date will be april 1, 2011. Business Standard. Retrieved 2 August 2013.
[53] Update: IFRS Developments Japan, October 2011
[54] van der Plaats, Erik; Nagy, David; Crnomarkovic, Aleksandar; Grabner, Gerhard; Kogler, Gerald; Hodgson,
Eddie; Corrigan, Patrick; McEntee, Edward (2007).
Report on the Observance of Standards and Codes
(ROSC): The Republic of Montenegro. World Bank.
[55] PricewaterhouseCoopers (2010).
trieved 21 June 2012.

Montenegro.

Re-

[56] IFAC (2011). Action Plan: Montenegro. Retrieved 21

June 2012.
[57] Process of Prescribing Accounting Standards, Retrieved
29 February 2008

64.12 Further reading

International Accounting Standards Board (2007):
International Financial Reporting Standards 2007
(including International Accounting Standards
(IAS(tm)) and Interpretations as at 1 January 2007),
LexisNexis, ISBN 1-4224-1813-8
Original texts of IAS/IFRS, SIC and IFRIC adopted
by the Commission of the European Communities and published in Ocial Journal of the European Union http://ec.europa.eu/internal_market/
accounting/ias_en.htm#adopted-commission
Case studies of IFRS implementation in Brazil,
Germany, India, Jamaica, Kenya, Pakistan, South
Africa and Turkey. Prepared by the United Nations
Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting
(ISAR).
Wiley Guide to Fair Value Under IFRS , John Wiley
& Sons.

64.13 External links

The International Accounting Standards Board
Free access to all IFRS standards, news and status
of projects in progress
PwC IFRS page with news and downloadable documents

Initial publication of the International Accounting

Standards in the Ocial Journal of the European
Union PB L 261 13-10-2003
Directorate Internal Market of the European Union
on the implementation of the IAS in the European
Union
Deloitte: An Overview of International Financial
Reporting Standards
The American Institute of CPAs (AICPA) in partnership with its marketing and technology subsidiary, CPA2Biz, has developed the IFRS.com web
site.
RSM Richter IFRS page with news and downloadable documents related to IFRS Conversions in
Canada
U.S. Securities and Exchange Commission Proposal
for First-Time Application of International Financial Reporting Standards by Foreign private issuers
registered with the SEC
IFRS for SMEs Presented by Michael Wells, Director of the IFRS Education Initiative at the IASC
Foundation
Pricewaterhousecooperss map of countries that apply IFRS

Chapter 65

ISO 31000
ISO 31000 is a family of standards relating to risk management codied by the International Organization for
Standardization. The purpose of ISO 31000:2009 is to
provide principles and generic guidelines on risk management. ISO 31000 seeks to provide a universally recognised paradigm for practitioners and companies employing risk management processes to replace the myriad of
existing standards, methodologies and paradigms that differed between industries, subject matters and regions.
Currently, the ISO 31000 family is expected to include:

ment processes throughout an organization. This approach to formalizing risk management practices will facilitate broader adoption by companies who require an
enterprise risk management standard that accommodates
multiple silo-centric management systems.[4]
The scope of this approach to risk management is to enable all strategic, management and operational tasks of
an organization throughout projects, functions, and processes to be aligned to a common set of risk management
objectives.

Accordingly, ISO 31000:2009 is intended for a broad

ISO 31000:2009 - Principles and Guidelines on stakeholder group including:
Implementation[1]
ISO/IEC 31010:2009 - Risk Management - Risk
Assessment Techniques
ISO Guide 73:2009 - Risk Management - Vocabulary
ISO also designed its ISO 21500 Guidance on Project
Management standard to align with ISO 31000:2009.[2]

executive level stakeholders

appointment holders in the enterprise risk management group
risk analysts and management ocers
line managers and project managers

65.1 Introduction

compliance and internal auditors

ISO 31000 was published as a standard on the 13th of
November 2009, and provides a standard on the implementation of risk management. A revised and har independent practitioners.
monised ISO/IEC Guide 73 was published at the same
time. The purpose of ISO 31000:2009 is to be applicable and adaptable for any public, private or community
enterprise, association, group or individual.[3] Accord65.3 Risk conceptualisation
ingly, the general scope of ISO 31000 - as a family of
risk management standards - is not developed for a particular industry group, management system or subject mat- Main article: Risk
ter eld in mind, rather to provide best practice structure
and guidance to all operations concerned with risk manOne of the key paradigm shifts proposed in ISO 31000 is
agement.
a controversial change in how risk is conceptualised. Under the ISO 31000:2009 and a consequential major revision of the terminology in ISO Guide 73, the denition
65.2 Scope
of risk is no longer chance or probability of loss, but
the eect of uncertainty on objectives ... thus causing
ISO 31000:2009 provides generic guidelines for the de- the word risk to refer to positive possibilities as well as
sign, implementation and maintenance of risk manage- negative ones.
339

340

CHAPTER 65. ISO 31000

65.4 ISO 31000 framework approach

may operate using relatively unsophisticated risk management processes, more material change will be required,
particularly regarding a clearly articulated risk management policy, formalising risk ownership processes, strucISO 31000:2009 has been received as a replacement turing framework processes and adopting continuous imto the existing standard on risk management, AS/NZS provement programmes.
4360:2004 (In the form of AS/NZS ISO 31000:2009).
Whereas the Standards Australia approach provided a
process by which risk management could be undertaken,
65.7 Managing risk
ISO 31000:2009 addresses the entire management system that supports the design, implementation, maintenance and improvement of risk management processes. ISO 31000:2009 gives a list on how to deal with risk:

65.5 Implementation
The intent of ISO 31000 is to be applied within existing management systems to formalise and improve risk
management processes as opposed to wholesale substitution of legacy management practices. Subsequently,
when implementing ISO 31000, attention is to be given
to integrating existing risk management processes in the
new paradigm addressed in the standard.
The focus of many ISO 31000 'harmonisation'
programmes[5] have centred on:
Transferring accountability gaps in enterprise risk
management
Aligning objectives of the governance frameworks
with ISO 31000

1. Avoiding the risk by deciding not to start or continue

with the activity that gives rise to the risk
2. Accepting or increasing the risk in order to pursue
an opportunity
3. Removing the risk source
4. Changing the likelihood
5. Changing the consequences
6. Sharing the risk with another party or parties (including contracts and risk nancing)
7. Retaining the risk by informed decision

65.8 Accreditation

Embedding management system reporting mecha- ISO 31000 has not been developed with the intention for
certication. (2009)
nisms
Creating uniform risk criteria and evaluation metrics Starting from March 2013, accreditation and certication of Professional Certicate Lead Trainer & Consultant for ISO 31000 would be organized and conferred
by Academy of Professional Certication (APC, http:
65.6 Implications
//www.apc.org.hk) in Hong Kong. APC is an authorized
representative of ISO/TC262 for HKSAR Hong Kong.
Most implications for adopting the new standard con- (2013)
cern the re-engineering of existing management practices to conform with the documentation, communication and socialisation of the new risk management operating paradigm; as opposed to wholesale re-orientation 65.9 See also
of management practice throughout an organisation. Ac Enterprise risk management
cordingly, most senior position holders in an enterprise
risk management organisation will need to be cognisant
International Organization for Standardization
of the implication for adopting the standard and be able
to develop eective strategies for implementing the stan International Disaster and Risk Conference
dard across supply chains and commercial operations.[6]
ISO 9000
Certain aspects of top management accountability, strategic policy implementation and eective governance
ISO 14001
frameworks, will require more consideration by organisa ISO/PAS 28000
tions that have previously used now redundant risk management methodologies.
PDCA
In some domains that concern risk management, in par Risk
ticular security and corporate social responsibility, which

65.11. EXTERNAL LINKS

RiskAoA
Risk management
Risk management tools
Security risk

65.10 References
[1] National Standards Authority of Ireland
[2] New ISO standard on project management. ISO. 2012.
[3] ISO 31000 catalogue http://www.iso.org/iso/catalogue_
detail.htm?csnumber=43170
[4] ISO 31000 Update
[5] ISO 31000 update: What it means to C-Suite Risk Owners
[6] Implications for ISO adoption http://www.optaresystems.
com/index.php/optare/publication_detail/iso_31000_
update_what_it_will_mean_for_a_cso/

Airmic / Alarm / IRM (2010) A structured approach to Enterprise Risk Management (ERM) and
the requirements of ISO 31000

65.11 External links

Standard International Organization for Standardization
Standard AS/NZS ISO 31000:2009 Risk management - Principles and guidelines
Discussion : LinkedIn discussion forum on ISO
31000:2009 Risk management - Principles and
guidelines
Article ISO 31000 : The Gold Standard, Alex Dali
and Christopher Lajtha, Strategic Risk, September
2009

341

Chapter 66

History of private equity and venture

capital
The history of private equity and venture capital and the 66.1 Pre-history
development of these asset classes has occurred through
a series of boom and bust cycles since the middle of the Main article: Early history of private equity
20th century. Within the broader private equity industry, Investors have been acquiring businesses and making
two distinct sub-industries, leveraged buyouts and venture
capital experienced growth along parallel, although interrelated tracks.
Since the origins of the modern private equity industry
in 1946, there have been four major epochs marked by
three boom and bust cycles. The early history of private equityfrom 1946 through 1981was characterized by relatively small volumes of private equity investment, rudimentary rm organizations and limited awareness of and familiarity with the private equity industry.
The rst boom and bust cycle, from 1982 through 1993,
was characterized by the dramatic surge in leveraged buyout activity nanced by junk bonds and culminating in
the massive buyout of RJR Nabisco before the near collapse of the leveraged buyout industry in the late 1980s
and early 1990s. The second boom and bust cycle
(from 1992 through 2002) emerged from the ashes of
the savings and loan crisis, the insider trading scandals,
the real estate market collapse and the recession of the
early 1990s. This period saw the emergence of more institutionalized private equity rms, ultimately culminating in the massive Dot-com bubble in 1999 and 2000.
The third boom and bust cycle (from 2003 through
2007) came in the wake of the collapse of the Dot-com
bubbleleveraged buyouts reach unparalleled size and J.P. Morgans acquisition of Carnegie Steel Company in 1901
the institutionalization of private equity rms is exem- represents arguably the rst true modern buyout
plied by the Blackstone Group's 2007 initial public ofminority investments in privately held companies since
fering.
the dawn of the industrial revolution. Merchant bankers
In its early years through roughly the year 2000, the hisin London and Paris nanced industrial concerns in
tory of the private equity and venture capital asset classes
the 1850s; most notably Crdit Mobilier, founded in
is best described through a narrative of developments in
1854 by Jacob and Isaac Pereire, who together with
the United States as private equity in Europe consistently
New York based Jay Cooke nanced the United States
lagged behind the North American industry. With the
Transcontinental Railroad.
second private equity boom in the mid-1990s and liberalization of regulation for institutional investors in Europe, Later, J. Pierpont Morgan's J.P. Morgan & Co. would
the emergence of a mature European private equity mar- nance railroads and other industrial companies throughout the United States. In certain respects, J. Pierpont
ket has occurred.
Morgan's 1901 acquisition of Carnegie Steel Company
342

66.2. ORIGINS OF MODERN PRIVATE EQUITY

343

66.2 Origins of modern private equity

Main article: Early history of private equity
It was not until after World War II that what is considered today to be true private equity investments began to
emerge marked by the founding of the rst two venture
capital rms in 1946: American Research and Development Corporation. (ARDC) and J.H. Whitney & Company.[1]

Andrew Carnegie sold his steel company to J.P. Morgan in 1901

in arguably the rst true modern buyout

from Andrew Carnegie and Henry Phipps for $480 million represents the rst true major buyout as they are
thought of today.
Due to structural restrictions imposed on American
banks under the GlassSteagall Act and other regulations
in the 1930s, there was no private merchant banking industry in the United States, a situation that was quite exceptional in developed nations. As late as the 1980s,
Lester Thurow, a noted economist, decried the inability of the nancial regulation framework in the United
States to support merchant banks. US investment banks
were conned primarily to advisory businesses, handling
mergers and acquisitions transactions and placements of
equity and debt securities. Investment banks would later
enter the space, however long after independent rms had
become well established.

ARDC was founded by Georges Doriot, the father of

venture capitalism[2] (founder of INSEAD and former
dean of Harvard Business School), with Ralph Flanders
and Karl Compton (former president of MIT), to encourage private sector investments in businesses run by soldiers who were returning from World War II. ARDCs
signicance was primarily that it was the rst institutional
private equity investment rm that raised capital from
sources other than wealthy families although it had several
notable investment successes as well.[3] ARDC is credited
with the rst major venture capital success story when its
1957 investment of $70,000 in Digital Equipment Corporation (DEC) would be valued at over $35.5 million after
the companys initial public oering in 1968 (representing a return of over 500 times on its investment and an
annualized rate of return of 101%).[4] Former employees of ARDC went on to found several prominent venture capital rms including Greylock Partners (founded
in 1965 by Charlie Waite and Bill Elfers) and Morgan,
Holland Ventures, the predecessor of Flagship Ventures
(founded in 1982 by James Morgan).[5] ARDC continued investing until 1971 with the retirement of Doriot.
In 1972, Doriot merged ARDC with Textron after having invested in over 150 companies.

J.H. Whitney & Company was founded by John Hay

Whitney and his partner Benno Schmidt. Whitney had
been investing since the 1930s, founding Pioneer Pictures
in 1933 and acquiring a 15% interest in Technicolor Corporation with his cousin Cornelius Vanderbilt Whitney.
By far, Whitneys most famous investment was in Florida
Foods Corporation. The company, having developed an
innovative method for delivering nutrition to American
soldiers, later came to be known as Minute Maid orange
juice and was sold to The Coca-Cola Company in 1960.
With few exceptions, private equity in the rst half of J.H. Whitney & Company continues to make investments
the 20th century was the domain of wealthy individuals in leveraged buyout transactions and raised $750 million
and families. The Vanderbilts, Whitneys, Rockefellers for its sixth institutional private equity fund in 2005.
and Warburgs were notable investors in private compa- Before World War II, venture capital investments (originies in the rst half of the century. In 1938, Laurance S. nally known as development capital) were primarily the
Rockefeller helped nance the creation of both Eastern domain of wealthy individuals and families. One of the
Air Lines and Douglas Aircraft and the Rockefeller fam- rst steps toward a professionally managed venture capily had vast holdings in a variety of companies. Eric M. ital industry was the passage of the Small Business InWarburg founded E.M. Warburg & Co. in 1938, which vestment Act of 1958. The 1958 Act ocially allowed
would ultimately become Warburg Pincus, with invest- the U.S. Small Business Administration (SBA) to license
ments in both leveraged buyouts and venture capital.
private Small Business Investment Companies (SBICs)

344

CHAPTER 66. HISTORY OF PRIVATE EQUITY AND VENTURE CAPITAL

to help the nancing and management of the small entrepreneurial businesses in the United States. Passage of
the Act addressed concerns raised in a Federal Reserve
Board report to Congress that concluded that a major gap
existed in the capital markets for long-term funding for
growth-oriented small businesses. Additionally, it was
thought that fostering entrepreneurial companies would
spur technological advances to compete against the Soviet
Union. Facilitating the ow of capital through the economy up to the pioneering small concerns in order to stimulate the U.S. economy was and still is the main goal of
the SBIC program today.[6] The 1958 Act provided venture capital rms structured either as SBICs or Minority
Enterprise Small Business Investment Companies (MESBICs) access to federal funds which could be leveraged
at a ratio of up to 4:1 against privately raised investment
funds. The success of the Small Business Administrations eorts are viewed primarily in terms of the pool of
professional private equity investors that the program developed as the rigid regulatory limitations imposed by the
program minimized the role of SBICs. In 2005, the SBA
signicantly reduced its SBIC program, though SBICs
continue to make private equity investments.
The real growth in Private Equity surged in 1984 to 1991
period when Institutional Investors, e.g. Pension Plans,
Foundations and Endowment Funds such as the Shell
Pension Plan, the Oregon State Pension Plan, the Ford
Foundation and the Harvard Endowment Fund started
investing a small part of their trillion dollars portfolios
into Private Investments - particularly venture capital and
Leverage Buyout Funds

66.3 Early venture capital and

the growth of Silicon Valley
(19591981)
Main article: Early history of private equity
During the 1960s and 1970s, venture capital rms focused their investment activity primarily on starting and
expanding companies. More often than not, these companies were exploiting breakthroughs in electronic, medical or data-processing technology. As a result, venture
capital came to be almost synonymous with technology
nance.
It is commonly noted that the rst venture-backed startup
was Fairchild Semiconductor (which produced the rst
commercially practicable integrated circuit), funded in
late 1957 by a loan from Sherman Fairchilds Fairchild
Camera with the help Arthur Rock, an early venture capitalist with the rm of Hayden Stone in New York (which
received 20% of the equity of the newly formed company). Another early VC rm was Venrock Associates.[7]
Venrock was founded in 1969 by Laurance S. Rockefeller, the fourth of John D. Rockefellers six children as
a way to allow other Rockefeller children to develop ex-

Sand Hill Road in Menlo Park, California, where many Bay Area
venture capital rms are based

posure to venture capital investments.

It was also in the 1960s that the common form of private
equity fund, still in use today, emerged. Private equity
rms organized limited partnerships to hold investments
in which the investment professionals served as general
partner and the investors, who were passive limited partners, put up the capital. The compensation structure, still
in use today, also emerged with limited partners paying
an annual management fee of 12% and a carried interest typically representing up to 20% of the prots of the
partnership.
An early West Coast venture capital company was Draper
and Johnson Investment Company, formed in 1962[8] by
William Henry Draper III and Franklin P. Johnson, Jr.
In 1964 Bill Draper and Paul Wythes founded Sutter Hill
Ventures, and Pitch Johnson formed Asset Management
Company.
The growth of the venture capital industry was fueled by
the emergence of the independent investment rms on
Sand Hill Road, beginning with Kleiner, Perkins, Caueld & Byers and Sequoia Capital in 1972. Located, in
Menlo Park, CA, Kleiner Perkins, Sequoia and later venture capital rms would have access to the burgeoning
technology industries in the area. By the early 1970s,
there were many semiconductor companies based in the
Santa Clara Valley as well as early computer rms using
their devices and programming and service companies.[9]
Throughout the 1970s, a group of private equity rms,
focused primarily on venture capital investments, would

66.4. EARLY HISTORY OF LEVERAGED BUYOUTS (19551981)

be founded that would become the model for later leveraged buyout and venture capital investment rms. In
1973, with the number of new venture capital rms increasing, leading venture capitalists formed the National
Venture Capital Association (NVCA). The NVCA was
to serve as the industry trade group for the venture capital industry.[10] Venture capital rms suered a temporary downturn in 1974, when the stock market crashed
and investors were naturally wary of this new kind of investment fund. It was not until 1978 that venture capital
experienced its rst major fundraising year, as the industry raised approximately $750 million. During this period, the number of venture rms also increased. Among
the rms founded in this period, in addition to Kleiner
Perkins and Sequoia, that continue to invest actively are
AEA Investors, TA Associates, Mayeld Fund, Apax
Partners, New Enterprise Associates, Oak Investment
Partners and Sevin Rosen Funds.

345

ration). These investment vehicles would utilize a number of the same tactics and target the same type of companies as more traditional leveraged buyouts and in many
ways could be considered a forerunner of the later private
equity rms. In fact, it is Posner who is often credited
with coining the term leveraged buyout or LBO[13]

Posner, who had made a fortune in real estate investments in the 1930s and 1940s acquired a major stake
in DWG Corporation in 1966. Having gained control
of the company, he used it as an investment vehicle that
could execute takeovers of other companies. Posner and
DWG are perhaps best known for the hostile takeover
of Sharon Steel Corporation in 1969, one of the earliest such takeovers in the United States. Posners investments were typically motivated by attractive valuations,
balance sheets and cash ow characteristics. Because of
its high debt load, Posners DWG would generate attractive but highly volatile returns and would ultimately land
Venture capital played an instrumental role in develop- the company in nancial diculty. In 1987, Sharon Steel
ing many of the major technology companies of the sought Chapter 11 bankruptcy protection.
1980s. Some of the most notable venture capital invest- Warren Buett, who is typically described as a stock marments were made in rms that include: Tandem Com- ket investor rather than a private equity investor, emputers, Genentech, Apple Inc., Electronic Arts, Compaq, ployed many of the same techniques in the creation on
Federal Express and LSI Corporation.
his Berkshire Hathaway conglomerate as Posners DWG

66.4 Early history of leveraged

buyouts (19551981)
Main article: Early history of private equity

66.4.1

McLean Industries and public holding companies

Although not strictly private equity, and certainly not labeled so at the time, the rst leveraged buyout may have
been the purchase by Malcolm McLean's McLean Industries, Inc. of Pan-Atlantic Steamship Company in January 1955 and Waterman Steamship Corporation in May
1955.[11] Under the terms of the transactions, McLean
borrowed $42 million and raised an additional $7 million through an issue of preferred stock. When the deal
closed, $20 million of Waterman cash and assets were
used to retire $20 million of the loan debt. The newly
elected board of Waterman then voted to pay an immediate dividend of $25 million to McLean Industries.[12]
Similar to the approach employed in the McLean transaction, the use of publicly traded holding companies as investment vehicles to acquire portfolios of investments in
corporate assets would become a new trend in the 1960s
popularized by the likes of Warren Buett (Berkshire
Hathaway) and Victor Posner (DWG Corporation) and
later adopted by Nelson Peltz (Triarc), Saul Steinberg
(Reliance Insurance) and Gerry Schwartz (Onex Corpo-

Corporation and in later years by more traditional private equity investors. In 1965, with the support of the
companys board of directors, Buett assumed control
of Berkshire Hathaway. At the time of Buetts investment, Berkshire Hathaway was a textile company, however, Buett used Berkshire Hathaway as an investment
vehicle to make acquisitions and minority investments
in dozens of the insurance and reinsurance industries
(GEICO) and varied companies including: American Express, The Bualo News, the Coca-Cola Company, Fruit
of the Loom, Nebraska Furniture Mart and Sees Candies. Buetts value investing approach and focus on
earnings and cash ows are characteristic of later private
equity investors. Buett would distinguish himself relative to more traditional leveraged buyout practitioners
through his reluctance to use leverage and hostile techniques in his investments.

66.4.2 KKR and the pioneers of private

equity
The industry that is today described as private equity was
conceived by a number of corporate nanciers, most notably Jerome Kohlberg, Jr. and later his protg, Henry
Kravis. Working for Bear Stearns at the time, Kohlberg
and Kravis along with Kravis cousin George Roberts began a series of what they described as bootstrap investments. They targeted family-owned businesses, many of
which had been founded in the years following World War
II and by the 1960s and 1970s were facing succession
issues. Many of these companies lacked a viable or attractive exit for their founders as they were too small to

346

CHAPTER 66. HISTORY OF PRIVATE EQUITY AND VENTURE CAPITAL

be taken public and the founders were reluctant to sell 66.4.3 Regulatory and tax changes impact
out to competitors, making a sale to a nancial buyer
the boom
potentially attractive. Their acquisition of Orkin Exterminating Company in 1964 is among the rst signicant
The advent of the boom in leveraged buyouts in the 1980s
leveraged buyout transactions.[14] In the following years,
was supported by three major legal and regulatory events:
the three Bear Stearns bankers would complete a series
of buyouts including Stern Metals (1965), Incom (a division of Rockwood International, 1971), Cobblers Industries (1971) and Boren Clay (1973) as well as Thomp Failure of the Carter tax plan of 1977 In his rst
son Wire, Eagle Motors and Barrows through their inyear in oce, Jimmy Carter put forth a revision to
vestment in Stern Metals. Although they had a number
the corporate tax system that would have, among
of highly successful investments, the $27 million investother results, reduced the disparity in treatment of
ment in Cobblers ended in bankruptcy.[15]
interest paid to bondholders and dividends paid to
stockholders. Carters proposals did not achieve
By 1976, tensions had built up between Bear Stearns and
support from the business community or Congress
Kohlberg, Kravis and Roberts leading to their departure
and were not enacted. Because of the dierent tax
and the formation of Kohlberg Kravis Roberts in that
treatment, the use of leverage to reduce taxes was
year. Most notably, Bear Stearns executive Cy Lewis had
popular among private equity investors and would
rejected repeated proposals to form a dedicated investbecome increasingly popular with the reduction of
ment fund within Bear Stearns and Lewis took excepthe capital gains tax rate.[20]
[16]
tion to the amount of time spent on outside activities.
Early investors included the Hillman Family[17] By 1978,
with the revision of the Employee Retirement Income Security Act regulations, the nascent KKR was successful
in raising its rst institutional fund with approximately
$30 million of investor commitments.[18] That year, the
rm signed a precedent-setting deal to buy the publicly
traded Houdaille Industries, which made industrial pipes,
for $380 million. It was by far the largest take-private at
the time.[19]
Meanwhile in 1974, Thomas H. Lee founded a new investment rm to focus on acquiring companies through
leveraged buyout transactions, one of the earliest independent private equity rms to focus on leveraged buyouts of more mature companies rather than venture capital investments in growth companies. Lees rm, Thomas
H. Lee Partners, while initially generating less fanfare
than other entrants in the 1980s, would emerge as one
of the largest private equity rms globally by the end of
the 1990s.
The second half of the 1970s and the rst years of the
1980s saw the emergence of several private equity rms
that would survive the various cycles both in leveraged
buyouts and venture capital. Among the rms founded
during these years were: Cinven, Forstmann Little &
Company, Welsh, Carson, Anderson & Stowe, Candover,
and GTCR.

Employee Retirement Income Security Act of 1974

(ERISA) With the passage of ERISA in 1974, corporate pension funds were prohibited from holding certain risky investments including many investments in privately held companies. In 1975,
fundraising for private equity investments cratered,
according to the Venture Capital Institute, totaling only $10 million during the course of the year.
In 1978, the US Labor Department relaxed certain parts of the ERISA restrictions, under the prudent man rule,[21] thus allowing corporate pension
funds to invest in private equity resulting in a major
source of capital available to invest in venture capital and other private equity. Time reported in 1978
that fund raising had increased from $39 million in
1977 to $570 million just one year later.[22] Additionally, many of these same corporate pension investors would become active buyers of the high yield
bonds (or junk bonds) that were necessary to complete leveraged buyout transactions.

Economic Recovery Tax Act of 1981 (ERTA) On

August 15, 1981, Ronald Reagan signed the KempRoth bill, ocially known as the Economic Recovery Tax Act of 1981, into law, lowering of the top
capital gains tax rate from 28 percent to 20 percent,
and making high risk investments even more attractive.

Management buyouts also came into existence in the

late 1970s and early 1980s. One of the most notable
early management buyout transactions was the acquisition of Harley-Davidson. A group of managers at HarleyDavidson, the motorcycle manufacturer, bought the company from AMF in a leveraged buyout in 1981, but racked
up big losses the following year and had to ask for protecIn the years that would follow these events, private equity
tion from Japanese competitors.
would experience its rst major boom, acquiring some of
the famed brands and major industrial powers of American business.

66.5. THE FIRST PRIVATE EQUITY BOOM (19821993)

66.5 The rst private equity boom

(19821993)
Main article: Private equity in the 1980s
The decade of the 1980s is perhaps more closely associated with the leveraged buyout than any decade before
or since. For the rst time, the public became aware of
the ability of private equity to aect mainstream companies and corporate raiders and hostile takeovers entered the public consciousness. The decade would see
one of the largest booms in private equity culminating in
the 1989 leveraged buyout of RJR Nabisco, which would
reign as the largest leveraged buyout transaction for nearly
17 years. In 1980, the private equity industry would raise
approximately $2.4 billion of annual investor commitments and by the end of the decade in 1989 that gure
stood at $21.9 billion marking the tremendous growth
experienced.[23]

66.5.1

Beginning of the LBO boom

347
vestors, which would later come to be known as Wesray
Capital Corporation, acquired Gibson Greetings, a producer of greeting cards. The purchase price for Gibson was $80 million, of which only $1 million was rumored to have been contributed by the investors. By mid1983, just sixteen months after the original deal, Gibson completed a $290 million IPO and Simon made approximately $66 million.[24][25] Simon and Wesray would
later complete the $71.6 million acquisition of Atlas Van
Lines. The success of the Gibson Greetings investment
attracted the attention of the wider media to the nascent
boom in leveraged buyouts.
Between 1979 and 1989, it was estimated that there
were over 2,000 leveraged buyouts valued in excess of
$250 million[26] Notable buyouts of this period (not described elsewhere in this article) include: Malone & Hyde
(1984), Wometco Enterprises (1984), Beatrice Companies (1985), Sterling Jewelers (1985), Revco Drug Stores
(1986), Safeway (1986), Southland Corporation (1987),
Jim Walter Corp (later Walter Industries, Inc., 1987),
BlackRock (1988), Federated Department Stores (1988),
Marvel Entertainment (1988), Uniroyal Goodrich Tire
Company (1988) and Hospital Corporation of America
(1989).
Because of the high leverage on many of the transactions
of the 1980s, failed deals occurred regularly, however the
promise of attractive returns on successful investments attracted more capital. With the increased leveraged buyout activity and investor interest, the mid-1980s saw a
major proliferation of private equity rms. Among the
major rms founded in this period were: Bain Capital,
Chemical Venture Partners, Hellman & Friedman, Hicks
& Haas, (later Hicks Muse Tate & Furst), The Blackstone
Group, Doughty Hanson, BC Partners, and The Carlyle
Group.
Additionally, as the market developed, new niches within
the private equity industry began to emerge. In 1982,
Venture Capital Fund of America, the rst private equity rm focused on acquiring secondary market interests
in existing private equity funds was founded and then,
two years later in 1984, First Reserve Corporation, the
rst private equity rm focused on the energy sector, was
founded.

66.5.2 Venture capital in the 1980s

Michael Milken, the man credited with creating the market for
high yield junk bonds and spurring the LBO boom of the 1980s

The beginning of the rst boom period in private equity would be marked by the well-publicized success of
the Gibson Greetings acquisition in 1982 and would roar
ahead through 1983 and 1984 with the soaring stock market driving protable exits for private equity investors.

The public successes of the venture capital industry in

the 1970s and early 1980s (e.g., DEC, Apple, Genentech) gave rise to a major proliferation of venture capital investment rms. From just a few dozen rms at the
start of the decade, there were over 650 rms by the end
of the 1980s, each searching for the next major home
run. While the number of rms multiplied, the capital managed by these rms increased only 11% from $28
billion to $31 billion over the course of the decade.[27]

In January 1982, former US Secretary of the Treasury

William E. Simon, Ray Chambers and a group of in- The growth the industry was hampered by sharply declin-

348

CHAPTER 66. HISTORY OF PRIVATE EQUITY AND VENTURE CAPITAL

ing returns and certain venture rms began posting losses

for the rst time. In addition to the increased competition among rms, several other factors impacted returns.
The market for initial public oerings cooled in the mid1980s before collapsing after the stock market crash in
1987 and foreign corporations, particularly from Japan
and Korea, ooded early stage companies with capital.[27]
In response to the changing conditions, corporations that
had sponsored in-house venture investment arms, including General Electric and Paine Webber either sold o
or closed these venture capital units. Additionally, venture capital units within Chemical Bank (today CCMP
Capital) and Continental Illinois National Bank (today
CIVC Partners), among others, began shifting their focus
from funding early stage companies toward investments
in more mature companies. Even industry founders
J.H. Whitney & Company and Warburg Pincus began to
transition toward leveraged buyouts and growth capital
investments.[27][28][29] Many of these venture capital rms
attempted to stay close to their areas of expertise in the
technology industry by acquiring companies in the industry that had reached certain levels of maturity. In 1989,
Prime Computer was acquired in a $1.3 billion leveraged
buyout by J.H. Whitney & Company in what would prove
to be a disastrous transaction. Whitneys investment in
Prime proved to be nearly a total loss with the bulk of
the proceeds from the companys liquidation paid to the
companys creditors.[30]
Although lower prole than their buyout counterparts,
new leading venture capital rms were also formed including Draper Fisher Jurvetson (originally Draper Associates) in 1985 and Canaan Partners in 1987 among
others.

Additionally, the threat of the corporate raid would lead

to the practice of "greenmail", where a corporate raider
or other party would acquire a signicant stake in the
stock of a company and receive an incentive payment
(eectively a bribe) from the company in order to avoid
pursuing a hostile takeover of the company. Greenmail
represented a transfer payment from a companys existing shareholders to a third party investor and provided
no value to existing shareholders but did benet existing
managers. The practice of greenmail is not typically
considered a tactic of private equity investors and is not
condoned by market participants.
Among the most notable corporate raiders of the 1980s
were Carl Icahn, Victor Posner, Nelson Peltz, Robert
M. Bass, T. Boone Pickens, Harold Clark Simmons,
Kirk Kerkorian, Sir James Goldsmith, Saul Steinberg and
Asher Edelman. Carl Icahn developed a reputation as
a ruthless corporate raider after his hostile takeover of
TWA in 1985.[32] The result of that takeover was Icahn
systematically selling TWAs assets to repay the debt he
used to purchase the company, which was described as
asset stripping.[33] In 1985, Pickens was proled on the
cover of Time magazine as one of the most famous and
controversial businessmen in the U.S. for his pursuit of
Unocal, Gulf Oil and Cities Services.[34] In later years,
many of the corporate raiders would be re-characterized
as "Activist shareholders".
Many of the corporate raiders were onetime clients of
Michael Milken, whose investment banking rm Drexel
Burnham Lambert helped raise blind pools of capital with
which corporate raiders could make a legitimate attempt
to take over a company and provided high-yield debt nancing of the buyouts.

Drexel Burnham raised a $100 million blind pool in 1984

for Nelson Peltz and his holding company Triangle Indus66.5.3 Corporate raiders, hostile takeovers tries (later Triarc) to give credibility for takeovers, repand greenmail
resenting the rst major blind pool raised for this purpose. Two years later, in 1986, Wickes Companies, a
Although buyout rms generally had dierent aims and holding company run by Sanford Sigolo raised a $1.2
methods, they were often lumped in with the corporate billion blind pool.[35]
raiders who came on the scene in the 1980s. The raiders
In 1985, Milken raised $750 million for a similar blind
were best known for hostile bidstakeover attempts that
pool for Ronald Perelman which would ultimately prove
were opposed by management. By contrast, private eqinstrumental in acquiring his biggest target: The Revlon
uity rms generally attempted to strike deals with boards
Corporation. In 1980, Ronald Perelman, the son of a
and CEOs, though in many cases in the 1980s they alwealthy Philadelphia businessman, and future "corporate
lied with managements that were already under pressure
raider" having made several small but successful buyfrom raiders. But both groups bought companies through
outs, acquired MacAndrews & Forbes, a distributor of
leveraged buyouts; both relied heavily on junk bond licorice extract and chocolate that Perelmans father had
nancing; and under both types of owners in many cases
tried and failed to acquire 10 years earlier.[36] Perelman
major assets were sold, costs were slashed and employwould ultimately divest the companys core business and
ees were laid o. Hence, in the public mind, they were
use MacAndrews & Forbes as a holding company inlumped together.[31]
vestment vehicle for subsequent leveraged buyouts inManagement of many large publicly traded corporations cluding Technicolor, Inc., Pantry Pride and Revlon. Usreacted negatively to the threat of potential hostile ing the Pantry Pride subsidiary of his holding company,
takeover or corporate raid and pursued drastic defensive MacAndrews & Forbes Holdings, Perelmans overtures
measures including poison pills, golden parachutes and were rebued. Repeatedly rejected by the companys
increasing debt levels on the companys balance sheet.

66.5. THE FIRST PRIVATE EQUITY BOOM (19821993)

board and management, Perelman continued to press forward with a hostile takeover raising his oer from an
initial bid of $47.50 per share until it reached $53.00
per share. After receiving a higher oer from a white
knight, private equity rm Forstmann Little & Company, Perelmans Pantry Pride nally was able to make
a successful bid for Revlon, valuing the company at $2.7
billion.[37] The buyout would prove troubling, burdened
by a heavy debt load.[38][39][40] Under Perelmans control,
Revlon sold four divisions: two were sold for $1 billion,
its vision care division was sold for $574 million and its
National Health Laboratories division was spun out to the
public market in 1988. Revlon also made acquisitions
including Max Factor in 1987 and Betrix in 1989 later
selling them to Procter & Gamble in 1991.[41] Perelman
exited the bulk of his holdings in Revlon through an IPO
in 1996 and subsequent sales of stock. As of December 31, 2007, Perelman still retains a minority ownership
interest in Revlon. The Revlon takeover, because of its
well-known brand, was proled widely by the media and
brought new attention to the emerging boom in leveraged
buyout activity.

349
day, including Morgan Stanley, Goldman Sachs, Salomon
Brothers, and Merrill Lynch were actively involved in advising and nancing the parties.

After Shearson Lehmans original bid, KKR quickly introduced a tender oer to obtain RJR Nabisco for $90
per sharea price that enabled it to proceed without the
approval of RJR Nabiscos management. RJRs management team, working with Shearson Lehman and Salomon Brothers, submitted a bid of $112, a gure they
felt certain would enable them to outank any response
by Kraviss team. KKRs nal bid of $109, while a lower
dollar gure, was ultimately accepted by the board of
directors of RJR Nabisco. KKRs oer was guaranteed, whereas the management oer (backed by Shearson Lehman and Salomon) lacked a reset, meaning that
the nal share price might have been lower than their
stated $112 per share. Additionally, many in RJRs board
of directors had grown concerned at recent disclosures
of Ross Johnson' unprecedented golden parachute deal.
TIME magazine featured Ross Johnson on the cover of
their December 1988 issue along with the headline, A
Game of Greed: This man could pocket $100 million
In later years, Milken and Drexel would shy away from from the largest corporate takeover in history. Has the
certain of the more notorious corporate raiders as buyout craze gone too far?".[42] KKRs oer was welDrexel and the private equity industry attempted to move comed by the board, and, to some observers, it appeared
that their elevation of the reset issue as a deal-breaker in
upscale.
KKRs favor was little more than an excuse to reject Ross
Johnsons higher payout of $112 per share. F. Ross Johnson received $53 million from the buyout.

66.5.4

RJR Nabisco and the Barbarians at

At $31.1 billion of transaction value, RJR Nabisco was
the Gate

by far the largest leveraged buyouts in history. In 2006

and 2007, a number of leveraged buyout transactions
were completed that for the rst time surpassed the RJR
Nabisco leveraged buyout in terms of nominal purchase
price. However, adjusted for ination, none of the leveraged buyouts of the 20062007 period would surpass
RJR Nabisco. Unfortunately for KKR, size would not
equate with success as the high purchase price and debt
load would burden the performance of the investment. It
had to pump additional equity into the company a year
after the buyout closed and years later, when it sold the
last of its investment, it had chalked up a $700 million
loss.[43]

Leveraged buyouts in the 1980s including Perelmans

takeover of Revlon came to epitomize the ruthless capitalism and greed popularly seen to be pervading Wall
Street at the time. One of the nal major buyouts of the
1980s proved to be its most ambitious and marked both
a high-water mark and a sign of the beginning of the end
of the boom that had begun nearly a decade earlier. In
1989, KKR closed on a $31.1 billion takeover of RJR
Nabisco. It was, at that time and for over 17 years, the
largest leverage buyout in history. The event was chronicled in the book, Barbarians at the Gate: The Fall of RJR
Nabisco, and later made into a television movie starring
James Garner.
Interestingly, two years earlier, in 1987, Jerome
F. Ross Johnson was the President and CEO of RJR Kohlberg, Jr. resigned from Kohlberg Kravis Roberts &
Nabisco at the time of the leveraged buyout and Henry Co. over dierences in strategy. Kohlberg did not favor
Kravis was a general partner at Kohlberg Kravis Roberts. the larger buyouts (including Beatrice Companies (1985)
The leveraged buyout was in the amount of $25 bil- and Safeway (1986) and would later likely have included
lion (plus assumed debt), and the battle for control took the 1989 takeover of RJR Nabisco), highly leveraged
hostile takeovers being pursued increasplace between October and November 1988. KKR would transactions or[44]
ingly
by
KKR.
The split would ultimately prove acrieventually prevail in acquiring RJR Nabisco at $109 per
monious
as
Kohlberg
sued Kravis and Roberts for what
share marking a dramatic increase from the original anhe
alleged
were
improper
business tactics. The case
nouncement that Shearson Lehman Hutton would take
[45]
Instead, Kohlberg chose
was
later
settled
out
of
court.
RJR Nabisco private at $75 per share. A erce series of
to
return
to
his
roots,
acquiring
smaller, middle-market
negotiations and horse-trading ensued which pitted KKR
and
in
1987,
he
would
found a new private
companies
against Shearson Lehman Hutton and later Forstmann
equity
rm
Kohlberg
&
Company
along with his son
Little & Co. Many of the major banking players of the

350

CHAPTER 66. HISTORY OF PRIVATE EQUITY AND VENTURE CAPITAL

James A. Kohlberg, at the time a KKR executive. Jerome

Kohlberg would continue investing successfully for another seven years before retiring from Kohlberg & Company in 1994 and turning his rm over to his son.[46]

his department. Giuliani began seriously considering indicting Drexel under the powerful Racketeer Inuenced
and Corrupt Organizations Act (RICO), under the doctrine that companies are responsible for an employees
[48]
As the market reached its peak in 1988 and 1989, new crimes.
private equity rms were founded which would emerge as The threat of a RICO indictment, which would have remajor investors in the years to follow, including: ABRY quired the rm to put up a performance bond of as much
Partners, Coller Capital, Landmark Partners, Leonard as $1 billion in lieu of having its assets frozen, unnerved
Green & Partners and Providence Equity Partners.
many at Drexel. Most of Drexels capital was borrowed
money, as is common with most investment banks and
it is dicult to receive credit for rms under a RICO
indictment.[48] Drexels CEO, Fred Joseph said that he
66.6 LBO bust (19901992)
had been told that if Drexel were indicted under RICO,
it would only survive a month at most.[49]
Main article: Private equity in the 1990s
With literally minutes to go before being indicted, Drexel
reached an agreement with the government in which it
By the end of the 1980s the excesses of the buyout mar- pleaded nolo contendere (no contest) to six felonies
ket were beginning to show, with the bankruptcy of sev- three counts of stock parking and three counts of stock
eral large buyouts including Robert Campeau's 1988 buy- manipulation.[48] It also agreed to pay a ne of $650 milout of Federated Department Stores, the 1986 buyout of lion at the time, the largest ne ever levied under secuthe Revco drug stores, Walter Industries, FEB Trucking rities laws. Milken left the rm after his own indictment
and Eaton Leonard. Additionally, the RJR Nabisco deal in March 1989.[49][50] Eectively, Drexel was now a conwas showing signs of strain, leading to a recapitalization victed felon.
in 1990 that involved the contribution of $1.7 billion of
In April 1989, Drexel settled with the SEC, agreeing to
new equity from KKR.[47] Additionally, in response to the
stricter safeguards on its oversight procedures. Later that
threat of unwelcome LBOs, certain companies adopted
month, the rm eliminated 5,000 jobs by shuttering three
a number of techniques, such as the poison pill, to prodepartments including the retail brokerage operation.
tect them against hostile takeovers by eectively selfdestructing the company if it were to be taken over (these Meanwhile, the high-yield debt markets had begun to shut
down in 1989, a slowdown that accelerated into 1990. On
practices are increasingly discredited).
February 13, 1990 after being advised by United States
Secretary of the Treasury Nicholas F. Brady, the U.S. Se66.6.1 The collapse of Drexel Burnham curities and Exchange Commission (SEC), the New York
Stock Exchange (NYSE) and the Federal Reserve SysLambert
tem, Drexel Burnham Lambert ocially led for Chapter
11 bankruptcy protection.[49]
Drexel Burnham Lambert was the investment bank most
responsible for the boom in private equity during the
1980s due to its leadership in the issuance of high-yield
66.6.2 S&L and the shutdown of the Junk
debt. The rm was rst rocked by scandal on May
Bond Market
12, 1986, when Dennis Levine, a Drexel managing director and investment banker, was charged with insider
trading. Levine pleaded guilty to four felonies, and In the 1980s, the boom in private equity transactions,
implicated one of his recent partners, arbitrageur Ivan specically leveraged buyouts, was driven by the availBoesky. Largely based on information Boesky promised ability of nancing, particularly high-yield debt, also
to provide about his dealings with Milken, the Securities known as "junk bonds". The collapse of the high yield
and Exchange Commission initiated an investigation of market in 1989 and 1990 would signal the end of the LBO
Drexel on November 17. Two days later, Rudy Giuliani, boom. At that time, many market observers were prothe United States Attorney for the Southern District of nouncing the junk bond market nished. This collapse
would be due largely to three factors:
New York, launched his own investigation.[48]
For two years, Drexel steadfastly denied any wrongdoing,
claiming that the criminal and SEC cases were based almost entirely on the statements of an admitted felon looking to reduce his sentence. However, it was not enough
to keep the SEC from suing Drexel in September 1988
for insider trading, stock manipulation, defrauding its
clients and stock parking (buying stocks for the benet
of another). All of the transactions involved Milken and

The collapse of Drexel Burnham Lambert, the foremost underwriter of junk bonds (discussed above).
The dramatic increase in default rates among junk
bond issuing companies. The historical default rate
for high yield bonds from 1978 to 1988 was approximately 2.2% of total issuance. In 1989, defaults

66.7. THE SECOND PRIVATE EQUITY BOOM AND THE ORIGINS OF MODERN PRIVATE EQUITY
increased dramatically to 4.3% of the then $190 billion market and an additional 2.6% of issuance defaulted in the rst half of 1990. As a result of the
higher perceived risk, the dierential in yield of the
junk bond market over U.S. treasuries (known as the
"spread") had also increased by 700 basis points (7
percentage points). This made the cost of debt in
the high yield market signicantly more expensive
than it had been previously.[51][52] The market shut
down altogether for lower rated issuers.
The mandated withdrawal of savings and loans from
the high yield market. In August 1989, the U.S.
Congress enacted the Financial Institutions Reform,
Recovery and Enforcement Act of 1989 as a response to the savings and loan crisis of the 1980s.
Under the law, savings and loans (S&Ls) could
no longer invest in bonds that were rated below
investment grade. Additionally, S&Ls were mandated to sell their holdings by the end of 1993 creating a huge supply of low priced assets that helped
freeze the new issuance market.

351

and respectability. Although in the 1980s, many of the

acquisitions made were unsolicited and unwelcome, private equity rms in the 1990s focused on making buyouts attractive propositions for management and shareholders. According to The Economist, [B]ig companies
that would once have turned up their noses at an approach
from a private-equity rm are now pleased to do business
with them.[3] Additionally, private equity investors became increasingly focused on the long term development
of companies they acquired, using less leverage in the acquisition. In the 1980s leverage would routinely represent 85% to 95% of the purchase price of a company as
compared to average debt levels between 20% and 40%
in leveraged buyouts in the 1990s and the rst decade of
the 21st century. KKR's 1986 acquisition of Safeway,
for example, was completed with 97% leverage and 3%
equity contributed by KKR, whereas KKRs acquisition
of TXU in 2007 was completed with approximately 19%
equity contributed ($8.5 billion of equity out of a total
purchase price of $45 billion). Additionally, private equity rms are more likely to make investments in capital
expenditures and provide incentives for management to
build long-term value.

