Chapter 2

Financial
markets

©2019 John Wiley & Sons Australia Ltd

 Learning objectives

After studying this presentation, you should be able to:

2.1 explain the characteristics of money market
instruments
2.2 explain the role and function of capital markets, and
how their role differs from that of the money
markets
2.3 differentiate treasury bonds, semis and corporate
bonds
2.4 explain how equity securities are traded in the
secondary markets and discuss how the markets are
operated
 Learning objectives

2.5 describe the most common types of derivative

contracts
2.6 explain how the foreign exchange markets operate
and facilitate international trade.
 Money markets

• The money markets:

– Where depository institutions and other businesses
adjust their liquidity positions by borrowing or
investing for short periods.
– The Reserve Bank of Australia (RBA) conducts
monetary policy in the money markets.
 Money markets

• The instruments traded in the money markets typically

have:
– short‐term maturities
– low default risk
– active secondary markets.
• Instruments have characteristics very similar to those of
money.
 Money markets

• The cash market:

‒ The market for cash held in exchange settlement funds
(ESAs) at the RBA.
‒ One of the most important financial markets in
Australia.
‒ Can be thought of as the ‘official’ short‐term money
market.
‒ Commercial banks and other financial institutions can
immediately trade large amounts of liquid funds over
short periods.
 Money markets

• The cash market:

‒ Cash rate:
• the overnight or one‐day interest rate
• measures the return on the most liquid of all
financial assets
• closely related to the conduct of monetary policy
• influences commercial banks’ decisions concerning
interest rates on loans to businesses, consumers
and other borrowers.
 Money markets

• One-name paper:
‒ Short‐term debt where the liability is with a single
issuer and it does not rely on the credit enhancement
provided by acceptance.
‒ Examples include:
• Treasury notes
• short‐term negotiable bank certificates of deposit
• short‐term asset‐backed securities
• short‐term debt issued by major corporations.
 Money markets

• One-name paper:
‒ The amount of one‐name paper outstanding in
Australia varies.
• Depends on economic and market conditions.
 Money markets

• One-name paper:
‒ Treasury notes:
• The AOFM issues various types of debt to finance
the operations of the Commonwealth Government,
Traditionally, Treasury notes.
• Issued by the Commonwealth Government to:
‒ cover current deficits
‒ refinance maturing Government debt.
 Money markets

• One-name paper:
‒ Treasury notes:
• T‐notes are sold through an auction process.
• Since July 2000, T‐notes have been issued at any
maturity under 1 year.
 Money markets

• One-name paper:
‒ Commercial paper:
• Sometimes called a corporate paper.
• Short‐term, unsecured promissory notes, typically
issued by large corporations to finance short‐term
working capital needs.
• Achieve interest rate savings as an alternative to
bank borrowing.
 Money markets

• One-name paper:
‒ Negotiable certificates of deposit (NCD):
• Bank term deposit that is negotiable
• It can be traded any number of times in the
secondary market before its maturity.
 Money markets

• One-name paper:
• Asset-backed commercial paper (ABCP):
• Issued in order to finance the purchase of financial
assets such as mortgages, receivables and long‐term
securities, including residential mortgage–backed
securities (RMBS).
• Generally have a term to maturity of less than 1
year.
• Relies on the ability to ‘roll over’ the paper when it
matures.
 Money markets

• Bank-accepted bills (BAB):

‒ Also called two-name or three-name papers.
‒ Most important instrument in the money markets.
‒ A time draft drawn on and accepted by a commercial
bank.
‒ Time drafts are orders to pay a specified amount of
money to the bearer on a given date.
 Money markets

• Bank-accepted bills (BAB):

‒ When drafts are accepted, a bank unconditionally
promises to pay to the holder the face value of the
draft at maturity.
• Even if the bank encounters difficulty in collecting
from its customers.
 Money markets

• Bank-accepted bills (BAB):

‒ Creating a bank-accepted bill:
• The sequence of a BAB transaction:
 Capital markets

• Capital goods are financed with stock or long‐term

debt instruments.
• Transactions match savings to the requirements of
individuals, businesses and governments for
investments that are longer term than those offered in
money markets.
• Individuals own real assets (capital goods) to produce
income and wealth.
• Capital goods are the stock assets used in production.
• Less marketable and default risk levels vary widely.
 Capital markets

• Functions of capital markets:

‒ The motive of firms for issuing or buying securities in
capital markets is very different from those for acting in
money markets.
‒ Firms like to finance capital goods with long‐term debt
or equity to lock in their borrowing cost for the life of
the project and to eliminate the problems associated
with periodically refinancing assets.
 Capital markets

• Capital market participants:

‒ The largest purchasers of capital market securities
are:
• individuals
• households
• foreign investors
• financial institutions.
 Capital markets

• Major capital market instruments:

‒ A financial instrument is classified as a capital market
instrument if it has an original term to maturity of 1
year or more.
 Capital markets

• Major capital market instruments:

‒ Bonds:
• Contractual obligations of a borrower to make
periodic cash payments to a lender over a given
number of years.
• Government bonds: long‐term debt obligations of
governments.
• Corporate bonds: long‐term IOUs that represent a
claim against the firm’s assets.
 Capital markets

• Major capital market instruments:

– Mortgages:
• long‐term loans secured by real estate
• largest segment in the capital markets in terms of
the amount outstanding.
 Capital markets

• Major capital market instruments:

‒ Shares:
• Ordinary shares:
‒ equity shares that represent the basic ownership
claim in a corporation
‒ holders are entitled only to a residual claim
against the firm’s cash flows or assets.
‒ limited liability applies.
 Capital markets

• Major capital market instruments:

‒ Shares:
• Preference shares:
• Represent an ownership interest in the
corporation.
• Holders receive preferential treatment with
respect to:
‒ dividend payments
‒ the claim against the firm’s assets in the
event of bankruptcy or liquidation.
 Capital markets

• Major capital market instruments:

‒ Shares:
• Preference shares:
‒ Adjustable-rate preference shares:
• Dividends are adjusted periodically in
response to changing market interest rates.
– Convertible preference shares:
• Can be converted into ordinary shares at a
predetermined ratio.
 Bond markets

• Major issuers of capital market securities:

– Commonwealth Government:
• Commonwealth Government Securities (CGSs) are
notes and bonds to finance operations or to
refinance existing debt.
– State Government:
• Issue debt to finance their operation, but cannot
issue stock.
– Corporations:
• Issue both bonds and stock.
 Bond markets

• Size of the bond markets:

– The long‐term debt or bond markets are massive in
scope, exceeding $1765.7 billion.
– The long‐term government bond market
(Commonwealth and semi‐government) is the largest
segment of the market as of June 2016.
– Its relative importance in the bond market has declined
since 1996.
 Bond markets

• Size of the bond markets:

– During the past decade the bonds issued by
non‐resident (i.e. foreign) companies have grown
exponentially.
– The corporate bond market, which includes both
financial and nonfinancial corporations, comes next.
– The asset‐backed securities market contracted after
the GFC.
 Bond markets

• Size of the bond markets:

– The structure of the Australian bond market has
changed greatly since 1992.
– The Commonwealth Government has played an
important role in this.
– Manages the timing of long‐term and short‐term cash
flows, and funds any shortfall in its long‐term capital
requirements.
 Bond markets

• Turnover in the bond markets:

– The secondary market for bonds is the market in which
bonds are sold from one investor to another.
– There are many reasons prompting market participants
to undertake transactions in the secondary market.
• For example, banks are required by law to hold a
portion of their assets in certain safe, liquid
securities, in what is known as a reserve
requirement.
 Bond markets

• Turnover in the bond markets:

– Institutions also hold securities in case they have a
liquidity shortfall and require cash quickly.
– Some institutions like to maintain a certain maturity
profile for their bond portfolios. For example:
• superannuation funds generally prefer to hold
long‐term bonds
• cash management trusts prefer short‐term bonds.
 Bond markets

• Commonwealth Government Securities:

– Treasury bonds and Treasury notes (T‐notes) issued by
the AOFM and are backed by the full faith and credit
of the Commonwealth Government.
– Considered to be free of default risk.
 Bond markets

• State government bonds:

– In case of funding shortfalls, state and territory
borrowing authorities issue bonds called semis
(semi‐government bonds) backed by their respective
governments.
• Corporate bonds:
– Are debt contracts requiring borrowers to make
periodic payments of interest and to repay principal at
the maturity date.
– Can be unsecured notes or debentures.
 Bond markets

• Investors in corporate bonds:

– The dominant purchasers of corporate bonds:
• life insurance companies
• superannuation funds
• households
• foreign investors.
– Corporate bonds are an attractive option because of
the stability of their cash flows and the long-term
nature of their liabilities.
 Bond markets

