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Capital Markets
Larry Cooperman
This work is produced by The Connexions Project and licensed under the Creative Commons Attribution License †
1 Capital Markets
1.1 Introduction
1.1.
In this course, we will examine several aspects of the global capital markets, including private and public nancial intermediaries, domestic and global security markets, organized exchanges for stock and bond securities trading, and capitalization structure. We will also learn the mechanics of the buy-side/sell-side, the role of investment bankers and brokers, the underwriting process, various types of nancial securities and derivatives, and other topics that are timely to today's global markets. The objective of this course is to provide students with a working knowledge of global capital markets. The ultimate goal is to obtain a level of knowledge of the capital markets that allows the con dence to perform an investor relations job with a new level of eectiveness and e ciency.
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- Examine the two goals of all nancial activities: cash ow transfers across time and risk transfer.
- Dierentiate between Funds De cit Units and Funds Surplus Units.
- Derive the e cient frontier in order to maximize return for any possible level of risk.
∗Version 1.1: May 1, 2009 6:06 pm GMT- †http://creativecommons.org/licenses/by/2.0/
1.2 Intertemporal Cash Flow Shifting
1.2.
Intertemporal Cash Flow Shifting When someone invests, they are simply transferring current cash ows to some point in the future. On the other hand, when someone borrows, they are transferring future cash ows to the present. Put it another way, when you invest your hard-earned dollars, you are putting your money to work for you today in the hope of having more money to enjoy in the future. When you borrow, you are enjoying the use of money - dollars you don't have today - that you will have to work for and pay back (usually with interest) to someone in the future.
Two transfers take place here: [U+0095] Investing (transferring cash ows into the future) [U+0095] Bor- rowing (transferring future cash ows into the present) These transfers of cash ow across time are one of the two primary goals of all nancial activity. They represent intertemporal cash ow shifting.
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Figure 2
The second primary goal of all nancial activity is the transfer of risk. Simply put, risk is uncertainty about future outcomes. Most people don't like risk. However, some will assume it if the future payo is deemed worthy. Others are more than willing to decline risk due to their own perception that the uncertainty at hand is intolerable.
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Figure 3
Intertemporal cash ow shifting and risk transfers are the two major goals of all nancial activities. They are the reason the global capital markets exist, and they drive all nancial market activity, including the nancial intermediaries that continue to change and shape our global capital markets. All of the nancial activities in this course will involve analysis that incorporates these two major nancial objectives.
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Figure 5
1.5 The E cient Frontier
1.5.
The e cient frontier can be de ned as the set of all portfolios that are not dominated by any other feasible portfolio.Most investors desire a high rate of return, but they do not want to take the risk associated with that potential return. How do we simplify this investment problem and choose the portfolio that gives the best return on our money with the least amount of risk?
Look at the two points Y and Z in Figure 1.5. Both portfolios oer an expected rate of return of 15%. Portfolio Z oers a risk factor of 10. Portfolio Y oers that same expected rate of return, but with a risk factor of 20 - double the risk of portfolio Z. When one investment portfolio is preferable to another, we say that it dominates the other portfolio. In this example, portfolio Z dominates portfolio Y.Similarly, let's compare portfolios Y and X. Both portfolios oer a risk factor of 20. However, portfolio X will pay you an expected rate of return of 20%, which is much better than the expected rate of return of 15% that portfolio Y oers for the same amount of risk. Thus, portfolio X dominates portfolio Y.
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Figure 6
Would any rational investor ever invest in portfolio Y when Z and X are available? Of course not! We all want the maximum rate of return with the least amount of risk. Thus, portfolio Y can be dropped as a possible choice. If we apply this reasoning to all of the possible portfolio choices shown in this gure, we can begin to create a curve that contains all of the best possible portfolio choices. This curve represents the e cient frontier, which as you recall contains the set of all portfolios that are not dominated by any other feasible portfolio. To put it another way, the e cient frontier contains all investments options that maximize return for a speci c risk factor and minimize risk for a speci c rate of return. Maximizing return while minimizing risk should be the ultimate goal of every investor.
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Figure 7
E cient Frontier In this gure, the e cient frontier is the curve that is drawn through points P (the least risky of all risky investments), Z, W, V, and nally point X (the most risky investment with the highest possible return). Remember, the curve contains no points that are dominated by other feasible points along the curve.If that concept is clear, congratulations! You have just derived the e cient frontier.
