Create base on the Revision slide on Black Board

Topic 1 – Intro to Financial Markets

Functions of the financial system
-To facilitate the transfer of funds from surplus economic units to deficit economic units, in
primary markets, by the creation of new financial assets
-To facilitate the trade of existing financial assets in secondary financial markets.

Attributes of financial assets

Return or yield
– Total financial compensation received from an investment expressed as a
percentage of the amount invested
• Risk
– Probability that actual return on an investment will vary from the expected return
(or variation in expected return)
• Liquidity
– Ability to sell an asset within reasonable time at current market prices and for
reasonable transaction costs

 Time-pattern of the cash flows

– When the expected cash flows from a financial asset are to be received by the
investor or lender

Classification of financial markets

• Primary and Secondary
 Markets in which financial assets are first created and Markets in which existing financial
assets are traded
• Money (<1 year) and Capital (>1 year)
• By type of financial assets traded:
 Money Market (topic 3)
 Foreign Exchange (topic 4)
 Debt-Capital Market (topic 5)
 Equity Market (topic 6)
 Derivatives Market (topic 7)

Methods of finance
Direct
Funds are transferred directly from surplus economic units to deficit economic units
Primary financial assets are issued directly from deficit units to surplus units
Financial institutions play a role in direct finance by providing financial services, such as financial
advice, underwriting, etc., in return for fees and commissions
Indirect
Also known as intermediated finance
Financial institutions act as intermediaries, borrowing from surplus units and lending to deficit
units
Primary financial assets are issued by deficit units to intermediaries, and secondary financial
assets are issued by intermediaries to surplus units
Financial institutions earn income by way of net interest margin
Advantages of financial intermediation

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 • Asset value transformation
• Maturity transformation
• Credit risk reduction and diversification
• Liquidity provision
Disadvantage:
• Increased cost of funds for borrowers
• Reduced return from lending for savers

Topic 2: The Flow of Funds and Determination of Interest Rates

Nature of interest rates
The cost of borrowing funds
The rate of return from lending
The opportunity cost of holding money
The time value of money

Interest rate calculations

Simple interest Compound interest

FV =PV +I t
Where
FV =PV ( 1+i )
FV=Future Value
PV=Present Value
I =Interest

m
i
Effective interest i e= 1 +
m (
Where: ‘ie‘ represents the effective interest rate
) −1

‘i’ represents the nominal annual interest rate

‘m’ represents the number of compounding periods in the year

Price of a discount security FV

PV =
(1+ yt )

Determination of the level of interest rates

Loanable fund theory
• The level of interest rates (i.e. the price of loanable funds) is determined by the
demand and supply of loanable funds.
• Loanable funds are the funds available in the financial system for lending
Two main factors affecting the D and S of loanable funds
• Inflationary expectations ( eg Inflation increase -> interest rate increase)

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 • Central Bank Action: Monetary and fiscal

Structure of interest rates

Term structure of interest rates
Shows how interest rates vary with term to maturity for otherwise identical financial assets (eg.
Gov’t bonds with different maturities).
= Rates are a function of time
Risk structure of interest rates
Shows interest rates vary with default risk
for otherwise identical financial assets
(eg. 10 year gov’t bonds and 10 year corporate bonds)
= Rates are a function of risk

Three theories to explain the shape of a yield curve:

Market (pure) Expectations
The term structure of interest rates is determined by:
Current short-term rates
Expected future short-term rates
Predicts that long-term rates will be the average of the expected future short-term rates over the
period

Expectations plus Liquidity premium

• In order to encourage investors to invest long-term, borrowers must offer higher returns for
long-term investments - a liquidity premium
• Predicts that the yield curve will show an “upward bias” compared to the yields predicted by
pure expectations

Segmented Market approach

• Markets for financial assets with different terms to maturity are seen as separate markets
from each other
• Predicts that yield for different maturities will be a function of supply of and demand for
investments with that maturity
• Assumptions:
• Investors see investments with different maturities as imperfect substitutes
• They are primarily concerned with matching the maturity of assets and liabilities in
order to minimise risk

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Topic 3: Money Markets
Only debt financial assets less than one year are traded in the Money Market

