LMS FM Chap1 Overview-Đã G P

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FINANCIAL MARKETS
CHAPTER 1. INTRODUCTION
Phan Quynh Trang
OUTLINE
• Primary and secondary markets; money and capital markets

• Foreign exchange markets; derivative securities markets
• Financial system
• Financial institutions
• Financial instruments
• Regulation for financial institutions
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FINANCIAL SYSTEM
 Money
 Financial markets
 Financial instruments
 Financial institutions
 Regulatory agencies
 Central banks (State banks)
FINANCIAL MARKETS
Financial markets are structures through

which funds flow
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FINANCIAL MARKETS
 Primary markets & Secondary markets

 Money markets & Capital markets
 Foreign exchange markets
 Derivatives markets
PRIMARY AND SECONDARY MARKETS
Primary markets Secondary markets

 Raise funds  Trade financial instruments
 Investment banks  Liquidity
 IPOs & SPOs
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MONEY AND CAPITAL MARKETS
Money markets Capital markets

 Less than one year  Equal and above one year
 OTC  Bond, stock, mortgage
 Money market instruments markets
 Capital market instruments
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FOREIGN EXCHANGE
 Operations
 Cash flow
 Exchange rate
 Foreign exchange risk
DERIVATIVES MARKETS
 Derivatives instruments
 OTC and exchanges
 Underlying assets
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FINANCIAL INSTRUMENTS
 Money market instruments

 Capital market instruments
 Derivative securities
 Valuation of securities
Money market instruments Capital market instruments

 Treasury bills  Stock
 Repurchase agreements  Mortgages
 Commercial paper  Corporate bonds
 Negotiable certificates of  Treasury bonds
deposit  Bank and consumer loans
 Bankers’ acceptances
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Store of value Transfer risk

 Bank loans  Insurance contracts
 Bonds  Futures contracts
 Home mortgages  Options
 Stocks  Swaps
 Asset-backed securities
FINANCIAL INSTITUTIONS
Perform the essential function of channeling

funds from those with surplus funds
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 Commercial banks
 Thrifts
 Insurance companies
 Securities companies and Investment banks
 Finance companies
 Investment funds
 Pension funds
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FINANCIAL INSTITUTIONS & SERVICES
For suppliers of funds For economy

 Monitoring costs  Money supply
 Liquidity and price risk transmission
 Transaction cost services  Credit allocation
 Maturity intermediation  Intergenerational wealth
 Denomination transfers
intermediation  Payment services
FINANCIAL INSTITUTIONS & RISKS
 Country risk
 Market risks (Interest rate risk, Foreign exchange risk,
commodity price risk, option price risk, stock price
risk)
 Credit risk
 Off-balance-sheet risk
 Liquidity risk
 Operational risk
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FINANCIAL INSTITUTIONS &

REGULATIONS
 Prevent FIs from market failures

 Enhance the social welfare benefits
 Mitigate the costs of the provision of FI services
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FINANCIAL MARKETS
CHAPTER 2. MONEY MARKETS
Phan Quynh Trang
OBJECTIVES
 Types of interest rates

 Money market securities.
 Process to issue Treasury securities.
 Participants
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TYPES OF INTEREST RATE
 Nominal • Coupon rate • Single-payment • Coupon rate

interest rate • Required rate of rate • Bond equivalent
 Real risk-free return • Compounded yield
rate • Expected rate of rate • Effective annual
return • Continuous return
• Realized rate of compounded • Discount yield
return rate
Nominal interest rates are the interest rates

actually observed in financial markets
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Real risk-free rate is the interest rate that would

exist on a risk-free security if no inflation were
expected over the holding period of a security.
TIME VALUE OF MONEY
A dollar received today is worth more than a

dollar received at some future date
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Lump sum payment is a single cash payment

received at the beginning or end of some
investment horizon
Annuity payments a series of equal cash flows

received at fixed intervals over the entire
investment horizon
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PRESENT/FUTURE VALUE OF A LUMP SUM
PRESENT/FUTURE VALUE OF AN ANNUITY
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Coupon rate on a bond instrument is the annual