The Thomas H. Lee Partners acquisition of Snapple Beverages, in 1992, is often described as the deal that marked
the resurrection of the leveraged buyout after several dormant years.[53] Only eight months after buying the company, Lee took Snapple Beverages public and in 1994,
only two years after the original acquisition, Lee sold the
to Quaker Oats for $1.7 billion. Lee was esti66.7 The second private equity company
mated to have made $900 million for himself and his inboom and the origins of mod- vestors from the sale. Quaker Oats would subsequently
sell the company, which performed poorly under new
ern private equity
management, three years later for only $300 million to
Nelson Peltzs Triarc. As a result of the Snapple deal,
Main article: Private equity in the 1990s
Thomas H. Lee, who had begun investing in private equity in 1974, would nd new prominence in the private
Beginning roughly in 1992, three years after the RJR equity industry and catapult his Boston-based Thomas H.
Nabisco buyout, and continuing through the end of the Lee Partners to the ranks of the largest private equity
decade the private equity industry once again experienced rms.
a tremendous boom, both in venture capital (as will be It was also in this timeframe that the capital markets
discussed below) and leveraged buyouts with the emer- would start to open up again for private equity transacgence of brand name rms managing multi-billion dollar tions. During the 19901993 period, Chemical Bank
sized funds. After declining from 1990 through 1992, the established its position as a key lender to private eqprivate equity industry began to increase in size raising uity rms under the auspices of pioneering investment
approximately $20.8 billion of investor commitments in banker, James B. Lee, Jr. (known as Jimmy Lee, not
1992 and reaching a high-water mark in 2000 of $305.7 related to Thomas H. Lee). By the mid-1990s, under
billion, outpacing the growth of almost every other asset Jimmy Lee, Chemical had established itself as the largest
class.[23]
lender in the nancing of leveraged buyouts. Lee built
a syndicated leveraged nance business and related advisory businesses including the rst dedicated nancial
66.7.1 Resurgence of leveraged buyouts
sponsor coverage group, which covered private equity
rms in much the same way that investment banks had
Private equity in the 1980s was a controversial topic, traditionally covered various industry sectors.[54][55]
commonly associated with corporate raids, hostile
takeovers, asset stripping, layos, plant closings and out- The following year, David Bonderman and James Coulsized prots to investors. As private equity reemerged ter, who had worked for Robert M. Bass during the
in the 1990s it began to earn a new degree of legitimacy 1980s completed a buyout of Continental Airlines in
Despite the adverse market conditions, several of the
largest private equity rms were founded in this period
including: Apollo Management, Madison Dearborn and
TPG Capital.

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CHAPTER 66. HISTORY OF PRIVATE EQUITY AND VENTURE CAPITAL

1993, through their nascent Texas Pacic Group, (today

TPG Capital). TPG was virtually alone in its conviction
that there was an investment opportunity with the airline. The plan included bringing in a new management
team, improving aircraft utilization and focusing on lucrative routes. By 1998, TPG had generated an annual
internal rate of return of 55% on its investment. Unlike
Carl Icahn's hostile takeover of TWA in 1985.,[32] Bonderman and Texas Pacic Group were widely hailed as
saviors of the airline, marking the change in tone from
the 1980s. The buyout of Continental Airlines would be
one of the few successes for the private equity industry
which has suered several major failures, including the
2008 bankruptcies of ATA Airlines, Aloha Airlines and
Eos Airlines.

ultimately generate the venture capital boom of the

1990s. Former Wharton Professor Andrew Metrick
refers to these rst 15 years of the modern venture capital
industry beginning in 1980 as the pre-boom period in
anticipation of the boom that would begin in 1995 and last
through the bursting of the Internet bubble in 2000.[57]

The late 1990s were a boom time for the venture capital, as rms on Sand Hill Road in Menlo Park and
Silicon Valley beneted from a huge surge of interest
in the nascent Internet and other computer technologies. Initial public oerings of stock for technology and
other growth companies were in abundance and venture
rms were reaping large windfalls. Among the highest
prole technology companies with venture capital backing were Amazon.com, America Online, E-bay, Intuit,
Among the most notable buyouts of the mid-to-late 1990s Macromedia, Netscape, Sun Microsystems and Yahoo!.
included: Duane Reade (1990 (1997), Sealy Corporation (1997), KinderCare Learning Centers (1997), J.
Crew (1997), Dominos Pizza (1998), Regal Entertain66.8 The bursting of the Internet
ment Group (1998), Oxford Health Plans (1998) and
Bubble and the private equity
Petco (2000).
As the market for private equity matured, so too did
crash (20002003)
its investor base. The Institutional Limited Partner Association was initially founded as an informal network- Main article: Private equity in the 21st century
ing group for limited partner investors in private equity The Nasdaq crash and technology slump that started
funds in the early 1990s. However the organization would
evolve into an advocacy organization for private equity investors with more than 200 member organizations from
10 countries. As of the end of 2007, ILPA members
had total assets under management in excess of $5 trillion with more than $850 billion of capital commitments
to private equity investments.

66.7.2

The venture capital boom and the

Internet Bubble (19952000)

Main article: Private equity in the 1990s

In the 1980s, FedEx and Apple Inc. were able to grow because of private equity or venture funding, as were Cisco,
Genentech, Microsoft and Avis.[56] However, by the end
of the 1980s, venture capital returns were relatively low,
particularly in comparison with their emerging leveraged
buyout cousins, due in part to the competition for hot
startups, excess supply of IPOs and the inexperience of
many venture capital fund managers. Unlike the leveraged buyout industry, after total capital raised increased
to $3 billion in 1983, growth in the venture capital industry remained limited through the 1980s and the rst half
of the 1990s increasing to just over $4 billion more than
a decade later in 1994.
After a shakeout of venture capital managers, the more
successful rms retrenched, focusing increasingly on improving operations at their portfolio companies rather
than continuously making new investments. Results
would begin to turn very attractive, successful and would

The technology-heavy NASDAQ Composite index peaked at

5,048 in March 2000, reecting the high point of the dot-com
bubble.

in March 2000 shook virtually the entire venture capital

industry as valuations for startup technology companies
collapsed. Over the next two years, many venture rms
had been forced to write-o large proportions of their investments and many funds were signicantly "under water" (the values of the funds investments were below the
amount of capital invested). Venture capital investors
sought to reduce size of commitments they had made
to venture capital funds and in numerous instances, investors sought to unload existing commitments for cents
on the dollar in the secondary market. By mid-2003,
the venture capital industry had shriveled to about half
its 2001 capacity. Nevertheless, PricewaterhouseCoop-

66.9. THE THIRD PRIVATE EQUITY BOOM AND THE GOLDEN AGE OF PRIVATE EQUITY (20032007)

353

ers MoneyTree Survey shows that total venture capital Muse at the end of 2004 and Forstmann Little was unable
investments held steady at 2003 levels through the sec- to raise a new fund. The treasure of the State of Connectiond quarter of 2005.
cut, sued Forstmann Little to return the states $96 million
Although the post-boom years represent just a small frac- investment to that point and to cancel the commitment
[68]
tion of the peak levels of venture investment reached in it made to take its total investment to $200 million.
2000, they still represent an increase over the levels of The humbling of these private equity titans could hardly
investment from 1980 through 1995. As a percentage of have been predicted by their investors in the 1990s and
GDP, venture investment was 0.058% percent in 1994, forced fund investors to conduct due diligence on fund
managers more carefully and include greater controls on
peaked at 1.087% (nearly 19x the 1994 level) in 2000
and ranged from 0.164% to 0.182% in 2003 and 2004. investments in partnership agreements.
The revival of an Internet-driven environment (thanks to
deals such as eBay's purchase of Skype, the News Corporation's purchase of MySpace.com, and the very successful Google.com and Salesforce.com IPOs) have helped
to revive the venture capital environment. However, as a
percentage of the overall private equity market, venture
capital has still not reached its mid-1990s level, let alone
its peak in 2000.

66.8.1

Stagnation in the LBO market

Meanwhile, as the venture sector collapsed, the activity in the leveraged buyout market also declined significantly. Leveraged buyout rms had invested heavily in
the telecommunications sector from 1996 to 2000 and
proted from the boom which suddenly zzled in 2001.
In that year at least 27 major telecommunications companies, (i.e., with $100 million of liabilities or greater) led
for bankruptcy protection. Telecommunications, which
made up a large portion of the overall high yield universe of issuers, dragged down the entire high yield market. Overall corporate default rates surged to levels unseen since the 1990 market collapse rising to 6.3% of
high yield issuance in 2000 and 8.9% of issuance in 2001.
Default rates on junk bonds peaked at 10.7 percent in
January 2002 according to Moodys.[58][59] As a result,
leveraged buyout activity ground to a halt.[60][61] The major collapses of former high-iers including WorldCom,
Adelphia Communications, Global Crossing and Winstar
Communications were among the most notable defaults
in the market. In addition to the high rate of default,
many investors lamented the low recovery rates achieved
through restructuring or bankruptcy.[59]

Deals completed during this period tended to be smaller

and nanced less with high yield debt than in other periods. Private equity rms had to cobble together nancing
made up of bank loans and mezzanine debt, often with
higher equity contributions than had been seen. Private
equity rms beneted from the lower valuation multiples.
As a result, despite the relatively limited activity, those
funds that invested during the adverse market conditions
delivered attractive returns to investors. Meanwhile, in
Europe LBO activity began to increase as the market continued to mature. In 2001, for the rst time, European
buyout activity exceeded US activity with $44 billion of
deals completed in Europe as compared with just $10.7
billion of deals completed in the US. This was a function
of the fact that just six LBOs in excess of $500 million
were completed in 2001, against 27 in 2000.[69]

As investors sought to reduce their exposure to the private

equity asset class, an area of private equity that was increasingly active in these years was the nascent secondary
market for private equity interests. Secondary transaction volume increased from historical levels of 2% or
3% of private equity commitments to 5% of the addressable market in the early years of the new decade.[70][71]
Many of the largest nancial institutions (e.g., Deutsche
Bank, Abbey National, UBS AG) sold portfolios of direct investments and pay-to-play funds portfolios that
were typically used as a means to gain entry to lucrative
leveraged nance and [[mergers and acquisitions]] assignments but had created hundreds of millions of dollars of
losses. Some of the most notable nancial institutions to
complete publicly disclosed secondary transactions during this period include: Chase Capital Partners (2000),
National Westminster Bank (2000), UBS AG (2003),
Deutsche Bank (MidOcean Partners) (2003) Abbey NaAmong the most aected by the bursting of the internet tional (2004) and Bank One (2004).
and telecom bubbles were two of the largest and most active private equity rms of the 1990s: Tom Hicks' Hicks
Muse Tate & Furst and Ted Forstmann's Forstmann Little & Company. These rms were often cited as the high- 66.9 The third private equity boom
est prole private equity casualties, having invested heavand the Golden Age of Private
ily in technology and telecommunications companies.[62]
Hicks Muses reputation and market position were both
Equity (20032007)
damaged by the loss of over $1 billion from minority investments in six telecommunications and 13 Internet companies at the peak of the 1990s stock mar- Main article: Private equity in the 21st century
ket bubble.[63][64][65] Similarly, Forstmann suered major losses from investments in McLeodUSA and XO As 2002 ended and 2003 began, the private equity sector,
Communications.[66][67] Tom Hicks resigned from Hicks had spent the previous three two and a half years reel-

354

CHAPTER 66. HISTORY OF PRIVATE EQUITY AND VENTURE CAPITAL

ing from major losses in telecommunications and technology companies and had been severely constrained by
tight credit markets. As 2003 got underway, private equity began a ve-year resurgence that would ultimately
result in the completion of 13 of the 15 largest leveraged
buyout transactions in history, unprecedented levels of investment activity and investor commitments and a major
expansion and maturation of the leading private equity
rms. An example would be the case of MidOcean Partners (headed by CEO Ted Virtue) which focused on middle market companies. This private equity rm invested
on brands such as Jenny Craig and LegalShield.

66.9.1 Resurgence of the large buyout

Marked by the two-stage buyout of Dex Media at the end
of 2002 and 2003, large multi-billion dollar U.S. buyouts could once again obtain signicant high yield debt nancing and larger transactions could be completed. The
Carlyle Group, Welsh, Carson, Anderson & Stowe, along
with other private investors, led a $7.5 billion buyout of
QwestDex. The buyout was the third largest corporate
buyout since 1989. QwestDexs purchase occurred in two
stages: a $2.75 billion acquisition of assets known as Dex
Media East in November 2002 and a $4.30 billion acquisition of assets known as Dex Media West in 2003. R.
H. Donnelley Corporation acquired Dex Media in 2006.
Shortly after Dex Media, other larger buyouts would be
completed signaling the resurgence in private equity was
underway. The acquisitions included Burger King (by
Bain Capital), Jeerson Smurt (by Madison Dearborn),
Houghton Miin[74][75] (by Bain Capital, the Blackstone
Group and Thomas H. Lee Partners) and TRW Automotive by the Blackstone Group.

The combination of decreasing interest rates, loosening lending standards and regulatory changes for publicly
traded companies would set the stage for the largest boom
private equity had seen. The Sarbanes Oxley legislation,
ocially the Public Company Accounting Reform and
Investor Protection Act, passed in 2002, in the wake of
corporate scandals at Enron, WorldCom, Tyco, Adelphia,
Peregrine Systems and Global Crossing among others,
would create a new regime of rules and regulations for
publicly traded corporations. In addition to the existing In 2006 USA Today reported retrospectively on the refocus on short term earnings rather than long term value vival of private equity:[76]
creation, many public company executives lamented the
extra cost and bureaucracy associated with SarbanesLBOs are back, only they've rebranded themOxley compliance. For the rst time, many large corposelves private equity and vow a happier ending.
rations saw private equity ownership as potentially more
The rms say this time its completely dierent.
attractive than remaining public. Sarbanes-Oxley would
Instead of buying companies and dismantling
have the opposite eect on the venture capital industry.
them, as was their rap in the '80s, private eqThe increased compliance costs would make it nearly imuity rms squeeze more prot out of underpossible for venture capitalists to bring young companies
performing companies.
to the public markets and dramatically reduced the opportunities for exits via IPO. Instead, venture capitalists
But whether todays private equity rms are simhave been forced increasingly to rely on sales to strategic
ply a regurgitation of their counterparts in the
buyers for an exit of their investment.[72]
1980s or a kinder, gentler version, one thing
remains clear: private equity is now enjoying a
Interest rates, which began a major series of decreases
Golden Age. And with returns that triple the
in 2002 would reduce the cost of borrowing and increase
S&P 500, its no wonder they are challenging
the ability of private equity rms to nance large acquisithe public markets for supremacy.
tions. Lower interest rates would encourage investors to
return to relatively dormant high-yield debt and leveraged
loan markets, making debt more readily available to - By 2004 and 2005, major buyouts were once again benance buyouts. Additionally, alternative investments also coming common and market observers were stunned
became increasingly important as investors focused on by the leverage levels and nancing terms obtained by
yields despite increases in risk. This search for higher nancial sponsors in their buyouts. Some of the notable
yielding investments would fuel larger funds, allowing buyouts of this period include: Dollarama (2004), Toys
larger deals, never before thought possible, to become re- R Us (2004), The Hertz Corporation (2005), MetroGoldwyn-Mayer (2005) and SunGard (2005).
ality.
Certain buyouts were completed in 2001 and early 2002,
particularly in Europe where nancing was more readily available. In 2001, for example, BT Group agreed
to sell its international yellow pages directories business
(Yell Group) to Apax Partners and Hicks, Muse, Tate &
Furst for 2.14 billion (approximately $3.5 billion at the
time),[73] making it then the largest non-corporate LBO in
European history. Yell later bought US directories publisher McLeodUSA for about $600 million, and oated
on Londons FTSE in 2003.

66.9.2 Age of the mega-buyout

Main article: Private equity in the 21st century
As 2005 ended and 2006 began, new largest buyout
records were set and surpassed several times with nine of
the top ten buyouts at the end of 2007 having been announced in an 18-month window from the beginning of
2006 through the middle of 2007. Additionally, the buyout boom was not limited to the United States as indus-

66.9. THE THIRD PRIVATE EQUITY BOOM AND THE GOLDEN AGE OF PRIVATE EQUITY (20032007)

355

portunities that private equity rms pursued in the public

markets. These options involved a public listing of either:
A private equity rm (the management company),
which provides shareholders an opportunity to gain
exposure to the management fees and carried interest earned by the investment professionals and managers of the private equity rm. The most notable
example of this public listing was completed by The
Blackstone Group in 2007

David Rubenstein, the head of the Carlyle Group, the largest private equity rm (by investor commitments) during the 200607
buyout boom.[77]

trialized countries in Europe and the Asia-Pacic region

also saw new records set. In 2006, private equity rms
bought 654 U.S. companies for $375 billion, representing
18 times the level of transactions closed in 2003.[78] Additionally, U.S. based private equity rms raised $215.4 billion in investor commitments to 322 funds, surpassing the
previous record set in 2000 by 22% and 33% higher than
the 2005 fundraising total.[79] However, venture capital
funds, which were responsible for much of the fundraising volume in 2000 (the height of the dot-com bubble),
raised only $25.1 billion in 2006, a 2% percent decline
from 2005 and a signicant decline from its peak.[80] The
following year, despite the onset of turmoil in the credit
markets in the summer, saw yet another record year of
fundraising with $302 billion of investor commitments
to 415 funds.[81]
Among the largest buyouts of this period included:
Georgia-Pacic Corp (2005), Albertsons (2006), Equity
Oce Properties (2006 ), Freescale Semiconductor
(2006), GMAC (2006), HCA (2006), Kinder Morgan (2006), Harrahs Entertainment (2006), TDC A/S
(2006), Sabre Holdings (2006), Travelport (2006),
Alliance Boots (2007), Biomet (2007), Chrysler (2007),
First Data (2007) and TXU (2007).

66.9.3

Publicly traded private equity

Although there had previously been certain instances of

publicly traded private equity vehicles, the convergence
of private equity and the public equity markets attracted
signicantly greater attention when several of the largest
private equity rms pursued various options through the
public markets. Taking private equity rms and private
equity funds public appeared an unusual move since private equity funds often buy public companies listed on
exchange and then take them private. Private equity
rms are rarely subject to the quarterly reporting requirements of the public markets and tout this independence
to prospective sellers as a key advantage of going private.
Nevertheless, there are fundamentally two separate op-

A private equity fund or similar investment vehicle,

which allows investors that would otherwise be unable to invest in a traditional private equity limited
partnership to gain exposure to a portfolio of private
equity investments.
In May 2006, Kohlberg Kravis Roberts raised $5 billion
in an initial public oering for a new permanent investment vehicle (KKR Private Equity Investors or KPE) listing it on the Euronext exchange in Amsterdam (ENXTAM: KPE). KKR raised more than three times what
it had expected at the outset as many of the investors
in KPE were hedge funds that sought exposure to private equity but that could not make long term commitments to private equity funds. Because private equity had
been booming in the preceding years, the proposition of
investing in a KKR fund appeared attractive to certain
investors.[82] KPEs rst-day performance was lackluster,
trading down 1.7% and trading volume was limited.[83]
Initially, a handful of other private equity rms, including Blackstone, and hedge funds had planned to follow
KKRs lead but when KPE was increased to $5 billion,
it soaked up all the demand.[84] That, together with the
slump of KPEs shares, caused the other rms to shelve
their plans. KPEs stock declined from an IPO price of
25 per share to 18.16 (a 27% decline) at the end of
2007 and a low of 11.45 (a 54.2% decline) per share
in Q1 2008.[85] KPE disclosed in May 2008 that it had
completed approximately $300 million of secondary sales
of selected limited partnership interests in and undrawn
commitments to certain KKR-managed funds in order to
generate liquidity and repay borrowings.[86]
On March 22, 2007, after nine months of secret preparations, the Blackstone Group led with the SEC[87] to
raise $4 billion in an initial public oering. On June 21,
Blackstone sold a 12.3% stake in its ownership to the public for $4.13 billion in the largest U.S. IPO since 2002.[88]
Traded on the New York Stock Exchange under the ticker
symbol BX, Blackstone priced at $31 per share on June
22, 2007.[89][90]
Less than two weeks after the Blackstone Group IPO, rival rm Kohlberg Kravis Roberts led with the SEC[91]
in July 2007 to raise $1.25 billion by selling an ownership interest in its management company.[92] KKR had
previously listed its KKR Private Equity Investors (KPE)
private equity fund vehicle in 2006. The onset of the

356

CHAPTER 66. HISTORY OF PRIVATE EQUITY AND VENTURE CAPITAL

Allied Capital Corp (NASDAQ:ALD), Ares Capital
Corporation (NASDAQ:ARCC), Gladstone Investment
Corp (NASDAQ:GAIN) and Kohlberg Capital Corp
(NASDAQ:KCAP).

66.9.4 Secondary market and the evolution

of the private equity asset class
Main article: Private equity secondary market
In the wake of the collapse of the equity markets in 2000,
many investors in private equity sought an early exit from
their outstanding commitments.[101] The surge in activity in the secondary market, which had previously been
a relatively small niche of the private equity industry,
credit crunch and the shutdown of the IPO market would
prompted new entrants to the market, however the market
dampen the prospects of obtaining a valuation that would
was still characterized by limited liquidity and distressed
be attractive to KKR and the otation was repeatedly
prices with private equity funds trading at signicant dispostponed.
counts to fair value.
Meanwhile, other private equity investors were seeking
Beginning in 2004 and extending through 2007, the secto realize a portion of the value locked into their rms.
ondary market transformed into a more ecient market
In September 2007, the Carlyle Group sold a 7.5% inin which assets for the rst time traded at or above their
terest in its management company to Mubadala Developestimated fair values and liquidity increased dramatically.
ment Company, which is owned by the Abu Dhabi InvestDuring these years, the secondary market transitioned
ment Authority (ADIA) for $1.35 billion, which valued
from a niche sub-category in which the majority of sellCarlyle at approximately $20 billion.[93] Similarly, in Janers were distressed to an active market with ample supuary 2008, Silver Lake Partners sold a 9.9% stake in its
ply of assets and numerous market participants.[102] By
management company to the California Public Employ2006 active portfolio management had become far more
ees Retirement System (CalPERS) for $275 million.[94]
common in the increasingly developed secondary marAdditionally, Apollo Management completed a private ket and an increasing number of investors had begun to
placement of shares in its management company in July pursue secondary sales to rebalance their private equity
2007. By pursuing a private placement rather than a pub- portfolios. The continued evolution of the private eqlic oering, Apollo would be able to avoid much of the uity secondary market reected the maturation and evopublic scrutiny applied to Blackstone and KKR.[95][96] In lution of the larger private equity industry. Among the
April 2008, Apollo led with the SEC[97] to permit some most notable publicly disclosed secondary transactions
holders of its privately traded stock to sell their shares (it is estimated that over two-thirds of secondary maron the New York Stock Exchange.[98] In April 2004, ket activity is never disclosed publicly): CalPERS (2008),
Apollo raised $930 million for a listed business devel- Ohio Bureau of Workers Compensation (2007), MetLife
opment company, Apollo Investment Corporation (NAS- (2007), Bank of America (2006 and 2007), Mellon FiDAQ: AINV), to invest primarily in middle-market com- nancial Corporation (2006), American Capital Strategies
panies in the form of mezzanine debt and senior secured (2006), JPMorgan Chase, Temasek Holdings, Dresdner
loans, as well as by making direct equity investments in Bank and Dayton Power & Light.
companies. The Company also invests in the securities
of public companies.[99]
Schwarzmans Blackstone Group completed the rst major IPO
of a private equity rm in June 2007.[77]

Historically, in the United States, there had been a group

of publicly traded private equity rms that were registered as business development companies (BDCs) under the Investment Company Act of 1940.[100] Typically, BDCs are structured similar to real estate investment trusts (REITs) in that the BDC structure reduces or eliminates corporate income tax. In return,
REITs are required to distribute 90% of their income,
which may be taxable to its investors. As of the end
of 2007, among the largest BDCs (by market value,
excluding Apollo Investment Corp, discussed earlier)
are: American Capital Strategies (NASDAQ: ACAS),

66.10 The Credit Crunch and

post-modern private equity
(20072008)
Main article: Private equity in the 21st century
In July 2007, turmoil that had been aecting the
mortgage markets, spilled over into the leveraged nance and high-yield debt markets.[103][104] The markets
had been highly robust during the rst six months of

66.11. RESPONSES TO PRIVATE EQUITY

2007, with highly issuer friendly developments including PIK and PIK Toggle (interest is "Payable In Kind)
and covenant light debt widely available to nance large
leveraged buyouts. July and August saw a notable slowdown in issuance levels in the high yield and leveraged
loan markets with only few issuers accessing the market.
Uncertain market conditions led to a signicant widening of yield spreads, which coupled with the typical summer slowdown led to many companies and investment
banks to put their plans to issue debt on hold until the
autumn. However, the expected rebound in the market
after Labor Day 2007 did not materialize and the lack
of market condence prevented deals from pricing. By
the end of September, the full extent of the credit situation became obvious as major lenders including Citigroup
and UBS AG announced major writedowns due to credit
losses. The leveraged nance markets came to a near
standstill.[105] As a result of the sudden change in the market, buyers would begin to withdraw from or renegotiate
the deals completed at the top of the market, most notably in transactions involving: Harman International (announced and withdrawn 2007), Sallie Mae (announced
2007 but withdrawn 2008), Clear Channel Communications (2007) and BCE (2007).
Additionally, the credit crunch has prompted buyout
rms to pursue a new group of transactions in order to
deploy their massive investment funds. These transactions have included Private Investment in Public Equity
(or PIPE) transactions as well as purchases of debt in existing leveraged buyout transactions. Some of the most
notable of these transactions completed in the depths of
the credit crunch include Apollo Managements acquisition of the Citigroup Loan Portfolio (2008) and TPG
Capital's PIPE investment in Washington Mutual (2008).
According to investors and fund managers, the consensus
among industry members in late 2009 was that private
equity rms will need to become more like asset managers, oering buyouts as just part of their portfolio, or
else focus tightly on specic sectors in order to prosper.
The industry must also become better in adding value
by turning businesses around rather than pure nancial
engineering.[106]

66.11 Responses to private equity

66.11.1

1980s reections of private equity

Although private equity rarely received a thorough treatment in popular culture, several lms did feature stereotypical corporate raiders prominently. Among the most
notable examples of private equity featured in motion pictures included:
Wall Street (1987) The notorious corporate
raider and greenmailer Gordon Gekko, representing a synthesis of the worst features of various

357
famous private equity gures, intends to manipulate
an ambitious young stockbroker to take over a failing but decent airline. Although Gekko makes a pretense of caring about the airline, his intentions prove
to be to destroy the airline, strip its assets and lay o
its employees before raiding the corporate pension
fund. Gekko would become a symbol in popular
culture for unrestrained greed (with the signature
line, Greed, for lack of a better word, is good) that
would be attached to the private equity industry.
Other Peoples Money (1991) A self-absorbed corporate raider Larry the Liquidator (Danny DeVito), sets his sights on New England Wire and Cable, a small-town business run by family patriarch
Gregory Peck who is principally interested in protecting his employees and the town.
Pretty Woman (1990) Although Richard Gere's
profession is incidental to the plot, the selection of
the corporate raider who intends to destroy the hard
work of a family-run business by acquiring the company in a hostile takeover and then selling o the
companys parts for a prot (compared in the movie
to an illegal chop shop). Ultimately, the corporate
raider is won over and chooses not to pursue his original plans for the company.
Two other works were pivotal in framing the image of
buyout rms.[107] Barbarians at the Gate, the 1990 best
seller about the ght over RJR Nabisco linked private
equity to hostile takeovers and assaults on management.
A blistering story on the front page of the Wall Street
Journal the same year about KKRs buyout of the Safeway supermarket chain painted a much more damaging
picture.[108] The piece, which later won a Pulitzer Prize,
began with the suicide of a Safeway worker in Texas who
had been laid o and went on to chronicle how KKR had
sold o hundreds of stores after the buyout and slashed
jobs.

66.11.2 Contemporary reections of private equity and private equity controversies

Carlyle group featured prominently in Michael Moores
2003 lm Fahrenheit 9-11. The lm suggested that The
Carlyle Group exerted tremendous inuence on U.S. government policy and contracts through their relationship
with the presidents father, George H. W. Bush, a former
senior adviser to the Carlyle Group. Additionally, Moore
cited relationships with the Bin Laden family. The movie
quotes author Dan Briody claiming that the Carlyle Group
gained from September 11 because it owned United
Defense, a military contractor, although the rms $11
billion Crusader artillery rocket system developed for the
U.S. Army is one of the few weapons systems canceled
by the Bush administration.[109]

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CHAPTER 66. HISTORY OF PRIVATE EQUITY AND VENTURE CAPITAL

Over the next few years, attention intensied on private

equity as the size of transactions and prole of the companies increased. The attention would increase signicantly following a series of events involving The Blackstone Group: the rms initial public oering and the
birthday celebration of its CEO. The Wall Street Journal
observing Blackstone Groups Steve Schwarzman's 60th
birthday celebration in February 2007 described the event
as follows:[110]
The Armorys entrance hung with banners
painted to replicate Mr. Schwarzmans sprawling Park Avenue apartment. A brass band
and children clad in military uniforms ushered
in guests. A huge portrait of Mr. Schwarzman, which usually hangs in his living room,
was shipped in for the occasion. The aair
was emceed by comedian Martin Short. Rod
Stewart performed. Composer Marvin Hamlisch did a number from A Chorus Line.
Singer Patti LaBelle led the Abyssinian Baptist Church choir in a tune about Mr. Schwarzman. Attendees included Colin Powell and
New York Mayor Michael Bloomberg. The
menu included lobster, baked Alaska and a
2004 Maison Louis Jadot Chassagne Montrachet, among other ne wines.
Schwarzman received a severe backlash from both critics of the private equity industry and fellow investors in
private equity. The lavish event which reminded many
of the excesses of notorious executives including Bernie
Ebbers (WorldCom) and Dennis Kozlowski (Tyco International). David Bonderman, the founder of TPG Capital remarked, We have all wanted to be private at least
until now. When Steve Schwarzmans biography with all
the dollar signs is posted on the web site none of us will
like the furor that results and thats even if you like Rod
Stewart.[110] As the IPO drew closer, there were moves
by a number of congressman and senators to block the
stock oering and to raise taxes on private equity rms
and/or their partnersproposals many attributed in part
to the extravagance of the party.[111]
David Rubenstein's fears would be conrmed when
in 2007, the Service Employees International Union
launched a campaign against private equity rms,
specically the largest buyout rms through public events, protests as well as leaeting and web
campaigns.[112][113][114] A number of leading private equity executives were targeted by the union members[115]
however the SEIUs campaign was non nearly as eective
at slowing the buyout boom as the credit crunch of 2007
and 2008 would ultimately prove to be.
In 2008, the SEIU would shift part of its focus from
attacking private equity rms directly toward the highlighting the role of sovereign wealth funds in private equity. The SEIU pushed legislation in California that

would disallow investments by state agencies (particularly CalPERS and CalSTRS) in rms with ties to certain sovereign wealth funds.[116] Additionally, the SEIU
has attempted to criticize the treatment of taxation of
carried interest. The SEIU, and other critics, point out
that many wealthy private equity investors pay taxes at
lower rates (because the majority of their income is derived from carried interest, payments received from the
prots on a private equity fund's investments) than many
of the rank and le employees of a private equity rms
portfolio companies.[117]

66.12 See also

Private equity rms (category)
Venture capital rms (category)
Private equity and venture capital investors (category)
Financial sponsor
Private equity rm
Private equity fund
Private equity secondary market
Mezzanine capital
Private investment in public equity
Taxation of Private Equity and Hedge Funds
Investment banking
Mergers and acquisitions
Business Development Company

66.13 Notes
[1] Wilson, John. The New Ventures, Inside the High Stakes
World of Venture Capital.
[2] WGBH Public Broadcasting Service, Who made
America?"-Georges Doriot
[3] The New Kings of Capitalism, Survey on the Private Equity industry The Economist, November 25, 2004
[4] Joseph W. Bartlett, What Is Venture Capital?"". Vcexperts.com. Retrieved 2012-05-18.
[5] Kirsner, Scott. Venture capitals grandfather. The
Boston Globe, April 6, 2008.
[6] United States. Small Business Administration Investment Division (SBIC)". Sba.gov. Retrieved 2012-05-18.

66.13. NOTES

[7] The Future of Securities Regulation speech by Brian

G. Cartwright, General Counsel U.S. Securities and Exchange Commission. University of Pennsylvania Law
School Institute for Law and Economics Philadelphia,
Pennsylvania. October 24, 2007.
[8] Draper Investment Company History Retrieved, July
2010
[9] In 1971, a series of articles entitled Silicon Valley USA
were published in the Electronic News, a weekly trade
publication, giving rise to the use of the term Silicon Valley.
[10] Ocial website of the National Venture Capital Association, the largest trade association for the venture capital
industry.
[11] On January 21, 1955, McLean Industries, Inc. purchased
the capital stock of Pan Atlantic Steamship Corporation
and Gulf Florida Terminal Company, Inc. from Waterman Steamship Corporation. In May, McLean Industries,
Inc. completed the acquisition of the common stock of
Waterman Steamship Corporation from its founders and
other stockholders.
[12] Marc Levinson, The Box: How the Shipping Container
Made the World Smaller and the World Economy Bigger,
pp. 4447 (Princeton Univ. Press 2006). The details of
this transaction are set out in ICC Case No. MC-F-5976,
McLean Trucking Company and Pan-Atlantic American
Steamship CorporationInvestigation of Control, July 8,
1957.

359

[22] Taylor, Alexander L. "Boom Time in Venture Capital".

TIME magazine, Aug. 10, 1981.
[23] Source: Thomson Financial's VentureXpert database for
Commitments. Searching All Private Equity Funds
(Venture Capital, Buyout and Mezzanine).
[24] Taylor, Alexander L. "Buyout Binge". TIME magazine,
Jul. 16, 1984.
[25] King of Capital, pp. 1516
[26] Opler, T. and Titman, S. The determinants of leveraged
buyout activity: Free cash ow vs. nancial distress costs.
Journal of Finance, 1993.
[27] POLLACK, ANDREW. "Venture Capital Loses Its
Vigor. New York Times, October 8, 1989.
[28] Kurtzman, Joel. "PROSPECTS; Venture Capital. New
York Times, March 27, 1988.
[29] LUECK, THOMAS J. "HIGH TECH'S GLAMOUR
FADES FOR SOME VENTURE CAPITALISTS . New
York Times, February 6, 1987.
[30] Norris, Floyd "Market Place; Buyout of Prime Computer
Limps Toward Completion. New York Times, August
12, 1992
[31] King of Capital, pp. 3644
[32] 10 Questions for Carl Icahn by Barbara Kiviat, TIME
magazine, Feb. 15, 2007

[13] Trehan, R. (2006). The History Of Leveraged Buyouts.

December 4, 2006. Accessed May 22, 2008

[33] TWA Death Of A Legend by Elaine X. Grant, St Louis

Magazine, Oct 2005

[14] The History of Private Equity (Investment U, The Oxford

Club

[34] GREENWALD, JOHN. High Times for T. Boone Pickens. Time magazine, March 4, 1985

[15] Barbarians at the Gate, p. 133-136

[35] Bruck, Connie. Predators Ball. New York: Simon and

Schuster, 1988. p.117 118

[16] In 1976, Kravis was forced to serve as interim CEO of a

failing direct mail company Advo.
[17] Refers to Henry Hillman and the Hillman Company. The
Hillman Company (Answers.com prole)
[18] Barbarians at the Gate, p. 136-140
[19] David Carey and John E. Morris, King of Capital The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman
and Blackstone (Crown 2010), pp. 1314
[20] Saunders, Laura. How The Government Subsidizes
Leveraged Takeovers. Forbes, November 28, 1988.
[21] The prudent man rule is a duciary responsibility of investment managers under ERISA. Under the original application, each investment was expected to adhere to risk
standards on its own merits, limiting the ability of investment managers to make any investments deemed potentially risky. Under the revised 1978 interpretation, the
concept of portfolio diversication of risk, measuring risk
at the aggregate portfolio level rather than the investment
level to satisfy duciary standards would also be accepted.

[36] Hack, Richard (1996). When Money Is King. Beverly

Hills, CA: Dove Books. p. 13. ISBN 0-7871-1033-7.
[37] Stevenson, Richard (1985-11-05). Pantry Pride Control
of Revlon Board Seen Near. New York Times. p. D5.
[38] Hagedom, Ann (1987-03-09). Possible Revlon Buyout
May Be Sign Of a Bigger Perelman Move in Works. Wall
Street Journal. p. 1.
[39] Gale Group (2005). Revlon Reports First Protable
Quarter in Six Years. Business Wire. Retrieved 200702-07.
[40] Cotten Timberlake and Shobhana Chandra (2005).
Revlon prot rst in more than 6 years. Bloomberg Publishing. Retrieved 2007-03-20.
[41] MacAndrews & Forbes Holdings Inc.. Funding Universe. Retrieved 2008-05-16.
[42] Game of Greed (TIME magazine, 1988)
[43] King of Capital, pp. 9799

360

CHAPTER 66. HISTORY OF PRIVATE EQUITY AND VENTURE CAPITAL

[44] STERNGOLD, JAMES. "BUYOUT PIONEER QUITTING FRAY. New York Times, June 19, 1987.
[45] BARTLETT, SARAH. "Kohlberg In Dispute Over Firm.
New York Times, August 30, 1989
[46] ANTILLA, SUSAN. "Wall Street; A Scion of the L.B.O.
Reects. New York Times, April 24, 1994
[47] Wallace, Anise C. "Nabisco Renance Plan Set. The
New York Times, July 16, 1990.
[48] Stone, Dan G. (1990). April Fools: An Insiders Account
of the Rise and Collapse of Drexel Burnham. New York
City: Donald I. Fine. ISBN 1556112289.
[49] Den of Thieves. Stewart, J. B. New York: Simon & Schuster, 1991. ISBN 0-671-63802-5.
[50] New Street Capital Inc. Company Prole, Information,
Business Description, History, Background Information
on New Street Capital Inc at ReferenceForBusiness.com
[51] Altman, Edward I. "THE HIGH YIELD BOND MARKET: A DECADE OF ASSESSMENT, COMPARING
1990 WITH 2000. NYU Stern School of Business, 2000
[52] HYLTON, RICHARD D. Corporate Bond Defaults Up
Sharply in '89 New York Times, January 11, 1990.
[53] Thomas H. Lee In Snapple Deal (The New York Times,
1992)

[66] Sorkin, Andrew Ross. "Business; Will He Be K.O.'d

by XO? Forstmann Enters the Ring, Again. New York
Times, February 24, 2002.
[67] Sorkin, Andrew Ross. "Defending a Colossal Flop, in His
Own Way. New York Times, June 6, 2004.
[68] "Connecticut Sues Forstmann Little Over Investments.
New York Times, February 26, 2002.
[69] Almond, Siobhan. "European LBOs: Breakin' away.
TheDeal.com, January 24, 2002
[70] Vaughn, Hope and Barrett, Ross. Secondary Private Equity Funds: The Perfect Storm: An Opportunity in Adversity. Columbia Strategy, 2003.
[71] Rossa, Jennifer and White, Chad. Dow Jones Private Equity Analyst Guide to the Secondary Market (2007 Edition).
[72] Anderson, Jenny. "Sharply Divided Reactions to Report
on U.S. Markets. New York Times, December 1, 2006.
[73] Yell.com History 2000+". Yell.com. Archived from
the original on 2007-12-10. Retrieved 2008-01-11.
[74] SUZANNE KAPNER AND ANDREW ROSS
SORKIN. "Market Place; Vivendi Is Said To Be Near
Sale Of Houghton. New York Times, October 31, 2002

[54] Jimmy Lees Global Chase. New York Times, April 14,
1997

[75] "COMPANY NEWS; VIVENDI FINISHES SALE OF

HOUGHTON MIFFLIN TO INVESTORS. New York
Times, January 1, 2003.

[55] Kingpin of the Big-Time Loan. New York Times, August

11, 1995

[76] Krantz, Matt. Private equity rms spin o cash USA Today, March 16, 2006.

[56] Private Equity: Past, Present, Future, by Sethi, Arjun May

2007, accessed October 20, 2007.

[77] Photographed at the World Economic Forum in Davos,

Switzerland in January 2008.

[57] Metrick, Andrew. Venture Capital and the Finance of Innovation. John Wiley & Sons, 2007. p.12

[78] Samuelson, Robert J. "The Private Equity Boom". The

Washington Post, March 15, 2007.

[58] BERENSON, ALEX. "Markets & Investing; Junk Bonds

Still Have Fans Despite a Dismal Showing in 2001.
[[New York Times]], January 2, 2002.

[79] Dow Jones Private Equity Analyst as referenced in U.S.

private-equity funds break record Associated Press, January 11, 2007.

[59] SMITH, ELIZABETH REED. "Investing; Time to Jump

Back Into Junk Bonds?. New York Times, September 1,
2002.

[80] Dow Jones Private Equity Analyst as referenced in Taub,

Stephen. Record Year for Private Equity Fundraising.
CFO.com, January 11, 2007.

[60] Berry, Kate. "Converging Forces Have Kept Junk Bonds

in a Slump. New York Times, July 9, 2000.

[81] Dow Jones Private Equity Analyst as referenced in Private

equity fund raising up in 2007: report, Reuters, January
8, 2008.

[61] Romero, Simon. "Technology & Media; Telecommunications Industry Too Devastated Even for Vultures. New
York Times, December 17, 2001.
[62] Atlas, Riva D. "Even the Smartest Money Can Slip Up.
New York Times, December 30, 2001

[82] Timmons, Heather. "Opening Private Equitys Door, at

Least a Crack, to Public Investors. New York Times,
May 4, 2006.

[63] Will He Star Again In a Buyout Revival (New York Times,

2003)

[83] Timmons, Heather. "Private Equity Goes Public for $5

Billion. Its Investors Ask, Whats Next?. New York
Times, November 10, 2006.

[64] Forbes Faces: Thomas O. Hicks (Forbes, 2001)

[84] King of Capital, pp. 218223

[65] An LBO Giant Goes Back to Basics (BusinessWeek,

2002)

[85] Anderson, Jenny. "Where Private Equity Goes, Hedge

Funds May Follow. New York Times, June 23, 2006.

66.14. REFERENCES

361

[86] Press Release: KKR Private Equity Investors Reports Re- [105]
sults for Quarter Ended March 31, 2008, May 7, 2008
[106]
[87] The Blackstone Group L.P., FORM S-1, SECURITIES
AND EXCHANGE COMMISSION, March 22, 2007
[107]
[88] King of Capital, pp. 255277
[108]
[89] SORKIN, ANDREW ROSS and DE LA MERCED,
MICHAEL J. "News Analysis Behind the Veil at Blackstone? Probably Another Veil. New York Times, March
[109]
19, 2007.

Turmoil in the marketsThe Economist July 27, 2007

Opalesque (19 November 2009). PE rms mull future as
asset managers.
King of Capital, pp. 98100
Susan Faludi, The Reckoning: Safeway LBO Yields Vast
Prots but Exacts a Heavy Human Toll, Wall Street Journal, May 16, 1990, p. A1
Pratley, Nils. Fahrenheit 9/11 had no eect, says Carlyle
chief, The Guardian, February 15, 2005.

[90] Anderson, Jenny. "Blackstone Founders Prepare to Count

[110] Sender, Henny and Langley, Monica. "Buyout Mogul:
Their Billions. New York Times, June 12, 2007.
How Blackstones Chief Became $7 Billion Man
Schwarzman Says Hes Worth Every Penny; $400 for
[91] KKR & CO. L.P., FORM S-1, SECURITIES AND EXStone Crabs. The Wall Street Journal, June 13, 2007.
CHANGE COMMISSION, July 3, 2007
[92] JENNY ANDERSON and MICHAEL J. de la MERCED. [111] King of Capital, pp. 271276
"Kohlberg Kravis Plans to Go Public. New York Times,
[112] Sorkin, Andrew Ross. "Sound and Fury Over Private EqJuly 4, 2007.
uity. The New York Times, May 20, 2007.
[93] Sorkin, Andrew Ross. "Carlyle to Sell Stake to a Mideast
[113] Heath, Thomas. "Ambushing Private Equity: As SEIU
Government. New York Times, September 21, 2007.
Harries New Absentee Owners, Buyout Firms Dispute the
Unions Agenda" The Washington Post, April 18, 2008
[94] Sorkin, Andrew Ross. "California Pension Fund Expected to Take Big Stake in Silver Lake, at $275 Million.
[114] Service Employees International Unions "Behind the
New York Times, January 9, 2008
Buyouts" website
[95] SORKIN, ANDREW ROSS and de la MERCED, [115] DiStefano, Joseph N. Hecklers delay speech; Carlyle CEO
MICHAEL J. "Buyout Firm Said to Seek a Private Market
notes private-equity purgatory The Philadelphia Inquirer,
Oering. New York Times, July 18, 2007.
Jan. 18, 2008.
[96] SORKIN, ANDREW ROSS. "Equity Firm Is Seen Ready [116] Californias Stern Rebuke. The Wall Street Journal, April
to Sell a Stake to Investors . New York Times, April 5,
21, 2008; Page A16.
2007.
[117] Protesting a Private Equity Firm (With Piles of Money)
[97] APOLLO GLOBAL MANAGEMENT, LLC, FORM SThe New York Times, October 10, 2007.
1, SECURITIES AND EXCHANGE COMMISSION,
April 8, 2008
[98] de la MERCED, MICHAEL J. "Apollo Struggles to Keep
Debt From Sinking Linens n Things. New York Times,
April 14, 2008.
[99] FABRIKANT, GERALDINE. "Private Firms Use
Closed-End Funds To Tap the Market. New York
Times, April 17, 2004.
[100] Companies must elect to be treated as a business development company under the terms of the Investment
Company Act of 1940 (Investment Company Act of 1940:
Section 54 Election to Be Regulated as Business Development Company)
[101] Cortese, Amy. "Business; Private Traders See Gold in
Venture Capital Ruins. New York Times, April 15, 2001.

66.14 References
Anders, George. Merchants of Debt: KKR and
the Mortgaging of American Business. Washington,
D.C.: Beard Books, 2002 (originally published by
Basic Books in 1992)
Ante, Spencer. Creative capital : Georges Doriot and
the birth of venture capital. Boston: Harvard Business School Press, 2008
Bance, A. (2004). Why and how to invest in private
equity. European Private Equity and Venture Capital Association (EVCA). Accessed May 22, 2008.

[102] Private Equity Market Environment: Spring 2004, Probitas Partners

Bruck, Connie. Predators Ball. New York: Simon

and Schuster, 1988.

[103] SORKIN, ANDREW ROSS and de la MERCED,

MICHAEL J. "Private Equity Investors Hint at Cool
Down. New York Times, June 26, 2007

Burrill, G. Steven, and Craig T. Norback. The

Arthur Young Guide to Raising Venture Capital.
Billings, MT: Liberty House, 1988.

[104] SORKIN, ANDREW ROSS. "Sorting Through the Buyout Freezeout. New York Times, August 12, 2007.

Burrough, Bryan. Barbarians at the Gate. New York

: Harper & Row, 1990.

362

CHAPTER 66. HISTORY OF PRIVATE EQUITY AND VENTURE CAPITAL

Carey, David and Morris, John E. King of Capital:

The Remarkable Rise, Fall and Rise Again of Steve
Schwarzman and Blackstone. New York: Crown
Business, 2010
Craig. Valentine V. Merchant Banking: Past and
Present. FDIC Banking Review. 2000.
Fenn, George W., Nellie Liang, and Stephen
Prowse. December, 1995. The Economics of the
Private Equity Market. Sta Study 168, Board of
Governors of the Federal Reserve System.
Gibson, Paul. The Art of Getting Funded. Electronic Business, March 1999.
Gladstone, David J. Venture Capital Handbook.
Rev. ed. Englewood Clis, NJ: Prentice Hall, 1988.
Hsu, D., and Kinney, M (2004). Organizing venture
capital: the rise and demise of American Research
and Development Corporation, 19461973. Working paper 163. Accessed May 22, 2008
Littman, Jonathan. The New Face of Venture Capital. Electronic Business, March 1998.
Loewen, J. (2008). Money Magnet: Attract Investors to Your Business: John Wiley & Sons. ISBN
978-0-470-15575-2
Loos, Nicolaus. Value Creation in Leveraged Buyouts. Dissertation of the University of St. Gallen.
Lichtenstein: Guttenberg AG, 2005. Accessed May
22, 2008.
National Venture Capital Association, 2005, The
2005 NVCA Yearbook.
Schell, James M. Private Equity Funds: Business
Structure and Operations. New York: Law Journal
Press, 1999.
Sharabura, Scott. (2002). Private Equity: past,
present, and future. GE Capital Speaker Discusses New Trends in Asset Class. Speech to GSB
2/13/2002. Accessed May 22, 2008.
Trehan, R. (2006). The History Of Leveraged Buyouts. December 4, 2006. Accessed May 22, 2008.
Chens, Brian. "THE ECLIPSE OF PRIVATE
EQUITY". Centre for Business Research, University Of Cambridge, 2007.

