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Financial Markets
Financial Markets
Financial Markets
Introduction
In order to finance their operations as well as expand, business firms must invest capital in
amounts that are beyond their capacity to save in any reasonable period of time. Similarly,
governments must borrow large amounts of money to provide the goods and services that the
people demand of them. The financial markets permit both business and government to raise the
needed funds by selling securities. Simultaneously, investors with excess funds are able to invest
and earn a return, enhancing their welfare.
A financial market, like any market, is just a way of bringing buyers and sellers together. In
financial markets, it is financial assets such as debt and equity securities that are bought and sold.
Financial markets differ in detail, however. The most important differences concern the types of
securities that are traded, how trading is conducted, and who the buyers and sellers are.
Financial markets are absolutely vital for the proper functioning of capitalistic economies, since
they serve to channel funds from savers to borrowers. Furthermore, they provide an important
allocative function by channeling the funds to those who can make the best use of them –
Presumably, the most productive.
In fact, the chief function of a financial market is to allocate resources optimally . In this chapter,
we will discuss the different types of financial markets.
Primary market
A primary market is one in which a borrower issues new securities in exchange for cash from an
investor (buyer). The issuers of these new securities receive cash from the buyers of these new
securities, who in turn receive financial claims that previously did not exist.
If the issuer is selling securities for the first time, these are referred to as initial public offerings
(IPOs). Alternatively, a primary market sale may be a seasoned offering, in which the firm
already has securities trading in the secondary markets. In general, the primary market involves
the distribution to investors of newly issued securities by central governments, its agencies,
municipal governments and corporations. The participants in the market place that work with
issuers to distribute newly issued securities are called investment bankers. Investment bankers
perform one or more of three functions: (1) advising the issuer on the terms and the timing of the
offering; (2) Buying the securities from the issuer; and (3) distributing the issue to investors.
Once the original buyers sell the securities, they trade in secondary markets. It is in the
secondary market where already issued financial assets are traded. Out standing securities may
trade repeatedly in the secondary market, but the original issuers will be unaffected in the sense
that they receive no additional cash from these transactions.
The Underwriting Process
Underwriting securities can be undertaken in various ways including the bought deal for the
underwriting of bonds, the auction process for both stocks and bonds, and rights offering for
underwriting common stock. This section presents the auction process for underwriting
securities.
Auction Process
In this method, the issuer announces the terms of the issue, and interested parties submit bids for
the entire issue. It is more commonly referred to as a competitive bidding underwriting. For
example, suppose that a public utility wishes to issue Br. 100 million of bonds. Various
underwriters will form syndicates and bid on the issue. The syndicate that bids the lowest yield
(i.e., the lowest cost to the issuer) wins the entire Br. 100 million bond issue and then reoffers to
the public.
In a variant of the process, the bidders indicate the price they are willing to pay and the amount
they are willing to buy. The security is then allocated to bidders from the highest bid price
(lowest yield in the case of a bond) to the lower ones (higher yield in the case of a bond) until the
entire issue is allocated.
Example
Suppose that an issuer is offering Br. 500 million of a bond issue, and nine bidders submitted the
following yield bids:
Bidder Amount (in millions) Bid Yield
A Br. 150 5.1 %
B 110 5.2
C 90 5.2
D 100 5.3
E 75 5.4
F 25 5.4
G 80 5.5
H 70 5.6
I 85 5.7
Let us see the allocation process
The next question concerns the yield that all of the six winning bidders – A, B,C,D,E and F –
will have to pay for the amount of the issue allocated to them. One way in which a competitive
bidding can occur is all bidders pay the highest winning yield bid called stop yield (or,
equivalently, the lowest winning price). In our example, all bidders would buy the amount
allocated to them at 5.4%. This type of auction is referred to as single price auction or a Dutch
auction. Another way is for each bidder to pay whatever each one bid. This type of auction is
called a multiple–Price auction.
Secondary markets
A secondary market transaction involves one owner or creditor selling to another. It is therefore
the secondary markets that provide the means for transferring ownership of corporate securities.
Although a corporation is only directly involved in a primary market transaction (when it sells
securities to raise cash ) , the secondary markets are still critical to large corporations. The reason
is that investors are much more willing to purchase securities in a primary market transaction
when they know that those securities can later be resold if desired.
