CHAPTER FOUR

FINANCIAL MARKETS IN THE FINANCIAL SYSTEM

4.1. Organization and Structure of Markets
There are many different types of financial markets. Each market serves a different region or
deals with a different type of security.
 Financial asset markets deal with stocks, bonds, notes, mortgages, and other claims on real
assets.
 Spot markets and futures markets are terms that refer to whether the assets are being bought
or sold for “on-the-spot” delivery or for delivery at some future date.
 Money markets are the markets for debt securities with maturities of less than one year.
 Capital markets are the markets for long-term debt and corporate stocks.
 Primary markets are the markets in which corporations raise new capital.
 Secondary markets are markets in which existing, already outstanding, securities are traded
among investors.
 The stock market is an especially important market because this is where stock prices (which
are used to “grade” managers’ performances) are established. There are two basic types of
stock- the organized exchanges and the over-the counter market.
Financial markets can be organized and structured in two broad financial markets. These
financial markets are the money markets and the capital markets.
4.2. Money Market- Characteristics & Importance
 Money markets are the markets for debt securities with maturities of less than one year.
These are instruments that obligate the debtor to make a contractually fixed series of payments
4.2.1. Security characteristics
Instruments Riskiness Original maturity
 Treasury bills Default-free 91 to 1 year
 Commercial paper Low default risk up to270 days
 Bankers’ acceptance Low degree of default risk if up to 180 days
guaranteed by a strong bank
 Negotiable CDs Default risk depends on strength up to 1 year
of the issuing bank

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4.2.2. Money Market Instruments
Money market instruments are debt obligations that at issuance have a maturity of one year or
less.
Treasury bills are treasury securities with a maturity of one year or less. Interest is not paid
periodically, but Treasury bills are issued at a discount from their face value. The interest the
investor earns is the difference between the face value received at the maturity date and the price
paid to purchase the Treasury bill. For example, suppose an investor purchases a six-month
Treasury bill that has a face value of Br. 10,000,000 for Br. 9,600,000. By holding the bill until
the maturity date, the investor will receive Br. 10,000,000; the difference of Br. 400,000 between
the proceeds received at maturity and the amount paid to purchase the bill represents the interest.
Treasury bills are the only one example of a number of money market instruments that are
discount securities.
Bids and offers on Treasury bills are quoted on a bank discount basis. Treasury bills are
auctioned on a regularly scheduled cycle. The yield on a bank discount basis is computed as
follows:
YD = D x 360
F t
Where: - YD = yield on a bank discount basis (expressed as a decimal)
D = dollar discount, which is equal to the difference between the face value and the
Price
F = face value
t = number of days remaining to maturity

or General calculation for yield on Treasury bills is

Commercial paper is a short-term unsecured promissory note issued in the open market that
represents the obligation of the issuing entity. It is sold on a discount basis. To avoid SEC
registration, the maturity of commercial paper is less than 270 days. Generally, commercial
paper maturity is less than 90 days so that it will qualify as eligible collateral for the bank to
borrow from the Federal Reserve Bank’s discount window. Financial and nonfinancial
corporations issue commercial paper, with the majority issued by the former. The commercial
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paper market was limited to entities with strong credit ratings, but lower-rated issuers have used
credit enhancements to enter the market. Direct paper is sold by the issuing firm directly to
investors without using a securities dealer as an intermediary; with dealer-placed commercial
paper, the issuer uses the services of a securities firm to sell its paper. There is little liquidity in
the commercial paper market.
Bankers’ acceptance is a vehicle created to facilitate commercial trade transactions, particularly
international transactions. They are called bankers’ acceptance because a bank accepts the
ultimate responsibility to repay a loan its holder. The use of bankers’ acceptance to finance a
commercial transaction is referred to as “acceptance financing.” Bankers’ acceptances are sold
on a discounted basis just as Treasury bills and commercial paper. The major investors in
bankers’ acceptance are money market mutual funds and municipal entities.
Negotiable Certificates of Deposits (CDs). A certificate of deposit (CD) is a financial asset
issued by a bank or thrift that indicates a specified sum of money has been deposited at the
issuing depository institution. CDs are issued by banks and thrifts to raise funds for financing
their business activities. A CD bears a maturity date and specified interest rate, and can be issued
in any denomination. CDs issued by banks are insured by the Federal Deposit Insurance
Corporation but only for amounts up to $100,000. As for maturity, there is no limit on the
maximum, but by Federal Reserve regulations CDs cannot have a maturity of less than seven
days.
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.
A. Economic Role of the money market
The most important economic function of the money market is to provide an efficient means for
economic units to adjust their liquidity positions. Money markets help governments, businesses,
and individuals to manage their liquidity by temporarily bridging the gap between cash receipts
and cash expenditures. If a firm is temporarily short of cash, it can borrow in the money market;
or if it has temporary excess cash, it can invest in short-term money market instruments. In doing
so a money market performs a number of functions in an economy.

 It provides funds
 It helps to use surplus funds
 It eliminates the need to borrow from banks
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  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.
B. Institutions of the Money Market
The various financial institutions which deal in short-term loans in the money market are:
1. The Central Bank: It does not itself enter into direct transactions. But control the money
market through variations in the bank rate and open market operation. It acts as a guardian of
the money market.
2. Commercial Banks: They deal in short-term loans which they lend to business and trade.
They discount bills of exchange and treasury bills. They lend against promissory notes and
through advances and overdrafts.
3. Non-bank Financial Intermediaries: This includes savings and loans associations, mutual
funds and credit unions. They deal in short term lending and advances.
4. Discount Houses and Bill Brokers: Discount houses’ primary function is to discount bills on
behalf of others. Bull brokers or dealers act as an intermediary between borrowers and
lenders by discounting bills of exchange at a nominal commission. Dealers buy securities for
their one position and sell from their security inventories, when a trade takes place. Dealers
and brokers specialize in one or more money market instruments and they remain to be the
main part of the money market.
5. Acceptance Houses: They act as agents between exporters and importers and lender and
borrower traders. They accept bills drawn on merchants whose financial standing is not
known in order to make the bills negotiable.