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Figure 8
E cient Frontier
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Figure 9
1.6 The Risk-Free Factor
1.6.
The Risk-Free Factor In the previous topic, we looked at examples containing all the various levels of risk. Next, we will examine new portfolio combinations that allow an investor to choose between risky portfolios along the e cient frontier and those that are risk-free - investments that contain no risk at all.
A good example of a risk-free investment is the three-month U.S. Treasury bill, or T-bill. A T-bill is an obligation of the U.S. government that is issued at a discount to its face value. Most importantly, it is guaranteed to pay a xed rate of interest based on the discount you received when you purchased it. For example, if you paid $950 for a T-bill (a $50 discount), you would receive $1,000 (face value) upon maturity. This represents a 5% return on your investment.
Thus, all points along the new e cient frontier represent various proportions in each investment, and the choice of the optimal investment is left up to the comfort level of the investor.As the proportion of an investor's money in risky portfolio M increases and the amount of money in the risk-free portfolio R(f ) decreases, both the risk factor and the expected rate of return increase.In sum, risk and reward tend to go hand in hand.
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Figure 12
1.7 Summary
1.7.
...That the two major goals of nancial activity are cash ow transfers, over time and risk transfer. Investors can maximize their personal return by choosing the best possible combinations of current and future cash ows and by identifying their most comfortable levels for risk and return. ...That an entity transferring future expected income levels into the present is called a Funds De cit Unit. One choosing to transfer current income for use in the future is called a Funds Surplus Unit. These two units have a symbiotic relationship. ...That investors can nd an optimal e cient portfolio by trading o risk for expected return. Those seeking a higher return will choose more risk than those who do not desire a higher return, who are more concerned with minimizing risk.
2 Financial Intermediaries
2.1 Introduction
2.1.
- Describe private Financial Intermediaries (FIs)
- Outline the role of FIs in our daily lives
- Recall how FIs act as nancial matchmakers, bringing together the two sides of a nancial transaction
- Identify the technologies used by FIs to intermediate between these parties
Financial Intermediaries (FIs) are the professionals that advise and guide us through our risk shifting and cash ow timing activities in the global capital markets. These private "for pro t" companies sell their services and expertise for the nancial opportunities we desire. Whether you are a Funds De cit Unit looking for your rst home loan or a Funds Surplus unit looking for a future stream of cash ows in mortgage backed securities, the FI is the go-between that makes either one of these goals possible. Simply put, the FI acts as the middleman, connecting those with excess funds or risk with those who want to take on additional funds or risk.
The main product that the FI has for sale is information - nancial information about the other side of the transaction. Thus, private FIs are seen as expansive private databases of nancial information that bring together risk shifting and cash ow timing opportunities - the two sides of a nancial transaction.
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2.2 What are Private FIs?
2.2.
What are Private FIs (Financial Institutions)? FIs consist of many dierent types of nancial institutions, including commercial banks, savings banks, credit unions, insurance companies, mutual funds, investment banks, and brokerage rms. The major dierence between an FI and most other companies is apparent when you compare the asset sides of their balance sheets. Most companies have real assets on their balance sheets, such as inventory, plant and equipment. However, the assets of an FI are predominately nancial, containing few real physical assets. Therefore, a private FI can be de ned as a pro t-seeking rm whose assets are predominantly nancial.
Since FIs act as the go-between for funds de cit and funds surplus units, just how does this intermediation create a balance sheet full of nancial assets? The answer depends on the type of intermediation technology used by the FI. The two main types of technologies are Broker/Dealer Operations and Asset Transformation. We'll examine these further in the next topic.
2.3 The Two Intermediation Technologies
2.3.
The Two Intermediation Technologies Let's rst look at Broker/Dealer Operations. An FI acting as a broker simply brings buyers and sellers together without acting as a principal in the transaction. In its purest form, the broker connects the buyer and seller in order for them to transfer nancial assets between themselves. This broker technology goes hand in hand with the dealer approach. A dealer "makes a market" in a nancial security, thereby acting as a principal in the nancial transaction.
Why do broker and dealer operations so often go hand in hand? Suppose that the client of an FI wishes to sell a security that is thinly traded. As broker, the FI looks for a buyer (the other side of the trade), but cannot nd one willing to pay the fair market value of the security. So, in order to make the client happy and to potentially make some money as well, the FI may oer to purchase the security for its own account.