Chapter 67

Recession
Not to be confused with Rescission.
gures for real GDP.[6][7] The exact same recession defThis article is about a slowdown in economic activity. inition applies for all member states of the European
For other uses, see Recession (disambiguation).
Union.
In economics, a recession is a business cycle contraction. It is a general slowdown in economic activity.[1][2] 67.2 Attributes
Macroeconomic indicators such as GDP (gross domestic product), investment spending, capacity utilization, A recession has many attributes that can occur simulhousehold income, business prots, and ination fall, taneously and includes declines in component measures
while bankruptcies and the unemployment rate rise.
of economic activity (GDP) such as consumption, inRecessions generally occur when there is a widespread vestment, government spending, and net export activdrop in spending (an adverse demand shock). This may ity. These summary measures reect underlying drivers
be triggered by various events, such as a nancial cri- such as employment levels and skills, household savings
sis, an external trade shock, an adverse supply shock rates, corporate investment decisions, interest rates, deor the bursting of an economic bubble. Governments mographics, and government policies.
usually respond to recessions by adopting expansionary
macroeconomic policies, such as increasing money supply, increasing government spending and decreasing taxation.

67.1 Denition
In a 1975 New York Times article, economic statistician
Julius Shiskin suggested several rules of thumb for dening a recession, one of which was two down consecutive
quarters of GDP.[3] In time, the other rules of thumb were
forgotten. Some economists prefer a denition of a 1.5%
rise in unemployment within 12 months.[4]
In the United States, the Business Cycle Dating Committee of the National Bureau of Economic Research
(NBER) is generally seen as the authority for dating US
recessions. The NBER denes an economic recession as:
a signicant decline in economic activity spread across
the economy, lasting more than a few months, normally
visible in real GDP, real income, employment, industrial
production, and wholesale-retail sales.[5] Almost universally, academics, economists, policy makers, and businesses defer to the determination by the NBER for the
precise dating of a recessions onset and end.

Economist Richard C. Koo wrote that under ideal conditions, a countrys economy should have the household sector as net savers and the corporate sector as net borrowers, with the government budget nearly balanced and net
exports near zero.[8][9] When these relationships become
imbalanced, recession can develop within the country or
create pressure for recession in another country. Policy
responses are often designed to drive the economy back
towards this ideal state of balance.
A severe (GDP down by 10%) or prolonged (three or
four years) recession is referred to as an economic depression, although some argue that their causes and cures
can be dierent.[4] As an informal shorthand, economists
sometimes refer to dierent recession shapes, such as Vshaped, U-shaped, L-shaped and W-shaped recessions.

67.2.1 Type of recession or shape

Main article: Recession shapes

The type and shape of recessions are distinctive. In the

US, V-shaped, or short-and-sharp contractions followed
by rapid and sustained recovery, occurred in 1954 and
199091; U-shaped (prolonged slump) in 197475, and
W-shaped, or double-dip recessions in 1949 and 1980
In the United Kingdom, recessions are generally dened 82. Japans 199394 recession was U-shaped and its 8as two consecutive quarters of negative economic growth, out-of-9 quarters of contraction in 199799 can be deas measured by the seasonal adjusted quarter-on-quarter scribed as L-shaped. Korea, Hong Kong and South-east
363

364

CHAPTER 67. RECESSION

Asia experienced U-shaped recessions in 199798, al- Japanese rms overall became net savers after 1998, as
though Thailands eight consecutive quarters of decline opposed to borrowers. Koo argues that it was massive sshould be termed L-shaped.[10]
cal stimulus (borrowing and spending by the government)
that oset this decline and enabled Japan to maintain its
level of GDP. In his view, this avoided a U.S. type Great
67.2.2 Psychological aspects
Depression, in which U.S. GDP fell by 46%. He argued
that monetary policy was ineective because there was
Recessions have psychological and condence aspects. limited demand for funds while rms paid down their liFor example, if companies expect economic activity to abilities. In a balance sheet recession, GDP declines by
slow, they may reduce employment levels and save money the amount of debt repayment and un-borrowed individrather than invest. Such expectations can create a self- ual savings, leaving government stimulus spending as the
reinforcing downward cycle, bringing about or worsen- primary remedy.[8][9][15][16]
ing a recession.[11] Consumer condence is one measure
Krugman discussed the balance sheet recession concept
used to evaluate economic sentiment.[12] The term animal
during 2010, agreeing with Koos situation assessment
spirits has been used to describe the psychological facand view that sustained decit spending when faced with
tors underlying economic activity. Economist Robert J.
a balance sheet recession would be appropriate. HowShiller wrote that the term "...refers also to the sense of
ever, Krugman argued that monetary policy could also
trust we have in each other, our sense of fairness in ecoaect savings behavior, as ination or credible promises
nomic dealings, and our sense of the extent of corruption
of future ination (generating negative real interest rates)
and bad faith. When animal spirits are on ebb, consumers
would encourage less savings. In other words, people
do not want to spend and businesses do not want to make
would tend to spend more rather than save if they be[13]
capital expenditures or hire people.
lieve ination is on the horizon. In more technical terms,
Krugman argues that the private sector savings curve is
elastic even during a balance sheet recession (responsive
67.2.3 Balance sheet recession
to changes in real interest rates) disagreeing with Koos
view that it is inelastic (non-responsive to changes in real
Main article: Balance sheet recession
interest rates).[17][18]
High levels of indebtedness or the bursting of a real estate or nancial asset price bubble can cause what is called
a balance sheet recession. This is when large numbers
of consumers or corporations pay down debt (i.e., save)
rather than spend or invest, which slows the economy.
The term balance sheet derives from an accounting identity that holds that assets must always equal the sum of
liabilities plus equity. If asset prices fall below the value
of the debt incurred to purchase them, then the equity
must be negative, meaning the consumer or corporation
is insolvent. Economist Paul Krugman wrote in 2014 that
the best working hypothesis seems to be that the nancial
crisis was only one manifestation of a broader problem
of excessive debt--that it was a so-called balance sheet
recession. In Krugmans view, such crises require debt
reduction strategies combined with higher government
spending to oset declines from the private sector as it
pays down its debt.[14]
For example, economist Richard Koo wrote that Japans
Great Recession that began in 1990 was a balance
sheet recession. It was triggered by a collapse in land
and stock prices, which caused Japanese rms to have
negative equity, meaning their assets were worth less than
their liabilities. Despite zero interest rates and expansion
of the money supply to encourage borrowing, Japanese
corporations in aggregate opted to pay down their debts
from their own business earnings rather than borrow to
invest as rms typically do. Corporate investment, a
key demand component of GDP, fell enormously (22%
of GDP) between 1990 and its peak decline in 2003.

A July 2012 survey of balance sheet recession research

reported that consumer demand and employment are affected by household leverage levels. Both durable and
non-durable goods consumption declined as households
moved from low to high leverage with the decline in
property values experienced during the subprime mortgage crisis. Further, reduced consumption due to higher
household leverage can account for a signicant decline
in employment levels. Policies that help reduce mortgage
debt or household leverage could therefore have stimulative eects.[19][20]

67.2.4 Liquidity trap

A liquidity trap is a Keynesian theory that a situation
can develop in which interest rates reach near zero (zero
interest-rate policy) yet do not eectively stimulate the
economy. In theory, near-zero interest rates should encourage rms and consumers to borrow and spend. However, if too many individuals or corporations focus on saving or paying down debt rather than spending, lower interest rates have less eect on investment and consumption behavior; the lower interest rates are like "pushing
on a string. Economist Paul Krugman described the
U.S. 2009 recession and Japans lost decade as liquidity traps. One remedy to a liquidity trap is expanding the money supply via quantitative easing or other
techniques in which money is eectively printed to purchase assets, thereby creating inationary expectations
that cause savers to begin spending again. Government

67.4. GOVERNMENT RESPONSES

stimulus spending and mercantilist policies to stimulate
exports and reduce imports are other techniques to stimulate demand.[21] He estimated in March 2010 that developed countries representing 70% of the worlds GDP
were caught in a liquidity trap.[22]

67.2.5

Paradoxes of thrift and deleveraging

Behavior that may be optimal for an individual (e.g., saving more during adverse economic conditions) can be
detrimental if too many individuals pursue the same behavior, as ultimately one persons consumption is another
persons income. Too many consumers attempting to save
(or pay down debt) simultaneously is called the paradox
of thrift and can cause or deepen a recession. Economist
Hyman Minsky also described a paradox of deleveraging as nancial institutions that have too much leverage
(debt relative to equity) cannot all de-leverage simultaneously without signicant declines in the value of their
assets.[23]
During April 2009, U.S. Federal Reserve Vice Chair
Janet Yellen discussed these paradoxes: Once this
massive credit crunch hit, it didnt take long before we
were in a recession. The recession, in turn, deepened the
credit crunch as demand and employment fell, and credit
losses of nancial institutions surged. Indeed, we have
been in the grips of precisely this adverse feedback loop
for more than a year. A process of balance sheet deleveraging has spread to nearly every corner of the economy.
Consumers are pulling back on purchases, especially on
durable goods, to build their savings. Businesses are cancelling planned investments and laying o workers to preserve cash. And, nancial institutions are shrinking assets
to bolster capital and improve their chances of weathering the current storm. Once again, Minsky understood
this dynamic. He spoke of the paradox of deleveraging,
in which precautions that may be smart for individuals
and rmsand indeed essential to return the economy to
a normal statenevertheless magnify the distress of the
economy as a whole.[23]

365
The three-month change in the unemployment rate
and initial jobless claims.[28]
Index of Leading (Economic) Indicators (includes
some of the above indicators).[29]
Lowering of asset prices, such as homes and nancial assets, or high personal and corporate debt levels.

67.4 Government responses

See also: Stabilization policy
Most mainstream economists believe that recessions are
caused by inadequate aggregate demand in the economy,
and favor the use of expansionary macroeconomic policy during recessions. Strategies favored for moving an
economy out of a recession vary depending on which
economic school the policymakers follow. Monetarists
would favor the use of expansionary monetary policy,
while Keynesian economists may advocate increased
government spending to spark economic growth. Supplyside economists may suggest tax cuts to promote business
capital investment. When interest rates reach the boundary of an interest rate of zero percent (zero interest-rate
policy) conventional monetary policy can no longer be
used and government must use other measures to stimulate recovery. Keynesians argue that scal policy
tax cuts or increased government spendingworks when
monetary policy fails. Spending is more eective because
of its larger multiplier but tax cuts take eect faster.

For example, Paul Krugman wrote in December 2010

that signicant, sustained government spending was necessary because indebted households were paying down
debts and unable to carry the U.S. economy as they had
previously: The root of our current troubles lies in the
debt American families ran up during the Bush-era housing bubble...highly indebted Americans not only cant
spend the way they used to, theyre having to pay down the
debts they ran up in the bubble years. This would be ne
if someone else were taking up the slack. But whats actually happening is that some people are spending much less
67.3 Predictors
while nobody is spending more and this translates into
a depressed economy and high unemployment. What the
There are no known completely reliable predictors, but government should be doing in this situation is spending
more while the private sector is spending less, supporting
the following are considered possible predictors.[24]
employment while those debts are paid down. And this
government spending needs to be sustained...[30]
[25]
Inverted yield curve,
the model developed by
economist Jonathan H. Wright, uses yields on
10-year and three-month Treasury securities as
well as the Feds overnight funds rate.[26] Another 67.5 Stock market
model developed by Federal Reserve Bank of New
York economists uses only the 10-year/three-month Some recessions have been anticipated by stock market
declines. In Stocks for the Long Run, Siegel mentions that
spread. It is, however, not a denite indicator;[27]

366

CHAPTER 67. RECESSION

since 1948, ten recessions were preceded by a stock mar- sequently, modern government administrations attempt
ket decline, by a lead time of 0 to 13 months (average to take steps, also not agreed upon, to soften a recession.
5.7 months), while ten stock market declines of greater
than 10% in the Dow Jones Industrial Average were not
followed by a recession.[31]
67.7 Consequences
The real-estate market also usually weakens before a
recession.[32] However real-estate declines can last much 67.7.1 Unemployment
longer than recessions.[33]
Since the business cycle is very hard to predict, Siegel ar- Unemployment is particularly high during a recesgues that it is not possible to take advantage of economic sion. Many economists working within the neoclassical
cycles for timing investments. Even the National Bureau paradigm argue that there is a natural rate of unemployof Economic Research (NBER) takes a few months to ment which, when subtracted from the actual rate of undetermine if a peak or trough has occurred in the US.[34] employment, can be used to calculate the negative GDP
gap during a recession. In other words, unemployment
During an economic decline, high yield stocks such as never reaches 0 percent, and thus is not a negative indicafast moving consumer goods, pharmaceuticals, and to- tor of the health of an economy unless above the natural
bacco tend to hold up better.[35] However when the econ- rate, in which case it corresponds directly to a loss in
omy starts to recover and the bottom of the market has gross domestic product, or GDP.[43]
passed (sometimes identied on charts as a MACD[36] ),
growth stocks tend to recover faster. There is signicant The full impact of a recession on employment may not
disagreement about how health care and utilities tend to be felt for several quarters. Research in Britain shows
recover.[37] Diversifying ones portfolio into international that low-skilled, low-educated workers and the young are
[44]
stocks may provide some safety; however, economies that most vulnerable to unemployment in a downturn. Afare closely correlated with that of the U.S. may also be ter recessions in Britain in the 1980s and 1990s, it took
ve years for unemployment to fall back to its original
aected by a recession in the U.S.[38]
levels.[45] Many companies often expect employment disThere is a view termed the halfway rule[39] according to crimination claims to rise during a recession.[46]
which investors start discounting an economic recovery
about halfway through a recession. In the 16 U.S. recessions since 1919, the average length has been 13 months, 67.7.2 Business
although the recent recessions have been shorter. Thus if
the 2008 recession followed the average, the downturn in Productivity tends to fall in the early stages of a recession,
the stock market would have bottomed around November then rises again as weaker rms close. The variation in
2008. The actual US stock market bottom of the 2008 re- protability between rms rises sharply. Recessions have
cession was in March 2009.
also provided opportunities for anti-competitive mergers,
with a negative impact on the wider economy: the suspension of competition policy in the United States in the
1930s may have extended the Great Depression.[45]

67.6 Politics

Generally an administration gets credit or blame for the

state of economy during its time.[40] This has caused disagreements about when a recession actually started.[41] In
an economic cycle, a downturn can be considered a consequence of an expansion reaching an unsustainable state,
and is corrected by a brief decline. Thus it is not easy to
isolate the causes of specic phases of the cycle.

67.7.3 Social eects

The living standards of people dependent on wages and
salaries are more aected by recessions than those who
rely on xed incomes or welfare benets. The loss of a
job is known to have a negative impact on the stability of
families, and individuals health and well-being.[45]

The 1981 recession is thought to have been caused by the

tight-money policy adopted by Paul Volcker, chairman of
67.8 History
the Federal Reserve Board, before Ronald Reagan took
oce. Reagan supported that policy. Economist Walter
Heller, chairman of the Council of Economic Advisers 67.8.1 Global
in the 1960s, said that I call it a Reagan-Volcker-Carter
recession.[42] The resulting taming of ination did, how- Main article: Global recession
ever, set the stage for a robust growth period during Reagans administration.
According to the International Monetary Fund (IMF),
Economists usually teach that to some degree recession is Global recessions seem to occur over a cycle lasting beunavoidable, and its causes are not well understood. Con- tween eight and 10 years.[47] The IMF takes many factors

67.8. HISTORY
into account when dening a global recession. Until April
2009, IMF several times communicated to the press, that
a global annual real GDP growth of 3.0 percent or less in
their view was "...equivalent to a global recession.[48][49]
By this measure, six periods since 1970 qualify: 1974
1975,[50] 19801983,[50] 19901993,[50][51] 1998,[50][51]
20012002,[50][51] and 20082009.[52] During what IMF
in April 2002 termed the past three global recessions of
the last three decades, global per capita output growth was
zero or negative, and IMF arguedat that timethat because of the opposite being found for 2001, the economic
state in this year by itself did not qualify as a global recession.[47]
In April 2009, IMF changed their Global recession denition to:

367
December 2007 June 2009: 18 months[56][57]
For the past three recessions, the NBER decision has approximately conformed with the denition involving two
consecutive quarters of decline. While the 2001 recession did not involve two consecutive quarters of decline,
it was preceded by two quarters of alternating decline and
weak growth.[55]

67.8.4 Late 2000s

Main article: Great Recession

Ocial economic data shows that a substantial number

2009. The US
A decline in annual percapita real World GDP (pur- of nations were in recession as of early
[58]
entered
a
recession
at
the
end
of
2007,
and 2008 saw
chasing power parity weighted), backed up by a demany
other
nations
follow
suit.
The
US
recession
of 2007
cline or worsening for one or more of the seven other
[59]
ended
in
June
2009
as
the
nation
entered
the
current
global macroeconomic indicators: Industrial produceconomic
recovery.
tion, trade, capital ows, oil consumption, unemployment rate, percapita investment, and percapita consumption.[53][54]
United States

By this new denition, a total of four global recessions

took place since World War II: 1975, 1982, 1991 and
2009. All of them only lasted one year, although the
third would have lasted three years (199193) if IMF
as criteria had used the normal exchange rate weighted
percapita real World GDP rather than the purchase
power parity weighted percapita real World GDP.[53][54]

The United States housing market correction (a possible consequence of United States housing bubble) and
subprime mortgage crisis signicantly contributed to a
recession.

The 20072009 recession saw private consumption fall

for the rst time in nearly 20 years. This indicates the
depth and severity of the current recession. With consumer condence so low, recovery takes a long time.
67.8.2 United Kingdom
Consumers in the U.S. have been hard hit by the current recession, with the value of their houses dropping
Main article: List of recessions in the United Kingdom
and their pension savings decimated on the stock market. Not only have consumers watched their wealth being
The most recent recession to aect the United Kingdom eroded they are now fearing for their jobs as unemployment rises.[60]
was the late-2000s recession.

67.8.3

United States

Main article: List of recessions in the United States

U.S. employers shed 63,000 jobs in February 2008,[61]

the most in ve years. Former Federal Reserve chairman
Alan Greenspan said on 6 April 2008 that There is more
than a 50 percent chance the United States could go into
recession.[62] On 1 October, the Bureau of Economic
Analysis reported that an additional 156,000 jobs had
been lost in September. On 29 April 2008, Moodys declared that nine US states were in a recession. In November 2008, employers eliminated 533,000 jobs, the largest
single month loss in 34 years.[63] For 2008, an estimated
2.6 million U.S. jobs were eliminated.[64]

According to economists, since 1854, the U.S. has encountered 32 cycles of expansions and contractions, with
an average of 17 months of contraction and 38 months of
expansion.[5] However, since 1980 there have been only
eight periods of negative economic growth over one scal quarter or more,[55] and four periods considered reThe unemployment rate in the US grew to 8.5 percent in
cessions:
March 2009, and there were 5.1 million job losses until March 2009 since the recession began in December
July 1981 November 1982: 14 months
2007.[65] That was about ve million more people unemployed compared to just a year prior,[66] which was the
July 1990 March 1991: 8 months
largest annual jump in the number of unemployed per March 2001 November 2001: 8 months
sons since the 1940s.[67]

368
Although the US Economy grew in the rst quarter by
1%,[68][69] by June 2008 some analysts stated that due to
a protracted credit crisis and "...rampant ination in commodities such as oil, food, and steel, the country was
nonetheless in a recession.[70] The third quarter of 2008
brought on a GDP retraction of 0.5%[71] the biggest decline since 2001. The 6.4% decline in spending during
Q3 on non-durable goods, like clothing and food, was the
largest since 1950.[72]

CHAPTER 67. RECESSION

[6] Q&A: What is a recession?". BBC News. 8 July 2008.

[7] Glossary of Treasury terms. HM Treasury. Retrieved
25 October 2012.
[8] Koo, Richard (2009). The Holy Grail of MacroeconomicsLessons from Japans Great Recession. John Wiley & Sons
(Asia) Pte. Ltd. ISBN 978-0-470-82494-8.
[9] Koo, Richard. The world in balance sheet recession:
causes, cure, and politics. real-world economics review,
issue no. 58, 12 December 2011, pp. 1937. Retrieved
15 April 2012.

A 17 November 2008 report from the Federal Reserve

Bank of Philadelphia based on the survey of 51 forecasters, suggested that the recession started in April 2008 and [10] Key Indicators 2001: Growth and Change in Asia and
would last 14 months.[73] They project real GDP declinthe Pacic. ADB.org. Retrieved 31 July 2010.
ing at an annual rate of 2.9% in the fourth quarter and
1.1% in the rst quarter of 2009. These forecasts repre- [11] Samuelson, Robert J. (14 June 2010). Our economys
crisis of condence. The Washington Post. Retrieved 29
sent signicant downward revisions from the forecasts of
January 2011.
three months ago.
A 1 December 2008, report from the National Bureau
of Economic Research stated that the U.S. has been in a
recession since December 2007 (when economic activity
peaked), based on a number of measures including job
losses, declines in personal income, and declines in real
GDP.[74] By July 2009 a growing number of economists
believed that the recession may have ended.[75][76] The
National Bureau of Economic Research announced on 20
September 2010 that the 2008/2009 recession ended in
June 2009, making it the longest recession since World
War II.[77]

[12] The Conference Board Consumer Condence Survey

Press Release May 2010. Conference-board.org. 25
March 2010. Retrieved 29 January 2011.

Other countries

[16] Richard Koo The World In Balance Sheet Recession

Real World Economics Review December 2011

[13] Shiller, Robert J. (27 January 2009). WSJ Robert

Shiller Animal Spirits Depend on Trust. The Wall Street
Journal. Retrieved 29 January 2011.
[14] NYT-Paul Krugman-Does He Pass The Test?-July
10,2014
[15] Gregory White (14 April 2010). Presentation by Richard
Koo The Age of Balance Sheet Recessions. Businessinsider.com. Retrieved 29 January 2011.

Many other countries, particularly in Europe, have under- [17] NYT Paul Krugman Notes on Koo August 2010
gone decreasing rates of GDP growth. Some countries
have been able to avoid a recession but have still experi- [18] VOX Paul Krugman Debt, Deleveraging and the Liquidity Trap November 18, 2010
enced slower economic activity, such as China. India and
Australia were able to maintain positive growth through- [19] NYT Paul Krugman Grim Natural Experiments July
out the late-2000s recession.
6, 2012

67.9 See also

67.10 References

[20] How Mortgage Debt is Holding Back the Economy Mike

Konczal Roosevelt Institute July 3, 2012
[21] Krugman, Paul (2009). The Return of Depression Economics and the Crisis of 2008. W.W. Norton Company
Limited. ISBN 978-0-393-07101-6.

[1] Recession. Merriam-Webster Online Dictionary. Retrieved 19 November 2008.

[22] How Much of the World is in a Liquidity Trap?". Krugman.blogs.nytimes.com. 17 March 2010. Retrieved 29
January 2011.

[2] Recession denition. Encarta World English Dictionary

[North American Edition]. Microsoft Corporation. 2007.
Retrieved 19 November 2008.

[23] Federal Reserve Janet Yellen A Minsky Meltdown

April 2009

[3] Shiskin, Julius (1 December 1974). The Changing Business Cycle. New York Times. p. 222.

[24] A Estrella, FS Mishkin (1995). Predicting U.S. Recessions: Financial Variables as Leading Indicators. MIT
Press.

[4] What is the dierence between a recession and a depression?" Saul Eslake Nov 2008
[5] Business Cycle Expansions and Contractions. National
Bureau of Economic Research. Archived from the original on 12 October 2007. Retrieved 19 November 2008.

[25] Grading Bonds on Inverted Curve By Michael Hudson

[26] Wright, Jonathan H., The Yield Curve and Predicting Recessions (March 2006). FEDs Working Paper No. 20067.

67.10. REFERENCES

369

[27] Signal or Noise? Implications of the Term Premium for

Recession Forecasting

[47] The Recession that Almost Was. Kenneth Rogo, International Monetary Fund, Financial Times, 5 April 2002

[28] Labor Model Predicts Lower Recession Odds. The Wall

Street Journal. 28 January 2008. Retrieved 29 January
2011.

[48] The world economy Bad, or worse. Economist.com.

2008-10-09. Retrieved 2009-04-15.

[29] Leading Economic Indicators Suggest U.S. In Recession

21 January 2008

[49] Lall, Subir. IMF Predicts Slower World Growth Amid

Serious Market Crisis, International Monetary Fund,
April 9, 2008.

[30] NYT Paul Krugman Block those Economic Metaphors

December 2010
[31] Siegel, Jeremy J. (2002). Stocks for the Long Run: The
Denitive Guide to Financial Market Returns and LongTerm Investment Strategies, 3rd, New York: McGraw-Hill,
388. ISBN 978-0-07-137048-6
[32] From the subprime to the terrigenous: Recession begins
at home. Land Values Research Group. 2 June 2009.
A downturn in the property market, especially in turnover
(sales) of properties, is a leading indicator of recession,
with a lead time of up to 9 quarters...
[33] Robert J. Shiller (7 June 2009). Why Home Prices May
Keep Falling. New York Times, June 6, 2009. Retrieved
10 April 2010.

[50] http://www.imf.org/external/pubs/ft/weo/2009/update/
01/index.htm IMF Jan 2009 update
[51] Global Recession Risk Grows as U.S. `Damage' Spreads.
Jan 2008. Bloomberg.com. 2008-01-28. Retrieved
2009-04-15.
[52] World Economic Outlook (WEO) April 2013: Statistical
appendix - Table A1 - Summary of World Output (PDF).
IMF. 16 April 2013. Retrieved 16 April 2013.
[53] Whats a Global Recession?". The Walstreet Journal. 22
April 2009. Retrieved 17 September 2013.
[54] World Economic Outlook - April 2009: Crisis and Recovery (PDF). Box 1.1 (page 11-14). IMF. 24 April
2009. Retrieved 17 September 2013.

[34] Recession Predictions and Investment Decisions by Allan

Sloan, 11 December 2007

[55] http://www.bea.gov/national/xls/gdpchg.xls

[35] Recession? Where to put your money now. Shawn Tully,

6 February 2008

[56] Isidore, Chris (1 December 2008). Its ocial: Recession since Dec. '07. CNN. Retrieved 29 January 2011.

[36] NASDAQ Composite Index ($COMPX) Stock chart,

Index chart MSN Money. Moneycentral.msn.com. Retrieved 29 January 2011.

[57] BBC News Business US economy out of recession.

BBC. 29 October 2009. Retrieved 6 February 2010.

[37] Rethinking Recession-Proof Stocks Joshua Lipton 28 January 2008

[58] Determination of the December 2007 Peak in Economic

Activity.. NBER Business Cycle Dating Committee. 11
December 2008. Retrieved 26 April 2009.

[38] Recession Stock Picks Douglas Cohen, 18 January 2008

[39] Gaen, David (11 November 2008). Recession Puts
Halfway Rule to the Test. The Wall Street Journal. Retrieved 29 January 2011.
[40] Economy puts Republicans at risk 29 January 2008
[41] The Bush Recession Prepared by: Democrat sta, Senate
Budget Committee, 31 July 2003
[42] Ready for a Real Downer Monday, 23 November 1981 By
GEORGE J. CHURCH
[43] The Saylor Foundation. Unemployment Rate. pp. 1
Accessed 20 June 2012
[44] Market Oracle John Mauldin Feb 2009 US in Recession
Rising Unemployment "
[45] Vaitilingam, Romesh (17 September 2009). Recession
Britain: New ESRC report on the impact of recession on
peoples jobs, businesses and daily lives. Economic and
Social Research Council. Retrieved 22 January 2010.
[46] Rampell, Catherine (11 January 2011). More Workers Complain of Bias on the Job, a Trend Linked to
Widespread Layos. The New York Times.

[59] Izzo, Phil (20 September 2010). Recession Over in June

2009. The Wall Street Journal.
[60] Economic Crisis: When will it End? IBISWorld Recession Brieng " Dr. Richard J. Buczynski and Michael
Bright, IBISWorld, January 2009
[61] Job Loss Predictions
[62] Recession unlikely if US economy gets through next two
crucial months
[63] Uchitelle, Louis; Andrews, Edmund L.; Labaton, Stephen
(6 December 2008). U.S. Loses 533,000 Jobs in Biggest
Drop Since 1974. The New York Times. Retrieved 10
April 2010.
[64]
[65]
[66] Employment Situation Summary. Bls.gov. 2 July 2010.
Retrieved 31 July 2010.
[67] Goldman, David (9 January 2009). Worst year for jobs
since '45. CNN. Retrieved 10 April 2010.

370

[68] Brent Meyer (16 October 2008). Real GDP FirstQuarter 2008 Preliminary Estimate :: Brent Meyer ::
Economic Trends :: 06.03.08 :: Federal Reserve Bank
of Cleveland. Clevelandfed.org. Retrieved 29 January
2011.
[69] Fragile economy improves but not out of woods yet: Financial News Yahoo! Finance
[70] Why its worse than you think, 16 June 2008, Newsweek.
[71] Gross Domestic Product: Third quarter 2008. Bea.gov.
Retrieved 29 January 2011.
[72] Chandra, Shobhana (30 October 2008). U.S. Economy
Contracts Most Since the 2001 Recession. Bloomberg.
Retrieved 29 January 2011.
[73] Fourth quarter 2008 Survey of Professional Forecasters.
Philadelphiafed.org. 17 November 2008. Retrieved 29
January 2011.
[74] Text of the NBERs statement on the recession. USA
Today. 1 December 2008. Retrieved 29 January 2011.
[75] Daniel Gross, The Recession Is... Over?, Newsweek, 14
July 2009.
[76] V.I. Keilis-Borok et al., Pattern of Macroeconomic Indicators Preceding the End of an American Economic Recession. Journal of Pattern Recognition Research, JPRR
Vol.3 (1) 2008.
[77] Business Cycle Dating Committee, National Bureau of
Economic Research

67.11 External links

Moore, Georey H. (2002). Recessions. In David
R. Henderson (ed.). Concise Encyclopedia of Economics (1st ed.). Library of Economics and Liberty.
OCLC 317650570, 50016270 and 163149563
Business Cycle Expansions and Contractions The
National Bureau Of Economic Research
Independent Analysis of Business Cycle Conditions American Institute for Economic Research
(AIER)

CHAPTER 67. RECESSION

Chapter 68

Stock market bubble

A stock market bubble is a type of economic bubble
taking place in stock markets when market participants
drive stock prices above their value in relation to some
system of stock valuation.
Behavioral nance theory attributes stock market bubbles to cognitive biases that lead to groupthink and herd
behavior. Bubbles occur not only in real-world markets, with their inherent uncertainty and noise, but also
in highly predictable experimental markets.[1] In the laboratory, uncertainty is eliminated and calculating the expected returns should be a simple mathematical exercise, because participants are endowed with assets that
are dened to have a nite lifespan and a known probability distribution of dividends. Other theoretical explanations of stock market bubbles have suggested that they
are rational,[2] intrinsic,[3] and contagious.[4]

68.1 Examples
Two famous early stock market bubbles were the
Mississippi Scheme in France and the South Sea bubble in England. Both bubbles came to an abrupt end
in 1720, bankrupting thousands of unfortunate investors.
Those stories, and many others, are recounted in Charles
Mackay's 1841 popular account, "Extraordinary Popular
Delusions and the Madness of Crowds".
5000

4000

3000

2000

1000

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
'70

'75

'80

'85

'90

'95

'00

'05

'10

'15

The Nikkei 225.

1990s were based on speculative activity surrounding the

development of new technologies. The 1920s saw the
widespread introduction of an amazing range of technological innovations including radio, automobiles, aviation
and the deployment of electrical power grids. The 1990s
was the decade when Internet and e-commerce technologies emerged.
Other stock market bubbles of note include the
Encilhamento occurred in Brazil during the late 1880s
and early 1890s, the Nifty Fifty stocks in the early 1970s,
Taiwanese stocks in 1987-1989 and Japanese stocks in
the late 1980s.
Stock market bubbles frequently produce hot markets
in initial public oerings, since investment bankers and
their clients see opportunities to oat new stock issues at
inated prices. These hot IPO markets misallocate investment funds to areas dictated by speculative trends,
rather than to enterprises generating longstanding economic value. Typically when there is an over abundance of IPOs in a bubble market, a large portion of
the IPO companies fail completely, never achieve what
is promised to the investors, or can even be vehicles for
fraud.

2005

The NASDAQ Composite index spiked in the late 90s and then
fell sharply as a result of the dot-com bubble.

68.2 Whether rational or irrational

The two most famous bubbles of the twentieth century, Emotional and cognitive biases (see behavioral nance)
the bubble in American stocks in the 1920s just before seem to be the causes of bubbles, but often, when the
the Great Depression and the Dot-com bubble of the late phenomenon appears, pundits try to nd a rationale, so
371

372
as not to be against the crowd. Thus, sometimes, people
will dismiss concerns about overpriced markets by citing
a new economy where the old stock valuation rules may
no longer apply. This type of thinking helps to further
propagate the bubble whereby everyone is investing with
the intent of nding a greater fool. Still, some analysts
cite the wisdom of crowds and say that price movements
really do reect rational expectations of fundamental returns. Large traders become powerful enough to rock the
boat, generate stock market bubbles.[5]
To sort out the competing claims between behavioral nance and ecient markets theorists, observers need to
nd bubbles that occur when a readily-available measure
of fundamental value is also observable. The bubble in
closed-end country funds in the late 1980s is instructive
here, as are the bubbles that occur in experimental asset markets. According to the ecient-market hypothesis, this doesn't happen, and so any data is wrong.[6]
For closed-end country funds, observers can compare the
stock prices to the net asset value per share (the net value
of the funds total holdings divided by the number of
shares outstanding). For experimental asset markets, observers can compare the stock prices to the expected returns from holding the stock (which the experimenter determines and communicates to the traders).
In both instances, closed-end country funds and experimental markets, stock prices clearly diverge from fundamental values. Nobel laureate Dr. Vernon Smith has
illustrated the closed-end country fund phenomenon with
a chart showing prices and net asset values of the Spain
Fund in 1989 and 1990 in his work on price bubbles. At
its peak, the Spain Fund traded near $35, nearly triple
its Net Asset Value of about $12 per share. At the same
time the Spain Fund and other closed-end country funds
were trading at very substantial premiums, the number
of closed-end country funds available exploded thanks to
many issuers creating new country funds and selling the
IPOs at high premiums.
It only took a few months for the premiums in closed-end
country funds to fade back to the more typical discounts
at which closed-end funds trade. Those who had bought
them at premiums had run out of greater fools. For
a while, though, the supply of greater fools had been
outstanding.

68.3 Positive feedback

A rising price on any share will attract the attention of
investors. Not all of those investors are willing or interested in studying the intrinsics of the share and for such
people the rising price itself is reason enough to invest.
In turn, the additional investment will provide buoyancy
to the price, thus completing a positive feedback loop.
Like all dynamic systems, nancial markets operate in
an ever changing equilibrium, which translates into price

CHAPTER 68. STOCK MARKET BUBBLE

volatility. However, a self-adjustment (negative feedback) takes place normally: when prices rise more people
are encouraged to sell, while fewer are encouraged to buy.
This puts a limit on volatility. However, once positive
feedback takes over, the market, like all systems with positive feedback, enters a state of increasing disequilibrium.
This can be seen in nancial bubbles where asset prices
rapidly spike upwards far beyond what could be considered the rational economic value, only to fall rapidly
afterwards.

68.4 Eect of incentives

Investment managers, such as stock mutual fund managers, are compensated and retained in part due to their
performance relative to peers. Taking a conservative or
contrarian position as a bubble builds results in performance unfavorable to peers. This may cause customers
to go elsewhere and can aect the investment managers
own employment or compensation. The typical shortterm focus of U.S. equity markets exacerbates the risk for
investment managers that do not participate during the
building phase of a bubble, particularly one that builds
over a longer period of time. In attempting to maximize returns for clients and maintain their employment,
they may rationally participate in a bubble they believe
to be forming, as the risks of not doing so outweigh the
benets.[7]

68.5 See also

Business cycle
Collective behavior
Diversication (nance)
Fictitious capital
Financial modeling
Irrational exuberance
Market trend
Stock market crash
Histoire des bourses de valeurs (French)

68.6 References
[1] Smith, Vernon L.; Suchanek, Gerry L.; Williams, Arlington W. (1988). Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets. Econometrica (The Econometric Society) 56 (5): 11191151.
doi:10.2307/1911361. JSTOR 1911361.

68.7. EXTERNAL LINKS

[2] De Long, J. Bradford; Shleifer, Andrei; Summers,

Lawrence H.; Waldmann, Robert J. (1990). Noise
Trader Risk in Financial Markets. Journal of Political
Economy 98 (4): 703738. doi:10.1086/261703.
[3] Froot, Kenneth A.; Obstfeld, Maurice (1991). Intrinsic
Bubbles: The Case of Stock Prices. American Economic
Review (American Economic Association) 81 (5): 1189
1214. doi:10.3386/w3091. JSTOR 2006913.
[4] Topol, Richard (1991). Bubbles and Volatility of Stock
Prices: Eect of Mimetic Contagion. The Economic
Journal (Blackwell Publishing) 101 (407): 786800.
doi:10.2307/2233855. JSTOR 2233855.
[5] Sergey Perminov, Trendocracy and Stock Market Manipulations (2008, ISBN 978-1-4357-5244-3).
[6] How Did Economists Get It So Wrong?". The New York
Times.
[7] Blodget-The Atlantic-Why Wall St. Always Blows It

68.7 External links

Accounts of the South Sea Bubble, John Law and
the Mississippi Company can be found in Charles
Mackay's classic Extraordinary Popular Delusions
and the Madness of Crowds (1843) available from
Project Gutenberg. Warning: this reference has
been widely criticized by historians.
Steimetz, Seiji S. C. (2008). Bubbles. In
David R. Henderson (ed.). Concise Encyclopedia
of Economics (2nd ed.). Indianapolis: Library of
Economics and Liberty. ISBN 978-0865976658.
OCLC 237794267.

373

Chapter 69

Stock market crash

A stock market crash is a sudden dramatic decline of
stock prices across a signicant cross-section of a stock
market, resulting in a signicant loss of paper wealth.
Crashes are driven by panic as much as by underlying
economic factors. They often follow speculative stock
market bubbles.
Stock market crashes are social phenomena where external economic events combine with crowd behavior and
psychology in a positive feedback loop where selling by
some market participants drives more market participants
to sell. Generally speaking, crashes usually occur under
the following conditions:[1] a prolonged period of rising
stock prices and excessive economic optimism, a market
where P/E ratios exceed long-term averages, and extensive use of margin debt and leverage by market participants.
There is no numerically specic denition of a stock market crash but the term commonly applies to steep doubledigit percentage losses in a stock market index over a
period of several days. Crashes are often distinguished
from bear markets by panic selling and abrupt, dramatic
price declines. Bear markets are periods of declining
stock market prices that are measured in months or years.
While crashes are often associated with bear markets,
they do not necessarily go hand in hand. The crash of
1987, for example, did not lead to a bear market. Likewise, the Japanese bear market of the 1990s occurred
over several years without any notable crashes.

69.1 Mathematical theory

The mathematical characterisation of stock market
movements has been a subject of intense interest. The
conventional assumption has been that stock markets behave according to a random log-normal distribution.[2]
Among others, mathematician Benot Mandelbrot suggested as early as 1963 that the statistics prove this assumption incorrect.[3] Mandelbrot observed that large
movements in prices (i.e. crashes) are much more common than would be predicted in a log-normal distribution. Mandelbrot and others suggest that the nature of
market moves is generally much better explained using
non-linear analysis and concepts of chaos theory.[4] This

has been expressed in non-mathematical terms by George

Soros in his discussions of what he calls reexivity of
markets and their non-linear movement.[5] George Soros
said in late October 1987, 'Mr. Robert Prechter's reversal
proved to be the crack that started the avalanche'.[6][7]
Research at the Massachusetts Institute of Technology
suggests that there is evidence the frequency of stock
market crashes follows an inverse cubic power law.[8]
This and other studies such as Prof. Didier Sornette's
work suggest that stock market crashes are a sign of
self-organized criticality in nancial markets.[9] In 1963,
Mandelbrot proposed that instead of following a strict
random walk, stock price variations executed a Lvy
ight.[10] A Lvy ight is a random walk that is occasionally disrupted by large movements. In 1995, Rosario
Mantegna and Gene Stanley analyzed a million records of
the S&P 500 market index, calculating the returns over
a ve-year period.[11] Researchers continue to study this
theory, particularly using computer simulation of crowd
behaviour, and the applicability of models to reproduce
crash-like phenomena.
Research at the New England Complex Systems Institute has found warning signs of crashes using new statistical analysis tools of complexity theory. This work
suggests that the panics that lead to crashes come from
increased mimicry in the market. A dramatic increase in
market mimicry occurred during the whole year before
each market crash of the past 25 years, including the recent nancial crisis. When investors closely follow each
others cues, it is easier for panic to take hold and aect
the market. This work is a mathematical demonstration
of a signicant advance warning sign of impending market crashes.[12][13]
The Hindenburg Omen, developed by physics professor
Jim Miekka, is a controversial indicator that is believed
by many to predict stock market crashes.
A recent phenomenon, known as the RR Reversal, has
also been well documented in recent years - where a
rapidly increasing stock experiences an inexplicable and
sudden pullback to the magnitude of 10 - 40% within a
month.

374

69.2. MAJOR CRASHES

69.2 Major crashes

69.2.1

Wall Street Crash of 1929

Main article: Wall Street Crash of 1929

The economy had been growing uidly for most of the

375
overwhelmed the ticker tape system that normally gave investors the current prices of their shares. Telephone lines
and telegraphs were clogged and were unable to cope.
This information vacuum only led to more fear and panic.
The technology of the New Era, much celebrated by investors previously, now served to deepen their suering.
The following day, Black Tuesday was a day of chaos.
Forced to liquidate their stocks because of margin calls,
overextended investors ooded the exchange with sell orders. The Dow fell 30 points to close at 230 on that day.
The glamour stocks of the age saw their values plummet.
Across the two days, the Dow Jones Industrial Average
fell 23%.
By the end of the weekend of November 11, the index stood at 228, a cumulative drop of 40 percent from
the September high. The markets rallied in succeeding
months but it would be a false recovery that led unsuspecting investors into further losses. The Dow Jones Industrial Average would lose 89% of its value before nally
bottoming out in July 1932. The crash was followed by
the Great Depression, the worst economic crisis of modern times that plagued the stock market and Wall Street
throughout the 1930s.

69.2.2 Crash of 20082009

Main article: Financial crisis of 200708
On September 16, 2008, failures of massive nancial

Crowd gathering on Wall Street the day after the 1929 crash.

Roaring Twenties. It was a technological golden age as

innovations such as radio, automobiles, aviation, telephone and the power grid were deployed and adopted.
Companies that had pioneered these advances, like Radio
Corporation of America (RCA) and General Motors saw
their stocks soar. Financial corporations also did well
as Wall Street bankers oated mutual fund companies
(then known as investment trusts) like the Goldman Sachs
Trading Corporation. Investors were infatuated with the
returns available in the stock market especially with the
use of leverage through margin debt.
On August 24, 1921, the Dow Jones Industrial Average
stood at a value of 63.9. By September 3, 1929, it had
risen more than sixfold, touching 381.2. It would not
regain this level for another 25 years. By the summer
of 1929, it was clear that the economy was contracting
and the stock market went through a series of unsettling
price declines. These declines fed investor anxiety and
events soon came to a head on October 24, 28, and 29
(known respectively as Black Thursday, Black Monday,
and Black Tuesday).
The collapse of Lehman Brothers was a symbol of the Crash of
On Black Monday, the Dow Jones Industrial Average fell 2008
38 points to 260, a drop of 12.8%. The deluge of selling

376

CHAPTER 69. STOCK MARKET CRASH

After having been suspended for three successive trading
days, i.e., October 9, October 10, and October 13, the
Icelandic stock market reopened on 14 October, with the
main index, the OMX Iceland 15, closing at 678.4, which
corresponds to a plunge of about 77% compared with the
closure at 3,004.6 on October 8. This reects the fact that
the value of the three big banks, which form 73.2 percent
of the value of the OMX Iceland 15, had been set to zero.

OMX Iceland 15 closing prices during the ve trading weeks from

September 29, 2008 to October 31, 2008.

institutions in the United States, due primarily to exposure of securities of packaged subprime loans and credit
default swaps issued to insure these loans and their issuers, rapidly devolved into a global crisis resulting in
a number of bank failures in Europe and sharp reductions in the value of stocks and commodities worldwide.
The failure of banks in Iceland resulted in a devaluation of the Icelandic krna and threatened the government with bankruptcy. Iceland was able to secure an
emergency loan from the International Monetary Fund
in November.[14] In the United States, 15 banks failed in
2008, while several others were rescued through government intervention or acquisitions by other banks.[15] On
October 11, 2008, the head of the International Monetary Fund (IMF) warned that the world nancial system
was teetering on the brink of systemic meltdown.[16]

On October 24, many of the worlds stock exchanges experienced the worst declines in their history, with drops
of around 10% in most indices.[24] In the US, the Dow
Jones industrial average fell 3.6%, not falling as much
as other markets.[25] Instead, both the US Dollar and
Japanese Yen soared against other major currencies, particularly the British Pound and Canadian Dollar, as world
investors sought safe havens. Later that day, the deputy
governor of the Bank of England, Charles Bean, suggested that This is a once in a lifetime crisis, and possibly
the largest nancial crisis of its kind in human history.[26]
By March 6, 2009 the DJIA had dropped 54% to 6,469
(before beginning to recover) from its peak of 14,164 on
October 9, 2007, over a span of 17 months.[27][28]

69.3 Mitigation strategies

One mitigation strategy has been the introduction of

trading curbs, also known as circuit breakers, which are
a trading halt in the cash market and the corresponding
The economic crisis caused countries to close their martrading halt in the derivative markets triggered by the halt
kets temporarily.
in the cash market, all of which are aected based on
On October 8, the Indonesian stock market halted trad- substantial movements in a broad market indicator.[29]
ing, after a 10% drop in one day.
The Times of London reported that the meltdown was
being called the Crash of 2008 and older traders were
comparing it with Black Monday in 1987. The fall that
week of 21 percent was not as large a drop as the 28.3
percent fall 21 years earlier, but some traders were saying
it was worse. At least then it was a short, sharp, shock on
one day. This has been relentless all week.[17] Business
Week also referred to the crisis as a stock market crash
or the Panic of 2008.[18]
Beginning October 6 and lasting all week the Dow Jones
Industrial Average closed lower for all ve sessions. Volume levels were also record breaking. The Dow Jones industrial average fell over 1,874 points, or 18%, in its worst
weekly decline ever on both a point and percentage basis.
The S&P 500 fell more than 20%.[19] The week also set
3 top ten NYSE Group Volume Records with October 8
at #5, October 9 at #10, and October 10 at #1.[20]

69.3.1 United States

There are three thresholds, each of which represent different levels of decline in terms of points in the Dow Jones
Industrial Average. These are computed at the beginning
of each quarter to establish a specic point value for the
quarter. For example, in the second quarter of 2011,
threshold 1 was a drop of 1200 points, threshold 2 was
2400 points, and threshold 3 was 3600 points.[30]
If threshold 2 is breached before 1 p.m., the market
would close for two hours. If such a decline took
place between 1 p.m. and 2 p.m., there would be a
one-hour pause. The market would close for the day
if stocks sank to that level after 2 p.m.
In the event where threshold 3 is breached, the market would close for the day, regardless of the time.