Thus, the existence of well–functioning secondary markets, where investors come together to
trade existing securities, assures the purchasers of primary securities that they can quickly sell
their securities if the need arises. Of course, such sales may involve a loss, because there are no
guarantees in the financial markets. A loss, however, may be much preferred to having no cash at
all if the securities can not be sold readily.
The key distinction between a primary market and a secondary market is that, in the secondary
market, the issuer of the assets does not receive funds from the buyer. Rather, the existing issue
changes hands in the secondary market, and funds flow from the buyer of the asset to the seller.
Treasury Bills
Treasury bills are issued by the treasury department of the government and backed by the full
faith and credit of the government. As a result, treasury bills carry no risk of default. The market
for treasury bills is the most liquid market in the world.
A treasury bill is a discount security. Such securities do not make periodic interest payments.
The security holder receives interest instead at the maturity date, when the amount received is the
face value (maturity value or par value) which is larger than the purchase price. For example,
suppose an investor purchases a 182-day Treasury bill that has a face value of Br. 100,000 for
Br. 96,000. By holding the bill until the maturity date, the investor will receive Br. 100,000; the
difference of Br. 4000 between the proceeds received at maturity and the amount paid to
purchase the bill represents the interest.
Y= D X 360
F t
Where D = Discount, which is equal to the difference between the face value and the price.
F= Face value
t= number of days remaining to maturity.
As an example, a Treasury bill with 100 days to maturity, a face value of Br. 100,000 and selling
for Br. 97,569 would be quoted at 8.75% on a bank discount basis:
D = Y x F x t / 360
The price is then:
Price = F- D
Price = F - YFt
360
Price= F (1 – Yt )
360
Example:
You want to purchase a 180 day Treasury bill with a face value of Br. 100,000 and a yield on a
bank discount basis of 8%.What is the price of the Treasury bill? What is the birr return on this
bill?
Commercial Paper
Commercial paper is a short-term unsecured promissory note that is issued in the open market
and represents the obligation of the issuing corporation. The issuance of commercial paper is an
alternative to bank borrowing for large corporations (non financial and financial) with strong
credit ratings.
Commercial paper, like treasury bills, is a discount instrument. Despite the fact that the
commercial paper market is larger than markets for other money market instruments, secondary
trading activity is much smaller. The yield on commercial paper is higher than treasury bills for
the same maturity. There are three reasons for this. First, unlike treasury bills, the investor in
commercial paper is exposed to credit risk. Second, interest on treasury bills is exempted from
tax; however, interest on commercial paper is taxable. To offset this tax advantage, commercial
paper should offer higher yield. Third, commercial paper is less liquid than treasury bills.
Bankers Acceptances
Simply put, a bankers acceptance is a vehicle created to facilitate commercial trade transactions.
The instrument is called a bankers acceptance because a bank accepts the ultimate responsibility
to repay a loan to its holder. Bankers acceptances are sold on a discounted basis just as treasury
bills and commercial paper. The major investors in bankers acceptances are money market
mutual funds and municipal entities.
Investing in bankers acceptances exposes the investor to credit risk. This is the risk that neither
the borrower nor the accepting bank will be able to pay the principal due at the maturity date.
The market interest rates that acceptances offer investors reflect this risk- bankers acceptances
have higher yields than treasury bills. The higher yield relative to treasury bills also includes a
premium for relative illiquidity.
A CD may be non–negotiable or negotiable. In the former case, the initial depositor must wait
until the maturity date of the CD to obtain the funds. If the depositor chooses to withdraw funds
prior to the maturity date, an early withdrawal penalty is imposed. In contrast, a negotiable CD
allows the initial depositor (or any subsequent owner of the CD) to sell the CD in the open
market prior to the maturity date. Unlike treasury bills, commercial paper , and bankers
acceptances, yields on CDs are quoted on an interest bearing basis. CDs with a maturity of one
year or less pay interest at maturity . For purposes of calculating interest , a year is treated as
having 360 days.
