Presentation 2

PRESENTATION 2
FINANCIAL MARKET STRUCTURE
Wednesday, December 29, 2021

Introduction
 Investors exchange financial instruments in a financial market.
 Financial markets are structures through which funds flow
 Financial markets can be distinguished along two dimensions
 Money versus capital markets
 Primary versus secondary markets
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Introduction
Primary markets
Markets in which users of funds (e.g., corporations and governments)
raise funds by issuing financial instruments (e.g., stocks and bonds)
Secondary markets
Markets where financial instruments are traded among investors
Money markets
Markets that trade debt securities with maturities of one year or less
Capital markets
Markets that trade debt (bonds) and equity (stock) instruments with
maturities of more than one year
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2.1 Money Markets
 The market where money and its equivalent traded
 Refers to the network of corporations, financial institutions, investors
and governments which deal with the flow of short-term capital.
 It is part of financial market where instruments with high liquidity and
very short term maturities i.e., one or less than one year are traded.
 Due to highly liquid nature of securities and their short term maturities,
money market is treated as a safe place.

2.1 Money Markets…
 They bring borrowers and investors together without the comparatively
costly intermediation of banks.
 They help borrowers meet short-run liquidity needs and deal with
irregular cash flows without resorting to more costly means of raising
money.
 Allows the investor institutions to optimize the yield on temporary
surplus funds.
 Instrument of Liquidity adjustment by Central Bank.

 What do money markets do?
 help issuers of instruments with cash management or with financing their
portfolios of financial assets.
 attach a price to liquidity, the availability of money for immediate
investment.
 active/liquid money markets allow borrowers and investors to engaging in a
series of short-term transactions rather than in longer-term transactions,
keeping down long-term interest rate.

 Types of instruments traded in Money Markets
 Commercial paper
 Bankers‟ acceptance
 Treasury bills
 Interbank loans
 Time deposits
 Repurchase agreement(Repos)
 Futures
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1. Commercial Paper
 a promissory note issued by a private-sector firm or a government-sponsored corporation
borrowers
 has maturity of between 3 days and 9 months,
 If more than these period, SEC registration is required, if so delay issuing process and
increase issuing costs
 is usually unsecured
 allows financially sound companies to meet their short-term financing needs at lower rates
than could be obtained by borrowing directly from banks.
 Most of the time backed up by a bank line of credit as issuer loses credit rating
 Bank charges fees for guaranteed line of credit
 Used as long-term financing by rolling over the paper
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2. Bankers’ Acceptance
 The banker's acceptance is a form of payment that is guaranteed by
a bank rather than an individual account holder.
 Is like post-dated check
 A bank takes responsibility for a future payment of trade bill of
exchange
 Used mostly in international transactions (import and export)
 Exporters send goods to a foreign destination and want payment
assurance before sending

2. Bankers’ Acceptance…
 Bank stamps a time draft from the importer ACCEPTED and
obligates the bank to make good on the payment at a specific time
 Exporter can hold until the date or sell before maturity
 If sold to get the cash before maturity, price received is a discount
from draft’s total
 Return is based on calculations for other discount securities

3. Treasury bills
 Securities with a maturity of one year or less, issued by national
governments
 Treasury bills issued by a government‟s own currency are considered as
the safest of all possible investments in that currency
 are used as principal source of financing where a government is
unable to convince investors to buy its longer-term obligations.
 as countries develop reputations for better economic and fiscal
management, they are often able to borrow for longer terms
3. Treasury bills…
 Governments may issue TBs denominated in foreign currency
 but a sudden decline in the value of the currency increases the debt
burden and may even cause a debt crises

4. Interbank Loans
 Loans extended from one bank to another with which it has no
affiliation
 Are used by the borrowing institution to re-lend to its own customers
 Includes overnight loans needed to maintain the required reserves
 Banks extend short-term loans to one another at agreed upon interest
rate.
 It is called LIBOR (London Inter Bank Offer Rate) in UK, Fed fund rate
in the US.
 A lending bank can charge more than LIBOR if the borrowing bank is
not creditworthy.
5. Time Deposits
 Also known as certificates of deposit (CDs)
 are interest-bearing bank deposits that cannot be withdrawn
without penalty before a specified date.

6. Repurchase Agreement(repos)
 a securities dealer, such as a bank, sells securities it owns to an
investor, agreeing to repurchase the securities at a specified higher
price at a future date.
 amount the investor lends is less than the market value of the
securities, a difference called the haircut which use as collateral, if the
value of securities, fall up to dealers repurchase.
 Classified into overnight and term repos

7. Futures
used for hedging and cash management
by buying or selling a futures contract on a short-term interest
rate or a short-term debt security, an investor can profit if the
relevant rate is above or below the chosen level on the contract‟s
expiration date.

