Chapter 4 Financial Markets PDF

Financial Markets ◦ Overview of Financial Markets ◦ Functions of Financial Markets ◦ Actors in Financial markets ◦ Financial Market structure ◦ Types of Financial Markets Financial markets 2  A market refers to an institution or arrangement that facilitates the p...

Financial Markets ◦ Overview of Financial Markets ◦ Functions of Financial Markets ◦ Actors in Financial markets ◦ Financial Market structure ◦ Types of Financial Markets Financial markets 2  A market refers to an institution or arrangement that facilitates the purchase and sale of goods and services.  In any market buyers and sellers meet together to exchange & this determines the price of what is exchanged and the quantity exchanged.  Financial markets are no different. Financial markets 3  In financial markets available funds are exchanged.  The sellers of the funds have excess funds and the buyers need those funds.  The equilibrium in these markets determines the price & quantity of financial instruments. Financial markets 4  If financial markets work well, then: ◦ useful investment occurs, ◦ production & economic efficiency increase, and ◦ every one in a given country will be benefited. Financial markets 5  A financial market is an institution or arrangement that facilitates the exchange of financial instruments including deposits and loans, stocks, bonds, etc.  It is a market where surplus funds (savings) of economic units (firms, households, government & foreign investors) are channeled to those economic units who have a shortage of funds (to those who wants to borrow funds). Financial markets & institutions 6 a) Factor market ◦ Allocates factors of production(land, labor & capital) b) Product market ◦ Includes trading of goods and services c) Financial market ◦ Flow of funds and financial claims are affected. Financial markets 7 In finance, financial markets facilitate: 1.The raising of capital (in the capital markets); 2. The transfer of risk (in the derivatives markets); 3. International trade (in the currency markets) Financial markets 8 Financial markets may classify based on different classification criteria or bases. These are: 1. Classification by type of financial claim: a) Equity (Stock) Market b) Debt Market 2. Classification by maturity of claim: a) Money Market which provide short term debt financing and investment. b) Capital Market: the market for debt instruments with a maturity of greater than one and equity instruments (Bond Market and Stock Market) Financial markets 9 3. Classification by origin/ nature of securities: a) Primary Market: Markets dealing with financial claim that are newly issued b) Secondary Market: markets dealing with previously issued financial claims. 4. Classification by organizational structure. a) Auction Market b) Over the Counter (OCT) Market- market by interconnected computers. 5. Other markets a) Commodity markets, which facilitate the trading of commodities. b) Foreign Exchange Markets, which facilitate the trading of foreign exchange c) Insurance Markets, which facilitate the redistribution of various risk d) Derivatives Markets, which provide instruments for the management of financial risk. e) Open Market f) Negotiated Market Financial markets 10  A financial market may or may not have a particular physical existence.  Financial market takes three basic forms: 1. Auction markets 2. Over-the-counter (OTC) markets 3. Organized Exchanges 4. Intermediation Financial Markets Financial markets 11 1. Auction markets: are markets conducted through brokers.  Areform of centralized facility by which buyers and sellers execute trades, through their commissioned agents (brokers) in an open & competitive bidding process.  The"centralized facility" is not necessarily a place where buyers & sellers physically meet.  Rather,it is any institution that provides buyers and sellers with a centralized access to the bidding process. Financial markets 12  All of the needed information about ◦ bid prices (offers to buy ) & ◦ asked prices (offers to sell ) is centralized in one location which is readily accessible to all the would-be buyers & sellers, such as through computer network. ◦ No private exchanges b/n individual buyers & sellers are made outside of the centralized facility. Financial markets 13  An auction market is typically a public market in the sense that it is open to all agents who wish to participate.  Relatively homogeneous assets such as Treasury bills, notes, & bonds are traded. Financial markets 14 2. Over-the-counter (OTC) : is market conducted through dealers;  An OTC market has no centralized mechanism or facility for trading.  It is a public market consisting of a number of dealers spread across a region, a country, or the world, who make the market in some type of asset. i.e., ◦ the dealers themselves post bid & asked prices of the assets, & ◦ stand ready to buy or sell the asset with anyone who chooses to trade at the posted prices. Financial markets 15  The dealers provide customers more flexibility in trading than brokers, because dealers can offset imbalances in the demand & supply of assets by trading out of their own accounts.  Many well-known common stocks are traded over-the-counter in the United States through NASDAQ (National Association of Securities Dealers' Automated Quotation System). Financial markets 16 3. Organized Exchanges: combine auction and OTC market features.  