(or periodic) cash flow that the bond issuer
contractually promises to pay the bond holder
BOND EQUIVALENT YIELDS
: nominal rate earned on an investment over a

one-year period (nominal annual interest)
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EFFECTIVE ANNUAL RETURNS
EAR: less than one year or compounded interest
DISCOUNT RATE
: yields on these securities use a 360-day year
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DISCOUNT YIELD INTO A BOND

EQUIVALENT YIELD
SINGLE-PAYMENT YIELD
Some money market securities (e.g., negotiable CDs

and fed funds) pay interest only at maturity.
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NOMINAL INTEREST RATE INTO A

BOND EQUIVALENT YIELD
INTEREST RATE
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Money market is a type of financial markets that

trade debt securities or instruments with
maturities of less than one year
TYPES OF MM SECURITIES
 Treasury Bills (T-bills)

 Fed funds
 Repurchase Agreement
 Commercial papers
 Certificates of deposit (CDs)
 Bank acceptances
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TREASURY BILLS
 Short-term obligations of the U.S. government

 default risk free, little interest rate risk and liquidity risk.
 Treasury bill auction
 The largest secondary market
TREASURY BILLS YIELDS
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BOND EQUIVALENT YIELDS
REPURCHASE AGREEMENTS
 Involve the sale of securities by one party to another with

a promise to repurchase the securities at a specified price
and on a specified date in the future
 overnight repos and term repos
 Collateral pledged in a repurchase agreement has a
“haircut” applied
 A reverse repurchase agreement (reverse repo)
 Maturity (generally from 1 to 14 days), but there is a
growing market for longer-term 1- to 3-month repos
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TRADING PROCESS
Be arranged either directly between two parties or with

the help of brokers and dealers.
REPURCHASE AGREEMENT YIELDS
 Be backed by Treasury securities

 Low credit risk investments; lower interest rates
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COMMERCIAL PAPER
 An unsecured short-term promissory note

 Denominations of $100,000, $250,000, $500,000, and $1
million.
 Maturities generally range from 1 to 270 days (20-45 days)
 no active secondary market
 Commercial paper issuers with lower than prime credit
ratings often back their commercial paper issues with a
letter of credit obtained from a commercial bank.
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COMMERCIAL PAPER YIELDS
CERTIFICATES OF DEPOSIT
 A bank-issued time deposit that specifies an

interest rate and maturity date and is negotiable in the
secondary market
 A single-payment securities (360-day year)
 Popular maturities:1, 2, 3, 6, and 12 months.
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TRADING PROCESS
 Banks issue, then sell

 Bank and investor directly negotiate
 Not very active in secondary market
BANK’S ACCEPTANCES
 A time draft payable by banks

 The underlying letters of credit (or time drafts)
 Can and are traded in secondary markets
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Source: dripcapital.com
PARTICIPANTS
1. Federal reserve system

2. Commercial banks
3. Mutual funds
4. Other financial institutions
5. Brokers and dealers
6. Corporations
7. Individuals
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FINANCIAL MARKETS
CHAPTER 3. BOND MARKETS
Phan Quynh Trang
OUTLINE
 Characteristics
 Bond pricing and present value; bond’s price and coupon
rate, current yield, yield to maturity, and holding period
return
 Bond risk
 Participants
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TERMS
• Capital markets: bonds, mortgages and equity

• Bonds: Treasury bonds, corporate bonds, and municipal
bonds
• Bond markets
BOND MARKET SECURITIES
1. Treasury notes and Bonds (STRIPS, TIPS)

2. Municipal bonds
3. Corporate bonds
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TREASURY NOTES AND BONDS
 T-notes and T-bonds

 Default risk free
 Maturity: T-notes: 1 – 10 years, T-bonds: 10+ years
 Two types of notes and bonds: fixed principal and
inflation-indexed
 Very active secondary markets
 https://www.wsj.com/market-data/bonds/treasuries
STRIPS
1. Separate Trading of Registered Interest and Principle