It has been noted that recent daily stock market drops are
overall nowhere near the severity experienced during the
last stock market crash in 1987.[21] Others have suggested 69.3.2 France
that the media is manipulating and over-inating stock
market drops and calling them crashes in order to create In France, daily price limits are implemented in cash and
derivative markets. Securities traded on the markets are
the perception of a great depression.[22][23]

69.5. REFERENCES
divided into three categories according to the number and
volume of daily transactions and price limits vary depending on the category to which the security belongs. For
instance, for the more liquid category, when the price
movement of a security exceeds 10% from the quoted
price at the close of the previous market day, quotation is
suspended for 15 minutes. After 15 minutes, transactions
are resumed. If the price then goes up or down by more
than 5%, transactions are again suspended for 15 minutes.
The 5% threshold may apply once more before transactions are halted for the rest of the day. When transactions are suspended in the cash market on a given security,
due to undue price movement, transactions on the option
based on the underlying security are also suspended. Further, when more than 35% of the capitalization of the
CAC40 Index is unable to be quoted, the calculation of
the CAC40 Index is suspended and the index is replaced
by a trend indicator. When less than 25% of the capitalization of the CAC40 Index is able to be quoted, quotations on the derivative markets are suspended for half
an hour or one hour when additional margin deposits are
requested.[29]

69.4 See also

377
Meltdown Monday
Subprime mortgage crisis
Flash crash

69.5 References
[1] Galbraith, J. The Great Crash 1929, 1988 edition,
Houghton Miin Co. Boston, p.xii-xvii
[2] Malkiel, Burton G. (1973). A Random Walk Down Wall
Street (6th ed.). W.W. Norton & Company, Inc. ISBN
0-393-06245-7.
[3] The (Mis-)Behavior Of Markets
[4] 'Father of Fractals takes on the stock market
[5] Soros, G. Alchemy of Finance, Wiley Investment Classics.
2003
[6] Marketwatch.com
[7] Thomas Jr, Landon (October 13, 2007). The Man Who
Won as Others Lost. The New York Times. Retrieved
May 24, 2010.
[8] Stock trade patterns could predict nancial earthquakes

List of stock market crashes

[9] Didier Sornette, Professor of Geophysics

VIX, Chicago Board Options Exchange Market [10] The variation of certain speculative prices
Volatility Index
General:
Mass hysteria
Behavioral nance
Business cycle
Economic bubble
Economic collapse
Financial market
Financial crisis
Flight-to-liquidity
Market trend
Modeling and analysis of nancial markets

[11] Scaling behaviour in the dynamics of an economic precursors and replicas. Journal de Physique I France 6, No.1,
pp. 167175.
[12] Predicting economic market crises using measures of collective panic arXiv:1102.2620v1 [q-n.ST]
[13] Possible Early Warning Sign for Market Crashes
[14] IMF approves $2.1bn Iceland loan
[15] Marketwatch.com Two banks fold, bringing total to 15
failures this year
[16] Canada.com Finance ministers face down crisis as IMF
head warns of 'meltdown'
[17] Business.timesonline.co.uk The Times
[18] Stock Market Crash: Understanding the Panic
[19] Telegraph.co.uk Financial crisis: US stock markets suer
worst week on record

Stock market boom

[20] NYXdata.com NYSE Group Volume Records Top 10

Days

Stock market bubble

[21] Mlive.com AP: Snowballing Sell O Spreads World Wide

Examples:

[22] Businessandmedia.org The Great Media Depression Report

Financial crisis of 200708

[23] Seekingalpha.com Seeking Alpha: This is not a Crash

Great Depression

[24] Marketwatch.com Indexes fall hard on bloody Friday

378

[25] CNBC.com Stocks Sello Fails to Meet Expectations

[26] Dailymail.co.uk 'Worst nancial crisis in human history':
Bank bosss warning as pound suers biggest fall for 37
years
[27] Leatherheadblog.com
[28] Finance.yahoo.com
[29] Riskinstitute.ch
[30] NYSE.com

69.6 External links

Stock Market Crash of 1929.
Crash of 2014: Like 1929, youll never hear it coming by Maketwatch.
Can the Government Control a Stock Market Crash
By HowStuWorks.

CHAPTER 69. STOCK MARKET CRASH

69.7. TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

379

69.7 Text and image sources, contributors, and licenses

69.7.1

Text

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Smallbones, KaiserbBot, Yidisheryid, JesseRafe, Addshore, RedHillian, Jmnbatista, COMPFUNK2, Mordea, Iamorlando, LeoNomis,
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CHAPTER 69. STOCK MARKET CRASH

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DVdm, Bgwhite, RocketPaul77, Gwernol, The Rambling Man, Ytrottier, Nirvana2013, Ospalh, GraemeL, Jaycarlson, DocendoDiscimus,
SmackBot, Reedy, CGameProgrammer, Sloman, Richard Woods, Baronnet, Justin Staord, Kuru, Ergative rlt, Mr. Lefty, Ckatz, Hu12,
DabMachine, Typelighter, Iridescent, Judgesurreal777, Picklegnome, Jdperren, Lethal D, Page Up, Berettachick, UFgirl, Karenjc, Cydebot, Meno25, Gogo Dodo, Ughh, Mojo Hand, Notmyrealname, Mmortal03, Luna Santin, Lfstevens, JAnDbot, MER-C, The Transhumanist, Accesspig, JaGa, Vigyani, Mermaid from the Baltic Sea, PCock, Pplata, Alexmeske, Oceanynn, Potatoswatter, Funandtrvl,
Bizhaoqi, Ask123, Someguy1221, Iasrar, AlleborgoBot, Calvinwalker, Winchelsea, Phe-bot, Emesee, Conant Webb, Counterfact, ClueBot,
Zippymobile, AQJKU6GMN, Harland1, Ktr101, Alexbot, SchreiberBike, Sousav, Md massimino, Downchi, Dthomsen8, Olapomona,
Liu.j.james, Addbot, Brumski, Oculus42, Rejectwater, Jreconomy, SOA, Yobot, Themfromspace, Theglovedepartment, Anamitraroy,
KamikazeBot, Examtester, AnomieBOT, Info.abstracta, Flewis, Silva.aldo, Ponticalibus, Cban, Agricmarketing, Transmissionelement,
Ksbhagwat, Jaquesryan, FrescoBot, Menwith, Haeinous, Oashi, Jen Svensson, Jonesey95, Consummate virtuoso, MastiBot, Anddrum,
Vrenator, Diannaa, RjwilmsiBot, Dewritech, Rouxf, Vandehey, Solarra, Pernilsson1980, Futuresfan, Will Beback Auto, ClueBot NG,
Mr. Glengarry Glen Ross, Snotbot, Widr, Chillllls, Okcodemonkey, Gavingee, Heading indexing, Northamerica1000, Virtuscience, DPL
bot, TheJJJunk, Khazar2, Usman.ijaz, Fritzbunwalla, SFK2, Commodityguy, Thisweirdtrick, Ptillabo, Backendgaming, Yenmaster66,
GirishKapoor, BHBrunt, WPGA2345, Notsosoros, Monkbot, Jesalshethna, Lord he, Johnalbertcraig and Anonymous: 224
Money market Source: http://en.wikipedia.org/wiki/Money%20market?oldid=649695484 Contributors: Ap, Edward, Pnm, Delirium,
Pcb21, Ellywa, Ahoerstemeier, Ronz, TUF-KAT, Ehn, Mydogategodshat, Jfeckstein, Raul654, Robbot, Dave6, J heisenberg, BenFrantzDale, Curps, Gugganij, Pgreennch, DMG413, Discospinster, Mazi, Hayabusa future, Aude, Maurreen, Jerryseinfeld, Pearle, Stephen
G. Brown, Siim, Gary, Pinar, Andrewpmk, Lightdarkness, Aegis Maelstrom, Versageek, Walshga, Oregon Bear, Woohookitty, GregorB,
SDC, Ctindal, Vegaswikian, Feco, Bhadani, Windchaser, Tedder, Jersey Devil, FrankTobia, Roboto de Ajvol, Clib, Lemon-s, Dtrebbien,
Badagnani, GeeSharpMinor, Toba, Voidxor, Sozin, Airodyssey, Tiger888, NeilN, WikiFew, DocendoDiscimus, Sardanaphalus, SmackBot, Vvarkey, Deli nk, Nbarth, DHN-bot, Smallbones, Jared, Byelf2007, ThurnerRupert, Razorlicious, ManiF, 16@r, Hu12, Courcelles,
Linkspamremover, Adam sk, Eastlaw, Dgw, Tosoft, Cranedata, Travelbird, Alaibot, Legis, Kozuch, Markber, Id447, LeetHaxor, AntiVandalBot, WinBot, Parnell88, Hijklmno, Hroulf, VoABot II, Iitkgp.prashant, Hbent, Mermaid from the Baltic Sea, J.delanoy, Tlim7882,
Mike.lifeguard, LordAnubisBOT, Hoppitt, Funandtrvl, VolkovBot, Philip Trueman, TXiKiBoT, Dirkbb, Lamro, SQL, Kbrose, Gerakibot, D420182, Agarcialw, Finnancier, ClueBot, Raj.agrawal, The Thing That Should Not Be, Drmies, Boing! said Zebedee, Imalbornoz,
Alexbot, NuclearWarfare, Zrinski, SoxBot III, Apparition11, Anual, XLinkBot, BodhisattvaBot, NellieBly, Noctibus, Addbot, Cst17,
Nolelover, Ehrenkater, Equilibrium007, Whitepearl543, OlEnglish, LuK3, Luckas-bot, Yobot, Azylber, SwisterTwister, Natywa, 5k3l3,
Obersachsebot, Heavypl, Maddie!, GrouchoBot, Omnipaedista, RibotBOT, FrescoBot, LucienBOT, Finalius, MondalorBot, Wortoleski,
Thestraycat57, RoadTrain, Vrenator, DARTH SIDIOUS 2, Mean as custard, RA0808, Pody9000067, K6ka, Chiton magnicus, ZroBot,
Morgankevinj, ClueBot NG, Jack Greenmaven, Pappu9252, Laura.rosner, Helpful Pixie Bot, BG19bot, Wiki13, Rovee.bhalla, Dan653,
Mark Arsten, Nijam122, Ruchishah312, Pinkie Pie, YFdyh-bot, Click2logme, Johnny33123, TwoTwoHello, Epicgenius, Rubyaxles,
Cliftonweathers, WilfredTheNerd, TranquilHope, Kiranlove1, IJASHIKALI and Anonymous: 189
Over-the-counter (nance) Source: http://en.wikipedia.org/wiki/Over-the-counter%20(finance)?oldid=638112084 Contributors: Mav,
Edward, VeryVerily, T6435bm, Jni, RickBeton, Inkling, RScheiber, MBisanz, Davidruben, Mdkarazim, Jerryseinfeld, Pearle,
Hooperbloob, Yeu Ninje, Mysdaao, BD2412, Sybren, Jweiss11, Commando303, FlaBot, Naraht, Ground Zero, Lmatt, Chobot, YurikBot,
RussBot, Nirvana2013, Voidxor, Zwobot, GraemeL, NeilN, Rayngwf, DocendoDiscimus, SmackBot, Eskimbot, Gilliam, Ohnoitsjamie,
Chris the speller, DHN-bot, Sbharris, A. B., Rlevse, Modest Genius, Monad21, Sgcook, Beetstra, Peterbr, Hu12, Iridescent, Yhager, JHP,
CapitalR, Atlantix, Cydebot, Future Perfect at Sunrise, Kozuch, Kubanczyk, Edupedro, Nick Number, TuvicBot, JAnDbot, JamesBWatson, Redboylabs, R'n'B, Oceanynn, VolkovBot, Zain Ebrahim111, Lamro, Why Not A Duck, SieBot, BotMultichill, Finnancier, ClueBot,
Swellsman, Snaeha, Niceguyedc, OccamzRazor, Jbaphna, Do DueDiligence, Excirial, Lizreed61, Mpizzo34, Addbot, Some jerk on the
Internet, MrOllie, Qwertyqwerty999, VP-bot, Luckas-bot, Lolyckan, AnomieBOT, Chelry, Materialscientist, Danno uk, Obersachsebot,
Xqbot, Urbansuperstar, Korvin2050, Haeinous, Oashi, Westmorlandia, Blacksabbath4343, TylerFinny, Sargdub, EmausBot, Kwds, Swayback Maru, Finance C, ZroBot, MRBigdeli, Jack Greenmaven, Emisanle, Binafhmz, Jabaquara, Alderonarino, Kkumaresan26, Idc209,
Meteor sandwich yum and Anonymous: 106
Private equity Source: http://en.wikipedia.org/wiki/Private%20equity?oldid=647707283 Contributors: Olivier, Edward, Pnm, Kku,
Gabbe, Egil, Mac, Ronz, Kaihsu, AWhiteC, ZimZalaBim, Nurg, Goodralph, Graeme Bartlett, Ds13, Curps, Alexf, Jossi, Mrtrey99,
Pgreennch, Cynical, Kareeser, Faderrattnerb, Liberlogos, Canterbury Tail, N328KF, Monkeyman, Brianhe, Rich Farmbrough, Wk
muriithi, YUL89YYZ, Bender235, TerraFrost, JoeSmack, CanisRufus, Livajo, Sfahey, Mwanner, Func, Jerryseinfeld, Vanished user
azby388723i8jfjh32, Espoo, Gary, John Quiggin, DreamGuy, Jheald, Sechzehn, Walshga, David Haslam, SDC, MarkusHagenlocher,
Paulho, Mandarax, BD2412, Xxpor, Rjwilmsi, Feco, Dhertog, Ground Zero, Algri, Gwernol, YurikBot, Hawaiian717, Angus Lepper,
Mikalra, Ksyrie, Lesotho, DaanAlberga, Dilaudid, Irishguy, Fredericks, Malcolma, Larry laptop, Roche-Kerr, DeadEyeArrow, Jpeob,
Calvin08, GraemeL, Alasdair, Lroden, Realkyhick, JLaTondre, NeilN, Carlosguitar, Sbellmore, Veinor, SmackBot, VCExperts, Ohnoitsjamie, PEedits, Valley2city, Chris the speller, Jprg1966, Roscelese, Stevage, Deli nk, Porcelain808, Golradir, KaiserbBot, Rrburke, Falconsgladiator, Ohconfucius, Lambiam, Kuru, Ehheh, Meco, PEC123, Arjan1071, Hu12, Quaeler, Iridescent, Woodshed, Maslakovic, Eastlaw, Cbmccarthy, CmdrObot, DeLarge, BigGoose2006, Future Perfect at Sunrise, Gogo Dodo, Captainm, Jrgetsin, Jlpspinto, Thijs!bot,
Diophantus, N5iln, A3RO, Wiki2don, Mk*, Pxn2883, Silver seren, JAnDbot, Barek, .anacondabot, SiobhanHansa, Magioladitis, AuburnPilot, Doncqueurs, Smoothsails, Lbressler, Wondercat, KConWiki, Indon, Praddy06, Edward321, Cemerritt, Venturenator, Montie01,
Franzean, JeM, Mike850, Imy187, Hitanshu D, Xiaohuialex, Drewwiki, Kforou01, Jeepday, (jarbarf), Jds2001, Soloren2001, Linkracer,
Michaellamb, DMCer, Funandtrvl, VolkovBot, Feldashv, Alexandria, BoogaLouie, A.Ward, TXiKiBoT, Parker007, Wikidemon, Chimpex, HarrisonScott, Aneebm, StephenWHarris, HP17BII, Finance Journalistico, Ihc2000, 120main, Yeokaiwei, Jackfork, Mannafredo,
JVitulli, Aarp, Urbanrenewal, Zain Ebrahim111, F iceberg, Wikiwikiwiki01, Lamro, Relocator100, Koeju, Semiquincentennial, SieBot,
Sarahleaton13, Andrewsmithlondon, WereSpielChequers, Archantos15, Tliaudet, Revent, Davidsnow1234774, Boldlyman, The Rosner
Family, StaticGull, Surng bird, Sammyjmoseley, Townblight, Finnancier, A83, Gillwill, Eggmanesquire, Sianie, Amperehelion, Sfan00
IMG, ClueBot, Bizhlp, Fadesga, Lpenn3, Cathaloconnor76, Mild Bill Hiccup, Jwihbey, Niceguyedc, Ottawahitech, Khmarks, Auntof6,
Kered1954, Sun Creator, Techfast50, M.O.X, Eustress, Ark25, La Pianista, Tazzlar, Kikos, Researcher999, Mhockey, Giuliosavo, DumZ-

69.7. TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

381

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1exec1, Mohit4victory, Ulric1313, Citation bot, Xqbot, Sketchmoose, Hankstmpr, Capricorn42, Giuseppe Giusti, DSisyphBot, Almabot,
Gabz80, Abigor, Azxten, FrescoBot, Fortdj33, Paine Ellsworth, Venture Capital in Pakistan, Jeanettelepper, Igor101, Atlantia, Blargh29,
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Monkbot, Sanjayrgupta48, Financialpoise and Anonymous: 362
Real estate Source: http://en.wikipedia.org/wiki/Real%20estate?oldid=648756259 Contributors: Fredbauder, Camembert, B4hand, Ubiquity, Michael Hardy, Pnm, Ixfd64, Skysmith, Tregoweth, Docu, Andres, Alex756, Mjklin, Saltine, Donreed, Moondyne, Altenmann, Mayooranathan, Llavigne, Cholling, Timrollpickering, Rasmus Faber, Hadal, Michael Snow, Thv, DocWatson42, Inter, Cobaltbluetony, Rj,
SWAdair, Lucky 6.9, Stevietheman, Chowbok, Antandrus, Beland, MarkSweep, CaribDigita, Scott Burley, Revised, Acsenray, Freakofnurture, O'Dea, Monkeyman, Discospinster, Rhobite, Notinasnaid, Pavel Vozenilek, Kaisershatner, JoeSmack, *drew, Karmast, El C,
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Colm O'Brien, Sj, Jorunn, Rjwilmsi, Wikibofh, Helvetius, RCSB, Bruce1ee, Roccyraccoon, Vegaswikian, GregAsche, SLi, Kvas, Gurch,
Leslie Mateus, Intgr, Pevernagie, Imnotminkus, Butros, DVdm, WriterHound, Gwernol, Hairy Dude, RussBot, Fabartus, Bhny, SluggoOne, SpuriousQ, Chaser, Davumaya, NawlinWiki, Msikma, Larry laptop, Dahveed323, Chichui, Aaron Schulz, Caerwine, Zzuuzz,
Squib, Omtay38, GraemeL, Streltzer, Alias Flood, Oswax, Peter, Ordinary Person, Mais oui!, Allens, Katieh5584, Kungfuadam, John
Broughton, BiH, DVD R W, Schizobullet, Sardanaphalus, A bit iy, SmackBot, Jls0000, Rfolwell, Blue520, Gilliam, Ohnoitsjamie, Amatulic, Shrensh, Chris the speller, Simon123, Movementarian, MK8, BrendelSignature, Clconway, Viva-Verdi, Pictowrit, Zsinj, Johngolds,
Tamfang, Frap, Yidisheryid, Frothy, Stevenmitchell, Soosed, Jamesr1ley, Hurker, Jawo, Kuru, Minna Sora no Shita, Zarita, Llosoc, Ckatz,
16@r, Slakr, Special-T, Texasyellowdog, Davemcarlson, Beetstra, TastyPoutine, KirrVlad, Peter Horn, LaMenta3, Betulsayar, Iridescent, Ewallace, Missionary, JHP, IvanLanin, UncleDouggie, Sparkie1506, Courcelles, Linkspamremover, Tawkerbot2, JForget, Kebeldin,
Wafulz, Woudloper, Steroid Expert, KyraVixen, Bigbewo, Jac16888, REW Webmaster, Marletbadeo, Cprntr, Gogo Dodo, Travelbird,
Energetic is francine@yahoo.com, Lisa 4 envyme@yahoo.com, ChesHagen, Kozuch, AnOrdinaryBoy, JamesAM, Barticus88, Jbvacations,
Andyjsmith, Marek69, Tapir Terric, Szymondrejewicz, Mentisto, KrakatoaKatie, Luna Santin, Seaphoto, Hensu, Hensu75, Kruglick,
Gregalton, Dylan Lake, Epiphanysolutions, Toddfugere, Barek, MER-C, Inks.LWC, Rrumford, Bookinvestor, Mauri.carrasco, LittleOldMe, Acroterion, Aruno, Magioladitis, Fadia ismael, Bongwarrior, Dhakaiya, Hullaballoo Wolfowitz, Nyttend, Berylgosney, Raulakh,
Allstarecho, MKS, Edward321, Sanraiden, Retail Investor, FisherQueen, CliC, REalSmartInvestor, Norawake, Alentejo, Glsvensson,
Sarahlibra22, DrKiernan, Trusilver, Bogey97, Haria6ul, B****n, Eyes of argus, Darth Mike, FrummerThanThou, Lamburov, DarkFalls,
Athene cunicularia, Skier Dude, AntiSpamBot, NewEnglandYankee, Soloren2001, FenderTele, Jevansen, Scott Illini, DASonnenfeld, RobCunningham, Stuart Chamberlin, Sam Blacketer, Mattmcb, 28bytes, CWii, ABF, Quintinreyes, Mnights, Legaldude222, Ldonna, OK dude,
Diovi, Jackfork, Lamala1, Miwanya, Jurusie, Siriushoward, Falcon8765, Discussall, MaCRoEco, Jacobsutton, Gcsapo, CMBJ, D. Recorder,
Oxtoby, Bfpage, Tresiden, Mrexxx, Jauerback, Dawn Bard, Viskonsas, Caltas, Wipqozn, Swaq, Yintan, Keilana, Puppet jimmy, Yerpo,
Nuttycoconut, Harry, World-Estate, Spitre19, Sir, Denisarona, WikipedianMarlith, Bajsejohannes, Ahousebuyer, ClueBot, Bettypoop,
Mariordo, Clavman, Gio86, The Thing That Should Not Be, Koqweerr, Alien 55555, Digitalhighs, For sale by owner, Unbuttered Parsnip,
Drmies, MangalamKumar, Uncle Milty, Kathleen.wright5, R0gu3, Swebkk, Piledhigheranddeeper, Neverquick, Kashi0341, Jasonthurman, Excirial, Jusdafax, Aliathus, Gregoryj77, Ykhwong, NuclearWarfare, Yesbensononline, Huntthetroll, Publictransport, SchreiberBike,
Annaotsuki, Ggarver, Prokopenya Viktor, PCHS-NJROTC, REGUY, XLinkBot, Arslion, WikHead, NellieBly, Mclex, Nanonerdz, Robholmes1, Aliaahussein, FireTown, Addbot, Ignite77, Beamathan, Vejvanick, Montgomery '39, Brekass, Creativerealestate, Zhangzuwu,
Ttippmann, Ejpk, MrOllie, WikiYiddish, Favonian, Jaydec, Bguras puppy, Lightbot, SDConnection, Kai Burghardt, Ben Ben, Ordeniz,
Yobot, Yizhan, HowAgentsMakeMoney, DonKofAK, AnomieBOT, Noq, Jim1138, Bajink, Hedgehog41, Materialscientist, Joedirtsmullet,
Fronteraprop, A123a, Bba21430, ..24, The Banner, Kichaa, Johnbrenner7530, LogoX, Srich32977, Meanderw, Stanconstantin,
Justdata4wiki, Mathonius, Headhitter, Doulos Christos, Jswiki14, 7y7y7y7yu8, Damien Abbott, Shadowjams, Aypeipei, Dougofborg,
Nagualdesign, FrescoBot, Brazen3000, Hamood741, Biog, HJ Mitchell, Wione, Littlephoenix, Snehaparmekar, Closingcorp, Xywar,
EditWrite2, I dream of horses, Chatfecter, Sundar77, Jschnur, Nodar Kherkheulidze, Littledogboy, Meaghan, Smileplz, Turian, Merlion444, Quadrillionaire, LM03, Clear memory, WeTheEconomy, Orenburg1, 69whitetigers, Seahorseruler, Shakti.kamisetty, PowerHouse
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Werkheiser, Hopetown233443243434, Kijkjklghlfae, SporkBot, Nrkondzic, Bemanna, Tolly4bolly, Giplestates, ICREA, Davisjames1, Wipsenade, Carmichael, Rangoon11, Fguilfuchi, Areetkid, Ellisun, TripleThreat117, Lombaks, ClueBot NG, Stampsmike, Disha
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Richardzamora12, Sphere123, O.Koslowski, Castncoot, Widr, Morgan Riley, Kishorenandha, LLRE168, Sharadkumarp, Helpful Pixie
Bot, BVILORIO, Merrypius, Mf1420, Walid.Saimoua, Millodelagarza, Mammoth67, DadrianT,Esq, JohnnyStupendous, YVSREDDY,
Lilgeo, 220 of Borg, Aisteco, Indiainternet6, Elisaias, Jlgearhart, Ctg4Rahat, Arkreddy2005, CarlS23, Mediran, Jose Pedro Moreira,
Grapeman4, Lexter John, Marketbhavish22, Vickyvns, OGSundry, Jrosado15, Puravida c, Himeghasingh, Mogism, Mjh335, SFK2, Retirementhomes, NYCUser404, NYCUser402, gneta, Consultantcr, Maisons Imoveis Maceio, Lmirshadlm, HelenePolly, Vatka Group,
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Propertymalta, Rahumish45, WPGA2345, Kwwheel, Donzay17870812, Crow, Jjque21, Alliance Web Solution, 222acres, Dominic E.
Obozuwa, AdventuresinCRE, Nattanin101, Wordscramble, Bhupirana79, Money9, Medo90zezo, Sophiewalsh114, JOSHNI ENCLAVE,
Linneaolsson, DwellingFinder, Aadeseye, Newinshappi3 and Anonymous: 612
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Sankalpdravid, Mcclarke, Abbas.msa, Tomas e, Parkwells, Addbot, Some jerk on the Internet, Ehrenkater, Zorrobot, Luckas-bot, Yobot,
KamikazeBot, AnomieBOT, RibotBOT, Oashi, RedBot, MastiBot, Sargdub, WikitanvirBot, Tymewriter, Jrinaldi97, BG19bot and Anonymous: 31
Stock market Source: http://en.wikipedia.org/wiki/Stock%20market?oldid=649940567 Contributors: The Anome, Malcolm Farmer, Andre Engels, Toby Bartels, Enchanter, Edward, Gabbe, Tannin, Ixfd64, AlexR, Gjbloom, Ahoerstemeier, Darkwind, , Glenn,

382

CHAPTER 69. STOCK MARKET CRASH

Nikai, Netsnipe, Kaihsu, Lukobe, Mxn, Mydogategodshat, Coren, Daniel Quinlan, Tpbradbury, Furrykef, Taxman, Carax, Raul654,
Pakaran, Robbot, Chocolateboy, Altenmann, Flauto Dolce, Texture, Gidonb, Sunray, TittoAssini, Hadal, Alan Liefting, Ancheta Wis,
Giftlite, DocWatson42, Nichalp, Marcika, C17GMaster, Edcolins, Utcursch, Trid, Bact, R. end, Gzuckier, Antandrus, Drue, OverlordQ, Cylauj, PFHLai, Joyous!, Kevin Rector, TheObtuseAngleOfDoom, Eep, Mike Rosoft, D6, Monkeyman, Discospinster, Jonmcaulie, William Pietri, Guanabot, Vsmith, Timsabin, Calion, Stamm, Notinasnaid, Alue, Bender235, Thebrid, JoeSmack, Professor,
MBisanz, Mwanner, Phoenix Hacker, Aude, Art LaPella, Bobo192, Cretog8, Hurricane111, Smalljim, Tronno, Viriditas, Toh, Jerryseinfeld, Microtony, Hesperian, Nsaa, Alansohn, Gary, Free Bear, Ricky81682, Pion, RussAbbott, L33th4x0rguy, Gdavidp, Dabbler,
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Quantass, Darth Panda, Ampere, Ramas Arrow, Royboycrashfan, Can't sleep, clown will eat me, Yourika, Nixeagle, Yidisheryid, Aristotelesnf, Whatthree16, Frothy, Parent5446, RedHillian, Thrane, Normxxx, Jmlk17, Valenciano, Shadow1, Richard0612, Tesseran, Ohconfucius, SashatoBot, Sdeeyre, Kuru, Adj08, Evenios, Wttsmyf2, Minna Sora no Shita, JohnWittle, Ben Moore, Ckatz, 16@r, Martinp23,
Jimmy Pitt, FredrickS, Ehheh, Ceeded, Ryulong, Hu12, Tawkerbot, BranStark, Typelighter, Iridescent, Joseph Solis in Australia, Fultonwilcox, IvanLanin, Onathinwhiteline, Jaksmata, Rubisco, Ofol, Tawkerbot2, Maslakovic, EightyOne, JForget, Investorz, Vanished user
qw388j3rie, Alex Shih, Page Up, Solobrian, Punk Boi 8, R9tgokunks, Indigenius, LittleT889, RichardFry, Karenjc, Typewritten, TJDay, Dogstar540, Durinmine, Burgwerworldz, RJH311, Bpr103, Meno25, Gogo Dodo, A Softer Answer, HumbleGod, Consequentially,
Dougweller, Chrislk02, Kozuch, ForbiddenWord, Gimmetrow, Epbr123, King Bee, Qwyrxian, Ri st, Sagaciousuk, Brianvannostrand, Nicman911, Pjvpjv, John254, Knighttp01, DeusMP, Wikidenizen, Dawnseeker2000, Natalie Erin, Tailchaser, Mentisto, AntiVandalBot,
Luna Santin, Seaphoto, CronopioFlotante, Opelio, Just Chilling, 2bornot2b, LibLord, Farosdaughter, Myanw, Ashleyy osaurus, JAnDbot, Barek, Bhamv, MER-C, The Transhumanist, Linkmanager, Andonic, Acroterion, Magioladitis, Bongwarrior, VoABot II, Kuyabribri,
Yandman, Pensivecow, Feeeshboy, Alanthwaits, Objectivesea, St.Geoluca Hadge, Catgut, Agent007bm, Accesspig, DerHexer, GermanX,
Maikoherajin, Miker70741, Pauly04, Weyandt, R'n'B, EdBever, Tgeairn, J.delanoy, Pharaoh of the Wizards, Herbythyme, Hans Dunkelberg, Tntdj, Drewwiki, Vision3001, Darth Mike, Tylerhammond2, Mr Rookles, Lowedown98, Daholl01, Randy Robertson, Share Investor, Bigheathbar, Darrendeng, Bushcarrot, Brian Pearson, Blackman2101, WJBscribe, Rzdds, Robertknyc, Jks23, Bolgin63, Beard0708,
BernardZ, Anupam luv, Stockmad, CardinalDan, RJASE1, Funandtrvl, Remi0o, ACSE, Deor, Preston47, CWii, ABF, Je G., Jennavecia,
Soliloquial, Devan424, DancingMan, Philip Trueman, MontyPh, FlatEricUK, Jakeofobness, Ridernyc, WikipedianYknOK, Sankalpdravid,
JayC, Qxz, Retiono Virginian, Anna Lincoln, Sintaku, DennyColt, Jackfork, Wassermann, Andyo2000, Mannafredo, Justinfr, Tygone2,
Zain Ebrahim111, RandomXYZb, Michaeldsuarez, Lamro, Falcon8765, Stinadragon, Burntsauce, Newsaholic, Why Not A Duck, Mh12,
Signsolid, Jimbobk, Kenji alexander, Coee, Ninington, Plinkit, Viskonsas, Yintan, Calabraxthis, The onion fatory, Keilana, Bentogoa,
Flyer22, Tiptoety, Radon210, JuanFox, Baxter9, Ayudante, Harry, KoshVorlon, Lightmouse, Jmalicki, C'est moi, StaticGull, Mygerardromance, Nn123645, Denisarona, Waterhoof, Deavenger, Twinsday, Loren.wilton, Martarius, ClueBot, Zippymobile, GorillaWarfare, The
Thing That Should Not Be, Helenabella, Unbuttered Parsnip, Arakunem, Drmies, DanielDeibler, Regibox, Blanchardb, Excirial, Anonymous101, Lartoven, The Founders Intent, NuclearWarfare, P.sasi.kanth, Lunchscale, Peter.C, Iohannes Animosus, Basketball110, Dekisugi, Thehelpfulone, Aleksd, La Pianista, Chakreshsinghai, Crusnik117, Pularoid, Thingg, DerBorg, Floul1, PCHS-NJROTC, SoxBot III,
Ninjenealogist, Vanished User 1004, Leib111, PretentiousSnot, Kraekuti, Hhhhhx, XLinkBot, Jovianeye, Whiteout23, Heretocausetrouble, Yodaki, XalD, Dukeblue82, Badgernet, Sapdutta, JinJian, Dwilso, JCDenton2052, Stonewhite, HexaChord, Brand93, Wyatt915, Addbot, Wy2008, Willking1979, Some jerk on the Internet, DOI bot, Captain-tucker, Brekass, Ronhjones, TutterMouse, Kenleezle, Scientus, Sandeep4321, CanadianLinuxUser, Fluernutter, MrOllie, Elnacho187, Download, Glane23, Chzz, Debresser, NittyG, Buddha24,
Ahmad.ghamdi.24, Simplesolutions, Ehrenkater, Tide rolls, Lightbot, Romaioi, Avono, , MuZemike, JEN9841, Yobot, Willydick,
Tohd8BohaithuGh1, II MusLiM HyBRiD II, House1630, Mmxx, Sarrus, Jakeroxs45, REDyellowGreenBLUE, South Bay, SigmetActive,
Backslash Forwardslash, AnomieBOT, Gnomeliberation front, Bsimmons666, Blahcake666, Jim1138, IRP, Tucoxn, Piano non troppo,
Aditya, Kingpin13, Awesomeman9921, Bluee Mountain, Flewis, Materialscientist, BasilSorbie, Citation bot, Elm-39, Elijah13, Maxis
ftw, Roux-HG, Teilolondon, Jdman123, Transity, Cureden, The sock that should not be, Stanton5, Capricorn42, Lusci, DSisyphBot,
Plasmon1248, Jmundo, Reliancepowercoin, Maddie!, Miguel in Portugal, Blaster395, Srich32977, Stevedodkins, Frosted14, Smurdah,
Siddhantsethi, Mathonius, AntiAbuseBot, The Wiki ghost, Doulos Christos, Mnmngb, SHallathome, E0steven, Cgersten, Tango Panach,
Ixamxjason, Graceinnes, Yellowweasel, FrescoBot, Bwehttam, Aig056789241, BillJr106, CoronaLover, Roos182, Bambuway, BenzolBot, Gganges, Citation bot 1, Nightsturm, Biker Biker, Pinethicket, I dream of horses, Tanweer Morshed, Jonesey95, Shepp20, Rushbugled13, A8UDI, Keenwords, Wizek, Guglie110, Wortoleski, Fumitol, Jujutacular, Samuelks, Kevinsleem, RANJINAP, Fabian5003, Lam
Kin Keung, Lotje, Krassotkin, Pennychestpennychest, Vrenator, ItayGolan, January, Beanpile, Benimblog, Eddiequest, Weedwhacker128,
Bobn4sh, Gabe19, Sargdub, Caster33, Slon02, Alison22,
, Ashton 29, Excelsior Deo, Immunize, Gfoley4, Katherine, Hblackhawks,
Matrix1010, RenamedUser01302013, NotAnonymous0, Solarra, Tommy2010, Wikipelli, White Trillium, FSE NEWS, Jfmrent, Flagit,
Anir1uph, Markhenderson1234, Werts14, Jayarajss, KuduIO, DoMayor, NGPriest, Wayne Slam, OnePt618, Tolly4bolly, Hardeepyadav,
Wagino 20100516, Vincentangeles, Seattle, BroJo79, Queenofgreen, Carmichael, Taenzee, Shi Hou, NeonGas, Anthoeleon, Petrb, Aujn,
ClueBot NG, Nathanielbartkus, Lenzcar, LogX, TehGrauniad, Satellizer, Shirshendusarkar90, Nanha atul, Snotbot, Tirupati balaji booking,
Pcparish, Corusant, Muon, 123Hedgehog456, O.Koslowski, Widr, Djb123, Brankin11, Helpful Pixie Bot, BG19bot, Arunstockguru, Contactus24by7, Thepoliticalmaster, Teonomics, Bignasty101, Mattzillahawkins, Wiki13, Altar, YVSREDDY, MaxUnited1999, CensoredBiscuit, Chased33, Yakmouth, Primedark75, Imhotech, AKumar14, Ndachuwa, Steve derheim, ChrisGualtieri, Batarang13, Nslemployee,
Khazar2, Jackwhite1940, Ekren, Kvntn, Natahere, Evolife, Lugia2453, Fritzbunwalla, Billycline, SFK2, Jreshu, Epicgenius, Ankitawebricks, Wandalowie, KnowlWiki, MilesIP43, EvergreenFir, Fortis est Veritas, Xxxpackpackxx, Kipstiger, Ginsuloft, Chhaya Sharma,
Sharestock, Vicmillion, Skyshooter, JaconaFrere, Kingresearch, Havanmcginnes, Ratsdomain, StudiesWorld, Mojotanios, LeDrewww,
Dodd.k.walsh, Jesalshethna, Rathod1100, Qwertyxp2000, Patron sev, A Zodiac A, Fungal vexation, Skipperstar, Mark33467, Wikicology,
Stupidguy101, Taylorsud, TranquilHope, Githamadhu, Bobby Brownie, Rdoz, Furqan2070, Ghaziassaf and Anonymous: 1238
Financial market participants Source: http://en.wikipedia.org/wiki/Financial%20market%20participants?oldid=648225783 Contributors: JALockhart, Woohookitty, AJR, Lmatt, SmackBot, Amatulic, Simon123, RomanSpa, Punanimal, Cosy, Alaibot, Barticus88, The
Transhumanist, Accesspig, Drewwiki, SueHay, ImperfectlyInformed, Lpcardoso, Addbot, Bihco, TechBot, Pisibe, Ripchip Bot, TheSoundAndTheFury, LWG, Pine, WPGA2345, Uday saha and Anonymous: 13
Investor Source: http://en.wikipedia.org/wiki/Investor?oldid=649767742 Contributors: Olivier, Pnm, Ronz, Furrykef, Topbanana, Lupin,

69.7. TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

383

Ravn, Pgreennch, Discospinster, Notinasnaid, Shreevatsa, -oo0(GoldTrader)0oo-, Plrk, Yzb, Voidxor, Dbrs, Phgao, Chase me ladies, I'm
the Cavalry, DaltinWentsworth, Yvwv, SmackBot, Ohnoitsjamie, MalafayaBot, DHN-bot, Iridescent, Barticus88, Andyjsmith, Kcurley,
JAnDbot, Gowish, R'n'B, J.delanoy, Drewwiki, Whitebox, Christian Storm, The Fat Guy, VolkovBot, CrashingWave, Wikidemon, Nickturton, Monkeynoze, Madhero88, Lamro, Falcon8765, TravelingCat, Dawn Bard, Maelgwnbot, StaticGull, ClueBot, Raj.agrawal, Muro Bot,
Carriearchdale, Attaboy, Mikemaadogg, Addbot, Ronhjones, Zorrobot, , Yobot, Reena6, Bungofpot, Materialscientist,
Nathansteel, FrescoBot, Thanu12, Roos182, Martinitus, Lotje, Kittymiss, Sargdub, Bleahy, Solarra, TuHan-Bot, Bryce Carmony, ClueBot
NG, O.Koslowski, Danceking5, CasualVisitor, Sigiheri, Mark Arsten, Bigsean0300, Bilderbear, Hgb1217, MichaelW01, Makecat-bot,
WBWDII, Backendgaming, Babitaarora, Smartguy912, Investor22, Abdulselam Barzani, NkZagreus, Falamander and Anonymous: 69
Institutional investor Source: http://en.wikipedia.org/wiki/Institutional%20investor?oldid=645435313 Contributors: Edward, Kaihsu,
Jerryseinfeld, Wikidea, PoptartKing, Dr Gangrene, Tabletop, Mandarax, Gettingtoit, BD2412, Vegaswikian, FlaBot, Nirvana2013, Grafen,
DocendoDiscimus, SmackBot, Gilliam, Simon123, Zoonfafer, Stevenmitchell, Kevlar67, Ohconfucius, Will Beback, Kuru, Robosh,
TastyPoutine, Reptile986, Hu12, Natrajdr, Trade2tradewell, CmdrObot, Future Perfect at Sunrise, Mojo Hand, Barek, Rich257, Praddy06,
Gowish, Drewwiki, DMCer, Funandtrvl, 386-DX, VolkovBot, Philip Trueman, McTavidge, Nxavar, Urbanrenewal, Lamro, Ubhudia, Altoids Man, Nopetro, Finnancier, Moorehaus, Celestial lady, Amyjbensted, Addbot, Misterx2000, Luckas-bot, AnomieBOT, Materialscientist, Maharbbal, Jean-Jacques Georges, Shadowjams, FrescoBot, Mamat Rohimat, CRoetzer, Skyerise, Xiaoshan Math, Gulbenk, ZroBot,
Cogiati, Taenzee, Rocketrod1960, ClueBot NG, StatPak, Widr, Tonyxc600, Styliann01, Kkumaresan26, Courage respect, SpanishFin777,
Msabbann and Anonymous: 54
Retail Source: http://en.wikipedia.org/wiki/Retail?oldid=647939005 Contributors: The Anome, Christian List, Roadrunner, DavidLevinson, AntonioMartin, Frecklefoot, Patrick, Michael Hardy, Fred Bauder, Zanimum, Cameron Dewe, TakuyaMurata, Tiles, Tregoweth,
Jeandr du Toit, Mydogategodshat, Markb, Guaka, RickK, Reddi, Sertrel, Silvonen, Topbanana, Dale Arnett, Hankwang, Baldhur,
Tim Ivorson, Postdlf, MarchHare, Hadal, Hcheney, Wile E. Heresiarch, Ancheta Wis, Bob Palin, Oberiko, Ferkelparade, Jgritz, Rick
Block, Siroxo, Bobblewik, ALargeElk, Chowbok, Lst27, Beland, Quarl, Rdsmith4, Jareha, Tyler McHenry, Gary D, Zondor, Gazpacho,
Discospinster, Westendgirl, JoeSmack, Bennylin, Art LaPella, Coolcaesar, Bobo192, Hurricane111, Sicherlich, Maurreen, Giraedata,
DrDeke, Alansohn, Alphaboi867, Arthena, Andrewpmk, Pmetzler, Velella, Gdavidp, Jrleighton, Dirac1933, Sumit Dutta, Ceyockey, Dennis Bratland, Woohookitty, Pol098, Dah31, NormanEinstein, Rchamberlain, Umofomia, Dysepsion, BD2412, Rjwilmsi, DeadlyAssassin,
Lockley, JoshuacUK, MZMcBride, NeonMerlin, ElKevbo, FlaBot, SchuminWeb, Margosbot, Ewlyahoocom, Tequendamia, KFP, Maustrauser, Pinotgris, YurikBot, Wavelength, Themepark, RobotE, Hede2000, Chris Capoccia, Stephenb, Rsrikanth05, AdamJaz, Cleared
as led, Nlu, Wknight94, Republican88, Zzuuzz, Malekhanif, Chase me ladies, I'm the Cavalry, GraemeL, Oswax, Katieh5584, Illumi
the trow, John Broughton, SmackBot, McGeddon, Eskimbot, Munboy, Cazort, Yamaguchi , Gilliam, Hmains, Fmheir, Bluebot, Oli
Filth, Kiellliam, Can't sleep, clown will eat me, Frap, Yidisheryid, Janem555, COMPFUNK2, BesselDekker, Nibuod, Nakon, MichaelBillington, Richard001, Ktpraveen, Cartoon-Fan, Hgilbert, Just plain Bill, Henning Makholm, LeoNomis, Bejnar, Kuru, SilkTork, JHman, Bjankuloski06, PowerCS, IronGargoyle, Timshuwy, Chrisch, 16@r, TastyPoutine, Peter Horn, , Eddie5000, Levineps,
OnBeyondZebrax, Woodshed, Fibre2fashion, ChrisCork, JForget, DangerousPanda, Hfb23, Retailpe, NaBUru38, Danrok, Gogo Dodo,
Futureobservatory, B, Luccas, Shirulashem, Jguard18, Tuxide, TonyTheTiger, Iedit, Heroeswithmetaphors, Gioto, Luna Santin, Wayiran,
Windbear Chime Guy, Monkeybreath, JAnDbot, Chaitanya.lala, Dan D. Ric, Getinthek, Barek, MER-C, RainbowCrane, LittleOldMe,
Naval Scene, VoABot II, Transcendence, Greenway6, Froid, Robkeenan11, WLU, Dardorosso, Nicolo Machiavelli, Archd3, MartinBot, Kiore, Naohiro19, Rettetast, Nirmal anand, R'n'B, LedgendGamer, Huzzlet the bot, J.delanoy, Trusilver, Svetovid, Reedy Bot,
EdWalker58, CallamRodya, Olegwiki, Iulus Ascanius, Potatoswatter, Fashiononly, Idioma-bot, Funandtrvl, Akuvodapainting, WWGB,
KingTheodin, VolkovBot, Dheerajakula, Thisisborin9, VasilievVV, Highlander15, Saddy Dumpington, Donrencz, TXiKiBoT, Gune,
Qwayzer, Palkema, Hqb, Mwutthip, Mkpumphrey, UnitedStatesian, Zhenqinli, Andrewaskew, Lamro, Angrymansr, Altermike, Enviroboy,
Sevela.p, Valce, SieBot, Angel2001, Plinkit, Jess schif, Purbo T, Bentogoa, Flyer22, MaynardClark, Blue Pixel, Bagatelle, Sliwers, Mansuetodigital, Distino, Mtaylor848, Lloydpick, Explicit, Smashville, ClueBot, Snigbrook, SevDrape, ZippyGoogle, Arakunem, Saddhiyama,
Fiet Nam, Hal8999, DanielDeibler, CounterVandalismBot, Axkey, Resoru, Moneywatch, KnowledgeBased, Vivio Testarossa, Singhalawap, Kaiba, SchreiberBike, Mlas, Thingg, Aitias, SoxBot III, Apparition11, Katzo9.7, Deanna08, XLinkBot, Andrew Siegwart, SeamusSweeney, Emapretail, Addbot, Mortense, Willking1979, 1123pizza, Jncraton, Ironholds, CanadianLinuxUser, Sam1223, Jim10701,
MrOllie, CarsracBot, CUSENZA Mario, Lightbot, Jarble, HerculeBot, Luckas-bot, Yobot, TaBOT-zerem, Evans1982, THEN WHO WAS
PHONE?, Max, Rsamason, AnomieBOT, Jim1138, Galoubet, Rajdeeprathod, Je Muscato, Xqbot, Sashadro, Wperdue, Priyankamathur,
Omnipaedista, SassoBot, CnkALTDS, Lucyatchalk, N419BH, Sesu Prime, Wikipe-tan, Jonathonhall, MGA73bot, Don 'Capitalized' A.
Clifton, Pbaril3456, Pinethicket, I dream of horses, Chris814, Carlosmessi, Blender09, SkyMachine, Cindylim123, FoxBot, Suusion of
Yellow, Tbhotch, Reach Out to the Truth, Pozytyv, DARTH SIDIOUS 2, Mean as custard, DexDor, Galloping Moses, Beyond My Ken,
Midhart90, BobbyChristmas, Felix0009, EmausBot, Orphan Wiki, Dewritech, GoingBatty, Pawanretail, We hope, Kkm010, Onced boath,
Ida Shaw, Nonstore, Debkajon, Kilopi, Gz33, Ocaasi, Erianna, Aeled, Apple520, ChuispastonBot, Sandyhirschel, Oce.ecr, ClueBot NG,
Retailworldonline, MelbourneStar, Satellizer, Wolf Uluz, ThinkingLeaders, Wiki helper guy, Castncoot, Widr, Jpquidores, Madhav86,
Onlinearticle, Helpful Pixie Bot, Mergers, Exec second, JohnEdit21, Northamerica1000, Kangaroopower, JohnChrysostom, AvocatoBot,
Gorthian, Altar, Creativecognizants, Aisteco, Arcamaxter, DarrenM18888, BattyBot, Several Pending, PDumeny-NJITWILL, Kylejb11,
ChrisGualtieri, Mediran, YFdyh-bot, Khazar2, JYBot, Wyskar7, Webclient101, Fabiopagoti, Stephenleehall, Wikimunter, Anatoly p,
Guphanti, SFK2, Pear285, Corn cheese, Guifeng, Raulcaeser, Royroydeb, Kukuecho9, 816phloh, Kahtar, Kim9988, Fredrockjtv, Jaaybiggz, Hellotherealex, ImTheNinja98, Mythnder, Patelbharat25, Sandana krishnan.S, Buvaneswari Pugazhendi, Jax-Jacq, Jorge104025,
James.bennett.russell and Anonymous: 431
Speculation Source: http://en.wikipedia.org/wiki/Speculation?oldid=646418717 Contributors: Alex.tan, Fredbauder, Karen Johnson,
Roadrunner, Olivier, Edward, Kwertii, Mic, Ihcoyc, Mac, Sabbut, Wst, Robbot, SEKIUCHI, Llavigne, P0lyglut, Psb777, Art Carlson,
Duncharris, Trid, Mendel, SURIV, Karol Langner, Elroch, Pgreennch, Rhobite, NeuronExMachina, Wk muriithi, Warpyght, Wsher,
Cretog8, Aml, Jerryseinfeld, La goutte de pluie, Nk, Siim, Alansohn, Javier Jelovcan, Burn, DoorFrame, CloudNine, OwenX, Woohookitty,
-oo0(GoldTrader)0oo-, Mbsuess, Bluemoose, Dovid, Magister Mathematicae, Crzrussian, Coneslayer, Rjwilmsi, Lockley, Bob A, Vegaswikian, Tadeu, Feco, Cethegus, FayssalF, Ground Zero, RexNL, Chobot, Algebraist, YurikBot, Jimp, RussBot, Splette, Gaius Cornelius, NawlinWiki, Bachrach44, Bruxism, Grafen, Nick C, Tomisti, Ms2ger, Zzuuzz, GraemeL, Shawnc, Tiger888, DocendoDiscimus,
Itub, SmackBot, Mitchan, Unyoyega, Alan McBeth, Ohnoitsjamie, Kevin Ryde, Chendy, Smallbones, Cyhatch, Fuhghettaboutit, Noblige,
Wossi, Nathanael Bar-Aur L., Kuru, Robosh, Wttsmyf2, 16@r, Dindiz, MarkSutton, Catquas, Levineps, B7T, K, Joseph Solis in Australia, Curtmack, Trade2tradewell, Gveret Tered, 1122334455, JForget, Superesto, Cydebot, Paddles, NorthernThunder, UberScienceNerd,
Thijs!bot, Marek69, Tapir Terric, Hcobb, Mmortal03, Mentisto, Fayenatic london, Scepia, NByz, JAnDbot, Nyq, Sushi Tax, Tedickey,
SSZ, THobern, MartinBot, Francis Tyers, PCock, Drewwiki, Nay Min Thu, Joshua Issac, Idioma-bot, TXiKiBoT, Ask123, Boreal321,
WikipedianYknOK, Wordsmith, LeaveSleaves, Urbanrenewal, SwahilidR, Orlica, Hcsknight, SieBot, Step 3, Caltas, Oda Mari, Investroll,