organized exchanges permit buyers & sellers to trade with each other in a centralized location, like an auction.  Securitiesare traded on the floor of the exchange with the help of specialist traders who combine broker and dealer functions. Financial markets 17  The specialists broker trades but also stand ready to buy and sell stocks from personal inventories if buy and sell orders do not match up.  such as the NYSE (New York Stock Exchange), which combine auction and OTC market features. Financial markets 18 4. Intermediation Financial Markets  Is a FM in which financial intermediaries help transfer funds from savers to borrowers by issuing financial assets to savers and receiving other type of financial assets from borrowers. Financial markets 19 Financial markets serve six basic functions: 1. Borrowing and Lending 2. Price Determination 3. Information Aggregation & Coordination 4. Risk Sharing 5. Liquidity 6. Efficiency Financial markets 20 ◦ Brokers ◦ Dealers ◦ Investment Banks ◦ Financial Intermediaries ◦ Governments ◦ Companies ◦ Individuals Financial markets 21  Financial markets include: 1. Primary market 2. Secondary market 3. Money market 4. Capital market 5. Foreign exchange markets 6. Derivative market Financial markets 22  Primary market is a market in which newly issued securities are sold to initial buyers by the corporation or government in raising the funds.  Securities available for the first time are offered through the primary market.  That is, In the primary market, companies interact with investors directly while in the secondary market investors interact with themselves. Financial markets 23  The securities offered may be a new type for the issuer or additional amounts of a security used frequently in the past.  The traditional middleman in the primary market is called an investment banker.  Investment banking firms play an important role in many primary market transactions by underwriting securities. Financial markets 24  That is, they buy the new issue from the issuer at an agreed upon price and hope to resell it to the investing public at a higher price.  Usually, a group of investment bankers joins to underwrite a security offering and form what is called an underwriting syndicate.  Companies raise new capital in the primary market through: i. Public issues ii. Right issue iii. Private placement Financial markets 25 i. In public offering: the will be established companies sell new securities to the public. i.e., to all individuals and institutions. ii. In right issue: offering of securities may be made only to the existing shareholders.  when securities are offered only to the company’s existing shareholders, it is called right issue. Financial markets 26 iii. Private placement: instead of public issue of securities, a company may offer securities privately only to a few investors. This is referred to as private placement.  The investment bankers may act as a finder, i.e., they locate the institutional buyer for a fee. Financial markets 27  Secondary market is a market where already issued or existing or outstanding financial assets are traded among investors.  Unlike primary market, in the secondary market the issuer of the asset does not receive funds from the buyer.  Rather the existing issue changes hands and funds flow from the buyer of the asset to the seller in the secondary market. Financial markets 28  The primary market provides a direct link between the prospective savers and the issuing company, while  Secondary market provides an indirect link between the savers and the company. Financial markets 29  By providing liquidity and safety, the secondary market encourages the public to subscribe to the new issues.  The marketability and capital appreciation provided in the secondary market are the major factors that attract the investing public towards the stock market. Financial markets 30  The money market is the market for shorter-term credit instruments/debt securities, generally those with one year or less remaining to maturity.  Because of their short period maturity, money market investments sometimes are also known as cash investments. Financial markets 31  Since money market instruments are very liquid, & very safe, they offer a lower return than most other securities.  Money market securities are traded in very high denomination. ◦ Thus, individual investors have limited access to them as compared to other market securities. Financial markets 32 1. Short term funds are borrowed and lent 2. No fixed place for conduct of operation e.g., through phone, etc 3. Dealing may be made with or without the help of brokers. 4. Funds are traded for a maximum period of one year. Financial markets 33  Money markets are important to: ◦ Central government- for controlling the money supply. ◦ Banks- to meet reserve requirements and as a place to use excess reserves. ◦ Brokers & dealers- keep the market moving ◦ Corporations- sources of short term funding and as a place to invest excess cash for short period of time. ◦ Other financial institution- a place to maintain liquidity. Financial markets 34 a) Treasury bill (TB):  It is a short term obligation/promissory note issued by the government,  sold at a discount from its face value &  redeemed of its face value upon maturity.  For example, if you buy a 90 day T-Bill having Br.10,000 face value at Br. 9,800 and held it until maturity, your interest would be Br. 200(=10,000-9,800).  