Introduction to Financial Markets

Introduction to Financial Markets

• The course will cover financial markets, financial institutions, and financial instruments.

Study Material

• The course will have a slide pack, lecture notes, and a handbook (Valdez, S. and P. Molyneux, An Introduction to Global Financial Markets).

Course Content

• The course will cover 12 units, including the financial system, money and bond markets, equity markets, risk and return, derivatives, and financial intermediation.

Teaching and Grading

• The course will have weekly lectures and recordings will be available.
• There will be an assignment and a written exam, with a total of 20 points.

The Financial System

• The financial system consists of households, corporates, financial institutions, and the government.
• Households are the ultimate owners of all assets in the economy and bearers of risk within the financial system.

The Actors

• Households can be classified as haves (lenders) or havenots (borrowers) on a macroeconomic level.
• The household balance sheet gives an overview of the assets and liabilities of a single household.
• Assets can be tangible, intangible, or financial, and include common stock, bonds, cash, and alternative assets.
• Liabilities include mortgage loans, consumer loans, and tax debt.
• Wealth creation is driven by value changes in assets and liabilities, net income, and inheritances.

The Balance Sheets of Other Actors

• Corporates use leverage to raise the return on equity (ROE) above the return on assets (ROA).
• The financial sector includes banks, mutual funds, and insurance companies.
• The government's balance sheet includes assets such as government bonds and liabilities such as government debt.

The Financial System

• The financial system facilitates economic growth and development.
• It plays a crucial role in channeling resources to their most efficient uses.
• The financial system can be direct or indirect, with direct finance involving financial markets and indirect finance involving financial intermediaries.

Role of the Government

• The government plays a role in regulating the financial system to prevent market failure.
• Regulation includes disclosure, market conduct, and financial institution regulation.
• The government can also influence the markets through monetary policy and provide bailouts.

Review Questions

• Unit 1 review questions cover topics such as borrowers and lenders, net wealth, asset classes, liabilities, and the financial system.

Unit 2 - Fixed Income Markets

• Financing sources include equity and debt instruments.
• Debt instruments are the oldest instruments in the world and include loans and debt securities.

Interest Rates

• Interest is the price of money and the reward for the lender to postpone consumption.

• The interest rate charged depends on the risks taken by the lender, including the creditworthiness of the borrower and the maturity of the debt.

• The term structure of interest rates shows the relationship between interest rates and maturities.### Term Structure of Interest Rates

• The term structure of interest rates is also known as the yield curve.

• It is less precise than the term structure of interest rates.

• Demand and supply for loanable funds determine a short-term risk-free interest rate.

• The interest rate rewards the delay in consumption.

• The lender faces risks for which a compensation (premium) is required.

Decomposition of an Interest Rate

• The lender adds a(n) expected inflation premium to each risk-free rate to obtain the term structure of nominal risk-free interest rates.
• The expected inflation premium can be different for different maturities.
• The lender will charge the borrowers with a credit spread for expected credit losses.
• The credit spread often embeds a liquidity premium.
• This results in a term structure of nominal rates for risky assets.

Irvin Fisher's Equation

• The relationship between nominal and real interest rates is: (1 + rnominal) = (1 + rreal) × (1 + πe)
• or: rnominal ≈ rreal + πe
• πe denotes the expected inflation, r stands for the interest rate.
• Most of the time, this Fisher equation is used to determine the real interest rate, given the observed nominal interest rates and an estimate of the expected inflation.

Time Value of Money

• To understand fixed income instruments, it is necessary to understand the time value of money.
• There are both simple interest rates and compounded interest rates.
• A timeline is a linear representation of the timing of potential cash flows.
• Inflows are positive cash flows, outflows are negative cash flows.

Single Cash Flow Compounding

• The formula for simple interest is: VT = V0 × (1 + r × T)
• The formula for annual compounding is: VT = V0 × (1 + r)T
• Any compounding frequency m can be chosen: VT = V0 × (1 + rm/m)mT

Single Cash Flow Discounting

• The formula for simple interest is: VT = V0 × (1 + r × T)
• The formula for annual compounding is: VT = V0 × (1 + r)T
• Any compounding frequency m can be chosen: VT = V0 × (1 + rm/m)mT

Multiple Cash Flows

• Cash flows can only be summed if their values are expressed at the same moment.
• The present value of a future cash flow can be computed using the formula: VT = V0 × (1 + r)T
• Bond pricing can be interpreted as a portfolio of single cash flow instruments.

Bond Pricing

• The present value of a future cash flow can be computed using the formula: VT = V0 × (1 + r)T
• The price of a bond is the sum of the present values of its cash flows.

Yields

• The return on a single cash flow that will be received at the end of period T is called a T-year spot rate.
• The single return on a stream of cash flows is called the yield-to-maturity, aka the internal rate of return, the actuarial rate of return, or the overall yield.

Ratings

• Ratings are used to solve the economic problem of asymmetric information.
• Modifiers, high grade or investment grade, speculative grade, split rating, credit watch and potential rating migration, downgrade or upgrade, and fallen angel are used to describe the creditworthiness of a borrower.

Instruments

• The market taxonomy is based on maturity at issuance, geographical span, and nature of the counterparties.
• Money market instruments are instruments with a maturity at issuance of at most 1 year.
• Capital markets group instruments with a maturity at issuance of more than 1 year.
• Private money market instruments are instruments issued by non-governmental entities.
• Public money market instruments are instruments issued by governmental entities.