Securities
2. Separate periodic coupon from each other and from the
final principle payment
3. Create two sets of securities: one set for each
(semiannual/annual) interest payment (Treasury zero-
coupon bonds) and one for final principle payment
(Treasury zero bonds)
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STRIPS
5-year T-notes
(face value: $10,000, Coupon rate:
8%, Payment: semiannual
N1: $400 N2: $400 – N3: $400 – N4: $400 – N10: $400 N11: $10,000
…..
– 5 yrs 5 yrs 5 yrs 5 yrs – 5 yrs – 5 yrs
Treasury Note and Bond Yields. Treasury note and bond yields to maturities and prices are calculated as:
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 Accrued Interest. portion of the coupon payment accrued between the last coupon
payment and the settlement
 Dirty price/full price = purchase price (clean price) + accrued interest
ACCRUED INTEREST
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TIPS
1. Treasury Inflation Protection Securities

2. Return tie to the inflation rate
TRADING PROCESS FOR BONDS
1. Primary market: press release one week before the

auction
2. Bids submit yield to maturity through Treasury Direct
website
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MUNICIPAL BONDS
1. Issuer: state and local (country, city, school) government

2. Be exempted from federal income taxes and almost state
and local income taxes
3. Types of municipal bonds: General obligation (GO) bonds
and Revenue bonds
4. Minimum denomination: $5,000
MUNICIPAL BONDS
 General obligation (GO) bonds are backed by the full faith

and credit of the issuer
 Revenue bonds are sold to finance a specific revenue-
generating project and are backed by cash flows from that
project
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MUNICIPAL BOND YIELDS
the after-tax (or equivalent tax exempt) yield on a taxable

bond:
TRADING PROCESS FOR MUNICIPAL

BONDS
 Primary market: through (1) a public offering, using an

investment bank serving as a security underwriter, or (2) a
private placement to a small group of investors
 Secondary market: thin
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TRADING PROCESS FOR MUNICIPAL

BONDS
Saunders (2018)
MUNICIPAL BONDS
1. Firm Commitment Underwriting

2. Best-Efforts Offering.
3. Private Placement.
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CORPORATE BONDS
1. Issuer: firms (corporations)

2. Bond indenture: legal contracts (rights and obligations),
contains covenants
3. Covenants: rules and restrictions
BOND CHARACTERISTICS
• Bearer bonds • Term bonds • Mortgages bonds • Convertible

• Registered • Serial bonds • Debentures Bonds
bonds • Subordinated • Stock Warrants
Debentures • Callable Bonds
• Sinking Fund
Bonds
PRESENTATION TITLE 23
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TRADING PROCESS
1. Primary market: public offering or private placement

2. Secondary market: exchanges or OTC
OTHERS
1. Bond rating
2. Interest rate spreads
3. Bond indexes
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1. Eurobonds
2. Foreign bonds
3. Sovereign bonds
PARTICIPANTS
1. Financial Business
2. Households
3. Foreign investors
4. Government
5. Non-financial Business
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SECURITIES IN INTERNATIONAL BOND

MARKETS
1. Eurobonds
2. Foreign bonds
3. Sovereign bonds
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FINANCIAL MARKETS
CHAPTER 4. STOCK MARKETS
Phan Quynh Trang
OUTLINE
 Characteristics of common stock and preferred stock.

 Primary and secondary stock markets.
 Market index, participants and process
 Market efficiency.
 Valuation of stock
 Market trends
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EQUITY FINANCE
• Private equity: Venture Capital Funds, Private Equity

Funds, Crowdfunding
• Public equity
EQUITY FINANCE
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EQUITY FINANCE
STOCK MARKET SECURITIES
1. Common stock
2. Preferred stock
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COMMON STOCK
• Discretionary dividend payments

• Residual claim status
• Limited liability
• Voting rights
DIVIDENDS
1. No guarantee
2. Be taxed twice
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DIVIDENDS
RESIDUAL CLAIM
The lowest priority claim in the event of bankruptcy

(employees, bond holders, government, preferred
stockholders)
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LIMITED LIABILITY
Common stockholder losses are limited to the amount of

their original investment in the firm if the company’s asset
value falls to less than the value of the debt it owes
VOTING RIGHTS
 Elect the board of directors