For this reason they are also called zero- coupon rate bonds. Financial markets 35   It is a way that government use to raise money from the public.  Is the most marketable money market securities & considered as risk-free investment area.  TBs are issued through the competitive bidding process at auctions. Financial markets 36  Futures of TB: 1. Issuer- it issued by the government for raising short term funds, for filling the deficit between revenue & expenditure. 2. Liquidity- it enjoys high degree of liquidity. 3. Tax- Interest exempt from state and local taxes 4. Monetary management- serve as an important tool of monetary management used by the central bank of the country to influence the economy. Financial markets 37  Negotiable CD is a deposit with a bank at special interest rate for specified period of time, which is less than one year.  It is issued by commercial banks in any denomination.  CDs offer a slightly higher yield than TBs because of the slightly higher default risk for a bank, but overall the probability of a large bank to default is very minimal. Financial markets 38  A bank issue time deposit with: ◦ Fixed interest rate and maturity ◦ Terms are negotiable ◦ Common maturities are less than 12 months ◦ They are more certain to banks than demand deposits that can leave at any time. ◦ Most CDs are sold directly to investors who hold to maturity ◦ Investors receive both principal & interest Financial markets 39  CP is Unsecured short-term promissory note: ◦ Generally issued by corporations or financial institutions ◦ Sold directly to institutions or through dealers. ◦ Is the largest (total $ value) of the money market securities ◦ Funds used to finance working capital requirements Financial markets 40 ◦ Usually issued at discount and held to maturity– no active secondary market ◦ Issued by high creditworthy & top rated corporations ◦ Taxed by all levels of government Financial markets 41  BA is a bank draft, a promise of payment similar to a check, issued by a firm , payable at some future date & guaranteed for by a fee by the bank that stamps it as “accepted”.  Or, it is a short term credit investment created by a non-financial firm and guaranteed by a bank to make payment.  The firm issuing the instrument is required to deposit the necessary funds into the account to cover the draft. Financial markets 42  If the firm fails to do so, the bank’s guarantee obligate the bank to cover the draft  These accepted drafts are often resold in a secondary market at discount similarly as treasury bill.  E.g., acceptance set at a discount from the face value: ◦ Face value of banker’s acceptance … Br. 100,000 ◦ Minus 1% commission/discount … … Br. 1000 ◦ Amount received by the holder … … Br. 99,000 Financial markets 43 ◦ Banks guarantee payments to secure orders of goods from manufacturers ◦ Are a type of “letter of credit” that guarantees a payment by the bank on a specific date ◦ Particularly useful between foreign trading partners where there is a high level of asymmetric information – Banks resolve this AI. Financial markets 44  Fed funds are bank deposits at a bank’s district Fed for the purpose of meeting reserve requirements  Banks with “excess” reserves at the Fed loan to those with a shortfall Financial markets 45  REPO is an agreement to buy any securities from a seller with the agreement that they will be repurchased at some specified date & price in the future.  REPO is a fully collateralized loan in which the collateral consists of mktable securities.  The repurchase price is higher than the initial sale price: the d/fce is Return to the lender. Financial markets 46  The capital market is the market for long-term securities, generally those with more than one year to maturity.  The primary participants raising funds in the capital markets are: ◦ Federal, state, & local governments; & ◦ Corporations.  Securities markets consist of organized exchanges & OTC markets. Financial markets 47  Security markets are considered to be efficient when prices adjust rapidly to new information.  Security legislation is intended to protect investors against fraud, manipulation, and illegal insider trading.  Capital market provides with: ◦ Long-term fixed income (in Debt market), & ◦ Equities (in Equity market) Financial markets 48  Treasury Notes & Bonds  Municipal Bonds  Corporate Bonds  Common stocks  Preferred stocks Financial markets 49 a) Treasury Bonds and Notes  Issued by government  Treasury Notes (mature 1-10 years)  Bonds (mature 10 – 30 years)  Quoted as a % of par value  Semi annual coupon payments  Denominations of $1,000 or more  Premium (selling price greater than face value) and discount bonds (selling price less than face value ) Financial markets 50 b) Municipal Bonds  Issued by State & Local Government  Tax Exempt c) Corporate Bonds  Issued by corporations  Semiannual coupon payment  Interest rate risk  Default risk exist Financial markets 51  d) Common Stock  Shares of ownership in a corporation  Right to residual claims  Right to vote on corporate matters  Limited Liability  Investor Equity Return = Dividend Yield + % of Price change Financial markets 52 e) Preferred Stock  Has debt & Equity Characteristics  Fixed Dividend Payout  Corporation pays taxes on preferred dividends unlike interest ◦ (double taxation, just like common dividends for individual investors) Financial markets 53  Foreign Exchange: all currencies other than the domestic currency (in our case, all currencies other than ‘birr’).  