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Learning objectives
Understanding…

Why do financial markets exist? Financial markets and

What types of financial markets are there? types of financial markets

Why do different financial markets exist? Financial instruments

Who participates in financial markets? Participants in financial markets
Why do financial institutions exist?
Why do different financial institutions exist?
What can go wrong with financial markets and institutions?

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 Why do financial markets exist?
o Financial instrument is the written legal obligation of one party to transfer something of value,
usually money, to another party at some future date, under specified conditions

o Financial markets are the places where financial instruments are bought and sold.

Now

Demand Supply

Future

To reallocate assets efficiently and support economic growth

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 Types of financial markets
• By instruments
Debt market •Debt instruments: retail private debt (credit card, car loan, mortgage), company private
debt, corporate bond, government bond, note and bill, asset-backed obligation
Equity market
•Equity instruments: Shares, listed company common and preferred shares
Derivatives market
•Options, swaps, forward, and future contracts
Foreign currency market
•Exchange of currency pairs
• By maturity
Money market
•Fixed income security with maturity less than a year
Capital market
•Security with maturity equal or greater than a year
• By order of entry
Primary market•The issuance of a security (=the first time a security is ready for purchase)
•Buy from the issuer (or underwriter)
Secondary market
•After the issuance of a security
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•Buy from other investors who hold that security 4
 Debt market versus equity market
Debt instruments
o Contractual agreements by the borrowers to pay the
holders of instruments fixed amounts at regular BALANCE SHEET of Issuers
intervals (interest and principal payments) until a
special date (the maturity date), when a final payment ASSETS LIABILITIES &
is made. EQUITIES

o The maturity of a debt instrument is the time (term) LIABILITIES

from issuing date to that instrument’s expiration date
EQUITIES
Equity instruments
o claims to share in the net income (income after
expenses and taxes) and the assets of a business

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 Money market versus capital market

MONEY Short – term

MARKETS instruments

CAPITAL Intermediate and long

MARKETS – term instruments

A money market is a financial market in which trades short – term (debt) instruments such as Treasury bill,
commercial paper…
A capital market is a financial market in which longer – term (debt) instruments (and equity instruments) such
as common stock, long – term bond… are traded.
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 Primary market versus secondary market

Issuers Initial buyers Other buyers

Secondary
Primary markets
markets
financial markets in which new issues financial markets in which securities that
of a security are sold to initial buyers have been previously issued can be resold

Liquidity: the relative ease and speed with which an asset can be converted into a medium of exchange/ money.
the degree of which securities can easily be liquidated (sold) without a loss of value

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 Primary market versus secondary market
A Primary market is a financial market in which new issues of a security, such
as a bond or a stock, are sold to initial buyers
 supply capital for corporations
A Secondary market is a financial market in which securities that have been
previously issued can be resold
 Allow a change of the ownership of the securities
 an important characteristic of securities that are traded in secondary markets
is liquidity, which is the degree to which securities can easily be liquidated
(sold)
Some securities have an active secondary market, meaning that there are many
willing buyers and sellers of the security at a given point in time
Determine the price of the security that the issuing firm sells in the primary
market

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 Exchanges and over-the-counter markets

EXCHANGES
One central
location

Brokers: agents of investors who match buyers with sellers of securities

OVER – THE – Difference
COUNTER
MARKETS locations
Dealers: agents link buyers and sellers by buying and selling securities at
stated prices.

Exchanges: buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades
An Over – the – counter market: dealers at different locations who have an inventory of securities stand ready to buy
and sell securities “over the counter” to anyone who comes to them and is willing to accept their prices

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 Margin (currency)
Open an
INVESTORS
account
Depository (securities)

Place an
the result order

Broker Check the order

The
Exchange
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 Why do different financial markets exist?
Now

Demand Supply

Future
Needs?? Available
•The length of fund usage
•The scale of fund in need
•The risk of funded project

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 Financial instruments
Underlying instruments Derivatives

Forwards
Short term Intermediate-Long term Futures
< 12 months > 12 months Options
Swaps
Debt Debt Equity

Sources Sources Sources

Treasury bills Term Loans Preference Shares
Negotiable bank certificates of deposit Leases Ordinary Shares
Commercial paper Debentures
Banker’s acceptance Unsecured Notes
Repurchase agreements Bonds
Other short-term instruments Project Finance

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 Money market instruments – Treasury bill
Treasury bills: short-term debt instruments to finance the government.

 paying a set amount at maturity (the

face value)
 no interest payments (paying interest
by initial selling at a discount)
Sold at a discount

The government does not actually pay interest on T- bills. Instead, they are issued at a discount from par (their
value at maturity). The investor’s yield comes from the increase in the value of the security between the time it
was purchased and the time it matures

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 Money market instruments – Treasury bill
You paid $98,000 for a $100,000 T-bill maturing in 120 days. If you hold it until maturity, what is the T-bill yield?

