CHAPTER TWO

FINANCIAL MARKETS AND INSTRUMENTS

 2.1. Meaning of financial market
 A financial market is a mechanism that allows people to easily buy and sell
(trade) financial securities (such as stocks and bonds) and different contractual
agreements.
 Financial market performs the function in financial system as facilitating
organizations.
 Unlike financial institution they are not source of funds but
 They are a link and provide a forum in which supplier of the funds and demanders of
the Loans can transact business directly.
 Cont…
 The loans and investments of financial institution are made without the direct
knowledge of the suppliers of the funds (i.e. investor),
 suppliers in financial market know where their funds are invested.
 There are two units in the economy;
 Surplus Units: provides/invests of capital that invest their capital in order to earn
profits (interest or dividend or capital gains)
 Deficiency Unit: are individuals or institutions with investment opportunities but
lack sufficient internal resources to finance it.
 These two parties meet in the financial market to trade:
 exchange money and securities
 Participants of financial market can be grouped in to two:
 Lenders (surplus units) that include individuals and corporation, and
 Borrowers (individuals, companies, central government, municipalities, public
corporation etc…, )
 2.2. Characteristics of financial market
 Finance and the financial markets play a critical role in the market economy
by allocating capital to productive investment, creating a virtuous circle of
wealth which drives economic growth.
 Beyond pooling savings into capital and allocating that as investment, a well-
functioning and sophisticated financial marketplace also does the following:
 Provides liquidity
 Facilitates price discovery
 Allows for the sharing and management of risk
Provides liquidity: It is the ability to rapidly access cash
 Many businesses have seasonal changes in their cash needs,

 for example, retail during major holidays, or agriculture during harvesting season.
 Liquidity also provides investors’ confidence that they can sell their financial
asset for cash if needed or desired.
Facilitates price discovery
 The act of determining the proper price of a security, commodity, or good or

service through the competitive market forces of supply and demand.

 This allows prices to efficiently signal the most productive use of financial resources.
Allows for the sharing and management of risk:
 The diversification of investments as well as by matching the risk appetite of

individual investors to the risk profile of different investments.

2.3. Functions of Financial Markets
2.4. Classification of Financial Markets
 By nature of claim
 There are broadly two kinds of claims, i.e. fixed claim and residual claim.
Debt Market: Debt market refers to the market where debt instruments such as
debentures, bonds, etc. are traded between investors.
 Such instruments have fixed claims, i.e. their claim in the assets of the entity

is restricted to a certain amount.

 These instruments generally carry a coupon rate, commonly known as

interest, which remains fixed over a period of time.

Equity Market: In this market, equity instruments are traded.
 Equity refers to the owner’s capital in the business and thus, have a residual

claim, implying, whatever is left in the business after paying off the fixed
liabilities belongs to the equity shareholders, irrespective of the face value of
shares held by them.
 By Maturity of Claim
 It is the time horizon of the investment
Money market is for short term funds, where the investors who intend to invest
for not longer than a year enter into a transaction.
 This market deals with Monetary assets such as treasury bills, commercial

paper, and certificates of deposits.

 Since these instruments have a low maturity period, they carry a lower risk

and a reasonable rate of return for the investors, generally in the form of
interest.
Capital market refers to the market where instruments with medium- and long-
term maturity are traded.
 This is the market where the maximum interchange of money happens, it

helps companies get access to money through equity capital, preference share
capital, etc. and
 It also provides investors access to invest in the equity share capital of the

company and be a party to the profits earned by the company.

 This market has two verticals:

 Primary Market
 Secondary market
 By Timing of Delivery
 This concept generally prevails in the secondary market or stock market.
Cash Market: transactions are settled in real-time and
 it requires the total amount of investment to be paid by the investors,

 either through their own funds or through borrowed capital, generally known as
margin, which is allowed on the present holdings in the account.
Futures Market: the settlement or delivery of security or commodity takes
place at a future date.
 In order to trade in the futures market, the total amount of assets is not

required to be paid, rather, a margin going up to a certain % of the asset

amount is sufficient to trade in the asset.
 By Organizational Structure
 the manner in which transactions are conducted in the market
Exchange-Traded Market is a centralized market, that works on pre-
established and standardized procedures.
 In this market, the buyer and seller don’t know each other.

 Transactions are entered into with the help of intermediaries, who are required

to ensure the settlement of the transactions between buyers and sellers.

 There are standard products that are traded in such a market, there cannot need

specific or customized products.

Over-the-Counter Market: This market is decentralized, allowing customers to
trade in customized products based on the requirement.
 In these cases, buyers and sellers interact with each other.