Repurchase Agreements
A repurchase agreement is the sale of a security with a commitment by the seller to buy the
security back from the purchaser at a specified price at a designated future date. Basically, a
repurchase agreement is a collateralized loan, where the collateral is a security. When the term of
the loan is one day, it is called an ‘’ overnight repo ‘’, a loan for more than one day is called a ‘’
term repo’’
Example
Suppose a bank enters a reverse repurchase agreement in which it agrees to buy treasury
securities from one of its correspondent banks at a price of Br. 10,000,000 with the promise to
sell these securities back at a price of Br. 10,008,548 (Br. 10,000,000 plus interest of Br. 8,548)
after five days. The yield on this repo to the bank is calculated as follows:
Federal Funds
The last market we will discuss is the federal funds market. As we explained in chapter 2,
depository institutions (commercial banks and thrifts) are required to maintain reserves. The
reserves are deposits at the Federal Reserve Bank, which are called federal funds. No interest is
earned on federal funds. Consequently, a depository institution that maintains federal funds in
excess of the amount required incurs an opportunity cost – the loss of interest income that could
be earned on the excess reserves. At the same time, there are depository institutions whose
federal funds are less than the amount required. One way that banks with less than the required
reserves can bring reserves to the required level is to enter into a repo with a nonbank customer.
An alternative is for the bank to borrow federal funds from a bank that has excess reserves. The
market in which federal funds are bought (borrowed) by banks that need these funds, and sold
(lent) by banks that have excess federal funds is called the federal funds market.
The equilibrium interest rate, which is determined by the supply and demand for federal funds, is
the federal funds rate. The federal funds rate is higher because the lending of federal funds is
done on an unsecured basis; this differs from the repo, in which the lender has a security as
collateral.
Common Stock
The most important form of corporate stock is common stock. Like all forms of equity, common
stock represents a residual claim against the assets of the issuing firm, entitling the owner to a
share in the net earnings of the firm when it is profitable and to a share in the net market value
( after all debts are paid) of the company’s assets if it is liquidated. By owning common stock the
investor is subject to the full risks of ownership, which means that the business may fail or its
earnings may fall to unacceptable levels. However, the risks of equity ownership are limited
because the stockholder is liable only for the amount of his or her investment of funds.
If a corporation with outstanding shares of common stock is liquidated, the debts of the firm
must be paid first from any assets available. The preferred stockholders then receive their
contractual share of any remaining funds. The residual, whatever is left accrues to common
stockholders on a pro rata basis.
Preferred Stock
The other major form of stock issued today is preferred stock. Each share of preferred stock
carries a stated annual dividend expressed as a percent of the stock’s par value. For example, if
preferred shares carry a Br. 100 par value with an 8 percent dividend rate, then each preferred
share holder is entitled to dividend of Br 8 per year on each share owned, provided the company
declares a dividend. Common stockholders receive what ever dividends remain after the
preferred shareholders receive their stated annual dividend.
Preferred stockholders have a prior claim over the firm’s assets and earnings relative to the
claims of common stockholders. We refer therefore to preferred stock as a senior corporate
security, in the sense that preferred stock interests are senior to the interests of common
stockholders. However, bondholders and other creditors must be paid before either Preferred or
common stock holders receive anything. The characteristic of common and preferred stock has
been widely addressed in prior courses and hence, the focus is towards other aspects of corporate
stock.
Second market- trading in the OTC market of stocks not listed an on exchange.
Fourth market- Private transactions between institutional investors who deal directly with each
other without utilizing the services of a broker-dealer intermediary. These types of markets are
discussed below.
Organized Exchanges
Stock exchanges are formal organizations, approved and regulated by the Securities and
Exchange Commission (SEC). These exchanges are physical locations where members assemble
to trade. Stocks that are traded on an exchange are said to be listed stocks. That is, these stocks
are individually approved for trading on the exchange by the exchange. The trading mechanism
on exchanges is the auction system, which results from the presence of many competing buyers
and sellers assembled in one place.
In the United States, there are two national stock exchanges: (1) the New York stock exchange
(NYSE), commonly called the Big Board, and (2) the American stock Exchange (AMEX or
ASE), also called the curb. National stock exchanges trade stocks of not only U.S corporations
but also non-U.S. corporations. In addition to the national exchanges, there are regional stock
exchanges in Boston, Chicago (called the Midwest exchange), Cincinnati; San Francisco (called
the pacific coast exchange). Regional exchanges primarily trade stocks from corporations based
within their region.
The large majority of securities bought and sold around the globe, especially debt securities are
traded over-the-counter (OTC) and not on organized exchanges. All money market instruments
are traded in the over-the-counter markets, as are the large majority of government bonds and
corporate bonds. While most common stocks are traded on exchanges, an estimated one quarter
to one third of all stocks are traded OTC. The U.S. OTC market is regulated by a code of ethics
established by the National Association of Security Dealers (Self-regulatory organization), a
private organization that encourages ethical behavior among its members. Trading firms or their
employees who break NASD’S regulations may be fined, suspended, or thrown out of the
organization. One of the most important contributions of NASD has been the development of
NASDAQ (the National Association of Security Dealers Automated Quotations system).