384

CHAPTER 69. STOCK MARKET CRASH

Nopetro, Moonraker12, Latics, Denisarona, ClueBot, RafaAzevedo, Dr. B. R. Lang, Arj179, Megiddo1013, SchreiberBike, Boyd Reimer,
Tiny giant what???, Addbot, AkhtaBot, MrOllie, AndersBot, Decibert, Steaxauce, Legobot II, Amirobot, AnomieBOT, DemocraticLuntz,
Joule36e5, Gobaudd, ChrisJ6, Radilam, Um, Je Muscato, Materialscientist, Xqbot, Ywaz, Erud, Drilnoth, Nasnema, Shadowjams,
Rtycoon, Moomoopower123, Cfainstructor, Forp, Kokoshky, Margo&Gladys, RjwilmsiBot, Sargdub, Bento00, Hajatvrc, Benwm, WikitanvirBot, GoingBatty, MariusBoo, Raoulhs, H3llBot, Shakinglord, ClueBot NG, Jack Greenmaven, Chrisminter, Ramza05, Danceking5,
Helpful Pixie Bot, BG19bot, Robert the Devil, CitationCleanerBot, CYYK, Shorvalu, Justin G. S. Peter, Lugia2453, LudicrousTripe,
Juhuyuta, EvilLair, Rmh789 and Anonymous: 174
Cash Source: http://en.wikipedia.org/wiki/Cash?oldid=648848119 Contributors: Skysmith, Ijon, Tkinias, Gutza, Scott Sanchez, Pakaran,
Auric, Raeky, Geeoharee, Bkonrad, Wmahan, Aughtandzero, M.e, Eisnel, Discospinster, Rich Farmbrough, Jnestorius, Bobo192, Smalljim, Walkiped, Maurreen, Minghong, Nik42, VladimirKorablin, Wtmitchell, Garzo, TenOfAllTrades, Mel Etitis, Camw, SDC, BD2412,
Canderson7, Mikepjones, The wub, FlaBot, El Cid, Chobot, Gwernol, Roboto de Ajvol, Stephenb, Manxruler, NawlinWiki, BigCow,
Nirvana2013, Korny O'Near, DeadEyeArrow, AjaxSmack, TransUtopian, Searchme, YolanCh, Allens, Katieh5584, SmackBot, Melchoir, Lawrencekhoo, Commander Keane bot, Gilliam, Ohnoitsjamie, Youremyjuliet, Hmains, Qwasty, Peterk2, Rogermw, Can't sleep,
clown will eat me, Whpq, Flyguy649, BostonMA, Rklawton, Gobonobo, JHunterJ, Slakr, KJS77, Kanatonian, Bsskchaitanya, Courcelles, IanOfNorwich, Lazulilasher, Karenjc, Pewwer42, Cydebot, Cahk, Gogo Dodo, B, DumbBOT, Thijs!bot, Gamer007, Mojo Hand,
Blathnaid, Tourdeforcex, Hmrox, RobotG, JAnDbot, Barek, MER-C, PubliusFL, Acroterion, Meeples, Magioladitis, Hullaballoo Wolfowitz, Tornvmax, JamesBWatson, Jsk Couriano, Edward321, Patstuart, Jim.henderson, Rettetast, AntiSpamBot, Touch Of Light,
Buhuzu, Joshua Issac, Abbashere, DorganBot, Klajdi2, CardinalDan, Marekzp, Rei-bot, Durkalurks, Palkaman34, Zhenqinli, Why Not
A Duck, Brianga, AlleborgoBot, SieBot, DerbyCountyinNZ, Brownsfrye9, Moonriddengirl, Dawn Bard, Everybean, Keilana, Tiptoety,
Shifty(clue), AppleMan1, Oxymoron83, Lightmouse, Alex.muller, Jimtpat, Egeydude, Denisarona, Martarius, ClueBot, Fyyer, The Thing
That Should Not Be, Epsilon60198, Excirial, F222, Cadeel, Shadowsx, JamieS93, Danielleevandenbosch, Stepheng3, Rui Gabriel Correia,
Chaosdruid, Franklin.vp, Versus22, V23gamer, Stickee, Rror, Cmr08, Cashwatson, Lillybitch, Addbot, Glass Sword, Tide rolls, Zorrobot, ValJor, Legobot, Luckas-bot, Yobot, Ptbotgourou, Fraggle81, Amirobot, Selawo Obmijo, AnomieBOT, Rubinbot, Kingbenny1990,
Jim1138, Piano non troppo, Veganfood, Materialscientist, Cameron Scott, Xqbot, Cresix, Psychonaught, Macgrrl, Ardg08, Erik9bot,
800doll, Surv1v4l1st, GreatestWisdom, Sky Attacker, StaticVision, Mikimik, Lawlcat69, Pinethicket, Reconsider the static, Lightlowemon, Ianplasma, Owner snake1, Nishikant.deshmukh, Sargdub, CashhMontana, EmausBot, WikitanvirBot, Mathfrancis, American Billionaire, RenamedUser01302013, ZxxZxxZ, Slightsmile, Pzhfbustc, Wikipelli, Tzaditron, Mattford110, Tolly4bolly, Davenotinuseplz,
Brandmeister, L Kensington, AreYouTheGateKeeper, Donner60, Scientic29, Therexbanner, ChuispastonBot, Happyappy1, Sophbish,
Brigade Piron, GrayFullbuster, Taenzee, Gogo57, ClueBot NG, Kilogmas, MelbourneStar, Tmghskcor8, Fahad.caan, Secertagent69,
YVSREDDY, Caphthor, Primetime123, ChrisGualtieri, Ancienzus, GurvinderJ, Wizkid10, Makecat-bot, Lugia2453, Hobawido, Wywin,
Dravidianhero, Dollarispro, Epicgenius, Pseudonymous Rex, Dirtbiker3969, Ginsuloft, Stylebox4you, Meteor sandwich yum, BjornEriks, I~AM~HERE~TO~HELP~YOU~THINK, DOMA MAN-IZ-THE~best, Ezza1995, KarakocanND, Yoon Aris, IMuhammadSiam, C
swagmama3, Biscuitsauce3 and Anonymous: 228
Line of credit Source: http://en.wikipedia.org/wiki/Line%20of%20credit?oldid=643445415 Contributors: Bdonlan, Scott Sanchez,
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Ckarta, Luckas-bot, Yobot, Fraggle81, Amirobot, AnomieBOT, Helvcn, Erik9bot, Immnancialcom, BenzolBot, I dream of horses,
A8UDI, Etmoonshade, ClueBot NG, Widr, Soverytall, Arudy, BattyBot, Tutelary, Samtan919, Prestafunding, Forjs429, Bharath villivalam and Anonymous: 43
Deposit account Source: http://en.wikipedia.org/wiki/Deposit%20account?oldid=646499793 Contributors: Heron, Pnm, Theresa knott,
NeoJustin, EugeneZelenko, Jerryseinfeld, 3mta3, Hooperbloob, Crosbiesmith, Mindmatrix, Lmatt, Roboto de Ajvol, RussBot, Nirvana2013, MarkSG, Mkill, Black Falcon, Airodyssey, Kungfuadam, Sardanaphalus, SmackBot, Lawrencekhoo, Simon123, Famspear,
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YiFeiBot, Dee59, The Construct, PrinceSulaiman and Anonymous: 71
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Derksen, Roadrunner, SimonP, Edward, Kchishol1970, Michael Hardy, Willsmith, Kwertii, Kku, Mic, Pcb21, JASpencer, Mydogategodshat, JidGom, Renamed user 4, Jfeckstein, Wik, Tpbradbury, Taxman, Topbanana, Carax, Jni, Robbot, RedWolf, ZimZalaBim, Gandalf61, Babbage, Sekicho, Hadal, Cyrius, Superm401, GreatWhiteNortherner, Alan Liefting, Fastssion, Marcika, Niteowlneils, Bobblewik, Utcursch, Piotrus, RayBirks, Urhixidur, MementoVivere, M1ss1ontomars2k4, Mike Rosoft, Chris Howard, Sebrenner, Rich
Farmbrough, Wk muriithi, Notinasnaid, Bender235, Fenice, Aecis, Aude, RoyBoy, Grick, C S, Jerryseinfeld, Nk, Rajah, John Fader,
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Woohookitty, Justinlebar, Robwingeld, Qaddosh, Dirnstorfer, Wikiklrsc, GregorB, Eyreland, Lfchuang, Ronnotel, FreplySpang, RxS,
Sybren, Rjwilmsi, Helvetius, Feco, Brighterorange, Nguyen Thanh Quang, Tuaw, Ground Zero, Strangnet, Bondwonk, Chobot, DaGizza,
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DocendoDiscimus, Sardanaphalus, Veinor, SmackBot, InverseHypercube, Vald, Phaldo, Eskimbot, IstvanWolf, SmartGuy Old, Yamaguchi , Ohnoitsjamie, Amatulic, Hippodrome, Chris the speller, JMSwtlk, Caissas DeathAngel, CSWarren, Nbarth, Ryan O'Rourke,
Zven, Can't sleep, clown will eat me, Mitsuhirato, Smallbones, Berland, KaiserbBot, Stevenmitchell, Jmnbatista, Wonderstruck, Salt Yeung,
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A. Parrot, Beetstra, Calibas, Treznor, Mr Stephen, TastyPoutine, Hu12, Quaeler, Levineps, Typelighter, IvanLanin, Philip ea, Mmaher,
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385

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386

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Robbot, Pfortuny, Dzhuo, Sbisolo, Donreed, Kwi, Hadal, ElBenevolente, Cpm, Enochlau, BenFrantzDale, Zigger, Bkonrad, Wgmccallum, Mirer, Guanaco, Christofurio, Arconada, Gadum, Jossi, Kelson, Joyous!, Fintor, Acad Ronin, Yethey, Random user, Rich Farmbrough, Bender235, Fenice, Lauciusa, Mwanner, Aude, Shanes, Gxti, Cmdrjameson, Maurreen, Giraedata, Jerryseinfeld, Tritium6, Haham hanuka, Leifern, Espoo, Jumbuck, Undecidable, Gary, JYolkowski, Orimosenzon, C960657, Arthena, Borisblue, Mu5ti, Andrew
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Phknrocket1k, Retail Investor, REalSmartInvestor, Halpaugh, R'n'B, Tgeairn, J.delanoy, Danpak, Barts1a, Katalaveno, Thomas Larsen,
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Mild Bill Hiccup, Boing! said Zebedee, Klmjet, DragonBot, Alfredchew, Excirial, Gtstricky, SchreiberBike, Thingg, Qwfp, Goodvac,
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Smallbones11, Fender0107401, Wiki5d, Citation bot, DannyAsher, LilHelpa, Xqbot, Day000Walker, Srich32977, Khaderv, Papercutbiology, RibotBOT, Satellite9876, Jayandsquids, Khandelwala1, Agbr, Mfwitten, Citation bot 1, Skyerise, Keenwords, RedBot, Sudfa, KBello,
Kirt Christensen, Toasterpastery, Sargdub, Ivj0915, EmausBot, John of Reading, WikitanvirBot, Swerfvalk, Dfdferer22, Drusus 0, NicatronTg, Caotuni, FBIMON, Richardminhle, Medeis, H3llBot, L Kensington, No intention of paying for a TV license, Erhimanshusavsani,
Alesander, DASHBotAV, Sethmethod, ClueBot NG, Cwmhiraeth, Varna burgas, Kasirbot, Statoman71, Widr, B107, Helpful Pixie Bot,
Adrian88888, Island Monkey, Bmusician, Raviprasadmr, Krobins1987, Kyleanthonypastor, Test12345test12345, Options-savvy, Optionbinaire, Lugia2453, SPECIFICO, BeachComber1972, Dhstarr, Epicgenius, ThinkerBlogs, Acetotyce, Amitontheline, BreenanWilliams0001,
UnicefFoundation53535, Kind Tennis Fan, TheDiogenes, Michaeltheonlyone, Mgkrupa, Diegodaquilio, Sushant00333 and Anonymous:
497
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Hardy, Mic, Pcb21, Ahoerstemeier, Vzbs34, Taxman, BenFrantzDale, Mervynl, Sam Hocevar, Fintor, D6, Jayjg, Rich Farmbrough,
Vsmith, Fenice, Marco Polo, Gxti, Giraedata, Zr40, Leifern, Mfolozi, Jumbuck, JYolkowski, Kanie, Ronark, Pethr, Mindmatrix,
Bluemoose, Mandarax, Ronnotel, Margosbot, Lmatt, Jersey Devil, YurikBot, Gaius Cornelius, Slawkenbergius, GraemeL, Shyam, DocendoDiscimus, Jphillips, CarbonCopy, Reedy, Btm, Rajah9, Jab843, CSWarren, Mitsuhirato, Smallbones, Sgcook, SashatoBot, Kuru,
Loadmaster, Slakr, MrDolomite, Hu12, Quaeler, JHP, Adambiswanger1, Shabbirbhimani, Amniarix, Cydebot, Legis, Janviermichelle,
Kablammo, Glennchan, Mentisto, WallStGolfer31, Static Electric, GeneralBob, Doctor Johnson, Gkklein, J.delanoy, Victorgehrke, LordAnubisBOT, Coppertwig, Kidlittle, Nburden, SueHay, Lamro, To rsyadav, Tpb, SieBot, Laoris, Cyfal, Finnancier, Willyv1, ClueBot,
The Thing That Should Not Be, Hal8999, Klmjet, Qwfp, Mespark, Nekiko, Addbot, Darrylbarnes, DiscoverOptions, Yobot, Ptbotgourou,
Manishji.gupta, Materialscientist, Xqbot, VladimirReshetnikov, Kalbasa, Smallman12q, Agbr, Thefoetus, Scootercatter, Fastilysock, Swerfvalk, Drusus 0, Aeonx, Sandkicker10, Sms2010, 28bot, ClueBot NG, Gareth Grith-Jones, Boothebeast, AllanEdwards999, Statoman71,
Bluebird222, Edaguy59, Soham, Realaboo, Monkbot, JasonWonder, Jurg k23, Sandra bk and Anonymous: 151
Exotic option Source: http://en.wikipedia.org/wiki/Exotic%20option?oldid=639682995 Contributors: Pcb21, Reiner Martin, Ary29, Fintor, Leifern, Arthena, JordanSamuels, Woohookitty, Bluemoose, Encyclops, RussBot, Bhny, Dilaudid, Chris. F. Masse, DocendoDiscimus,
Betacommand, Chris the speller, Nbarth, Sgcook, Ulner, Robosh, Thisisarun, Hu12, Jackzhp, Cydebot, Hypersphere, MrAWO, BetacommandBot, Nshuks7, Severo, Oceanynn, Trushar, Lamro, Cool Cosmos, BigSwingingSomething, Finnancier, Obiezyswiat, Saddhiyama,
Addbot, TaBOT-zerem, Hairhorn, Citation bot, Quebec99, Xqbot, FrescoBot, Shoval55, Vovchyck, Sargdub, Bento00, Dewritech,
Njgdekker, Isoventures73, Pokbot, ChrisGualtieri, Dashm79, Shamoo67, WeRegretToInform, Monkbot and Anonymous: 37
Put option Source: http://en.wikipedia.org/wiki/Put%20option?oldid=643632641 Contributors: Andre Engels, Enchanter, Michael Hardy,
Kwertii, Mic, Pcb21, Mydogategodshat, Juxo, Robbot, DocWatson42, Herr Klugbeisser, Joconnor, Sam Hocevar, Fintor, Mike Rosoft, Discospinster, Rich Farmbrough, Calion, Fenice, Ghostal, Gxti, Obradovic Goran, Leifern, Landroni, Mfolozi, Jumbuck, Atlant, Gaytan, Ercolev, Nefertum17, Bluemoose, Ronnotel, A Train, FlaBot, Margosbot, Ayla, Valor, Pigman, CambridgeBayWeather, Brandon, GraemeL,
DocendoDiscimus, SmackBot, Mikesheer, Jphillips, CarbonCopy, Vald, Phaldo, Edgar181, ERcheck, Varmaa, Ken'ichi, Kevininspace,
CSWarren, Zven, A. B., Mitsuhirato, Smallbones, Haigh21, Ritafelgate, Savidan, Sgcook, Mion, Gyre86, Potuspanze, Christopherdunlap,
Loadmaster, Hu12, JHP, Shabbirbhimani, CmdrObot, Van helsing, Neelix, Cydebot, Myscrnnm, Surturz, Legis, Kablammo, JurgenG,
WallStGolfer31, Greg Comlish, Jersey Skies, GeneralBob, Doctor Johnson, CliC, Victorgehrke, Wcspaulding, Nwbeeson, Robetcher,
DMCer, Nburden, Optionportfolio, Netsumdisc, Wooseock, Zdhan1, Shdv, Investor84, AlleborgoBot, SieBot, Suemolen, Artoasis, Paint-

69.7. TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

387

man, Finnancier, Denisarona, ClueBot, Jan1nad, Klmjet, Ludwigs2, NJGW, Johnuniq, Humanengr, Vigormaster, Gerard Samuel, Mespark, Jedihawk, Addbot, Yasha1969, Tkeller28, Zorrobot, AnomieBOT, Kingpin13, Materialscientist, Danno uk, Kalbasa, Pyxu619,
Datakid1100, Erik9bot, Alpesh24, Joshuwaliu, Tebitby, Jschnur, Prathishpeeriz, Bravenewlife, EmausBot, Exok, Drusus 0, Ego White
Tray, ClueBot NG, P4VV, Kostdro, CallidusUlixes, Widr, DudeOnTheStreet, KingNik073, Michaelsun1980, Freddie23h, I am One of
Many, Zohoarbish and Anonymous: 145
Security (nance) Source: http://en.wikipedia.org/wiki/Security%20(finance)?oldid=648762182 Contributors: The Cunctator, Bryan
Derksen, Enchanter, Heron, Isis, Edward, Patrick, Mic, Eric119, Ahoerstemeier, Ronz, Nikai, Smack, NilsB, Ishu, Taxman, K1Bond007,
Skyre, Robbot, Altenmann, Nurg, Ojigiri, Gidonb, Adam78, Pablo-ores, Dmb000006, Ezhiki, Adam McMaster, Trid, Antandrus,
Ary29, Biot, Creidieki, Tsemii, Maury, WOT, Random contributor, Wk muriithi, Notinasnaid, Longhair, John Vandenberg, Jerryseinfeld,
Waphle, Hesperian, Jumbuck, Gary, Atlant, Wikidea, Yeu Ninje, Bantman, Svartalf, Melaen, TenOfAllTrades, Woohookitty, 2004-1229T22:45Z, Sachindole, Dpr, Pdelong, Tawker, Feco, Czalex, Nicolas1981, Yamamoto Ichiro, Windchaser, Ground Zero, Margosbot,
Bondwonk, Nicholasink, Chobot, Gwernol, Roboto de Ajvol, Elapsed, Jlittlet, RussBot, DanMS, Matt Fitzpatrick, Akamad, NawlinWiki,
Spike Wilbury, Aeusoes1, Grafen, Pkearney, Wknight94, Shawnc, DocendoDiscimus, SmackBot, Lds, Kopaka649, Sectryan, IstvanWolf,
DomQ, Ohnoitsjamie, Rmosler2100, Chris the speller, Simon123, DHN-bot, Zambaccian, Whpq, Flyguy649, Radagast83, Cybercobra,
Ritafelgate, EPM, SashatoBot, Lambiam, Kuru, Breno, Bjankuloski06en, Ckatz, Beetstra, Gondooley, Xionbox, Phuzion, Honksandsirens,
Hu12, Simon12, Philippschaumann, Deetdeet, Eastlaw, Cbmccarthy, Vanished user qw388j3rie, Page Up, PegArmPaul, Cydebot, Road
Wizard, Burgwerworldz, Mato, Bmathis, Kilva, Akittredge, WinBot, Pauljohny, SummerPhD, Gregalton, Bona Fides, MER-C, PhilKnight,
Cynwolfe, RBBrittain, Iitkgp.prashant, JohnLai, Snchain4484, Bnichols, Mermaid from the Baltic Sea, R'n'B, Smokizzy, Lilac Soul, McSly, Prementon, Oceanynn, Wcspaulding, Bushcarrot, Brian Pearson, DMCer, Stockmad, Funandtrvl, Remi0o, Jennavecia, MontyPh,
Jkeene, Sankalpdravid, Qxz, Zjak, Lamro, Chaosandwalls, AlleborgoBot, Dudebri1, Dan Polansky, SieBot, Israel32, Purbo T, Faradayplank, Lcz2005, Conant Webb, ClueBot, Rjd0060, Ewawer, PixelBot, AZatBot, M.O.X, BVBede, DerBorg, XLinkBot, Ost316, Jprw,
WikHead, Jon poynter, Maimai009, Addbot, TutterMouse, Fieldday-sunday, Cognatus, AndersBot, Chzz, Lightbot, Apteva, Luckas-bot,
Yobot, Ptbotgourou, Amirobot, Galatee, Santryl, Materialscientist, Xqbot, Wikicontra, SassoBot, Sophus Bie, Mnmngb, Alialiac, Symphoney, Kickyandfun, FrescoBot, Mark Renier, CRoetzer, Decimalcarrion, Jonah Bloch-Johnson, Reviewer2009, Tremain34, TobeBot,
Lotje, Specs112, Pozytyv, DARTH SIDIOUS 2, Sargdub, Holly25, Skalmier, EmausBot, Zollerriia, Neechalkaran, Morkovna, Zfeinst,
ClareCottrell, EdoBot, Rocketrod1960, ClueBot NG, Baldy Bill, Snotbot, Cntras, Asukite, Sm4150, Pine, Aourangzaib, AvocatoBot,
Empire.stock, Codeh, Njeriannk, DaltonCastle, Katie gotlieb, Lowenherzderek20, Yamaha5, Neudabei and Anonymous: 263
Stock Source: http://en.wikipedia.org/wiki/Stock?oldid=647467795 Contributors: Damian Yerrick, Paul Drye, TwoOneTwo, WojPob,
Mav, Robert Merkel, Youssefsan, Fredbauder, Enchanter, SimonP, Heron, Topory, Olivier, Rickyrab, Edward, Patrick, Modster, Mic,
Jakub, Gbleem, Mbessey, Ronz, Angela, Julesd, Netsnipe, Rob Hooft, Mydogategodshat, Charles Matthews, Espertus, Maximus Rex,
Furrykef, Itai, Taxman, Pakaran, Jni, Rogper, Dzhuo, Chrism, Jmabel, Brw12, Davodd, Dodger, Quadalpha, Psb777, Matthew Stannard,
Matt Gies, DocWatson42, Orangemike, Bkonrad, Christopherlin, Utcursch, Antandrus, Phe, Pgreennch, Sonett72, MementoVivere, Mike
Rosoft, Pmadrid, EugeneZelenko, Discospinster, Notinasnaid, Xezbeth, Mystique, Bender235, Fenice, Brian0918, Lycurgus, Aude, Art
LaPella, Bobo192, Smalljim, Tomheaton, Jerryseinfeld, Tritium6, JesseHogan, SPUI, Espoo, Alansohn, Gary, Arthena, Atlant, Andrewpmk, Riana, Bruce Couper, Viridian, Gautam3, Snowolf, Ronark, RJII, Versageek, HenryLi, Stuartyeates, Rodii, Mindmatrix, TarmoK,
LOL, Guy M, Madchester, -oo0(GoldTrader)0oo-, SDC, KKramer, Sam Ellens, Megabyte73, Rejnal, Sachindole, Graham87, Deltabeignet,
RxS, Dpr, Sj, Sjakkalle, Stsmith, TitaniumDreads, Roccyraccoon, Miha Ulanov, Haya shiloh, Feco, Leithp, Titoxd, Wragge, Nihiltres,
Nivix, CarolGray, Gurch, Leslie Mateus, Lmatt, Chobot, DVdm, Gwernol, The Rambling Man, Latch, Petiatil, Ytrottier, Stephenb, Manop,
CambridgeBayWeather, NawlinWiki, Grafen, Clam0p, Retired username, Cholmes75, Amitn, Nate1481, Alpha 4615, ClaesWallin,
Zzuuzz, Maomaothecat, Theda, Closedmouth, NYArtsnWords, Lendu, Skullssion, Petri Krohn, GraemeL, DocendoDiscimus, Veinor,
SmackBot, KnowledgeOfSelf, Vald, Paul.Paquette, Brick Thrower, KVDP, Edgar181, The great kawa, PeterSymonds, Ohnoitsjamie,
Hmains, Chris the speller, JMSwtlk, Persian Poet Gal, Rex Germanus, Oli Filth, RayAYang, Baa, Mkamensek, A. B., WikiPedant, AntiVan, Smallbones, JonHarder, Yidisheryid, Frothy, Xiner, Rrburke, Dripp, Aquahelper, Stevenmitchell, Radagast83, Dreadstar, Astroview120mm, Peteforsyth, Zogmen, Ravionweb, Kuru, John, Gobonobo, KenBest, IronGargoyle, Ckatz, 16@r, Slakr, Ehheh, Dicklyon, Big
Smooth, Bwpach, Caiaa, Hu12, Levineps, Typelighter, OnBeyondZebrax, Sabik, Tawkerbot2, Marceki111, Mellery, 5-HT8, Nettrust,
Dgw, Bakanov, Prestonp, Xzqx, Burgwerworldz, Atticmouse, Neil9999, Wikipediarules2221, Tawkerbot4, Minfo, Zanzaro, Zalgo, Satori
Son, Andyjsmith, Bahnemann, Tellyaddict, Notmyrealname, Leon7, Malxirocon, Rompe, Escarbot, AntiVandalBot, Amcguinn, QuiteUnusual, Lootzynewiki, Alphachimpbot, AZard, JAnDbot, Barek, MER-C, Epeeeche, Db099221, Struthious Bandersnatch, Andonic,
Xeno, PhilKnight, SiobhanHansa, Gumby600, SmUX, Bongwarrior, VoABot II, Smartal, JNW, Yandman, Mbc362, Rami R, Rich257,
Deliriousandlost, Catgut, Iitkgp.prashant, JohnLai, MetsBot, 28421u2232nfenfcenc, Cpl Syx, GeneralBob, Calltech, Pikitfense, Makro,
Dieseltaylor, MartinBot, Kateshortforbob, Nono64, LedgendGamer, Radbug, J.delanoy, Pharaoh of the Wizards, Hans Dunkelberg, Andrei
Lissovski, Drewwiki, Natty4bumpo, Zaremik, RIPSAW1986, McSly, LinkSpamCop, DjScrawl, Cometstyles, Lebob, DMCer, Anupam
luv, CardinalDan, VolkovBot, The Wild Falcon, TallNapoleon, Soliloquial, Al.locke, Gobiman, Aesopos, Philip Trueman, TXiKiBoT,
Rollo44, SueHay, Binaryalchemy, WikipedianYknOK, Netsumdisc, OneSix, PDFbot, Optigan13, Zjak, Shanata, Urbanrenewal, Edvvc,
Lamro, Aigiqinf, Falcon8765, Alaniaris, Cnilep, Book worm sween, Why Not A Duck, Gregpadden, Delgolo, Logan, Kbrose, Akhilbansal
2007, SieBot, Israel32, Nubiatech, Financeeditor, Scarian, Euryalus, Tray65, Jauerback, Caltas, Timothy Cooper, Yintan, Keilana, Wepsiatwin, Oda Mari, Oxymoron83, Artoasis, Ddxc, Easycash81, Lightmouse, SH84, Bharath.desai, Pocopocopocopoco, Upax, Pinkadelica, Rinconsoleao, Martarius, ClueBot, Wikievil666, The Thing That Should Not Be, Postmortemjapan, Rjd0060, Ark2120, Shahrams,
Oriolpont, Excirial, Ontopofthewall, John Nevard, SpikeToronto, Ottawa4ever, Thingg, Aitias, ZombiesAteTexas, Party, DumZiBoT, Apnakharian, BarretB, XLinkBot, Jumuji, Stickee, Jovianeye, Avoided, Maudonk, NellieBly, PL290, Cochese516, NonvocalScream, Addbot, Null0trooper, Boomur, SexyUser, KorinoChikara, CanadianLinuxUser, Download, Chzz, Gpeterw, Favonian,
, Renatokeshet,
OlEnglish, C933103, Yobot, Fraggle81, TaBOT-zerem, Jan Arkesteijn, Randyintally, AnomieBOT, Galoubet, Flewis, Materialscientist,
Vincekd, Xqbot, Srich32977, Korvin2050, ProtectionTaggingBot, Shirik, Transmissionelement, Mnmngb, N419BH, iedas, Jasoncoolax,
Leonid Antonenko, Rkr1991, ZenerV, Sopher99, Hamtechperson, A8UDI, Jschnur, Lomara1, Infotechguy1969, Jonkerz, Lotje, Gulbenk, Vrenator, Clarkcj12, Duoduoduo, Tbhotch, Reach Out to the Truth, DARTH SIDIOUS 2, Kenettic, Onel5969, Mscomeon, Jakebowles, Aaa8841, EmausBot, Orphan Wiki, Dewritech, Anadihrishi, Iris91, Dfdferer22, TheSoundAndTheFury, Rabbabodrool, Wikipelli,
K6ka, Ida Shaw, MithrandirAgain, Hazard-SJ, Wayne Slam, ICEQUITY, Donner60, Summer Investor, Tot12, Peter Karlsen, SEOAngel, DASHBotAV, ClueBot NG, Jameshobbs, Satellizer, Quazzaazazazaazaza, Mrcapitalgain, Oddbodz, Brankin11, Helpful Pixie Bot,
Calabe1992, WNYY98, Zhoutong, Island Monkey, Krenair, M0rphzone, Smoof 313, MusikAnimal, Mark Arsten, Atomician, Jeancey,
Mathnerd314159, BattyBot, W.D., Troll1184, Hmainsbot1, Webclient101, Katie gotlieb, Isarra (HG), SFK2, SPECIFICO, Yayoyoyayo,
DeviantSerpent, IamSwitzerland, Babitaarora, Bigawesome12345, Ugog Nizdast, GirishKapoor, Donkeykong1234, Grahamwhenderson,
Banzai6666, Dee59, Gronk Oz, Whikie and Anonymous: 714
Time deposit Source: http://en.wikipedia.org/wiki/Time%20deposit?oldid=643549572 Contributors: Pnm, Nikai, Robbot, Antandrus,

388

CHAPTER 69. STOCK MARKET CRASH

Pgreennch, Jutta, Jerryseinfeld, Anon customer, David Gale, Lugevas, Feco, Ground Zero, Fresheneesz, Yellow Element, Pinikas, Rlove,
Sardanaphalus, Carl.bunderson, Simon123, Sgt Pinback, Cybercobra, Iridescent, Birdhurst, Julian Mendez, Independncia, Visik, Caper13, TXiKiBoT, Sankalpdravid, Synthebot, SieBot, Mhockey, Tidalbobo, Glavkos, Addbot, Manu5402, Galoubet, Law, Materialscientist, Xqbot, FrescoBot, Pestergaines, Reissgo, Small Bug,
, Duoduoduo, Sargdub, EmausBot, Alan m, JasonXPT, ClueBot NG,
Pasco, Snotbot, Helpful Pixie Bot, Kyle Donaldson, , Mikelonni, Sowndaryab and Anonymous: 40
Certicate of deposit Source: http://en.wikipedia.org/wiki/Certificate%20of%20deposit?oldid=645942174 Contributors: Edward,
PhilipMW, Michael Hardy, Pnm, Bdonlan, Redjar, SEWilco, Dpbsmith, Vikreykja, Sam Hocevar, Austin Hair, Calwatch, Canterbury Tail,
Mike Rosoft, AAAAA, ESkog, JoeSmack, El C, Mr2001, Jerryseinfeld, David Gale, Alansohn, Diego Moya, Lightdarkness, Mac Davis,
Versageek, Roboshed, OwenX, Woohookitty, Barrylb, SDC, Deltabeignet, Kbdank71, BorgHunter, Arabani, Feco, Michaelbluejay, Ground
Zero, Chobot, Uvaduck, RussBot, Clib, Bhny, Bovineone, The Hokkaido Crow, NawlinWiki, Aeusoes1, Dmaestoso, Arthur Rubin,
Airodyssey, Lando242, Nsevs, Kungfuadam, Samuel Blanning, SmackBot, Eveningmist, Rtc, Ohnoitsjamie, Betacommand, Rmosler2100,
Bluebot, Jeretad, Rkitko, MalafayaBot, Deli nk, Zven, JesseRafe, RedHillian, Cybercobra, ElizabethFong, Ohconfucius, ThurnerRupert,
NikoSilver, Kuru, Masciare, JoshuaZ, Evan Robidoux, Bilby, Linkspamremover, Aaronak, Tosoft, Lazulilasher, No1lakersfan, Gregbard,
Cdduncan, Cydebot, Travelbird, Epbr123, Erbus, Markber, Marek69, Kob zilla, Talar, Widefox, Richard Stuart Otto, JAnDbot, MERC, Magioladitis, Chaseroden, Bnet504, DerHexer, JaGa, Bradgib, Poeloq, J.delanoy, Pharaoh of the Wizards, Hippasus, Thatedeguy,
2help, CardinalDan, Jkeene, Cactus2, Crschultz33, My man manny, Burntsauce, Miltimj, Winchelsea, Andrew.whittle777, JD554, Bjornte,
Tombomp, Jay42, Tiredofscams, Dstebbins, ClueBot, Andrew Nutter, The Thing That Should Not Be, Arakunem, Wkfswebmistress,
DragonBot, Robert Skyhawk, Excirial, SophiaLucille, XLinkBot, Alexius08, Thatguyint, Addbot, Poco a poco, Ronhjones, Leszek
Jaczuk, Gail, Jaxcharger, Yobot, DeeMusil, AnomieBOT, Galoubet, Proger, Meya, Kingpin13, Cdrates, Materialscientist, Rockent,
Passtr, Agc0408, FrescoBot, Epsilon97, Mutinus, MastiBot, Tea with toast, Duoduoduo, RjwilmsiBot, Bento00, Caster33, John of Reading, Gfoley4, Thinktwins, Benjamin1414141414141414, Alan m, Philafrenzy, Donner60, Cpotts11, Mikhail Ryazanov, ClueBot NG,
WikiPuppies, Jollmic1, Prash920523, ChidemK, O moore 100, Chriscd2, Fylbecatulous, BattyBot, Mcagle86, FrigidNinja, FilipeCMD,
Quenhitran, Spud12345, Donkeykong1234, HARISHMM1990 and Anonymous: 278
Accounting Source: http://en.wikipedia.org/wiki/Accounting?oldid=649759391 Contributors: Paul Drye, Mav, Wesley, Bryan Derksen,
The Anome, Berek, Tarquin, Stephen Gilbert, Ap, Mark Ryan, Mirwin, Fredbauder, William Avery, Heron, Gog, Isis, Nairobiny, Stevertigo, Cointyro, Michael Hardy, Modster, Voidvector, Oliver Pereira, Stephen C. Carlson, Delirium, Minesweeper, Tregoweth, Ams80,
Ahoerstemeier, Haakon, Ronz, Duckie, Cherkash, Rl, Mydogategodshat, Hashar, Guaka, Vanished user 5zariu3jisj0j4irj, Majabl, David
Newton, Juxo, Ike9898, Dysprosia, Jstanley01, Timc, Dmp, Furrykef, Shizhao, Joy, Rogper, Robbot, Chocolateboy, AltMazter, Academic Challenger, Texture, Ojigiri, Hadal, UtherSRG, Guy Peters, Alan Liefting, DocWatson42, Beardo, Guanaco, Gzornenplatz, Bobblewik, JRR Trollkien, Golbez, Wmahan, Stevietheman, Utcursch, Andycjp, HorsePunchKid, Quarl, Maximaximax, Jokestress, Krupo,
Lacrimosus, Freakofnurture, Poccil, DanielCD, Rich Farmbrough, Clawed, MeltBanana, Mani1, Kbh3rd, JoeSmack, Violetriga, Appleboy, *drew, EDGE, Jendallas, Sanjiv swarup, Mdd, Musiphil, Alansohn, Anthony Appleyard, Polarscribe, Neonumbers, John Quiggin,
Cjthellama, Pmeisel, Hu, Avenue, Silroquen, Shinjiman, Wtmitchell, TaintedMustard, Knowledge Seeker, Vcelloho, Sciurin, Versageek,
Instantnood, David1776, KTC, Brookie, Feezo, Woohookitty, Mazca, Je3000, MONGO, Mrc, Liface, Rad Racer, Graham87, Magister Mathematicae, Jobnikon, BD2412, Jaddle, FreplySpang, Dpr, Fcoulter, Josh Parris, Sj, Drbogdan, Jweiss11, Tangotango, Bruce1ee,
Jmcc150, Vegaswikian, HappyCamper, Olessi, Sleepyhead81, Seattleu542, Johnmcummings, RexNL, Gurch, Quuxplusone, Lmatt, Srlefer, Chobot, Bornhj, Bgwhite, Shomat, Gwernol, Aluvus, Encyclops, Pip2andahalf, Ghasn43, RussBot, Novastarj, Bhny, Anomalocaris,
Renata3, Pkearney, SM, Manosh, Doncram, PGPirate, Pinkdramon, FF2010, KeithMatthew, Phgao, Zzuuzz, Closedmouth, KGasso, Crandles, JoanneB, Shyam, VodkaJazz, Jaranda, ArielGold, Heebiejeebieclub, Haramis, Paul Erik, Diligent, DVD R W, DocendoDiscimus,
Vanka5, Attilios, SmackBot, Reedy, KnowledgeOfSelf, TestPilot, Hydrogen Iodide, Melchoir, McGeddon, C J Cowie, Ariedartin, Vald,
Wegesrand, Luistamez, Jagged 85, Davewild, Cdcon, Alsandro, Arthur edward andersen, Gilliam, Toddintr, Ohnoitsjamie, Hmains, Shatner, Knowledge4all, Simon123, MK8, Fantadrink11, Kitzke, Liamdaly620, SchftyThree, Deli nk, Kungming2, Colonies Chris, Suqrul,
Countersubject, Famspear, Sholto Maud, Darthgriz98, Yidisheryid, Rgill, Gavin Moodie, Cj aba2002, MrRadioGuy, Fuhghettaboutit,
Radagast83, Rangermike, RJN, Mtmelendez, Weregerbil, Akinsope, Ceteris paribus, J.smith, Gmags2003, SirIsaacBrock, Mukadderat,
EMU CPA, Harryboyles, NotMuchToSay, Mouse Nightshirt, Kuru, Buchanan-Hermit, Cmlau, William Wang, Tim Q. Wells, Groggy Dice,
IronGargoyle, Chrisch, 16@r, Meco, Texas Dervish, Jose77, Hu12, Bryanhall, Mig77, Nehrams2020, Iridescent, Veyklevar, Beno1000,
Jalesh, Courcelles, Linkspamremover, Audiosmurf, Maslakovic, Nyarpy, Jake381, Rdunn, Eastlaw, BrianMc, Jetghterboy, Phillip J, CmdrObot, Sir Vicious, Basawala, DanielRigal, NickW557, Argon233, Kpaddle, Fletcher, Kenstandeld, Shanew2, Razbox, Nilfanion, Cydebot, BrettE, Burgwerworldz, Gw beith, Gogo Dodo, Flowerpotman, Tawkerbot4, DumbBOT, Ameliorate!, Viridae, Humphrey Nash,
Omicronpersei8, Aldis90, Thijs!bot, Barticus88, Freebieweb, N5iln, Tobz1000, Minutiaman, Mojo Hand, CharlesHoman, Nezzadar,
NilssonDenver, The Hybrid, Mailcpathetsang, Nick Number, THJames, MichaelMaggs, Tinot, Dawnseeker2000, Smorter, Porqin, AntiVandalBot, Meph1986, Luna Santin, Seaphoto, Matias.Reccius, Billscottbob, Mercunis, Alone Coder, Gregalton, Alphachimpbot, Psnae,
Dougher, Storkk, EECavazos, Vraghavan26, JAnDbot, Husond, Barek, MER-C, Newsucnuse, Slabba, 100110100, H.al-shawaf, Bookinvestor, Jimmy R, Magioladitis, Ady4bv, VoABot II, Accounting school, Jeubben, Vanish2, Yandman, Lewislams, Wikapedia, What123,
Fabricebaro, Catgut, Indon, EagleFan, 28421u2232nfenfcenc, Allstarecho, Sorezki, Lethaniol, LindaWarheads, Chris G, DerHexer, WLU,
Calltech, Shorelander, Cocytus, FisherQueen, MartinBot, Grandia01, BetBot, Jonathan Hall, R'n'B, Ash, J.delanoy, Sasajid, Pharaoh of
the Wizards, Trusilver, Nachostalgia, Chandni5rose, Drewwiki, FactsAndFigures, Gzkn, Modelwatcher, McSly, Scratty, Gurchzilla, AntiSpamBot, NewEnglandYankee, Bobcar61, Student7, Milogardner, Cbddoughboy, Zooyork17, Far Beyond, Uhai, Glossary, Treisijs, Diletante, Kvdveer, DeFaultRyan, Doctoroxenbriery, SkyBoxx, My wing hk, Varnent, Idioma-bot, Mrtts, Usho, Remi0o, Deor, King Lopez,
VolkovBot, Njonsey, Philip Trueman, TXiKiBoT, Jacob Lundberg, Ocalucci, PizzaBox, Lmbhmb, SueHay, Guillaume2303, Anonymous
Dissident, Hasheem haider, Jsscpa, Solidbob, Nonstandard, BotKung, Jinky32, Gavin.collins, Townlake, Fernando7382, Eartzi, Magiclite,
Accelli, Dmcq, Ericmelse, Grinq, Wikinvestor, Dhshah, Herbou, Kalivd, Traxinet, Michellecrisp, Thucydides of Thrace, SieBot, Nibloe85,
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Stathisgould, MarceloB, Farhanmukadam, Cometstyles, Kenckar, Malik Shabazz, SueHay, Lamro, PatentSearch, Flyer22, StaticGull,
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Bgwhite, YurikBot, Gaius Cornelius, Ksyrie, Welsh, Joel7687, Dilaudid, GraemeL, VodkaJazz, Nelson50, Suburbanslice, That Guy, From
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390