 Generally, Over-the-counter market transactions involve transactions for hedging of

foreign currency exposure, exposure to commodities, etc.
 These transactions occur over-the-counter as different companies have
different maturity dates for debt, which generally doesn’t coincide with the
settlement dates of exchange-traded contracts.
2.5. Features & functions of primary & secondary market
Primary Market – refers to the market, where the company lists security for
the first time or where the already listed company issues fresh security.
 The amount paid by shareholders for the primary issue is received by the

company.
 There are two major types of products for the primary market.

 Initial Public Offer (IPO) or

 Further Public Offer (FPO).
 A company can raise money from the primary market even after the securities
list on the secondary market.
 A company can do so by issuing the right shares to the investors at a price lower than
the prevailing secondary market price.
Secondary Market – Once a company gets the security listed, the security
becomes available to be traded over the exchange between the investors.
 The market that facilitates such trading is known as the secondary market or

the stock market.

 Transactions of the secondary market don’t impact the cash flow position of

the company, as such, as

 the receipts or payments for such exchanges are settled amongst investors, without
the company being involved.
 Stock markets such as the New York Stock Exchange (NYSE) and the
NASDAQ are examples of the secondary markets.
 Features of Secondary Market
 Gives liquidity to all investors.
 Very little time lag between any new news or information on the company and the
stock price reflecting that news.
 The secondary market quickly adjusts the price to any new development in the
security.
 Lower transaction costs due to the high volume of transactions.
 Demand and supply economics in the market assist in price discovery.
 An alternative to saving.
 Secondary markets face heavy regulations from the government as they are a vital
source of capital formation and liquidity for the companies & the investors.
 High regulations ensure the safety of the investor’s money.
Major Instruments and Players in Secondary Market

The secondary market deals with fixed income, variable income, and hybrid
instruments.
 Fixed income instruments are usually debt securities like bonds, debentures.

 Variable income instruments are equity and derivatives.

 Hybrid instruments are preference shares and convertible debentures.

Basis of Primary Market Secondary Market
Comparison
Meaning A platform that offers security for the first The market where investor’s trade already issued
time is the primary market. securities is known as the secondary market.
Another name New issue market (NIM). Aftermarket or share market.
Type of Products are limited, and mainly include IPO Many products are available such as shares,
product and FPO (Further Public Offer). warrants, derivatives and more.
Purchase type All the purchases in this market happen The issuer (company raising capital) is not involved
directly. in the trading.
Frequency of Security can be sold to the investors just once Here the traders can buy and sell the shares as
selling in this market. many times they want.
Parties Company and the investors are involved in Here investors buy and sell the securities among
involved buying and selling the security. themselves.
Beneficiary Company Investor
Several tools are available to the investors to help
How to identify Investors primarily rely on prospectus and
word-of-mouth publicity to pick an them pick good investments, such as price to
investment? investment in the primary market. earnings (P/E), price to book (P/B), price to sales
(P/S) and more.
Intermediary Underwriters are the intermediaries in the Here the intermediaries are the brokers.
primary market.
Purpose Help new and existing companies to raise Does not provide funding to companies; rather help
capital for expansion and diversification. investors to make money.
Price The company sells the shares to the investors Both buy and sell-side investors work towards
at a fixed price. finding the best price for the trade.
Presence There is no organization set up for the primary There is a geographical setup and organizational
market presence for the secondary market.
Rules and The company issuing securities goes through Here investors and brokers need to follow the rules
Regulations a lot of regulation and due diligence. set by the exchange and the governing agency.
 2.6. Features of stock exchange and OTC market
 There are two types of secondary markets:
Stock Exchanges: It is a marketplace, wherein there is no direct contact
between the buyer and the seller, like NYSE or NASDAQ.
 There is no counterparty risk as an exchange is a guarantor.

 Also, heavy regulations make it a safe place for investors to trade securities.

 However, investors face a comparatively higher transaction cost due to

exchange fees and commission.