Types of M/M instruments

Cash products
Lending normally takes place on an unsecured basis
The size of loans or deposits vary but two main terms are:
11.00 am or overnight money
7-day cash or 24 hour cash
term fixed for 7 days and then at 24-hour call
rate is reset daily after the initial period
Commercial bills,
Drawer (borrower)
Acceptor/Drawee/Guarantor
Discounter (lender)/ Investor
If the bill is sold in the secondary market, it must be endorsed, which incurs a “contingent liability”
P-notes,
Also known as:
Discount Securities Promissory Notes , Commercial Paper or ‘One name paper’ as there is no
acceptor
Essentially an IOU
Only issued by large companies with excellent credit ratings
No endorsement is required if sold in the secondary market. So traders have no contingent liability
Higher yields than BAB’s because P-Notes are riskier than BAB’s
T-notes,
• Essentially P-notes but issued by the Gov’t rather than corporations
• Maturities are 5, 13 and 26 weeks
• Considered to be the most liquid instrument beside cash.
• Lower yields than BAB’s because of lower risk (gov’t securities)
• Main purchasers of T-Notes are banks and NBFI’s
Negotiable Certificates of Deposit
• Similar to a P-Note but issued by a bank rather than a corporation
• Yields are the same as those on BAB’s (they both carry the bank’s credit rating)
• Maturities range up to 180 days
• Minimum amount is usually $50,000
• The short-term money market has an active secondary market in CDs
• Calculations—use discount securities formulae

Alternative sources of short term finance

• Bank Overdrafts or Lines of Credit
• Trade credit
– Using credit terms from suppliers to delay payment of invoices
• Accruals
– Delaying payment of obligations such as tax and leave entitlements
• Accounts Receivable Finance and Factoring

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Topic 4: Foreign Exchange Markets
• Standard convention in Vietnam is for USD to be the base currency (or commodity currency)
and VND the terms currency
– Eg. USD/VND = 20,850 or 1 USD = 20,850 VND
Base / Terms
Participant : Dealers/ Corporations/ Brokers/ Central bank

Types of FX transactions:

Spot:
• The most often quoted rate
• The exchange will take place 2 business days after the deal is done
• Eg. If the deal is done on Monday, the delivery (or settlement) date is Wednesday
• Intervening weekends or public holidays will delay the settlement date
Short-dated:
• TOD contracts
– The exchange will occur “today” (the day on which the deal is done)
• TOM contracts
– The exchange will occur “tomorrow” (the next business day
Forward.
• The exchange will take place 3 or more business days in the future
• The most common settlement periods are 30 - 180 days
• The settlement period is the period beyond the spot settlement date
Rather than quoting actual forward rate, dealers will quote “forward points”
• To get the forward rates, either add (or subtract) the forward points to (from) the spot
rates.
• Forward Rate = Spot Rate +(-) Forward points
• The spot rate is always “low-high”
• If the forward points are “low-high”, they must be added to the spot rate
• If the forward points are “high-low”, they must be subtracted
• The spread always gets larger in the forward market
• Example
• Spot AUD/USD = 0.8446/56
• 1 month fwd points = 14/13 (high/low => subtract)
• 1 month fwd rate = 0.8432/43
• Example
• Spot USD/JPY = 110.25/40
• 1 month fwd points = 10/12 (low/high => add)
• 1 month fwd rate = 110.35/52

1+r terms t
f comm/terms=Scomm /terms
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[ 1+r comm t ]
Two-way pricing :
Bid/offer = price maker buy/sell

Cross rates – calculations

Cross rates with bid/offer spread
• Example: Find AUD/EUR, given:
AUD/USD = 0.8446/56
USD/EUR = 0.7975/85
• Bid rate= 0.8446 x 0.7975
= 0.6736
• Offer rate = 0.8456 x 0.7985
= 0.6752
• AUD/EUR = 0.6736/52

FX swaps (spot contract + fwd contract of same currency)

• An FX swap is created when a currency is purchased in the spot market and simultaneously
sold in the forward market, or vice versa.
• Involves a spot and a forward contract of the same currency
• It can be used to hedge the risks of a continuous series of exposures (eg. importing or
exporting)
• Eg. ABC co. borrows USD funds for 3 months, in order to avoid exchange rate risk:
• It would sell USD in the spot market (to convert USD funds into VND); and
• Simultaneously, buy USD in the 3-month forward market (to fix the FX rate for
repayment of the funds)
• This is called a “sell/buy FX swap”
• In an FX swap, the underlying spot rate is irrelevant. Only the difference between the spot
and forward rates is relevant.
• This is why dealers quote forward points instead of outright fwd rates
• For this reason, forward points are sometimes referred to as “swap points”

Exchange rate determination: Supply and Demand

• The exchange rate for a currency is determined by the buying and selling decisions of those
who trade in the FX market
• Market forces will establish the level of supply and demand
• The equilibrium exchange rate will be established by the interaction of supply and demand