C. Sub Markets of the Money Market

The money market is a network of markets that are grouped together because they deal in
financial instruments that have a similar function in the economy and are to some degree
substitutes from the point of view of holders. However, these markets use different credit
instruments. As the money market consists of varied types of institutions dealing in different
types of instruments, it operates through a number of sub-markets.
1. The call loan market: It is a market for marginal funds, for temporarily unemployed or
unemployable funds. For instance, commercial banks advance loans to bill brokers and
dealers in stock exchange so as to use the fund to discount or purchase bills or stocks for a
short period of time, one night, a week or not more than 14 days. The same thing is true that
central banks advance loans to commercial banks for a short period. The central bank applies
a rate called “call rate”, which is usually less than the normal rate but sometimes it may be
even greater than the normal rate.
2. The bill market: It is the short period loan market. In this market Commercial banks, discount
houses and brokers lend to businesspersons. The commercial banks discount bills of
exchange, lend against promissory notes, or through advances or overdrafts to the
businessperson and lend government through treasury bills.
The discount houses and bill brokers lend to businesspersons by discounting their bills of
exchange before they mature.
3. The collateral loan market: the commercial banks lend the discount houses and bill brokers
against collateral bonds, stocks; securities, etc. The commercial banks borrow from big/large/
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 banks and the central bank on the basis of collateral securities.
4. The acceptance market: The merchant bankers accept bills drawn on domestic and foreign
traders whose financial standing is not known commercial banks have started the acceptance
business.

D. Characteristics of the Money Market

Money markets may be developed and undeveloped markets. Their characteristics can be
presented as follows.
i. Characteristics of an Undeveloped Money Market

The main characteristics of such a market are:

1. There is Personal Touch: The lender and borrower are known each other and decision 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 moneylender.
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 moneylender.
4. Varied Interest Rates are Applied: The rate depends on the need of the borrower, the amount
of the loan, the time for which it is required and the nature of security.
5. Defective Accounting System: The accounts of the moneylenders are not liable to checking
by any higher authority.
6. Absence of link with the developed Market: There is no established channel to create a link
between the developed and undeveloped markets. The undeveloped money market consists
of the moneylenders, the indigenous bankers, traders, merchants, landlords, brokers, etc.

ii. Characteristics of a Developed Money Market

The main characteristics of such a market are:
1. It is a well-developed market and consists of the central bank, the commercial bank, bill
brokers, discount houses, acceptance houses, 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 such as the call loan market, the bill market, the treasury bill market, the
collateral loan market, the acceptance market and the foreign exchange market.
4. It has a large number of near money assets of various types such as: bills of exchange,
promissory notes, treasury bills, securities, bonds, etc.
5. It has an integrated interest rate structure. The change in the bank rate leads to proportional
changes in the interest rate prevailing in the sub-markets.
6. It has an adequate financial resources form both within and outside the country.
7. It provides easy and cheep 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.

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4.3. Capital Markets

Capital market is a market for long term securities as opposed to short term money
market. Capital Market is a financial market where financial assets that have an original
maturity greater than 1 year are traded. The primary issuer of capital market securities is
Federal and Local Government and corporations. Federal and local governments issue
long-term notes and bonds. Corporations issues bonds and stock. The largest purchasers
of capital market securities are households. Frequently individuals and households invest
in financial institutions such as mutual funds and pension funds that use the fund to invest in
capital market instruments.
Capital market trading occurs in primary market or secondary market. The secondary market can
be (a) Organized Securities Exchange, and (b) Over-The-Counter Exchange (OTC).
(a) Organized Securities Exchange
Organized Securities Exchange has a building where securities trade. There are so many
Organized exchanges throughout the world e.g., NYSE, London Stock exchange, Tokyo Stock
Exchange, etc. Only securities listed in a particular exchange will be traded there. A firm must
file an application form and fulfill the criteria imposed by the exchange to list the securities for
trading.
(b) Over-The-Counter Exchange (OTC)
Over-The-Counter Exchange (OTC) is another type of exchange. In this market dealers who
have inventory of securities stands ready to buy and sell the securities over-
the-counter to anyone who come to them and willing to accept their price. This market is
not organized in the sense it has no specific building or location where trading takes place
instead trading occur through supplicated telecommunication network. OTC is much
popular among small investors and regionally popular securities of small companies.

Importance or Functions of Capital Market

The capital market helps in capital formation and economic growth of the county. The
functions/importance are discussed as follows:
1. It acts as an important link between savers and investors
The savers are called the “surplus units” and they are lenders of funds. Whereas the investors
are called the “deficit units” and they are borrowers of funds. Hence, the capital market is the
transmission mechanism between surplus units and deficit units. It is a conduct through
which surplus units lend their surplus funds to the deficit units. Surplus units buy securities
with their surplus funds and deficit units sell securities to raise funds they need. This fund
flow may be directly or indirectly.
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2. It gives incentives to savers and investors
Savers or surplus spending units will be rewarded in a form of interest, if they deposit their
money in a bank and buy interest bearing financial assets or in a form of dividend, if they
buy shares and stocks, for their postponement of present consumption. This leads to capital
formation which is used by investors or deficit spending units. Investors of DSUs will be also
rewarded in a form of profit from their investment activity. By doing so, it diverts resources
from wasteful and unproductive channels to productive investments.
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
The various institutions which operates in the capital market give quantitative and qualitative
direction to the flow of funds and bring rational allocation of resources. They do so by
converting financial assets in to productive physical assets. Business firms invest in the
projects offering the highest rates of return and that households invest in direct or indirect
financial claims offering the highest yields for given levels of risk.