Face value/ par value:

$100,000

T-bill yield

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Money market instruments – Negotiable bank certificates of deposit

Negotiable bank certificates of deposit:

•short-term debt instruments/ a time deposit
•issuer: banks
•paying periodic interest
•paying the principal at maturity
•being resold in a secondary market

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Money market instruments – Commercial paper
Commercial paper is a short – term debt instrument issued by large banks and
well – known corporations to acquire funds:
paying a set amount at maturity (the face value)

having no interest payments

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Money market instruments – Commercial paper
Goods/
services
Seller Buyer
The contract
Bill of exchange/ Promissory
draft note
a request of unconditional an unconditional promise of the
payment for a definite amount of issuer in writing to pay a determinate
money to beneficiary amount of money to beneficiary

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Money market instruments – Banker’s acceptance
• Banker’s acceptance is a
bank draft issued by a firm,
payable at some future date,
and guaranteed for a fee by
the bank that stamps it
“accepted”

• The firm issuing the

instrument is required to
deposit the required funds
into its account to cover the
draft

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Money market instruments – Banker’s acceptance
Repurchase agreement is an agreement:
• the borrower agree to sell an amount of securities (usually T-bills) to
the lender and
• commit to repurchase them at a specified date and price
Short – term loans (normally, a maturity of less than two weeks) ;
• Treasury bills: collateral (an asset that the lender receives if the
borrower does not pay back the loan)

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Capital market instruments – Bond
Bonds are long-term debt securities:
• issued by corporations and government agencies to support their operations
• which the issuers promise to repaid to bondholders in some date in the future
Maturity: The period from the date of issuing to expired date
Par value/ face value: the amount that the issuer must pay to maturity

By issuer: Corporate bonds & Treasury bonds

By interest payment: Coupon bonds & Discount bonds

By coupon rate: Plain – vanilla bonds & floating rate bonds

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Capital market instruments – Coupon bond
Coupon bond: bond that the issuer promises:
• to make periodic payments of interest – called coupon payments * –
to the bondholder for the life of the bond,
• to pay the face value of the bond when the bond matures
* Coupon payments: at coupon rate – the interest rate applied to the face value
E.g. A bond with a face value of $1.000 that makes annual coupon payment
at a coupon rate of 10% and its maturity is 10 years.

 The issuer has to pay (every year)

 At the end of 10 years, the issuer pays

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Capital market instruments – Coupon bond
E.g. To raise fund, on March 10th, 2022 company A issues 1000 bonds which
promise to repay the holder $1000 at the date of March 10th, 2032 and pay $100
every six months. The company sells them at the price of $950.
1. The face value is
a. $1000 c. $950
b. $100 d. All of above are wrong
2. The maturity is
a. 1 year c. 3 years
b. 2 years d. All of above are wrong
3. The coupon rate is
a. 10%/year c. 10,52%/6months
b. 10%/6months d. All of above are wrong

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Capital market instruments – Discount bond (zero-coupon bond)
(Pure) discount bonds (zero – coupon bonds): bonds that promise a single payment
of cash at some date in the future, called the maturity date.
 The interest earned by investors:
the face value – the price

E.g. A pure discount bond with a face value of $1000 maturing in one year and a purchase price of $950

 During this 1 year, it does not make any payment

 At the end of 1 year, the holder receives the amount of $1000 (face value)

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Capital market instruments – Bond

The issuer
The right to redeem bonds before
Callability the final maturity date
Callable bond

The holder The right to convert the bond into

Convertibility a pre-specified number of shares
of common stock
Convertible bond

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 Capital market instruments – Stock
Issuers

Maturity: no
STOCK
Ownership
Face value

Dividend
residual Limited
Shareholders
claimant liability
Equity
securities Book value Stocks are equity claims on the net income and assets of
a corporation
A share of stock in a firm represents ownerships
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Capital market instruments – Stock
• Stockholders: who hold stock in a corporation owns a percentage interest in a
firm, consistent with the percentage of outstanding stock held. This ownership is in
contrast to a bondholder, who holds no ownership interest but is rather a creditor
of the firm
• Residual claim means that stockholders are the last in line of all those who
have a claim on the assets and income of the corporation.
• Dividends: stockholders are paid dividends from the net earnings of the
corporation. They are paid periodically, usually every quarter
• Limited liability means that the most shareholders can lose in the event of
failure of the corporation is their original investment.

