Chapter 4

FINANCIAL MARKETS
A financial market is a market where financial assets are traded (exchanged). Although existence
of a financial market is not a necessary condition for the creation and exchange of a financial
asset, in more economies, financial assets are created and subsequently traded in some type of
organized financial market structure.
4.1. THE ROLE OF FINANCIAL MARKETS
Financial market provides three economic functions first, the interaction of buyers and sellers in a
financial market determine the price of the traded asset or the required rate on the financial
asset is determined. This is called the price discovery process. Second, financial markets provide
a mechanism for an investor to sell a financial asset. Because of this feature, it is said that a
financial market offers liquidity to sell the financial asset. In the absence of liquidity, the owner
will be forced to hold a debt instrument until it matures and an equity instrument until the
company is liquidated. The third economic function of a financial market is that it reduces the
search and information costs of transacting. Search costs represent explicit costs such as the
money spent to advertise the desire to sell or purchase a financial asset and implicit costs such as
the value of time spent in locating a counter party. The presence of some form of organized
financial market reduces search costs.
4.2. CLASSIFICATION OF FINANCIAL MARKETS
There are many ways to classify financial markets. One way is by the type of financial claim. The
claim traded in a financial market may be either for a fixed dollar amount or a residual amount.
The former financial assets are referred to as debt instruments and the financial market in which
such instruments are traded in is called the debt market. The later financial assets are called equity
instruments and the financial market where such instruments are traded is known as the equity
market (stock market). Preferred stock is an equity claim that in titles the investor to receive a
fixed dollar amount. Consequently, preferred stock shares characteristics of instruments classified
as partly of the debt market and partly of the equity market. Generally, debt instruments and
preferred stock are classified as part of the fixed income market. The sector of the stock market
that does not include preferred stock is called common stock market.

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Another way to classify financial market is by the maturity of the claims. There is a financial
market for short-term financial assets called the money market and another for longer maturity
financial assets called the capital market. The traditional cut-off between short term and long term
is one year. That is a financial asset with a maturity of one year or less is considered short term
and therefore part of the money market. A financial asset with a maturity of more than one year is
part of the capital market.
A third way to classify financial markets is by whether the financial instruments are newly issued
or not. When an issuer sells a new financial asset is called the primary market. After a certain
period of time, the financial asset is bought and sold amongst investors. The market where this
activity takes place is referred to as the secondary market.
A forth class of a market is by its organizational structure. These organizational structures can be
classified as auction markets, over-the-counter markets, & intermediate markets. Over-the-
counter:- when the price of the items are tagged either by the producer or the Merchandiser and
sold with out auction process it is called over-the-counter. The market where such items are traded
is called the over-the-counter-market. Intermediate market:- when there are intermediaries
(brokerages) (investment bankers) (underwriters) between the seller and the buyer, the market in
which such trade is taken place is called the intermediate market.
Financial Markets can also be classified as cash (Spot) markets and derivative markets. Cash
(Spot) Markets:- If transaction and exchange of cash are occurred at the same time when financial
assets are traded immediately by receiving cash (on cash basis), the market is called cash (spot)
market. With some contracts, the contract holder has either the obligation or the choice to buy or
sell a financial asset at some future time. The price of any such contract derives its value from the
value of the underlying financial asset, financial index, or interest rate. Consequently, these
contracts are called derivative instruments.
4.3. GLOBALIZATION OF FINANCIAL MARKETS
Globalization in this context means integration of financial markets throughout the world into an
international financial market. Because of the globalization of the financial markets, entities in any
country seeking to raise funds need not be limited to their domestic financial market. Nor are
investors in a country limited to the financial assets issued in their domestic market.

The factors that have led to the integration of financial markets are:

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1. Deregulation or liberalization of markets and the activities of the market participants in key
financial centers of the world: Global competition has forced governments to deregulate or
liberalize various aspects of their financial markets so that their financial enterprises can
compete effectively around the world.
2. Technological advancements for monitoring world markets and analyzing financial
opportunities: Technological advancements have increased the integration and efficiency of
the global financial market. Advances in computer technology coupled with advanced
telecommunication systems allow the transmission of real time information on security
practice and other key information to many participants in many places. Therefore, many
investors can monitor global markets and simultaneously assesses how this information will
impact the risk/ reward profile of their portfolios.
3. Increased institutionalization of Financial Markets: The shifting of the role of retail and
institutional investors in financial markets is the 3 rd factor that has led to the integration of
financial markets. The US financial markets have shifted from being dominated by retail
investors to being dominated by institutional investors. Retail investors are individuals while
institutional investors are financial institutions such as pension funds, insurance companies,
investment companies’, commercial banks, saving and loan associations. The shifting of the
financial markets from dominance by retail investors to institutional investors is referred to as
the institutionalization of financial markets. The same thing is occurring in other
industrialized countries. Unlike retail investors, institutional investors have been more willing
to transfer funds across national borders to improve portfolio diversification and/or exploit
perceived mispricing of financial assets in foreign countries. The potential portfolio
diversification benefits associated with global investing have been documented in numerous
studies, which have heightened the awareness of investors about the virtues of global
investing.
4.4. CLASSIFICATION OF GLOBAL FINANCIAL MARKETS
Although there is no uniform system for classifying the global financial markets, an appropriate
schematic presentation appears. From the perspective of a given country, financial markets can be
classified as either internal or external. The internal market is also called the national market. It
is composed of two parts: the domestic market and the foreign market. The domestic market is
where issuers domiciled in a country issue securities and where those securities are subsequently

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traded. The foreign market of a country is where the securities of issuers not domiciled in the
country are sold and traded. The rules governing the issuance of foreign securities are those
imposed by regulatory authorities where the security is issued. For example, securities issued by
non-U.S. corporations in the United States must comply with the regulations set forth in U.S.
securities law. A non-Japanese corporation that seeks to offer securities in Japan must comply
with Japanese securities law and regulations imposed by the Japanese Ministry of Finance.
Nicknames have developed to describe the various foreign markets. For example, the foreign
market in the United States is called the Yankee market. The foreign market in Japan is nicknamed
the Samurai market, in the United Kingdom the Bulldog market, in the Netherlands the Rembrandt
market, and in Spain the Matador market.
The external market also called the international market allows trading of securities with two
distinguishing features: (1) at issuance securities are offered simultaneously to investors in a
number of countries, and (2) they are issued outside the jurisdiction of any single country. The
external market is commonly referred to as the offshore market or more popularly the Euro
market (even though this market is not limited to Europe, it began there).

4.5. MONEY AND CAPITAL MARKETS

4.5.1. Money Market
In this section, we will discuss debt securities/instruments. That obligates the debtor to make a
contractually fixed series of payments, up to some terminal maturity date. We will focus on debt
instruments that at the time of issuance have a maturity of one year or less. These instruments are
referred to as money market instruments and the market in which these instruments are traded is
called money market. The assets traded in money market include: Treasury-bills, commercial
papers, medium-term notes, and Bankers acceptance (LC), short-term federal agency securities,
and short-term municipal obligations, certificate of deposits, repurchase agreements, floating-rate
instruments and federal funds.
A. Treasury Bills (T-bills)
Treasury-bills are issued by governments and are backed by the full faith and credit of the
government. As a result, market participants perceive treasury securities to carry no risk of default.
There are three types of treasury securities: Bills, Notes and Bonds.
At issuance, Bills have a maturity of one year or less, Notes more than two years but not more
than 10 years to maturity and bonds more than 10 years to maturity.

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In this topic, we will discuss treasury-bills because they fall into the category of money market
instruments (instruments with maturity of one year or less).
A. Treasury bill (T-bill)
T-bill is a discounted security. It does not make periodic interest payments rather the security
holder receives interest at the maturity date when the amount received (Principal value) (Maturity
value) is larger than the purchase price. E.g., suppose an investor purchases a 6-month T-bill
having a principal of 100,000 for 96,000 by holding the bill until maturity date, the investor will
receive $100,000 the different amount (4000) between the proceeds received at maturity and the
amount paid to purchase the bill represents the interest. T-bill is the only one example of a number
of market instruments that are discounted securities.
The Primary Market for T-Bills
Treasury securities typically are issued on an auction basis according to regular cycles for specific
maturities. Three month and 6-month T-bills are auctioned every Monday. The one-year (52-
weeks) T-bills are auctioned in the third week of every month.
B. Commercial Papers (CP)
CP is a short-term unsecured promissory note that is issued in the open market and represents the
obligation of the issuing corporation. In US, since 1988, there have been some years in which the
size of the commercial paper market has exceeded that of the T-bill market. In the 1980s, medium
and low-quality corporate issuers were able to raise funds via the commercial paper market.
However, since 1989 such issuers have not found a respective market for their issues and
withdraw from the market.
The issuance of commercial paper is an alternative to bank borrowing for large corporations with
strong credit rating. The original purpose of commercial paper was to provide short-term funds for
seasonal and working capital needs. It provided a less expensive form of short-term borrowing for
high credit quality corporations than from borrowing at the bank. Commercial papers are also used
for “bridge financing”.
E.g. Suppose that a corporation needs long-term needs to build a plant or acquire equipment.
Rather than raising long-term funds immediately, the corporation may elect to postpone the
offering until more favorable capital market conditions prevail. The funds raised by issuing the
commercial papers (CP) are used until long-term securities are sold. As merger and acquisition