 Dual class firms
 Cumulative voting: all directors up for the election are
voted on at the same time
 Straight voting: the vote on the board of directors occurs
one director at a time
 Proxy Votes
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CUMULATIVE VOTE
• Number of share outstanding: 1,000

• Number of directors to be elected: 3 (highest numbers of
votes)
• Number of candidates: 4
• Number of votes: 3,000
How many possible outcomes can happen?
CUMULATIVE VOTE
• Number of shares ( ) needs, number of candidate wants

to be successful
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STRAIGHT VOTE
• Number of votes = Number of share outstanding: 1,000

• Number of directors to be elected: 3 (above a half of
numbers of votes)
• One candidate own a half of number share
• One candidate own a one-forth of number share
What possible outcomes can happen?
PREFERRED STOCK
 Both bonds and common stock

 Not a tax deductible expense
 Dividends on preferred stock are generally fixed
 Do not have voting rights
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PREFERRED STOCK
• Nonparticipating preferred stock: fixed dividend

• Participating preferred stock: actual dividend may be
higher than promised dividend
PREFERRED STOCK
• Cumulative preferred stock: missed dividends go into

arrears and must be made up before any common stock
dividends can be paid
• Noncumulative preferred stock
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PRIMARY STOCK MARKET
1. New issues (first time and not first time)

2. IPOs and SPOs
PRIMARY MARKET
1. Preemptive right: SPOs must offer to existing

shareholders fist
2. Registration
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PRIMARY MARKET
PRIMARY STOCK MARKET
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SECONDARY STOCK MARKET
1. Secondary stock markets are the markets in which stocks,

once issued, are traded—that is, bought and sold by
investors
2. Stock Exchanges. The two major U.S. stock markets are
the New York Stock Exchange Euronext (NYSE Euronext)
and the National Association of Securities Dealers
Automated Quotation (NASDAQ) system
SECONDARY STOCK MARKET
1. The Trading Process: market order and limit order
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TERMS
 Market order/Limit order

 Program trading
 Controversial Trading Practices.
 Flash trading
 Naked access trading
 Dark pools of liquidity
STOCK MARKET INDEXES
1. A stock market index is the composite value of a group of

secondary market–traded stocks.
2. Movements in a stock market index provide investors
with information on movements of a broader range of
secondary market securities
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PARTICIPANTS
 Household sector  Life insurance companies

 State and local governments  Property-casualty insurance
 Rest of world companies
 Federal government  Private/Public pension funds
 Monetary authority  Mutual/Closed-end/Exchange-

trade funds
 Depository institutions
 Brokers and dealers
 Finance companies
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ECONOMIC INDICATORS
1. Stock market indexes might be used to forecast future

economic activity
2. Stock market movements and economic cycles might be
related
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MARKET EFFICIENCY
1. Weak form: current stock prices reflect all historic price

and volume information about a company.
2. Semi-strong form: the speed with which public
information is impounded into stock prices
3. Strong form: stock prices fully reflect all information
about the firm, both public and private
REGULATIONS
 Information disclosure
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FINANCIAL MARKETS
CHAPTER 5. MORTGAGE MARKETS
Phan Quynh Trang
OUTLINE
• Mortgages and mortgage-backed securities.

• Types of mortgages
• Mortgage amortization
• Mortgage sales; pass-through securities; collateralized
mortgage obligations.
• Mortgage holders
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MORTGAGES FLOW
MORTGAGES
1. Mortgages are loans to individuals or businesses to

purchases a home, land, or other real property.
2. Residential mortgages are securitized (60%)
3. Major categories of mortgages: Home mortgages,
commercial mortgages, multifamily dwellings and farms
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MORTGAGE CHARACTERISTICS
1. Collateral
2. Down payment
3. Insured versus Conventional Mortgages
4. Mortgage Maturities
5. Interest rate
COLLATERAL
i. Mortgage is back by property (a lien)

ii. A lien is a public record attached to the title of the
property
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DOWN PAYMENT
 Is a portion of the purchases price of the property at

