Financial Markets in the Financial

System
 Organization and Structure of
Markets

 A Financial Market is a market in which financial

assets (securities) can be purchased or sold.
 Financial markets facilitate transfers of funds from
person or business without investment opportunities
(i.e., “Lender-Savers”, or “Surplus Unit”) to those
who have investment opportunities (i.e., “Borrower-
Spenders”, or “Deficit Unit”).

2
 Organization and Structure of
Markets

 Both general markets and specialized markets

exist.
 Markets work by placing many interested sellers
in one "place", thus making them easier to find for
prospective buyers.
 An economy which relies primarily on interactions
between buyers and sellers to allocate resources
is known as a market economy.

3
 Organization and Structure of
Markets

 Essential characteristics of a well-run financial

market:
– Must be designed to keep transaction costs low.
 Operational Efficiency
– Information the market pools and communicates must
be accurate and widely available and as a result prices
reflect relevant information.
 Informational Efficiency
– Borrowers’ promises to pay lenders must be credible
and the market results in highest/best use of funds.
 Allocational Efficiency
4
 Organization and Structure of
Markets

 Because of these criteria, the governments

are an essential part of financial markets as
they enforce the rules of the game.
– Countries with better investor protections have
bigger and deeper financial markets.

5
 Types of financial markets

 Physical assets vs. Financial assets

– Physical vs claims on real assets
 Primary vs. Secondary
– Originally (IPO) sold versus traded after (Secondary offering)
 Money vs. Capital
– Short term vs long term
 Spot vs. Futures
– Now vs later price
 Public vs. Private
– Standardized on recognized exchanges versus direct negotiation
 domestic vs. international

6
 Primary and secondary market

• Primary Market
– When a corporation issues securities, cash flows
from investors to the firm.
– Usually an Investment Banker is involved
• Secondary Markets
– Involve the sale of “used” securities from one
investor to another.

7
Primary and secondary market
Investors

securities
Stocks and Yeshi Belay
Firms money
Bonds

Money

Primary Market

Secondary Market
 Primary Markets

Funds

Primary
Market
Securities

9
 Primary Markets

 Could be an Initial Public Offering (IPO) or issue of new shares

of an existing publicly traded company.
– Initial public offering (IPO): An IPO occurs when a company
offers stock for sale to the public for the first time.
– Seasoned equity offering (SEO): If a company already has public
shares, an SEO occurs when a company raises more equity.
 Functions of Investment Bankers
– Advising issuer on terms and timing of offering
 advisor
– Buying securities from issuer
 underwriting
– Distributing issue to public
 distributor
10
Variations in the Underwriting
Process

 Bought Deal
– underwriting of bonds
 Auction Process
– underwriting of stocks and bonds
 Preemptive Rights Offering
– underwriting common stock
Bought Deal

 Investment banking firm or group of firms

offers to buy an entire issue from the issuer.
 Attractive features:
– quick in bringing issue to market
– lower risk of capital loss
Auction Process

 In this method, the issuer announces the terms of the issue,

and interested parties submit bids for the entire issue.
 Competitive Bidding Underwriting
– After collecting competitive bids from several underwriters, the issuer
awards the contract to the underwriter with the best price and contract
terms.
 Single-Price Auction or Dutch Auction
– all bidders pay the highest winning yield bid (or,equivalently , the lowest
winning price).
 Multiple-Price Auction
– each bidder pays whatever he/she bids
Preemptive Rights Offering

 A preemptive right grants existing shareholders the rights

to buy some proportion of the new shares issued at a price
below market value.
 The price at which new shares can be purchased is called
the subscription price.
 the underwriting services of an investment banker are not
needed.
– However the issuing corporation may use the services of an
investment banker for the distribution of common stock that is not
subscribed.
– A standby underwriting arrangement will be used in such instances
to buy unsubscribed shares.
Private Placement of Securities

 Sale of securities to a limited number of

institutional investors.
 Regulatory body may specify conditions to
be met for private placement.
 Issuers work with investment bankers.
 Secondary Markets

Funds

Secondary
Market

Securities

are where financial claims “live”—are

resold and repriced
16
Function of Secondary Markets

 Providing security values and required

returns
 Providing liquidity
Trading Locations

 Centralized exchanges - buyers and sellers

meet in a central, physical location.
 Over-the-counter markets (OTC’s) -
decentralized markets where dealers stand
ready to buy and sell securities electronically.
 Electronic communication networks (ECN’s) -
electronic system bringing buyers and sellers
together without the use of a broker or dealer.