2.2 Bond Markets
 Bond markets are markets in which bonds are issued and traded.
 the word “bond” means contract, agreement, or guarantee.
 an investor who purchases a bond is lending money to the issuer
 a bond represents the issuer‟s contractual promise to pay interest
and repay principal according to specified terms.
 bonds offer a way for governments to borrow from many individuals
rather than just a handful of bankers
 are the most widely used of all financial instruments.

2.2 Bond Markets...
Why issue a bond?
 Diversify sources of funding – the issuer can raise far more money
without exhausting its traditional credit lines with direct lenders.
 Minimize cost of capital – cost is lower due to tax deductibility and
the funds can be repaid over a longer period
 Avoiding short-term financial constraints – governments and firms
may turn to the bond markets to avoid financial constraints such as
wage reduction, tax increase, etc.

2.2 Bond Markets...
Why issue a bond?
 Matching revenue and expenses – bonds offer a way of linking the
repayment of borrowings for long term projects to anticipated revenue.
 Promoting inter-generational equity – bonds offer a means of
requiring future taxpayers to pay for the benefits they enjoy, rather
than putting the burden on current taxpayers.
 Controlling risk – the obligation to repay a bond can be tied to a
specific project or a particular government agency, insulating the
parent corporation or government from responsibility.

2.2 Bond Markets...
The issuers
National governments
 bonds backed by the full faith and credit of national governments are called sovereigns.
 are generally considered the most secure type of bond.
Lower levels of government
 bonds issued by a government at the sub-national level, such as a city, a province or a
state, are called semi-sovereigns.
 Riskier than sovereigns
Corporations
 are issued by a business enterprise - owned by private investors or gov‟t.
 in issuing a secured obligation, the firm must pledge specific assets to
bondholders.
2.2 Bond Markets ...
Issuing bonds
 Each issue is preceded by a lengthy legal document- the offer document
or prospectus.
 offer document lays out in detail
the financial condition of the issuer;
the purposes for which the debt is being sold
the schedule for the interest and principal payments
the security offered to bondholders in the event the debt is not serviced as
required.
 a bond can be issued either through underwriters & dealers or directly
to the investors
2.2 Bond Markets...
Types of bonds
Straight bonds
 also known as debentures
 are the basic fixed-income investment
 owner receives interest payments on specified dates, usually every six
months or every year following the date of issue.
 the issuer must redeem the bond from the owner at its face value on a
specific date.

2.2 Bond Markets...
Types of bonds …
 Callable bonds
 the issuer may reserve the right to call the bonds at particular dates
 the difference between the call price and the current market price is the call
premium.
 a bond that is callable is worth less than an identical bond that is non-callable
 Putable bonds
 gives the investor the right to sell the bonds back to the issuer at par value on
designated dates.
 this benefits the investor if interest rates rise
2.2 Bond Markets...
Types of bonds …
Perpetual debentures – also known as irredeemable debentures,
 are bonds that will last forever unless the holder agrees to sell them back to the
issuer.
Zero-coupon bonds - do not pay periodic interest.
 Issued at less than par value and are redeemed at par value
 are designed to eliminate reinvestment risk - the loss an investor suffers
if future income or principal payments from a bond must be invested at
lower rates than those available today.

2.2 Bond Markets...
Properties of bonds
 Maturity/due date – has a date on which the bond issuer will have
repaid all of the principal and will redeem the bond.
 Coupon – the stated annual interest rate as a percentage of the price
at issuance. once a bond has been issued, its coupon never changes.
 Maturity/par/redemption/face value - amount that the issuer must
pay at maturity

2.3 Mortgage Markets
Mortgage – is a pledge of property (home)to secure payment of a debt.
Represents the deference between downpaymnet and value paid to
property
Involves two parties: mortgagor (home owner) and mortgagee (lender).
real estate that can be pledged as a mortgage are divided into two as
residential and non-residential property.
Originators
Commercial banks, thrift(S&Ls), and mortgage banks
Generate income from origination fee, application fee and profit from
selling a mortgage at a higher price
2.3 Mortgage Markets …
Origination process
1. Homeowner applies for a mortgage loan
2. Mortgage originator performs credit evaluation of the applicants based
on:
 Loan-to-Value ratio(LTV) – measures the market value of the property
 Payment to Income ratio(PTI) – measures ability to pay
 Borrowers credit history – measure past performance of the applicant
3. Contract signed

2.3 Mortgage Markets …
Originators can
1. keep mortgage in their portifolios
2. Sell to an investor that wish to hold it in its portfolio
3. Use it as a collateral for issuance of a security (securatized)

Classification of Mortgages
Prime versus Supreme Mortgages
1. Prime: mortgage offered to borrowers those meet traditional lending
standards
2. Supreme: those do not qualify for Prime mortgage because of;
 Lower income
 High existing debt
 Low down payment

Classification of Mortgages …
 Insured versus Conventional Mortgages
 Insured mortgages: insured by federal
 Conventional insured by privates