Money Market Instruments

• Call money is an unsecured loan made between banks.
• Repurchase agreements (repos) are a secured lending using securities.
• Commercial paper (CP) is a short-term instrument issued by companies.
• Large-denomination negotiable certificates of deposit are short-term instruments issued by banks.
• Money market funds are a type of investment fund that invests in money market instruments.### The Instruments
• Commercial Paper (CP):
  • A short-term unsecured promissory note issued in the open market
  • Represents the obligation of the issuing company
  • Used for seasonal financing of working capital and bridge financing
  • Primary market based on best effort arrangements
  • Hardly any secondary trading
  • Short-term, typically 90 days in the US, with a maximum term of 270 days
  • Yields can be quoted on a discount basis or in interest-bearing form
• Commercial Paper Ratings:
  • Simplified ratings for short-term commercial paper
• Certificates of Deposit (CDs):
  • A financial obligation issued by a depository institution
  • Indicates a specific sum of money deposited at the issuing depository institution for a specific time period
  • Deposit insurance applies for small denominations
  • Can be negotiable or non-negotiable (i.e., not resellable in the market)
  • Large-denomination negotiable CDs have denominations of $10 million or more
• Other Money Market Instruments:
  • Household debt instruments: consumer loans
  • Corporate debt instruments: intercompany loans, trade credit, straight loans, overdrafts, factoring, and forfaiting
• Public Money Market Instruments:
  • Treasuries:
    • Names: Treasury Bills (T-Bills) in the US, and various names in Europe (e.g., T-bill, schatkistcertificaat, Bon du Trésor)
    • Typically off-the-run issues are less liquid
    • Maturities at issuance: 3, 6, and 12 months
    • Fungibility
  • Auctions (tenders) as the primary market mechanism

Capital Market Instruments

• Long-term Loans:
  • Household debt: mortgage loans
  • Corporate debt: credit lines, investment credit, revolving credits, and leasing
• Debt Securities:
  • Issued by borrowers to obtain liquidity for short-term or long-term needs
  • Embed the obligation of issuers-borrowers to make a certain promised stream of cash flows in the future
  • Debt markets (fixed-income markets) are markets where debt securities trade
  • Some equity instruments, such as preferred stock, may be considered fixed-income instruments
• Characteristics of Debt Securities:
  • The repayment of debt securities takes precedence over the payment streams to residual cash flow instruments
  • Secured debt is backed by tangible assets (often called senior debt)
  • Unsecured debt (debentures)
  • Debt contracts specify events that precipitate default
  • Non-payment of promised coupons
  • Non-payment of the balloon payment
  • In case of default, bondholders have the right to take over the firm
  • Can re-negotiate the contract
• Traditional Bond:
  • Visualized in its traditional form
  • Identifiers: CUSIP-code or ISIN-code
  • The name: issuer of the bond
  • Coupon style: zero coupon, fixed coupon, floating, multicoupon, and linkers
  • Coupon frequency: annual, semi-annual, quarterly, or monthly
  • Maturity date: date on which the principal amount is due
  • Issue date: the day on which the security is issued
  • Dated date: the day from which the first coupon starts to accrue interest
  • Settlement day: the day on which the parties will exchange cash and securities
  • Maturity: treasury (discount) bills, treasury (coupon) notes, and treasury (coupon) bonds
  • Issued amount: the size of the bond issue
  • Issue price: the percentage paid at issuance
  • Spread at issuance: the spread in basis points over a benchmark Treasury Bond

Players

• Sovereign bonds: issued by the highest level of government in a country
• Subnational government debt: issued by states, regions, provinces, counties, municipalities, and local utility companies
• Supranationals: issued by multilateral financial institutions (e.g., IMF, World Bank, EBRD, Asian Development Bank)
• Corporates: issue corporate bonds and Medium-Term Notes (MTNs)
• Bond indentures: promises of the issuer and rights of the investors
• Covenants: restrictions imposed on management

Characteristics of Corporate Bonds

• General classification: public utilities, transportation, banks, finance companies, and industrials
• Bond indentures: promises of the issuer and rights of the investors
• Covenants: restrictions imposed on management
• A pledge of a real property is a mortgage
• A pledge of personal property is collateral
• Debenture bond: not secured by a specific pledge of property
• Guaranteed bond: cash flows guaranteed by a third party

Terminology

• Convertible bond
• Exchangeable bond
• High-yield bond

Medium-Term Notes (MTNs)

• Offered continuously
• Maturities: 9 months to 30 years
• Best effort basis
• Shelf registration
• Often structured (e.g., inverse floaters)

Primary Market

• Objectives: ensure cost-effectiveness, encourage participation, maximize competition, minimize placement risk, and foster transparency
• Distribution methods: auctions with a stop yield, syndication, and tap sales
• Primary dealers: active market makers

Secondary Markets

• Objectives: low transaction costs, continuous and wide disseminated price information, immediate execution of trades, safe and rapid settlement, and efficient custodial and safekeeping services
• Trading: order-driven markets, quote-driven markets
• Stripping: creation of coupon and principal strips (IO and PO strips)
• Bond indices: more difficult to create than equity indices due to the larger number of bonds, variety of features, and constantly changing universe