• The primary market for corporate bonds:

– New corporate bond issues may be brought to market
by two methods:
• Public sale: the bond issue is offered publicly in the
open market to all interested buyers.
• Private placement: the bonds are sold privately to a
few investors.
 Bond markets

• The secondary market for corporate bonds:

– Most secondary trading of corporate bonds occurs
through dealers.
– The market is thin compared with the markets for
money market securities or corporate stock.
– Corporate bonds are less marketable for two reasons:
• They have special features, such as call provisions or
sinking funds, that make them difficult to value.
• They are long term, which makes them riskier.
 Equity markets

• Equity securities, also known as shares and stocks,

represent part ownership of a corporation.
• Today in Australia and New Zealand, most equity
securities are no longer (paper) certificates but ownership
rights held on electronic databases.
• Equities are the most visible securities in most modern
economies.
 Equity markets

• Primary equity markets:

– New issues of securities are called primary offerings
because they are sold in the primary market.
– If the company has never before offered shares to the
public, the primary offering is called an initial public
offering (IPO).
 Equity markets

• Secondary equity markets:

– Any trade of a security after its primary offering is said
to be a secondary‐market transaction.
– When an investor buys 1000 shares of ANZ Bank on the
ASX, the proceeds of the sale do not go to ANZ but
rather to the investor who sold the shares.
– In Australia, almost all secondary‐market equity trading
is done on the ASX.
 Equity markets

• Characteristics of markets:
– The function of secondary markets is to provide
liquidity at fair prices.
– Liquidity is the ease with which an asset may be
converted to cash without a loss in value.
 Equity markets

• Characteristics of markets:
– Several liquidity‐related characteristics of a desirable
secondary market:
• Market depth: orders exist both above and below
the price at which a security is currently trading.
• Market breadth: orders that give the market depth
exist in significant volume.
• Market resilience: new orders pour in promptly in
response to price changes resulting from temporary
order imbalances.
 Equity markets

• Equity trading:
– Three licenced stock exchanges in Australia:
• ASX
• NSX
• Chi-X Australia.
– All transactions conducted under the auspices of the
ASX are done electronically.
 Equity markets

• Equity trading:
– Types of orders:
• Market order: an order to buy or sell at the best
price available at the time the order reaches the
market.
• Limit order: an order to buy or sell at a designated
price (the limit price stated on the order) or any
better price.
 Derivative markets

• The derivatives markets provide significant benefits to

national financial market:
– allows risk to be shared among market participants
– can increase liquidity in any given market by increasing
turnover and trading depth
– the transmission of information.
 Derivative markets

• A derivative security is a financial instrument whose value

depends on, or is derived from, some underlying security.
• Derivative securities generate substantial fee income for
the financial institutions that invent and market them.
• Most common types of derivative contracts are:
– forward contract
– futures contract
– option contract.
 Derivative markets

• Differences between futures and forward markets:

– Futures contracts are:
• traded on an organised exchange
• standardised in quantities, delivery periods and
grades of deliverable items.
– Forward contracts are:
• traded in the informal OTC market
• not standardised in quantities, delivery periods and
grades of deliverable items.
 Derivative markets

• Uses of the financial futures markets:

– Grown rapidly because they provide a way for financial
market participants to insulate themselves against
changes in interest rates and asset prices.
– Financial futures can be used to reduce the systematic
risk of share portfolios or to guarantee future returns or
costs.
 Derivative markets

• Options markets:
– Options have been available on shares for many years
and have been traded on organised exchanges globally
since 1973.
– In 1980, the Sydney Futures Exchange (SFE) introduced
the world’s first exchange‐traded options on financial
futures with options on bank bills and US dollars.
– US exchanges offered their first futures options in 1982.
 Derivative markets

• Options markets:
– The nature of options:
• Strike or exercise price: predetermined price.
• Option premium: the price that an option buyer
pays an option seller.
• American option: the option can be exercised at
any time before and including the expiry date.
• European option: the option can be exercised only
on the expiry date.
 Derivative markets

• Options markets:
– Options versus futures:
• Gains and losses on options and futures contracts
if options are exercised at expiry:
 Foreign exchange markets

• Australian firms that conduct business in foreign countries

with different currencies face two additional risks:
– Currency risk: the values of currencies fluctuating
relative to each other.
– Country risk: the possibility of financial claims and
other business contracts being repudiated or becoming
unenforceable because of a change in government
policy or government.
 Foreign exchange markets