NASDAQ displays bid and ask prices for OTC-traded securities on video screens connected
electronically to a central computer system. All NASD member firms trading in a particular
stock report their bid-ask price quotations immediately to NASDAQ. This nationwide
communications network allows dealers, brokers, and customers to determine instantly the terms
currently offered by major securities dealers.
The third market provides additional competition for the organized exchanges, especially the
New York stock exchange. Moreover, along with the other over-the-counter markets, the third
market has been a catalyst in reducing brokerage fees and promoting trading efficiency.
Where Dt = Dividend Paid out to Stockholders at the end of the year T (t= 1, 2…)
Ks = required rate of return on equity.
If the stock is expected not to be hold forever, the formula can be modified as follows:
D1 D2 DN PN
1
+ 2
+.. . ..+ N
+ N
P0 =
( 1+ K )
s ( 1+ K )
s ( 5)
1+ K s ( 1+ K )
Where PN = Final sales pr ice of the stock.
Example
You are considering the purchase of a stock that you expect to own for the next three years. The
required rate of return on the stock is 16.25 percent and you expect to sell it for Br. 45 in three
years time. You also expect the stock to pay an annual dividend of 1.5 on the last day of each of
the next three years. What is the price of the stock?
1 .5 1. 5 46 .5
1
+ 2
+ 3
Po= ( 1 .1625 ) ( 1 .1625 ) ( 1. 1625 )
Po = Br. 32
If the current market price and the cash flows from the stock are known, the expected return on
the stock can be calculated in different ways depending on the pattern of cash flows.
In the above example, if the current market price of the stock was known to be Br. 32, the
expected return on the stock can be determined by trial and error. The expected rate of return is
simply the discount rate that equates the present value of the cash flows from the stock to its
current market price.
Thus,
1.5 1. 5 46 .5
+ +
32 = ( 1+ K s ) ( 1+ K s ) ( 1+ K s )3
2
By trial and error, the expected return ( Ks) is found to be 16.25 percent.
As stated above, the price or value of a stock is equal to the present value of its future dividends (
Dt), whose values are uncertain. This requires an infinite number of future dividend values to be
estimated, which makes the general formula above difficult to use for stock valuation and
expected return calculation. Accordingly, assumptions are normally made regarding the expected
pattern of the uncertain flow of dividends over the life of the stock. Three assumptions that are
commonly used include ( 1) Zero growth in dividends over the ( infinite ) life of the stock (2) a
constant growth rate in dividends over the (infinite ) life of the stock, and ( 3) supernormal ( or
non – Constant ) growth in dividends .
P0 = D
Ks
Thus, the expected return ( Ks ) in this case will be:Ks = D
P0
Where P0 = Price or value of stock
D = constant annual dividend
Ks = required returns on stock
Example
A stock you are evaluating is expected to pay a constant dividend of Br. 5 per year for many
years to come. The expected rate of return on the stock is 12 percent. What is the value (Price) of
this stock?
Po = Do ( 1+g ) = D1
Ks – g Ks – g
Pt = Dt + 1
Ks-g
This equity valuation formula can also be rearranged to determine a rate of return on the stock if
it were purchased at a price, P0.
Ks = Do ( 1+g ) + g = D1 + g
Po Po
Example
A stock you are evaluating paid a dividend of Br 3.50 at the end of last year. Dividends have
grown at a constant rate of 2 percent per year over the last 20 years and this constant growth rate
is expected to continue in to the indefinite future. The required rate of return on the stock is 10
Percent. What is the value of this stock?
The investor would be willing to pay no more than Br. 44.63 for this stock.
To illustrate the calculation of the expected return on a stock, consider the following example. A
stock you are evaluating paid a dividend at the end of last year of Br. 4.80. Dividends have
grown at a constant rate of 1.75 percent per year over the last 15 years and this constant growth
rate is expected to continue in the future. The stock is currently selling at a price of Br. 52 per
share. What is the expected rate of return on this stock?
To find the present value of a stock experiencing super normal or nonconstant dividend growth,
we calculate the present value of dividends during the two different growth periods. A three step
process is used as follows:
Step 1: Find the present value of the dividends during the period of supernormal growth;
Step2: Find the Price of the stock at the end of the supernormal growth period (when constant
growth in dividends begins) using the constant growth in dividends model. Then discount this
price to a present value.