the day the mortgage is issued (the closing)
 Decreases the probability of mortgage default
 The size of the down payment (20%): private mortgage
insurance
INSURED VS. CONVENTIONAL MORTGAGES
 Federally insured mortgages are originated by financial

institution, but repayment is guaranteed by either the
Federal Housing Administration (FHA) or the Veterans
Administration (VA)
 Conventional mortgages are held by financial
institutions and are not federally insured (private
mortgage insurance)
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MORTGAGE MATURITY
 15 years or 30 years
 Mortgage allow the borrower to prepay all or part of
the mortgage principal early without penalty
 Balloon payment mortgages require a fixed monthly
interest payment for a three-to five-year period
INTEREST RATE
i. A fixed-rate mortgage
ii. A adjustable-rate mortgage
iii. Discount points: fees (percent of principal value)
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OTHER FEES
• Application fee
• Title search
• Appraisal fee
• Loan origination fee
• Closing agent and review fee
• Other costs
MORTGAGE REFINANCING
 A mortgage borrower takes out a new mortgage and uses

the proceeds obtained to pay off the current mortgage
 Transaction and re-contracting cost
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MORTGAGE AMORTIZATION
 The fixed monthly payment made by a mortgage borrower

 An amortization schedule shows how the fixed monthly
payments are split between principal and interest
PV × r
PMT =
1
1−
1+r
PMT: monthly payment, PV: mortgage principal, r: monthly

rate, t: number of months
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OTHER TYPES OF MORTGAGES
• Jumbo mortgages
• Subprime mortgages
• Alt-A mortgages
• Option ARMs
• Second mortgages
• Reverse-Annuity mortgages
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MORTGAGE SALES
1. A mortgage sale: FI originates a mortgage and sells it with

or without recourse to an outside buyer
2. Purpose: manage credit, liquidity, interest rate risk and asset
diversification
RISKS
• Credit risk
• Interest rate risk
• Prepayment risk
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MORTGAGE-BACKED SECURITIES
1. Three types of mortgage-backed securities:

i. The pass-through security
ii. The collateralized obligation
iii. The mortgage backed bond
2. Mortgage-backed securities allow mortgage issuers to
separate the credit risk exposure from the lending process
itself
PASS-THROUGH SECURITIES
1. Pool mortgages and other assets to offer investors

2. Promise payments of principal and interest on pools of
mortgage to secondary market investors
3. Issuers: public (GNMA, FNMA, FHLMC) and private (banks,
thrifts..)
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COLLATERALIZED MORTGAGE OBLIGATION
 A multiclass pass-through with a number of different bond

holder classes (tranches)
 Has guaranteed coupon
 Prepayment risk
MORTGAGE-BACKED BONDS
 Remain on the balance sheet

 Cash flows on mortgages do not directly link to the
interest and principal payments of MMBs
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PARTICIPANTS
 Mortgage Pools
 Depository Institutions
 Mortgage Companies
 Life Insurance Companies
 Other Financial Institutions
 Others
USE OF MORTGAGES
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TRENDS
 Third-party technology and data providers are streamlining more

parts of the mortgage process.
 Nonbank lenders continue to grow market share.
 Next-generation “subservicers”3 are introducing more-efficient
digital platforms.
 Companies are bundling home-buying services, including
mortgages.
 Nonqualified mortgage (non-QM) lenders are reentering the
market.
https://www.mckinsey.com/industries/private-equity-and-principal-
investors/our-insights/five-trends-reshaping-the-us-home-mortgage-
industry
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FINANCIAL MARKETS
CHAPTER 6. DERIVATIVES MARKETS
Phan Quynh Trang
OBJECTIVES
• Types of derivative instruments

• Understand caps, floors, and collars.
• Identify the biggest derivative securities markets globally.
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OVERVIEW
 The payoff is linked to another security (underlying assets)

 Involve an agreement: predetermined price and at a
specified date in the future
 Involve the buying and selling of risk
 Basic instruments: forward, futures, swaps, options
 Underlying assets: interest rate, equity, foreign exchange,
energy, grain…..
WHAT IS A DERIVATIVE?
A derivative is a financial instrument whose value

depends on the values of other underlying variables
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UNDERLYING ASSETS
• Agriculture: Corn, Soybean, Soymeal…

