Financial Instruments Lecture 1: Introduction to Financial Markets (2024-2025) PDF

Financial Instruments Lecture 1: Introduction to Financial Markets Fanny VIDAL [email protected] ENSAE 2nd year 2024-2025 October 2, 2024 F...

Financial Instruments Lecture 1: Introduction to Financial Markets Fanny VIDAL [email protected] ENSAE 2nd year 2024-2025 October 2, 2024 Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 0 / 113 Objectives of this Lecture Learning outcomes At the end of this session, you should be able to: have a global overview and understanding of financial markets and financial instruments summarize the basic functions performed by financial markets explain why financial markets are classified as debt and equity markets, primary and secondary markets, exchanges and over-the-counter markets, and money and capital markets describe the main traded money markets, capital markets and derivatives instruments be aware of the use of financial derivatives and understand the need for risk management Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 1 / 113 Table of Contents 3 Structure of Financial Markets 1 Preamble Money Markets Why Study Financial Markets? Capital Markets Historical Financial Losses Bond Markets 2 Global Overview of Financial Stock Markets Markets Derivatives Markets Definition FX Markets Players Credit Markets* Purposes Securitization* Types Key Takeaways Key Takeaways 4 Bibliography *: good to know but out of scope of the exam Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 2 / 113 Lecture 1: Introduction to Financial Markets 1. Preamble Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 3 / 113 Preamble Why Study Financial Markets? Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 4 / 113 Why Study Financial Markets and Financial Instruments? Because you would like to: have the basic knowledge of financial markets and financial instruments to understand better the financial news, the financial crises and the economy, Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 5 / 113 Why Study Financial Markets and Financial Instruments? Because you would like to: have the basic knowledge of financial markets and financial instruments to understand better the financial news, the financial crises and the economy, become a future practitioner in financial markets, such as a trader, a structurer, a risk manager, or a quantitative analyst (aka quant) known also as a “rocket scientist of Wall Street” (cf Investopedia) or, Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 5 / 113 Why Study Financial Markets and Financial Instruments? Because you would like to: have the basic knowledge of financial markets and financial instruments to understand better the financial news, the financial crises and the economy, become a future practitioner in financial markets, such as a trader, a structurer, a risk manager, or a quantitative analyst (aka quant) known also as a “rocket scientist of Wall Street” (cf Investopedia) or, become an actuary and validate this module for the Institute of Actuaries Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 5 / 113 Why Study Financial Markets and Financial Instruments? Because you would like to: have the basic knowledge of financial markets and financial instruments to understand better the financial news, the financial crises and the economy, become a future practitioner in financial markets, such as a trader, a structurer, a risk manager, or a quantitative analyst (aka quant) known also as a “rocket scientist of Wall Street” (cf Investopedia) or, become an actuary and validate this module for the Institute of Actuaries Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 5 / 113 Why Study Financial Markets and Financial Instruments? Because you would like to: have the basic knowledge of financial markets and financial instruments to understand better the financial news, the financial crises and the economy, become a future practitioner in financial markets, such as a trader, a structurer, a risk manager, or a quantitative analyst (aka quant) known also as a “rocket scientist of Wall Street” (cf Investopedia) or, become an actuary and validate this module for the Institute of Actuaries “ The most important investment you can make is in yourself” Warren Buffet Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 5 / 113 Contents of this Course This course provides you the basic principles of the financial markets and financial instruments within. Its a continuity of the course “Economie Ban- caire et Financière” taught in the first year at ENSAE. Some part of this course can be a reminder of the latter one. In this course, we will focus on (see next section on the structure of the financial markets for the definitions of the keywords listed below): 1 the bond market 2 the equity market 3 the derivative market, including forward and future contracts, and options. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 6 / 113 Preamble Historical Financial Losses Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 7 / 113 Why it is Important to Master Financial Instruments “Derivatives are financial weapons of mass destruction” Warren Buffet “Some things never change - there will be another crisis, and its impact will be felt by the financial markets.” Jamie Dimon “Developments in financial markets can have broad economic ef- fects felt by many outside the markets.” Ben Bernanke “Although we work through financial markets, our goal is to help Main Street, not Wall Street” Janet Yellen Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 8 / 113 History of Financial Evolution Table 1: Financial Instruments Innovation Year Financial Instrument 1990 Equity index swaps 70’s Currency Swaps 1991 Differential Swaps 1970 Mortgage-Backed Securities (MBS) 1992 CAT and future insurance options 1971 Equity Index Funds 1993 Captions / Floortions 1972 Foreign Currency Futures 1994 Credit Default Swaps (CDS) 1973 Stock Options (Black-Scholes Model) 1996 Electricity futures 1975 Treasury bond futures 1997 Weather derivatives 1979 OTC Currency Options 2001 Single-stock futures 1981 Interest Rate Swaps (IRS) 2002 Collateralized Fund Obligations (CFO) 1982 Equity Index Futures 2004 Volatility Index Futures 1983 Equity Index Options 2007 Green Bond Interest Rate Caps/Floors 2021 Digital Bond, with blockchain technology Collateralized Mortgage Obligations 2022 Sovereign Sustainability-Linked Bond 1985 Swaptions Asset-Backed Securities (ABS) 1987 Path-dependent Options 1987 Collateralized Debt Obligations (CDO) 1989 Quanto Options Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 9 / 113 Major Financial Losses I Table 2: Major financial losses (*in millions of USD) for the past 30 years around the world. Source: Wikipedia Date Financial Institution Description Losses* 1987 377 Merril Lynch Unauthorized transactions on Mortgage Bond Se- (USA) curities (MBS) 1993 1,500 Metalgesellschaft Trading positions on oil futures contracts. Issue AG (Germany) with their hedging strategy 1994 1,700 Orange County Leveraged derivatives transactions. Problem with (USA) product design and sales practices 1995 1,400 Barings (Sin- Unauthorized trading with hidden and massive po- gapour) sitions on futures in Nikkei index 1998 4,000 Long Term Cap- Massive exposition on the Russian debt in the time ital Management of default of Russia. Liquidity squeeze via margin (USA) calls on trading positions 2008 13,000 Northern Rock Britains’s first bank run in 140 years (UK) Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 10 / 113 Major Financial Losses II Date Financial Institution Description Losses* 2008 7,600 Société Générale Massive positions on the Eurostoxx, DAX et FTSE (France) indices, unauthorized and hidden by fictitious transactions 2008 1,880 Deutsche Bank Proprietary trading on credit derivatives 2008 619,000 Lehman Brothers Bankruptcy of a “too big to fail” FI due to bad (USA) investment into MBSs and CDOs, which led to the Global Financial Crisis 2008 US bns Fannie Mae & Mispricing in mortgage loans (CDO ABS). Political gov’t Freddie Mac pressure to facilite origination of loans to increas- support (USA) ingly risky customers 2011 2,300 UBS (UK) Fictitious transactions on equity actions and ETF, exploiting the delays between confirmations and payments 2018 296 Natixis (HK) Equities Derivatives (hedging issue with autocalls) 2021 170 Evergrande (HK) Default in payments lead to a restructuring by the Chinese gvt Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 11 / 113 Major Financial Losses III Date Financial Institution Description Losses* 2021 10,000 Archegos Capi- Default on margin calls due to the abusive use of tal Management Total return swaps to hide his high exposures from (USA) lending banks 2022 15,000 FTX (Bahamas, First bankruptcy of a large cryptocurrency ex- USA) change due to liquidity crisis 2023 212,000 Silicon Valley Bank Bankruptcy due to losses from bonds (1.8 Bn) with (USA) the rise of interest rates and bank run Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 12 / 113 Major Financial Losses III Date Financial Institution Description Losses* 2021 10,000 Archegos Capi- Default on margin calls due to the abusive use of tal Management Total return swaps to hide his high exposures from (USA) lending banks 2022 15,000 FTX (Bahamas, First bankruptcy of a large cryptocurrency ex- USA) change due to liquidity crisis 2023 212,000 Silicon Valley Bank Bankruptcy due to losses from bonds (1.8 Bn) with (USA) the rise of interest rates and bank run Financial losses mainly came from the misuses of derivatives (futures, equi- ties and credit derivatives) and securitization products (MBS, CDO ABS), default on margin calls and bank runs. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 12 / 113 Lecture 1: Introduction to Financial Markets 2. Global Overview of Financial Markets Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 13 / 113 Global Overview of Financial Markets Definition Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 14 / 113 Definition I More broadly, a financial system consists of: Financial markets Financial instruments Financial institutions Financial services Money (means of payment) Figure 1: Financial System Components. Source: Wall Street Mojo Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 15 / 113 Definition II Financial markets include any (physical or virtual) market place or system that provides buyers and sellers the means to trade financial instruments. 1 International Accounting Standards Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 16 / 113 Definition II Financial markets include any (physical or virtual) market place or system that provides buyers and sellers the means to trade financial instruments. Financial instruments are legal contracts between two or more parties, which can be traded and settled, that define conditions under which one party (the buyer) receives benefits (financial asset) and the other party (the seller) incurs costs (financial liability or equity instrument) (cf IAS1 32). 1 International Accounting Standards Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 16 / 113 Definition II Financial markets include any (physical or virtual) market place or system that provides buyers and sellers the means to trade financial instruments. Financial instruments are legal contracts between two or more parties, which can be traded and settled, that define conditions under which one party (the buyer) receives benefits (financial asset) and the other party (the seller) incurs costs (financial liability or equity instrument) (cf IAS1 32). A collection of financial instruments is called: 1 International Accounting Standards Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 16 / 113 Definition II Financial markets include any (physical or virtual) market place or system that provides buyers and sellers the means to trade financial instruments. Financial instruments are legal contracts between two or more parties, which can be traded and settled, that define conditions under which one party (the buyer) receives benefits (financial asset) and the other party (the seller) incurs costs (financial liability or equity instrument) (cf IAS1 32). A collection of financial instruments is called: a portfolio if hold by an investor, asset manager, fund manager; 1 International Accounting Standards Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 16 / 113 Definition II Financial markets include any (physical or virtual) market place or system that provides buyers and sellers the means to trade financial instruments. Financial instruments are legal contracts between two or more parties, which can be traded and settled, that define conditions under which one party (the buyer) receives benefits (financial asset) and the other party (the seller) incurs costs (financial liability or equity instrument) (cf IAS1 32). A collection of financial instruments is called: a portfolio if hold by an investor, asset manager, fund manager; a book if run by a broker, or; 1 International Accounting Standards Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 16 / 113 Definition II Financial markets include any (physical or virtual) market place or system that provides buyers and sellers the means to trade financial instruments. Financial instruments are legal contracts between two or more parties, which can be traded and settled, that define conditions under which one party (the buyer) receives benefits (financial asset) and the other party (the seller) incurs costs (financial liability or equity instrument) (cf IAS1 32). A collection of financial instruments is called: a portfolio if hold by an investor, asset manager, fund manager; a book if run by a broker, or; a trading book if run by a trader. 1 International Accounting Standards Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 16 / 113 Definition III Financial institutions (FI) are companies providing financial services by the form of financial and monetary transactions such as deposits, loans, investments, and currency exchange. Financial institutions include a broad range of business operations within the financial services sector, including banks, insurance companies, brokerage firms, and asset managers. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 17 / 113 Definition III Financial institutions (FI) are companies providing financial services by the form of financial and monetary transactions such as deposits, loans, investments, and currency exchange. Financial institutions include a broad range of business operations within the financial services sector, including banks, insurance companies, brokerage firms, and asset managers. Money is a liquid asset that has 3 main functions: (i) a medium of exchange between individuals and entities to facilitate transactions, (ii) a unit of account that can measure the value of other goods and (iii) a store of value to allocate and save capital Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 17 / 113 Global Overview of Financial Markets Players Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 18 / 113 Participants 4 types of financial market participants: 1 retail investors, including households and individuals; 2 firms (e.g. corporates); 3 governments (e.g. French Ministry of Debt); 4 financial intermediaries, grouping into: 1 monetary financial institutions, such as banks, central banks, or pension funds. They are traditionally regulated. 2 non-bank financial intermediaries, such as hedge-funds or family offices. A non-bank financial intermediary does not accept deposits from the general public, provides services similar to traditional commercial banks but outside normal banking regulations (shadow banking ). The first 3 participants are part of the so called ’real economy’. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 19 / 113 Buy-Side vs Sell-Side Figure 2: Sell vs Buy Side Schema. Source: Website Buy-side is the side of the financial market buying and investing large portion of securities, such as fund manager. While, sell-side is the other side of the financial market which deals with the creation, promotion and selling of traded securities to the public. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 20 / 113 Key Players* Figure 3: Key Players in the Financial Markets What are the difference between all of these jobs? Video: https://www.youtube.com/watch?v=Lwqz8F-JgqA&list=PLkJQh4 index=13 Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 21 / 113 Key Players* I Definitions Analyst provides information for the institutions and contribute to the sell-side activity. Analysts deal with stocks and analyze one or more companies. They can issue buy/sell/hold signals and provide forecasts. Arbitrageur is an investor who exploit market inefficiencies by making simultaneous trades that offset each other to capture risk-free profits. Asset manager typically works with individuals or businesses that have extensive amounts of money. Broker provides a platform where the buyers and sellers can get together. Brokers do not hold inventories, and act as intermediaries between an investor and a securities exchange which accept only orders from members of the exchange. Dealer quotes two-way prices and holds large inventories of a particular instrument, maybe for a longer period than a market maker. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 22 / 113 Key Players* II Definitions Hedge fund manager is a firm or an individual who manages, makes investment decisions, and oversees the operations of a hedge fund. Hedger takes an equal but opposite position in the futures market to the one held in the cash market to avoid the risk of an adverse price move. Investor is a person who allocates financial capital with the expectation of a future return (profit) or to gain an advantage (interest). Market-maker ’makes markets’ by providing quoted prices, both bid and ask prices in a financial instrument held in inventory.They have to buy or sell at their quoted prices. Market-makers make money on the bid-ask spread. Pension fund manager is a professional responsible for the financial management of pension funds. Portfolio manager is a professional responsible for making investment decisions and carrying out investment activities on behalf of vested individuals or institutions. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 23 / 113 Key Players* III Definitions Quantitative analyst or quant for short is an engineer that design and implement complex models that allow financial firms to price and trade financial instruments, while mitigating risks. Quants are described as the “rocket scientists of Wall Street” by Investopedia since their advanced skills in mathematics, finance, and technology/computer science. Regulator is the guardian of the markets, since practitioners may take positions of tax arbitrage or regulatory arbitrage (e.g. ECB, ACPR) that can threaten financial stability. Researcher, as analyst, provides information for the institutions and contribute to the sell-side activity. They provide macrolevel forecasting and advice. Risk manager assesses the trades and positions taken by traders, and give approval if the trade remain within preselected boundaries. Sales serves customers by selling products and meeting customer needs. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 24 / 113 Key Players* IV Definitions Short-seller is a speculative investor who borrows a security, sells it on the open market, and expects to buy it back later for less money. Speculator is a sophisticated investor or trader who purchases assets for short periods of time and employ strategies in order to profit from changes in its price Structurer designs structured products based on other financial instruments (stocks, bonds,...). Trader buys and sells securities and derivatives. A trader’s role is to execute clients’ orders and trade for the company given his position limits. Treasurer manages the financial assets and liabilities of a company. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 25 / 113 Evolution of the Trader’s Job Figure 4: Cartoon for “Flash boys”, Michael Lewis’s book, author of “The Big Short”, adapted to the cinema in 2015; Jordan Belfort, a former stockbroker, published his memoir “The Wolf of Wall Street” in 2007, which was adapted into a Martin Scorsese film released in 2013 Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 26 / 113 Banking Organisation* Source: Investopedia On a conceptual level, the operations in banks are divided into three parts: the front office, the middle office, and the back office. The front office is typically composed of customer-facing employees, such as the marketing, sales, and service departments. The middle office is responsible for managing risk and corporate strategy. The back office is made up of administration and support personnel who are not client-facing. BO functions include settlements, clearances, record maintenance, regulatory compliance, accounting, and IT services. See video of the trading room of CA-CIB: https://www.youtube.com/ watch?v=ZRNuAjMROr0 Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 27 / 113 Global Overview of Financial Markets Purposes Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 28 / 113 Big Picture Figure 5: Flow of funds. Source: Mishkin Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 29 / 113 Functions of the Financial Markets Financial markets enable efficient allocation of resources across time and space, through the trading of financial instruments. 1 Financial markets help to finance the economy Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 30 / 113 Functions of the Financial Markets Financial markets enable efficient allocation of resources across time and space, through the trading of financial instruments. 1 Financial markets help to finance the economy Companies can raise capital, either by issuing bonds (debt securities) or shares (titles of property). Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 30 / 113 Functions of the Financial Markets Financial markets enable efficient allocation of resources across time and space, through the trading of financial instruments. 1 Financial markets help to finance the economy Companies can raise capital, either by issuing bonds (debt securities) or shares (titles of property). States can issue (only) government bonds (e.g. Agence France Trésor (AFT) manages the French sovereign debt with Obligation Assimilable du Trésor (OAT)). Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 30 / 113 Functions of the Financial Markets Financial markets enable efficient allocation of resources across time and space, through the trading of financial instruments. 1 Financial markets help to finance the economy Companies can raise capital, either by issuing bonds (debt securities) or shares (titles of property). States can issue (only) government bonds (e.g. Agence France Trésor (AFT) manages the French sovereign debt with Obligation Assimilable du Trésor (OAT)). 2 Financial markets allow transfer of risk (asset transformation), generally through derivatives (hedging instruments) ⇒ diversification FI serve as intermediaries within the financial markets. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 30 / 113 Functions of the Financial Markets Financial markets enable efficient allocation of resources across time and space, through the trading of financial instruments. 1 Financial markets help to finance the economy Companies can raise capital, either by issuing bonds (debt securities) or shares (titles of property). States can issue (only) government bonds (e.g. Agence France Trésor (AFT) manages the French sovereign debt with Obligation Assimilable du Trésor (OAT)). 2 Financial markets allow transfer of risk (asset transformation), generally through derivatives (hedging instruments) ⇒ diversification FI serve as intermediaries within the financial markets. 3 Financial markets help to provide liquidity and information, protecting investors from incentive problems (e.g. frauds, inside trading) Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 30 / 113 Global Overview of Financial Markets Types Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 31 / 113 Types of Financial Instruments I There are commonly two types of financial instruments: 1 Cash Instruments: Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 32 / 113 Types of Financial Instruments I There are commonly two types of financial instruments: 1 Cash Instruments: a financial asset, which is a legal claim on a real asset (e.g. a property, a commodity, cash (but no cryptocurrencies) or gold); Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 32 / 113 Types of Financial Instruments I There are commonly two types of financial instruments: 1 Cash Instruments: a financial asset, which is a legal claim on a real asset (e.g. a property, a commodity, cash (but no cryptocurrencies) or gold); a financial security, which is a tradable legal claim on a firm’s assets or income that is traded in an organized market (e.g. securities, such as bonds and shares); Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 32 / 113 Types of Financial Instruments I There are commonly two types of financial instruments: 1 Cash Instruments: a financial asset, which is a legal claim on a real asset (e.g. a property, a commodity, cash (but no cryptocurrencies) or gold); a financial security, which is a tradable legal claim on a firm’s assets or income that is traded in an organized market (e.g. securities, such as bonds and shares); ⇒ Settlement takes place immediately (e.g. t+2, based on market conventions) Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 32 / 113 Types of Financial Instruments I There are commonly two types of financial instruments: 1 Cash Instruments: a financial asset, which is a legal claim on a real asset (e.g. a property, a commodity, cash (but no cryptocurrencies) or gold); a financial security, which is a tradable legal claim on a firm’s assets or income that is traded in an organized market (e.g. securities, such as bonds and shares); ⇒ Settlement takes place immediately (e.g. t+2, based on market conventions) 2 Derivative Instruments, which are contracts on one or more underlying assets. A derivative is an instrument whose value is derived from the value of another asset, the underlying, which does not have to be a traded asset or an interest rate but must be measurable (e.g. futures on carbon emissions). Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 32 / 113 Types of Financial Instruments I There are commonly two types of financial instruments: 1 Cash Instruments: a financial asset, which is a legal claim on a real asset (e.g. a property, a commodity, cash (but no cryptocurrencies) or gold); a financial security, which is a tradable legal claim on a firm’s assets or income that is traded in an organized market (e.g. securities, such as bonds and shares); ⇒ Settlement takes place immediately (e.g. t+2, based on market conventions) 2 Derivative Instruments, which are contracts on one or more underlying assets. A derivative is an instrument whose value is derived from the value of another asset, the underlying, which does not have to be a traded asset or an interest rate but must be measurable (e.g. futures on carbon emissions). ⇒ Settlement takes place at pre-specified future date (futures) or within a pre-specified time period (option). Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 32 / 113 Types of Financial Instruments II Financial instruments may also be divided according to an asset class 1 Equity-based financial instruments, that are ownership of an asset. 2 Debt-based financial instruments, that represent a loan made by an investor to the owner of the asset. 3 Foreign exchange instruments, which involve more than two currencies and traded in the Foreign exchange market. NB: Real assets and securities are ON balance sheet, while derivatives are OFF balance sheet. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 33 / 113 Bank Balance Sheet, a Simplified Version Assets Liabilities Cash Due to Central Banks Loans and Leases Deposits - Mortgages - Deposit Accounts - Consumer Credit - Savings Deposits - Credit Cards - Term Deposits Interbank Loans Interbank Funding Investment in Securities Short-term Debt - Sovereign Bonds Subordinated Debt - Corporate Bonds Reserves Other Assets Equity Capital Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 34 / 113 Types of Markets I Primary Market and Secondary Market There are two types of markets: 1 Primary Market, also called New Issue Market, where companies issue a new security, not previously traded on any exchange, in particular in the form of initial public offerings (IPOs), capital increases or bond issues. Main purpose: to raise funds 2 Secondary Market, where existing financial instruments are traded among investors. Main purpose: to provide liquidity and facilitate risk management Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 35 / 113 Types of Markets II Primary Market and Secondary Market Bonds are issued via underwriting from banks and then traded on sec- ondary market via brokers and dealers. Equities are first issued in a primary market via an initial public of- fering (IPO)1 or a follow-on public offering (FPO)2 then traded on exchanges in secondary markets. 1 An IPO is the process through which a company offers equity to investors for the first time and becomes a publicly-traded or listed company. 2 A FPO, also known as Seasoned New Issue (SNI) or Seasoned Equity Offering (SEO), is a process by which already listed companies issue new securities in order to raise additional funds. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 36 / 113 Types of Markets Over-The-Counter Market and Organized Market There are two types of secondary markets: Over-the-counter2 markets (off-exchange) where traders, fund managers and corporate treasurers contact each other directly. Trades are customized contracts. Examples: Foreign exchange, Bond market Organized markets (on-exchange) where all the transactions pass through a central source, a central clearing house. They may be electronic or open-outcry exchanges. Trades are standardized contracts. Examples: New York Stock Exchange (NYSE), Chicago Board Options Exchange (CBOE), London Metal Exchange (LME) 2 Traditionally, the expression over-the-counter (OTC) is assigned for OTC drugs that are medicines sold directly to a consumer without a medical prescription, that a pharmacist give to the consumer over the counter. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 37 / 113 Exchange Markets Evolution of Exchange Markets From 1800’s, in London, the Royal Exchange was used for trading commodities → creation of the London Stock Exchange (LSE)...... to the creation of the CME Group in 2007 which includes: - the New York Mercantile Exchange (NYMEX), - the commodity exchange (COMEX), - the Chicago Board Options Exchange (CBOE), - the Kansas City Board of Trade (KCBT) Open Outcry This is when brokers shout and use hand signals to transfer buy and sell orders to dealers on exchanges. It is still used on some commodity exchanges (CME, LME, CBOT) and on NYSE (Eurodollar options), but since 2000, most exchanges have used electronic platforms. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 38 / 113 Exchange Markets (a) First Stock Exchange market under a (b) Open OutCry Cartoon buttonwood tree in NY (Buttonwood Agreement) Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 39 / 113 OTC vs Exchange Markets Evolution Figure 7: Size of OTC (principal amounts) and Exchange-Traded (value of underlying assets) Markets. Source: BIS and Hull 2021 Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 40 / 113 Central Clearing House I Definition A clearing house acts as an intermediary between buyers and sellers of financial instruments, and responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery, and reporting trading data. Clearing is the process of reconciling purchases and sales of options, futures, or securities, and the direct transfer of funds from one financial institution to another. The process validates the availability of the appropriate funds, records the transfer, and in the case of securities, ensures the delivery of the security to the buyer. Non-cleared trades can result in settlement risk with financial losses. Purpose of a clearing house: to improve the efficiency of the markets and add stability to the financial system Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 41 / 113 Central Clearing House II Each futures exchange has its own clearinghouse. In OTC markets, it is called central counterparty clearinghouse, fa- mously known as CCP. To protect traders in the futures market, members of an exchange are re- quired to: to deposit an initial margin (IM), the original deposit amount, a percentage of the total value of the contract; to clear their trades through the clearing house at the end of each trading session (e.g. futures are marked-to-market daily); to maintain a maintenance margin, a slightly smaller amount in order to hold the trading position (daily settlement), and to deposit variation margin in order to cover the member’s debit balance; to contribute to a guaranty fund in case of default of a counterparty or losses encountered while closing out member’s positions Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 42 / 113 Margin A Margin Call occurs when the percentage of an investor’s equity in a margin account falls below the broker’s3 required amount. Figure 8: IM, VM, Maintenance Margin and Margin Call. Source: Assure Hedge See also one of the many learning videos from the CME Group 3 Brokers who are not members themselves must channel their business through a member and post margin with the member. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 43 / 113 Margin Example A futures contract of cacao requires an initial margin deposit of $1,000 (which is held by the clearing house) and a maintenance margin of $800. If before the contract’s maturity the value of the cacao contract declines by more than $200 (=$1,000-$800), then the buyer will need to deposit additional funds in his trading account in order to hold onto the contract. Otherwise, the clearing house will liquidate his position at the best available market price. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 44 / 113 Global Overview of Financial Markets Key Takeaways Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 45 / 113 Key Takeaways Financial markets include any market place or system that provides buyers and sellers the means to trade financial instruments. A financial instrument can be a cash instrument (asset or security) or a derivative instrument, and a debt or equity or FX-based instrument. A derivative derives from an underlying asset. A security can be a bond (a debt instrument) or a share (a title of property). Once the securities have been issued in the primary markets, they become available for purchase and sale in the secondary markets. There are two types of secondary markets: OTC markets and organized (or exchange) markets In an organized market, there is always a clearing house. In the OTC market, a (central counterparty) clearing house is commonly named CCP. Margins are key elements for trading activities through clearinghouse in order to maintain financial stability. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 46 / 113 Lecture 1: Introduction to Financial Markets 3. Structure of Financial Markets Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 47 / 113 Structure of Financial Markets I Financial markets can classically be divided according the following sectors (see Neftci ): 1 Money markets Short-term debt market with maturity’s FI ranging from 1D to 1Y, e.g. interbank certificates of deposit (CDs), or deposits (depos), commercial papers (CPs), Treasury bills (T-Bills), banker’s acceptances and reverse/repurchase agreements (reverse repos/repos) → Repo market Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 48 / 113 Structure of Financial Markets I Financial markets can classically be divided according the following sectors (see Neftci ): 1 Money markets Short-term debt market with maturity’s FI ranging from 1D to 1Y, e.g. interbank certificates of deposit (CDs), or deposits (depos), commercial papers (CPs), Treasury bills (T-Bills), banker’s acceptances and reverse/repurchase agreements (reverse repos/repos) → Repo market 2 Bond markets Long-term debt market, e.g. bonds, notes, and Floating Rate Notes (FRNs) Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 48 / 113 Structure of Financial Markets I Financial markets can classically be divided according the following sectors (see Neftci ): 1 Money markets Short-term debt market with maturity’s FI ranging from 1D to 1Y, e.g. interbank certificates of deposit (CDs), or deposits (depos), commercial papers (CPs), Treasury bills (T-Bills), banker’s acceptances and reverse/repurchase agreements (reverse repos/repos) → Repo market 2 Bond markets Long-term debt market, e.g. bonds, notes, and Floating Rate Notes (FRNs) 3 Stock markets Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 48 / 113 Structure of Financial Markets I Financial markets can classically be divided according the following sectors (see Neftci ): 1 Money markets Short-term debt market with maturity’s FI ranging from 1D to 1Y, e.g. interbank certificates of deposit (CDs), or deposits (depos), commercial papers (CPs), Treasury bills (T-Bills), banker’s acceptances and reverse/repurchase agreements (reverse repos/repos) → Repo market 2 Bond markets Long-term debt market, e.g. bonds, notes, and Floating Rate Notes (FRNs) 3 Stock markets 4 Foreign exchange markets Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 48 / 113 Structure of Financial Markets I Financial markets can classically be divided according the following sectors (see Neftci ): 1 Money markets Short-term debt market with maturity’s FI ranging from 1D to 1Y, e.g. interbank certificates of deposit (CDs), or deposits (depos), commercial papers (CPs), Treasury bills (T-Bills), banker’s acceptances and reverse/repurchase agreements (reverse repos/repos) → Repo market 2 Bond markets Long-term debt market, e.g. bonds, notes, and Floating Rate Notes (FRNs) 3 Stock markets 4 Foreign exchange markets 5 Energy and Commodity markets Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 48 / 113 Structure of Financial Markets II 6 Derivatives markets e.g. forwards, swaps and options for different asset classes (IR, FX, Equity, Credit and Commodity) Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 49 / 113 Structure of Financial Markets II 6 Derivatives markets e.g. forwards, swaps and options for different asset classes (IR, FX, Equity, Credit and Commodity) 7 Credit markets e.g. high-yield bonds, corporate bonds, credit derivatives or CDSs Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 49 / 113 Structure of Financial Markets II 6 Derivatives markets e.g. forwards, swaps and options for different asset classes (IR, FX, Equity, Credit and Commodity) 7 Credit markets e.g. high-yield bonds, corporate bonds, credit derivatives or CDSs 8 Securitization e.g. Structured products MBS, CDO, ABS Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 49 / 113 Structure of Financial Markets II 6 Derivatives markets e.g. forwards, swaps and options for different asset classes (IR, FX, Equity, Credit and Commodity) 7 Credit markets e.g. high-yield bonds, corporate bonds, credit derivatives or CDSs 8 Securitization e.g. Structured products MBS, CDO, ABS Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 49 / 113 Structure of Financial Markets II 6 Derivatives markets e.g. forwards, swaps and options for different asset classes (IR, FX, Equity, Credit and Commodity) 7 Credit markets e.g. high-yield bonds, corporate bonds, credit derivatives or CDSs 8 Securitization e.g. Structured products MBS, CDO, ABS Money market + Bond market (incl. MBS) = Fixed income securities Bond market (incl. MBS) + Stock market = Capital market Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 49 / 113 Structure of Financial Markets II 6 Derivatives markets e.g. forwards, swaps and options for different asset classes (IR, FX, Equity, Credit and Commodity) 7 Credit markets e.g. high-yield bonds, corporate bonds, credit derivatives or CDSs 8 Securitization e.g. Structured products MBS, CDO, ABS Money market + Bond market (incl. MBS) = Fixed income securities Bond market (incl. MBS) + Stock market = Capital market Figure 9: Time zone wall clock in a trading floor to simultaneously display time in different countries/exchanges. The Forex market never sleeps. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 49 / 113 Structure of Financial Markets Money Markets Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 50 / 113 Money Market Instruments Bills, which can be: 4 In US slang, a repo man is the nickname of the bailiff, the person whose job is repossessing merchandise from buyers who have failed to make payments in due. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 51 / 113 Money Market Instruments Bills, which can be: Certificate of Deposits (CD) and Commercial Papers (CP) are unsecured (i.e. not backed by any form of collateral) short term debt issued respectively by banks and corporates. 4 In US slang, a repo man is the nickname of the bailiff, the person whose job is repossessing merchandise from buyers who have failed to make payments in due. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 51 / 113 Money Market Instruments Bills, which can be: Certificate of Deposits (CD) and Commercial Papers (CP) are unsecured (i.e. not backed by any form of collateral) short term debt issued respectively by banks and corporates. Treasury bills (T-bill) are short-term debt obligation issued by sovereign governments. 4 In US slang, a repo man is the nickname of the bailiff, the person whose job is repossessing merchandise from buyers who have failed to make payments in due. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 51 / 113 Money Market Instruments Bills, which can be: Certificate of Deposits (CD) and Commercial Papers (CP) are unsecured (i.e. not backed by any form of collateral) short term debt issued respectively by banks and corporates. Treasury bills (T-bill) are short-term debt obligation issued by sovereign governments. Repurchase agreements (repo)4 , which are short-term sources of funds to holders of securities that require instant liquidity. A repo is the sale of a security with a commitment by the seller to repurchase (buy back) the security from the purchaser at a specified amount and at a specified date. The security backed by the repo is the collateral of the transaction. A reverse repo is the opposite transaction. 4 In US slang, a repo man is the nickname of the bailiff, the person whose job is repossessing merchandise from buyers who have failed to make payments in due. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 51 / 113 Repurchase Agreements I At the settlement date: sell security Seller Buyer (Borrower in cash) (Lender of cash) buy back security For example, the seller sells a bond that worths 100 today, and receives 100 cash for the bond. At the maturity date, re-purchase of bond Seller Buyer (Borrower in cash) (Lender of cash) pays 100 plus repo rate Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 52 / 113 Repurchase Agreements II Seller’s motivation securities Trader Buyer (Borrower in cash) (Lender of cash) cash to purchase The trader pays a repo rate that is lower than the 1-month Libor rate because the loan is now secured by securities Due to collateralization, the repo rates trade lower than, for instance, inter- bank market rates. Buyer’s motivation The buyer who enters into a reverse repo market makes an investement at repo rates. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 53 / 113 Structure of Financial Markets Capital Markets Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 54 / 113 Bond Market (a) Bon à 5 ans d’une valeur nominale de (b) USD 1,000 30Y US Treasury Bond, 1000 Frs, Crédit Agricole, issued in 1942 issued in 1978 Figure 10: Bonds in France and in the US, historical archives Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 55 / 113 Bonds Definition A bond is a type of security under which the issuer (debtor ) owes the holder (creditor ) a debt, and is obliged – depending on the terms – to repay the principal (i.e. amount borrowed) of the bond at the maturity date as well as interest (called the coupon) over a specified amount of time. Interest is usually payable at fixed intervals. Uses: Bonds provide the borrower with external funds to finance long-term investments or, in the case of government bonds, to finance current expenditure. Types of issuers: Municipalities, corporates, or governments Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 56 / 113 Types of Bonds I Standard or bullet bond Fixed-rate bond: the coupon rate is constantly fixed Figure 11: 10Y US Treasury Bond. Source: Bloomberg Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 57 / 113 Types of Bonds II Non-standard or non-bullet bond Floating-rate bond, variable- or adjustable-rate bond, known also as floating-rate note: the coupon rate is based on a reference rate Zero-coupon bond: pay no interest and are sold at a discount from their par value. Amortizing bond: some of principle were scheduled to pay out before the maturity Callable / Putable bond: the issuer has the right to redeem the bond before maturity at a formula price Convertible bond: a bond that can be converted into a predetermined number of common stock or equity shares Perpetual bond: a bond with no maturity Inflation-Indexed bond: a bond whose coupons and principals are indexed to