Banking

1. Banking Chapter 20 Money Market and Capital Market Department of Business Administration Hong Kong Institute of Vocational Education

2. Lecture Objectives To describe the money market in Hong Kong which consists of • Interbank market • Negotiable Certificate of Deposit (NCD) market

3. Lecture Objectives To describe the capital market in Hong Kong which consists of • Bond market • Stock, Futures and Options markets

4. Money Market Money market are exchange systems where short-term, usually less than one year, highly liquid and marketable credit instruments are traded by financial institutions, brokers and dealers. The money market in Hong Kong is made up of two markets : the interbank market and the negotiable certificate of deposit market.

5. Interbank Market The participants of the Hong Kong interbank market are the licensed banks, the restricted licence banks and the deposit-taking companies. The lenders are the local note-issuing banks and Chinese banks while the borrowers are the foreign banks, the restricted licence banks and the deposit-taking companies which have not a substantial local currency deposit base. The predominant proportion of the market’s business consists of overnight money, call money and short-term money up to two weeks, although money of longer maturities is also available. The loans take the forms of cash deposits and normally no collateral security is asked or given.

6. Interbank Market A swap mechanism exists in the market through which the non-British foreign banks, restricted licence banks and deposit-taking companies may obtain Hong Kong dollar funds by selling US dollar funds with an agreement to repurchase them at a fixed price at a future date.

7. Interbank Market The interbank market is important to the financial institutions because it allows them to adjust their day-to-day liquidity positions, enables banks to use their surplus funds profitably and to obtain marginal funds to support increased business. The existence of an efficient interbank market means that a bank’s lending activities, and therefore profitability, are not limited by the amount of its retail deposits.

8. Interbank Market With the repo transactions with the Hong Kong Monetary Authority, the financial institutions in Hong Kong can satisfy the official requirement and prudential need for maintaining liquidity, cut the margin of their liquidity to a minimum and acquire profit-making assets. The lending rate of the interbank market is the Hongkong InterBank Offer Rate (HIBOR), which is important as a determinant of the interest rates banks charge and pay to borrowers and deposits respectively. The HKMA can influence the short-term interest rates in Hong Kong by influencing the HIBOR.

9. Interbank Market The Hong Kong dollar interbank market plays a central role in the financial intermediation process. Many funds are channeled from depositors via retail banks through the interbank market to foreign banks without branch networks, and finally to the ultimate borrowers, in forms of short-term wholesale funds.

10. Interbank Market The borrowing banks have to rely heavily on the interbank market to acquire necessary funding to meet the demand for Hong Kong dollar credit from their customers. They have a market share of only 3.5% of Hong Kong dollar deposits but a significant share of 14% of Hong Kong dollar loans. The lending banks, mainly locally incorporated banks with a widespread branch network, find the interbank market an efficient channel to invest their funds for up to one year. Although the interest margin derived from the interbank lending is lower than that from customer loans, the interbank market offers smaller counter-party risks and administrative overheads, as well as higher liquidity.

11. Negotiable Certificate of Deposit (NCD) Market Unlike a time deposit, a negotiable certificate of deposit can be sold before the maturity date. Of course, NCDs can be held till the maturity date when the issuer will pay the holder the principal amount plus the accrued interest. Many banks and deposit-taking companies issue NCDs to gather funds from the public which mature beyond one year.

12. Negotiable Certificate of Deposit (NCD) Market Currently over half of the NCDs issued by authorized institutions are held within the local banking sector. The NCD market is dominated by investors who intended to hold the NCDs till maturity. This restricted the liquidity of the market.

13. Negotiable Certificate of Deposit (NCD) Market Most NCDs are priced above one-month, three-month or six-month HIBOR, reflecting the liquidity premium attached to longer-term funds. Issuing NCDs requires legal documentation that spells out the details of the instrument, including the issue amount, maturity, coupon rate, the facility type (e.g. floating rate or fixed rate) and security conditions. There are also additional costs relating to services provided by underwriters, manager banks and arrangers, therefore, making a successful NCDs issue expensive.

14. Negotiable Certificate of Deposit (NCD) Market However, authorized institutions have to use NCDs to obtain funding with maturity over one to ten years to match the longer-term assets on the balance sheets. With the initiatives of the HKMA in improving the market infrastructure, such as the Central Moneymarkets Unit which provides an efficient and low cost clearing service for Hong Kong dollar debt instruments and the extension of eligible securities for access to the Liquidity Adjustment Facility, the liquidity of NCDs market has experienced significant improvements.

15. Capital Market Capital market trades debt and equity. The capital market is an important source of finance for the government, public utilities and corporations. In Hong Kong the capital market consists of the bond market, the stock market and the futures market.

16. Bond Market The bond market in Hong Kong is still in its early stage of development and is dominated by issues from the Government and the public utilities. In order to improve monetary management and stimulate the debt market, the Government launched the Exchange Fund Bills in 1990 and the Exchange Fund Notes in 1993. This established a benchmark yield curve for the debt market in Hong Kong. A subsequent issue of three-year Hong Kong dollar bonds by the World Bank was priced at 10 basis points above the benchmark yield established by the three-year Exchange Fund Notes.

17. Bond Market Exchange Fund Bills and Notes were well received by the market as instruments most attractive to bank investors because they can be used as collateral to obtain liquidity through the Liquidity Adjustment Facility offered by the HKMA.

18. Bond Market The World Bank bonds marked the beginning of an influx of supra-national corporations into the Hong Kong bond market. The International Finance Corporation and the Asian Development Bank have also successful issued bonds in Hong Kong. This in turn encouraged multinationals such as General Electric Capital Corporation to tap the local bond market for long-term funds.

