Introduction to Financial Instruments and Financial Markets PDF

FI Lecture 1 in brief Introduction to Financial Instruments and Financial Markets ENSAE Fanny.Vidal@ensae...

FI Lecture 1 in brief Introduction to Financial Instruments and Financial Markets ENSAE [email protected] Summary Institutional investors are organizations that invest money, trade securities in the market on behalf of other people or organization. Lecture 1 gives you an overview of the financial markets, and the main build- Types of Funds ing blocks for the understanding of financial instruments. All the financial instruments described in this course will be reviewed and Regulated or Registered Investment Funds deepened through the next lectures. Exchange Traded Fund (ETF) is a fund whose shares trade on stock exchanges Keywords: financial system, financial markets, financial instruments, secu- and replicates stock index. rities, derivatives, exchanges vs over-the-counter markets, clearinghouse / Pension funds are large pooled investment funds which provide retirement CCP, margin, primary market vs secondary market, buy-side vs sell-side, income. funds, IPO*, money markets, capital markets, stock, options, futures, for- Collective Investment Schemes (CIS) or “Organismes de placement collectif wards, bonds, repos, floating rate notes, swaps (IRS, CRS, CDS*), securitiza- en valeurs mobilières” (OPCVM) are financial intermediaries that give their tion*, ABS*, MBS*, CDO* subscribers the possibility of investing on financial markets to which it would be difficult for them to have access otherwise (foreign financial and money mar- *: good to know, but out of scope of the exam kets, unlisted shares...). - Main activity of CIS: collecting funds and issuing securities to various agents Global Overview of Financial Markets (private individuals, companies, etc.) with a view to acquiring financial assets. - 2 types of CIS based on its organisation: Definitions – Open-end Investment Companies (OEIC) or “Sociétés d’Investissement à Capital Variable” (SICAV) which are companies with a board of directors A financial system consists of: and, 1. Financial markets – Mutual funds or “Fonds communs de placement” (FCP) which are not legal 2. Financial instruments entities and are created on the initiative of a management company or a bank 3. Financial institutions serving as custodian 4. Financial services Unregulated (or Loosely Regulated) or Unregistered Investment Funds 5. Money (means of payment) Private Equity refers to asset managers who make equity investments in com- panies that are not publicly traded (e.g. start-ups) 1. Financial markets include any (physical or virtual) market place or system that Example: venture capital, type of financing that investors provide to startup provides buyers and sellers the means to trade financial instruments. companies and small businesses that are believed to have long-term growth 2. Financial instruments are legal contracts between two or more parties, which potential can be traded and settled, that define conditions under which one party (the Hedge Funds are open to a small number of qualified investors, such as pen- buyer) receives benefits (financial asset) and the other party (the seller) incurs sion funds, and wealthy individuals. They use complex trading, portfolio con- costs (financial liability or equity instrument). struction and risk management techniques to improve performance such as leverage, short-selling, and derivatives. 3. A collection of financial instruments is called: Family office is a privately held company that handles investment manage- a portfolio if hold by an investor, asset manager, fund manager; ment and wealth management for a wealthy family, generally one with at least a book if run by a broker, or; $50–100 million in assets, with the goal being to effectively grow and transfer a trading book if run by a trader. wealth across generations. 4. Financial institutions (FI) are companies providing financial services by the Buy-Side vs Sell-Side form of financial and monetary transactions such as deposits, loans, invest- Buy-side is the side of the financial market buying and investing large portion ments, and currency exchange. of securities, such as fund manager. Financial institutions include a broad range of business operations within the financial services sector, including banks, insurance companies, brokerage While, sell-side is the other side of the financial market which deals with the firms, and asset managers. creation, promotion and selling of traded securities to the public, such as sales. 