1 slides - 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.


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


Participants of Financial System

The Government Sector

The Household Sector

The Business Sector


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


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


Raise funds to finance budget deficits

Regulatory roles

The Government Sector


Implications of Clientele Demands

Investment Banking

Financial Intermediation

Financial Innovations

Responses to Taxation and Regulations


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


Investment Banking

Specialise in selling securities to public on behalf of firms or governments.

Advisory role


A security whose value depends on the value of underlying asset.

Commodity futures

Derivatives in hedging

Financial Innovations


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


Financial Instruments

Money Market Instruments

Capital Market Instruments


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:



Fixed income market InstrumentsInstruments for long-term borrowings

Government bondsConventional, Index linked

Corporate bonds

Longer-term and riskier securities



Equity market Instruments

Ordinary sharesResidual claim and limited

liabilityPreference shares

Stock market indices Equally weighted / value weighted

Longer-term and riskier securities



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.


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?


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)?


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?


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?


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).


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


Investment vehicles

Securities available for investment purpose include:

Money-market securities

Bonds

Stocks

Derivative securities

They offer a trade-off between risk and return


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.


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.


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


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


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.

1 slides - overview

Economy & Finance