Over-The-Counter (OTC) Markets: It is a decentralized place, where the
market is made up of members trading among themselves.
 Without a fundamental substantial location, where market participants trade

with one another through different communication modes such as

 the telephone, email and proprietary electronic trading systems.
 Foreign exchange market (FOREX) is one such type of market.
 There is more competition among the participants to get higher volume, so
prices of security may vary from seller to seller.
 Also, OTC markets suffer from counterparty risk as parties deal with each
other directly.
 2.7. Features and instruments of money market
 Money market is created by a financial relationship between supplier and
demanders of short-term funds which have maturity of one year or less.
 The broad objectives of money market are three-fold
 An equilibrating mechanism for evening out short-term deficiency and surplus in
financial system
 A focal point of intervention by the central bank for influencing liquidity in the
economy
 A reasonable access to the users of short-term funds to meet their requirements and
temporary development of funds for earning returns to the supplier of funds.
 The Importance of money market
 For most individuals and institutions, inflows and out flows of cash is rarely
in perfect harmony with each other.
 There is a time lag between collections and disbursements.
 When taxes are collected; government usually will have funds that exceed
their immediate cash needs.
 At this, the government frequently enters the money markets as the lenders and
purchase financial assets like bank deposits.
 As cash runs low relative to the expenditures, the government once again
enters the money market as a borrower of the funds,
 by issuing Short-term notes such as treasury bills attractive to money market
investors.
 The checking accounts of an active business firm fluctuated daily between
large surplus, low or nonexistent balance.
 At the time a surplus cash position, they bring such funds in to money markets as net
lender of funds.
 However, at the time of cash deficits it forces them into the borrowing side.
 When idle cash is not invested, the holders incur an opportunity cost in term
of interest income forgone.
 The goals of the money market investors
 Investor in the money market seek mainly safety and liquidity plus the
opportunity to earn some interest income.
 For this reason, money market investor is sensitive to risk, they are strongly
risk averts.
 Types of investment risk faced by investors in the money markets are:
 Market risk: this risk is the risk that the market price of an asset will decline,
resulting in decline in capital loss when sold.
 Default risk: the probability that the borrowers will feel to meet its promised
principal and interest on loan or security.
 Inflation risk: the risk that increases in general price level will reduce the
purchasing power of earning from a loan, security or other investment.
 Currency risk: the risk that adverse movements in price of national currency vis-à-
vis another will reduce the net rate of return from foreign investment.
 Sometimes referred to as exchange rate risk
 Political risk: The probability that changes in government’s laws or regulations will
reduce investors expected return from an investment.
 Common money market instrument
I. Treasury bills
The current yield or true return rate of interest Treasury bill is calculated as
follows:
Y=D/P*365/t*100
Where; Y=the annualized yield (interest rate), D=discount to face value (D=face
value less price), P= current market price or selling price, t= the number of days
remaining to maturity. 365=days in a year
For example: the interest rate or yield on issue of a six month (180 days).
Treasury bill with the face values of $ 100, sold at $95 can be calculated as
Y= 5/95*365/180=10.67%
II. Bankers’ acceptance: is a time draft drawn on or accepted by the bank.
 Before acceptance, the draft is not an obligation of the bank.

 It is merely an order by the drawer to the bank to pay specified sum of money

on specified date to the named person or the bearer of the draft.

 A banker’s acceptance starts as an order to the bank by a banks customer is

accepted
 to pay a sum of money at the future date, typically within six months.
 BA is a vehicle created to facilitate trade transactions,
 BA is a time draft payable to the seller of goods with payment guaranteed by
bank,
 The transaction in which BA are created includes:
 the import of goods into a country,
 the export of goods from a given country,
 the storing and shipping of goods between two foreign countries.
III. A certificate of deposit or CD: is a time deposit, financial product
commonly offered to customers by banks, saving institutions and credit unions.
 Such CDs are similar to the saving accounts in that they are insured and

virtual risk free; they are money in bank.

 They are different from saving account in that the CDs has specific, fixed term

(often three months, six months, one to five years) and usually fixed interest
rates.
 It is intended that the CD be held until maturity, at which time money may be

withdrawn together with the accrued interest.

IV. Repurchase agreement (repo): RP is an agreement involving the sale of
securities by one party to another with a promise to repurchase the security at a
specified price and on a specific date in the future.
 Individuals or firms with temporary idle or excess capital buy short-term

securities (e.g. T-Bills) from their banks in order to earn small return until the
money is needed.
 In this case the firm uses its idle fund to buy T-bills from its bank.

 The bank then agrees to repurchase the T-bills in the future at a higher price.
 The repo rate is the difference between borrowed and paid back cash
expressed as a percentage.
 It is economically similar to secured loans, with the buyer receiving securities
as collateral to protect against default.
 Example Repo: interest rate or yield on RP is calculated an annual basis. Yield
rate=RP-PP/PP*365/t; RP= Repurchase price; PP=Purchase price
 Example suppose a bank enters in a repurchase agreement in which it agrees to buy
treasury securities from one of its correspondent bank at a price of $ 10,000,000, with
promise to sell these securities back at a price of $ 10,002,986 after five days. The
yield on this repo to the bank is:
 $ 10,002,986-10,000,000/10,000,000*365/5=2.15%
 There are three types of repo maturity
1. Overnight repo-it refers one-day maturity transaction.
2. Term repo-refers to a repo with specified end date.
3. Open repo-simply has no end date.
V. Commercial paper (CPs): CPs are unsecured promissory notes issued by
companies with strong credit rating to raise short-term cash often to finance
working capital requirement.
 Issuance of CPs is an alternative to bank borrowing for large corporations.