18
Market Structures

 Continuous Market
– prices are determined continuously throughout
the trading day
 Call Market
– orders are grouped together for simultaneous
execution at the same price
 Mixed Market
– using elements of the continuous and call market
Perfect Markets

 Large number of buyers and sellers

 Buyers and sellers are price takers
 Market is frictionless with no transactions
costs, taxes and other impediments
 Ability to sell short
Brokers as Match Makers

 A broker acts on behalf of an investor who

wishes to execute orders.
 Broker functions:
– Receives, transmits and executes orders
– Brings together buyers and sellers
– Negotiates prices
 In return, the broker receives a commission.
Dealers as Market Makers

 The dealer holds in inventory the financial

asset traded.
 Dealer functions:
– Takes a position (long or short) in the asset
– Provides opportunity to trade immediately
– Offers price information
– Serves as auctioneer
 Dealer profit is the bid-ask spread.
 Money and Capital Markets

 Money markets: wholesale markets for short-

term debt instruments resembling money itself
 Capital markets: where “capital goods” are
permanently financed through long-term
financial instruments
(“Capital goods”—real assets held long-term to
produce wealth—land, buildings, equipment, etc.)

23
 Money Markets
 The money market is a market for short-term instruments
that are close substitutes for money.
 The short-term instruments are highly liquid, easily
marketable, with little chance of loss or low default risk
and low cost of executing transactions.
 It provides for the quick and dependable transfer of
short-term debt instruments, which are used to finance
the needs of consumers, business, agriculture and the
government.
 Money markets are markets in which commercial banks
and other businesses adjust their liquidity position by
borrowing, lending or investing for short periods of time.
24
 Economic Role of the money
market
 It provides funds
 It helps to use surplus funds
 It eliminates the need to borrow from banks
 It helps government to borrow money at a lower interest rate
 It helps the implementation of the monetary policies of the
central bank
 It facilitates the financial mobility from one sector to the other
 It promotes liquidity and safety of financial institutions
 It brings equilibrium between demand and supply of funds
 It economizes the use of cash.

25
 Characteristics of the Money Market

i. Characteristics of an Undeveloped Money Market

1. There is Personal Touch: The lender and borrower know each
other and decisions made in this market are not rational and
objective.
2. There is flexibility in loans: The amount of the loan depends upon
the nature of security or the borrowers good will with the money
lender.
3. Multiplicity of Lending Activities: Money lending activity is
combined with other economic activities i.e., money lending is not
the only activity of the money lender.
4. Varied Interest Rates are Applied
5. Defective Accounting System: not liable to checking by any higher
authority.
26 6. Absence of link with the developed Market
 ii. Characteristics of a Developed Money Market

1. It is a well-developed market and consists of the central bank, the

commercial bank, non-bank financial intermediaries, etc
2. The central bank controls, regulates and guides the entire money
market
3. It consists of a number of specialized sub markets dealing in various
types of credit instruments
4. It has a large number of near money assets of various types such
as: bills of exchange, promissory notes, treasury bills, bonds, etc.
5. It has an integrated interest rate structure.
6. It has an adequate financial resources from both within and outside
the country.
7. It provides easy and cheap remittance facilities for transferring funds
from one market to the other.
8. It is highly influenced by such factors as restrictions on international
transactions, crisis, boom, depression, war, political instability, etc.
27
 Common Money Market Instruments

1. Treasury Bills:
 Short-term debt obligations of a national government that are issued
to mature in less than 12 months.
 are very safe short-term investments issued by the federal
government
 Like zero-coupon bonds, they do not pay interest prior to maturity;
instead they are sold at a discount of the par value to create a
positive yield to maturity