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 Capital market instruments – Common Stock vs Preferred stock

No maturity, no refund

Limited liability

Common Common Claims on income and Preferred Preferred

stock shareholder assets shareholder stock
Voting right

Preemptive right

Income
Dividend fixed Dividend
Dividend policy
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Capital market instruments – Preferred stock

Some types of preferred stock:

•Cumulative preferred stock (CPS)/accumulative p.s.
•Non-cumulative preferred stock/ Non APS
•Participating preferred stock
•Convertible preferred stock
•Callable preferred stock

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Derivative instruments
Derivative instruments are financial contracts whose values are derived from
the values of underlying assets (such as debt instruments or equity securities)
Many derivative instrument enable investors to engage in speculation and
risk management
Speculation: allow an investor to speculate on movements in the value of the
underlying assets without having to purchase those assets. Allowing investors to
benefit from an increase in the value of the underlying assets, whereas others
allow investors to benefit from a decrease in the assets’ value.

Risk management: they can be used in a manner that will generate gains if the
value of the underlying assets declines. Consequently, financial institutions and
other firms can use derivative securities to adjust the risk of the existing
investments in securities.

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Derivative instruments - Forwards/ forward contracts
Forwards are contract that obligate the holder to buy or sell a specified amount of a specified financial
instrument (underlying assets) for a predetermined delivery price at a predetermined future date
The buyer of the underlying asset takes a long position
The seller takes a short position
The transaction does not take place until after the expiration date
Traded on the over-the-counter market
 Obligation of buying and selling

Spot contracts: agreements to buy or sell an asset today

 Spot price: the price for immediate delivery of the asset

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Derivative instruments - Forwards/ forward contracts

Today
Contract that obligates B to deliver B corp. sells
A corp. buys 10000 T – bills at a price of $1,000
forward forward
per T – bill in 3 months

At the end of
the 3 months
Cash 10,000 x $1,000

A corp. B corp.

10000 T - bills
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Derivative instruments - Forwards/ forward contracts

• Delivery price/ forward price: $1,000/T-Bill

Spot price Long position ($1,000) Short position (1,000)

1,200 – 1 + 1.2 = + 0.2 – 1.2 + 1 = – 0.2

1,000 –1+1 = 0 –1+1 = 0
800 – 1 + 0.8 = – 0.2 – 0.8 + 1 = + 0.2

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Derivative instruments - Forwards/ forward contracts
• Futures/ future contracts: standardized agreements to buy or
sell an asset at a certain time in the future for a certain price
• Like forward contracts
• Traded on organized exchanges – standardizing certain features
of the contract

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Derivative instruments – Options- Call option vs put option
An option represents the right to buy (call) or sell (put) a specific asset
(underlying) at a certain price (strike or exercise price) during (American)
or at the end of (European) a specified duration
• A call option gives the holder the right to buy the underlying asset by a
certain date for a certain price (strike price)
• A put option gives the holder the right to sell the underlying asset by a
certain date for a certain price.
• American options can be exercised at any time up to the expiration date or
maturity.
• European options can be exercised only on the expiration date itself.

Sellers of call options receive an up – front fee (the premium) from the purchaser
as compensation
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Derivative instruments – Call option

A purchases a the strike price: $50

Today call option the premium: $1/ share
The volume: 100 shares
on B stock
The maturity: 90 days

Cash
In 90
days A
100 shares of B
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Derivative instruments – Put option

the strike price: $50

A purchases a
Today put option the premium: $1/ share
The volume: 100 shares
on B stock
The maturity: 90 days

100 shares of B
In 90
days A
Cash
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Derivative instruments – Swap

• Swap is an arrangement by two counterparties to

exchange one stream of cash flows for another

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 Why do financial institutions exist?

Demand Supply

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 Why do financial institutions exist?

What we want

Demand Supply

What we have

Demand Supply

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 Why do financial institutions exist?
What we have

Demand Supply

Adverse selection
Information asymmetry
Moral hazard
Transaction cost
Individuals tend to be significantly less risk averse when they make decisions over another person's
money compared to decisions that they make over their own money. (Chakravarty, el at, 2011)

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