• Cryptocurrencies
• Energy
• Equities
• FX
• Interest rates
• Metals
• Real Estates
• Weather
https://www.cmegroup.com/markets/products.html#pageNumber=6&sortDirection=asc&sortField=group
HISTORY OF DERIVATIVES MARKETS
CME CBOE CBOE IRS

CBOT
futures Call option Put option IBM-WB
1848 1919 1973 1977 1981
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DERIVATIVES INSTRUMENTS
• Forward contract • OTC markets

• Futures contract • Exchange-traded markets
• Swaps
• Options
TRANSACTION
Forwards Futures Swaps Options
OTC EX OTC OTC/EX
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TYPES OF TRADERS
Hedgers
Speculators
Arbitrageur
TYPES OF TRADERS
1. Floor broker
2. Professional trader
3. Position traders
4. Day traders
5. Scalpers
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POSITIONS
• Short • Opening a position

• Long • Closing a position
HEDGING WITH FORWARDS
• In May 5, 2023, Hoa Phat Group (HPG) knows that they will
have to pay $10 million on August 6, 2023 for steel they
imported from a U.S supplier. The USD/VND exchange rate
quotes by Vietcombank are shown as below.
Spot 24,000 24,020

1-month forward 24,100 24,150
• How could HPG hedge its foreign exchange risk?
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HEDGING WITH OPTIONS
In May 5, 2023, Hoa Phat Group (HPG) knows that they will
have to pay $10 million on June 6, 2023 for steel they
imported from a U.S supplier. The USD/VND exchange rate
quotes by Vietcombank are shown as below.
Bid Ask Option price Option

Spot 24,000 24,020
1-month strike price 24,100 24,150 5 8
FORWARDS
1. For example, in a three-month forward contract to deliver

$100 face value of 10-year bonds, the buyer and seller
agree on a price and amount today, but the delivery of the
10-year bond for cash does not occur until three months
into the futures
2. If the forward price agree to at time zero was $98 per
$100 of face value, in three months’ time the seller delivers
$100 of 10-year bonds and receives $98 from the buyer
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FORWARD MARKETS
1. Participants: Commercial banks, investment banks and

broker-dealers
2. Underlying asset are non-standardized: foreign currencies,
interest rates…
3. Credit forward is a forward agreement that hedges against
an increase in default risk on a loan after loan rate is
determined and the loan is issue by a banks
FUTURES
1. A futures contract, like a forward contract, is an agreement

between a buyer and a seller at time 0 to exchange a
standardized, prespecified asset at some later date at a
price set at time 0.
2. Futures trading occurs on organized exchanges
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FUTURES
1. Long position
2. Short position
3. Clearing house
FUTURES
1. Open interest: the total number of contracts outstanding

equal to number of long positions or number of short
positions
2. Settlement price: the price just before the final bell each
day used for the daily settlement process
3. Volume of trading: the number of trades in one day
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FUTURES
• When Futures Price Decreases • When Futures Price Increases
Clearing House Clearing House
Clearing House Clearing House Clearing House Clearing House

Member Member Member Member
Broker Broker Broker Broker
Long Trader Short Trader Long Trader Short Trader
OPTIONS
Types of options
 A Call option
 A Put option
Option style
 American option
 European option
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OPTIONS
Types of position Option positions

 Long position  Long call
 Short position  Long put
 Short call
 Short put
OPTIONS
• intrinsic value: The difference between the underlying

asset’s spot price and an option’s exercise price
• time value: The difference between an option’s price (or
premium) and its intrinsic value
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OPTION POSITIONS
• Long Call : max(S − K, 0)

• Short Call : -max(S − K, 0)= min(K − S , 0)
• Long Put : max(K − S , 0)
• Short Put : -max(K − S , 0)= min(S − K, 0)
OPTION VALUE
ITM ATM OTM