5. Money is a liquid asset that has 3 main functions: (i) a medium of exchange be- Who are the players in financial institutions? tween 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 Active players: Other players: save capital market-makers quantitative analysts traders analysts and researchers brokers risk managers Players dealers regulators 4 types of financial market participants: hedgers treasurers 1. retail investors, including households and individuals; arbitrageurs 2. firms (e.g. corporates); speculators 3. governments (e.g. French Ministry of Debt); structurers 4. financial intermediaries, grouping into: sales (a) monetary financial institutions, such as banks, central banks, or pension fund managers funds. They are traditionally regulated. Arbitrageurs are is an investor who exploit market inefficiencies by making (b) non-bank financial intermediaries, such as hedge-funds or family offices. simultaneous trades that offset each other to capture risk-free profits. A non-bank financial intermediary does not accept deposits from the general Brokers provide a platform where the buyers and sellers can get together. Con- public, provides services similar to traditional commercial banks but outside trary to dealers, they do not hold inventories, and act as intermediaries be- normal banking regulations (shadow banking). tween an investor and a securities exchange which accept only orders from The first 3 participants are part of the so called ’real economy’. members of the exchange. 1  FI Lecture 1 in brief Introduction to Financial Instruments and Financial Markets ENSAE [email protected] Hedgers take an equal but opposite position in the futures market to the one Accepting deposits and providing loans held in the cash market to avoid the risk of an adverse price move. Creating money Market-markers make markets by quoting bid and ask prices for financial in- Transmitting monetary policy struments held in inventory. Making profit Can you define the bid and ask prices? Assets Liabilities – A bid price (or the bid) is the highest price that a buyer (i.e. bidder) is willing Cash Due to Central Banks to pay for a goods. Loans and Leases Deposits – An ask price (or offer) is the lowest price that a seller is willing to sell the - Mortgages - Deposit Accounts asset. - Consumer Credit - Savings Deposits You SELL at BID and BUY at ASK price (generally, bid ≤ ask) - Credit Cards - Term Deposits Interbank Loans Interbank Funding Investment in Securities Short-term Debt Purposes - Sovereign Bonds Subordinated Debt Merton and Brodie (1995) defined 6 functions of the financial system: - Corporate Bonds Reserves 1. Clearing and Settling Payments Other Assets Equity Capital 2. Pooling Resources and Subdividing Shares Table 1: A simplified bank balance sheet 3. Transfering Resources across Time and Space Primary Market and Secondary Market 4. Managing Risks There are two types of financial markets: 5. Providing Information 1. Primary Market, also called New Issue Market, where companies issue a new 6. Dealing with Incentive Problems security, not previously traded on any exchange, in particular in the form of Financial markets enable efficient allocation of resources across time and initial public offerings (IPOs), capital increases or bond issues. space, through the trading of financial instruments. Main purpose: to raise funds 2. Secondary Market, where existing financial instruments are traded among in- 1. Financial markets help to finance the economy vestors. Companies can raise capital, either by issuing bonds (debt securities) or Main purpose: to provide liquidity and facilitate risk management shares (titles of property). Bonds are issued via underwriting from banks and then traded on secondary States can issue (only) government bonds (e.g. Agence France Trésor (AFT) market via brokers and dealers. manages the French sovereign debt with Obligation Assimilable du Trésor (OAT)). Equities are first issued in a primary market via an initial public offering (IPO) or a follow-on public offering (FPO) then traded on exchanges in secondary 2. Financial markets allow transfer of risk (asset transformation), generally markets. through derivatives (hedging instruments) ⇒ diversification FI serve as intermediaries within the financial markets. Over-The-Counter Market and Organized Market 3. Financial markets help to provide liquidity and information, protecting in- There are two types of secondary markets: vestors from incentive problems (e.g. frauds, inside trading) Over-the-counter markets (off-exchange) where traders, fund managers and corporate treasurers contact each other directly. Types Trades are customized contracts. Examples: Foreign exchange, Bond market There are commonly two types of financial instruments: Organized markets (on-exchange) where all the transactions pass through a 1. Cash Instruments: central source, a central clearing house. a financial asset, which is a legal claim on a real asset (e.g. a property, a com- They may be electronic or open-outcry exchanges. modity, cash (but no cryptocurrencies) or gold); Trades are standardized contracts. a financial security, which is a tradable legal claim on a firm’s assets or in- Examples: New York Stock Exchange (NYSE), Chicago Board Options Exchange come that is traded in an organized market (e.g. securities, such as bonds and (CBOE), London Metal Exchange (LME) shares); How an exchange market works? What is a clearinghouse? Settlement takes place immediately (e.g. t+2, based on market conventions) Each futures exchange has its own clearinghouse. 