 Therefore, small investors can invest in CPs;

 has a fixed maturity;

 they are liability to the issuing company;
 usually sold at a discount from face;
 issuers pay the face value to holders of the security at maturity.
 Difference between the face value and selling price is an implicit interest to
the holder.
Yield = (D/Par*360/t)*100
 Example: suppose an investor purchases 95-days commercial paper with a
par value of $ 1,000,000 for a price of $999,854.
 The discount yield is $1,000,000-994,854/1,000,000*360/95

=0.055%
 Risk to investors on CPs: To pay off holders of maturing paper, issuers
generally use the proceeds obtained by selling new commercial paper.
 The risk the investor in CP faces is that the issuer may be unable to sell new
paper at maturity.
VI. Municipal bond is a bond issued by states, cities, and countries or their
agency (the principal issuer) to raise funds.
 The methods and practices of issuing debt are governed by an extensive

system of laws and regulations.

 Bonds bear interest at either a fixed or a variable rate of interest.

 The interest received by the holder of the municipal bonds often exempt from

the federal income tax and from the income tax of the state in which they are
issued.
 Characteristics of municipal bonds

1. Taxability: one of the primary reason municipal bonds are considered

separately from other types of bonds is their special availability to provide tax-
exempt income.
2. Risk: the risk of municipal bond is measure of how likely the issuer is to
make all payment on time and in full, as promised in agreement between the
issuer and the bondholder.
viii. Federal funds: are overnight borrowings by the banks to maintain their
banks reserves at Federal Reserve.
 Banks keeps reserves at federal reserve banks (central banks in our country) to

meet their reserve requirement and clear financial transaction.

 Fed fund are short-term funds transferred between financial institutions

usually for no more than a day.

 For example, one commercial bank with short of reserves, may borrow from another
bank that has a surplus.
 2.8. Capital market and instruments
 It is financial relationship created by a number of institutions and
arrangements that allows supplier and demanders of long-term funds (i.e.
funds with maturity exceeds one year) to make transactions.
 It supplies industry with fixed and working capital and finances medium term
and long-term borrowing of central, state and local governments.
 Importance or function of capital markets
 The capital market helps in capital formation and economic growth of the
country.
1. It acts as an important link between savers and investors
2. It gives incentives to the savers and investors.
 in the form of interest and dividend
3. It brings stability in value of stocks and security
4. It encourages economic growth.
 Capital market instrument
 Treasury bond: this is bonds and notes issued by the government.
 Notes have original maturity of 1-10 years while bonds are original maturity of 10-30
years.
 Corporate long-term bonds: the corporations in which the borrowing terms
spelled out in a bond indenture issue this.
 The indenture spells out term, interest rate, collateral offered.
 State and local bonds (municipal bonds): These are bonds issued by the
local, county and state government and agency of these government units.
 These bonds are typically used to finance schools, public building, and transportation
infrastructure.
 Common stock and preferred stock
 Mortgage: are long-term loans which has collaterals of real property.
 Mortgage are used to finance residential and non-residential property such as:
 office building,
 shopping center,
 warehouse and
 other income producing real estate.
 2.9. Third and fourth market
Third market Fourth market

*These markets are over-the-counter markets.

* Where hedge funds and other institutional investors typically exchange large volumes of shares.
 It’s reserved specifically for institutional
 a combination between the secondary investors, used for trading huge blocks directly
market and the OTC market. between funds.
 via the Electronic Communications Network (ECN).
 exchange-listed securities trade over-the-
 trading can happen after market hours, when
counter. exchanges close.
 To cut out the middle man
 encompasses both exchange-traded and OTC
 trades are relatively anonymous securities or non-exchange traded securities, as
well as derivatives.
 Fund managers and other institutional
 Fourth market trading differs from third market
investors have access to the capital and
trading in that there is no intermediary or broker
systems to facilitate trades. facilitating the trade.
 They don’t require the liquidity or security
offered by an exchange or broker.
 2.10. Derivative market
 A derivative security is a financial security whose payoff is linked to another,
previously issued security.
 Derivative securities generally involve an agreement between two parties to
 exchange a standard quantity of an asset or cash flow at a predetermined price and at
a specified date in the future.
 As the value of the underlying security to be exchanged changes, the value of
the derivative security changes.
 Derivatives involve the buying and selling, or transference, of risk.
 However, derivative securities’ traders can experience large losses if the price
of the underlying asset moves against them significantly.
 2.10.1. Forwards and futures

 A spot contract is an agreement between a buyer and a seller at time 0,

 when the seller of the asset agrees to deliver it immediately and
 the buyer agrees to pay for that asset immediately.