future inflation rates Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 58 / 113 Inflation-Indexed Bonds I A little bit of history UK, 1981: first issue of an inflation-indexed bonds for institutional investors → Index-linked Gilt, inflation measured based on the Retail Price Index (RPI) USA, 1997: launch of the TIPS program by the US Treasury → TIPS (“Treasury Inflation Protection Securities”), measured based on the non-seasonally Consumer Price Index for all Urban Consumers France, September 1998: first issue of an OAT indexed to the French Consumer Price Index (CPI) by the State → OATi (“Obligation Assimilable du Trésor Indexée sur l’indice des prix à la consommation (hors tabac) en France”) France, October 2001: first issue of an OAT indexed to the euro-area CPI (OATei) Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 59 / 113 Inflation-Indexed Bonds II Uses of inflation-indexed bonds: Designed for all types of investors looking to protect the purchasing power of their investments (hedged against a rise in inflation rate), improve their asset-liability management or diversify their investment portfolio Mainly issued by governments willing to maintain a low inflation level Types of investors: insurance companies, pension and social welfare funds, asset managers and banks, as well as retail investors The Debt of the French Government Managed initially by the Spécialistes en Valeurs de Trésor (SVT) who are the primary dealers of the French government securities, and by the Agence France Trésor (AFT), which manages the French state’s cash requirements Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 60 / 113 Inflation-Indexed Bonds III Figure 12: OATi March 2025. Source: AFT Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 61 / 113 Inflation-Indexed Bonds IV Figure 13: OATi. Source: Bloomberg Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 62 / 113 Bond Vs Loan Source: Wall Street Mojo Bonds and loans are debt instruments, but have some large differences: Source place Bonds are traded in the bond markets (trading book), while loans are delivered by banks mostly (banking book). Trading Since bonds are sold and purchased at the bond markets, bond prices can change like stock prices, whereas loans are generally fixed. Interest rates Government bond yields or interest rates are low, since they are considered to be safer investments, while loans if unsecured, tend to be higher. Participants Government or FI usually sell bonds, while corporates and individuals borrow loans. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 63 / 113 Capital Markets Stock Markets Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 64 / 113 Stock Market Figure 14: Bull Market vs Bear Market. A Bull Market is a period of generally rising prices in the stock market (bulls attack upwards with their horns), while a Bear Market is a general decline of prices over a period of time (bears attack downwards with their claws). Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 65 / 113 Equities Equity securities are commonly called shares (or “stocks”). Shares repre- sent interest in ownership of companies and are claims on the residual value of this company after the claims of all creditors have been met. Equities often make periodic payments (dividends) to their holders and are considered long-term securities because they have no maturity date. Types of shares: listed or unlisted shares, referred to as “quoted shares” or “unquoted shares” and sometimes “private equity”, i.e. resp. registered on a stock exchange or unquoted; ordinary or preferred shares, referred to as “common” shares or “preferred stocks”, relative to voting rights. Ordinary shares give holders the right to one vote at a company shareholders’ meeting and don’t guarantee dividend. Preferred shares rank higher than ordinary shares, with more voting rights and dividend guaranteed. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 66 / 113 Stock Index I Stock Index Stock Index is an index that measures the stock market/economy “heath” and helps investors to compare market performance. Major stock indices are: Dow Jones Industrial Average (DJIA) 30 “blue chip” industrial firms S&P 500 500 large companies listed on stock exchanges in the US NASDAQ 100 102 large non-financial companies listed on the NASDAQ (National Association of Securities Dealers Automated Quotation) Stock Exchange FTSE 100 (the “Footsie”) 100 largest companies listed on the London Stock Exchange Eurostoxx 50 50 stocks from 11 countries in the Eurozone, traded on Eurex Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 67 / 113 Stock Index II Nikkei 225 225 large public companies in Japan, traded on the Tokyo Stock Exchange MSCI Morgan Stanley Capital International (MSCI) provides the MSCI World ans MSCI Emerging Market Indexes. Figure 15: Returns of some main indexes. Source: Google Finance Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 68 / 113 Stock Exchanges The market capitalization (or Market Cap) value of a listed company is the total amount of issued share capital multiplied by the current share price. This represents the total value or worth of the company. Figure 16: Major stock exchange groups (the current top 10 by market capitalization) of issued shares of listed companies. Source: Wikipedia Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 69 / 113 Institutional Investors Institutional investors are organizations that invest money, trade securities in the market on behalf of other people or organization. Figure 17: Institutional Investors. Source: Wall Street Mojo Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 70 / 113 Institutional Investors Asset Managers Source: Wikipedia Asset management firm is a financial company with experts (asset managers) who manage money and handle the investments of clients. This is done either actively or passively. Active asset management: involves active tasks such as studying the client’s assets to planning and looking after the investments, Passive asset management: assets are allocated to mirror a market or a sector index. Asset management aims to maximize returns while minimizing risk, while hedge funds (see definition below) aim to generate high returns regardless of market conditions. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 71 / 113 Types of Funds I Regulated or Registered Investment Funds Exchange Traded Fund (ETF) is a fund whose shares trade on stock exchanges and replicates stock index. Examples: spiders (first ETF who tracks the S&P 500), diamonds (DJIA), cubes (NASDAQ 100) Pension funds are large pooled investment funds which provide retirement income. Collective Investment Schemes (CIS) or “Organismes de placement collectif en valeurs mobilières” (OPCVM) are financial intermediaries that give their subscribers the possibility of investing on financial markets to which it would be difficult for them to have access otherwise (foreign financial and money markets, unlisted shares...). Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 72 / 113 Types of Funds II Regulated or Registered Investment Funds - Main activity of CIS: collecting funds and issuing securities to various agents (private individuals, companies, etc.) with a view to acquiring financial assets. - 2 types of CIS based on its organisation: Open-end Investment Companies (OEIC) or “Sociétés d’Investissement à Capital Variable” (SICAV) which are companies with a board of directors and, Mutual funds or “Fonds communs de placement” (FCP) which are not legal entities and are created on the initiative of a management company or a bank serving as custodian Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 73 / 113 Types of Funds I Unregulated or Unregistered Investment Funds Private Equity refers to asset managers who make equity investments in companies that are not publicly traded (e.g. start-ups) Example: venture capital, type of financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential Hedge Funds are open to a small number of qualified investors, such as pension funds, and wealthy individuals. They use complex trading, portfolio construction and risk management techniques to improve performance such as leverage, short-selling, and derivatives. Family office is a privately held company that handles investment management and wealth management for a wealthy family, generally one with at least $50–100 million in assets, with the goal being to effectively grow and transfer wealth across generations. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 74 / 113 Bonds vs Stocks Main differences between bonds and stocks 1 Stockholders have an equity stake in a company (i.e. they are owners), whereas bondholders have a creditor stake in the company (i.e. they are lenders). As creditors, bondholders have priority over stockholders. This means they will be repaid in advance of stockholders, but will rank behind secured creditors, in the event of bankruptcy. Bonds are sometimes referred to unsecured debt. 2 Bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks typically remain outstanding indefinitely, exception with the irredeemable bond or perpetual bond which has no maturity. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 75 / 113 Securities Seniority Ranking Figure 18: Seniority Ranking. Source: https://www.perpetual.com.au/income/ insights/perpetual-knowledge-bank-series-seniority-of-assets Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 76 / 113 Structure of Financial Markets Derivatives Markets Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 77 / 113 Derivatives Definition A derivatives contract is a contract whose value depends on or is derived from the value of an underlying asset, which does not have to be a traded asset or an interest rate but must be measurable. Derivatives contracts can be divided into two general families: 1 Contingent claims, such as options 2 Forward claims, which include swaps, futures and forwards There are always two counterparties to a derivatives transaction - the buyer (long position) and the seller (short position). In accounting standards (IFRS 13), derivatives are measured as their fair value or market-to-market (MtM). Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 78 / 113 Global Derivatives Market, June 2021 Figure 19: Amounts outstanding in billions of $US, H2 2021. Source: BIS Semi-annual survey Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 79 / 113 Futures and Forwards I Forward contracts A forward contract is an agreement where one party promises to buy an asset from another party at some specified time (the delivery date or maturity) in the future and at some specified price (the delivery price). The asset could be a stock, a commodity or a currency. Forward contracts are traded in OTC market. Example: FX forward Futures A futures is like a forward contract but traded on an exchange market, with specific maturities and more standardized contracts. Example: Eurodollar5 futures 5 Initially the name eurodollars referred to dollar-denominated deposits largely held in European banks, but now dollar deposits are held in a variety of banks across the globe. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 80 / 113 Futures and Forwards II Payoff Payoff 0 0 K ST K ST (a) long position (b) short position Table 3: Payoffs from forward contracts, with K delivery price, ST asset price at maturity T Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 81 / 113 Futures and Forwards I History A bit of history Since the middle ages, farmers would sell a crop for delivery at some agreed time in the future a price agreed today, in order to hedge against uncertainty in future spot price fluctuations ⇒ forward contract Around 1630, the Royal Exchange in London allowed forwards on tulip bulbs to be traded. Tulip mania was the first major financial bubble happened. It hap- pened in Holland between 1636–1637. The tulip mania was more un- known socio-economic phenomenon than a significant financial crisis. The term “tulip mania” is now often used metaphorically to refer to any large economic bubble when asset prices deviate from intrinsic values. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 82 / 113 Futures and Forwards II History (a) Tulip price index. Source: Link (b) “Allegory of the Tulipomania”, painting by Jan Brueghel the Younger (1601-1678), around 1640 Figure 20: Tulip Mania Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 83 / 113 Swaps I Definition A swap is an agreement traded in the OTC market between two parties to exchange or swap sequences of cash flows for a set period of time. At least one of these series of cash flows (a “leg”) is determined by an uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price. Main types of swaps: Interest rate swaps (IRS): swaps which define the nature of an exchange of payments benchmarked against an interest rate index Plain vanilla IRS: fixed interest rate versus floating interest rate Cross-currency swaps (CRS): swaps similar to IRS, except that exchange of interest payments and principal are denominated in two different currencies. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 84 / 113 Swaps II Another common examples of swaps respectively in the equity market and in the credit market are Total Return Swaps (TRS) and Credit Default Swaps (CDS) (see next sections). Uses of swaps: to change the nature of the cash flow to reduce interest rate risk and foreign exchange risk Payoff = (leg 1 - leg 2) x notional leg 1 Counterparty Counterparty A B leg 2 Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 85 / 113 Interest Rate Swap Example A vanilla IRS has a notional amount of USD 100 million. A 7% fixed rate for 2 years is paid semi-annually against a cash-flow generated by 6-month USD LIBOR. There are two set of cash-flows: 1 for the fixed leg: 4 payments of USD 35 000 each, known at t0 and paid at the end of each 6-month period 2 for the floating leg: 4 LIBOR rates are observed during the 2 years. The first LIBOR L0 is known at t0 ; the remaining LIBOR rates are observed at fixing dates occuring in the future, but are unknown initially. Fixed rate 7% Counterparty Counterparty A B 6m USD LIBOR Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 86 / 113 Total Return Swaps I Definition A Total Return Swap (TRS) is a swap agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset (a bond or any portfolio of assets) for LIBOR plus a spread. Uses: Total return swaps are often used as a financing tool. Example 5-year agreement with a notional principal of $100 million to exchange the total return on a corporate bond for LIBOR plus 25 basis points. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 87 / 113 Total Return Swaps II Total return (interest and appreciation) Counterparty Counterparty A B LIBOR + spread, plus depreciation Cash flow A: Total Return payer or ’Beneficiary’ Underlying asset B: Total Return receiver or ’Guarantor’ Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 88 / 113 Credit Derivatives Definitions Credit Derivatives are OTC financial contracts designed to hedge credit risk exposure by providing insurance against deterioration in credit quality of the borrowing entity and against losses suffered due to credit events. A credit event is defined in a legal document within the credit derivative contract, e.g. bankruptcy, restructuring or liquidation of a company. A credit derivative works like an insurance policy, with regular premiums paid by the protection buyer to the protection seller, and a payout in the event of a specified credit event following two types of settlement (physical or cash settlement). Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 89 / 113 Credit Default Swaps I Definition A Credit Default Swap (CDS) is a bilateral contract in which a periodic fixed fee or CDS spread or a one-off premium is paid to a protection seller, in return for which the seller makes a payment on the occurrence of a specified credit event. In this form, a CDS provides insurance to the protection buyer against the risk of default by a particular company. Uses: - for banks, insurers, asset managers: hegding credit risk - for hedge fund, banks: leverage Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 90 / 113 Credit Default Swaps II Example Let’s consider a CDS with notional $100 million and a 120 basis points CDS spread for a 5-year deal. The insurance premium would be 120 basis points applied to $100 million or $1.2 million per year. If the reference entity does not default during the 5 years, nothing is received in return for the insurance premiums. If reference entity does default and bonds issued by the reference entity are worth 40 cents per dollar of principal immediately after default (recovery rate = 40%), the seller of protection has to make a payment to the buyer of protection equal to $60 million. The idea here is that, if the buyer of protection owned a portfolio of bonds issued by the reference entity with a principal of $100 million, the payoff would be sufficient to bring the value of the portfolio back up to $100 million. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 91 / 113 Credit Default Swaps III Fee or premium Counterparty A Counterparty B Buyer of protection Seller of protection Default payment on triggering event Cash settlement or Reference asset Physical settlement Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 92 / 113 Options I Definition Options are financial derivatives that give the holders the right, but not the obligation, to buy (call) or sell (put) an underlying asset, which can be stocks, bonds, ETFs, and even mutual funds, at an agreed-upon price, called the strike price, and at an expiry date. Call options and put options form the basis for a wide range of option strategies designed for hedging, income or speculation. Put options are popular insurance contracts against a price fall. There are commonly three types of options: European - can only be exercised on the expiry date American - can be exercised on or before the expiry date Bermudan - can be exercised on specific dates on or before expiry Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 93 / 113 Options II Options are issued on the primary market at a premium which is usually a small fraction of the underlying’s market price and then traded on the secondary market Distinction should be made between the market price of the option and the market price of the underlying Moneyness of an option contract: Let’s note S the spot price and K the strike price of the option. Type of Option Contract Call Option Put Option In The Money (ITM) S ≥K S ≤K At The Money (ATM) S =K S =K Out The Money (OTM) S ≤K S ≥K Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 94 / 113 Options III Payoff Payoff 0 K ST 0 K ST (a) Long call (b) Short call Payoff Payoff 0 0 K ST K ST (c) Long put (d) Short put Figure 21: Payoffs from European options with premium and strike K Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 95 / 113 Exotic Options Exotic options have more complex features than vanilla options and are generally traded on the OTC market, e.g. options on equity index with Asian features, barriers and/or American exercise. Examples of exotic options (see Hull chapter 26): Binary or digital option Path-dependent options Barrier option Capped option Asian option Look-back options Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 96 / 113 Structure of Financial Markets FX Markets Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 97 / 113 Definition Exchange rate It is the price of one currency in terms of another one. Examples: US Dollar, Euro Brazilian Real When a currency increases in value, it experiences appreciation. On the contrary, it undergoes depreciation. Two types of exchange rate transactions: 1 spot transactions, immediate (two-day) exchange of bank deposits ⇒ spot exchange rate 2 forward transactions, exchange of bank deposits at some specified future date ⇒ forward exchange rate The foreign exchange (FX or Forex) market is the financial market where exchange rates are determined. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 98 / 113 Forex Market I Source: Mishkin Why Are Exchange Rates Important? Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 99 / 113 Forex Market I Source: Mishkin Why Are Exchange Rates Important? Because they affect the relative price of domestic and foreign goods. When a country’s currency appreciates (rises in value relative to other currencies), the country’s goods abroad become more expensive and foreign goods in that country become cheaper (holding domestic prices constant in the two countries). Conversely, when a country’s currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive. The US dollar price of French goods to an American is determined by the interaction of two factors: the price of French goods in euros and the eu- ro/dollar exchange rate. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 99 / 113 Forex Market II How Are Foreign Exchange Instruments Traded? Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 100 / 113 Forex Market II How Are Foreign Exchange Instruments Traded? In the OTC market Remark: when we say that a bank is buying dollars in the foreign exchange market, what we actually mean is that the bank is buying deposits denom- inated in dollars. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 100 / 113 Forex Market II How Are Foreign Exchange Instruments Traded? In the OTC market Remark: when we say that a bank is buying dollars in the foreign exchange market, what we actually mean is that the bank is buying deposits denom- inated in dollars. Which Foreign Exchange Instruments are Traded? Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 100 / 113 Forex Market II How Are Foreign Exchange Instruments Traded? In the OTC market Remark: when we say that a bank is buying dollars in the foreign exchange market, what we actually mean is that the bank is buying deposits denom- inated in dollars. Which Foreign Exchange Instruments are Traded? FX spot or deposits denominated in currencies derivatives: currency swaps, FX swaps, FX forwards, FX options Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 100 / 113 Forex Market II How Are Foreign Exchange Instruments Traded? In the OTC market Remark: when we say that a bank is buying dollars in the foreign exchange market, what we actually mean is that the bank is buying deposits denom- inated in dollars. Which Foreign Exchange Instruments are Traded? FX spot or deposits denominated in currencies derivatives: currency swaps, FX swaps, FX forwards, FX options What is the difference between a currency swap and a FX swap? Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 100 / 113 CRS vs FX Swap (a) FX swap schema (b) CRS schema Figure 22: FX swap vs CRS. Source: BIS https://www.bis.org/publ/qtrpdf/r_qt0803z.htm Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 101 / 113 Forex Market III Figure 23: FX market turnover by instrument. Source: BIS Triennal Central Bank Survey, 2019. Daily average turnover: Total amount of derivatives contracts traded in a day, calculated as the amount traded over a specified time period divided by the number of business days within this period. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 102 / 113 Structure of Financial Markets Credit Markets* Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 103 / 113 Securitization I Securitization is the financial practice of: 1 pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and; 2 selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS). Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 104 / 113 Securitization II Purpose: transforming illiquid assets of a lending entity (financial institution or cor- poration) into tradable securities, backed by these assets, generally a pool of loans Lender / originator Pool of loans / receivables Special Purpose Vehicle Investor (SPV) ABSs / MBSs Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 105 / 113 Securitization Uses Uses of MBSs and ABSs From the issuer size to reduce the size of their balance sheet and release capital that can be reused ⇒ Leverage From the investor size to capture spread over Treasury bonds and enhance the yield on their portfolios without giving up credit quality and liquidity Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 106 / 113 Collateralized Debt Obligations I Collateralized Debt Obligations (CDOs) are tranched products because of the tranching or cutting up of a pool of assets, and credit correlation prod- ucts because of built-in correlation risks (and leverage) within the tranches. A cash-flow CDO is not a credit derivative. It is a structured finance product in which a distinct legal entity known as special-purpose vehicle issues bonds or notes against an investment in cash flows of an underlying pool of assets. CDOs were developed as repackaging structures for high-yield bonds and illiquid instruments such as certain convertible bonds. Uses: Banks and financial institutions use CDOs to diversify their sources of fund- ing, manage portfolio risk, and obtain regulatory capital relief. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 107 / 113 Collateralized Debt Obligations II Types of CDOs: 1 collateralized bond obligations (CBOs) 2 collateralized loan obligations (CLOs) Figure 24: CDO Schema. Source: Wall Street Mojo Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 108 / 113 Structure of Financial Markets Key Takeaways Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 109 / 113 Key Takeaways I Financial markets are classified into several markets depending on the nature of: the claims: cash market vs derivatives market, the asset: debt or equity or FX, the maturity: money market vs capital market, the settlement: spot market vs future market Money markets contain short-term debt instruments less than 1Y maturity (e.g. Treasury bills and repos). Capital market is made of bond market and equity market. Derivatives markets contain contingent claims (options) or forward claims (swaps, futures and forwards). FX market is an OTC market for the trading of currencies and by far the largest market in the world. Securitization pools or groups debt into portfolios to repackage them into interest-bearing securities. Issuers create tradable financial instruments by merging various financial assets into tranches. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 110 / 113 Key Takeaways II Figure 25: Financial Instruments and Financial Markets Classification. Source: https: //www.sketchbubble.com/en/presentation-financial-instruments.html Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 111 / 113 Lecture 1: Introduction to Financial Markets 4. Bibliography Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 112 / 113 References BIS. Semi-annual survey H2 2021. url: https : / / www. bis. org / statistics/derstats.htm. BIS. Triennial Central Bank Survey of FX and OTC Derivatives Market in 2019. url: https://www.bis.org/statistics/rpfx19.htm. John Hull. Options, Futures and Other Derivatives. 11th ed. Pearson, 2021. url: https://www- 2.rotman.utoronto.ca/ ~hull/ofod/ index.html. Frederic Mishkin. The Economics of Money, Banking, and Financial Markets. 13th ed. Pearson, 2021. Frederic Mishkin and Stanley Eakins. Financial Markets and Institu- tions. 7th ed. Pearson, 2012. Salih N. Neftci. Principles of Financial Engineering. 2nd ed. Elsevier, 2008. Fanny VIDAL (ENSAE) Financial Instruments October 2, 2024 113 / 113