Foreign exchange market refers to any and all places where different currencies are traded for one another.  Exchange Rate: the price of one country's currency in terms of another country's currency; ◦ Is the rate at which two currencies are traded for another. Financial markets 54 1. Spot Market: - immediate transaction at spot rate  participants are: commercial banks, brokers, and customers of commercial and central banks 2. Forward Market: - transactions take place at a specified future date, at forward rate.  participants are: arbitrageurs, traders, hedgers, and speculators  It is the act of reducing exchange rate risk. Financial markets 55  Spot versus forward exchange rates i. Spot exchange rate: is the rate existing on the day of the transaction. i. Forward exchange rate: is the exchange rate fixed today at which future transaction is exchanged. Financial markets 56  Bid-Ask Spread used to calculate the fee charged by the bank  Bid = the price at which the bank is willing to buy  Ask = the price at which the bank will sell the currency Financial markets 57  The derivatives market is the financial market for derivatives.  Derivative financial instruments are: ◦ Forward contract, ◦ Futures contracts, ◦ Options & ◦ Swap  which are derived from other forms of assets. Financial markets 59  A Derivative is a tradable financial instrument whose value depends on the value of the underlying asset.  Very often, the underlying derivatives are the price of the traded asset.  For example, a stock future is a derivative whose value depends on the price of the stock.  Derivative securities provide a number of useful functions in the area of risk management and investment. Financial markets 60  For example, ◦ A wheat farmer can fix the price of his crop before harvest to eliminate price risk. ◦ An importer can fix a foreign exchange rate before any trade arrangement to eliminate foreign exchange risk. Financial markets 61  A forward contract: is an agreement that obligates the holder to buy or sell an asset at a predetermined delivery price during a specified future time.  The buyer of a forward contract agrees to take delivery of an underlying asset at a future time, T, at a price agreed upon today.  The seller also agrees to delver the underlying asset at a future time, T, at a price agreed upon today. Financial markets 62  A forward contract, therefore, simply amounts to setting a price today for a trade that will occur in the future.  These contracts are traded in over-the- counter market(OTC) rather than on exchange market-usually between two parties. Financial markets 63  A future contract: is an agreement that obligates the holder to buy or sell an asset at a predetermined delivery price during a specified future time.  It is similar to a forward contract except for some differences.  Future contracts are traded in an exchange market. Financial markets 64  Because of its daily settlement procedure, intermediate gains or losses are posted each day during the life of the future contract. This feature is known as marking -to -market.  To make the trade possible, the exchange specifies certain standardized futures of the contract, like: ◦ Contract size (number of units delivered in one contract) ◦ Delivery date ◦ Quality of the underlying asset Financial markets 65  Forward Future - Private contract b/n -Traded on an two parties (OTC) exchange - Not standardized - Standardized contract - Settled at the end - settled daily of contract - Some default risk - no default risk Financial markets 66  It is the right to buy or sell an asset.  In option the counter parties are: ◦ The maker/writer ◦ The buyer/holder – this will have the right/option to choose to sell or to buy the asset.  There are two types of options: ◦ Call option ◦ Put option Financial markets 67  Call option: it gives the holder the option or the right to buy an asset by a certain date for a certain price.  Put option: it gives the holder the option or the right to sell an asset by a certain date for a certain price. Financial markets 68  Call Option – ◦ If you buy a call you have limited loss & unlimited gain ◦ If you sell a call you have limited gain but unlimited loss if you do not own the underlying security – naked option)  Put Option – ◦ If you buy a put you have limited loss and unlimited gain ◦ If you sell a put you have limited gain and your loss is limited to the exercise price of the asset in the contract. Financial markets 69  The date specified in the contract is known as the expiration date or maturity date.  The price specified in the contract is known as the exercise price or strike price.  Options can also be classified in to two based on the date to exercise the right: ◦ American option: it can be exercised at any time up to the expiration date. ◦ European option: it can be exercised only on the expiration date. Financial markets 70  A swap is an agreement between two parties to exchange cash flows in the future at the agreed upon (notional) amount.  Swap can be: ◦ Interest rate swap ◦ Currency swap  Interest rate swap: it involves the exchange of interest payment.  Currency swap: it involves the exchange of different currencies Financial markets 71 END OF THE CHAPTER! ! ! Financial markets 72