[ ]
Face Value - Price x n
r =
Face value
 Where “n” is the inverse of the fraction of a year the bill takes to mature
For example, the government made an issue of Br100,000 ninety-one
28 day bills, each at a discount of Br1,000. Yield/ discount rate = 4%
 2. Certificate of deposit
 CDs are similar to savings accounts in that they are insured and
thus virtually risk-free; they are "money in the bank".
 They are different from savings accounts in that the CD has a
specific, fixed term (often three months, six months, or one to five
years), and, usually, a fixed interest rate.
 It is intended that the CD be held until maturity, at which time the
money may be withdrawn together with the accrued interest.
 R = D × (1 + c · n); where: R, redemption value; D, initial deposit; c, coupon
rate; n , term to muaturity (fraction of a year)
 P = R ÷ (1 + i · n); where: P, price; R, redemption value; i, short-term rate
Exercise: Assume a three-month Br50,000 CD, paying 10%
(a) Calculate its redemption value. Br51,250
(b) Find the its price if it has 36 days to maturity and short-term interest rates are 10%.
29 Br50749
 3. Repurchase agreement (RPs or repos)

 Short-term loans—normally for less than two weeks and

frequently for one day—arranged by selling securities to an
investor with an agreement to repurchase them at a fixed price on
a fixed date.
 A repo is economically similar to a secured loan, with the buyer
receiving securities as collateral to protect against default.
 The repurchase price is higher than the initial sale price, and the
difference in price constitutes the return to the lender.
 The repo rate is the difference between borrowed and paid back
cash expressed as a percentage.
 i = (R − P)/P · n; Where: R, resell value; P, purchase price
 Where “n” is the fraction of a year the repo takes to mature
 NBE agrees to a repurchase deal with CBE to buy the bonds for Br1m,
30 agreeing to resell in fourteen days for Br1.002m. Yield =5.26%
 4.Commercial paper

 Commercial paper is an unsecured promissory notes with

a fixed maturity of less than 1 year issued by large banks
and corporations.
 It is generally not used to finance long-term investments but
rather to purchase inventory or to manage working capital.
 usually sold at a discount from face value and the return is
thus calculated in exactly the same way as for treasury bills

[ ]
Face Value - Price x n
r =
Face value

31
 5.Bankers' acceptance

A banker's acceptance, or BA
 is a time draft drawn on and accepted by a 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 a
specified sum of money on a specified date to a
named person or to the bearer of the draft.
 Upon acceptance, which occurs when an authorized
bank accepts and signs it, the draft becomes a primary
and unconditional liability of the bank

32
 6. Municipal bond

 A municipal bond (or muni) is a bond issued by a

state, city or other local government, or their agencies.
 Potential issuers of municipal bonds include cities,
counties, redevelopment agencies, school districts,
publicly owned airports and seaports, and any other
governmental entity (or group of governments) below
the state level

33
 The Capital Market
 The capital market is a market which deals in
long-term loans.
 It functions through the stock exchange
market.
 A stock exchange market is a market which
facilitates buying and selling of shares, stocks,
bonds, securities and debentures for both new
and old ones.
 Capital Markets are divided in to
 Debt Markets
34  Equity Markets
 Importance or Functions of
Capital Market
1. It acts as an important link between savers and investors
 the capital market is the transmission mechanism between surplus
units and deficit units
2. It gives incentives to savers and investors
 Savers or surplus spending units will be rewarded in a form of interest by
investing in stocks or bonds
 Investors or DSUs will be rewarded in a form of profit from their investment
activity.
3. It brings stability in the value of stocks and securities
 It does so by providing capital to the needy at reasonable interest
rates and helps in minimizing speculative activities.
4. It encourages economic growth
 brings rational allocation of resources by converting financial assets in to
35 productive physical assets
 Distinction between Money And
Capital Markets