 Thus, the unique feature of a spot market is the immediate and simultaneous
exchange of cash for securities.
 Cont…

 Spot transactions occur because the buyer of the asset believes its value will
increase in the immediate future (over the investor’s holding period).
 If the value of the asset increases as expected, the investor can sell the asset at
its higher price for a profit.
 For example, if the 20-year bond increases in value to $98 per $100 of face value, the
investor can sell the bond for a profit of $2 per $100 of face value.
 Forward contract agreement between a buyer and a seller at time 0 to
exchange a non-standardized asset for cash at some future date.
 Customized to a commodity, amount, and delivery date.
 Commodities traded can be grains, precious metals, natural gas, oil, or even poultry.
 The details of the asset and the price to be paid at the forward contract
expiration date are set at time 0.
 The price of the forward contract is fixed over the life of the contract.
 Forward contracts do not trade on a centralized exchange and are therefore
regarded as over-the-counter (OTC) instruments.
 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 future. If the
forward price agreed to initially 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. This
is the price the buyer must pay and the seller must accept no matter what happens to
the spot price of 10-year bonds during the three months between the time the
contract is entered into and the time the bonds are delivered for payment
 (i.e., whether the spot price falls to $97 or below or rises to $99 or above).
 Futures contract agreement between a buyer and a seller at time 0 to
exchange a standardized asset for cash at some future date.
 Each contract has a standardized expiration and transactions occur in a
centralized market.
 The price of the futures contract changes daily as the market value of the asset
underlying the futures fluctuates.
 Futures trading occurs on organized exchanges—for example, the Chicago
Board of Trade (CBT) and the New York Mercantile Exchange (NYMEX).
 Difference between forwards and futures is that:
 Forward contracts are bilateral contracts subject to counterparty default risk,
 But the default risk on futures is significantly reduced by the futures exchange
guaranteeing to indemnify counterparties against credit or default risk.
 Another difference relates to the contract’s price,
 which in a forward contract is fixed over the life of the contract (e.g., $98 per $100 of
face value for three months to be paid on expiration of the forward contract),
 whereas a futures contract is marked to market daily.
 This means that the contract’s price is adjusted each day as the price of the asset underlying
the futures contract changes and as the contract approaches expiration.
 The default risk of a futures contract is less than that of a forward contract for
at least four reasons:
(1) daily marking to market of futures (so that there is no buildup of losses or gains),
(2) margin requirements on futures that act as a security bond minimize a counterparty
default,
(3) the price movement limits the theat spread extreme price fluctuations over time, and
(4) default guarantees by the futures exchange itself.
 2.11. Foreign Exchange Market
 Individuals, corporations, banks, and governments interact to convert one
currency to another.
 The foreign exchange markets represent the biggest financial markets, with
transactions totaling more than $1.5 trillion per day and hundreds of trillions
of dollars per year.
 Foreign exchange markets provide a mechanism for transferring purchasing
power
 from individuals who normally deal in one currency to people who generally transact
business using a different monetary unit.
 Reason for efficient foreign exchange market development:

 First: Importing and exporting goods and services are facilitated by this
conversion service.
 The currencies of some countries are not easily convertible into other
currencies.
 If a corporation chartered in another country wants to do business with a
country whose currency is nonconvertible, the corporation may be required to
accept locally produced merchandise in lieu of money as payment for goods
and services.
 This practice is known as countertrade.
 Cont…

 A second reason that efficient foreign exchange markets have developed is

that they provide a means for passing the risk associated with changes in
exchange rates to professional risk takers.
 This hedging function is particularly important to corporations in the present
era of floating exchange rates.
 The third important reason for the continuing importance of foreign
exchange markets is the provision of credit.
 The time span between shipment of goods by the exporter and their receipt by
the importer can be considerable.
 Market structure: There is no single formal foreign exchange market such as
the one that exists for the sale of stocks and bonds on the New York Stock
Exchange.
End of the chapter!