Another example is a certi cate of deposit (CD), such as those issued by your local bank. In this type of asset transformation, the bank issues a CD and promises to pay a speci c rate on the money you have deposited at a set date in the future. The bank in turn uses your money by "transforming" it into loans to other customers at a higher rate than they are paying you.
As you can see from the previous examples, asset transformation can take place through nancial interme- diation. FIs use both broker/dealer operations and asset transformation - the two main technologies used in nancial intermediation.
2.6 Financial Intermediation
2.6.
Financial Intermediation The three FIs (brokers, dealers, and underwriters/investment banks) are "trans- parent" FIs those that specialize in broker/dealer operations. This is in contrast to the three bottom FIs (mutural funds, banks, and insurance companies), which are "opaque" FIs those that specialize in asset transformation.
The three FIs at the top of the chart sell the same nancial securities to Surplus Units that they buy from De cit Units. This can be accomplished in one of three ways:
- Acting as the middle man (dealer operation)
- Identifying and matching buyers and sellers (broker operation)
- Advising (underwriting) the issuer on how to best structure a nancial security on how to best structure a nancial security
On the other hand, the three FIs at the bottom of the chart "transform" the nancial securities they purchase from De cit Units. By altering the risk/reward and cash ow timing of securities, asset transformers ll the Surplus Units' need for new nancial securities. Again, a good example of this is the "translucent" mutual fund.
Sometimes the same nancial security can be transferred using both technologies simultaneously. Loan securitization is a good example of this practice. Securitization is the packaging (asset transformation) of nontraded nancial securities into a newly created tradable (broker/dealer operation) nancial security.
2.7 How Technologies Utilize Their Funds
2.7.
How Technologies Utilize Their Funds However, the receipt of funds from Surplus Units is only half of the nancial intermediation equation. Let's examine the other half, which is the transfer of monies to De cit Units for the purpose of funding investment projects. This is what is meant by "use" of the FI's funds. The primary function of a broker/dealer is to provide liquidity to the nancial markets. As a security becomes more actively traded, it becomes more liquid. In other words, a greater number of active buyers and sellers in a nancial security creates greater liquidity.
Asset transformers are not limited to investing in marketable securities. Indeed, it is just this exibility that enables them to be creative as intermediaries. They can invent new nancial assets with distinctive risk/reward relationships as well as dierent types of cash ows to be paid over various times.
The fair market value of any security is determined by the present value of its future cash ows. This enables asset transformers to have a better knowledge of a newly created nancial security than an outsider who may not be able to correctly evaluate its fair market value. However, this knowledge creates a whole set of new problems, because it gives the FI the ability to create "lemons" and sell them to unsuspecting buyers, while keeping the "gems" for itself.
2.8 Moral Hazard and Information Asymmetries
2.8.
Moral Hazard and Information Asymmetries A moral hazard occurs when one party has an incentive to shift risk onto an uninformed other party. Moral hazard problems may occur whenever information asymmetries exist; in other words, when one side is more informed than the other. For this reason, all asset transforming FIs are constantly judged on their ability (or inability) to bring quality nancial securities and packaged products to the markets. If you've ever wondered at the source of the old adage Caveat Emptor Let the Buyer Beware this is why it exists.
2.9 Summary
2.9.
...That private FIs employ two dierent types of technologies to perform their intermediation functions:
- Broker/Dealers
- Asset Transformation
...That broker/dealers transfer nancial securities from De cit Units to Surplus Units in an unaltered state. In contrast, asset transformers create new nancial securities by changing risk/reward and cash ow timing characteristics to meet the demands of their clients. ...That the asset transformation FI is considered "opaque." Broker/Dealers, on the other hand, are "transparent."
3 The World's Central Bank
3.1 Introduction
3.1.
- Recall why governments set up public FIs
- Describe an overview of the three major goals of public FIs
- Compare characteristics of some of the most important public FIs in the world
3.3 Supervision of Private FIs
3.3.
Supervision of Private FIs Private FIs receive much more regulatory attention than do non- nancial corporate organizations, as indeed they should. The main goal of this supervision is to monitor the FI's safety and soundness, along with its implementation of rules, regulations, and guidelines pertaining to public disclosure. This helps protect small investors and also promotes e ciency in nancial intermediation. The purpose of all of these supervisory activities is the same: to provide investor protection while preserving the integrity and smooth operational e ciency of the global nancial markets.