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activities increased in 1980s, commercial paper was used as a bridge financing to financial
corporate takeovers.
Characteristics of Commercial Papers
The maturity date of the CP is typically less than 270 days and the most common maturity range is
30-50 days or less. The security act of 1933 requires that securities be registered with the SEC.
special provisions in the act exempt CPs from registration so long as the maturity does not exceed
270 days. Hence, to avoid costs of registering in the SEC, firms rarely issue commercial paper
with maturity exceeding 270 days.
Another distinction is the greater diversity of dealers in the Euro CP market. In the US only a few
dealers dominate the market.
Finally, because of the longer maturity of the Euro CP, it is traded more often in the secondary
market than the US CP. In US, investors of commercial paper are typically buy-and-hold, and the
secondary market is thin and illiquid.
C. Bankers Acceptances / Letter of Credit/
Simply, a banker’s acceptance is a vehicle created to facilitate commercial trade transactions. The
instrument is called a banker’s acceptance because a bank accepts the ultimate responsibility to
repay a loan to its holder. The use of bankers acceptance to finance a commercial transaction is
referred to as “acceptance financing”.
The transactions in which bankers acceptance are created include:
i) Importing and exporting goods into and/or from the US
ii) Storing & shipping goods between two US entities or between two foreign countries
where neither the importer nor the exporter is a US firm.
Bankers’ acceptance is sold on the discounted basis as treasury bills and CP. The major investors
in the bankers’ acceptance are: - Money market
A. Mutual funds and
B. Municipal entities
Accepting Banks: Banks that create bankers acceptances are called accepting banks. These banks
maintain their own sales forces to sell bankers acceptances rather than using the services of a
dealer. However, they will use dealers to unload those they cannot sell. Japanese city banks are
now major issuers of bankers’ acceptances. Because they do not have sales force to distribute the

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bankers acceptance they create directly to investors, Japanese accepting banks use the services of
dealers.
D. Repurchase Agreements (Repo market)
A Repo is the sale of a security with a commitment by the seller to buy the security back from the
purchaser at a specified price at a designated future date. It is a collateralizing loan, where the
collateral is a security (T-bill). The transaction is referred to as a repurchase agreement because it
calls for the sale of the security and its repurchase at a future date. Both the sale price and the
purchase price are specified in the agreement. The difference between the purchase (repurchase)
price and the sale price is the dollar interest cost of the loan.
Participants in the “repo” market
The repo market has evolved into one of the largest sectors of the money market. Financial and
non-financial firms’ participate in the market as both sellers and buyers depending on the
circumstances they face. Another participant is the repo broker. The Federal Reserve is also
involve in the repo market.
Money Market Securities
Money market includes short-term, highly liquid, relatively low risk debt instruments sold by
government, financial institutions and corporations to investors with temporary excess funds to
invest. This market is dominated by financial institutions particularly banks and governments. The
maturity of money market instruments range from one day to one year and are often less than 90
days. Money market is the market for short-term highly liquid low risk assets such as treasury
bills, negotiable CDS, commercial papers, Bankers acceptances and Repurchase Agreements.
Although in some pure sense there is no such thing as a risk free financial asset, the Treasury bill
is risk free financial asset. There is no particular risk of default by the US government. Treasury-
bill is a short-term money market instrument sold at discount by the US government. The Treasury
bill rate, denoted RF, is used throughout the text as a proxy for the nominal risk free rate of return
available to investors. Investors purchase Treasury-bills at weekly auctions at a discount from face
value. Treasury-bills are redeemed at face value, there by providing investors with their return.
Convention in the US for many years is to state the yield on bills with six month maturities or less
on a discount yield basis using a 360- day year.