Distinction between Money And Capital Markets

The money market differs from the capital market on several grounds.
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, insurance companies, leasing companies, investment
banks, investment trust, etc, operate.

Interrelation between Money and Capital Markets

These markets are closely interrelated because most corporations and financial institutions are
active in both. Their interrelation is discussed as follows:
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. Funds flow back and forth between the two markets whenever the treasury finances maturing
bills with treasury securities or whenever a bank lends the proceeds of a maturing loan to a
firm on a short-term basis.
6. Yields in the money market are related to those of the capital market. As the long-term
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 interest rates fall, the short-term interest rate will fall. However, money market interest rates
are more sensitive than are long-term interest rates in the capital market.

Capital markets can be divided into two debt market and equity market.

4.3.1. Debt Market

Bond market

Bonds generally can trade anywhere in the world that a buyer and seller can strike a deal. There
is no central place or exchange for bond trading, as there is for publicly traded stocks. The bond
market is known as an "over-the-counter" market, rather than an exchange market. There are
some exceptions to this. For example, some corporate bonds in the United States are listed on an
exchange. Also, bond futures, and some types of bond options, are traded on exchanges. But the
overwhelming majority of bonds do not trade on exchanges. (This article refers to marketable
bonds where trading is permitted. Trading is sometimes not permitted for government savings
bonds.)

Bond Dealers
While investors can trade marketable bonds among themselves whenever they want, trading is
usually done with bond dealers, more specifically, the bond trading desks of major investment
dealers. The dealers occupy centre stage in the vast network of telephone and computer links that
connect the interested players. Bond dealers usually "make a market" for bonds. What this means
is that the dealer has traders whose responsibility is to know all about a group of bonds and to be
prepared to quote a price to buy or sell them. 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. The name of the trading game is to take a spread between the
price the bonds are bought at and the price they are sold at. This is the main way that bond
dealers make (or lose) money. Dealers often have bond traders located in the major financial
centers and are able to trade bonds 24 hours a day (although not usually on weekends).

Bond Investors
The major bond investors are financial institutions, pension funds, mutual funds and
governments, from around the world. These bond investors, along with the dealers, comprise the
"institutional market", where large blocks of bonds are traded. A trade of $1-million-worth of
bonds would be considered a small ticket. There is no size limit, and trades involving $500
million or $1 billion at a time can take place. There similarly is no size restriction in the "retail
market," which essentially involves individual investors buying and selling bonds with the bond
trading desks of investment dealers. However, the size of trades is usually under $1 million.

Types of bond markets

The Securities Industry and Financial Markets Association classifies the broader bond market
into five specific bond markets.

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  Corporate
 Government & Agency
 Municipal
 Mortgage Backed, Asset Backed, and Collateralized Debt Obligation
 Funding

Bond market participants

Bond market participants are similar to participants in most financial markets and are essentially
either buyers (debt issuer) of funds or sellers (institution) of funds and often both.

Participants include:

 Institutional investors;
 Governments;
 Traders; and
 Individuals

Because of the specificity of individual bond issues, and the lack of liquidity in many smaller
issues, the majority of outstanding bonds are held by institutions like pension funds, banks and
mutual funds. In the United States, approximately 10% of the market is currently held by private
individuals.

Corporate bond

A Corporate Bond is a bond issued by a corporation. The term is usually applied to longer-term
debt instruments, generally with a maturity date falling at least a year after their issue date. (The
term "commercial paper" is sometimes used for instruments with a shorter maturity.)

Types

Corporate debt falls into several broad categories:

 secured debt vs unsecured debt

 senior debt vs subordinated debt

Generally, the higher one's position in the company's capital structure, the stronger one's claims
to the company's assets in the event of a default.

Subordinated debt
In finance, subordinated debt (also known as subordinated loan, subordinated bond, subordinated
debenture or junior debt) is debt which ranks after other debts should a company fall into
receivership or be closed.
Senior debt
In finance, senior debt, frequently issued the form of a senior note, is debt that takes priority over
other debt securities sold by the issuer. Senior debt has greater seniority in the issuer's capital
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structure than subordinated debt. In the event the issuer goes bankrupt, senior debt must be
repaid before other creditors receive any payment.
Secured loan
A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as
collateral for the loan, which then becomes a secured debt owed to the creditor who gives the
loan.

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.

R i sk

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. Some counter examples do
exist where a government has defaulted on its domestic currency debt, such as Russia in 1998-
the "ruble crisis", though this is very rare.

Types of Government Bonds

Supranational Agencies
A supranational agency, such as the World Bank, levies assessments or fees against its member
governments. Ultimately, it is this support and the taxation power of the underlying national
governments that allow these organizations to make payments on their debts.
National Governments
The "central" or national governments also have the power to print money to pay their debts, as
they control the money supply and currency of their countries. This is why most investors
consider the national governments of most modern industrial countries to be almost "risk-free"
from a default point of view.
Provincial or State Governments
Provincial or state governments also issue debt, depending on their constitutional ability to do
this. Canadian provinces, notably Ontario, borrow more than many smaller countries. Most
investors consider provincial or state issuers to be very strong credits because they have the
power to levy income and sales taxes to support their debt payments. Since they can not control
monetary policy like national governments, they are considered lesser credits than national
governments.
Municipal and Regional Governments
Cities, towns, counties and regional municipalities issue bonds supported by their property taxes.
School boards also issue bonds, supported by their ability to levy a portion of property taxes for
education.