1. The money market deals in short-term funds, whereas, the

capital market deals in long-term funds.
2. The money market uses short-term instruments, such as
promissory notes, bills of exchange, treasury bills,
certificates of deposits, commercial papers, etc. whereas;
the capital market uses long-term securities such as
shares, debentures, bonds of industrial concerns and
bonds and securities of the government.
3. Institutions operating in the two markets differ. In the
money market: the central bank, commercial banks, non-
bank financial intermediaries and bill brokers operate. In
the capital market, stock exchange, mutual funds,
36 insurance companies, leasing companies, investment
banks, investment trust, etc, operate.
 Interrelation between Money and Capital
Markets

1. Lenders may choose to direct their funds to either or both

markets depending on the availability of funds, the rates of return
and their investment policies.
2. Borrowers may obtain their funds from either or both markets
according to their requirements.
3. Some corporations and financial institutions serve both markets
by buying and selling short-term and long-term securities.
4. All long-term securities become short-term instruments at the
time of maturity. So some capital markets instruments also
become money market instruments.
5. Yields in the money market are related to those of the capital
market. As the long-term interest rates fall, the short-term
37 interest rate will fall.
 Debt Market
Bond market
 Bonds generally can trade anywhere in the world that a buyer and seller can
strike a deal.
 Generally traded in over-the-counter market—usually by telephone
 Bond Dealers
– Bond dealers usually "make a market" for bonds.
– The role of the dealers is to provide "liquidity" for bond investors, thereby
allowing investors to buy and sell bonds more easily and with a limited
concession on the price. Dealers also buy and sell amongst themselves,
either directly or anonymously via bond brokers
 Bond Investors
– The major bond investors are financial institutions, pension funds, mutual
funds and governments, from around the world. These bond investors,
38 along with the dealers, comprise the "institutional market", where large
blocks of bonds are traded.
 Corporate bond
 A Corporate Bond is a bond issued by a
corporation.
– Corporations borrow across all maturity ranges—
mainly at the long end
– High-quality corporate bonds usually yield more than
government bonds and are safer than corporate
stocks
– Bonds have prior claim before stocks—payment of
interest is first priority
– Being long term, these bonds are subject to interest-
39 rate risk—interest rises, prices fall
 Corporate bond

 Callable V Convertible bonds

– Callable bonds
 Issuer has right to pay off the bond before maturity date
 Bond option will be exercised if it is in the interest of the borrower
 These carry higher interest rate

– Convertible bonds—holders have right to convert to common stock

at predetermined price
 secured bond vs unsecured bond
– A secured bond is a loan in which the borrower pledges some asset.
 Serial vs Term

40
 Corporate bond

 Junk bonds
– Very risky, but pay high interest to compensate for risk
– Tend to perform well when the economy is strong, but
extremely risky when economy does poorly
 There are three principal issue methods
– Public issue—issued to the public at large, by prospectus
– Family issue—issued to existing shareholders and
investors by prospectus
– Private placement—issued to institutional investors,
prospectus not required

41
 Government bond

 A government bond is a bond issued by a

national government denominated in the
country's own currency. Bonds issued by
national governments in foreign currencies are
normally referred to as sovereign bonds.
 Government bonds are usually referred to as
risk-free bonds, because the government can
raise taxes or simply print more money to
redeem the bond at maturity

42
 Municipal bonds

 Municipal bonds are issued by state and

local governments, often to finance specific
projects such as highways, schools,
recreational facilities, and the like.
 While they typically pay lower interest rates
than corporate bonds, the interest income is
generally exempt from federal income tax and
frequently from state and local taxes, as well.

43
Foreign Currency Bonds

 A "foreign currency" bond is a bond that is

issued by an issuer in a currency other than its
national currency.
 Issuers make bond issues in foreign currencies
to make them more attractive to buyers and to
take advantage of international interest rate
differentials.