Determinants of the FX value of a currency:

– Relative interest rates
• The traditional view was that an increase in interest rates would have the following effects:
– Encourages capital inflow, increasing demand for the AUD
– Discourages capital outflow, decreasing supply of the AUD
• The net effect would be an appreciation of the AUD
– Relative inflation rates
If Australia has higher inflation than its trading partners, it will experience:
– Less demand for Australian exports, and therefore less demand for AUD => D curve
for AUD shifts to left
– More demand for imports, and therefore more supply of the AUD => S curve for
AUD shifts to right
=>The above two effects => a fall in the value of AUD

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 – Relative eco. Growth rates
• One effect of higher levels of economic growth is an increased demand for imports
– This will increase the supply of the AUD, and shift the supply curve to the right
• Another effect could be to increase the level of overseas investment (ie. increase in capital
outflows)
– This will increase the demand for the AUD, and shift the demand curve to the right

 Unpredicted in rate but increase quantity

Topic 5: Debt Capital Markets

Key features of a standard domestic bond
• Face value
– The amount to be repaid on maturity
• Coupon rate
– The annual rate of interest.
Annual Interest Amount = Face Value x Coupon rate
• Maturity Date
– The date on which the bond matures
• Term to maturity
– The period of time between now and the maturity date
• Price
– The present value of the cash flows to be received by the bond-holder
• Yield
– The rate of return if the bond is held to maturity
– “Market yield”

Bond pricing – calculations

n Ct
P=∑ t
t =1 ( 1+k d )
P= Price of the bond
C t = Cash flow at time period t
k d = Market yield per period or required rate of return for debt
n= Number of cash flows or number of periods
n
INT t FV
P=∑ t
+ n
t =1 ( 1+ k d ) ( 1+ k d )
• The price is inversely related to the market yield

• If yield > coupon rate, price < face value.

Bond trades at a discount.
• If yield < coupon rate, price > face value.
Bond trades at a premium.

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 • If yield = coupon rate, price = face value.
Bond trades at par.
Relationship between bond price and market yield (market interest rate)
Can establish the following relationships
 rise (fall) in market yields leads to fall (rise) in market value of financial assets
 price of longer term bonds, all else being equal, more sensitive to changes in market
yields
 price of low coupon bonds, all else being equal, more sensitive to changes in market
yields

Differences between domestic bonds, foreign bonds and euro-bonds.

• Domestic bonds
– Bond issue into a local market, in the local currency, by a local company
• Foreign bonds
– Bond issue into a foreign market, in the local currency of that market
• Eurobonds
– Bond issue in a currency other than the currency of the market in which it is issued

Other sources of medium to L-T finance:

Term loans
• Short-term loans
– A “rolling” series of short-term loans gives effective access to medium-term funds
• Bank bills (direct finance)
– A bank bill facility enables a company to access medium-term funds through a series
of bank bills
• Sometimes referred to as “fully drawn advances” to distinguish them from overdrafts
• Offered by commercial banks, merchant banks, finance companies
• Can be tailored to suit the needs of the borrower
• The interest rate is usually variable

Mortgage finance
• A mortgage is a form of security for a loan
• The borrower (mortgagor) conveys an interest in the property/land to the lender
(mortgagee)
• The mortgage is registered on the land title
• The mortgage is discharged when the loan is repaid
• If the mortgagor defaults on the loan, the mortgagee is entitled to foreclose on the property
• Mortgage loans can be either residential or commercial

Lease finance
• Instead of borrowing money to buy an asset, lease finance is essentially borrowing the asset.
– Common types of assets: office equipment (eg. Computers, office furniture), cars
and machinery
• The lessee pays a periodic lease payment to the lessor
• To qualify as lease finance (rather than a rental agreement) the lease is not cancellable by
the lessee.
• Finance companies, banks and merchant banks are main providers of lease finance
Advantages of leasing
 Conserves capital
 Provides 100% financing

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  Matches cash flows (i.e. rental payments with income generated by the asset)
 Less likely to breach any existing loan covenants
 Rental payments are tax deductible

Topic 6: Equity Capital Market

Debt vs Equity
• Equity involves ownership
• Equity v. Debt
 Perpetuity vs defined maturity
 Residual vs contractual claim
 Variable vs fixed return
 “Risk capital” vs moderate risk
 Share market: A formal exchange facilitating the issue, buying and selling of equity
securities. Both a retail and wholesale market.
• Participant:
Broker
Investors
Private/ Institutional/ Overseas
Stock exchange
Companies