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Quasi-Government Issuers
Many government related institutions issue bonds, some supported by the revenues of the
specific institution and some guaranteed by a government sponsor. In Canada, Federal
government agencies and Crown corporations issue bonds. For example, The Federal Business
Development Bank (FBDB) and the Canadian Mortgage and Housing Corporation (CMHC)
bonds are directly guaranteed by the Federal government. Provincial crown corporations such as
Ontario Hydro and Hydro Quebec are guaranteed by the Provinces of Ontario and Quebec
respectively

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. Thus, a lower-yield municipal bond could
actually be more attractive than a higher-paying taxable instrument when the relative tax
consequences are figured into the comparison, especially in the higher income tax brackets.

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. Foreign currency
bonds can "swapped" or converted in the swap market into the home currency of the issuer.
Bonds issued by foreign issuers in the United States market in U.S. dollars are known as
"Yankee" bonds. Bonds issued in British pounds in the British bond market are known as
"Bulldogs". Yen denominated bonds by foreign issuers are known as "Samurai" bonds.

Foreign currency bonds have a vocabulary all their own. Bonds issued in foreign currencies are
given the names listed beside the currencies below:
 "Yankee Bonds" for U.S. dollars;
 "Samurai Bonds" for Japanese Yen;
 "Bulldog Bonds" for British pounds; and
 "Kiwi Bonds" for New Zealand dollars.

Mortgage-Backed Securities
A mortgage-backed security (MBS) is a security that is based on a pool of underlying mortgages.
MBS are usually based on mortgages that are guaranteed by a government agency for payment
of principal and a guarantee of timely payment. The analysis of MBS concentrates on the nature
of the underlying payment stream, particularly the prepayments of principal prior to maturity.

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Key Characteristics of Bonds
Although all bonds have some common characteristics, they do not always have the same
contractual features. For example, most corporate bonds have provisions for early repayment
(call features), but these provisions can be quite different for different bonds. Differences in
contractual provisions, and in the underlying strength of the companies backing the bonds, lead
to major differences in bonds’ risks, prices, and expected returns. To understand bonds, it is
important that you understand the following terms.
Par Value. The par value is the stated face value of the bond; for illustrative purposes we
generally assume a par value of Br. 1,000, although any multiple of Br. 1,000 (for example, Br.
5,000) can be used. The par value generally represents the amount of money the firm borrows
and promises to repay on the maturity date.
Coupon Interest Rate. GERD bonds require the government to pay a fixed number of birrs of
interest each year (or, more typically, each six months). When this coupon payment, as it is
called, is divided by the par value, the result is the coupon interest rate. For example, GERD
bonds have a Br. 1,000 par value, and they pay Br. 100 in interest each year. The bond’s coupon
interest is Br. 100, so its coupon interest rate is Br. 100/Br. 1,000 = 10 percent. The Br. 100 is the
yearly “rent” on the Br. 1,000 loan.
In some cases, a bond’s coupon payment may vary over time. These floating rate bonds works as
follows. The coupon rate is set for, say, the initial six-month period, after which it is adjusted
every six months based on some market rate. Some bonds pay no coupons at all, but are offered
at a substantial discount below their par values and hence provide capital appreciation rather than
interest income. These securities are called zero coupon bonds (“zeros”).
Maturity Date. Bonds generally have a specified maturity date on which the par value must be
repaid. GERD bonds, which were issued on April 5, 2012, will mature on April 4, 2017; thus,
they had a 5-year maturity at the time they were issued. Most bonds have original maturities (the
maturity at the time the bond is issued) ranging from 10 to 40 years, but any maturity is legally
permissible.
Call Provisions. Most corporate bonds contain call provisions, which gives the issuing
corporation the right to call the bonds for redemption. The call provision generally states that the
company must pay the bondholders an amount greater than the par value if they are called. The
additional sum, which is termed as call premium, is typically set equal to one year’s interest if

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the bonds are called during the first year, and the premium declines at a constant rate of INT/N
each year thereafter, where INT = annual interest and N = original maturity in years.
Sinking Funds. Some bonds also include a sinking fund provision that facilitates the orderly
retirement of the bond issue. Typically, the sinking fund requires the firm to retire apportion of
the bonds each year. On rare occasions the firm may be required to deposit money with a trustee,
which invests the funds and then uses the accumulated sum to retire the bonds when they mature.
Usually, though, the sinking fund is used to buy back a certain percentage of the issuer each year.
A failure to meet the sinking fund requirement causes the bond issue to be thrown into default,
which may force the company into bankruptcy. Obviously, a sinking fund can constitute a
significant cash drain on the firm.
Other Features. Several other types of bonds are used sufficiently often to warrant mention. First,
convertible bonds are bonds that are convertible into shares of common stock, at a fixed price, at
the option of the bondholder. Bonds issued with warrants are similar to convertibles.
Warrants are options which permit the holder to buy stock for a stated price, thereby providing a
capital gain if the price of the stock rises. Bonds that are issued with warrants, like convertibles,
carry lower coupon rates than straight bonds.
4.3.2. Equity Market
Firms obtain equity capital either internally by earning money and retaining it within the firm or
externally by issuing new equity securities. There are three different kinds of equity that a firm
can issue:
A. Common stock
It is a share of ownership in a corporation that usually entitles its holder to vote on the
corporation’s affairs. The common stockholders of a firm are generally viewed as the firm’s
owners. They entitled to the firm’s profits after other contractual claims on the firm are satisfied
and have the ultimate control over how the firm is operated. Although most firms have only one
type of common stock, in some instances classified stock is used to meet the special needs of the
company. Generally, when special classifications of stock are used, one type is designated class
A, another class B, and so on.
Note that “Class A,” “Class B,” and so on, have no standard meanings. Most firms have no
classified shares, but a firm that does could designate its Class B shares as founders’ shares and
its Class A as those sold to the public, while another could reverse these designations. Still other
firms could use stock classifications for entirely different purposes.
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Market for Common Stock
Some companies are so small that their common stocks are not actively traded; they are owned
by only a few people, usually the company’s’ managers. Such firms are said to be privately
owned, or closely held corporations, and their stock is called closely held stock. In contrast, the
stocks of larger companies are owned by a large number of investors, most of whom are not
active in management. Such companies are called publicly owned corporations, and their stock is
called publicly held stock.
B. Preferred stock
It is a financial instrument that gives its holders a claim on a firm’s earnings that must be paid
before dividends on its common stock can be paid. Preferred stock also is a senior claim in the
event of reorganization or liquidation, which is the sale of the assets of the company. However,
the claims of preferred stockholders are always junior to the claims of the firm’s debt holders.
Preferred stock is used much less than common stock as a source of capital.
Preferred stock is like debt in that its dividend is fixed at the time of sale. In some cases,
preferred stock has a maturity date much like a bond. In other cases, preferred stock is more like
common stock in that it never matures. Preferred shares are almost always cumulative: if the
corporation stops paying dividends, the unpaid dividends accumulate and must be paid in full
before any dividends can be paid to common shareholders. Preferred stockholders do not always
have voting rights, but they often obtain voting rights when the preferred dividends are
suspended.
 Convertible preferred. Convertible preferred stock is similar to the convertible debt
instruments. These instruments have the properties of preferred stock prior to being
converted, but can be converted into the common stock of the issuer at the preferred
stockholder’s discretion. In addition to the standard features of preferred stock, convertible
preferred stock specifies the number of common shares into which each preferred share can
be converted.
 Adjustable-Rate Preferred. In each form of adjustable –rate preferred stock, the dividend
is adjusted quarterly (sometimes monthly) by an amount determined by the change in some
short-term interest rate. Most of the adjustable-rate preferred stock is sold by financial
institutions seeking deposits and is bought by corporate financial managers seeking a tax-
advantaged investment for short-term funds.