44
 Mortgage Securities

 Most complicated of all debt instruments

 Borrowing by individuals using real estate as
collateral
 Most mortgages are insured by some type of
government agency minimizing potential
default of borrowers
– Governmental National Mortgage Association
– Federal Home Loan Mortgage Corporation

45
Acceptable Collateral for
Mortgages

 Residential Properties
– houses, condominiums, cooperatives, apartments
 Commercial Properties
– multifamily properties, office buildings, industrial
properties, shopping centers, hotels, health care
facilities
Mortgage Originator

 Principal originators of residential mortgage

loans
– Thrifts
– Commercial banks
– Mortgage banks
 Other private mortgage originators
– Life insurance companies
– Pension funds
 Equity Market

 A stock market or (equity market) is a private or

public market for the trading of company stock
and derivatives of company stock at an agreed
price; both of these are securities listed on a
stock exchange as well as those only traded
privately.
 The expression 'stock market' refers to the
market that enables the trading of company
stocks (collective shares), other securities, and
48 derivatives.
The role of stock exchanges

 Raising capital for businesses

– The Stock Exchange provides companies with the facility to
raise capital for expansion through selling shares to the
investing public.
 Mobilizing savings for investment
 Facilitating company growth
– both casual and professional stock investors, through dividends
and stock price increases that may result in capital gains, will
share in the wealth of profitable businesses.
 Creating investment opportunities for small investors
 Barometer of the economy
– the movement of share prices and in general of the stock indexes can
49 be an indicator of the general trend in the economy.
 Common Stock vs. Preferred Stock
 Common Stock
– The holders of common stock can reap two main
benefits from the issuing company: capital
appreciation and dividends
Preferred Stock
– Preferred stock doesn't offer the same potential for
profit as common stock, but it's a more stable
investment vehicle because it guarantees a regular
dividend that isn't directly tied to the market like the
50 price of common stock
 Characteristics of Preferred stock

 Their dividend never changes, but common share dividends

can go up.
 Some preferred shares have special voting rights to
approve certain extraordinary events (such as the issuance
of new shares or the approval of the acquisition of the
company) or to elect directors, but most preferred shares
provide no voting rights
 They have preferential right.
 when interest rates go up, the share price will go down.
When interest rates go down, the share price will go up -
almost automatically.
 price of preferred stock = Dividend divided by rate of
51 interest
Common types of preferred stocks

 Cumulative preferred stock - If the dividend is not paid,

it will accumulate for future payment.
 Non-cumulative preferred stock - Dividend for this type of
preferred stock will not accumulate if it is unpaid.
 Convertible preferred stock - This type of preferred
stock carries the option to convert into a common stock
at a prescribed price.
 Exchangeable preferred stock - This type of preferred
stock carries the option to be exchanged for some other
security upon certain conditions.
52
 Common types of preferred stocks
 Participating preferred stock - This type of preferred
stock allows the possibility of additional dividend above
the stated amount under certain conditions.
 Perpetual preferred stock - This type of preferred stock
has no fixed date on which invested capital will be
returned to the shareholder, although there will always
be redemption privileges held by the corporation.
 Puttable preferred stock - These issues have a "put"
privilege whereby the holder may, upon certain
conditions, force the issuer to redeem shares

53
 Issuing shares
 1. Flotation
– Flotation, also known as an initial public offering
(IPO), is the process by which a firm sells its shares
to the public. This may occur for a number of reasons.
 The firm may require additional capital to take advantage of
new opportunities.
 Some of the firm's original investors may want it to buy them
out so they can put their money to work elsewhere.
 The firm may also wish to use shares to compensate
employees, and a public share listing makes this easier as
the value of the shares is freely established in the market
place

54
 2. Private offering

 Rather than selling its shares to the public, a firm may

raise equity through a private offering.
 Only sophisticated investors, such as money
management firms and wealthy individuals, are
normally allowed to purchase shares in a private
offering, as disclosures about the risks involved are
fewer than in a public offering.
 Shares purchased in a private offering are common
equity and are therefore entitled to vote on corporate
matters and to receive a dividend, but they usually
cannot be resold in the public markets for a specified
period of time.
55
 3.Secondary offering

 A secondary offering occurs when a firm

whose shares are already traded publicly sells
additional shares to the public or when one or
more investors holding a large proportion of a
firm's shares offers those shares for sale to the
public. Firms that already have publicly traded
shares may float additional shares to increase
their total capital.