CHAPTER 69. STOCK MARKET CRASH

BG19bot, Mysidae, Sledge 1981, FxHVC, Ducksfordollars, AdventurousSquirrel, Dezastru, A2-33, B.Andersohn, Shubh.sbk, BattyBot,
Booba1058, Necrosiz, Khazar2, RulerofKnowledge, VelocityRun, Natahere, Dexbot, Tahoepark, Vhmtap, Ruby Murray, Stevenson7869,
Wikiuser13, Nyc393, Bedya, Elaqueate, Stamptrader, Dwagner20, Monkbot, Teachanewdog and Anonymous: 169
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Pnm, Taxman, Quadell, Antandrus, Fintor, D6, DS1953, Maurreen, Juzeris, Woohookitty, Je3000, Btyner, EcoMan, Ligulem, DKoenig,
StuOfInterest, Htournyol, That Guy, From That Show!, DocendoDiscimus, SmackBot, F, Bluebot, Nick Levine, Kuru, Veneto, Ksvrando,
Hu12, Outriggr, CmdrDan, Cydebot, Eximexchange, Gregalton, Chunt@euromoney.com, Drewwiki, Ypetrachenko, KylieTastic, Poppybaobao, Altruism, Struway, Dvandeventer, Barkeep, Regregex, LeadSongDog, Metosa, ClueBot, Aintneo, Wombatfrog, Addbot, Debresser, Favonian, Luckas-bot, Yobot, Materialscientist, Citation bot, Editor1962, FrescoBot, Avssrs, DrilBot, Agacademic 2001, Iratheclimber, Taenzee, Riskrisk, Dashdash99, Shaun.lee.scott, Pratyya Ghosh, Tentinator, Geo s8, Zach merchant and Anonymous: 62
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Edward, Pnm, Duckie, Juxo, DJ Clayworth, David Shay, Texture, DocWatson42, Mintleaf, Alan Davies, OverlordQ, Ukexpat, MementoVivere, EagleOne, Jayjg, Rich Farmbrough, Rhobite, NrDg, *drew, Jerryseinfeld, Zetawoof, DCEdwards1966, Espoo, PaulHanson, Civvi,
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XLinkBot, GordonUS, Well-rested, Hjstern, Avoided, Addbot, Fieldday-sunday, MrOllie, CUSENZA Mario, Green Squares, Fraudy,
Haakon K, Gail, Luckas-bot, TaBOT-zerem, Reena6, Twish, Rubinbot, Jim1138, EryZ, Alfonso13, Materialscientist, Kalamkaar, ArthurBot, Capricorn42, Nola 9622, Haen, RibotBOT, Financial-projections, Mnmngb, Azxten, Cekli829, Ddd0dd, FrescoBot, Student1024,
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Bot, EmausBot, EDIFICAS, Badar002, Donner60, Taenzee, 28bot, ClueBot NG, RudyMpls, Wiklinkwonder, Comboapp, Widr, MerlIwBot, ISTB351, Markmarhon, LodeBogaert, Kkumaresan26, Epicgenius, Tentinator, Mbrus, JaconaFrere, Csusarah, Obi-Wan Spiderman,
Hari5125 and Anonymous: 169
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Markowitz, Olivier, Mrwojo, Edward, Ronz, Rossami, Mcenedella, Chrism, Imf980, ShaunMacPherson, Edcolins, Faderrattnerb, Canterbury Tail, EagleOne, N328KF, Rich Farmbrough, Bender235, JoeSmack, Livajo, Sfahey, Mwanner, Marcok, Maurreen, Jerryseinfeld,
Arthena, Ashley Pomeroy, Jheald, RainbowOfLight, Empoor, Flawiki, Woohookitty, David Haslam, Plek, Dfranke, Jugger90, Mandarax,
BD2412, Eyu100, Gene Wood, SchuminWeb, Ground Zero, Lmatt, Tysto, Mtpruitt, Gwernol, YurikBot, Herbertxu, TEB728, Dialectric,
Larry laptop, VodkaJazz, DocendoDiscimus, SmackBot, Elonka, Lohad55, Saihtam, Verne Equinox, Eskimbot, Ohnoitsjamie, Chris the
speller, Jprg1966, Mgeorg, Deli nk, SquarePeg, Nbarth, Kelvintsang, WikiPedant, Kendrick7, Deiz, Rossp, Rigadoun, Meco, PEC123,
Stuarthill, Arjan1071, Amitch, Hu12, Menswear, 1122334455, CmdrObot, Bons, Anoneditor, Gogo Dodo, Biblbroks, Narendrachokshi,
Liquid-aim-bot, Rico402, Barek, MER-C, Andrewericoleman, .anacondabot, SiobhanHansa, Patroiz, Smoothsails, KConWiki, Flowanda,
Pselcke, Dondepam, Gkklein, Uriel8, Hitanshu D, Athaenara, Bobbyi, David.lijin.zhang, Neilclasper, Ontarioboy, FinanceGuy2006,
Linkracer, Idioma-bot, VolkovBot, Acorncreationgroup, Wikidemon, Chimpex, HarrisonScott, Monkey Bounce, Zenswashbuckler, Aarp,
Urbanrenewal, Wikiwikiwiki01, Lamro, Kid Bugs, AlleborgoBot, Ponyo, SieBot, Ymegahed, Judicatus, EvoL88Hate, John.L.Kramer,
Bombastus, A83, Escape Orbit, ClueBot, Paul Abrahams, Mild Bill Hiccup, Boing! said Zebedee, Niceguyedc, Kered1954, Sun Creator, Iohannes Animosus, Vanished user uih38riiw4hjlsd, Life of Riley, Riceman1974, Ost316, Ktpartridge, Addbot, Twaz, Suisse Banker,
Jtzell, MrOllie, LAMooney, Numbo3-bot, Lightbot, Legobot, Bungofpot, Jean.julius, AnomieBOT, CBooch10, Ulric1313, Srich32977,
Omnipaedista, SassoBot, Sfpcxn, Jaeljojo, FrescoBot, Dbrandon30, Dewritech, TheSoundAndTheFury, BuyTheBottom, Stevencmiller,
ZroBot, Alpha Quadrant (alt), Sofra, Eparksbuckeye, 96Barolo, Helpful Pixie Bot, Navid1366, Curb Chain, Mike450, BattyBot, Cyberbot II, Khazar2, Hmainsbot1, Makecat-bot, Stormdancer1231, BGreenMA, Claritybones, Andres Possee, JeDubreuil, BIGSEAN22143,
Wikiwizard57685, Suvidhamhatre, Financialpoise and Anonymous: 195
Mergers and acquisitions Source: http://en.wikipedia.org/wiki/Mergers%20and%20acquisitions?oldid=647813462 Contributors: The
Anome, Nate Silva, Heron, Olivier, Edward, Michael Hardy, Ronz, Angela, DropDeadGorgias, SNowwis, Cherkash, Charles Matthews,
Choster, Jay, Andrewman327, Zoicon5, Pedant17, Furrykef, Nricardo, Mneumisi, Tjdw, Bearcat, Rfc1394, Sekicho, Superm401, DocWatson42, Cool Hand Luke, Wicked, Waltpohl, Solipsist, Jackol, Edcolins, Chowbok, SoWhy, Loremaster, Pgreennch, Neutrality, Picapica,
Canterbury Tail, Monkeyman, Poccil, Brianhe, Rich Farmbrough, Wk muriithi, Bender235, S.K., Livajo, Bobo192, Sanjiv swarup, Snc,
Maurreen, Giraedata, Jerryseinfeld, VBGFscJUn3, Larry V, Towel401, Pearle, Mdd, Poweroid, Gintautasm, John Quiggin, Wikidea,
Kurt Shaped Box, ReyBrujo, RJFJR, Daedelus, Alai, Drbreznjev, Ceyockey, RPIRED, Stephen, Empoor, Flawiki, Firsfron, Woohookitty,
Camw, Guy M, Uncle G, JBellis, Miss Madeline, Uris, Bluemoose, Jugger90, SDC, BD2412, Sapin, Plainsong, Tangotango, Vegaswikian,
Haya shiloh, The wub, Nivix, Mark83, RexNL, Gurch, RobSiddall, Planetneutral, Chobot, Benlisquare, Bgwhite, Manscher, Samwaltz,
Roboto de Ajvol, YurikBot, RussBot, Muchness, Hede2000, 1Winston, IanManka, Bovineone, Bachrach44, Justin Eiler, Ke5crz, Speedoight, Gunis del, Open2universe, Ninly, Mike Dillon, JLaTondre, ViperSnake151, DVD R W, That Guy, From That Show!, DocendoDiscimus, SmackBot, Looper5920, Estoy Aqu, Reedy, DCDuring, RedSpruce, Bmearns, Aksi great, Gilliam, Ohnoitsjamie, Hmains,
Getramkumar, ERcheck, Slo-mo, Saros136, Chris the speller, Master Jay, Ian3055, Colonies Chris, Darth Panda, Ian Burnet, Can't sleep,
clown will eat me, Mitsuhirato, Smallbones, KaiserbBot, Addshore, Solarapex, Nubeli, A.R., Yom, Anstri, Sigma 7, Mion, Noblige, Microlog, JzG, Kuru, Sbmehta, EnumaElish, Hmbr, Berliner88, Gigahz, JHunterJ, MarkSutton, Audude08, TastyPoutine, Zapvet, PEC123,
Hu12, DabMachine, Wizard191, Iridescent, TwistOfCain, Mikehelms, Mhpolak, Joseph Solis in Australia, Polar Bear, Eastlaw, Btgiles,
Bijoalex, Jackzhp, Megaboz, WeggeBot, Neelix, Penbat, No1lakersfan, 137 0, Chhajjusandeep, Prabhuts, Chrislk02, PamD, Busiken, Mattisse, Thijs!bot, Epbr123, GentlemanGhost, Colin Rowat, Bobblehead, Escarbot, AntiVandalBot, Yupik, RobotG, Parnell88, Seaphoto,
Prolog, College Watch, Jenny Wong, Aurora sword, Barek, MER-C, Mewtwowimmer, Mbc362, Badamvenki, Fabrictramp, Spontini,
Dck7777, Accesspig, Esanchez7587, Dxlondon, Patstuart, Brettalan, Arthur Markham, Gwern, MartinBot, Gasheadsteve, Juansidious,
CalendarWatcher, R'n'B, FMAFan1990, Sp3000, Jesant13, Athaenara, Drewwiki, Thaurisil, Bluepoint951, Tcalves, Katharineamy, B64,
LeighvsOptimvsMaximvs, Madhava 1947, S2desai, Bonadea, S, Version.J, CardinalDan, Idioma-bot, Funandtrvl, Hunt 4 Orange November, Cristine87, Deor, VolkovBot, Marylandwizard, JohnBlackburne, AlnoktaBOT, Philip Trueman, Jkeene, Ldmerriam, Wikidemon,
Chimpex, Someguy1221, KarynN1, LeaveSleaves, Urbanrenewal, Zain Ebrahim111, Lamro, Enviroboy, IFRS303, Insanity Incarnate,

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Addbot, Leadperson22, Grayfell, Phil3rdks, Philsimpson101, Maxrose, Mjakubowski, GSMR, Osayi, Armanbhab, MrOllie, CarsracBot,
Quercus solaris, Craigsjones, Lightbot, Goldie2223, Jarble, Legobot, Yobot, Lbook52, Examtester, AnomieBOT, Gnomeliberation front,
Hairhorn, IRP, Nstse, Elmmapleoakpine, BasilSorbie, Videogameguy100, ..24, LilHelpa, Borcho, GrouchoBot, Wikicontra,
Pereant antiburchius, Doulos Christos, Serbian Defense Forces, Richardrdp, Farmerbill555, The myoclonic jerk, PM800, BoomerAB,
FrescoBot, Ohio Boy, Eanc, Backtofront001, Mrhenrik, Dbrandon30, Venture Capital in Pakistan, Igor101, ClickRick, Citation bot 1,
Stevi10623, ElsevierTim, Meaghan, Sallukhan, Brokshen, PiRSquared17, Edo248, Gulbenk, Fourmanfurnace, Abroadconsultants, Gavelaa, Suusion of Yellow, RjwilmsiBot, Viniciusmc, Rollins83, Ahsanalpha, Klubell, EmausBot, Segenay, FinanceQ, Davidgardner1911,
Jdrew9, Minimacs Clone, TheSoundAndTheFury, Slightsmile, Imkilby, Oldjasd5150, Josve05a, Missy2468, Curiouslearn, Sofra, Wikfr,
Stmlj, Lilljeni, Andystwong, Autoerrant, Orange Suede Sofa, Cssrinivasareddy, Zjla0523, Giorno2, Sdavis7, ClueBot NG, Sachin55555,
Pa.masson, Catlemur, Dvp60, Aqeelzam, Expertz123, Dmlee90, Uclabruins818, Theopolisme, MerlIwBot, Razmcy, Grinsp, Helpful
Pixie Bot, Mkennedy1981, BG19bot, BendelacBOT, Fleuu, Sameer.sa20, Fairlyoddparents1234, AcademicBusinessResearch, LCamino,
Snow Blizzard, Ashaik, Rodaen, DC hawkeye, Mdavis01, Mrt3366, 81M, Icefrost123, Little green rosetta, Athomeinkobe, Iammiwei, Hillbillyholiday, Coachjrb, HaIsStKo, Faizan, IbankingMM, Sonanto, AggieKMA, Bluepapyrus, CorpFinance, Generalusgrant, Lechevarria,
Mrm7171, Mikeewen101, Namowiki, Stamptrader, JaconaFrere, Sgg greegord, Monkbot, Cs.k.srinivasareddy, Codebook44, Wikiwizard57685, M.Jormungand, Policyhelp, OptimalWebmaster, Blart versenwald, Erinmaker, Haloedscape, Jdfsmsu and Anonymous: 669
Structured nance Source: http://en.wikipedia.org/wiki/Structured%20finance?oldid=644230971 Contributors: Edward, Fred Bauder,
Choster, Topbanana, Nurg, BenFrantzDale, Dratman, Christofurio, Pgreennch, Smyth, Borofkin, Tjic, John Vandenberg, Jerryseinfeld, Atlant, Billlund, Dan100, Oblivia, MONGO, Marudubshinki, Yamamoto Ichiro, Gwernol, Aeusoes1, Dogcow, Moe Epsilon, DocendoDiscimus, SmackBot, Hmains, Colonies Chris, Dicklyon, Hu12, Conor Kenny, Iamisha, Barticus88, Ioeth, Bequw, Drewwiki,
Helle55953, Madbassist, Boikej, CWii, BoogaLouie, Lars valk, Zjak, Urbanrenewal, Lamro, SieBot, Nyresearcher, Steven Zhang, North
wiki, Authoress, Thacher Prott, Wyattmj, Vijitb, Finnancier, Vladkornea, ImperfectlyInformed, Bhuna71, Alexbot, Sun Creator, Banavalikar, Mdeutsch81, Addbot, LaaknorBot, Eran117, Decora, Modailkoshy, Dvink, Josh134, RjwilmsiBot, Laneways, ClareCottrell, ClueBot
NG, Statoman71, Alpha7248, Systrator, Vjhamilton, Blythe2011, Patrug, Wodrow, ChrisGualtieri, TeeKay1980, Glins1, Ioanna94, Arbeitenindia and Anonymous: 65
Venture capital Source: http://en.wikipedia.org/wiki/Venture%20capital?oldid=648097246 Contributors: PierreAbbat, Roadrunner,
Olivier, Frecklefoot, Edward, Michael Hardy, Modster, NuclearWinner, Mac, Ronz, LouI, Nikai, Rokahn, Ehn, Mydogategodshat, Jengod, Andrewman327, Zoicon5, Munford, Furrykef, Itai, Mowgli, Jecar, Earl Andrew, Kizor, Naddy, Bmcdaniel, Gidonb, A-research,
DocWatson42, Niteowlneils, Archie, Tom-, Jepace, Ragib, Beland, Heman, Tothebarricades.tk, Icairns, Cglassey, WpZurp, Sfreeden,
Fintor, Goobergunch, TJSwoboda, Faderrattnerb, Mike Rosoft, Monkeyman, Discospinster, Kait, YUL89YYZ, Je.Donohue, JoeSmack,
Ylee, Livajo, El C, DS1953, Mwanner, Lyght, Jburt1, One-dimensional Tangent, Thu, Truthux, Mike Schwartz, Func, Snc, Jerryseinfeld,
Minghong, HasharBot, Frodet, Alansohn, Interiot, Andrewpmk, Ricky81682, Saga City, Fourthords, RaiderRobert, Jheald, Bookandcoffee, RHaworth, TigerShark, Barrylb, Wikiklrsc, Ronreed, SDC, Waldir, Paulho, BD2412, FreplySpang, Nlsanand, Rjwilmsi, JoshuacUK,
JP Richards, Feco, Bhadani, DoubleBlue, FlaBot, DDerby, Latka, Mark83, Btmccarthy17, Coolhawks88, Gwernol, YurikBot, Borgx,
Sceptre, Bhny, Kvuo, Stunetii, Gaius Cornelius, Ksyrie, Nowa, Shadowfax0, Larry laptop, Mgcsinc, DeadEyeArrow, Drogers, GraemeL,
Shawnc, Danrua, NeilN, Harthacnut, Yakudza, SmackBot, Nkrupans, Rhanbury, Rdale, Srnelson, Gilliam, Ohnoitsjamie, Skizzik, Nfgii,
Chris the speller, Bluebot, Kurykh, Duozmo, Deli nk, Kotra, Cvparikh, Abaddon314159, SamOdio, Jmlk17, Russell Newman, Cybercobra, Vprajkumar, Anazem, SParekh, Dross82, Kendrick7, Risker, Pekiro, Deepred6502, Kuru, Khazar, Wissons, Hmbr, Mrom, Savdawgshox, Dfrench, Kompere, Stwalkerster, Davemcarlson, Vijaymv in, Ehheh, Nivi, Bugwit, PEC123, Arjan1071, Hu12, OnBeyondZebrax, QuantumOne, Oliviachang, FairuseBot, AbsolutDan, INO Exodus, CmdrObot, Akottas, DeLarge, Jokes Free4Me, Logical2u, Old
Guard, Madda, Jehfes, Cydebot, Fnlayson, Gogo Dodo, Alihoward, Whiskey Pete, Kozuch, Omicronpersei8, Oddmoe, Epbr123, Andyjsmith, Helgus, James086, Porqin, AntiVandalBot, MrMarmite, Abu-Fool Danyal ibn Amir al-Makhiri, Gioto, SummerPhD, Livioq, Isilanes, Res2216restar, JAnDbot, Barek, MER-C, Wgpkeyser, Andonic, SiobhanHansa, Zulander, Jayrammenon, Ashleymiller, Hroulf,
Bkleinhe, Maheshkumaryadav, Froid, Pacmoney, Praddy06, MattDLD, Donbueck, David Eppstein, Spellmaster, DerHexer, Abejma,
Purslane, Lady Mondegreen, Anshul 2, Drvannie, MartinBot, Wseblen, Franzean, Isill, Rettetast, Imy187, R'n'B, CommonsDelinker,
GrowthinkResearch, Jsgbrown, Nico415, Ibn Battuta, Xiaohuialex, Svetovid, Uncle Dick, Drewwiki, Sramana18, WarthogDemon, Smonsalve, MatchStickEleven, Jrisku, Neilclasper, DadaNeem, Soloren2001, Wallacrw, Cmichael, AshleysBrain, Alawner, Idarin, Wikieditor06, VolkovBot, Seattle Skier, Mmetrics, HolidayIn, Philip Trueman, Mercurywoodrose, Kmcguinness, JewelieSF, Krunal800, Wikidemon, HarrisonScott, Bjb84, Joliecide, DragonLord, Jackfork, UnitedStatesian, Scott denne, Aarp, Urbanrenewal, Roland Kaufmann, Advocate.rajat, Lamro, HopsonRoad, Dspenciner, Davidl40, CorporateVenturing, Kchampcal, Sfmammamia, Uvf123, SieBot, Gregsend,
Financeeditor, EwokiWiki, Joaquin Tres, Caltas, Matthew Yeager, Jojalozzo, Nopetro, Laila choe, Karthikganesh, KathrynLybarger,
Open Research, Jonathanrubin921, StaticGull, Hoiung, Andryuha, Townblight, Denisarona, AjohnsonFMC, Lawcatalog, Q1Capital, ClueBot, RFID-pro, Percent, The Thing That Should Not Be, Dastvatsat, Rosuav, Mchan2008, Niceguyedc, Ottawahitech, Khmarks, Pointillist, -Midorihana-, Iner22, Simonefrassanito, Rhododendrites, Ilyabodner, Cenarium, Arjayay, Techfast50, M.O.X, FDP1, Michalowicz,
Wikipengia, Bald Zebra, Chipmunker, Mhockey, Vigilius, John0101ddd, XLinkBot, Mdeutsch81, Mnwiwapany, Joerubin, Briangogan,
Tonyabu1, Munnifar, Engkamalzack, Addbot, Larrycheng, Jncraton, MrOllie, Tripsspace, Greentarget, Tide rolls, Lightbot, Abduallah mohammed, Luckas-bot, Yobot, Ptbotgourou, TaBOT-zerem, Norils, MSClaudiu, I9o0q1, The Earwig, DB.Gerry, Bungofpot, Oldcommguy,
Eric-Wester, Saparagus, AnomieBOT, CBooch10, Rubinbot, Piano non troppo, Unara, Kingpin13, Ulric1313, Materialscientist, Valleyofdawn, Bosssailor, Quebec99, Giuseppe Giusti, Seedless Maple, Jsharpminor, GrouchoBot, Solphusion, Abigor, Omnipaedista, RibotBOT,
INeverCry, Sandymok, FrescoBot, Correnos, Chevymontecarlo, TanLineGirl, Venture Capital in Pakistan, Udubjoe, Haeinous, HamburgerRadio, Martinbueno, VenkatesaMadhan, Sixmeters, Kops2222, Hellknowz, Jandalhandler, Ieshkar, Kaitco, Tubby23, Douglasclayton, Theresadoan, DanIce99, Swhippo, Djgbradley, Daugh016, Dewritech, GoingBatty, TheSoundAndTheFury, Mo ainm, Tommy2010,
Eks287, Nhan.t.nguyen, K6ka, Samder, ZroBot, Rx7supra911, Naushmalik, Shmilyshy, Nudecline, Miladja, Donner60, ChuispastonBot,
Jezinbris, Mittgaurav, ClueBot NG, Danversb, Frietjes, Muon, Helpful Pixie Bot, Aco241, Jeanette114, BG19bot, Fauncehouse, Wiki13,
Compfreak7, Lakshmi.nuthakki, Ugncreative Usergname, AdventurousSquirrel, Bjam1965, Nabeel cheema, Readerglb123, Glacialfox,
TBrandley, Nickmich84, Matthew David Gonzlez, Eew657ew676yhse, BattyBot, JonathanD23, Chunfeng90, None but shining hours,
Vadimferenets, N2V, Keferyn, Innovosource, Thermocycler, Catalinka, GabeIglesia, Dnader, BoyRD, Sodla, Pictuga, LeopoldFlechsenberger, Cafelido, FundingFounders, Smartguy912, Nonenina, Venturecapital33, Jianhui67, Kim Asheld, KyleD 999, JaconaFrere, I3roly,
Anazre, STORMYISTHEBESTSINGER, Karenluo87, Bikingaccidents, Sgmurph, Lexus49, Venture it services, DemetriusGiannopoulos,
Anishzz, Adealy, SandSlosher, Financialpoise and Anonymous: 602

392

CHAPTER 69. STOCK MARKET CRASH

Credit (nance) Source: http://en.wikipedia.org/wiki/Credit%20(finance)?oldid=645269493 Contributors: William Avery, SimonP,

Michael Hardy, Pnm, Mac, Choster, Altenmann, Psychonaut, Nurg, Terjepetersen, Mboverload, Wmahan, Pgan002, HorsePunchKid,
Andylkl, Monkeyman, EugeneZelenko, Discospinster, Rhobite, Notinasnaid, El C, Stesmo, Maurreen, Nsaa, Alansohn, Gary, VladimirKorablin, Versageek, Dismas, Weyes, Graham87, ScottJ, Feco, Dmccreary, Quuxplusone, DrVeghead, Bmicomp, DVdm, Gwernol, YurikBot,
RussBot, Bhny, Ksyrie, CambridgeBayWeather, DJ Bungi, UDScott, Aaron Brenneman, Malcolma, Zzuuzz, GraemeL, LeonardoRob0t,
Fram, Andman8, Sardanaphalus, Veinor, SmackBot, Lawrencekhoo, Ohnoitsjamie, Hmains, Anwar saadat, Amatulic, Deli nk, DHN-bot,
Yidisheryid, DMacks, SashatoBot, Kuru, Robosh, Mets501, Hu12, Gaohoyt, Crobb305, Linkspamremover, Vision Thing, Creditease,
Neelix, Cydebot, Bomzhik, Mattisse, Thijs!bot, Barticus88, Mojo Hand, Techartist, Fayenatic london, Danger, JAnDbot, Barek, Xeno,
Bongwarrior, Thedrooling, Dsmelnick, Torchiest, Marianna1407, CliC, R'n'B, EdBever, 72Dino, Marcusmax, It Is Me Here, Thomas
Larsen, NewEnglandYankee, Gcpeoples, Signalhead, VolkovBot, Es fsl, Philip Trueman, TXiKiBoT, Nkohkit, IpWorld, Diovi, Mark R
Stoneman, Dargente, Zhenqinli, AlleborgoBot, Biztrackers, SieBot, Accounting4Taste, AS, Flyer22, Radon210, Finnancier, Martarius,
ClueBot, Snigbrook, ImperfectlyInformed, Nymphonicz, JJMcVey, Blanchardb, Pearrari, Hamone1, Sonu Rawal, Dekisugi, Thingg, Vegetator, DerBorg, NJGW, Ceri sullivan, LiptonIcedTea, Addbot, Sabine McNeill, Schoneth, NjardarBot, Download, Luckas-bot, DisillusionedBitterAndKnackered, Washburnmav, Eric-Wester, Finlays, ArthurBot, , Cameron Scott, Xqbot, Smallman12q,
LucienBOT, D'ohBot, Dinamik-bot, Vrenator, Alph Bot, EmausBot, Davejohnsan, ScottyBerg, Bdicorp, Wikipelli, Erpert, ZroBot, L
Kensington, Taenzee, ClueBot NG, Azrielaja, Yoursmile, Credito2011, MusikAnimal, Soverytall, Clanchatton, Rassal, BattyBot, Cimorcus, The Illusive Man, SD5bot, Kumioko, Lugia2453, SFK2, Gino Duval, TroyGab, Joancdocyogen, Monkbot, Smith114 and Anonymous:
179
Consumer debt Source: http://en.wikipedia.org/wiki/Consumer%20debt?oldid=643444131 Contributors: Edward, Pnm, T0ky0, Texture, The Land, Mu Gamma, WpZurp, Joyous!, Dcandeto, Sebmol, Maurreen, Jerryseinfeld, David Gale, Rd232, PaigePhault, Versageek, Flawiki, Feco, RussBot, Anomalocaris, Nirvana2013, Aaron Brenneman, Natkeeran, Sardanaphalus, SmackBot, Cazort, Ohnoitsjamie, Deli nk, Jimmy116, SpacemanAfrica, Headshaker, Kuru, Tazmaniacs, Beetstra, TastyPoutine, Linkspamremover, Hisako, Ouishoebean, Treybien, Richhoncho, Carolmooredc, Gregalton, Barek, Bstroh, Xeno, Nclark42, Geo riley, Koska98, FisherQueen, Funandtrvl,
VolkovBot, Mcalmartin, Hempage, TXiKiBoT, Gz1694, Enigmaman, Lamro, Icobi, Aliencafe, Addbot, Rose68, Schmidtmandaddy,
Themfromspace, SterlingTrust, Bluerasberry, JimVC3, Mnmngb, DrilBot, Vrenator, Txhoya, Rockruler, ZroBot, Lyonscars, ClueBot
NG, Dysanzw, BattyBot, Bc239, Sminthopsis84 and Anonymous: 46
Employment contract Source: http://en.wikipedia.org/wiki/Employment%20contract?oldid=636293273 Contributors: Ronz, Julesd,
Hectorthebat, Pakaran, Vt-aoe, Postdlf, Wolf530, Edcolins, Jklamo, Mwanner, The bellman, Longhair, Smalljim, Pearle, Grutness,
Wikidea, Versageek, Lofor, Jake Wartenberg, Arabani, LeCire, BMF81, Roboto de Ajvol, YurikBot, RussBot, Bullzeye, Joelr31, Vlad,
MarkBrooks, Light current, Poppy, Carabinieri, Robaker, SmackBot, PJM, Baronnet, Nixeagle, Snowmanradio, Bpiereck, RoyalBlueStuey,
Maelnuneb, Lapaz, Matty-chan, Beetstra, Levineps, DangerousPanda, Trident13, Justdignity, Thijs!bot, Frank, Just Chilling, Jobshoppinfool, JAnDbot, Peteark, Magioladitis, VoABot II, JamesBWatson, Ensign beedrill, Rwil02, CliC, Adavidb, J Dezman, Ingram, Hellno2,
VolkovBot, Gvanrossum, Rei-bot, Adazka, SieBot, Rob72, OKBot, Martarius, ClueBot, PipepBot, Quercus basaseachicensis, Jusdafax,
Nagika, Ni'jluuseger, Promethean, BOTarate, Jimmy Fleischer, XLinkBot, Hctor Guido Calvo, GordonUS, Skarebo, WikHead, SilvonenBot, Addbot, Misterx2000, SpBot, 5 albert square, IrishHR, Tide rolls, Avono, Jarble, Ptbotgourou, Embiggens, Hairhorn, Kingpin13, Bluerasberry, Limideen, Dargen, Clark89, Xqbot, Capricorn42, Gx872op, Templater, Tabbelio, Robertdriver, E Shelkova, Bento00,
Wikipelli, Dcirovic, Sheeana, David efc, Wikfr, Orange Suede Sofa, Taenzee, ClueBot NG, ClaretAsh, Jack Greenmaven, MerlIwBot,
Nodulation, Helpful Pixie Bot, Ajayshirma, BG19bot, Vagobot, AvocatoBot, Torvalu4, Khazar2, Hendrick 99, Ginsuloft and Anonymous:
72
Financial planner Source: http://en.wikipedia.org/wiki/Financial%20planner?oldid=649538273 Contributors: Edward, Profmike, SD6Agent, Chowbok, Discospinster, Spalding, Smalljim, Enric Naval, Polluks, RJFJR, Ceyockey, Lkinkade, Tabletop, BD2412, Ground Zero,
CambridgeBayWeather, Nicholas Perkins, Zzuuzz, GraemeL, DocendoDiscimus, Veinor, SmackBot, Haymaker, Lcarsdata, KnowledgeOfSelf, Simon123, A. B., Famspear, Aquarius Rising, KaiserbBot, Snowmanradio, OSborn, Risker, Ser Amantio di Nicolao, Kuru, JohnI,
Eliashc, Hu12, Skapur, Brett k, CmdrObot, JohnCD, Brianbellco, DanielRigal, Requestion, Outriggr, PKT, Epbr123, HappyInGeneral,
Gregalton, Jtroska, Enlightenedone, Roleplayer, Davesoli, JorgeS, Balloonguy, Animum, Globalprofessor, Chivista, PoliticalJunkie, Luqalkeem, Rwil02, CliC, Kontar, J.delanoy, Drewwiki, Ben5082, Lyseong, Sanusi.husain, Cpchoy, Darkedict, Milehighharris, SueHay,
InfoRealtors, JayC, Financiallawyer, Insanity Incarnate, AlleborgoBot, Shortanswer, Happysailor, Hello71, Dbs35, Denisarona, Philipcalvert, ClueBot, Rfpi, Mild Bill Hiccup, Boing! said Zebedee, Ottawahitech, Geovf, Quercus basaseachicensis, Sun Creator, Peter.C,
Wacko39, XLinkBot, Avoided, Zodon, Addbot, Laurabrook, Misterx2000, Eddyelm, MrOllie, Nbomnbardier, Morning277, Ehrenkater,
Yobot, Senator Palpatine, Evans1982, Eumolpo, LilHelpa, Xqbot, M778little, Eugene-elgato, GliderMaven, I dream of horses, Mutinus,
Fpresearch, Gulbenk, Crysb, Sargdub, Beyond My Ken, Bavarianantler, Slon02, Deagle AP, DASHBot, AndrewN, Magic1410, ElissaBuie,
Taenzee, ClueBot NG, Coxeagle, CanFinancial, Snotbot, Theadvisors, MusikAnimal, Karkovkarkov, 1292simon, Gregnazvanov, Viveksharma020, Mkreft, Jasonwilliamcarter, Finplanwiki, Epicgenius, SomeFreakOnTheInternet, Mrgalerte1, Atonegonancial, Moneypitfall,
James.Vinicombe, Smoothpanda, ADRIAN GARCIA VASQUEZ, Kirkchisholm and Anonymous: 169
Retirement Source: http://en.wikipedia.org/wiki/Retirement?oldid=649215790 Contributors: AxelBoldt, Magnus Manske, Malcolm
Farmer, 0, Rgamble, Fredbauder, Gianfranco, Enchanter, SimonP, DavidLevinson, Heron, KF, Frecklefoot, Patrick, Michael Hardy, Shellreef, Arpingstone, Ahoerstemeier, Baylink, Jebba, Cherkash, Dmsar, Dysprosia, Itai, Joy, Vt-aoe, ZimZalaBim, Phanly, Alan Liefting,
Christopher Parham, Fennec, Wikilibrarian, Hokanomono, Edcolins, Chowbok, Andycjp, RobinCarmody, Pgreennch, Tyler McHenry,
Gary D, Kate, Discospinster, Rhobite, Smyth, Notinasnaid, Mani1, JoeSmack, MBisanz, Mwanner, TomStar81, Billymac00, ClementSeveillac, Arthena, Atlant, Rwoodsco, Idont Havaname, Snowolf, Bookandcoee, Wikiklrsc, Patman, Graham87, GregAsche, Narxysus,
KFP, DVdm, Bgwhite, Borgx, Jepw, Huw Powell, NawlinWiki, Diotti, Yzb, FF2010, Open2universe, Abune, Ahmad510, GraemeL,
Mdwyer, MansonP, Sardanaphalus, SmackBot, Unschool, Jphillips, Thunderboltz, Pasajero, GT, PeterSymonds, Myrmidon101, Rediscombe, Anwar saadat, Timneu22, Nbarth, Darren Wickham, Can't sleep, clown will eat me, OrphanBot, Azumanga1, GVnayR, COMPFUNK2, Albertalbs, Magellan nh, Shadow1, Dacxjo, GreyDesk, Xlnz, Kuru, John, Ybact, AnonEMouse, Voceditenore, Beetstra, TastyPoutine, Marcipangris, Hu12, Nehrams2020, Adambiswanger1, Peter1c, Ale jrb, GeorgeLouis, Joncnunn, Billsbest, Macktheknifeau, Cydebot, Gogo Dodo, Bridgecross, A Softer Answer, Ebyabe, Woody, Peace01234, Leon7, AntiVandalBot, WinBot, Luna Santin, Suzmanr,
Flyingdc, Dory36, Sgw1009, Falconleaf, JAnDbot, Barek, MER-C, Xeno, SiobhanHansa, Magioladitis, Imwid3awak3, Ptrpro, Flowanda,
MartinBot, CliC, Splash15, Hypersigil, Brothejr, Drewwiki, Martinduo, AntiSpamBot, Plasticup, Tygrrr, Jks23, Ja 62, Hellno2, Malik
Shabazz, PacicBasin, Retirement, Gilgongo, Socialinnovations, Zhenqinli, Steddyeddy, Basweerman, MaCRoEco, Bmds, Reallykool, Caltas, Sacredhands, JetLover, Mikebent2007, Cnblackman, Pvara 99, Escape Orbit, Xyz7890, Cj0642, Beeblebrox, Jan kokochak, Ahroda,
Fadesga, Plastikspork, Ferdilan, Bun39, Qualitylife, Tomas e, Do DueDiligence, Nagika, Gwguey, Datastat, Dannyboy25wht, EManganiello, Ptylam, Orioriori, Edwardinnz, Oriborenstein, Mhockey, DumZiBoT, Msabin, Streamline59, Rreagan007, Pocketshepherd, D.M.

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Thomas Blomberg, SmackBot, Kth, Alksub, Brossow, Ohnoitsjamie, Betacommand, Schmiteye, Tyciol, Chris the speller, Kurykh, Fuzzform, SheeEttin, Nixeagle, JesseRafe, Arizona Web, Tim Josling, DMacks, Esrever, Kuru, StanBrinkerho, RichardF, Fan-1967, Walton
One, Natrajdr, Linkspamremover, Z4ns4tsu, CmdrObot, Triage, Basawala, Holgerho, Agrahlma, Pit-yacker, Cahk, Andreas Akerman,
Gogo Dodo, JFreeman, Sbwalker, DumbBOT, Ethan01, Daniel, PerfectStorm, Runninn, Uncle Grover, EarthPerson, David Shankbone,
Barek, LitCigar, Magicbom, Brotown, Hmu111, Flowanda, Racepacket, Bheneghan, GURULAK, Bschusterbauer, 1.1.1, ILuvTea, Trusilver, 72Dino, Andyem, Xbspiro, Naniwako, Creditdan, AntiSpamBot, Ottwolves, Peter1402, Vilhelmcorlin, Han Solar de Harmonics,
RB972, Brack1969, Tiggerjay, Nigelloring, Red Thrush, Funandtrvl, DanBealeCocks, Feverinlove, BradPierce0001, DoorsAjar, Rstambau, Marih, Davidicu, Cef01, Andy Dingley, Jbjardine, Michaelbeno, Ellbeecee, Elewisva, Thawt, Badmash007, Quad entendre, Jphuddleston, Flyer22, Eleavor, Denisarona, JL-Bot, ClueBot, ImperfectlyInformed, Monthlimit, Polyamorph, Tm1209, XLinkBot, Addbot,
MrOllie, Debresser, Tassedethe, Evans1982, Mail2yogie, DrFleischman, AnomieBOT, Newwiki84, Erik9bot, FrescoBot, HJ Mitchell, Betgarant, Berknyc81, Pinethicket, PrincessofLlyr, Maxaroni2006, Stephaniesoftball, Seahorseruler, Suusion of Yellow, Tbhotch, Onel5969,
John kristoph, RjwilmsiBot, Bobroyan, RobertAlanHarris, Lizgareld, 478jjjz, Nuujinn, Cobra243, Zzxxpity, Misty MH, Khole707,
AvicAWB, Hon3ybee, Katieo1live, LSchlosser30, Chrissycal, AndyTheGrump, ClueBot NG, Philmanx, Joesmack1, Joupellet, Bblawsonnn, Dreeves007, Helpful Pixie Bot, Moray An Par, Ahsansaeed2011, Calidum, Kfabbio, Ymblanter, Geniusanalyser, Luciparmer,
Orlov.Alex777, Absconditus, BattyBot, 4nn1l2, Bc239, Sminthopsis84, SFK2, Marksinclair1, Lawnaut, Koreagirl, Lemnaminor, LibrarianAnnie, Abhijeet.125, Jessica Brodkin Webb, 2.0.Specialist, Epparadox, Planetit, StudiesWorld, Wellington41, JattSaini and Anonymous:
286
Government spending Source: http://en.wikipedia.org/wiki/Government%20spending?oldid=646978058 Contributors: Edward, Earth,
RickK, Mrand, Zigger, Michael Devore, Beland, The Land, One Salient Oversight, Neutrality, RedWordSmith, Cretog8, Jerryseinfeld,
Alansohn, Arthena, Masterdeath1987, Versageek, Instantnood, Richard Arthur Norton (1958- ), Mangojuice, Tiresais, Cwisehart, Yamamoto Ichiro, Nihiltres, John Z, Bgwhite, Wavelength, Morphh, NawlinWiki, DragonHawk, Black Falcon, Mais oui!, Trickstar, SmackBot, Oscar ., InverseHypercube, Lawrencekhoo, Brossow, Baronnet, DHN-bot, VMS Mosaic, EPM, Dicklyon, Levineps, Iridescent,
Aphswarrior, Jamamala, Thomasmeeks, Cydebot, Richhoncho, Epbr123, N5iln, Oliver202, AntiVandalBot, Cinemetre, Wantonknave,
EECavazos, Penubag, VoABot II, ngel Luis Alfaro, Deagro, J.delanoy, Mattnad, Detah, Rockalot01, Israel Walker, Jehuty Strife,
ChrisChantrill, Sdsds, Mluehrmann, Michaeldsuarez, MaCRoEco, HybridBoy, GlassCobra, AlexWaelde, Oxymoron83, Faradayplank,
Yone Fernandes, Rinconsoleao, ClueBot, Vinny Burgoo, Jeanenawhitney, Nagika, Aitias, 7, Humanengr, DumZiBoT, Dthomsen8, Addbot, Casperdc, West.andrew.g, Lightbot, Yobot, TaBOT-zerem, AnomieBOT, Kingpin13, Materialscientist, Monroecccforthewin, Elm39, Capricorn42, A455bcd9, Srich32977, Group 5! TMS, Falseymcfalserson, Paulbunyon62, FrescoBot, Ong saluri, Oashi, Kusluj,
Pinethicket, MoralMoney, Vrenator, Duoduoduo, , Jsg278, EmausBot, Ibdbgr, RA0808, DjKinDayton, CrimsonBot, AutoGeek, Ubikwit, Xerographica, ClueBot NG, Jack Greenmaven, RedScourge, Widr, Helpful Pixie Bot, Dtellett, TCN7JM, HSKRoTYS3G, tats canadiens, Vinophil, MadGuy7023, Markrm13, Onepebble, VictorD7, King jakob c, Cupco, Septimus.stevens, Neo Poz, EllenCT, Wellyshore,
Filedelinkerbot, SantiLak, Alexlenk and Anonymous: 109
Government nal consumption expenditure Source:
http://en.wikipedia.org/wiki/Government%20final%20consumption%
20expenditure?oldid=580746662 Contributors: SmackBot, Aka042, LilHelpa, Ibdbgr, Taenzee and Anonymous: 1
Government operations Source: http://en.wikipedia.org/wiki/Government%20operations?oldid=641801687 Contributors: AxelBoldt,
Charles Matthews, Beland, Johnmoe, R, Jerryseinfeld, Cjnm, Jguk, Revived, Woohookitty, DoubleBlue, FayssalF, WouterBot, RussBot,
Morphh, Closedmouth, SmackBot, D-Rock, Ww2censor, Conrad.Irwin, Eastlaw, Mereda, R'n'B, Squids and Chips, Z.E.R.O., Sushiya,
Kaori, Poindexter Propellerhead, Addbot, AnomieBOT, J04n, 1958publius, DixonDBot, Sumone10154, Cogiati and Anonymous: 9
Redistribution of income and wealth Source: http://en.wikipedia.org/wiki/Redistribution%20of%20income%20and%20wealth?oldid=
646303837 Contributors: Edward, Gabbe, Discospinster, LindsayH, Bender235, Woohookitty, Drbogdan, Born2cycle, Chobot, Volunteer
Marek, Wavelength, Hauskalainen, Ericorbit, Morphh, Allens, SmackBot, InverseHypercube, Chris the speller, Nbarth, Battlecry, Dl2000,
Thomasmeeks, Spylab, DumbBOT, Jaywilson, JAnDbot, Barek, Eurobas, Parsecboy, R'n'B, UBeR, DadaNeem, Extermino, DASonnenfeld, Xenophrenic, BriEnBest, KyZan, Thatotherdude, Saddhiyama, Tomas e, Drmies, Der Golem, Mild Bill Hiccup, Belchre, RogDel,
Rreagan007, Addbot, CarsracBot, Jarble, Corymchapman, Azcolvin429, AnomieBOT, OpenFuture, Dylan Hsu, Srich32977, Gabiteodoru,
Shadowjams, Thehelpfulbot, FrescoBot, Cismador, Adam9389, HJ Mitchell, Kiwikibble, DrilBot, Pinethicket, Jabshappie, SpringSloth,
FoxBot, LilyKitty, Ivantalk, Brambleclawx, Onel5969, Erntab72, WikitanvirBot, Slightsmile, Traimb, Ritterhude, Welhaven, L Kensington, Ssk352, Adrianw61, Taenzee, Fattyacids1234, ClueBot NG, Wikigold96, Somedierentstu, Vacation9, Arch Mute Brave, Djpugel,
Trift, Helpful Pixie Bot, 2001:db8, Guest2625, Topherdane3, BG19bot, Rober-houdin, Texasholdsem, Irishfrisian, Attleboro, Dawakin,
Mogism, Cupco, Paum89, MillennialDan, EllenCT, HazelAddams, SkateTier, Blamethemessenger and Anonymous: 134
Transfer payment Source: http://en.wikipedia.org/wiki/Transfer%20payment?oldid=623868334 Contributors: SimonP, Robbot, Greyfedora, Jdevine, Neutrality, Kate, RedWordSmith, Saintswithin, Scott Ritchie, Jerryseinfeld, Gary, John Quiggin, Lenar, Tabletop, Kbdank71,
FreplySpang, Bgwhite, Hauskalainen, Avalon, Whobot, SmackBot, Brossow, Can't sleep, clown will eat me, Anlace, Hu12, CapitalR,