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Warrants there are several other equity-related securities that firms issue to finance their
operations. Firms sometimes issue warrants, which are long-term call options on the issuing
firm’s stock. Call options give their holders the right to buy shares of the firm at a pre-specified
price for a given period of time. These options are often included as part of a unit offering,
which includes two or more securities offered as a package. For example, firms might try to sell
one common share and one warrant as a unit.

Market participants

Many years ago, worldwide, buyers and sellers were individual investors, such as wealthy
businessmen, with long family histories (and emotional ties) to particular corporations. Over
time, markets have become more "institutionalized"; buyers and sellers are largely institutions
(e.g., pension funds, insurance companies, mutual funds, hedge funds, investor groups, and
banks). The rise of the institutional investor has brought with it some improvements in market
operations. Thus, the government was responsible for "fixed" (and exorbitant) fees being
markedly reduced for the 'small' investor, but only after the large institutions had managed to
break the brokers' solid front on fees (they then went to 'negotiated' fees, but only for large
institutions)

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

When people draw their savings and invest in shares, it leads to a more rational allocation of
resources because funds, which could have been consumed, or kept in idle deposits with banks,
are mobilized and redirected to promote business activity with benefits for several economic
sectors such as agriculture, commerce and industry, resulting in a stronger economic growth and
higher productivity levels and firms.

 Facilitating company growth

Companies view acquisitions as an opportunity to expand product lines, increase distribution
channels, hedge against volatility, increase its market share, or acquire other necessary business
assets. A takeover bid or a merger agreement through the stock market is one of the simplest and
most common ways for a company to grow by acquisition or fusion.

 Redistribution of wealth
Stocks exchanges do not exist to redistribute wealth. However, 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.

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  Creating investment opportunities for small investors
As opposed to other businesses that require huge capital outlay, investing in shares is open to
both the large and small stock investors because a person buys the number of shares they can
afford. Therefore the Stock Exchange provides the opportunity for small investors to own shares
of the same companies as large investors.

 Government capital-raising for development projects

Governments at various levels may decide to borrow money in order to finance infrastructure
projects such as sewage and water treatment works or housing estates by selling another category
of securities known as bonds. These bonds can be raised through the Stock Exchange whereby
members of the public buy them, thus loaning money to the government. The issuance of such
bonds can obviate the need to directly tax the citizens in order to finance development, although
by securing such bonds with the full faith and credit of the government instead of with collateral,
the result is that the government must tax the citizens or otherwise raise additional funds to make
any regular coupon payments and refund the principal when the bonds mature.

 Barometer of the economy

At the stock exchange, share prices rise and fall depending, largely, on market forces. Share
prices tend to rise or remain stable when companies and the economy in general show signs of
stability and growth. An economic recession, depression, or financial crisis could eventually lead
to a stock market crash. Therefore the movement of share prices and in general of the stock
indexes can be an indicator of the general trend in the economy.