56
 Foreign Exchange Market

 The foreign exchange market

– Is the market where one buys or sells
the currency of country A with
the currency of country B
 comprise all financial transactions
denominated in foreign currency
 Facilitate exchange of value from one
currency to another
 Functions of FX Market
 The foreign exchange market is the
mechanism by which participants:
– transfer purchasing power between countries
– obtain or provide credit for international trade
transactions, and
– minimize exposure to the risks of exchange rate
changes.

58
 Types of Transactions
1. A Spot transaction in the interbank market is the purchase
of foreign exchange, with delivery and payment between
banks to take place, normally, on the second following
business day.
– e.g. used if an Ethiopian importer has an account in USD to pay
within the next few days
2. Forward transaction requires delivery at a future value date
of a specified amount of one currency for a specified
amount of another currency.
 The exchange rate is established at the time of the agreement, but
payment and delivery are not required until maturity.
– e.g. used if Ethiopian importer has to pay a USD liability in 2 months
 Forward exchange rates are usually quoted for value dates of one, two,
59 three, six and twelve months.
 Market Participants

 The foreign exchange market consists of two tiers:

– the interbank or wholesale market
– the client or retail market (specific, smaller amounts).
 There are different categories of participants that operate
within these two tiers:
– bank and nonbank foreign exchange dealers
– individuals and firms
– speculators and arbitragers
– central banks and treasuries
– foreign exchange brokers.
60
– Investors & Borrowers
 Market Participants

1. Banks and a few nonbank foreign exchange dealers

operate in both the interbank and client markets.
 They profit from buying foreign exchange at a “bid” price
and reselling it at a slightly higher “offer” or “ask” price.
2. Individuals (such as tourists) and firms (such as
importers, exporters and MNEs) conduct commercial and
investment transactions in the foreign exchange market.
 Exporters receive Foreign currency up on sale of goods & use
forex market to sell foreign currency & buy Birr.
 Importers use the FX market to buy foreign currency (sell Birr) to
61 be used for purchasing imports
 Market Participants

3. Speculators and arbitragers seek to profit from

trading in the market itself.
 They operate in their own interest, without a need or obligation
to serve clients or ensure a continuous market.
 While dealers seek the bid/ask spread, speculators seek all the
profit from exchange rate changes and arbitragers try to profit
from simultaneous exchange rate differences in different
markets.
 Speculation : An activity that leaves one open to exchange
rate fluctuations where one aims to make a profit.
 Hedging: Allows the firm to transfer exchange rate risk
62 inherent in foreign currency transactions or positions.
 Market Participants

4. Central banks and treasuries use the market to acquire or

spend their country’s foreign exchange reserves as well as to
influence the price at which their own currency is traded.
 They may act to support the value of their own currency
because of policies adopted at the national level or because
of commitments entered into through membership in joint
agreements
 The motive is not to earn a profit as such, but rather to
influence the foreign exchange value of their currency in a
manner that will benefit the interests of their citizens.
 They may also purchase foreign currency to pay for imports
or interest on foreign debt.
63
 Market Participants

5. foreign exchange brokers transact almost

exclusively with FX dealers
6. Investors & Borrowers
 Commercial bank foreign borrowings are usually converted
into the home currency
 Corporations and financial institutions investing overseas
– Need to purchase FX in order to make the investments
– Dividends or interest payments received from overseas
investments will be denominated in a foreign currency

64
Foreign Exchange Rates & Quotations

 A foreign exchange rate is the price of one

currency expressed in terms of another
currency.

 A foreign exchange quotation (or quote) is a

statement of willingness to buy or sell at an
announced rate.