Example
A stock you are evaluating is expected to experience supernormal growth in dividend of 10
percent over the next five years. Following this period dividends are expected to grow at a
constant rate of 4 percent. The stock paid a dividend of Br. 4 last year, and the required rate of
return on the stock is 15 percent. What is the fair market value of the stock?
Year Dividends
1 4( 1.1 ) 1 = 4.4
2 4( 1.1 ) 2 = 4.84
3 4( 1.1 ) 3 = 5.324
4 4( 1.1 ) 4 = 5.856
5 4( 1.1 ) 5 = 6.442
6 6.442(1.04) = 6.6997
The degree to which financial Security prices adjust to ‘’ news ‘’ and the degree (and Speed)
with which stock prices reflect information about the firm and factors that affect firm value is
referred to as market efficiency. Three measures (weak form, semi strong form, and strong form
market efficiency) are commonly used to measure the degree of stock market efficiency. The
measures differ in the type of information or news (e.g., public versus private, historic versus
non historic) that is impounded into stock prices.
The theory that historic prices of a stock can not help an investor to predict future stock prices is
also consistent with the random walk hypothesis. Stock prices follow a ‘’ random walk ‘’ if
changes in the future price of a stock are independent of historical price changes, or the
correlation between the return on a stock today and its return yesterday is Zero.
Empirical research on weak form market efficiency generally confirms that markets are weak
form efficient. Evidence suggests that successive price changes are generally random and that the
correlation between stock prices from one day to the next is virtually Zero. Thus, historical price
trends are of no help in predicting future price movements.
Since historical information is a subset of all public information (historic and non–historic or
current), if semi-strong form market efficiency holds, weak form market efficiency must hold as
well. However, it is possible for weak form market efficiency to hold when semi strong form
market efficiency does not. This implies that investors can earn abnormal returns by trading on
current public news releases. The quicker the stock market impounds this information, the
smaller any abnormal returns will be.
Financial markets have generally been found to immediately reflect information from news
announcements. That is, abnormal returns cannot consistently be achieved when news is
released. Thus, financial markets are generally semi-strong form market efficient.
If strong form market efficiency holds, semi-strong form market efficiency must hold as well.
However, semi-strong form market efficiency can hold when strong form market efficiency does
not. This implies that private information can be used to produce abnormal returns, but as soon
as the private or inside information is publicly released, abnormal returns are unobtainable.
Empirical evidence suggests that not all insiders have been able to earn abnormal returns using
inside information. However, studies have found that corporate insiders (e.g. ., directors, officers,
and chairs) do earn abnormal returns from trading and that the more informed the insider, the
more often abnormal returns are earned. Therefore, information possessed by corporate insiders
can be used in trading to earn abnormal returns.
Because private information can be used to earn abnormal returns, laws prohibit insiders from
trading on the basis of their private information (insider trading) although they can trade, like any
investor, based on publicly available information about the firm.
Generally, the hypothesis that stock markets are efficient will be true only if a sufficiently large
number of investors disbelieve its efficiency. Large number of market participants should receive
and analyze information. If this cease, financial markets would become markedly less efficient.
Bond Markets
Bond markets are markets in which bonds are issued and traded. They are used to assist in the
transfer of funds from individuals, corporations, and government units with excess funds to
corporations and government units in need of long–term debt funding. Bond markets are
traditionally classified in to three types: (1) Treasury notes and bonds, (2) Municipal bonds, and
(3) corporate bonds.
Like T-bills, T–notes and bonds are backed by the full faith and credit of the U.S. government
and are, therefore, default risk free. As a result, T–notes and bonds pay relatively low rates of
interest (yields to maturity) to investors. T-notes and bonds, however, are not completely risk
free. Given their longer maturity ( i.e., duration ) , these instruments experience wider price
fluctuations than do money market instruments as interest rates change ( and thus are subject to
interest rate risk). Further , many of the older issued bonds and notes- ‘’ off-the-run issues’ may
be less liquid than newly issued bonds and notes – ‘’ on-the-run ‘’ issues – in which case they
may bear an additional premium for illiquidity risk .
In contrast to T- bills, which are sold on a discount basis from face value, T–notes and T-bonds
pay coupon interest (semiannually). Further, T – bills have an original maturity of less than one
year. Treasury notes have original maturities from 2 to 10 years, while T-bonds have original
maturities from over 10 to 30 years.