Call S>K S=K S<K
Put S<K S=K S>K
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OPTION POSITIONS
STOCK OPTIONS
1. The underlying asset on a stock option contract is the

stock of a publicly
2. One option generally involves 100 shares of the underlying
stock
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STOCK INDEX OPTIONS
1. The underlying asset on a stock index option is the value of

a major stock market index
2. The difference between a stock option and stock index
option is that at expiration, the stock index option holder
cannot settle the option contract with the actual purchase
or sales of the underlying stock index
3. Stock index options are settle in cash
OPTION ON FUTURES CONTRACTS
1. The underlying asset on a futures option is a futures

contract
2. The buyer of a call (put) option on a futures contract has
the right to buy (sell) the underlying futures contract at or
before expiration while the seller of a call (put) option on a
futures contract creates the obligation to sell (buy) the
underlying futures contract on exercise by the option
buyer.
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CREDIT OPTIONS
 Hedge credit risk

 Credit spread call option: a call option whose payoff
increases as the (default) risk premium or yield spread on a
specified benchmark bond of the borrower increase above
some exercise spread.
 Digital default option: an option that pays a stated amount
in the event of a loan default (the extreme case of
increased credit risk).
REGULATIONS OF FUTURES AND

OPTIONS MARKETS
1. Regulators of derivatives specify “permissible activities” that

the institutions may engage in
2. Once permissible activities have been specified, institutions
engaging in those activities are subjected to supervisory
oversight
3. Regulators attempt to judge the overall integrity of each
institution engaging in derivatives activities by assessing the
capital adequacy of the institutions and by enforcing
regulations to ensure compliance with those capital
requirement
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SWAPS
1. A swap is an OTC derivatives agreement between two

companies to exchange cash flows at specified future times
according to certain specified rules
2. Example: Currency swap between firm A and firm B. Firm A

had a loan in US dollars while firm B had a loan in Euro.
Firm A agreed to pay the interest on firm’s B borrowings
while firm B agreed to pay the interest on firm A’s
borrowing also.
INTEREST RATE SWAPS
1. An interest rate swap is a succession of forward contracts

on interest rates arranged by two parties
2. The swap buyer agrees to make a number of fixed interest
rate payments based on a principal contractual amount
(notional principal) on periodic settlement dates to the
swap seller. The swap seller, in turn, agrees to make floating-
rate payments, tied to some interest rate, to the swap
buyer on the same periodic settlement date.
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INTEREST RATE SWAPS – HEDGING

INTEREST RATE RISK
INTEREST RATE SWAPS – HEDGING

INTEREST RATE RISK
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CURRENCY SWAPS
CREDIT SWAPS
1. Hedge credit risk

2. A total return swap involves swapping an obligation to pay
interest at a specified fixed or floating rate for payments
representing the total return on a loan (interest and
principal value changes) of a specified amount
3. In a pure credit swap, the financial institution lender will
send (each swap period) a fixed fee or payment (like an
insurance premium) to the counterparty
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SWAP MARKETS
1. Swap transactions are heterogenous in terms of maturities,

indexes used to determine payments, and timing of
payments
2. Swap markets were governed by very little regulation
CAPS, FLOORS, AND COLLARS
1. Help to hedge interest rate risk.

2. Buying a cap means buying a call option or a succession of
call options on interest rates
3. Buying a floor is similar to buying a put option on interest
rates
4. A collars occurs when a firm takes a simultaneous position
in a cap and a floor
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FINANCIAL MARKETS
CHAPTER 7. FOREIGN EXCHANGE MARKETS
Phan Quynh Trang
OBJECTIVES
• Foreign exchange markets and foreign exchange rates

• Spot foreign exchange transaction and forward foreign
exchange transaction; real and nominal exchange rates
• Return and risk on foreign exchange transactions.
• Role of financial institutions in FX transactions
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INTRODUCTION
1. The euro is the name of the European Union’s (EU’s) single

currency
2. The use of a foreign currency in parallel to the local
currency is referred to as dollarization
3. Free floating Yuan
FOREIGN EXCHANGE RATE
• A foreign exchange rate is the price at which one currency

can be exchanged for another currency
• FX risk: potential exposure due to the fluctuation of
exchange rate
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QUOTE
• Direct quote: local currency received for one unit of the

foreign currency exchanged (in VND)
USD/VND=22,000
EUR/VND=26,000
• Indirect quote: foreign currency received for one unit of
local currency (per VND)
VND/USD=1/22,000=0.000045
VND/EUR=1/26,000=0.000038
CROSS-EXCHANGE RATE
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CROSS-EXCHANGE RATE
• USD/VND=22,000 • USD/VND=22,000 • USD/THB=35