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4.5.2. Capital Markets
4.5.2.1. Primary and Secondary Markets
Primary markets are markets where existing securities are traded among investors. Ones new
securities have been sold in the primary market, an efficient mechanism must exist for their resale
if investors are to view securities as attractive opportunities. Secondary markets provide investors
with a mechanism for trading existing securities. Secondary markets exist for the trading of
common and preferred stocks, warrants, bonds puts and calls / equities, bonds and derivative
securities. These are discussed below.
1. US securities Markets for the Trading of Equities
i) The New York stock exchange (NYSE)
ii) The American stock exchange (Amex) and
iii) The NASDAQ of stock market (NASDAQ)
In addition, there are regional stock exchanges in several cities.
The NYSE, Amex & NASDAQ are the three major markets for trading of US securities. Each of
these markets involves the trading of listed securities. Companies that issue stock for public
trading must choose where their shares will be listed for trading and then apply for listing in one
of these three markets.
The NYSE and Amex are auction markets involving physical locations in New York, where as the
NASADAQ stock market is an electronic market of dealers who make a market in each of the
NASDAQ stocks. In either case, investors are represented by brokers, intermediaries who
represents both buyers and sellers and attempt to obtain the best price possible for either party in a
security transaction and receives a commission.
i) New York stock exchange: is the major secondary market for the trading of equity securities.
The NYSE is the oldest secondary market in US tracing its history back to 1792. The NYSE is
regarded as the best-regulated exchange in the world and has proven its ability to function in
crisis. “The NYSE is not-for-profit Corporation”. The NYSE has specific listing requirements
that companies must meet in order to be listed (i.e. accepted for trading)
ii) American stock exchange (Amex): is the only other national organized exchange. Relative to
NYSE, the Amex is smaller. The listing requirements are less for stocks on the Amex than for
stocks on the NYSE. Regardless of the lower level of activity on the Amex, some companies
choose to be listed on the Amex.

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iii) The NASDAQ (National Association for Securities Dealers Automation (Quotation) stock
market. In contrast to auction markets, the NASDAQ stock market is a competing dealer
market consisting of a network of dealers (market makers) who make a market by standing
ready to buy and sell securities at specified prices (quoted prices) (Tagged prices). Dealer is an
individual (a firm) who makes a market in a stock by buying from and selling to investors.
Most of the actively traded stocks are part of the NASDAQ stock market. The NASDAQ is the
automated quotation system for the over counter market, showing current bid ask prices for
many of stocks.
1. Derivatives Vs Cash (Spot) markets
A derivative is a financial instrument, whose pay offs and values are derived from or depend on
some thing else. Often we speak of the thing that the derivative depends on as a primitive or
underlying. E.g., the value of the future contract depends on the value of the underlying instrument
on the settlement or delivery date. The market in which derivative instruments such as futures
constructs, forward contracts and options are traded is called a derivative market.
Future Market
A futures contract is an agreement that requires a party to the agreement either to buy or sell
something at the designated future date (delivery date) at a predetermined price (future price). It is
a legal agreement between a buyer/seller and a clearinghouse in which the buyer/seller agrees to
take/make delivery of something at a specified price at the end of a designated period. The
function of the clearinghouse is guaranteeing that the two parties in the transaction will perform.
Another function of the clearinghouse is to protect some potential problems that might occur on
the delivery date as a result of price fluctuations. When an investor takes a position in the market,
the clearinghouse takes the opposite position and agrees to satisfy the terms set forth in the
contract. Because of the clearinghouse, the investor need not worry about the financial strength
and integrity of the party taking the opposite side of the contract. Another function of the clearing
house is that it makes simple for the parties (buyer &/or seller) to unwind their positions.
Forward contracts
A forward contract like a future contract is an agreement for future delivery of some thing at a
specified price on the delivery date. Future contracts are standardized agreements as to delivery
date, quality, & are traded on an organized exchanged. Forward contracts differ in that it is usually
non-standardized (i.e. the terms of each contract are negotiated individually between the buyer &

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seller), and there is no clearinghouse. The parties in the forward contract are exposed to credit risk
because either party may default on the obligation. Credit risk is minimal in the case of futures
contract because the clearinghouse guarantees the other side of the transaction.
Options
Options are special contractual arrangements giving the owner (holder) the right to buy or sell an
asset at a fixed price at any time before or on the delivery date. An option is a unique type of
financial contract because it gives the holder (the owner) the right but not the obligation to do
something. The owner of the option uses it only it is a smart thing to do so, otherwise the option
can be thrown away. If the owner of the option uses it, it is said to be exercise, otherwise is let to
be expired.
Exercising the option: the act of buying or selling the underlying asset via the option contract is
referred to as exercising the option.
Striking or exercise price: the fixed price in the option contract at which the holder (owner) can
buy or sell the underlying asset is called striking or exercise price.
Expiration Date: the maturity date of the option is referred to as expiration date. After this date the
option is dead.
Types of options
There are two types of options. These are the call option & the put option
i) Call option- this option gives the owner (holder) the right but not the obligation to buy an
asset at a fixed price during a particular time period.
ii) Put option- this option gives the owner (holder) the right but not the obligation to sell an
asset at a fixed price during a particular period of time.