Methods of raising equity capital (advantages & disadvantages of each)

Private placement
Shares are placed privately with a large investor or institutional investor (eg. a mutual fund)
Advantages:
Least expensive method
Quick
Higher subscription price
No need for a prospectus
Disadvantages
Some lack of liquidity for investor in short term
Dilution of existing shareholdings
Private placements must be approved by existing shareholders and the stock exchange
Restricted to 10% of company’s issued capital in any one year
Public offer
Involves inviting the public at large to subscribe to shares
• Advantages
 Larger amounts of capital can be raised than with other methods of raising equity
capital
• Disadvantages
 Costly (a prospectus is required)
 Lengthy process
 Often heavily discounted subscription price
 Dilution of existing shareholdings

Rights issue
Rights are given to existing shareholders to purchase new shares at a discounted price

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Rights granted on a pro-rata basis
Advantages:
No dilution of existing shareholdings
Disadvantages:
As with public offer
Lengthy and costly process
Often heavily discounted subscription price

Right to buy new shares can be renouncable or non-renouncable

 Renounceable
 The rights can be sold separately from the shares in the secondary market and
exercised by the buyer
 Non-renounceable
 The rights cannot be sold separately
 If they are not exercised by the shareholder, they will lapse
 Most rights issues are renouncable as this is in the interest of shareholders

Equity instruments: ord. shares, pref. shares, convertible bonds, etc

Ordinary shares
• The most common instrument traded in the equity market.
• Represent an ownership interest
 Each shareholder owns part of the company
 Ownership is proportional to the number of shares held
• Represent a residual claim
 collectively own the company and profits that remain after contractual claims met
 no legal requirement for company to pay dividends at particular rate or at all
• Other rights accrue to equity holders:
 Right to vote at the Annual General Meeting (AGM) including right to appoint
Directors
 Limited liability
 Irredeemable (no maturity date)
Preference Shares
 Receive preferential ranking in the payment of dividends and distribution of company’s
assets should it be liquidated
 still rank behind debt holders but ahead of ordinary shareholders
 Usually receive a fixed dividend set at time of issue
 Subject to less risk than ordinary shareholders
 Referred to as hybrid securities
 Have features of both debt and equity
 Technically equity as dividends paid out of company’s after tax profits (Interest
payments to debt holders are tax deductible)
 Some features of preference shares are highly flexible
 Cumulative Preference Shares
 Dividends which are not paid or paid in full accumulate and must be paid in future
years
 if the shares are non cumulative, no need to make up short fall in subsequent years
 Participating Preference Shares
 shareholders “participate” in extra profits along with ordinary shareholders
 Non participating preference shares can never be paid more than the fixed dividend
 Redeemable Preference Shares

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 can be sold back to the company at specified price under certain conditions
 company may also have right to buy back shares at specified price under certain
conditions
 if non redeemable - no right of sale or purchase exists

Convertible bonds
• Corporate bonds give the holder the right to convert to shares
• Give the investor exposure to the equity market
• May be a “cheaper” form of debt for the company
• Represents a way of issuing shares
• Are usually unsecured
• Usually issued at lower coupon rate than “straight” bonds
Share options
• Give the holder the right (but not the obligation) to buy shares at a fixed (preset) price on or
before a certain date
• The company receives the premium on the options, and then the subscription price if and
when they are exercised
• Included in remuneration packages for its executives
Warrants
• There are differences between countries as to what exactly constitutes a
warrant.
• In Australia, it is generally taken to mean an option (over shares) issued
by an Australian Securities and Investments Commission (ASIC) approved
investor - usually a registered bank.
• It is distinguished from company options that are issued by companies
themselves.
Distribution of earnings: dividends, bonus dividends, bonus shares
Dividends
• The most common method of distribution of earnings
• Expressed as cents per share
• At the discretion of management/board of directors
• Shareholders have the option of dividend reinvestment
 Buy new shares
 Avoid stamp duty and brokerage fees
Bonus shares
• Issued at no cost on a pro-rata basis to existing shareholders eg. 1 bonus share for every 5
existing shares
• Increase the number of shares but don’t add value to the company
• In theory, the capital of the company is distributed over a larger number of shares, and the
values of all shares will fall
• Bonus share may be a good idea if:
• The market interprets the issue as good news and share values rise
• It is believed that the company can maintain the current dividend rate
• It is the intention of the company to reduce the value of shares to make them more
accessible

