Fundamentals of Financial Instruments. Sunil K. Parameswaran

company individually.

      10 If there is a corporate action such as a stock dividend or a stock split, the shares are automatically credited to the investor's account.

TABLE 1.1 Commercial Banks and Depositories (Similarities and Differences)

Commercial Bank	Depository
Holds funds in an account	Holds securities in an account
Enables fund transfers between accounts after receiving instructions from the account holder	Enables transfers of securities between accounts after receiving instructions from the account holder
Facilitates transfers of funds without having to handle money	Facilitates transfers of share ownership without having to handle securities
Facilitates safekeeping of money	Facilitates safekeeping of securities

CUSTODIAL SERVICES

A custodian bank, a.k.a. a custodian, is a financial institution entrusted with the responsibility of safeguarding the financial assets of an individual or, more commonly, an institutional investor. The custodian typically performs one or more of the following functions:

      1 It holds stocks and bonds in safekeeping.

      2 It arranges for settlement whenever securities are purchased or sold. In the event of a purchase it ensures that securities are credited and cash is debited, while in the event of a sale it ensures that securities are debited and that cash is credited.

      3 It collects dividends on shares and interest on bonds and ensures that the investor's account is credited.

      4 It provides information related to the companies whose securities are being held by the investor, such as the schedule of their annual general meetings (AGMs).

      5 It provides foreign exchange transactions if required.

      Global custodians hold assets for their clients in multiple locations around the globe, using their own local branches or other local custodians. The advantage of employing a global custodian is that a settlement instruction needs to be sent to a single destination. Investors may also opt to use a network of local custodians, one in each financial center where they undertake trades.

      If a custodial facility is availed of, the shares will be held in the name of the custodian, with the investor continuing to remain as the beneficial owner of the securities. The advantages of employing the facilities of a custodian may be summarized as follows:

      1 It makes it easier and quicker to trade securities, particularly international shares.

      2 It simplifies the management and reporting of share transactions. At the end of every financial year, the investor will receive a single consolidated statement giving details of purchases and sales, and any dividend or interest income received during the period.

      3 The custodial facility also makes it easier to track the performance of the investor's portfolio.

GLOBALIZATION – THE NEW MANTRA

The word globalization indicates international integration of markets and economies, whereby they become interdependent and interconnected. In today's world, large corporations obtain financing from major money centers around the world in many different currencies to finance their global operations. The major money markets in the world include New York, London, Singapore, and Tokyo. The global nature of operations also forces many corporate treasurers to establish international banking relationships and place short-term funds in several different currencies. The effective management of foreign exchange risk is therefore an integral part of the duties of a modern treasury department. Individual investors too have started investing in the securities of many different countries to take advantage of the better performance potential from internationally diversified portfolios of financial assets.

      The integration of financial markets around the world is due to four major factors.

      Many countries have deregulated their money and capital markets substantially. The developed and some of the developing countries allow foreign brokerage firms to operate in their domestic stock exchanges to facilitate greater competition. The majority of countries have eliminated the structure of fixed brokerage commissions which used to exist. Commissions are now largely negotiable between the brokers and the clients and very often are a function of the trading volume and the quality of service that is sought. Interest rate ceilings have been largely removed, and offshore banking facilities (international banking facilities, or IBFs, in the United States) are available.

      IBFs allow US banks to use domestic branches to service foreign customers with international transactions, both deposit and loan services, free of reserve requirements and interest rate regulations. Other countries have followed suit. The objective was obviously to make US banks competitive with respect to players outside the United States who were accepting deposits denominated in dollars and making loans in dollars.

      Many countries have also sought to do away with the distinction between Commercial Banking and Investment Banking, and thus move toward Universal Banking. Most major banks these days are giant financial conglomerates that serve as one-stop financial solutions providers.

      EXAMPLE 1.6

      (An Illustration from India)

      Take, for instance, the case of ICICI Bank, which is India's second largest bank. It is a traditional commercial bank on the one hand, in the sense that it accepts deposits from the public and makes loans. It has, however, an Asset Management Company that manages mutual funds in collaboration with Prudential Plc. ICICI Prudential is into Life Insurance. ICICI Lombard is into General Insurance. ICICI Home Finance is a subsidiary that makes real estate loans.

      Constant product and process innovations are a major feature of the modern financial market. Innovations have manifested themselves in two forms: (1) many new products have been created and (2) new methods have been devised to facilitate the transfer of risks.

Of course, none of the observed advances in global markets would have been feasible without the developments in telecommunications, computer hardware, and software that we have witnessed in the recent past. They have helped develop systems where links can be instantly established, and funds and securities can be transferred safely and quickly. Companies like Bloomberg now provide round-the-clock access to prices and news from financial centers round the world. Most exchanges are now fully automated and electronic.

      Today's markets are also characterized by the increasing sophistication of investors and borrowers. Multinational corporations and, surprisingly, even governments have become more sophisticated. Corporate treasurers, fund managers, and bureaucrats are highly educated and aware. Today's markets also tend to be largely dominated by institutions. These giants can take advantage of economies of scale worldwide. They can also afford to employ large teams of highly qualified experts.

NOTES

      1 1 See Rose (2000).

      2 2 Obviously, the price of good A in terms of good B is the reciprocal of the price of good B in terms of good A.

      3 3 See Geddes, 2001.

CHAPTER 2 Mathematics of Finance