FIs can only perform their functions properly if they maintain the con dence of their partners and clientele. Many nancial products oer commitments, or promises to pay. These commitments only remain credible if the FI is solvent at the time the commitment is exercised or performed. Safety and soundness is mainly ensured through capital regulation. Capital regulation mandates the minimum required levels of capi- tal that must be maintained by the FI. It also represents the investment made by both shareholders and stakeholders in the FI.
Many FIs issue highly liquid liabilities called demand deposits, which are basically checking accounts. They invest the proceeds from these accounts in fairly illiquid assets, such as bank loans. If the bank experiences a large deposit drain, it may have insu cient cash on hand to meet withdrawal requirements. This could lead to a bank run, which occurs when the rst depositors who withdraw their money are paid in full, leaving others with nothing left to do but to wait.
To prevent these types of problems, public FIs require banks to hold minimum levels of liquid assets, called reserves. These reserves can be used to meet the bank's liquidity needs. In the United States, the reserve requirement on demand deposits is currently set at 10 percent. These reserves are generally kept as vault cash or bank demand deposits at the central bank. This fractional reserve system of banking allows banks to be highly pro table, since 90 percent of their investments can be invested at higher rates. However, it also leaves them subject to liquidity risk.
Public FIs require private FIs to disclose fairly detailed nancial reports at prescribed intervals (weekly, monthly, quarterly, or annually). For example, all banks in the U.S. must provide quarterly detailed nancial data in the form of Call Reports. (This is similar to the SEC requirement of ling a 10-Q for a publicly traded company.) The call report contains certain balance sheet and income statement data, as well as o- balance sheet items such as swaps, futures and option transactions. The U.S. has the strictest disclosure requirements in the developed world. Their purpose is to send potential "early warning signals" to all market participants.
The most detailed nancial reports can often obscure nancial results due to generally accepted accounting principals (GAAP). This is because GAAP, the recognized rules of nancial accounting required of all com- panies, often utilizes Book Value Accounting Methods. Book Value Accounting values assets and liabilities on the basis of historical acquisition cost, as opposed to actual current market values. In contrast, Market Value Accounting evaluates assets and liabilities at their current market prices.
Accurate nancial data that is disclosed to market participants in a timely manner enhances the oversight ability of the participants as they monitor FIs. In addition, regulators use these reports to monitor the FIs capital level and its overall nancial condition.
For example, a CAMEL rating of 4 or 5 may put a bank on a "watch list." However, that watch list may not be disclosed to the public, so you can see why FI oversight is important. Underwriters also face strict disclosure requirements. The process for complying with these procedures is so time consuming that a fair percentage of all debt oerings are shelf registrations. A shelf registration allows the issuing rm to provide the SEC with all of the required disclosure information during the initial registration period, prior to the sale of securities. This type of registration allows the expeditious sale of those securities without providing additional information for a period of 2 years.
Improving the quality of data required in nancial reports increases the oversight eectiveness of FIs. How- ever, some governments consider major FIs to be "too big to fail." This mentality has sometimes led to nancial distress and a disruption in the integrity of payments. If this condition persists, it can produce a contagion. A contagion occurs when a troubled FI's liquidity problem produces nancial distress at other FIs. A good example of this is the "Asian Contagion" or East Asian Financial Crisis that occurred in
- More Information^1
3.4 Managing the Level of Aggregate Economic Activity
3.4.
You should now have a better understanding of the issues involved in the supervision of private FIs. In this topic, let's take a look at the management of aggregate economic activity. Central bankers play a major role in macroeconomic policy. If the economy is sluggish with high unemployment or overheated with high in ation, the central banker will often be called upon to x the current condition and bring the economy back into balance. Monetary policy is the manipulation of monetary aggregates or interest rates for the purpose of achieving the macroeconomic objectives of full employment and stable prices.
An easy money policy stimulates the economy by increasing credit and decreasing interest rates. This encourages investment and consumer purchases of durable goods, thereby causing in increase in employment. In contrast, a tight money policy reduces credit by making interest rates higher and consumption and investment lower. This inevitably reduces general price in ation.