65
Bid & Ask Quotes

 Foreign currency dealers provide two quotes:

Bid Price: Price at which the dealer is willing to buy
foreign currency from you.
Ask Price: Price at which the dealer is willing to sell
foreign currency to you.
 It is always the case that the Ask Price > Bid Price. The
difference is the Bid-Ask spread.
 The less traded and more volatile a currency, the greater is
66 the spread.
Direct & Indirect Quotes

 Direct Quote: Home currency per unit of Foreign

currency (FC) - e.g. Birr/$ quote is 0.0520 – 0.0523
 Indirect Quote: Foreign currency per unit of Home
currency - e.g. $/Birr quote of 19.113 – 19.225

 Example Bid Ask

$/Birr 19.153 19.371

 Bid: Dealer buys $ for Birr at the Bid, Client sells $ for Birr (i.e., dealer will buy
$100,000 for Br1,915,300).
 Ask: Dealer sells $ for Birr at the Ask, Client buys $ for Birr (i.e., dealer will
67 sell $100,000 for Br1,937,100).
Bid – Ask Spread

 Banks act as market makers and realise their

profits from the spread:
Bid-Ask Spread = (Ask-Bid)/Ask
 Consider the INDIRECT quote of Br19.153 – 19.371/$

% spread 
19.371  19.153
 100  1.13%
19.371
68
Cross Rates

 Many currency pairs are inactively traded, so their

exchange rate is determined through their relationship
to a widely traded third currency.
 For example, an Ethiopian importer needs Danish
currency to pay for purchases in Copenhagen.
 The Ethiopian Birr is not widely quoted against the
Danish kroner (symbol DKr).
 However, both currencies are quoted against the U.S.
dollar. Assume the following quotes:
69 Ethiopian Birr Birr19.231/US$
Danish kroner DKr7.0575/US$
Cross Rates

 The Ethiopian importer can buy one U.S.

dollar for Birr19.231 and with that dollar buy
DKr7.0575. The cross-rate calculation
would be:
Ethiopian birr/U.S. dollar Birr19.231 /US$
  2.7249Birr/DKr
Danish kroner/U.S . dollar DKr7.0575/US$

70
 Measuring a Change in the Spot Rate

 Measuring a change in the foreign currency

for quotations expressed in home currency
terms (direct):
%∆ = Ending rate – Beginning Rate x 100
Beginning Rate
 Quotations expressed in foreign currency
terms (indirect):
%∆ = Beginning Rate – Ending Ratex 100
Ending Rate
71
Example

 The Ethiopian birr was quoted at US$0.0533/Birr

on Aug 19, 2012, while on November 2, 2013 it
was quoted at US$0.0501/Birr.

What is the appreciation/depreciation of the Birr?

72
Example

 Thus, the appreciation/depreciation of the Birr,

relative to the US$ from t-1 to t is:

Rt-1,t = 0.0501 – 0.0533 = -6%

0.0533
Thus, the Ethiopian Birr has depreciated
relative to the U.S.$ by 6%

73
Example

 To calculate the appreciation/depreciation of the

US$, relative to the Birr, we want the denominator
currency to be the US$:
 At t-1: US$0.0533/Birr= Birr18.7617/US$
 At t: US$0.0501/Birr= Birr19.9601/US$
Rt-1,t = 19.9601 – 18.7617 = 6.4%
18.7617
Thus, the US$ has appreciated relative to
the Birr by 6.4%
74
Birr depreciation, US$ appreciation not equal

 In general, the percentage appreciation in one

currency is not equal to the percentage
depreciation in the other currency. Instead…

1
________________________

1 + RUS$ = (1 + RBirr)

75
DERIVATIVE MARKETS

Derivatives derive their price from an underlying

asset in derivatives markets
 Two main types of derivative contracts
– Commodity (e.g. gold, wheat and cattle)
– Financial (e.g. shares, government securities and
money market instruments)
 Three main types derivatives markets
1. Futures Markets
2. Forward Markets
3. Options
 FUTURES MARKETS
 A futures contract is the right to buy or sell a specific item at a specified
future date at a price determined today.
 Standardized contracts permit centralized trading without market makers.
 Main Features of futures Markets
1. Orders and agreement to trade
 Futures contracts are highly standardised and an order normally specifies
– Whether it is a buy or sell order
– The type of contract (varies between exchanges)
– Delivery month (expiration)
– Price restrictions (if any) e.g. limit order
– Time limits on the order (if any)
 Main Features of futures Markets

