1 Financial Markets and Instruments: An Overview
1
Financial Markets and Instruments:An Overview
SA: Financial Markets and Instruments: An Overview 2
Objective of this session
To introduce major features of financial markets, market
participants, financial securities, and investment
process.
SA: Financial Markets and Instruments: An Overview 3
Financial Markets
Primary Markets: Deal with Initial Public Offers
Versus
Secondary Markets: Deal with post IPO securities
Money Markets: Deal with short-term securities
Versus
Capital Markets: Deal with long-term securities
SA: Financial Markets and Instruments: An Overview 4
Participants of Financial System
The Government Sector
The Household Sector
The Business Sector
SA: Financial Markets and Instruments: An Overview 5
The Household Sector
Concerned with investing their savings
Interested in a wide array of assets
Taxes and risk preferences can lead to a widely varying asset
demands
SA: Financial Markets and Instruments: An Overview 6
Concerned with raising capital Borrow from banks (loan) or households (bonds) Take in new partners (issue equity)
Objectives re issuing securities: Get the best possible price Low cost of marketing
The Business Sector
SA: Financial Markets and Instruments: An Overview 7
Raise funds to finance budget deficits
Regulatory roles
The Government Sector
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Implications of Clientele Demands
Investment Banking
Financial Intermediation
Financial Innovations
Responses to Taxation and Regulations
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Banks – borrowing / lending
Investment companies Pooling of resources Achieve diversification in investments Expertise
Mutual Funds Arise out of the “smallness problem” Gain the benefit of large scale trading Investment trusts, Unit trusts
Financial Intermediation
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Investment Banking
Specialise in selling securities to public on behalf of firms or governments.
Advisory role
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A security whose value depends on the value of underlying asset.
Commodity futures
Derivatives in hedging
Financial Innovations
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Zero Coupon Bonds
Dual Fund:
A derivative asset, income and capital shares on a portfolio of stocks
are sold separately.
Eurodollar market:
Regulation-Q: Limits the bank deposit interest rate.
Reserve requirement: Foreign branches of the US banks are exempt
from reserve requirements.
These are considered to be the reasons for the emergence of
Eurodollars.
Responses to Taxation and Regulation
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Financial Instruments
Money Market Instruments
Capital Market Instruments
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Treasury bills: Issued weekly by government
Certificates of deposit: Time deposit with a bank
Commercial paper: Well-known companies’ unsecured short-term debt
Bankers’ acceptance: Client writes and bank accepts
Repos
LIBOR market
Money market Instruments
Short-term, marketable, liquid, low-risk debt securities:
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Capital Market Instruments
Fixed income market InstrumentsInstruments for long-term borrowings
Government bondsConventional, Index linked
Corporate bonds
Longer-term and riskier securities
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Capital Market Instruments
Equity market Instruments
Ordinary sharesResidual claim and limited
liabilityPreference shares
Stock market indices Equally weighted / value weighted
Longer-term and riskier securities
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Capital Market Instruments
Derivative market InstrumentsA security whose value depends on the value
of another security or asset.
OptionsA security that gives the holder the right to buy (call) or sell (put) an asset at a specified price on or possibly before a specific date.
FuturesAn agreement between two parties to trade a specific asset or security at a future date, with the terms and price agreed upon today.
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Investor borrows part of purchase price from a broker
Interest charge (broker loan rate)
Collateral
Initial margin and maintenance margin
Margin Purchase
What is meant by buying on margin?
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Initial Margin
*
*200*£60
0.50200*60
£6000
N P BIM
N PB
then
B
Initial Margin (IM) is amount required to be deposited with the broker (as % of total value of securities purchased)
*
*
If price falls to£55 then:
200*55 6000 500045.5%
200*55 11000
Valueof stock borrowing N P BAM
Valueof stock N P
AM
Actual Margin (AM) =
ConsiderNumber of shares purchased (N): 200Price per share (P): £60Initial margin requirement (IM): 50%How much the investor could borrow (B)?
SA: Financial Markets and Instruments: An Overview 20
Maintenance Margin
'
1
£6000 6000£50
200(1 0.4) 120
BP
N MM
Consider
N = 200
Purchase price per share: £60
Borrowing: $6000 (initial margin 50%)
Maintenance margin: 40%
What should be the price for margin call?
Maintenance Margin (MM) is required to minimise the risk of default. When share price declines below certain level MM is called by the broker.
200*40 60000.40
200*40
0.40*200*40 200*40 £6000
£1200
cashMM
cash
How much you need to deposit if share price falls to £40?
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Investor borrows stocks to sell
How about dividend?
Brokerage firms lend the stocks
Deposit of sale proceeds
Margin
Short Selling
What is meant by short-selling in stock markets?
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The Investment Process
1. Investor characteristics
2. Investment vehicles
3. Strategy development
4. Strategy implementation
5. Strategy monitoring
5. Strategy monitoring
Source: Levy and Post (2005).
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Investor characteristics
Investor should establish an investment policy
Objectives regarding return requirements, risk tolerance, liquidity requirements etc. should be documented.
Typical issues to be considered include: Investor’s financial situation Available resources Future investable income Future cash-flow needs Risk tolerance of investor Tax status
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Investment vehicles
Securities available for investment purpose include:
Money-market securities
Bonds
Stocks
Derivative securities
They offer a trade-off between risk and return
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Strategy development
Optimise the investment vehicles and investor characteristics
Asset allocation
Security selection
The strategy developed depends on the investor’s perception re market efficiency
Markets are efficient: Design well diversified and immunised portfolio.
Markets are not efficient: Search for mispriced securities.
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Strategy implementation
Successful implementation of strategy may lead to complexities due to frequent changes in portfolio.
Transaction costs (spread, commission, price concessions) could be barriers.
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Strategy monitoring
The strategies should be re-valued periodically. Changes may be required due to:
Changes in market conditions
Changes in security regulations
Changes in tax laws
Suitability of assets allocation strategy
Changes in investor’s objectives and constraints
SA: Financial Markets and Instruments: An Overview 28
Z. Bodie, A. Kane and A. J. Marcus, Investments, McGraw-Hill. Chapters: 1,2,3
Levy, H. and T. Post (2005), Investments, FT Prentice Hall. Chapters 1,2 and 3.
Essential Readings
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Seminar Questions
1. Discuss how taxes and risk preference of household sector lead to widely varying asset demands.
2. Discuss the justifications for the existence of financial intermediaries.
3. Outline the major features of prominent financial instruments used in money markets.
4. Explain the followings:
a. Margin purchase
b. Short-selling
5. ‘Managing investment is a dynamic and on going process.’ Comment.