19. Bond Market The construction of the new airport and the infrastructure projects also helped boost the debt market because they required huge funds to be raised. The establishment of the Hong Kong Mortgage Corporation (HKMC) has significant implications for the local debt market, particularly concerning the securitization of mortgage loans, i.e. replacement of bank mortgage loans by mortgage-backed securities.

20. Bond Market Unlike banks which rely on short-term funding, e.g. customer deposits and interbank borrowing, to finance long-term mortgage loans, the HKMC plays the role of channeling long-term savings, such as insurance premiums and provident funds, to meet the demand for long-term home financing. By releasing banks from the overloaded mortgage loans, the HKMC can reduce the concentration and liquidity risks of banks in mortgage loan business.

21. Bond Market The future development of the bond market is the H-bond, i.e. the issuing and listing of Hong Kong dollar debt in Hong Kong by Chinese entities. The first issue of H-bond was by the People’s Construction Bank of China in 1995.

22. Bond Market The corporate bonds have been least developed in the Hong Kong debt market. The reasons are : • The taxation of interest received on non-bank Hong Kong dollar bonds. • The absence of a Hong Kong-based independent rating authority to assess the risks of individual bonds. • The difficulty in arranging transactions of less than HK$100,000 or more than HK$20 million, thus excluding both the small private investors and the large institutional buyers from the market.

23. Hong Kong Exchanges and Clearing Limited (HKEX) The reform of the stock and futures markets in Hong Kong took place in 1999-2000 with the aims to increase competitiveness and meet the challenges of an increasingly globalised market. Under the reform, The Stock Exchange of Hong Kong Limited, Hong Kong Futures Exchange Limited demutualised and together with Hong Kong Securities Clearing Company Limited, merged under a single holding company called Hong Kong Exchange and Clearing Limited. HKEX listed its shares by introduction to the stock exchange in 2000.

24. Cash Market The Stock Exchange of Hong Kong Limited (SEHK) was incorporated in 1986 by merging the four exchanges : Hong Kong Stock Exchange, Far East Stock Exchange, Kam Ngan Stock Exchange and Kowloon Stock Exchange. Unification provided a single set of listing rules, membership qualifications and operating practices. The computer-assisted trading system was also introduced to improve efficiency.

25. SEHK Organization Structure Listing Division ensures that all listed companies comply with the Listing Rules. Issues of securities in companies are governed by the Companies Ordinance, with evaluation of issues performed by both company registrars and the Securities and Futures Commission (SFC). The SFC is responsible for the ultimate approval of sale of equity to the public.

26. SEHK Organization Structure Compliance Division ensures that securities trading is conducted in the best interests of investors and the markets. It oversees the behaviour of brokers and market performance. Trading Technology and IT Division operates and modernizes the Computerised Trading System to ensure it copes with the growth of the market. Research and International Relations Department helps to formulate long-term development and strategies for the SEHK and conducts research to support planning.

27. SEHK Organization Structure Membership Department ensures that all brokers have satisfactory qualifications and adequate financial resources, and develops training programmes and examinations to upgrade the quality of brokers and to maintain the professional standards of the whole industry.

28. Derivatives Market The Hong Kong Futures Exchange Limited was established in 1976 to provides efficient and diversified markets for trading futures and options contracts. There are a broad range of products including equity index, stock, interest rate and foreign exchange futures and options.

29. Derivatives Market Futures is a derivative product. When investors take a long (short) position in futures contracts, they have bought into an agreement which oblige them to buy (or sell) the contract’s underlying assets (e.g. stocks indices, stocks and bonds etc.) at a predetermined price within a prescribed period.

30. Derivatives Market There are 3 main reasons for investors to invest in futures: directional trading, hedging and arbitrage.Take the example of stock futures; an investor is doing directional trading when he predicts a stock price to rise and buys a futures contract. He can earn profits when the underlying stock price is higher than the strike price on the settlement day of the futures contracts. In contrast, the investor would sell futures if he anticipates a fall in the stock price.

31. Derivatives Market Hedging is the strategy to offset the negative effect on the return on a primary position by taking a secondary position in derivative products. Hedging can further be broken down into “short hedge” and “long hedge”. In performing a short hedge, an investor can offset his loss in stocks in a bearish market by the profit gained from shorting a futures contract. An investor can apply a long hedge to lock in the price for buying the underlying stock on a future date by buying a futures contract. If the underlying stock price rises, this will guarantee the investor to be able to buy the stock at a price lower than the prevailing price.

32. Derivatives Market Arbitrage allows investor to earn profits by capitalising on the price difference of the underlying stock in the futures and cash markets by buying low and selling high in the respective markets.

33. Derivatives Market An option is a contract between parties, a buyer and a seller, whereby the buyer has the right but not obligation to trade an underlying asset with the seller at a predetermined price within a certain time. Again, the position of a holder is a long position and the position of a writer is a short position.

34. Derivatives Market In a call option, the holder has the right to buy but the writer has the obligation to sell. In a put option, the holder has the right to sell but the writer has the obligation to buy. The underlying asset of an option can be equity stock, stock index or bond. The expiry date is the last day on which the option can be exercised. The exercise price is the predetermined price of the underlying asset. The premium is the price that the holder must pay for holding the option contract.

35. Derivatives Market The benefits of trading futures and options are the leveraged returns and the protection of the value of a portfolio of assets in a falling market. The costs of trading futures and options are the margin deposit requirement for futures contracts and the premium for option contracts. The risk of trading futures is the financial leverage so that the loss can be very great.