Accrued Interest
When an investor buys a T – note or T –bond between coupon payments, the buyer must
compensate the seller for that portion of the coupon payment accrued between the last coupon
payment and the settlement day. This amount is called accrued interest. Thus, at settlement. The
buyer must pay the seller the purchase price of the T-note or T-bond plus accrued interest. The
sum of these two is often called the full price or dirty price of the security. The price without the
accrued interest added on is called the clean price.
Accrued interest on a T-note or T-bond is based on the actual number of days the bond was held
by the seller since the last coupon payment:
Example
On August 4, 1999, you Purchase a Br. 10000 T-not that matures on May 15, 2006. The coupon
rate on the T –note is 5.875 Percent and the current price quoted on the bond is 101. 34375 % of
the face value of the T-note. The last coupon payment occurred on May 15, 1999 (81 days before
purchase), and the next coupon payment will be paid on November 15, 1999 (103 days from
purchase).
The accrued interest due to the seller from the buyer as settlement is calculated as:
( 5 . 875 % ) 81
X =1. 29314 %
2 184
of the face value of the bond , or Br. 129.31. The dirty price of this transaction is :
Municipal Bonds
Municipal bonds also called ‘’ munis ‘’ are securities issued by state and local governments to
fund either temporary imbalances between operating expenditures and receipts or to finance
long-term capital outlays for activities such as school construction, public utility construction, or
transportation systems. Tax receipts or revenues generated from a project are the source of
repayment on municipal bonds.
Municipal bonds are attractive to household investors since interest payments on municipal
bonds (but not capital gains) are exempt from federal income taxes. As a result, the interest
borrowing cost to state or local government is lower, because investors are willing to accept
lower interest rates on municipal bonds relative to comparable taxable bonds such as corporate
bonds.
Example
To illustrate the comparison of municipal bonds and fully taxable corporate bond rates, suppose
you can invest in taxable corporate bonds that are paying a 10 percent annual interest rate or
municipal bonds that pay 8 percent annual interest rate. If your marginal tax rate is 28 percent,
the after-tax or equivalent tax exempt rate of return on the taxable bond is:
Thus, the comparable interest rate on municipal bonds of similar risk would be 7.2 percent. In
our example, the municipal bond is paying 8 percent which is greater than 7.2 percent. Thus, you
should invest in the municipal bond since it pays a higher return than the taxable corporate
bonds.
The secondary market for municipal bonds is thin (i.e.; trades are relatively infrequent). Thin
trading is mainly a result of a lack of information on bond issuers, as well as special features
(such as covenants) that are built into those bond’s contracts. Information on municipal bond
issuers (particularly of smaller government units) is generally more costly to obtain and evaluate.
Corporate Bonds
Corporate bonds are all long-term bonds issued by corporations. There are two secondary
markets in corporate bonds: the exchange market (e.g., the NYSE) and the over-the –counter
(OTC) market.
As major market, the derivative securities markets are the newest of the financial security
markets. Derivative securities include forward and futures contracts, option contracts, swap
agreements, and cap and floor agreements. This section will be devoted to the discussion of
forward contracts, futures contracts and option contracts. The other derivative instruments are
left for advanced levels.
Spot Markets
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.
Forward Markets.
A forward contractual is a contractual agreement between a buyer and a seller at time 0 to
exchange a pre-specified asset for cash at some later date. Market participants take a position in
forward contracts because the future (spot) price or interest rate on an asset is uncertain. Such a
contract lets the market participant hedge the risk that future spot prices on an asset will move
against him or her by guaranteeing a future price for the asset today.
For example, in a three-month forward contract to deliver Br.100 face value of 10-year bonds,
the buyer and seller agree on a price and amount today ( time 0 ), but the delivery (or exchange)
of the 10-year bond for cash does not occur until three months into the future. If the forward
price agreed to at time 0 was Br. 98 per Br. 100 of face value, in three months time the seller
delivers Br. 100 of 10–year bonds and receives Br. 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 was entered into and the time the bonds
are delivered for payment (i.e., whether the spot price falls to Br. 97 or below or rises to Br. 99
or above).