Mortgage-backed securities
 involves securities issued with mortgages used as a collateral
 THREE types:
1. Pass through securities
2. Collateralized mortgage obligation(CMO)
3. Mortgage backed bond

1. Pass through securities
 a security created by pooling mortgages and selling
shares/participation certificates in the pool.
 gives the investors a pro rata share of the principal and interest
on the pool
 the pool may consist several thousands or just a few
 help investors eliminate the unsystematic risk

2. Collateralized Mortgage Obligation
 a multi-class pass through with a number of bond holder classes
 each bond holder has a different guaranteed coupon paid
semiannually

3. Mortgage-backed bonds
bonds in which mortgages are used as a collateral
is more a collateralization than securitization

2.4 Stock Markets
 Stock Markets – are where equity claims are traded
 Common(ordinary) stock and preferred stock
 Includes both primary market and secondary market
 Primary market is where IPOs are issued and also where
seasoned (rights)offerings are made
 Secondary markets – where stocks once issued are traded
 include floor-based exchange(NYSE) and electronic-based
exchange (NASDAQ)
 NOTE:
 NASDAQ, acronym of National Association of Securities Dealers
Automated Quotations, an American stock market that handles electronic
securities trading around the world.
2.4 Stock Markets

2.5 Foreign Exchange Markets
Foreign Exchange Markets – is a markets where currencies of
different countries are traded or exchanged
The price of one currency interms of another is exchange rate
 The rate may be spot rate and forward rate
Foreign exchange risk is the risk that cash flows will vary as the
actual amount of birr received on a foreign investment changes due to
a change in foreign exchange rates.

2.5 Foreign Exchange Markets …
 Currency Depreciation – occurs when a country‟s currency falls in value
relative to other currencies
 Domestic goods become cheaper for foreign buyers.
 Foreign goods become more expensive for domestic purchasers
 Currency Appreciation – occurs when a country‟s currency rises in
value relative to other currencies.
 Country‟s good abroad become expensive and
 Foreign goods in that country become cheaper

 Determinants of Exchange Rate
 Relative interest rate
 Relative income levels
 Government controls
 Expectation
 Relative inflation rates

Government influence on exchange rates
1. Direct Intervention
 by exchanging foreign currency with local currency
 can be sterilized or non-sterilized intervention
Sterilized intervention
 the government buys or sells local currency (in the forex market) to
manipulate the exchange rate and at the same time undertakes an offseting
transaction in the money market to keep money supply unaffected

Non-sterilized intervention
 The gov„t buys or sells local currency to manipulate its value
 No offseting transaction is undertaken in the money market to keep
money supply unaffected

2. Indirect Intervention
 Adjustment of interest rate – increase interest rate to discourage
outflow of funds
 Using foreign exchange controls – restriction on the exchange of the
currency

2.7 Derivative Securities Markets
 Derivative Securities Markets – are the markets in which derivative securities are
traded
 Derivative Security – is an agreement between two parties to exchange a standard
quantity of an asset at a predetermined price at a specific date in the future
 It involves the buying and selling (i.e., the transfer of) risk, which results in
a positive impact on the economic system
 Derivatives are used for hedging and for speculation
 are created to manage price volatility

2.7.1 Forwards and Futures
 A spot contract is an agreement to transact involving the immediate
exchange of assets and funds
 A forward contract is a non standardized agreement to transact
involving the future exchange of a set amount of assets at a set price.
 A futures contract is a standardized exchange traded agreement to
transact involving the future exchange of a set amount of assets for a
price that is settled daily

Futures Markets
 Futures contracts are usually traded on organized exchanges
 Exchanges indemnify counterparties against credit (i.e., default) risk
 Futures are market to market daily
 Describes the prices on outstanding futures contracts that are adjusted each day to
reflect current futures market conditions
 A long position is the purchase of a futures contract
 A short position is the sale of a futures contract

2.7.2 Options
 An option is a contract that gives the holder the right, but not the obligation, to
buy or sell the underlying asset at a specified price within a specified period of
time
 Two types:
i. Call Option – is an option that gives the purchaser the right, but not the
obligation, to buy the underlying security from the writer of the option at a
specified exercise price on (or up to) a specified date
ii. Put Option – is an option that gives the purchaser the right, but not the
obligation, to sell the underlying security to the writer of the option at a
specified exercise price on (or up to) a specified date
 The trading process for options is similar to that for futures contracts

2.7.3 Swap Markets
 A swap is an agreement between two parties to exchange assets or a series of cash
flows for a specific period of time at a specified interval
 An interest rate swap is an exchange of fixed-interest payments for floating-interest
payments by two counterparties
the swap buyer makes the fixed-rate payments
the swap seller makes the floating-rate payments
the principal amount involved in a swap is called the notional principal
 A currency swap is a swap used to hedge against exchange rate risk from mismatched
currencies on assets and liabilities
 Credit swaps allow financial institutions to hedge credit risk

Thank You

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PRESENTATION 2

FINANCIAL MARKET STRUCTURE

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