394

CHAPTER 69. STOCK MARKET CRASH

Eastlaw, CmdrObot, Z10x, Severo, Jmorrison230582, Velveteman1, Joeldl, SieBot, Flyer22, Decoratrix, Rinconsoleao, Mrfebruary, Icysnowake, Puchiko, PixelBot, Dshade89, XLinkBot, Addbot, Tide rolls, Newportm, Xqbot, Botity, DARTH SIDIOUS 2, Erntab72,
EmausBot, Traimb, Somedierentstu, Widr, WNYY98, Hurutch, Cupco, Sosthenes12, Sneatson and Anonymous: 62
Government revenue Source: http://en.wikipedia.org/wiki/Government%20revenue?oldid=647824664 Contributors: Bearcat, Rpyle731,
Anythingyouwant, Neutrality, Xezbeth, Bgwhite, VolkovBot, Nagika, Addbot, Tedtoal, Luckas-bot, EmausBot, Oldtaxguy, Somedierentstu, MelbourneStar, Rhbsihvi, Guest2625, The Wikimon, Library Guy, TerryAlex, Alexlenk and Anonymous: 9
Tax Source: http://en.wikipedia.org/wiki/Tax?oldid=649755122 Contributors: Derek Ross, WojPob, Bryan Derksen, Slrubenstein,
DanKeshet, Ed Poor, Eclecticology, PierreAbbat, Karen Johnson, William Avery, SimonP, Anne, Graft, Hotlorp, Youandme, KF, Topory,
Olivier, Edward, Patrick, RTC, Michael Hardy, Zocky, Stormwriter, Pnm, Jketola, Dori, (, Haakon, Mac, Den fjttrade ankan, Kingturtle,
Rossami, Nikai, Rob Hooft, Pm67nz, Jstanley01, Tb, Wik, Tpbradbury, Furrykef, Taxman, Tempshill, SEWilco, Lensi, Lord Emsworth,
Joy, Bjarki S, Jecar, Fvw, Raul654, Pakaran, Jusjih, David.Monniaux, King brosby, Madelinefelkins, Cncs wikipedia, Gromlakh, Robbot,
Chealer, Jakohn, Alno, Goethean, Seglea, Lowellian, Mayooranathan, Henrygb, Intangir, Hadal, Terjepetersen, Cedars, Psb777, Matthew
Stannard, Alexwcovington, JamesMLane, DocWatson42, Akadruid, Nikodemos, ShaunMacPherson, Tom harrison, MSGJ, Eagle, Robert
Bruce Livingston, Ans, Djegan, Chameleon, Bobblewik, Golbez, Wmahan, Stevietheman, Gadum, Andycjp, Mike R, Antandrus, Piotrus, Rdsmith4, The Land, RetiredUser2, Sam Hocevar, Allissonn, Cynical, CGorman, Lindberg G Williams Jr, Neutrality, DanMatan,
Pm215, Joyous!, Ojw, Dcandeto, Gerrit, CohenTheBavarian, Hillel, RevRagnarok, Mike Rosoft, Jayjg, Freakofnurture, DanielCD, A-giau,
Discospinster, Rich Farmbrough, Rhobite, Pavel Vozenilek, Tyc20, ESkog, Mateo SA, Jnestorius, Mr. Billion, El C, Shanes, RoyBoy, Coolcaesar, Iralith, Bobo192, Cretog8, Mreini, Circeus, Meestaplu, Sanjiv swarup, Elipongo, Jerryseinfeld, Joshlmay, VBGFscJUn3, Jeremyremery, Cherlin, Pearle, Jonathunder, Alansohn, Gary, Anthony Appleyard, Trysha, Arthena, John Quiggin, Wikidea, Gaytan, Lightdarkness,
Kurieeto, Walkerma, Cdc, Eukesh, Malo, Snowolf, Velella, TaintedMustard, Fourthords, Suruena, Lev lafayette, RJII, RainbowOfLight,
Geraldshields11, Jguk, Versageek, HenryLi, Mmxbass, Adrian.benko, Dismas, Brookie, Bastin, Zntrip, Swzine, Roland2, Richard Arthur
Norton (1958- ), Simetrical, Woohookitty, Mindmatrix, IRbaboon, TigerShark, Camw, Marc K, Borb, James Kemp, Bonus Onus, Miss
Madeline, Acerperi, Bkwillwm, Easyas12c, Xipheus865, Eyreland, Jon Harald Sby, Wiki-vr, Prashanthns, Karam.Anthony.K, Kingsleyj,
Mandarax, Graham87, GoldRingChip, Lastorset, BD2412, Kbdank71, Fcoulter, Phoenix-forgotten, Sj, Jorunn, Rjwilmsi, Mayumashu,
Coemgenus, Wahoove, FSUCriminole, TexasDawg, Seraphimblade, DWR, Vegaswikian, Moorlock, Czalex, The wub, Bhadani, Titoxd,
FlaBot, Sky Harbor, AED, Nihiltres, Crazycomputers, Mark83, RexNL, Ewlyahoocom, Gurch, Alphachimp, Tedder, Getzolt, Gangstories, Saswann, WouterBot, SGreen, ChrisChiasson, Theo Pardilla, Socratesone, BeTheBest, DVdm, 121a0012, Skraz, Dnadan, Vmenkov,
Roboto de Ajvol, YurikBot, Wavelength, Sceptre, Hairy Dude, Pip2andahalf, RussBot, Hauskalainen, Muchness, Bhny, Chaser, O^O, Morphh, NawlinWiki, Rick Norwood, Wiki alf, Nirvana2013, Jaxl, Thiseye, THB, Aquarius rising, Misza13, Lomn, Aleichem, M3taphysical,
Action potential, DeadEyeArrow, Tullie, CLW, Lapafrax, Grcampbell, Avalon, Bdell555, 21655, Zzuuzz, Closedmouth, Skenmy, Arthur
Rubin, Wikiant, Peyna, Garion96, Allens, Katieh5584, Junglecat, Shepard, NeilN, GrinBot, DVD R W, AndyJones, Flix2000, Zova,
Intangible, SmackBot, FocalPoint, Wraithstrider, Slarre, Unschool, Mroeder74, Reedy, Slashme, Unyoyega, CyclePat, Poldavo, C.Fred,
Lawrencekhoo, VivekM, Niayre, Eskimbot, Canthusus, Scott Paeth, BiT, Swerdnaneb, Cool3, Gilliam, Ohnoitsjamie, Hmains, ERcheck,
Kmarinas86, Anwar saadat, Tyciol, Chris the speller, TimBentley, Hahahayeah, PointyShinyBurning, Thom2002, Bjmullan, SchftyThree,
Victorgrigas, Eudaemonic3, A. B., Chendy, Darren Wickham, Famspear, Can't sleep, clown will eat me, Bigjimmic, Battlecry, JRPG,
Nixeagle, Addshore, Mr.Z-man, Samsamm, Zrulli, EPM, Nakon, Nicholasethier, John wesley, Lpgeen, Jklin, Maelnuneb, RiseRover,
Drunken Pirate, GameKeeper, Emmisa, Wilt, Byelf2007, AnnikaWithers, Ktep, Agradman, Dbtfz, Kuru, Dreslough, Scientizzle, Kipala,
Mgunn, Cyclopaedic, Soumyasch, Sir Nicholas de Mimsy-Porpington, Mickalos, Ben Moore, Slakr, Beetstra, , TastyPoutine, Ryulong, Hu12, Chief of Sta, Levineps, BranStark, Nehrams2020, AlexLibman, Tony Fox, Octane, Peterfa, Tawkerbot2, JRSpriggs, Generalcp702, Filelakeshoe, Nydas, Victoryspear, JForget, Jonas Silk, CRGreathouse, CmdrObot, Tanthalas39, Jackzhp, Kthor, Blue-Haired
Lawyer, Rawling, The sauce, ShelfSkewed, Timothylord, Requestion, MarsRover, Siriudie, HonztheBusDriver, Equendil, Gogo Dodo, Andrei.badea, T4, Tawkerbot4, Roberta F., Phydend, Jrgetsin, Bencollins, Viridae, Legis, Salvor Hardin, JodyB, CieloEstrellado, Epbr123,
Ancatdubh43, Ucanlookitup, Peter Znamenskiy, Frank, James086, Phooto, Stratvic, Its The Economics, Stupid!, Big Bird, Drak1970,
Escarbot, AntiVandalBot, Opelio, QuiteUnusual, Prolog, SteveWolfer, DarkAudit, Jj137, Dylan Lake, Ned Netterville, Spartaz, Bconroy,
JAnDbot, MER-C, Skomorokh, Tim Kirkpatrick, Sanchom, LisaAndrew, Suryadas, CParish, Roleplayer, RebelRobot, Bookinvestor, SiobhanHansa, Jimmy R, Penubag, Caveat, Bennybp, Bongwarrior, VoABot II, Richard Taylor APP, Fusionmix, JNW, SHCarter, Bloublou,
TARBOT, Redaktor, Bubba hotep, Fabrictramp, JLMadrigal, Indon, Mattyblueeyes, Nposs, Chivista, Beagel, Roy Langston, Anarchocapitalism, DerHexer, Bibliophylax, Khalid Mahmood, Andronico, Enaidmawr, Binh Giang, Patstuart, Greenguy1090, FisherQueen,
Hdt83, MartinBot, Priyapangi, KalusK9, Roastytoast, Bigus100, R'n'B, Ghileman, Pbroks13, Lilac Soul, Wiki Raja, Tgeairn, J.delanoy,
Pharaoh of the Wizards, Kimse, P jeric, Boboboby7547567567, UBeR, Numbo3, Peter Chastain, Discott, Maurice Carbonaro, Drewwiki,
Extransit, Tmtoulouse, Smeira, McSly, Koven.rm, Linuxmatt, NewEnglandYankee, Rosenknospe, ChiaraMcD, Joshua Issac, Juliancolton,
Cometstyles, Jamesontai, Binris, Inter16, DASonnenfeld, Idioma-bot, DrLutz, VolkovBot, D54312351, ABF, Njonsey, Pleasantville,
John31600, Science4sail, I'mDown, Carpet9, Katydidit, Philip Trueman, TXiKiBoT, Brainiac128, Ldonna, SueHay, Ann Stouter, Jsbhavsar, Ghfkddkdkk, Abbw254, Lradrama, Hburg, Winklethorpe, LeaveSleaves, Dargente, Dinbogogo, Wykypydya, SpecMode, CO, AnnaHoa, Larklight, Ladislav Simko, Dolphinhoney, Altermike, Falcon8765, RaseaC, Sapphic, Edwardjacobs123, FutureDomain, Monty845,
Twooars, MaCRoEco, HippieChick1776, MrChupon, Nouse4aname, HybridBoy, Lancelot8001, FinanceMan1, The Random Editor, EJF,
The cov, SieBot, Dunganb, Nubiatech, Meldor, Hertz1888, Winchelsea, Dawn Bard, Caltas, Ravensre, Yintan, Farshadmx, Babbleman, KErmababa, Toddst1, Flyer22, Gongi123456789, Bendy660, Universalcosmos, Strife911, Oxymoron83, Avnjay, Steven Zhang,
Lightmouse, Poindexter Propellerhead, Lalunaestelle, Dillard421, Correogsk, Rakesh999991, Fuddle, Mygerardromance, Alfred Noakes,
WikiLaurent, Wahrmund, Blindman6, Efe, Rinconsoleao, Precious Roy, Escape Orbit, ShajiA, Olivierandassociates, Martarius, ClueBot,
Mariordo, Orangedolphin, Zippymobile, Avenged Eightfold, Bkoerts, Snigbrook, DePury, The Thing That Should Not Be, Robomanx,
Meekywiki, Chimpanz6, Drmies, Lilbrandy69 2006, Vikram infodrive, Rasmusdahl, Duane-light, Harland1, Dylan620, Namazu-tron,
Puchiko, Auntof6, Jjscone, Grunty Thraveswain, Excirial, Jusdafax, Estirabot, Lartoven, Sun Creator, Ywah80, Psinu, Iohannes Animosus, Steelmate, Kippson, Gundersen53, Andeclercq, Anubis Godfather, Thingg, Aitias, Schmidtzelfritzenbanger, Indiainnk, Versus22,
SoxBot III, Egmontaz, Snotbrain, DumZiBoT, Doopdoop, Jbrtax, Neuralwarp, XLinkBot, Zachpoulin, Boyd Reimer, Rror, Robinharoldbarry, NellieBly, Joe Masterguns, Sean.auckland, JinJian, Ahadisnain, Lemmey, Cyrusace, RyanCross, Gggh, Addbot, Some jerk on
the Internet, Melab-1, Whliang8118, FreiheitKampfer, Betterusername, Fredrick taylor, CanadianLinuxUser, Chamal N, Atomicnomad,
Glane23, Bassbonerocks, Casperdc, Stukins, Random9, West.andrew.g, Terrillja, Aldrich Hanssen, Numbo3-bot, Lacey.Loftin, Pietrow,
Avono, Gail, Zorrobot, Micki, Spearo523, LuK3, Blablablob, Legobot, Luckas-bot, Yobot, 2D, Tohd8BohaithuGh1, Fraggle81, TaBOTzerem, Cm001, Legobot II, II MusLiM HyBRiD II, Reena6, MarcoAurelio, Karanne, Jh39, THEN WHO WAS PHONE?, Hamsterham,
Eric-Wester, AnomieBOT, Rubinbot, Killiondude, Jim1138, IRP, Jambobambo, AdjustShift, Kingpin13, Toutafada, Materialscientist,
Eumachia, It420, ICAEW, Williamsburgland, Xqbot, The sock that should not be, JimVC3, Capricorn42, Gdilz189, Stars4change, XZeroBot, Teamitem, Inferno, Lord of Penguins, Srich32977, GrouchoBot, Coltsfan, RibotBOT, Peanutcactus, Howsa12, Kirsted, Shadowjams,

69.7. TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

395

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of Bakerseld, Jem147, Bgpaulus, C messier, Wayne Riddock, Gryllida, FoxBot, TobeBot, Ray G. Van De Walker, Tibetan Prayer, Lotje,
Natalwoods, Rentzepopoulos, David Hedlund, Geek Unit22, Everyone Dies In the End, Jerd10, Adi4094, Rahuloof, Lindafoust, DARTH
SIDIOUS 2, RjwilmsiBot, Conorbrady.ie, NameIsRon, Slon02, Deagle AP, EmausBot, Proud Liberal 6, WikitanvirBot, Nerissa-Marie,
Armaiti, Racerx11, Mytaxissues, Tommy2010, Wikipelli, Oldtaxguy, Sepguilherme, Economicrealist, Grouchy Larry, Jafar351, Shuipzv3,
MithrandirAgain, Kelly061, Jonpatterns, Nicolas Eynaud, Alpha Quadrant (alt), AConcernedChicken, Itsurfers, Wayne Slam, Tolly4bolly,
Jay-Sebastos, Fergusonian, Brandmeister, L Kensington, Paul Hield, Donner60, Jahnavi24, Xerographica, Financestudent, ChuispastonBot, Prince denison, Ashishdhyani90, DASHBotAV, Gmikeyg, Taenzee, Kwesiidun91, Petrb, Signalizing, ClueBot NG, Rich Smith,
Ilickbuttsyum, Chetrasho, Jjp08146, W.Kaleem, Carpalim, MelbourneStar, Jawsthecat, Batool Fatima, Baseball Watcher, Widr, Smartdawgz, Darrend67, Telecoms1987, Helpful Pixie Bot, HMSSolent, Divoc, Guest2625, Tklink, BigEars42, BG19bot, NewsAndEventsGuy, Krenair, Jwcga, Fabior79, MusikAnimal, Mark Arsten, Shyguy76767, A-etaxes, Boleeva, Legolover26, Sparkie82, Samyjain2010,
HarrisonHill, Glacialfox, BattyBot, NikaJiadze, Vanished user lt94ma34le12, Koolman678, ChrisGualtieri, Khazar2, Kennethhead623,
JYBot, IjonTichyIjonTichy, Dexbot, SantoshBot, Sae Harshberger, Webclient101, Onlyfactsbball21, Goodell, Geverss, Lemonsticks, Lugia2453, CaSJer, SFK2, Graphium, Cupco, RotlinkBot, Paum89, Awesomeguy12345, Sonanto, FiredanceThroughTheNight, Jakesonz,
Ladypamelao, ProtossPylon, Tentinator, WyeatesODI, B14709, DavidLeighEllis, New worl, Kirjava15, Conigliomannaro, Ugog Nizdast,
Prankster1000, Qed237, YOMAL SIDOROFF-BIARMSKII, Jackmcbarn, IDropBabies, Monicakruger, Itsalleasy, Csusarah, ProtestDichter, Melcous, Olekwoj, MicroMacroMania, Taxadvocate, MasterM2400, Fuckherinthepussy, Netvictory, Iwilsonp, Neudabei, Mememan6969, HandleTheNoScopes, RossAyodeji69, Swagbantayolo, Albertibeke, XXWOJXx, KFCLOVER69, Talcisgoodforyou, 19twitt2,
Brigidmcfarland and Anonymous: 1108
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Charles Matthews, Cvaneg, No Guru, Jdevine, Ellsworth, Sam Hocevar, Ukexpat, Tcr25, Trey Stone, TerraFrost, Ylee, Triona, Bobo192,
Maurreen, Gary, Zntrip, Kzollman, Pol098, Bluemoose, Yamamoto Ichiro, FlaBot, John Z, Sceptre, Kvn8907, Zwobot, Speedoight,
JoanneB, SmackBot, Tarret, InverseHypercube, Lawrencekhoo, Ohnoitsjamie, TimBentley, Nbarth, Baronnet, Chendy, Bcasterline, Kuru,
Mikelr, Ntsimp, Shirulashem, Underpants, Natalie Erin, Mentisto, Dreaded Walrus, LeedsKing, Fetchcomms, PhilKnight, VoABot
II, Onigame, TimidGuy, R'n'B, LordAnubisBOT, Brahmastra, Jarry1250, ExecTaxes, Perspicacite, Cloversmate, Rinconsoleao, ClueBot, The Thing That Should Not Be, CounterVandalismBot, SchreiberBike, Egmontaz, XLinkBot, Nepenthes, Almost-instinct, J. Milch,
AnomieBOT, Materialscientist, Citation bot, Geregen2, ArthurBot, Xqbot, Srich32977, SassoBot, Annie.barber, Edderso, 478jjjz, GoingBatty, Danish Expert, Wikipelli, Trmsola44, PietrotheSecond, Welhaven, Jelohman, Taenzee, Spicemix, ClueBot NG, Widr, Helpful
Pixie Bot, PropNate, Williamalaroque, Sparkie82, Delhatch, Onepebble, Sgranado, Thebrandonamir, Wmcneel1, Nasmith1234, Manul,
Therealpirateblue, RobertMorrisIV, 7shots and Anonymous: 138
Government budget Source: http://en.wikipedia.org/wiki/Government%20budget?oldid=633628186 Contributors: Andres, Sean Heron,
Jklamo, Art LaPella, PaulHanson, Eixo, GeorgeStepanek, Nuno Tavares, Jonathan de Boyne Pollard, BD2412, Ground Zero, Latka, YurikBot, NawlinWiki, Bota47, Ageekgal, Shawnc, Mais oui!, Anwar saadat, DHN-bot, Kuru, Robosh, Ambuj.Saxena, Hu12, Nikhilpatlolla,
Courcelles, Travisl, Escarbot, Superzohar, Arsenikk, JAnDbot, Severo, ngel Luis Alfaro, Velveteman1, Mikael Hggstrm, Perohanych,
Klip game, Beyond silence, Kulikovsky, SieBot, AS, Quest for Truth, Rinconsoleao, Ochendzki, Ewawer, Summit84, BodhisattvaBot,
Addbot, AkhtaBot, Uncia, Kisbesbot, DirtTrail, Greyhood, Luckas-bot, J. Milch, AnomieBOT, Fender0107401, Xqbot, Srich32977, FrescoBot, Sic6sic, EmausBot, WikitanvirBot, Lokpest, Noodleki, Pochsad, Taenzee, ClueBot NG, MorganCanb, Frze, Mandoastu, MelVic,
ChrisGualtieri, The Wikimon, Skr15081997, Itsalleasy and Anonymous: 31
Government budget balance Source: http://en.wikipedia.org/wiki/Government%20budget%20balance?oldid=648525008 Contributors:
SimonP, Hephaestos, Edward, Lir, Infrogmation, Minesweeper, Tregoweth, Ronz, Nickshanks, Pakaran, Johnleemk, Robbot, C i wood,
Seabhcan, Everyking, Pgan002, Andycjp, Geni, Jdevine, Kusunose, The Land, Ellsworth, Atemperman, Creidieki, Randwicked, Duja,
Rich Farmbrough, Loren36, Walkiped, Abtin, CoolGuy, Jjron, Goldom, Yuranlu, RJFJR, Dragunova, Dan100, Joriki, Hughcharlesparker,
Mayumashu, Fred Hsu, Vary, FlaBot, Chris Pressey, Ground Zero, Latka, Margosbot, Lmatt, YurikBot, RobotE, MMuzammils, RussBot,
Morphh, ENeville, Nirvana2013, JeremyStein, EconomistUK, Knotnic, Rlove, Shawnc, Mais oui!, Teryx, DocendoDiscimus, SmackBot,
Lawrencekhoo, Eskimbot, Timotheus Canens, Ohnoitsjamie, Bluebot, Mikcob, Foxjwill, Can't sleep, clown will eat me, Cybercobra,
EdGl, Ugur Basak Bot, Byelf2007, SashatoBot, Kuru, Ulner, Tim bates, 16@r, Davemcarlson, Jspeis, Hu12, Joseph Solis in Australia,
JoeBot, Oobug, Netvegetable, Amniarix, J Milburn, CmdrObot, Patchouli, Thomasmeeks, Ahuds, David Warner, Cydebot, Gogo Dodo,
Shirulashem, Chillysnow, Mentisto, Mibs, A.szczep, BigMacDaddy007, Alphachimpbot, PhilKnight, Aaustin, Magioladitis, JamesBWatson, MartinBot, Numbo3, Fiachra10003, Brahmastra, CardinalDan, Sirmont, VolkovBot, Orcano, Rockstar915, Sicjedi, Topdeck,
LuigiManiac, Beadbs, Hazel77, SieBot, Lucky Mitch, Finnancier, Rinconsoleao, Jons63, Sivullinen, ClueBot, The Thing That Should
Not Be, Ewawer, Ottawahitech, Crywalt, Tomeasy, Sheilawiki2, Summit84, Sapdutta, SlubGlub, ConCompS, Hspeers, Aliensh0meless,
Favonian, 84user, Tide rolls, OlEnglish, J. Milch, Yobot, Ptbotgourou, II MusLiM HyBRiD II, AnomieBOT, Rubinbot, ..24,
Mgmwki, Raamaiden, Srich32977, Jmazzwiki, RibotBOT, Shikhashrestha, Smallman12q, Bdcheung, Joxemai, Ftkurt, Haeinous, Lil
hayesy, DrilBot, HRoestBot, DixonDBot, Yunshui, Lotje, Duoduoduo, Suusion of Yellow, Ripchip Bot, EmausBot, WikitanvirBot, Danish Expert, RenamedUser01302013, Ocaasi, Welhaven, L Kensington, Jelohman, Climbtastic, Taenzee, Petrb, ClueBot NG, TaraUKY,
Helpful Pixie Bot, Guest2625, Shajackson14, Superotterman, Happenstancial, Nju'tscho, Dobie80, Geyer.david93, Lugia2453, LCCX,
Ouzotech, Yamaha5, The Herald, YiFeiBot, Lizemanuel and Anonymous: 161
Government debt Source: http://en.wikipedia.org/wiki/Government%20debt?oldid=649245212 Contributors: SimonP, Pnm, Ronz, Feedmecereal, Selket, Maximus Rex, Rnbc, Nickshanks, Pakaran, Romanm, Rebrane, Superm401, Psb777, Achurch, Andy, Sloyment, Everyking, Kravietz, Andycjp, Dvavasour, Beland, Trevor MacInnis, Heryu, Rich Farmbrough, Smyth, MeltBanana, Kbh3rd, Mr. Billion,
El C, RoyBoy, Danshil, Bobo192, Jerryseinfeld, Rajah, PaulHanson, Sligocki, Marianocecowski, Gpvos, Sciurin, Versageek, Gene
Nygaard, Kazvorpal, ABostrom, Stoft, Bobrayner, Woohookitty, Astator, Je3000, Deltabeignet, Magister Mathematicae, Grammarbot, Rjwilmsi, Alaney2k, Feydey, FlaBot, Ground Zero, Margosbot, Vsion, John Z, Leslie Mateus, Orborde, John Maynard Friedman,
Vircum, WouterBot, Bgwhite, Wavelength, Clemente, Dannycas, RussBot, Splash, Alex Bakharev, Morphh, Dialectric, Nirvana2013,
Rjensen, Moe Epsilon, Danlaycock, Syrthiss, Black Falcon, Zzuuzz, Arthur Rubin, Badgettrg, Jonathan.s.kt, Thomas Blomberg, Teryx,
Mardus, Qero, DocendoDiscimus, Pankkake, SmackBot, PiCo, Meshach, Rtc, Alex1011, Lawrencekhoo, Brossow, Timotheus Canens,
Srnec, Gilliam, Ohnoitsjamie, TimBentley, Audacity, Simon123, Persian Poet Gal, Mgeorg, Baronnet, MarshallPoe, A. B., Supercowfan, Rrburke, Emre D., Fuhghettaboutit, Pilotguy, Lambiam, Petr Kopa, Kuru, Peace Inside, Tazmaniacs, Poster123321, Mr Stephen,
Shinryuu, Hogyn Lleol, DGtal, Hu12, Joseph Solis in Australia, CecilPL, Nmoyster, Markbassett, Ouishoebean, Flickboy, Tachi, CmdrObot, Iamhungey, Thomasmeeks, Ken Gallager, Kozuch, Richhoncho, Thijs!bot, Epbr123, Barticus88, Qwyrxian, Alkari, Sukisuki,

396

CHAPTER 69. STOCK MARKET CRASH

Peace01234, Geneects, AntiVandalBot, JimScott, Winterelf, Xolom, Rdavi404, Barek, Sanchom, Xeno, Greensburger, Magioladitis,
VoABot II, MartinDK, Dannyc77, Appraiser, Soulbot, WalkingTarget, Chunt@euromoney.com, Rettetast, Christian.Mercat, Ghileman,
Mbhiii, Tgeairn, J.delanoy, Shroudan, Mike.lifeguard, Tomgibbons, LordAnubisBOT, Buxley Hall, Mikael Hggstrm, JayJasper, Shomroni, Colchicum, Brahmastra, Rodgermitchell, PeaceNT, VolkovBot, Edukaplan, Philip Trueman, Mercy, Broadbot, Masaqui, Billinghurst,
Prius 2, Uncle Scrooge, VVVBot, Veddharta, OsamaBinLogin, OKBot, WikiLaurent, Rinconsoleao, Romit3, ClueBot, Avenged Eightfold,
Phuzzeelogic2001, Ewawer, Dwrcan, Royksprekk, OplusO, EMajor, Thingg, Jonverve, XLinkBot, Blaznspadz, Facts707, WikHead, ZooFari, RyanCross, Thebestofall007, Addbot, CubBC, Sabine McNeill, Binary TSO, Ironholds, Leszek Jaczuk, MrOllie, Lihaas, Casperdc,
Favonian, Ehrenkater, Luckas-bot, Yobot, AnomieBOT, Tavatar, Bsimmons666, Piano non troppo, Materialscientist, ArthurBot, Cameron
Scott, Obersachsebot, Xqbot, Ponticalibus, TechBot, Srich32977, Reedloar, Miesianiacal, The Wiki Octopus, N419BH, Eruvian, FrescoBot, Gkb1337, Drew R. Smith, Pinethicket, Ecoperson9, Jirka.h23, Lotje, Vovchyck, Sirkablaam, Stroppolo, Mean as custard, Codehydro, Powerkeys, Lac.ideas, Keisyz, EmausBot, John of Reading, Dewritech, GoingBatty, Tommy2010, ZroBot, PrinceVikings, Cogiati,
AvicAWB, PCGull, Pibolata, PietrotheSecond, Kilopi, Nudecline, Chezi-Schla, L Kensington, Noodleki, Bill william compton, Federale, Eculligan, Kookiethebird, Taenzee, Diamondland, ClueBot NG, Go Phightins!, Widr, Mouramoor, Potomac Oracle, Curb Chain,
Guest2625, BG19bot, MacarenaV, Roberticus, Vagobot, Amelapay, Badon, Etchman45, ThanosA, Happenstancial, Professor henderson
the fourth, B.Andersohn, GaillardA, DiligenceDude, Hoatrant, Johnsenms, YFdyh-bot, Erathouis, RuralWI Citizen, Rikeus, SFK2, Johnjay1745, Chris97531, I am One of Many, Lenartwiki, Canadianpolisci, Radio439045, Peter m 2001, Koopatroopa645, UseACalculator,
Leeds1995, G anshul1993, 115ash, Alexlenk and Anonymous: 297
Non-tax revenue Source: http://en.wikipedia.org/wiki/Non-tax%20revenue?oldid=630125275 Contributors: Edward, Neutrality,
Woohookitty, RadioFan, James086, Nick Number, R'n'B, Arjayay, Nutriveg, Jim1138, Minigoody101, Frietjes, Onepebble and Anonymous: 10
Warrant of payment Source: http://en.wikipedia.org/wiki/Warrant%20of%20payment?oldid=594419746 Contributors: Neutrality, Bender235, RussBot, SmackBot, Hmains, The359, Cybercobra, Greensburger, Magioladitis, Majormax, ImageRemovalBot, Muhandes, Dana
boomer, John Chamberlain, TheBigZzz, A.amitkumar, Sargdub, BassJapas and Anonymous: 4
Central bank Source: http://en.wikipedia.org/wiki/Central%20bank?oldid=646370003 Contributors: WojPob, Css, Youssefsan, Roadrunner, Olivier, Stevertigo, Edward, Pit, Earth, Fred Bauder, Mic, Ixfd64, Fruge, TakuyaMurata, Arwel Parry, Duckie, Mk270, Jiang, Kaysov,
Raven in Orbit, Mydogategodshat, Tridy, Greenrd, Wik, Vancouverguy, Itai, Karukera, Shizhao, Scott Sanchez, Eugene van der Pijll,
Guppy, Hjr, Donarreiskoer, Robbot, RedWolf, Nurg, Lowellian, T0ky0, Vikingstad, Finlander, Davidcannon, Terjepetersen, J heisenberg, Nichalp, James Trounson, Gro-Tsen, Robert Weemeyer, Gnossie, Jason Quinn, Kpalion, Foobar, Wmahan, Andycjp, OverlordQ, The
Land, PFHLai, Pgreennch, Joyous!, Herschelkrustofsky, DMG413, Rich Farmbrough, Guanabot, Notinasnaid, Mani1, Mateo SA, CanisRufus, Riyehn, Agoode, Spinboy, Bobo192, Cretog8, Maurreen, Jerryseinfeld, La goutte de pluie, Pearle, HasharBot, Alansohn, Rd232,
Keenan Pepper, John Quiggin, Darrelljon, Trjumpet, InShaneee, HenkvD, Docboat, RJII, Mikeo, Versageek, HGB, Feezo, Bobrayner, Barrylb, Benbest, Chochopk, Tabletop, Dzordzm, Paxsimius, Graham87, Miq, Jorunn, Rjwilmsi, Koavf, RCSB, Martin-C, Commando303,
MapsMan, Cassowary, SLi, Wikiliki, Sky Harbor, SchuminWeb, Ground Zero, Bdolicki, Pumeleon, John Z, Shadow007, Diza, Chobot, Bgwhite, Pending deIetion script, Dnadan, UkPaolo, YurikBot, Hairy Dude, Dailo, RussBot, Stephenb, Rsrikanth05, NawlinWiki, EWS23,
Nirvana2013, VinceBowdren, Bota47, Sandstein, Lendu, Rlove, VodkaJazz, Spliy, Hagie, Thomas Blomberg, Teryx, DocendoDiscimus,
Sardanaphalus, SmackBot, Estoy Aqu, Bravo-Alpha, Unyoyega, Lawrencekhoo, Mauls, By78, Gilliam, Hmains, Afa86, Chris the speller,
Nbarth, ABACA, DHN-bot, Da Vynci, A. B., Famspear, Zleitzen, VMS Mosaic, Rsm99833, Zvar, Andiloew, WayKurat, Byelf2007,
SashatoBot, Takamaxa, iga, Marco polo, Green Giant, Luokehao, McTrixie, Ryulong, Keycard, Spinnick597, Courcelles, Tubbyspencer,
Pepitopax, CRGreathouse, Vision Thing, Ninetyone, Jordan Grant, Basawala, DanielRigal, Wikism, Ankit jn, Gospelnous, Christian75,
Daa89563, Fisherjs, Najro, VikasGorur, Escarbot, Gregalton, Deadbeef, Barek, DPoon, KuwarOnline, RebelRobot, SiobhanHansa, Yahel
Guhan, MartinDK, RBBrittain, JamesBWatson, Rich257, M8al, Vancouverjersey, Roewuck, Pikitfense, Kayau, Sadowski, Mister doodi,
Trusilver, Mapep, Jonpro, Drewwiki, Robertintveld, Wikigi, Fooghter20x, Treisijs, Andy Marchbanks, Solian en, Funandtrvl, VolkovBot,
Marinangelov, Je G., Naktion, Vipinhari, Nargalzius, NPrice, Don4of4, Broadbot, ^demonBot2, PDFbot, Sovereignpeoples, Kesshaka,
AlleborgoBot, Yousri, Sfmammamia, Beadbs, Signsolid, Isis07, The Random Editor, SieBot, Moonriddengirl, BotMultichill, Ori, Takeiteasyfellow, Eagleal, Ravensre, Radon210, Artoasis, Lightmouse, Techman224, OKBot, Jfromcanada, Tantrumizer, Jmryts, Rinconsoleao,
Escape Orbit, WordyGirl90, Sfan00 IMG, EGeek, Joaoantunescosta, ClueBot, PipepBot, Wysprgr2005, Tkeu, Epsilon60198, Brewcrewer,
Excirial, Alexbot, Maser Fletcher, WarwickAllison, P.jasons, Marmeladka, Bossesbosso, Edson Rosa, Thingg, BigK HeX, XLinkBot, AgnosticPreachersKid, Fastily, Nikrashid, Karpouzi, Alexius08, Tomic, Addbot, Benjo71, Jojhutton, ThisIsMyWikipediaName, Ronhjones,
Misterx2000, Alexftalbott, Download, Lihaas, 5 albert square, Numbo3-bot, Teles, Andrevruas, Ettrig, Swarm, Legobot, Luckas-bot,
Yobot, Darx9url, Nallimbot, Max, Examtester, AnomieBOT, Floquenbeam, Rubinbot, Fender0107401, LetThemMintPaper, Limideen,
Xqbot, TheAMmollusc, KHirsch, AntonioMustDie, Gilo1969, Geomatters, Munozdj, C+C, Mario777Zelda, Smallman12q, Danperley,
Shadowjams, Cheasone, Pvtrick123, Guidouk, The Nerd from Earth, Oakshield, Persia2, Finalius, Ivanleo, OgreBot, Aogouguo, Intelligentsium, Redrose64,
, 1olomot, Dark Charles, Londonjackbooks, RedBot, SpaceFlight89, , Nmout, Portsaid, TobeBot,
, Polkiuj0987, ShaneKinder, Harald Meier, Suusion of Yellow, Sideways713, RjwilmsiBot, Sargdub, TjBot, Ripchip Bot, Phlegat, Beyond My Ken, Rollins83, Tensing2001, Dewritech, RA0808, Ballofstring, BreakthruMarco, Vanished user zq46pw21, Slightsmile,
Tommy2010, Systempause, Serketan, ZroBot, Ida Shaw, Kostya0106, Dolovis, JackD523, Alabasterstein, Noodleki, Quite vivid blur,
Orange Suede Sofa, S.saurabh.p, Pierpietro, Taenzee, TitaniumCarbide, Petrb, ClueBot NG, SpikeTorontoRCP, Chetrasho, StefanVK,
Sasakubo1717, Laura.rosner, Wkerbler, Tol182, Giorgos pkls, Hightide818, BG19bot, WecksyRex, Dwarrodelf, Crislingle, Solomon7968,
Snow Blizzard, WikiHannibal, Ludwigjim, Davadhyll, Piero Testa, Pratyya Ghosh, Celtechm, Jemappelleungarcon, SPECIFICO, FRB123,
Ivanjoaojr, Neeraj08558, Douglashouston, Canadianpolisci, Bahooka, HugeLorry, Crow, Hefti Coulda, Monkbot, Muttalib12, Najeraheriberto, Prawnathon and Anonymous: 384
Fractional-reserve banking Source: http://en.wikipedia.org/wiki/Fractional-reserve%20banking?oldid=648162388 Contributors: The
Anome, Edward, Michael Hardy, Dante Alighieri, Darkwind, Susurrus, Cimon Avaro, Mydogategodshat, Charles Matthews, Jstanley01, Zoicon5, Morwen, David Shay, Populus, Khym Chanur, Dpbsmith, AnonMoos, Jerzy, Johnleemk, AnthonyQBachler, L3prador,
Kadin2048, Goethean, Chris Roy, Rfc1394, Sunray, Saforrest, Finlander, Terjepetersen, Alan Liefting, Clementi, Massysett, Lethe, Cool
Hand Luke, Jason Quinn, Neilc, Ben Arnold, Utcursch, Pgreennch, RevRagnarok, Jkl, Rich Farmbrough, Will2k, User2004, LindsayH, Chadlupkes, Bender235, Rubicon, Shrike, Grick, Cretog8, Jerryseinfeld, Alansohn, Eleland, Hipocrite, John Quiggin, Gaytan,
RoySmith, Grobertson, Drbreznjev, Crosbiesmith, Bobrayner, Benbest, Chochopk, Tabletop, Striver, GoldRingChip, BD2412, Rjwilmsi,
TitaniumDreads, Brighterorange, Toby Douglass, Ewlyahoocom, Fresheneesz, Lmatt, Torkillbruland, Diza, Volunteer Marek, Bgwhite,
Borgx, Hairy Dude, Snappy, DMahalko, Hauskalainen, Akamad, Afelton, Nirvana2013, Grafen, Plhofmei, StarTrekkie, Retired username,
Rjlabs, Oaklid, Sandstein, Brozen, Arthur Rubin, Vino s, Kru, Mozkill, Ogo, DVD R W, DocendoDiscimus, Sardanaphalus, SmackBot, Michael%Sappir, Gigs, Lawrencekhoo, Fulldecent, Bluebot, Simon123, Timneu22, IIXII, Nbarth, Sbharris, Chendy, Rogermw,

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vanU, CmdrObot, Nysin, Thepatriots, Yourmanstan, Dgw, Garyonthenet, DumbBOT, Satori Son, Thijs!bot, Egrin, Najro, Itsmejudith, Kborer, Weaponbb7, Bcnviajero, Threlicus, Carolmooredc, Gregalton, JAnDbot, The Transhumanist, BenB4, Theblackbay, Magioladitis, VoABot II, Dekimasu, Yandman, Appraiser, Hendrixjoseph, Smash1gordon, Bmirkalami, Quietvoice, Strikehold, Crash site,
Mm1972, ExplicitImplicity, Ectoplasmical, RalfTheDog, Pharaoh of the Wizards, Wideshanks, Lulolean, JKoulouris, AltiusBimm, Interstategar, Arronax50, Nemo bis, Bernard S. Jansen, Olegwiki, Juxtapos99, Natl1, Funandtrvl, Ddd1600, Yitzhak1995, VolkovBot, Ticklemygrits, Childhoodsend, Michael H 34, Broadbot, Jackfork, Chateauxc, Dirc, Maktimothy, Vincent the Vain, Larklight, Sue Rangell,
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Jerryseinfeld, Gary, Antagonist, Nik42, Andrewpmk, John Quiggin, Hoggr, Gaytan, Sligocki, Caesura, Stephan Leeds, Henrym, Versageek,
MiguelTremblay, Crosbiesmith, Feezo, Bobrayner, Dandv, Chochopk, Btyner, ZephyrAnycon, Prothonotar, CharlBarnard, Fleisher, JIP,
Dearsina, Hellothatsme, Buldri, TitaniumDreads, Kinu, Helvetius, Feco, Cassowary, Ground Zero, Ewlyahoocom, Andlarry, Tequendamia,
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Edokter, Gregalton, Ae, Msankowski, Hayesgm, JAnDbot, LinusK, Smulthaup, BenB4, Greensburger, Yahel Guhan, VoABot II, MartinDK, Wickit1, JBKramer, Mtiany71, Jason Hommel, Sojournerpaul, LorenzoB, SlamDiego, Binh Giang, MichaelGood, Ariel., Rricci,
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EJM86, Canadianpolisci, Bluidsports, Glaisher, Akosiaris, Chrisred01, Korakys, Monkbot, Cole kaminski and Anonymous: 367
Lists of banks Source: http://en.wikipedia.org/wiki/Lists%20of%20banks?oldid=643547902 Contributors: Christopher Mahan, Torfason, DavidLevinson, Mintguy, Montrealais, Olivier, Chris Q, Vkem, AntonioMartin, EddEdmondson, Wshun, Mic, TakuyaMurata,
Minesweeper, Ahoerstemeier, J'raxis, Docu, Bogdangiusca, Kirun, Kaihsu, Lukobe, Marknew, Ffransoo, PatriceNe, Popsracer, Guaka,
Choster, Fuzheado, WhisperToMe, Thue, Joy, Canrocks, Jason M, Qertis, Camerong, Pumpie, Perez, Donarreiskoer, Vardion, Dale Arnett, Pigsonthewing, Postdlf, Rfc1394, Alexblainelayder, Henrygb, TimR, Der Eberswalder, ZekeMacNeil, Gidonb, Starpeak, Radagast,
Pabouk, ShaneKing, Niteowlneils, Mboverload, Zoney, Djegan, Gzornenplatz, Avala, Alvestrand, Edcolins, Ragib, Neilc, Gadum, Kevintoronto, Sohailstyle, J. 'mach' wust, Ebear422, Sumsumne, CaribDigita, Gschizas, Huaiwei, CGorman, Acad Ronin, Laisak, DMG413,
Zondor, Millisits, Grstain, D6, Noisy, Rich Farmbrough, Martpol, Dyl, *drew, Coolcaesar, Zaidiwaqas, Markussep, CeeGee, Spinboy,
Bobo192, Alkiviadis, Mochi, Cmdrjameson, Kappa, Juzeris, Jerryseinfeld, Cavrdg, Newfoundglory, Bijee, Rye1967, Vizcarra, Alansohn,
Gary, Arnesaele, Rd232, Batmanand, Supergloom, Saga City, Mtiedemann, Ning, Instantnood, Nightstallion, Ceyockey, AnIco, B1mbo,
Woohookitty, Quattrop, Alanmak, Robwingeld, JFG, JeremyA, Chochopk, Pixeltoo, Tabletop, GregorB, SDC, JIP, Josh Parris, Ketiltrout, Jorunn, Rjwilmsi, NIKE, Amire80, Viakenny, ManuP, Oblivious, Sghan, Bhadani, Fish and karate, FayssalF, Sky Harbor, Ground