• EUR/VND=26,000 • VND/THB=0.0014 • USD/VND=22,000
• EUR/USD? • USD/THB? • THB/VND?
FOREIGN EXCHANGE TRANSACTIONS
1. Spot foreign exchange transactions involve the immediate

exchange of currencies at the current (or spot) exchange
rate
2. A forward foreign exchange transaction is the exchange of
currencies at a specified exchange rate (or forward
exchange rate) at some specified date in the future
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FOREIGN EXCHANGE TRANSACTIONS
EXCHANGE RATE SYSTEMS
• 1944 – 1971: Breton Wood era

• Dirty float
• Freely floating system
• Pegged exchange system
• Eurozone
• Crypto currencies
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RISK AND RETURN
• Depreciation: a country’s currency falls in value relative to

other currencies
• Appreciation: a country’s currency rises in value relative to
other currencies
RISK AND RETURN
1. The risk involved with a spot foreign exchange transaction

is that the value of the foreign currency may change relative
to the U.S. dollar over a holding period
2. Hedging
 Forward
 On-balance-sheet
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INFLATION, INTEREST RATE, EXCHANGE

RATE
1. Fisher effects
2. Purchasing power parity (PPP)
3. Interest rate parity (IRP)

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1/2/2024

Phan Quynh Trang

• Primary and secondary markets; money and capital markets

Financial markets are structures through

 Primary markets & Secondary markets

PRIMARY AND SECONDARY MARKETS

Primary markets Secondary markets

MONEY AND CAPITAL MARKETS

Money markets Capital markets

 Money market instruments

Money market instruments Capital market instruments

Store of value Transfer risk

Perform the essential function of channeling

FINANCIAL INSTITUTIONS & SERVICES

For suppliers of funds For economy

FINANCIAL INSTITUTIONS & RISKS

FINANCIAL INSTITUTIONS &

 Prevent FIs from market failures

Phan Quynh Trang

 Types of interest rates

TYPES OF INTEREST RATE

 Nominal • Coupon rate • Single-payment • Coupon rate

Nominal interest rates are the interest rates

Real risk-free rate is the interest rate that would

TIME VALUE OF MONEY

A dollar received today is worth more than a

Lump sum payment is a single cash payment

Annuity payments a series of equal cash flows

PRESENT/FUTURE VALUE OF A LUMP SUM

PRESENT/FUTURE VALUE OF AN ANNUITY

Coupon rate on a bond instrument is the annual

BOND EQUIVALENT YIELDS

: nominal rate earned on an investment over a

EFFECTIVE ANNUAL RETURNS

EAR: less than one year or compounded interest

: yields on these securities use a 360-day year

DISCOUNT YIELD INTO A BOND

Some money market securities (e.g., negotiable CDs

NOMINAL INTEREST RATE INTO A

Money market is a type of financial markets that

 Treasury Bills (T-bills)

 Short-term obligations of the U.S. government

TREASURY BILLS YIELDS

BOND EQUIVALENT YIELDS

 Involve the sale of securities by one party to another with

Be arranged either directly between two parties or with

REPURCHASE AGREEMENT YIELDS

 Be backed by Treasury securities

 An unsecured short-term promissory note

COMMERCIAL PAPER YIELDS

 A bank-issued time deposit that specifies an

 Banks issue, then sell

 A time draft payable by banks

1. Federal reserve system

Phan Quynh Trang

• Capital markets: bonds, mortgages and equity

BOND MARKET SECURITIES

1. Treasury notes and Bonds (STRIPS, TIPS)

TREASURY NOTES AND BONDS

 T-notes and T-bonds

1. Separate Trading of Registered Interest and Principle

 Dirty price/full price = purchase price (clean price) + accrued interest