The central bank uses the banking system to conduct its monetary policy. As a regulator, the central bank is able to pursue a tight (or easy) money policy using some combination of the following three tools of monetary policy:
- Raising or lowering the discount rate
- Raising or lowering the reserve requirement
- Selling or buying government securities, a process known as open market operations
By impacting the money supply, each of these tools aects both interest rates and the price of money. (^1) http://en.wikipedia.org/wiki/Asian_contagion
The Bank of England The Bank of England is responsible for the implementation of monetary policy, foreign exchange operations, and the supervision of the British Financial System. It is divided into two parts:
- the Banking Department
- the Issue Department
The Banking Department monitors the activities of FIs in the United Kingdom, and the Issue Department implements the UK's monetary policy.
Initially, the Chancellor of the Exchequer announces the government's monetary policy goals in the form of a letter to the Treasury. Next, the Bank of England implements the policies required to achieve those goals and publishes an independent assessment on a quarterly basis.
The Bank of England has historically taken a laissez-faire approach toward banking supervision, with much of the authority informally administered through a tradition-bound "old boys" network. Universal Banking is permitted in the United Kingdom, allowing FIs to engage in a broad range of nancial and commercial activities. These include banking, insurance, securities trading, and underwriting.
The Bundesbank of Germany The Bundesbank is probably the most conservatively managed central bank in the world. Its rst priority is to maintain price stability. Accordingly, growth-enhancing policies are scrutinized for their impact on price in ation. The Bundesbank has a strong social mandate to pursue price stability because of the German memories of hyperin ation in 1923. (There were 4.2 DM to the US dollar in 1914, and that rose to 4 billion DM to the US dollar in 1923.)
Because of this fear of in ation, the Bundesbank law of 1957 granted the central bank independent powers unmatched by those of any other country. The law speci cally states that the central bank "shall be independent of instructions from the federal government." It is designated as the "protector of the currrency" and is largely free from political pressure imposed by elected o cials.
The Bundesbank is structured regionally so as to diuse power, similar to the design of the US Federal Reserve System. The main policy making body is the Central Bank Council (CBC), which meets every two weeks. The CBC uses four instruments in their decision making:
- The Discount Rate
- The Lombard Rate
- Open Market Operations
- Minimum Bank Reserve Policy
The Bank of Japan The Bank of Japan acts as a banker to the government of Japan. Together with the Ministry of Finance, it closely administers the lending activities of Japanese banks both at home and abroad. The policy of Bank of Japan and the Ministry of Finance is transmitted to the non- nancial sector via the keiretsu (literally "business a liations"), which are cohesive groups of companies centered around each keiretsu commercial city bank. The stability of each keiretsu is enhanced by reciprocal corporate shareholding amongst its members.
Currently, there are six large keiretsu in Japan. This Main Bank System is a relationship form of banking, whereby close bank- rm ties are fostered by interlocking directorates and cross holdings of shares. Currently, there are six large keiretsu in Japan. Their main banks are:
- Mitsubishi Bank
- Sakura Bank
- Sumitomo Bank
- Fuji Bank
- Sanwa Bank
- Daiichi Kangyo Bank
3.7 Summary
3.7.
In this last topic, you'll receive an overview of the major international public FIs. The rst type of interna- tional public FI we'll discuss are Regional Development Banks, which intermediate between developed and developing countries. They are funded by large capital commitments as well as by loans from developed countries such as the United States, Japan, and Switzerland. These funds are then lent out at a low rate of interest to developing countries and used to nance basic projects that invest in the country's infrastructure.
The Bank of International Settlements (BIS), headquartered in Basel, Switerland, can be viewed as a central banker's bank. The BIS facilitates the international transfer of funds between central banks by maintaining accounts for all major central banks. For instance, the BIS was empowered to manage Germany's payments of World War I reparations. The BIS also acts as a lender of last resort, providing funds to central banks around the world to meet sudden nancial crises.
Both The World Bank and the IMF were originally capitalized by contributions of the wealthy member banks. The World Bank promotes broad-based economic growth, encourages human development programs, protects the environment, stimulates the private sector, and reorients governments to become more e cient.
The IMF began operating in 1947 with a fund of $9 billion in gold and currency, a third of which was contributed by the U.S. In 1969, the IMF created a type of reserve asset called Special Drawing Rights (SDRs) that acts as the IMF's unit of account. SDRs are IMF reserve assets consisting of a basket of ve international currencies with a value equal to the weighted average of the currencies' values. The ve currencies included in the SDR are the U.S. dollar, the Deutsche Mark, the Japanese Yen, the French Franc, and the Pound Sterling.