4.4. Foreign Exchange Markets

U.S. borrowers and investors need not look solely to domestic financial markets to accomplish
their financial goals. Nor need foreign entities depend solely on their domestic markets. As a
result, payments for liabilities made by borrowers and cash payment received by investors may
be denominated in a foreign currency.
Foreign Exchange Rates
An exchange rate is defined as the amount of one currency that can be exchanged per unit of
another currency or the price of one currency in terms of another currency. For example,
consider the exchange rate between the U.S. dollar and the Swiss franc. The exchange rate could
be quoted in one of two ways:
1. The amount of U.S. dollars necessary to acquire one Swiss franc, or the dollar price of
one Swiss franc.
2. The amount of Swiss francs necessary to acquire one U.S. dollar, or the Swiss franc price
of one dollar.
Exchange rate quotations may be either direct or indirect. To understand the difference, it is
necessary to refer to one currency as a local currency and the other as a foreign currency. For
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example, from the perspective of a U.S. participant, the local currency would be U.S. dollars, and
any other currency, such as Swiss franc, would be the foreign currency. From the perspective of
a Swiss participant, the local currency would be Swiss francs, and other currencies, such as U.S.
dollars, the foreign currency.
Direct quote is the number of units of a local currency exchangeable for one unit of a foreign
currency. An indirect quote is the number of units of a foreign currency that can be exchanged
for one unit of a local currency. Looking at this from a U.S. participant’s perspective, a quote
indicating the number of dollars exchangeable for one unit a foreign currency is a direct quote.
An indirect quote from the same participant’s perspective would be the number of units of the
foreign currency that can be exchanged for one U.S. dollar. Obviously, from the point of view of
a non-U.S. participant, the number of U.S. dollars exchangeable for one unit of a non-U.S.
currency is an indirect quote; the number of units of a non-U.S. currency exchangeable for a U.S.
dollar is a direct quote.
Given a direct quote, we can obtain an indirect quote (the reciprocal of the direct quote), and
vice versa. For example, suppose that a U.S. participant is given a direct quote of dollars for
Swiss francs of 0.7402 – that is, the price of a Swiss franc is $0.7402. The reciprocal of the direct
quote is 1.3508, which would be the indirect quote for the U.S. participant; that is, one U.S.
dollar can be exchanged for 1.3508 Swiss francs, which is the Swiss franc price of dollar.
If the number of units of a foreign currency that can be obtained for one dollar – the price of a
dollar or indirect quotation – rises, the dollar is said to appreciate relative to the foreign currency,
and the foreign currency is said to depreciate. Thus appreciation means a decline in the direct
quotation.
Foreign-Exchange Risk
From the perspective of a U.S. investor, the cash flows of assets denominated in a foreign
currency expose the investor to uncertainty as to the cash flow in U.S. dollars. The actual U.S.
dollars that the investor gets depend on the exchange rate between the U.S. dollar and the foreign
currency at the time the non-dollar cash flow is received and exchanged for U.S. dollars. If the
foreign currency depreciates (declines in value) relative to the U.S. dollar (i.e., the U.S. dollar
appreciates), the dollar value of the cash flows will be proportionately less. This risk is referred
to as foreign-exchange risk.
Any investor who purchases an asset denominated in a currency that is not the medium of
exchange of the investor’s country faces foreign-exchange risk. For example, a Greek investor
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who acquires a yen-denominated Japanese bond is exposed to the risk that the Japanese yen will
decline in value relative to the Greek drachma.
Foreign- exchange risk is a consideration for issuers too. Suppose that IBM issues bonds
denominated in Japanese yen IBM’s foreign-exchange risk is that at the time the coupon interest
payments must be made and the principal repaid, the U.S. dollar will have depreciated relative to
the Japanese yen, requiring that IBM pay more dollars to satisfy its yen obligation.
Spot Market
The spot exchange rate market is the market for settlement within two business days. Since the
early 1970s, exchange rates between major currencies have been free to float, with market forces
determining the relative value of a currency. Thus, each day a currency’s price relative to another
currency may stay the same, increase, or decrease.
While quotes can be either direct or indirect, the problem is defining from whose perspective
the quote is given. Foreign exchange conventions in fact standardize the ways quotes are given.
Because of the importance of the U.S. dollar in the international financial system, currency
quotations are all relative to the U.S. dollar. When dealers quote, they either give U.S. dollars per
unit of foreign currency (a direct quote from the U.S. perspective) or the number of units of the
foreign currency per U.S. dollar (an indirect quote from the U.S. perspective). Quoting in terms
of U.S. dollars per unit of foreign currency is called American terms, while quoting in terms of
the number of units of the foreign currency per U.S. dollar is called European terms.
A key factor affecting the expectation of changes in a country’s exchange rate is the relative
expected inflation rate. Spot exchange rates adjust to compensate for relative inflation rate
between two countries. This is the so called purchasing-power parity relationship. It says that the
exchange rate – the domestic price of the foreign currency – is proportional to the domestic
inflation rate, and inversely proportional to foreign inflation.
Cross Rates
Barring any government restrictions, riskless arbitrage will assure that the exchange rate between
two countries will be the same in both countries. The theoretical exchange rate between two
countries other than the U.S. can be inferred from their exchange rate with the U.S. dollar. Rates
computed in this way are referred to as theoretical cross rates. They would be computed as
follows for two countries, X and Y:
Quote in American terms of currency X
Quote in American terms of currency Y
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 To illustrate how this is done, let’s calculate the theoretical cross rate between German marks
and Japanese yen using the exchange rates. The exchange rate for the two currencies in
American terms is $0.6234 per German marks and $0.009860 per Japanese yen. Then the
number of Japanese yen (Y) per unit of German marks (X) is:
$0.6234 = 63.23 yen/mark
$0.009860
Taking the reciprocal gives the number of German marks exchangeable for one Japanese yen.
In our example it is 0.01581.
New Issue Vs Stock Exchanges
New issue: a stock issued for the first time to raise new equity capital, this transaction is said to
occur in the primary market. Initial public offerings by privately held firms: the IPO market. The
act of selling stock to the public at large by closely held corporation or its principal stockholders.
The Stock Exchanges
There are two basic types of stock markets: (1) organized exchanges, which include the New
York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and several regional
exchanges, and (2) the less formal over-the=counter market.
The organized security exchanges are tangible physical entities. Each of the larger ones
occupies its own building, has a limited number of members, and has an elected governing body
– its board of governors. Members are said to have “seats” on the exchange, although everybody
stands up. These seats, which are bought and sold, give the holder the right to trade on the
exchange. There are more than 1,300 seats on the New York Stock Exchange, and recently
NYSE seats were selling for about $1.5 million.
Most of the larger investment banking houses operates brokerage departments, and they own
seats on the exchanges and designate one or more of their officers as members. The exchange are
open on all normal working days, with the members meeting in a large room equipped with
telephones and other electronic equipment that enable each member to communicate with his or
her firm’s offices throughout the country.
Like other markets, security exchanges facilitate communication between buyers and sellers.
For example, Merrill Lynch (the largest brokerage firm) might receive an order in its Atlanta
office from a customer who wants to buy 100 shares of AT&T stock. Simultaneously, Dean
Witter’s Denver office might receive an order from a customer wishing to sell 100 shares of
AT&T. each broker communicates by wire with the firm’s representative on the NYSE. Other
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brokers throughout the country are also communicating with their own exchange members. The
exchange members with sell orders offer the shares for sale, and they are bid for by the members
with buy orders. Thus, the exchanges operate as auction market.
The Efficient Markets Hypothesis
A body of theory called the Efficient Markets Hypothesis (EMH) holds (1) that stocks are always
in equilibrium and (2) that it is impossible for an investor to consistently “beat the market.”
Levels of Market Efficiency
If markets are efficient, stock prices will rapidly reflect all available information. This raises an
important question: what types of information are available and, therefore, incorporated into
stock prices? Financial theorists have discussed three forms, or levels, of market efficiency.
Weak-Form Efficiency. The weak-form of the EMH states that all information contained in past
price movements is fully reflected in current market prices. If this is true, then information about
recent trends in stock prices would be of no use in selecting stocks – the fact that a stock has
risen for the past three days, for example, would give us no useful clues as to what it will do
today or tomorrow. People who believe that weak-form efficiency exists also believe that “tape
watchers” and “chartists” are wasting their time. 1
For example, after studying the past history of the stock market, a chartist might “discover”
the following pattern: If a stock falls three consecutive days, its price typically rises 10 percent
the following day. The technician would conclude that investors could make money by
purchasing a stock whose price has fallen three consecutive days.
Semi Strong-Form Efficiency. The semi strong form of EMH states that current market prices
reflect all publicly available information. Therefore, if semi strong-form efficiency exists, it
would do no good to pore over annual reports or other published data because market prices
would have adjusted to any good or bad news contained in such reports back when the news
came out. With semi strong-form efficiency, investors should expect to earn the returns predicted
by the SML, but they should not expect to do any better unless they have good luck or
information that is not publicly available. However, insiders (for example, the presidents of
companies) who have information which is not publicly available can earn abnormal returns
(returns higher than those predicted by the SML) even under semi strong-form efficiency.
Another implication of semi strong-form efficiency is that whenever information is released
to the public, stock prices will respond only if the information is different from what had been
expected.
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Strong-Form Efficiency. The strong form of EMH states that current market prices reflect all
pertinent information, whether publicly available or privately held. If this form holds, even
insiders would find it impossible to earn abnormal returns in the market.
Many empirical studies have been conducted to test for the three forms of market efficiency.
Most of these studies suggest that the stock market is indeed highly efficient in the weak form
and reasonably efficient in the semi strong form, at least for the larger and more widely followed
stocks. However, the strong-form EMH does not hold, so abnormal profits can be made by those
who possess inside information.
4.5 Derivative Market