2. Margin requirements
– Both the buyer (long position) and the seller (short
position) pay an initial margin, held by the clearing
house, rather than the full price of the contract
– Margins are imposed to ensure traders are able to pay
for any losses they incur due to unfavourable price
movements in the contract
– Subsequent margin calls may be made, requiring a
contract holder to pay a maintenance margin to top-up
the initial margin to cover adverse price movements

78
 Main Features of futures Markets

3. Closing out of a contract

– Involves entering into an opposite position
– Example: if company S initially entered into a ‘sell one ten-year
treasury bond contract’, it would close out the position by
entering into a ‘buy one ten-year treasury bond contract’
4. Contract delivery
– Most parties to a futures contract
 Manage a risk exposure or speculate
 Do not wish to actually deliver or receive the underlying
commodity/instrument and close out of the contract prior to
delivery date

79
Futures Market Participants

 Four main categories of participants

– Hedgers
– Speculators
– Traders
– Arbitragers
 These participants provide depth and liquidity
to the futures market; thus, improving its
efficiency
Four main categories of
participants

 Hedgers
– Attempt to reduce the price risk from exposure to
changes in interest rates, exchange rates and share
prices
– Take the opposite position to the underlying, exposed
transaction
– Example: exporter has USD receivable in 90 days. To
protect against fall in USD over next 3 months,
exporter enters into a futures contract to sell USD
Four main categories of
participants (cont.)

 Speculators
– Expose themselves to risk in the attempt to make
profit
– Enter the market in the expectation that the market
price will move in a favourable direction for them
– Example: speculators who expect the price of the
underlying asset to rise will go long and those that
expect the price to fall will go short
Four main categories of
participants (cont.)

 Traders
– Special class of speculator
– Trade on very short-term changes in the price of
futures contracts (i.e. intra-day changes)
– Provide liquidity to the market
Four main categories of
participants (cont.)

 Arbitragers
– Simultaneously buy and sell to take advantage of price
differentials between markets
– Attempt to make profit without taking any risk
– Example: differentials between the futures contract
price and the physical spot price of the underlying
commodity
 FORWARD MARKETS

 The owner of a forward has the OBLIGATION to sell or buy

something in the future at a predetermined price. The
difference to a future contract is that forwards are not
standardized.
 A forward contract is traded in the over-the-counter market—
usually between two financial institutions or between a
financial institution and one of its clients.
 A Forward Contract underlies the same principles as a future contract,
besides the aspect of non-standardization. Thus, a detail illustration is not
necessary as I already elaborated in the mechanism of the futures contract.

85
The differences between forwards and
futures
 Forward contact is typically a credit instrument between a bank
and its client; in futures delivery is reinforced only by depositing a
margin.
 Forwards are tailor-made (the bank sets the maturity date and
the amount by responding to its client’s needs), futures contracts
are standardized.
 Forwards are an OTC instrument, futures trade in organized
centralized exchanges supported by centralized clearing houses.
 Thus, settlement and margins are strictly regulated in futures;
subject to ‘relations’ in forwards
 In futures, the clearing house is the counterparty to all
outstanding contracts.
 Options Markets

 An option gives the buyer the right, but not the obligation, to
buy or sell a specified commodity or financial instrument at a
predetermined price (exercise or strike price), on or before a
specified date (expiration date)
 Options limit the effects of adverse price movements without
reducing profits from favourable price movements
 Options involve a premium to be paid by the buyer to the seller
(writer)
 An option will only be exercised if it is in the buyer’s best
interest
 Options can trade both in OTC and in organized exchanges.
The Nature of Options

 Types of options
– Call options
 Give the option buyer the right to buy the commodity or
instrument at the exercise price
– Put options
 Give the buyer the right to sell the commodity or instrument at
the exercise price
 Options can be exercised either (option style)
– Only on expiration date (European)
– Any time up to expiration date (American)
The Nature of Options

 Premium is the price paid by an option buyer to the

writer (seller) of the option
 ‘Cap’—an options contract that places an upper limit
on an interest rate/ exchange rate/security price
 ‘Floor’—an options contract that places a lower limit
on an interest rate / exchange rate/security price
 ‘Collar’—a combination of cap and floor options
limiting upper and lower rates/ prices