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Topic 7: Derivatives Market
What is a derivative?
• A financial asset which derives its value from the value of some other asset, rate or index
 Future contract on gold is based on actual price of gold in spot or physical
market
 Future contract on interest rate may be based on a 90-day BAB or 10-year T-
bond rate
• Variation in the value of the underlying asset will result in variation in the value of the
derivative
• The main reason for using derivatives is risk management
• Hedging - to reduce the overall level of risk (and possibly the expected return)
• Speculation - to increase the level of risk in expectation of a profit

4 main types of derivatives:

Forward contracts
• The fundamental type of derivative products
• Other types of derivatives represent variations on forward contracts (eg. options, futures
and swaps)
• Not standardized, flexible, negotiable and traded over-the-counter (OTC)
• A contract to buy or sell a commodity at a fixed price on a fixed date in the future
• Two parties with opposite exposures can use a forward contract to eliminate risk for both
parties
Advantages
• Flexible in terms of amount, time period, price.
• No premium is payable
Disadvantages
• Difficult to find a counterparty (can be overcome by using an intermediary like a broker or a
bank. Intermediaries quote 2-way prices )
• Difficult (or almost impossible) to get out of, or unwind, a forward contract.
• Credit risk of the counterparty (risk of default or dishonouring the contract).
• No “upside” benefit if price moves in your favour
Futures
• Futures contracts are forward contracts that are standardised with respect to:
 the underlying asset (e.g. gold, wool, oil, financial assets etc.)
 the size of the contract (such as 100oz of gold, 1000 barrels of oil)
 the expiry date of the contract
• Standardisation allows for the development of a secondary market

• If you buy a futures contract (or “go long”), you are entering into a contract to buy the
underlying asset for the agreed price on the maturity of the contract.
• If you sell a futures contract (or “go short”) you are are entering into a contract to sell the
underlying asset in the future
• To unwind (or close out) a futures position, you buy the same contracts that you have sold,
or vice versa

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CASE 1: If you plan to BUY a commodity in the future, a price rise will hurt you, so you should BUY
a futures contract.
• If the physical price rises,
– the value of the futures contract will increase,
– and you will make a profit in the futures market
– to offset your loss in the physical market
• If the price falls,
– the value of the contracts will fall,
– and you will make a loss in the futures market,
– but you will make a profit in the physical market
Case 2: If you plan to SELL a commodity in the future, a price fall will hurt you, so you should SELL
a futures contract
• If the physical price falls,
– the value of the futures contract will decrease,
– and you will make a profit in the futures market
– offset your loss in the physical market
• If the price rises:
– the value of the future contract will rise,
– and you will make a loss in the futures market (when you buy them to close
out your position )
– but you will make a profit in the physical market
Speculation with futures
• If you buy or sell futures without an existing exposure, you are speculating on future price
movements
• If you expect the value of the contract to increase, you will buy
• If you expect the value of the contract to decrease, you will sell

Swaps
• A swap is an agreement between two parties to exchange cash flows based on some agreed
basis.
• Some of the most common are:
 Interest rate swaps
 Currency swaps
 Commodity swaps
• Also known as a “Plain Vanilla” Swap
• An agreement between two parties to exchange interest payments
• It will occur when each party has a comparative advantage in one market but would prefer
to borrow in another market

The following table shows the best interest rate that each company can obtain in the fixed and
floating rate market
– Company A has a comparative advantage in the floating rate market but prefers to
borrow fixed-rate funds.
– Company B has a comparative advantage in the fixed rate market but prefers to
borrow floating-rate funds.

Company Preference Fixed Floating

A Fixed 10% pa LIBOR + 1.5% pa

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 B Floating 9% pa LIBOR + 2.5% pa

Strategy
• Company A borrows in floating rate market, where it has comparative advantage (i.e. LIBOR
+ 1.5% pa)
• Company B borrows in the fixed rate market where it has comparative advantage (ie. 9% pa)

Options
 An Option is a contract that gives the buyer or holder of the option the right, but not the
obligation, to buy or sell an underlying asset at an agreed price on or before a particular date
in the future.
 Call option is the option to buy an underlying asset
 Put option is option to sell an underlying asset
Note: the writer (or seller) of the option has no option, but must comply with the contract if it is
exercised

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 • Call option profit and loss payoff profiles:
–
Premium $1.50; Exercise price $20

Put option profit and loss payoff profiles

Premium $0.70; Exercise price $6.00

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