398

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Zero, Abeorch, Oliver Chettle, Weihao.chiu, CarolGray, Gurch, McDogm, Dkam, Wasted Time R, Hairy Dude, RussBot, DanMS, Gaius
Cornelius, Eleassar, A314268, Nirvana2013, Grafen, Siddiqui, Varlagas, Welsh, Vivenot, Stijn Calle, Rjlabs, Bob247, Timouton, MCB,
Open2universe, Ahmednh, GraemeL, JLaTondre, Airodyssey, Curpsbot-unicodify, Che829, Indiana Fats, Qero, DocendoDiscimus, Sardanaphalus, SmackBot, Radak, Janawar, Thelem, Well, girl, look at you!, Nije bitno..., Spag85, Raghuraaman, Stie, Paxse, Robfuller,
Mak17f, Sloman, Hmains, Tettyan, Oscarthecat, Brio-En, Chris the speller, Ian3055, Oxford Starter, Raja Hussain, Fddfred, Rick Smit,
Wedian, Colonies Chris, Louis3ham, Rijesh, Zvonko, Andrew Reynolds, Tryggvia, Bobby35, Muzi, Kittybrewster, Steelbeard1, Arab
Hafez, Gragox, Pondster123, Kevlar67, Shmuliko, Garcia84, J.smith, Ardenn, Thewiikione, Johndoe0307, Zahid Abdassabur, CrashMex, Gobonobo, AB, SMasters, JHunterJ, Lucky1503, Sir192, McTrixie, Babak 91, Alast0r, Agent 86, Tomraider, Dushan wideway,
Jlss73, Iridescent, Aeons, Linkspamremover, AussieDingo83, Tawkerbot2, Joeyfootball73, Grasshoppa, Naween, Nguyentv61, RatMax,
Asimkhan, CmdrObot, A1sun, Joseph Cauld, Rahulswarnkar, Keithh, Peripitus, Tawkerbot4, Gaston28, Robin Hood 1212, TruthbringerToronto, Epbr123, Armanaziz, Fhilal, Lavaneer, LS1010, Vineethmenon, Waban101, FirefoxRocks, Fayenatic london, Isilanes, Kzaral,
Aaronhumes, .tom, Arsenikk, Wini1, Patriot77, Husond, Benstown, Murtoa, Hroulf, Deejay78, Maneeshm, Shenzhen, Adrianski, Excretion, Dvergar, Ssublyme, Dxlondon, DinoBot, FisherQueen, Pedronet, Hashem84, R'n'B, Peter Clarke, Tikiwont, Petrochik, Kilikar,
Majed.taheri, Kangie, JavMilos, Frmar122, Andrezein, Belovedfreak, STBotD, Pashaf, DMCer, Nesavi, Spino tap, Hulaa, Nguyenhuonggiang102, Funandtrvl, Signalhead, Jamcib, Ewehbe, Aesopos, Epson291, Fsmatovu, Rkt2312, TXiKiBoT, Waleed, Garcie, Suhakri,
PrinceGloria, Zondi, UnitedStatesian, Medvall, Individual5, Manjunatha.nayak, Ashishgala, Roberto82, Why Not A Duck, Nagy, Jisulee96,
S.rvarr.S, Dan69en, SieBot, Vedhas, WereSpielChequers, BotMultichill, Gerakibot, Jkbinay, Massacre819, Mr. Neutron, Thelmadatter, NA112, Wuhwuzdat, Very Input, Tikko1, Jbanwo, ClueBot, Bunnarith, Soorajdivakaran, Raghuraman.b, Umi1903, Pakaraki,
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DougSLloyd, Fab at FFI, Smoothpanda and Anonymous: 8
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Kwertii, Fred Bauder, Lexor, Skysmith, (, Duckie, Cimon Avaro, Cherkash, Alex S, Furrykef, Jlavezzo, Dale Arnett, Altenmann, Centrx, HangingCurve, Zigger, Marcika, Rj, Peruvianllama, Finn-Zoltan, Christofurio, Gadum, Toytoy, Quadell, Fangz, Antandrus, PDH,
Calwatch, Rkuris, Rich Farmbrough, Dave Foley, LeeHunter, Kbh3rd, Euniana, Maurreen, Jerryseinfeld, Cavrdg, Wikidea, Mailer diablo, Batmanand, RoboAction, GJeery, KTC, Ceyockey, Woohookitty, Mindmatrix, MartinVillafuerte85, SDC, Graham87, BD2412,
Kbdank71, Rjwilmsi, Joe Decker, RobertG, Gparker, New Thought, Chobot, Bgwhite, Beebebebebe, RussBot, Gustavb, Jaufrec, Vitacore,
O!, Lockesdonkey, Mamawrites, Fram, VodkaJazz, Kaicarver, TrustTruth, DocendoDiscimus, SmackBot, D-bot, Paulmeisel, CrypticBacon, Hmains, Chris the speller, Bazonka, Tjdigit, M.arunprasad, Mayur cfe, Ohconfucius, SirIsaacBrock, Caravaca, Abpillai, Kuru, T
g7, TJ Spyke, Hu12, WilliamJE, Statelypenguin, CmdrObot, Ban.wma, Van helsing, Jesse Viviano, Balloonman, Cydebot, Realvenky,
Dancter, Barticus88, Id447, Dawnseeker2000, Konman72, Markthemac, SiobhanHansa, JaGa, D.h, Flowanda, SlowJog, Cryptonymius,
Gypsydoctor, Matthardingu, White 720, Malik Shabazz, Michael Frind, Venky2007, Euryalus, Bentogoa, BlueAzure, Thomasmack8,
Jan1nad, Drmies, OccamzRazor, Ottawahitech, Apparition11, XLinkBot, WikHead, Addbot, Mac canccce, MrOllie, Mentisock, Download, Lightbot, Michaelpower14, AnomieBOT, Aldo samulo, Jerrysmp, Usa8000, Lotje, RjwilmsiBot, Scottrothstein, Immunize, FAEP,
Dapper cthulhu, Gunter.Schmidt, MithrandirAgain, Insommia, JereyPaglio-NJITWILL, ClueBot NG, Hrsiddique, Egent404, BG19bot,
Magui348, Alangar Manickam, BilliamWiggles, Mark Arsten, Bprajakta, Raymond050191, Ibal3, RscprinterBot, Te, Zeeyanwiki,
Lev Janashvili, SAMWAM88, Uncletomwood, New worl, Fuzzy mongoose, Libraues, Sowndaryab, Stamptrader, Obi-Wan Spiderman,
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20Standards?oldid=649872803 Contributors: Enchanter, Nairobiny, Edward, Michael Hardy, Voidvector, Jiang, Cherkash, Nricardo, MHenry, Palere, EdwinHJ, Rfc1394, Centrx, DocWatson42, Nifboy, Cobaltbluetony, Zigger, Macrakis, Pamri, SarekOfVulcan, Ukexpat,
MementoVivere, Zro, Mormegil, Rich Farmbrough, Vapour, Xezbeth, Cavebear42, Quistnix, Bender235, Thebrid, Neko-chan, Sicherlich, Martg76, Landroni, Pion, Saga City, Camw, Tabletop, Hughcharlesparker, BD2412, Nlsanand, Ttwaring, FlaBot, Linghow, Gurch,
Chobot, Maxx.T, Bgwhite, RobotE, RussBot, Petesmiles, Gaius Cornelius, NawlinWiki, Dtrebbien, Grafen, Pkearney, Tony1, MSJapan,
Bota47, Upsss, Cwiltshire, JLaTondre, Auroranorth, CrniBombarder!!!, Finell, Hgaronfolo, DocendoDiscimus, SmackBot, Reedy, Hydrogen Iodide, Chairman S., Eskimbot, Gilliam, Ohnoitsjamie, Chris the speller, Bluebot, Lincs geezer, Nbarth, RedHillian, Gerryfarm,
Ohconfucius, SirIsaacBrock, Kuru, Naerhu, Shlomke, Vashtihorvat, Dl2000, Hu12, Nehrams2020, Roris, CmdrObot, Janegca, Glanthor Reviol, Vatech09, Cydebot, Clappingsimon, Chhajjusandeep, JJC1138, Bouchecl, THJames, Priyanshu, Mercunis, Fayenatic london,
JAnDbot, Sheitan, .anacondabot, Magioladitis, JamesBWatson, Theroadislong, Sherden, Xhosan, Hintswen, Ash, Tenorsaw, J.delanoy, Gogal, Yonidebot, Colincbn, Octopus-Hands, TEX 0309 FOU L2, Gavinayling, SJP, 2help, STBotD, Andrey Chudakov, DonovanHawkins,
Jamesontai, My wing hk, Funandtrvl, STDCAT, Stdadd615, VolkovBot, Njonsey, Joesydney, GillesAuriault, Technopat, NVO, Grace E.
Dougle, Sintaku, Broadbot, Mmutilva, IFRS303, Jhaxtra, Ninthangel, SieBot, Swinnow16, Moonriddengirl, Davidramsey, Winchelsea,
Jojalozzo, Afraietta, Pinkadelica, Rachelgoodwin, Mazlum, ClueBot, Fish, LAX, Eciency576os, PipepBot, Kotniski, EoGuy, ImperfectlyInformed, Bhuna71, Niceguyedc, MARKELLOS, P2IntCR 08, Dylan620, Auntof6, DragonBot, Jusdafax, PixelBot, AnthonyUK,
Salvi.simone, Draper1901, SpikeToronto, Carsonius, Arjayay, Iohannes Animosus, D0nnie Dark0 96, AssetInfo, DumZiBoT, Rror, Wellrested, BIG4PAPA, Vqors, Gordonheard, Thatguyint, Addbot, Proofreader77, MirandaSHEK, Philsimpson101, Geitost, Mole31, Opeless, MrOllie, Fdcpa, Oszzz, Zorrobot, Legobot, Luckas-bot, Yobot, WikiDan61, Ptbotgourou, Fraggle81, Maher nasri, Vikeka, Avalpert,
Tempodivalse, Sivanesh, AnomieBOT, Greno, Baswerkhoven, GordonGross, PennySeven, ICAEW, Kalamkaar, LilHelpa, Capricorn42,
Dcomus, Sean19, GrouchoBot, Newsi, Mathonius, VoItorb, Emekadavid, Eugene-elgato, Jswhit02, Themeparkgc, FrescoBot, D'ohBot,
Davidburdett, Student1024, HavocXphere, Janakmalvi, BenzolBot, Lilaac, Bohuma, Ikswezsamot, Galapagos999, Thabick, Full-date
unlinking bot, Larry Dunn of Bakerseld, ReClassify, TobeBot, Vancouver Outlaw, No One of Consequence, Fastilysock, Tbhotch,
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HIDECCHI001, MusikAnimal, Sarangvk, Chip123456, MadGuy7023, Sae Harshberger, LightandDark2000, Yefdcxx, Csusarah, Chiascuro and Anonymous: 1039
Stock market bubble Source: http://en.wikipedia.org/wiki/Stock%20market%20bubble?oldid=637103582 Contributors: Malcolm
Farmer, Kowloonese, Fredbauder, Roadrunner, R Lowry, Hephaestos, Olivier, Edward, Mic, Egil, Jiang, Choster, Zoicon5, King
brosby, Skybunny, Hankwang, Altenmann, TittoAssini, Dbenbenn, Foobar, Toytoy, Quarl, Pgreennch, Oceanhahn, Absinf, Bender235, Lalala666, Cretog8, Smalljim, Hesperian, Woohookitty, The Brain, Rjwilmsi, Renaissance Man, FlaBot, VKokielov, Hairy
Dude, Htournyol, Epolk, EWS23, Nirvana2013, Rjlabs, Tiger888, Luk, DocendoDiscimus, EncMstr, Smallbones, Stevenmitchell, Kuru,
Wttsmyf2, TastyPoutine, Hu12, Joseph Solis in Australia, GDallimore, Legis, SparhawkWiki, Magioladitis, Olikea, Sandshoe, Skylights76,
MrPPH, WynnQuon, NerdyNSK, Smileygandhi, Funandtrvl, Bogeyo, Wassermann, Farcaster, Happysailor, Rinconsoleao, XLinkBot,
Rreagan007, Misterx2000, Chzz, Tassedethe, Themfromspace, Examtester, Stanton5, Smitsulstix, Srich32977, Shirik, Tango Panach,
FrescoBot, Citation bot 1, Cheapscheisst, Schwede66, Gfs6gradeA, WikiStockGuy, John of Reading, AvicBot, Taenzee, ClueBot NG,
Andrew Gwilliam, CitationCleanerBot, Cimorcus, Mzsapi, BeachComber1972, SamoaBot, Monkbot, Zerowaltz, Orphankid and Anonymous: 52
Stock market crash Source: http://en.wikipedia.org/wiki/Stock%20market%20crash?oldid=645063328 Contributors: AxelBoldt, The
Cunctator, Derek Ross, WojPob, Robert Merkel, The Anome, Ed Poor, Youssefsan, Fredbauder, SimonP, Daniel C. Boyer, R Lowry,
Olivier, Edward, Fred Bauder, Mic, Jbotz, Pcb21, CesarB, Kingturtle, Alvaro, Cimon Avaro, Evercat, GCarty, Selket, Haukurth, Pacic1982, Gakrivas, Finlay McWalter, Slawojarek, Robbot, Chealer, Astronautics, Altenmann, TittoAssini, PBP, Jimpaz, DocWatson42, Inter, HangingCurve, Slyguy, Bobblewik, StuartH, CryptoDerk, Formeruser-81, Antandrus, Quarl, OwenBlacker, Pgreennch,
Vsb, Alperen, Moxfyre, Gazpacho, Discospinster, Rich Farmbrough, Notinasnaid, Bender235, ESkog, Lalala666, Remember, Bobo192,
Smalljim, Cje, KPalicz, Timl, Douglasr007, DCEdwards1966, Nsaa, Alansohn, Free Bear, Arthena, Atlant, Penwhale, Ashley Pomeroy,
Mysdaao, Snowolf, Brookie, Thryduulf, Boothy443, Woohookitty, Doctor Boogaloo, Mindmatrix, Before My Ken, Junes, Dtaw2001,
Rjwilmsi, Stsmith, Wahkeenah, The wub, VKokielov, Ground Zero, Nivix, Ewlyahoocom, Gurch, MoRsE, DVdm, Korg, Wasted Time
R, YurikBot, RobotE, ChiLlBeserker, Hairy Dude, Clinevol98, Anomalocaris, NawlinWiki, Nirvana2013, Arichnad, Rjensen, Dilaudid,
CecilWard, Bkil, DeadEyeArrow, Qrfqr, Nlu, Sandstein, 21655, Closedmouth, JonRoma, Shawnc, Peter, Allens, Tiger888, Someje, Luk,
DocendoDiscimus, SmackBot, Aelfthrytha, KnowledgeOfSelf, Flemavenger, Delldot, HalfShadow, Gilliam, Cabe6403, Vvarkey, Shicoco,
EncMstr, Nbarth, Doctormarton, Darth Panda, Eusebeus, Can't sleep, clown will eat me, MyNameIsVlad, Tamfang, Smallbones, Zone46,
KevM, Frothy, Rrburke, Addshore, Stevenmitchell, Daamien, MEJ119, Lcarscad, Evenel, Kotjze, Polihale, Scientizzle, Jaer, Abrazame,
CPMcE, Ramayan, Joelmills, Lazylaces, Wttsmyf2, Beetstra, Noah Salzman, SQGibbon, FedericoEcon, DabMachine, Levineps, Joseph
Solis in Australia, CP\M, Tawkerbot2, Dlohcierekim, JForget, JohnCD, Vyznev Xnebara, Jesse Viviano, Victor 2, Karenjc, Rschu, Christian75, EqualRights, Epbr123, Mawve, Sagaciousuk, WilliamH, Marek69, John254, James086, Nezzadar, Tellyaddict, Davidhorman,
Spirit Of Truth, BernieBeau, Mmortal03, Hires an editor, AntiVandalBot, Mackan79, Darklilac, Ctrow, DagosNavy, Barek, MER-C,
EvilPizza, Freedomlinux, Bongwarrior, VoABot II, Haku8645, -Kerplunk-, BrianGV, Johnbibby, Allstarecho, Chivista, DerHexer, B.
Wolterding, MartinBot, Poeloq, Pupster21, Anaxial, Mschel, WynnQuon, J.delanoy, Eitan rubin, Zorakoid, Nihilozero, Uncle Dick, Jerry,
Acalamari, McSly, SJP, Woood, Der.Gray, Beezhive, Wikieditor06, Beatfox, CWii, ABF, Mrh30, Fejj the ritual, Jennavecia, Helenalex,
Malinaccier, King Fish76, Vipinhari, Libereco Li, Saber girl08, OpenCWs, Camp0s, Wassermann, UnitedStatesian, Ilyushka88, Maxim,
Lamro, Falcon8765, Coolio124, Logan, Bubblebuns43, Coee, Cheuler, Ellbeecee, Zephyrus67, Bubblebuns44, Caltas, Thlopez, Peter
cohen, Dakatt, BlueAzure, Stockboy11, Jojalozzo, Oxymoron83, Spitre19, Rinconsoleao, Ratemonth, ClueBot, History Wizard, The
Thing That Should Not Be, Abhinav, Jan1nad, Arakunem, Stock trad3r, Niceguyedc, Daigaku2051, Dylan620, Otolemur crassicaudatus, Do DueDiligence, Manishearth, Excirial, Pumpmeup, Bjrothschild7, Encyclopedia77, Billopesha, Lartoven, Carlingford, NuclearWarfare, CowboySpartan, Razorame, Mikaey, La Pianista, Dlawbailey, Thingg, Aitias, Hunterrepublicans, Versus22, Goodvac, Mildred36, DumZiBoT, Bla4433, XLinkBot, John Bahrain, Addbot, Deepmath, Aslmno, Betterusername, Brekass, Misterx2000, CanadianLinuxUser, Cst17, Kaleal92, Mentisock, Download, Glane23, Tyw7, Nlayton, Tide rolls, Luckas Blade, Luckas-bot, Schmidtmandaddy,
Yobot, Jdc0604, , Eric-Wester, Tempodivalse, Examtester, Backslash Forwardslash, AnomieBOT, Puttey, Coopkev2, Mr.Grave,
Jim1138, IRP, Dwayne, Piano non troppo, Ulric1313, LowLevelMason, Materialscientist, Colbert231, Mdroxas, Hr5556, JohnnyB256,
Nsousa817, Zad68, Sionus, Mikefozzy, Polemyx, Coretheapple, GrouchoBot, Shadowjams, FrescoBot, Klubbit, Chris814, PrincessofLlyr,
Vashinta, MastiBot, SparkleCents, Digilante, Fireball20, Merlion444, Brightonr, NortyNort, Lotje, Vrenator, MrX, S.e.atkinson.25, Minimac, DARTH SIDIOUS 2, ArwinJ, RjwilmsiBot, Sargdub, WildBot, Ccrazymann, WikitanvirBot, Racerx11, GaryLKaplan, GoingBatty,
Slightsmile, Rcsprinter123, Taenzee, ClueBot NG, MelbourneStar, Movses-bot, Muon, Widr, Helpful Pixie Bot, Onoclea, Curb Chain,
Tmarcus001, BG19bot, Mhakcm, Benzband, Falkirks, Idiotic radish1276, Snow Blizzard, Tyler Bowling, Glacialfox, W1kipedla cha1n
ger69, 2494yaiknow, 123454321dog, CarrieVS, Khazar2, RThompson82, Hamioraoz, K7L, Stewy5400, Hmainsbot1, Webclient101, Cerabot, Lugia2453, Kevin12xd, Everymorning, Bloweld, Melody Lavender, Jonestebanee, Pointe Drive, Snoopypie and Anonymous: 609

69.7.2

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File:2005private_sector_credit.PNG Source: http://upload.wikimedia.org/wikipedia/commons/7/76/2005private_sector_credit.PNG

License: CC BY-SA 3.0 Contributors: Transferred from en.wikipedia; transferred to Commons by User:Stefan4 using CommonsHelper.
Original artist: Original uploader was Anwar saadat at en.wikipedia
File:2006budget_income.PNG Source: http://upload.wikimedia.org/wikipedia/commons/e/ef/2006budget_income.PNG License: CC
BY-SA 3.0 Contributors: Transferred from en.wikipedia; transferred to Commons by User:Stefan4 using CommonsHelper. Original artist:
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Contributors: self-made, inspired by Gnome globe current event.svg, using Information icon3.svg and Earth clip art.svg Original artist:
Vipersnake151, penubag, Tkgd2007 (clock)
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69.7. TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

401

File:Anarchy-symbol.svg Source: http://upload.wikimedia.org/wikipedia/commons/7/7a/Anarchy-symbol.svg License: Public domain

Contributors: Own work Original artist: Linuxerist, Froztbyte, Arcy
File:Ancientchinesecoins.jpg Source: http://upload.wikimedia.org/wikipedia/commons/8/87/Ancientchinesecoins.jpg License: CC BYSA 2.0 Contributors: Chinese coins Original artist: mc559
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org/wikipedia/commons/b/b5/Andrew_Carnegie%2C_three-quarter_length_portrait%2C_seated%2C_facing_slightly_left%2C_1913.
jpg License: Public domain Contributors: Library of Congress Original artist: Theodore C. Marceau
File:Assorted_United_States_coins.jpg Source: http://upload.wikimedia.org/wikipedia/commons/5/5e/Assorted_United_States_coins.
jpg License: Public domain Contributors: Own work Original artist: Elembis
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for Wikimedia
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Charter_sealing_1694.jpg License: Public domain Contributors: Alice Archer Houblon, The Houblon Family, vol. 1, 1907 Original artist:
Lady Jane Lindsay
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Basel_-_Bank_f%C3%BCr_internationalen_Zahlungsausgleich3.jpg License: FAL Contributors: Own work Original artist: Taxiarchos228
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License: Public domain Contributors: ? Original artist: ?
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Company_flag.svg License: Public domain Contributors: Own work Original artist: User:Wdflake
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File:CDS_volume_outstanding.png Source: http://upload.wikimedia.org/wikipedia/commons/9/93/CDS_volume_outstanding.png License: CC BY-SA 3.0 Contributors: Own work Original artist: MartinD
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Contributors:
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File:Coin_of_Maximian.jpg Source: http://upload.wikimedia.org/wikipedia/commons/a/a0/Coin_of_Maximian.jpg License: CC BYSA 3.0 Contributors: Transferred from en.wikipedia
Original artist: Rasiel Suarez. Original uploader was Rasiel at en.wikipedia
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artist: ?
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Components_of_the_United_States_money_supply2.svg License: Public domain Contributors: See table below for source data. Edited
version of Image:Components_of_the_United_States_money_supply.svg wikipedia commons so that it now includes currency. Original
artist: User:El T (talk), Analoguni (talk), User:Jklamo (talk)
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stlouisfed.org/) Original artist: ?
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domain Contributors: ? Original artist: ?
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LGPL Contributors: Sabine MINICONI Original artist: Sabine MINICONI
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BY-SA 2.0 Contributors: World Economic Forum Annual Meeting Davos 2008 Original artist: Remy Steinegger, World Economic Forum
from Cologny, Switzerland
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Occupy_Wall_Street_2011_Shankbone_7.JPG License: CC BY 3.0 Contributors: Own work Original artist: David Shankbone

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File:Decrease2.svg Source: http://upload.wikimedia.org/wikipedia/commons/e/ed/Decrease2.svg License: Public domain Contributors:

Own work Original artist: Sarang
File:Depense-publique-sur-PIB.png Source: http://upload.wikimedia.org/wikipedia/commons/3/3a/Depense-publique-sur-PIB.png
License: CC BY-SA 3.0 Contributors: Own work Original artist: Marc Baronnet
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of_Wealth_in_the_United_States.jpg License: CC BY-SA 3.0 Contributors: Own work Original artist: Guest2625
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Tango! Desktop Project. Original artist:
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minimally).
File:Emblem-money.svg Source: http://upload.wikimedia.org/wikipedia/commons/f/f3/Emblem-money.svg License: GPL Contributors:
http://www.gnome-look.org/content/show.php/GNOME-colors?content=82562 Original artist: perfectska04
File:Euro_money_supply_Sept_1998_-_Oct_2007.jpg Source: http://upload.wikimedia.org/wikipedia/commons/d/d0/Euro_money_
supply_Sept_1998_-_Oct_2007.jpg License: Public domain Contributors: Self-made by Analoguni. Created with openoce.org calc
using data from the European Central Bank. The M1-M3 statistics were found in the Historical monetary statistics le on this page:
http://www.ecb.int/stats/services/downloads/html/index.en.html The actual le location is: https://stats.ecb.europa.eu/stats/download/bsi_
ma_historical/bsi_ma_historical.zip The amount of currency in circulation was found on the same page but in the statistics pocket book
link at the right side of the page. The statistics pocket book le link is here: http://www.ecb.int/stats/pdf/spb_full.zip The currency in
circulation data is in the spb027.csv le. Transferred from en.wikipedia Original artist: Analoguni (talk) at en.wikipedia
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Contributors: http://openclipart.org/detail/24112/flag-of-afghanistan-by-anonymous-24112 Original artist:
User:Zscout370
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Contributors: ? Original artist: ?
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Drapeau Algrien", in English). Original artist: This graphic was originaly drawn by User:SKopp.
File:Flag_of_Angola.svg Source: http://upload.wikimedia.org/wikipedia/commons/9/9d/Flag_of_Angola.svg License: Public domain
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Contributors: Own work Original artist: SKopp
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domain Contributors: http://www.elibrary.az/docs/remz/pdf/remz_bayraq.pdf and http://www.meclis.gov.az/?/az/topcontent/21 Original
artist: SKopp and others
File:Flag_of_Bahrain.svg Source: http://upload.wikimedia.org/wikipedia/commons/2/2c/Flag_of_Bahrain.svg License: Public domain
Contributors: http://www.moci.gov.bh/en/KingdomofBahrain/BahrainFlag/ Original artist: Source: Drawn by User:SKopp, rewritten by
User:Zscout370
File:Flag_of_Bangladesh.svg Source: http://upload.wikimedia.org/wikipedia/commons/f/f9/Flag_of_Bangladesh.svg License: Public
domain Contributors: http://www.dcaa.com.bd/Modules/CountryProfile/BangladeshFlag.aspx Original artist: User:SKopp
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Denelson83
File:Flag_of_Belarus.svg Source: http://upload.wikimedia.org/wikipedia/commons/8/85/Flag_of_Belarus.svg License: Public domain
Contributors: http://www.tnpa.by/ViewFileText.php?UrlRid=52178&UrlOnd=%D1%D2%C1%20911-2008 Original artist: Zscout370
File:Flag_of_Belgium_(civil).svg Source: http://upload.wikimedia.org/wikipedia/commons/9/92/Flag_of_Belgium_%28civil%29.svg
License: Public domain Contributors: ? Original artist: ?
File:Flag_of_Belize.svg Source: http://upload.wikimedia.org/wikipedia/commons/e/e7/Flag_of_Belize.svg License: Public domain Contributors:
Used
as
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L/,<span>,&,</span>,sid=4b37e91656bda8ae09cb1eb875668eba'>here</a>

text'

href='http:

69.7. TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

403

Improved version from xrmap ag collection 2.9.

Original artist: Caleb Moore
File:Flag_of_Benin.svg Source: http://upload.wikimedia.org/wikipedia/commons/0/0a/Flag_of_Benin.svg License: Public domain Contributors: Own work Original artist: Drawn by User:SKopp, rewritten by User:Gabbe
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Contributors: Originally from the Open Clip Art website, then replaced with an improved version. Original artist: w:en:User:Nightstallion
(original uploader), the author of xrmap (improved version)
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Herzegovina.svg License: Public domain Contributors: Own work Original artist: Kseferovic
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User:Madden
File:Flag_of_Brazil.svg Source: http://upload.wikimedia.org/wikipedia/en/0/05/Flag_of_Brazil.svg License: PD Contributors: ? Original
artist: ?
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From the Open Clip Art website. Original artist: User:Nightstallion
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000005&g= as: Original artist: SKopp
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File:Flag_of_Cape_Verde.svg Source: http://upload.wikimedia.org/wikipedia/commons/3/38/Flag_of_Cape_Verde.svg License: Public
domain Contributors: Own work Original artist: Drawn by User:SKopp
File:Flag_of_Chad.svg Source: http://upload.wikimedia.org/wikipedia/commons/4/4b/Flag_of_Chad.svg License: Public domain Contributors: Quelle Fonto: http://www.crwflags.com/fotw/flags/td.html Original artist: SKopp & others (see upload log)
File:Flag_of_Chile.svg Source: http://upload.wikimedia.org/wikipedia/commons/7/78/Flag_of_Chile.svg License: Public domain Contributors: Own work Original artist: SKopp
File:Flag_of_Colombia.svg Source: http://upload.wikimedia.org/wikipedia/commons/2/21/Flag_of_Colombia.svg License: Public domain Contributors: Drawn by User:SKopp Original artist: SKopp
File:Flag_of_Costa_Rica.svg Source: http://upload.wikimedia.org/wikipedia/commons/f/f2/Flag_of_Costa_Rica.svg License: Public
domain Contributors: This vector image was created with Inkscape. Original artist: Drawn by User:SKopp, rewritten by User:Gabbe
File:Flag_of_Croatia.svg Source: http://upload.wikimedia.org/wikipedia/commons/1/1b/Flag_of_Croatia.svg License: Public domain
Contributors: http://www.sabor.hr/Default.aspx?sec=4317 Original artist: Nightstallion, Elephantus, Neoneo13, Denelson83, Rainman,
R-41, Minestrone, Lupo, Zscout370,
<a href='//commons.wikimedia.org/wiki/User:MaGa' title='User:MaGa'>Ma</a><a href='//commons.wikimedia.org/wiki/File:
Croatian_squares_Ljubicic.png'
class='image'><img
alt='Croatian
squares
Ljubicic.png'
src='//upload.wikimedia.org/
wikipedia/commons/thumb/7/7f/Croatian_squares_Ljubicic.png/15px-Croatian_squares_Ljubicic.png'
width='15'
height='15'
srcset='//upload.wikimedia.org/wikipedia/commons/thumb/7/7f/Croatian_squares_Ljubicic.png/23px-Croatian_squares_Ljubicic.png
1.5x,
//upload.wikimedia.org/wikipedia/commons/thumb/7/7f/Croatian_squares_Ljubicic.png/30px-Croatian_squares_Ljubicic.png
2x' data-le-width='202' data-le-height='202' /></a><a href='//commons.wikimedia.org/wiki/User_talk:MaGa' title='User
talk:MaGa'>Ga</a> (based on Decision of the Parliament)
File:Flag_of_Cuba.svg Source: http://upload.wikimedia.org/wikipedia/commons/b/bd/Flag_of_Cuba.svg License: Public domain Contributors: Drawn by User:Madden Original artist: see below
File:Flag_of_Cyprus.svg Source: http://upload.wikimedia.org/wikipedia/commons/d/d4/Flag_of_Cyprus.svg License: Public domain
Contributors: Own work Original artist: User:Vzb83
File:Flag_of_Cte_d'Ivoire.svg Source: http://upload.wikimedia.org/wikipedia/commons/f/fe/Flag_of_C%C3%B4te_d%27Ivoire.svg
License: Public domain Contributors: Own work Original artist: Jon Harald Sby
File:Flag_of_Denmark.svg Source: http://upload.wikimedia.org/wikipedia/commons/9/9c/Flag_of_Denmark.svg License: Public domain Contributors: Own work Original artist: User:Madden
File:Flag_of_Djibouti.svg Source: http://upload.wikimedia.org/wikipedia/commons/3/34/Flag_of_Djibouti.svg License: CC0 Contributors: From the Open Clip Art website. Original artist: ?

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CHAPTER 69. STOCK MARKET CRASH

File:Flag_of_Dominica.svg Source: http://upload.wikimedia.org/wikipedia/commons/c/c4/Flag_of_Dominica.svg License: CC0 Contributors: Own work: Flag of Dominica originally from the Open Clip Art website. Redrawn by User:Vzb83 except for the parrot. Colours
are adapted from FOTW Flags Of The World website because of the currentness (refreshed 2001). The colour sceme is found at the
government website of the Commonwealth of Dominica and THE WORLD FACTBOOK of the CIA. Original artist: User:Nightstallion
File:Flag_of_East_Timor.svg Source: http://upload.wikimedia.org/wikipedia/commons/2/26/Flag_of_East_Timor.svg License: Public
domain Contributors: ? Original artist: ?
File:Flag_of_Ecuador.svg Source: http://upload.wikimedia.org/wikipedia/commons/e/e8/Flag_of_Ecuador.svg License: Public domain
Contributors: http://www.presidencia.gob.ec/pdf/Simbolos-Patrios.pdf Original artist: President of the Republic of Ecuador, Zscout370
File:Flag_of_Egypt.svg Source: http://upload.wikimedia.org/wikipedia/commons/f/fe/Flag_of_Egypt.svg License: CC0 Contributors:
From the Open Clip Art website. Original artist: Open Clip Art
File:Flag_of_El_Salvador.svg Source: http://upload.wikimedia.org/wikipedia/commons/3/34/Flag_of_El_Salvador.svg License: Public
domain Contributors: Own work Original artist: user:Nightstallion
File:Flag_of_Equatorial_Guinea.svg Source: http://upload.wikimedia.org/wikipedia/commons/3/31/Flag_of_Equatorial_Guinea.svg
License: CC0 Contributors: ? Original artist: ?
File:Flag_of_Eritrea.svg Source: http://upload.wikimedia.org/wikipedia/commons/2/29/Flag_of_Eritrea.svg License: CC0 Contributors:
From the Open Clip Art website. Original artist: user:
File:Flag_of_Estonia.svg Source: http://upload.wikimedia.org/wikipedia/commons/8/8f/Flag_of_Estonia.svg License: Public domain
Contributors: http://www.riigikantselei.ee/?id=73847 Original artist: Originally drawn by User:SKopp. Blue colour changed by User:PeepP
to match the image at [1].
File:Flag_of_Ethiopia.svg Source: http://upload.wikimedia.org/wikipedia/commons/7/71/Flag_of_Ethiopia.svg License: Public domain
Contributors: http://www.ethiopar.net/type/Amharic/hopre/bills/1998/654.ae..pdf Original artist: Drawn by User:SKopp
File:Flag_of_Europe.svg Source: http://upload.wikimedia.org/wikipedia/commons/b/b7/Flag_of_Europe.svg License: Public domain
Contributors:
File based on the specication given at [1]. Original artist: User:Verdy p, User:-x-, User:Paddu, User:Nightstallion, User:Funakoshi,
User:Jeltz, User:Dbenbenn, User:Zscout370
File:Flag_of_Federated_States_of_Micronesia.svg Source:
http://upload.wikimedia.org/wikipedia/commons/e/e4/Flag_of_the_
Federated_States_of_Micronesia.svg License: Public domain Contributors: ? Original artist: ?
File:Flag_of_Fiji.svg Source: http://upload.wikimedia.org/wikipedia/commons/b/ba/Flag_of_Fiji.svg License: CC0 Contributors: ?
Original artist: ?
File:Flag_of_Finland.svg Source: http://upload.wikimedia.org/wikipedia/commons/b/bc/Flag_of_Finland.svg License: Public domain
Contributors: http://www.finlex.fi/fi/laki/ajantasa/1978/19780380 Original artist: Drawn by User:SKopp
File:Flag_of_France.svg Source: http://upload.wikimedia.org/wikipedia/en/c/c3/Flag_of_France.svg License: PD Contributors: ? Original artist: ?
File:Flag_of_Gabon.svg Source: http://upload.wikimedia.org/wikipedia/commons/0/04/Flag_of_Gabon.svg License: Public domain
Contributors: ? Original artist: ?
File:Flag_of_Georgia.svg Source: http://upload.wikimedia.org/wikipedia/commons/0/0f/Flag_of_Georgia.svg License: Public domain
Contributors: Own work based on File:Brdzanebuleba 31.pdf Original artist: User:SKopp
File:Flag_of_Germany.svg Source: http://upload.wikimedia.org/wikipedia/en/b/ba/Flag_of_Germany.svg License: PD Contributors: ?
Original artist: ?
File:Flag_of_Ghana.svg Source: http://upload.wikimedia.org/wikipedia/commons/1/19/Flag_of_Ghana.svg License: Public domain
Contributors: ? Original artist: ?
File:Flag_of_Greece.svg Source: http://upload.wikimedia.org/wikipedia/commons/5/5c/Flag_of_Greece.svg License: Public domain
Contributors: own code Original artist: (of code) cs:User:-xfi- (talk)
File:Flag_of_Guatemala.svg Source: http://upload.wikimedia.org/wikipedia/commons/e/ec/Flag_of_Guatemala.svg License: Public domain Contributors: Own work Original artist: User:K21edgo
File:Flag_of_Guinea-Bissau.svg Source: http://upload.wikimedia.org/wikipedia/commons/0/01/Flag_of_Guinea-Bissau.svg License:
Public domain Contributors: ? Original artist: ?
File:Flag_of_Guinea.svg Source: http://upload.wikimedia.org/wikipedia/commons/e/ed/Flag_of_Guinea.svg License: Public domain
Contributors: ? Original artist: ?
File:Flag_of_Guyana.svg Source: http://upload.wikimedia.org/wikipedia/commons/9/99/Flag_of_Guyana.svg License: Public domain
Contributors: ? Original artist: ?
File:Flag_of_Haiti.svg Source: http://upload.wikimedia.org/wikipedia/commons/5/56/Flag_of_Haiti.svg License: Public domain
Contributors: Coat of arms from: Coat of arms of Haiti.svg by Lokal_Prol and Myriam Thyes Original artist: (colours and size changes
of the now deletied versions) Madden, Vzb83, Denelson83, Chanheigeorge, Zscout370 and Nightstallion
File:Flag_of_Honduras.svg Source: http://upload.wikimedia.org/wikipedia/commons/8/82/Flag_of_Honduras.svg License: Public domain Contributors: ? Original artist: ?
File:Flag_of_Hong_Kong.svg Source: http://upload.wikimedia.org/wikipedia/commons/5/5b/Flag_of_Hong_Kong.svg License: Public
domain Contributors: http://www.protocol.gov.hk/flags/chi/r_flag/index.html Original artist: Tao Ho
File:Flag_of_Hungary.svg Source: http://upload.wikimedia.org/wikipedia/commons/c/c1/Flag_of_Hungary.svg License: Public domain
Contributors:
Flags of the World Hungary Original artist: SKopp

69.7. TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

405

File:Flag_of_Iceland.svg Source: http://upload.wikimedia.org/wikipedia/commons/c/ce/Flag_of_Iceland.svg License: Public domain

Contributors: Islandic National Flag Original artist: var Arnfjr Bjarmason, Zscout370 and others
File:Flag_of_India.svg Source: http://upload.wikimedia.org/wikipedia/en/4/41/Flag_of_India.svg License: Public domain Contributors:
? Original artist: ?
File:Flag_of_Indonesia.svg Source: http://upload.wikimedia.org/wikipedia/commons/9/9f/Flag_of_Indonesia.svg License: Public domain Contributors: Law: s:id:Undang-Undang Republik Indonesia Nomor 24 Tahun 2009 (http://badanbahasa.kemdiknas.go.id/
lamanbahasa/sites/default/files/UU_2009_24.pdf) Original artist: Drawn by User:SKopp, rewritten by User:Gabbe
File:Flag_of_Iran.svg Source: http://upload.wikimedia.org/wikipedia/commons/c/ca/Flag_of_Iran.svg License: Public domain Contributors: URL http://www.isiri.org/portal/files/std/1.htm and an English translation / interpretation at URL http://flagspot.net/flags/ir'.html
Original artist: Various
File:Flag_of_Iraq.svg Source: http://upload.wikimedia.org/wikipedia/commons/f/f6/Flag_of_Iraq.svg License: Public domain Contributors:
This image is based on the CIA Factbook, and the website of Oce of the President of Iraq, vectorized by User:Militaryace Original artist:
Unknown, published by Iraqi governemt, vectorized by User:Militaryace based on the work of User:Hoshie
File:Flag_of_Ireland.svg Source: http://upload.wikimedia.org/wikipedia/commons/4/45/Flag_of_Ireland.svg License: Public domain
Contributors: Drawn by User:SKopp Original artist: ?
File:Flag_of_Israel.svg Source: http://upload.wikimedia.org/wikipedia/commons/d/d4/Flag_of_Israel.svg License: Public domain Contributors: http://www.mfa.gov.il/MFA/History/Modern%20History/Israel%20at%2050/The%20Flag%20and%20the%20Emblem Original artist:
File:Flag_of_Italy.svg Source: http://upload.wikimedia.org/wikipedia/en/0/03/Flag_of_Italy.svg License: PD Contributors: ? Original
artist: ?
File:Flag_of_Jamaica.svg Source:
http://upload.wikimedia.org/wikipedia/commons/0/0a/Flag_of_Jamaica.svg License:
Public
domain Contributors: Own work Original artist: The source code of this SVG is <a data-x-rel='nofollow' class='external text'
href='http://validator.w3.org/check?uri=http%3A%2F%2Fcommons.wikimedia.org%2Fwiki%2FSpecial%3AFilepath%2FFlag_of_
Jamaica.svg,<span>,&,</span>,ss=1#source'>valid</a>.
File:Flag_of_Japan.svg Source: http://upload.wikimedia.org/wikipedia/en/9/9e/Flag_of_Japan.svg License: PD Contributors: ? Original
artist: ?
File:Flag_of_Jordan.svg Source: http://upload.wikimedia.org/wikipedia/commons/c/c0/Flag_of_Jordan.svg License: Public domain
Contributors: ? Original artist: ?
File:Flag_of_Kazakhstan.svg Source: http://upload.wikimedia.org/wikipedia/commons/d/d3/Flag_of_Kazakhstan.svg License: Public
domain Contributors: own code, construction sheet Original artist: -x File:Flag_of_Kenya.svg Source: http://upload.wikimedia.org/wikipedia/commons/4/49/Flag_of_Kenya.svg License: Public domain
Contributors: http://www.kenyarchives.go.ke/flag_specifications.htm Original artist: User:Pumbaa80
File:Flag_of_Kiribati.svg Source: http://upload.wikimedia.org/wikipedia/commons/d/d3/Flag_of_Kiribati.svg License: Public domain
Contributors: ? Original artist: ?
File:Flag_of_Kuwait.svg Source: http://upload.wikimedia.org/wikipedia/commons/a/aa/Flag_of_Kuwait.svg License: Public domain
Contributors: Own work Original artist: SKopp
File:Flag_of_Kyrgyzstan.svg Source: http://upload.wikimedia.org/wikipedia/commons/c/c7/Flag_of_Kyrgyzstan.svg License: Public
domain Contributors: Drawn by User:SKopp, construction sheet. Redo by: cs:User:-xfi- Original artist: Made by Andrew Duhan for
the Sodipodi SVG ag collection, and is public domain.
File:Flag_of_Laos.svg Source: http://upload.wikimedia.org/wikipedia/commons/5/56/Flag_of_Laos.svg License: Public domain Contributors: ? Original artist: ?
File:Flag_of_Latvia.svg Source: http://upload.wikimedia.org/wikipedia/commons/8/84/Flag_of_Latvia.svg License: Public domain
Contributors: Drawn by SKopp Original artist: Latvija
File:Flag_of_Lebanon.svg Source: http://upload.wikimedia.org/wikipedia/commons/5/59/Flag_of_Lebanon.svg License: Public domain
Contributors: ? Original artist: Traced based on the CIA World Factbook with some modication done to the colours based on information
at Vexilla mundi.
File:Flag_of_Lesotho.svg Source: http://upload.wikimedia.org/wikipedia/commons/4/4a/Flag_of_Lesotho.svg License: Public domain
Contributors: Own work Original artist: Zscout370
File:Flag_of_Liberia.svg Source: http://upload.wikimedia.org/wikipedia/commons/b/b8/Flag_of_Liberia.svg License: Public domain
Contributors: Version 1: SKopp
Original artist: Government of Liberia
File:Flag_of_Libya.svg Source: http://upload.wikimedia.org/wikipedia/commons/0/05/Flag_of_Libya.svg License: Public domain
Contributors: File:Flag of Libya (1951).svg Original artist: The source code of this SVG is <a data-x-rel='nofollow' class='external text'
href='http://validator.w3.org/check?uri=http%3A%2F%2Fcommons.wikimedia.org%2Fwiki%2FSpecial%3AFilepath%2FFlag_of_
Libya.svg,<span>,&,</span>,ss=1'>valid</a>.
File:Flag_of_Liechtenstein.svg Source: http://upload.wikimedia.org/wikipedia/commons/4/47/Flag_of_Liechtenstein.svg License:
Public domain Contributors: ? Original artist: ?
File:Flag_of_Lithuania.svg Source: http://upload.wikimedia.org/wikipedia/commons/1/11/Flag_of_Lithuania.svg License: Public domain Contributors: Own work Original artist: SuKopp
File:Flag_of_Luxembourg.svg Source: http://upload.wikimedia.org/wikipedia/commons/d/da/Flag_of_Luxembourg.svg License: Public domain Contributors: Own work http://www.legilux.public.lu/leg/a/archives/1972/0051/a051.pdf#page=2, colors from http://www.
legilux.public.lu/leg/a/archives/1993/0731609/0731609.pdf Original artist: Drawn by User:SKopp

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File:Flag_of_Macau.svg Source: http://upload.wikimedia.org/wikipedia/commons/6/63/Flag_of_Macau.svg License: Public domain

Contributors: GB 17654-1999
Original artist: PhiLiP
File:Flag_of_Macedonia.svg Source: http://upload.wikimedia.org/wikipedia/commons/f/f8/Flag_of_Macedonia.svg License: Public domain Contributors: Own work Original artist: User:SKopp, rewritten by User:Gabbe
File:Flag_of_Madagascar.svg Source: http://upload.wikimedia.org/wikipedia/commons/b/bc/Flag_of_Madagascar.svg License: Public
domain Contributors: ? Original artist: ?
File:Flag_of_Malawi.svg Source: http://upload.wikimedia.org/wikipedia/commons/d/d1/Flag_of_Malawi.svg License: Public domain
Contributors: ? Original artist: ?
File:Flag_of_Malaysia.svg Source: http://upload.wikimedia.org/wikipedia/commons/6/66/Flag_of_Malaysia.svg License:
domain Contributors: Create based on the Malaysian Government Website (archive version)
Original artist: SKopp, Zscout370 and Ranking Update

Public

File:Flag_of_Maldives.svg Source: http://upload.wikimedia.org/wikipedia/commons/0/0f/Flag_of_Maldives.svg License: Public domain Contributors: Own work Original artist: user:Nightstallion
File:Flag_of_Mali.svg Source: http://upload.wikimedia.org/wikipedia/commons/9/92/Flag_of_Mali.svg License: Public domain Contributors: ? Original artist: ?
File:Flag_of_Malta.svg Source: http://upload.wikimedia.org/wikipedia/commons/7/73/Flag_of_Malta.svg License: CC0 Contributors: ?
Original artist: ?
File:Flag_of_Mauritania.svg Source: http://upload.wikimedia.org/wikipedia/commons/4/43/Flag_of_Mauritania.svg License: Public
domain Contributors: ? Original artist: ?
File:Flag_of_Mauritius.svg Source: http://upload.wikimedia.org/wikipedia/commons/7/77/Flag_of_Mauritius.svg License: Public domain Contributors: Own work Original artist: Zscout370
File:Flag_of_Mexico.svg Source: http://upload.wikimedia.org/wikipedia/commons/f/fc/Flag_of_Mexico.svg License: Public domain
Contributors: This vector image was created with Inkscape. Original artist: Alex Covarrubias, 9 April 2006
File:Flag_of_Moldova.svg Source: http://upload.wikimedia.org/wikipedia/commons/2/27/Flag_of_Moldova.svg License: Public domain
Contributors: vector coat of arms image traced by User:Nameneko from Image:Moldova gerb large.png. Construction sheet can be found
at http://flagspot.net/flags/md.html#const Original artist: Nameneko and others
File:Flag_of_Mongolia.svg Source: http://upload.wikimedia.org/wikipedia/commons/4/4c/Flag_of_Mongolia.svg License: Public domain Contributors: Current version is SVG implementation of the Mongolian ag as described by Mongolian National Standard MNS
6262:2011 (Mongolian State Flag. General requirements [1]
Original artist: User:Zscout370
File:Flag_of_Montenegro.svg Source: http://upload.wikimedia.org/wikipedia/commons/6/64/Flag_of_Montenegro.svg License: Public
domain Contributors: Own work Original artist: B1mbo, Froztbyte
File:Flag_of_Morocco.svg Source: http://upload.wikimedia.org/wikipedia/commons/2/2c/Flag_of_Morocco.svg License: Public domain
Contributors: adala.justice.gov.ma (Ar) Original artist: Denelson83, Zscout370
File:Flag_of_Mozambique.svg Source: http://upload.wikimedia.org/wikipedia/commons/d/d0/Flag_of_Mozambique.svg License: CC0
Contributors: From the Open Clip Art website. Original artist: User:Nightstallion
File:Flag_of_Myanmar.svg Source: http://upload.wikimedia.org/wikipedia/commons/8/8c/Flag_of_Myanmar.svg License: CC0 Contributors: Open Clip Art Original artist: Unknown
File:Flag_of_Namibia.svg Source: http://upload.wikimedia.org/wikipedia/commons/0/00/Flag_of_Namibia.svg License: Public domain
Contributors: ? Original artist: ?
File:Flag_of_Nepal.svg Source: http://upload.wikimedia.org/wikipedia/commons/9/9b/Flag_of_Nepal.svg License: Public domain Contributors: Constitution of The Kingdom of Nepal, Article 5, Schedule 1 [1] Original artist: Drawn by User:Pumbaa80, User:Achim1999
File:Flag_of_New_Zealand.svg Source: http://upload.wikimedia.org/wikipedia/commons/3/3e/Flag_of_New_Zealand.svg License:
Public domain Contributors: http://www.mch.govt.nz/files/NZ%20Flag%20-%20proportions.JPG Original artist: Zscout370, Hugh Jass
and many others

File:Flag_of_Nicaragua.svg
Source:
http://upload.wikimedia.org/wikipedia/commons/1/19/Flag_of_Nicaragua.svg
License:
Public domain Contributors:
Own work based on:
<a data-x-rel='nofollow' class='external text' href='https:
//docs.google.com/viewer?a=v,<span>,&,</span>,q=cache:tRiqYRg_YJ4J:www.casc.gob.ni/index.php?option%3Dcom_
docman%26task%3Ddoc_download%26gid%3D704%26Itemid%3D4+ley+sobre+los+simbolo+patrios+nicaragua+
2002,<span>,&,</span>,hl=es,<span>,&,</span>,gl=ni,<span>,&,</span>,pid=bl,<span>,&,</span>,srcid=ADGEEShaqFptSDRqZyUoeWlWgMGTvcFvWOs
About Characteristics And Use Of Patriotic Symbols of Nicaragua</a> Original artist: C records (talk contribs)
File:Flag_of_Niger.svg Source: http://upload.wikimedia.org/wikipedia/commons/f/f4/Flag_of_Niger.svg License: Public domain Contributors:
The burnt orange color in the top band and circle is Pantone(166), i.e. RGB(224,82,6) = #E05206 on sRGB CRT screen, or
CMYK(0,65%,100%,0) for process coated print, BUT NOT light orange #FF7000 which is somewhere between Pantone(130C) and Pantone(151), and is even lighter than X11 orange! See http://www.seoconsultants.com/css/colors/conversion/100/ The central white band is
plain D65 reference white = RGB(255,255,255) = #FFFFFF.
Original artist: Made by: Philippe Verdy User:verdy_p, see also fr:Utilisateur:verdy_p.
File:Flag_of_Nigeria.svg Source: http://upload.wikimedia.org/wikipedia/commons/7/79/Flag_of_Nigeria.svg License: Public domain
Contributors: ? Original artist: ?
File:Flag_of_North_Korea.svg Source: http://upload.wikimedia.org/wikipedia/commons/5/51/Flag_of_North_Korea.svg License: Public domain Contributors: Template:
Original artist: Zscout370

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File:Flag_of_Norway.svg Source: http://upload.wikimedia.org/wikipedia/commons/d/d9/Flag_of_Norway.svg License: Public domain

Contributors: Own work Original artist: Dbenbenn
File:Flag_of_Oman.svg Source: http://upload.wikimedia.org/wikipedia/commons/d/dd/Flag_of_Oman.svg License: CC0 Contributors:
? Original artist: ?
File:Flag_of_Pakistan.svg Source: http://upload.wikimedia.org/wikipedia/commons/3/32/Flag_of_Pakistan.svg License: Public domain
Contributors: The drawing and the colors were based from agspot.net. Original artist: User:Zscout370
File:Flag_of_Panama.svg Source: http://upload.wikimedia.org/wikipedia/commons/a/ab/Flag_of_Panama.svg License: Public domain
Contributors: ? Original artist: ?
File:Flag_of_Papua_New_Guinea.svg Source: http://upload.wikimedia.org/wikipedia/commons/e/e3/Flag_of_Papua_New_Guinea.
svg License: Public domain Contributors: Own work, FOTW Original artist: User:Nightstallion
File:Flag_of_Paraguay.svg Source: http://upload.wikimedia.org/wikipedia/commons/2/27/Flag_of_Paraguay.svg License: CC0 Contributors: This le is from the Open Clip Art Library, which released it explicitly into the public domain (see here). Original artist: Republica
del Paraguay
File:Flag_of_Peru.svg Source: http://upload.wikimedia.org/wikipedia/commons/c/cf/Flag_of_Peru.svg License: Public domain Contributors: Peru Original artist: David Benbennick
File:Flag_of_Poland.svg Source: http://upload.wikimedia.org/wikipedia/en/1/12/Flag_of_Poland.svg License: Public domain Contributors: ? Original artist: ?
File:Flag_of_Portugal.svg Source: http://upload.wikimedia.org/wikipedia/commons/5/5c/Flag_of_Portugal.svg License: Public domain
Contributors: http://jorgesampaio.arquivo.presidencia.pt/pt/republica/simbolos/bandeiras/index.html#imgs Original artist: Columbano
Bordalo Pinheiro (1910; generic design); Vtor Lus Rodrigues; Antnio Martins-Tuvlkin (2004; this specic vector set: see sources)
File:Flag_of_Qatar.svg Source: http://upload.wikimedia.org/wikipedia/commons/6/65/Flag_of_Qatar.svg License: Public domain Contributors: Drawn by User:SKopp Original artist: (of code) cs:User:-xfi File:Flag_of_Romania.svg Source: http://upload.wikimedia.org/wikipedia/commons/7/73/Flag_of_Romania.svg License: Public domain Contributors: Own work Original artist: AdiJapan
File:Flag_of_Russia.svg Source: http://upload.wikimedia.org/wikipedia/en/f/f3/Flag_of_Russia.svg License: PD Contributors: ? Original artist: ?
File:Flag_of_Rwanda.svg Source: http://upload.wikimedia.org/wikipedia/commons/1/17/Flag_of_Rwanda.svg License: Public domain
Contributors: http://www.primature.gov.rw/component/option,com_docman/task,doc_download/gid,859/Itemid,95/ Original artist: This
vector image was created with Inkscape by Zscout370, and then manually edited.
File:Flag_of_Saint_Lucia.svg Source: http://upload.wikimedia.org/wikipedia/commons/9/9f/Flag_of_Saint_Lucia.svg License: Public
domain Contributors: Own work, Government of Saint Lucia Original artist: SKopp
File:Flag_of_Saint_Vincent_and_the_Grenadines.svg Source: http://upload.wikimedia.org/wikipedia/commons/6/6d/Flag_of_Saint_
Vincent_and_the_Grenadines.svg License: Public domain Contributors: ? Original artist: ?
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