Forward contracts often involve underlying assets that are non-standardized, because the terms
of each contract are negotiated individually between the buyer and the seller. As a result, the
buyer and seller involved in a forward contract must locate and deal directly with each other in
the over–the-counter market to set the terms of the contract rather than transacting the sale in a
centralized market (such as a futures market exchange). Because of the presence of secondary
market trading, it has become increasingly easy to get out of a forward position by taking an
offsetting forward position in the secondary market. Secondary market activity in forward
contracts has made them more attractive to firms and investors that had previously been reluctant
to get locked into a forward contract until expiration. However, secondary trading activity for
forward contracts is thin.
Futures Markets
A futures contract, like a forward contract, is an agreement between a buyer and a seller at time 0
to exchange a prespecified asset for cash at some later date. Thus, a futures contract is very
similar to a forward contract. The difference relates to where they trade. A future contract is
traded on an organized exchanges such as the New York Futures Exchange (NYFE), where as a
forward contract is an OTC instrument. Another difference is that a futures contract involve
underlying assets that are standardized as to delivery date and quality of the deliverable whereas
a forward contract is usually nonstandardized because the terms of each contract are negotiated
individually between buyer and seller. Also unlike futures contracts, there is no clearing house
for trading forward contracts, and secondary markets are often non–existent or extremely thin.
Finally, the parties in a forward contract are exposed to credit risk because either party may
default on the obligation. Credit risk is minimal in the case of futures contracts because the
clearing house associated with the exchange guarantees the other side of any transaction.
Solution
F= P + P(r-y)
F=P + Pr - Py
F= 100 + (8% x Br. 100 x 3/12) -3
F=100 + 2-3
F=Br.99
Thus, the theoretical futures Price is Br. 99.
Options Contracts
There are two parties to an option contract: the buyer and the writer (also called the seller). In an
option contract, the writer of the option grants the buyer of the option the right , but not the
obligation , to purchase from or sell to the writer something at a specified price within a
specified period of time ( or at a specified date ) . The writer grants this right to the buyer in
exchange for a certain sum of money, which is called the option price or option premium. The
price at which the underlying (that is, the asset or commodity) may be bought or sold is called
the exercise price or strike price. The date after which an option is void is called the expiration
date or maturity date.
When an option grants the buyer the right to purchase the underlying from the writer (seller), it is
referred to as a call option, or simply, a call. When the option buyer has the right to sell the
underlying to the writer, the option is called a put option , or simply, a put.
The timing of the possible exercise of an option is an important characteristic of the contract.
There are options that may be exercised at any time up to and including the expiration date. Such
options are referred to as American options. Other options may be exercised only at the
expiration date; these are called European options.
Call Option
A call option is a hedging device for the option buyer against a rise in asset prices. To illustrate,
assume that there is a call option on asset XYZ that expires in one month and has a strike price of
Br. 100. The option Price is Br. 3. Suppose that the current price of Asset XYZ is Br.100. What
is the profit or loss for the investor who purchases this call option and holds it to the expiration
date assuming the price of the asset at the expiration date is:
Case1: Less than Br. 100.
Case2: Equal to Br. 100.
Case3: More than Br. 100 but less than or equal to Br. 103.
Case4: More than Br. 103 (say, Br. 115).
Solutions
Case 1: Since the asset is selling for less than Br. 100 in the market, buying the asset from the
option seller at Br. 100 entails a loss. Thus, the investor is advised to buy the asset from the
market, not from the option seller. The loss to the investor, in this case would be br.3 which is
the price of the option the investor has paid at the beginning.
Case 2: The asset is trading at Br. 100 in the market. Thus, buying the asset from the option
seller at Br. 100 has no economic significance. Thus, our recommendation is that the investor
should not exercise the option and the loss is simply Br.3 (the option price).
CCCase 3: In this case, the investor should exercise the option (that is, buy the asset from the
option seller at Br.100) because the asset is selling at above Br .100 but less than or equal to 103.
This helps to minimize the loss; the loss is, in this case, less than Br.3.
Case 4: The investor should exercise the option. Since the asset is trading at Br. 115 in the
market the investor can buy the asset from the option seller at Br. 100 and sell in the open
market for Br.115. The gain would be Br.15 (= Br.115 - Br.100). The investor has paid Br.3. for
the call option. Thus, the net profit is Br.12 (=Br. 15 – Br. 3).
The profit and loss for the seller of call options is the mirror image of the profit and loss for the
call option buyer. Thus, the profit for call option buyer reflects a loss for the call option seller
and the loss for the call option buyer reflects a profit for the call option seller. In the above
example, case 4, the seller of the call option would face a loss of Br.12.