Let's brie y review public and private FIs. The goal of all public FIs is to continuously monitor the overall health of the general economy while steering a course between the two perils of unemployment and in ation. The actions of private FIs in the global marketplace help central banks determine how they will implement monetary policy initiatives. Extensive coordination and cooperation between private and public FIs is required for successful monetary policy.
4.2 What is Money?
4.2.
What is Money? In this topic, we will explore a number of dierent de nitions of money. Money is not just the cash you have in your pocket or the funds you have on deposit in your checking or savings account. Instead, the characteristic that makes something "money-like" is its liquidity. The more liquid an asset, the higher the degree of its "moneyness." Most nancial assets have varying degrees of liquidity. In order to understand this concept fully, let's look at the liquidity spectrum shown on this screen.
In general, the more liquid the asset, the more likely it is to be "money-like." On the liquidity spectrum shown here, money can be de ned as the most liquid asset on the line up to a certain point. This point is determined by the person doing the de ning. In most cases, it would be a point on the left side of the line, closest to the more liquid forms of nancial assets. These also have the lowest transaction costs. Next, let's look at how the Fed de nes money.
4.3 How does the Fed De ne Money?
4.3.
The Fed has four dierent de nitions of money, which it uses to measure the money supply. These de nitions are called M1 (the narrowest de nition), M2, M3, and L (the broadest de nition). M1 consists of the following:
- Currency in circulation
- Non-bank and non-governmental demand deposits at all commercial banks, credit unions, and thrift institutions
- Less cash items in the process of collections and the Federal Reserve oat
- Travelers checks
- Other checkable deposits
M2 consists of everything contained in M1, plus the following:
- Savings and time deposits in amounts less than $100,
- Money market deposit accounts
- Balances in money market mutual funds (except for IRAs and Keogh plan balances)
- Overnight repurchase agreements issued by all commercial banks
- Overnight Eurodollars issued to U.S residents by foreign branches of U.S. banks
Finally, L consists of M3 and:
- Non-bank public holdings of U.S. savings bonds
- Non-bank public holdings of short term Treasury securities
- Commercial paper
- Bankers acceptances
- Less money market holdings of the above assets
So, with all of these de nitions, what actually determines the amount of money in circulation? In short, it involves many factors. Money supply is aected by both the public and private sectors, and is the result of a myriad of decisions by private FIs, public FIs, non- nancial businesses, and individuals.
4.4 The Private Sector and Money Supply
4.4.
The private sector plays a crucial role in determining money supply. First of all, individuals and non- nancial businesses must determine how they will hold their assets. Should they hold assets evenly distributed along the liquidity spectrum or keep them in the more "moneylike" categories on the left side of the spectrum? Individuals and businesses hold money for transaction purposes. Suppose you had a mortgage payment due this week. Chances are, you would increase the liquidity of your assets in order to make your payment. If all of your assets were in illiquid investments, it would be costly for you to liquidate your holdings and make that payment.
Individuals and businesses also hold money for speculative purposes. Access to readily available funds is often necessary to take advantage of an extraordinary sale or unanticipated business opportunity. Rapid liquidation of illiquid assets can be so costly that it may not make that speculative opportunity worth your while. All things being equal, the more liquid the asset, the lower its required rate of return. In other words, the longer you tie up your assets, the more you should get paid for them. Greater liquidity entails an opportunity cost, measured as the foregone return on alternative investments.
By weighing the bene ts of liquidity against opportunity costs, individuals and businesses determine how to best manage their assets to meet their short and long term goals. If they choose to hold less money, that money will have to work harder to pay for goods and services. Each dollar, in turn, will be re-spent with greater frequency due to reduced balances. Because this money is being spent at a faster rate, we say that the velocity of money is increasing.
At this point, we've examined how individuals and businesses choose to hold on to money balances, but this type of demand is only half of the equation. Next, let's take a look at the banking system's role in supplying money. The narrowest de nition of the money supply, M1, includes currency and checking accounts held by individuals and businesses in the private sector. Banks also hold currency, or vault cash, as well as demand deposits. However, vault cash and demand deposits are not included in the de nition of money supply. These balances do not enter the money supply until they are transferred to individuals or businesses. While they are still in the possession of the banks, they are called reserves.