2. Derivative Instruments, which are contracts on one or more underlying assets. A clearing house acts as an intermediary between buyers and sellers of finan- A derivative is an instrument whose value is derived from the value of another cial instruments, and responsible for settling trading accounts, clearing trades, asset, the underlying, which does not have to be a traded asset or an interest rate collecting and maintaining margin monies, regulating delivery, and reporting but must be measurable (e.g. futures on carbon emissions). trading data. Settlement takes place at pre-specified future date (futures) or within a pre- specified time period (option). The purpose of a clearing house is to improve the efficiency of the markets and add stability to the financial system. Financial instruments may also be divided according to an asset class Clearing is the process of guaranteeing financial market transactions between 1. Equity-based financial instruments, that are ownership of an asset. the execution of transaction and its settlement. 2. Debt-based financial instruments, that represent a loan made by an investor to the owner of the asset. Explain the differences between a clearinghouse and a central counterparty 3. Foreign exchange instruments, which involve more than two currencies and clearinghouse (CCP) traded in the Foreign exchange market. CCPs are clearinghouses for OTC derivatives that are similar to exchange clear- NB: Real assets and securities are ON balance sheet, while derivatives are OFF ing houses. balance sheet. Explain the differences between initial margin, maintenance margin, variation Can you describe the bank balance sheet and the purposes of the bank? margin and margin call. Role of banks: initial margin: deposit amount required at the beginning if the transaction; 2  FI Lecture 1 in brief Introduction to Financial Instruments and Financial Markets ENSAE [email protected] maintenance margin: slightly smaller amount that must be maintained in the Securitization* trader’s account in order for them to continue to hold their trading position; variation margin: difference between initial margin and margin account Securitization is the financial practice of: margin call: broker’s demand that an investor deposit additional money so 1. pooling various types of contractual debt such as residential mortgages, com- that the account is brought up to the initial margin. If the investor’s funds mercial mortgages, auto loans or credit card debt obligations and; don’t arrive promptly, the broker may liquidate part or all of the position to 2. selling their related cash flows to third party investors as securities, which may end the margin call. be described as bonds, pass-through securities, or collateralized debt obliga- tions (CDOs). Structure of Financial Markets Which markets are the most important in terms of outstanding amounts? IR and FX markets represent roughly 97% of the notional size of the OTC market. Overview 1. Money markets: short-term debt market (with maturity less than 1Y), such as Which financial instruments are traded the most? certificate of deposit (CDs), or deposits (depos), commercial papers (CPs), Trea- Interest Rate Swaps (IRS) (with $400 trillion of outstanding amounts at end-June sury bills (T-Bills), banker’s acceptances and reverse/repurchase agreements 2021) represent 2/3 of the OTC Market and are the most bilaterally traded finan- (reverse repos/repos) cial instruments (Source: BIS) 2. Bond markets: Long-term debt market, e.g. Bonds, notes, and Floating Rate Notes (FRNs) Why using a financial instrument? 3. Stock markets capital raising 4. Foreign exchange markets consumption smoothing 5. Derivatives markets e.g. forwards, swaps and options for different asset risk management classes (IR, FX, Equity, Credit and Commodity) speculation 6. Energy and Commodity markets 7. Credit markets e.g. high-yield bonds, corporate bonds, credit derivatives or CDSs 8. Securitization e.g. Structured products MBS, CDO, ABS Description of Some Financial Instruments Money market + Bond market (incl. MBS) = Fixed income securities Bond market (incl. MBS) + Stock market = Capital market Fixed-income Securities Let’s note that financial instruments from the capital market are traded either in the primary or secondary market, while derivatives are traded either on the exchange or in the OTC market. Money-Market Instruments Certificate of deposit (CD) is an unsecured (i.e. not backed by any form of Securities collateral) short-term debt issued by banks. There are two main types of securities: Commercial paper (CP) is a form of unsecured short-term debt commonly is- 