4.6. FOREIGN EXCHANGE MARKET

Payments for liabilities made by borrowers and cash payment received by investors may be
denominated in a foreign currency.
FOREIGN EXCHANGE RATES
An exchange rate is defined as the amount of one currency that can be exchanged per unit of
another currency or the price of one currency in terms of another currency.
The exchange rate between the US dollar and the Swiss Franc could be quoted in one of two ways.
i) The amount of US dollars necessary to acquire one Swiss Franc or the dollar price of one
Swiss Franc or

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ii) The amount of Swiss Franc necessary to acquire one US dollar or the Swiss franc price of one
US dollar.
Exchange rate quotations may be either direct or indirect.
A direct quote is the number of units of a local currency exchangeable for one unit of a foreign
currency. An indirect quote is the number of units of a foreign currency that can be exchanged for
one unit of a local currency.
From a US perspective, a quote indicating the number of dollars exchangeable for one unit of a
foreign currency (say birr) is a direct quote. (i.e. 1/60 USD = 1 birr) or from the Ethiopian
perspective 60 birr = 1 USD is a direct quotes. From a US perspective, the amount of foreign
currency that can be exchanged for one US dollars is called an indirect quote (i.e. 1 USD = 9 birr).
For Ethiopia it is 1 birr = 1/9 USD.
Given a direct quote, we can obtain an indirect quote (the reciprocal of the direct quote) and vice
versa. E.g. Suppose that a US participant is given a direct quote of dollars for Swiss franc of
0.7402 (i.e. the price of one Swiss franc is $ 0.7402). The reciprocal of the direct quote is 1.3509,
which could be the indirect quote for the US participant (i.e. 1 USD can be exchanged for 1.3509
Sf).
Or 1 sf = 0.7402 USD
? = 1 USD
? = 1.3509 Swiss franc
FOREIGN EXCHANGE RISK
From a perspective of a US investor, the actual USD that the investor gets depend on the exchange
rate between the USD and the foreign currency at the time the non dollar cash flow is received and
exchanged for USDs. If the foreign currency depreciates relative to the USD, (i.e. the USD
appreciates and the foreign currency declines in value), the dollar value of the cash flows will be
proportionately less. This risk is referred to as foreign exchange risk.

4.7. SPOT EXCHANGE RATE MARKET

The spot exchange rate market is the market for settlement with in two business days. A key factor
affecting the expectation of changes in a country’s exchange rates is the relative expected inflation
rate. Spot exchange rates adjust to compensate for the relative inflation rate between two
countries. This is the so called purchasing power parity relationship. It says that the exchange rate

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the domestic price for the foreign currency is proportional to the domestic inflation rate and
inversely proportional to foreign inflation.
CROSS RATES
The exchange rate between two countries will be the same in both countries. The theoretical
exchange rate between two countries other than the US can be inferred from their exchange rate
with the US dollar. Rates compared in this way are referred to as theoretical cross rates.
They would be computed as follows for two countries X & y.
Quote in American terms of currency x
Quote “ “ “ “ “ y
- Quoting in terms of USDs per unit of foreign currency is called American terms.
- Quoting in terms of the # of units of the foreign currency per USD is called European
terms.
To illustrate how this is done, let’s calculate the theoretical cross rate between German marks and
Japanese yen. The exchange rate for the two countries currencies in American term on a certain
day was $ 0.6234 per German mark & $0.009860 per Japanese yen. Then the number of units of
Japanese yen (y) per unit of German mark (x) is given below.
# of units of Japan yen per unit of German mark = $0.6234/$0.009860= 63.23 yen/mark
Taking the reciprocal gives the number of German mark exchanged for one Japanese yen & is
given below.
# of units of German mark per unit of Japanese yen = $0.009860/$0.6234 = 0.0158/mark/yen
In the real world there are rare instances where the theoretical cross rate as computed from actual
dealer dollar exchange rate quotes will differ from the actual cross rate quoted by some dealer.
When the discrepancy is large enough after translation costs, a risk less arbitrage opportunity
arises. Arbitrage to take advantage of cross rate mispricing is called Triangular arbitrage so named
because it involves positions in three currencies:
The USD & the two foreign currencies

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