Notice that the maximum loss for the call option buyer is limited to the option price, in our
example Br. 3. However, the upside potential is not limited. Whereas, the maximum profit for
the call option seller is the option price. However, the downside risk is not limited.
Put Options
A put option is a hedging device against a decline in asset prices. To illustrate, assume that there
is a put option on asset XYZ that expires in one month and a strike price of Br.100. Assume the
put option is selling for Br. 2. The current price of asset XYZ is Br.100. what is the profit or loss
for the investor who purchases this put option and holds it to the expiration date assuming the
price of the asset at the expiration date is:
Case 1. greater than Br. 100
2. equal to Br. 100
3. greater than or equal to Br.98 but less than Br. 100.
4. less than Br.98 (say, Br.90).
Solution
Case1: since the asset is selling at above Br.100, the option buyer should not sell the asset to the
option seller at Br. 100. It would be preferable for the option buyer to sell its asset in the market.
The loss to the option buyer, in this case, is simply the option price (i.e. Br. 2).
Case2. In this case, since the asset is selling at Br.100 in the market, selling the asset to the
option seller at Br.100 has no economic significance. The option buyer will incur a loss of Br.2,
which is the price it has paid for the put option at the beginning.
Case3. Here the put option buyer should exercise the option (that is sell the asset to the option
seller at Br.100). In doing so, the option buyer will be able to minimize the loss. The loss will be
less than Br.2.
Case 4. Since the asset is selling at Br.90 in the market, the option buyer should exercise the
option. The option buyer can sell the asset to the option seller at Br.100 while the market price is
Br.90. The gain in this case is Br.10. The option buyer has paid Br.2. for the put option. Thus,
the net profit is Br.8.
The profit and loss for the seller of the put options is the mirror image of the profit and loss for
the put option buyer.
Like the call option, the maximum loss for the put option buyer is limited to the option price, in
our example, Br.2.The upside potential is limited, in our example, to a profit of Br. 98 and this
occurs if the price of the asset declines to zero. Whereas, the maximum profit for the put option
seller is limited to the option price. The downside risk is limited to a loss of Br.98 and this occurs
if the put option seller has to buy the asset at Br.100 while the market price has declined to zero.
An indirect quote is the number of units of a foreign currency that can be exchanged for one unit
of a local currency. For example, from U.S. point of view Br.9.10 per $ 1 is an indirect quote.
The relation among the spot exchange rate, inflation rate in two countries and the forward rate is
as follows:
( 1+ I h )
s
F= ( 1+ I f )
Where F= forward rate (units of domestic currency per unit of foreign currency)
S = Spot exchange rate (units of domestic currency per units of foreign currency)
Ih =Inflation rate prevailing in the home (domestic) country.
If =Inflation rate prevailing in the foreign country
Example
Assume that the Canadian dollar’s spot rate is $ 0.85 and that Canada experiences 5- percent
inflation, while the United States experiences 3-Percent inflation. According to purchasing
power parity, what will be the new value of the Canadian dollar after it adjusts to the inflationary
changes?
( 1+ I h )
F= S ( 1+ I f )
( 1.03 )
F= $ 0.85 x 1.05
F= $ 0.83
Example
To illustrate suppose that the interest rate for one year in the United States is 7 percent and in
Germany 9 percent. The spot rate is $0.6234.In order for interest rate parity to prevail, what
should be the forward exchange rate?
( 1+ ih ) 0 . 6234 x 1 .07
=
( 1+i f ) 1 .09
F=S
F= $0.6120
Thus, the forward exchange rate is $ 0.6120.
Exchange Rate Systems
Exchange rate systems can be classified according to the degree by which exchange rates are
controlled by the government. Exchange rate systems normally fall in to one of following
categories:
Fixed
Freely floating
Managed float
Pegged
The exchange rate system that exists today for some currencies lies somewhere between fixed
and freely floating. It resembles the freely floating system in that exchange rates are allowed to
fluctuate on a daily basis and official boundaries do not exist. Yet, it is similar to the fixed
system in that governments can and some times do intervene to prevent their currencies from
moving too much in a certain direction. This type of system is known as a managed float or
“dirty’’ float.
Some countries use a pegged exchange rate arrangement, in which their home currency’s value is
pegged to a foreign currency or to some unit of account. While the home currency’s value is
fixed in terms of the foreign currency (or unit of account) to which it is pegged, it moves in line
with that currency against other currencies.