1. Fixed income securities, e.g. money market instruments, bonds sued by companies to finance their short-term liabilities. Have a defined maturity and carry a regular periodic payment called a coupon Treasury bill (T-bill) is a short-term debt obligation issued by sovereign gov- - typically fixed but can be floating ernments, with a maturity of one year or less. Are subject to credit risk of the issuer Repurchase agreement (repo) is the sale of a security with a commitment by 2. Equity, e.g. shares on common stock the seller to repurchase (buy back) the security from the purchaser at a specified In case of default, bond holders have preference claim over shareholders regard- amount and at a specified date. ing capital recovered. Reverse repurchase agreement (reverse repo) is the opposite transaction. What are the main differences between bonds and stocks? Uses: 1. Stockholders have an equity stake in a company (i.e. they are owners), whereas to provide short-term liquidity bondholders have a creditor stake in the company (i.e. they are lenders). 2. Bonds usually have a defined term, or maturity, after which the bond is re- deemed, whereas stocks typically remain outstanding indefinitely, exception Bonds with the irredeemable bond or perpetual bond which has no maturity. A bond is a type of security under which the issuer (debtor) owes the holder What are the main differences between bonds and loans? (creditor) a debt, and is committed to repay the principal (i.e. amount bor- Bonds are traded in the bond markets, while loans are delivered by banks rowed) of the bond at the maturity date as well as interest (called the coupon) mostly. over a specified amount of time. Government or financial institutions usually sell bonds, while corporates and – When the coupon rate is fixed, bonds are called standard or bullet bonds, individuals borrow loans. otherwise non-standard bonds or non-bullet bonds. A green bond is a fixed-income financial instruments (bonds) which are used Derivatives to fund projects that have positive environmental and/or climate benefits. There are two main types of derivatives: An inflation-Indexed bond is a bond whose coupons and principals are in- 1. Contingent claims, such as options dexed to future inflation rates. 2. Forward claims, such as futures and forwards Uses: There are always two counterparties to a derivatives transaction - the buyer (long Bonds provide the borrower with external funds to finance long-term invest- position) and the seller (short position). ments or, in the case of government bonds, to finance current expenditure. 3  FI Lecture 1 in brief Introduction to Financial Instruments and Financial Markets ENSAE [email protected] Securitized Products* Uses: for banks, insurers, asset managers: hegding credit risk An asset-backed security (ABS) is a type of financial investment that is col- lateralized by an underlying pool of assets - usually ones that generate a cash for hedge funds, banks: leverage flow from debt, such as loans, leases, credit card balances, or receivables, but no mortgages. Collateralized Debt Obligations* A mortgage-backed security (MBS) is a specific type of ABS whose collateral Collateralized Debt Obligations (CDOs) are tranched products because of the is a pool of mortgage loans. tranching or cutting up of a pool of assets, and credit correlation products be- cause of built-in correlation risks (and leverage) within the tranches. Equity Instruments 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 Equities notes against an investment in cash flows of an underlying pool of assets. CDOs were developed as repackaging structures for high-yield bonds and illiq- Equity securities are commonly called shares (or stocks). Shares represent in- uid instruments such as certain convertible bonds. terest in ownership of companies or corporations and are claims on the residual value of this company or corporation after the claims of all creditors have been Uses: met. Shares may be listed or unlisted, and may be ordinary or preferred shares. Banks and financial institutions use CDOs to diversify their sources of funding, manage portfolio risk, and obtain regulatory capital relief. Derivatives Options Options are financial derivatives that give the holders the right, but not the obli- gation, 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. Forwards 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. Futures A futures is like a forward contract but traded on an exchange market, with spe- cific maturities and more standardized contracts. Swaps A swap is an agreement 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. Uses: to change the nature of the cash-flow to reduce interest rate risk and foreign exchange risk Credit Derivatives* 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 con- tract, e.g. bankruptcy, restructuring or liquidation of a company. 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. 4