In industrialized countries, apart from money market and capital market securities, a
variety of other securities known as derivates has now become available for
investment and trading. There is a demand in different country to introduce these
securities and to take policy measures to develop markets.
The establishment and growth of financial derivatives markets has been major development
trend in financial markets over the past thirty-five years. Financial innovation and increased
market demand led to a rapid growth of derivatives trading. Development of financial
derivatives was speeded up by the globalization of business, the increased volatility of
foreign exchange rates, and increasing and fluctuating rates of inflation.

Derivative market is a financial market where derivative securities are traded. Derivatives or
derivative securities are contracts which are written between two parties
(counter parties) and whose value is derived from the value of underlying widely-held
and easily marketable assets such as agricultural and other physical (tangible)
commodities or currencies or short-term or long-term financial instruments or intangible
things like commodities price index (inflation rate), equity price index, bond price index.
The counter parties to such contracts are those other than the original issuer (holder) of
the under of the underlying assets. Derivatives are also known as "deferred delivery or
deferred payment instruments" in a sense that they are similar to securitized asset, but unlike
the later, they are not the obligations which are backed by the original issuer of the
underlying asset or security. The value of derivatives and those of their underlying assets
are closely related. Usually, in trading derivatives, the taking or making of delivery of
underlying assets is not involved; the transactions are mostly settled by taking offsetting

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positions in the derivatives themselves.
In general, derivatives contracts promise to deliver underlying products at some time in the
future or give the right to buy or sell them in the future. They can be based on different types of
assets (such as equities or commodities), prices (such as interest rates or exchange rates), or
indexes (such as a stock-market index). The types of derivative securities (derivatives) include:

 Forwards
 Futures
 Options
 Swaps
In general, derivative securities provide the following services:
a) To control, shift, avoid, reduce, eliminate, and manage efficiently various types of
risks through hedging, arbitraging-and acquiring insurance against them. In times of
erratic trading, volatile interest rates and exchange rates, monetary chaos, national income
turbulence and volatile markets, derivatives are said to enable investors to
modify suitably the risk characteristics of their portfolios or to shift the risk on to
those (speculators who are willing to assume it for higher profits. They increase the
capability of the markets to absorb risk, and this has a beneficial effect on the level of
commercial and industrial activity. In their absence, the cost of risk of economy would be
higher, and it would, therefore, be worse off.
b) To help in disseminating information which enables the society to discover or form suitable
correct/ true/ equilibrium prices. They serve as barometers of future trends in
prices which resulting the formation of correct prices on the spot markets now and in
future. They provide for centralized trading where information about fundamental
supply and demand conditions are efficiently assimilated and acted on. The economic
and social benefits of accurate and equilibrium prices thus arrived at are many, the
superior allocation of resources being one of them.
c) To enhance liquidity and reduce transaction costs in the markets for underlying
assets.
d) To enable individuals and managers of large pools of funds to devise or design
strategies for proper asset allocation, yield enhancement, and achieving other
portfolio goals. They provide opportunities for using certain kinds of special
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 knowledge to obtain portfolio which offer higher expected returns than other
portfolios comprising common stock, bonds, etc with the same degree of risk.
e) To smoothen out price fluctuations, to narrow down the price spread, to integrate price
structure at different points of time, and to avoid gluts and shortages in the markets. The
existence of speculation, competitive trading, and differing risk-taking
preferences of the market operators help in achieving these results.
f) To act as "starter form of investment" this results in a wider participation in the
securities markets. They attract young investors, who would not otherwise invest in
stocks, to the securities industry. They act as catalyst to the growth of stock markets.
g) To offer important advantages of diversification and enable the society to reach the position
of Pareto optimally by developing "complete markets". Given the total return
in its each state, the financial market is said to be Pareto optimal or efficient if no other set of
securities can make some investors better off without making at least one
other investor worse off. The securities market said to be complete if the patterns of
returns of all additional securities are spanned by the already existing securities in it,
or if it provides so many securities that no additional security can be created whose
returns cannot be duplicated by a portfolio of existing securities.
Financial derivatives are so effective in reducing risk because they enable financial
institutions to hedge; that is, engage in a financial transaction that reduces or eliminates
risk. When a financial institution has bought an asset, it is said to have taken a long
position, and this exposes the institution to risk if the returns on the asset are uncertain.
On the other hand, if it has sold an asset that it has agreed to deliver to another party at a
future date, it is said to have taken a short position, and this can also expose the
institution to risk. Financial derivatives can be used to reduce risk by invoking the
following basic principle of hedging: Hedging risk involves engaging in a financial
transaction that offsets a long position by taking an additional short position, or offsets a
short position by taking an additional long position. In other words, if a financial
institution has bought a security and has therefore taken a long position, it conducts a
hedge by contracting to sell that security (take a short position) at some future date.
Alternatively, if it has taken a short position by selling a security that it needs to deliver at a
future date, then it conducts a hedge by contracting to buy that security (take a long

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position) at a future date.
Dear learner, in this section you will study the most important financial derivatives that
managers of financial institutions use to reduce risk by hedging: Forward contracts,
Futures contracts, Options, and Swaps.

1. Forward Contracts

Forward contracts are agreements by two parties to engage in a financial transaction at a

future (forward) point in time. It is a particularly simple derivative in which an
agreement obligates the holder to buy or sell an asset at a predetermined delivery price
during a specified future time period. It is traded in the 0- T -C market-usually between
two financial institutions or between financial institution and its client.
2. Futures Contracts

Given the default risk and liquidity problems in the interest-rate forward market, another solution
to hedging interest-rate risk was needed. This solution was provided by the development of
financial futures contracts.
A financial futures contract is similar to an interest-rate forward contract; in that it
specifies that a financial instrument must be delivered by one party to another on a stated future
date. However, it differs from an interest-rate forward contract in several ways that overcome
some of the liquidity and default problems of forward markets. In line with the terminology used
for forward contracts, parties who have bought a futures contract and thereby agreed to buy (take
delivery of) the bonds are said to have taken a long position, and parties who have sold a futures
contract and thereby agreed to sell (deliver) the bonds have taken a short position.
Dear learner, to make our understanding of this contract more concrete, let's consider
what happens when you buy or sell a Treasury bond futures contract. Let's say that on
February 1, you sell one Br. 100,000 June contract at a price of 115 (that is, Br. 115,000).
By selling this contract, you agree to deliver Br. 100,000 face value of the long-term
Treasury bonds to the contract's counterparty at the end of June for Br. 115,000. By
buying the contract at a price of 115, the buyer has agreed to pay Br. 115,000 for the Br.
100,000 face value of bonds when you deliver them at the end of June. If interest rates on
long-term bonds rise, so that when the contract matures at the end of June, the price of
these bonds has fallen to 110 (Br. 110,000 per Br. 100,000 of face value), the buyer of the
contract will have lost Br. 5,000, because he or she paid Br. 115,000 for the bonds

24
can sell them only for the market price of Br. 110,000. But you, the seller of the contract
will have gained Br. 5,000, because you can now sell the bonds to the buyer for Br.
115,000 but have to pay only Br. 110,000 for them in the market.
3. Options

Another vehicle for hedging interest-rate and stock market risk involves the use of
options on financial instruments. Options are contracts that give the purchaser the option,
or right, to buy or sell the underlying financial instrument at a specified price, called the
exercise price or strike price, within a specific period of time (the term to expiration). The
seller (sometimes called the writer) of the option is obligated to buy or sell the financial
instrument to the purchaser if the owner of the option exercises the right to sell or buy. Two
basic instruments traded in the options market are, call and puts. A Call option
entitles the holder to buy an underlying asset at a stated price on or before a fixed expiration
date. A put option entitles the holder to sell an underlying asset at a stated
price on or before a fixed expiration date. Thus, the option to buy an asset is known as a
call option and the option to sell an asset is called a put option. The price at which option
can be exercised is called the striking or exercise price, (i.e. Because the right to buy or
sell a financial instrument at a specified price has value, the owner of an option is willing
to pay an amount for it called a premium), and The asset on which the put or call option
is created is referred to as the underlying asset.
i: CALL OPTION
A call option is a contract that gives the owner the right to buy a financial instrument at
the exercise price within a specific period of time.

A. PUT OPTION
A put option is a contract that gives the holder a right to sell (or put) a specified an asset
at an agreed exercise price on or before a given maturity period.
4. Swaps
In addition to forwards, futures, and options, financial institutions use one other
important financial derivative to manage risk. Swaps are financial contracts that obligate
each party to the contract to exchange (swap) a set of payments (not assets) it owns for
another set of payments owned by another party.

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