• The difficulties of international trade:

– Process is complicated by at least four factors:
• One of the two parties to the transaction will be
forced to deal in a foreign currency.
• No single country has total authority over all
aspects of these transactions.
• Countries may have different legal traditions.
• Banks and other lending agencies often find it
difficult to obtain reliable information on which to
base credit decisions in many countries.
 Foreign exchange markets

• The difficulties of international trade:

– Two distinct international markets:
• International money and capital markets:
– Provide the market for credit (international
lending and borrowing).
• FX markets:
– Deal in the media of exchange or the means of
payment.
 Foreign exchange markets

• The difficulties of international trade:

– Exchange rates:
• The price of one monetary unit stated in terms of
another currency unit.
• Base currency: first currency in the quote.
• Terms currency: the second currency named in the
quote.
 Foreign exchange markets

• The operations of foreign exchange markets:

– Each country or monetary union around the world is
responsible for the determination of its exchange rate
regime.
– Fixed exchange rate: system where each country was
required to fix the value or exchange rate of its currency
in terms of the USD, with only the USD being
convertible to gold.
– Floating exchange rate: used by major currencies.
 Foreign exchange markets

• The operations of foreign exchange markets:

– Managed float: where the currency is allowed to
move within a defined range or band relative to
another major currency such as the USD.
– Other systems include crawling peg and pegged
exchange rate.
 Foreign exchange markets

• The operations of foreign exchange markets:

– Inflation and exchange rates:
• Exchange rates are materially affected by changes in
a country’s rate of inflation.
– Foreign exchange markets:
• They provide a mechanism for transferring
purchasing power from those who normally deal in
one currency to those who generally do business in
another.
 Foreign exchange markets

• The operations of foreign exchange markets:

‒ Market structure:
• The FX market is composed of a group of informal
markets closely interlinked through international
branch banking and correspondent bank
relationships.
 Foreign exchange markets

• The operations of foreign exchange markets:

‒ Major participants:
• large multinational commercial banks
• investment banking houses
• banks.
 Foreign exchange markets

• The operations of foreign exchange markets:

‒ Trading foreign exchange:
• In commercial banks, FX trading is usually done by
only a few people.
• The pace of transactions is rapid and traders must
be able to make on‐the‐spot judgements about
whether to buy or sell a particular currency.
 Foreign exchange markets

• The operations of foreign exchange markets:

‒ Transfer process:
• The large multinational banks of each country are
linked through international correspondent
relationships and their worldwide branching
systems.
• Within each country, regional banks are linked to
international banks’ main offices.
‒ Nationwide branching systems or domestic
correspondent networks.
 Foreign exchange markets

• Balance of payments:
‒ A convenient way to summarise a country’s
international balance of trade (its exports less its
imports) and the payments to and receipts from
foreigners.
 Foreign exchange markets

• Balance of payments:
‒ International trade and exchange rates:
• Five factors that influence long‐run supply and
demand conditions are:
‒ relative prices
‒ barriers to trade
‒ resource endowment
‒ tastes
‒ productivity.
 Foreign exchange markets

• Balance of payments:
‒ International trade and exchange rates:
• A theory that explains international trade flows is
purchasing power parity (PPP).
 Foreign exchange markets

• Balance of payments:
‒ Capital flow and exchange rates:
• At least three types of international capital flows can
affect a currency’s exchange rate:
‒ investment capital flows
‒ political capital flows
‒ central banks’ FX market operations.
 Foreign exchange markets

• The globalisation of financial markets:

‒ Financial instruments and even entire markets that did
not exist in the early 1970s have developed and grown
to maturity.
‒ A complex interaction of historical, political and
economic factors drives the globalisation of financial
markets.
 Foreign exchange markets

• The globalisation of financial markets:

‒ Long‐term economic and technological factors that have
promoted the internationalisation of financial markets
include:
• the global trend towards financial deregulation
• standardisation of business practices and processes
• ongoing integration of international product and
service markets
• breakthroughs in telecommunications and IT.
 Foreign exchange markets

• The globalisation of financial markets:

‒ Emergence of floating exchange rates:
• Australia floated its currency in late 1983.
• Having a floating rate that was set by supply and
demand in the market allowed the RBA to regain
control over economic activity through using
expansionary or contractionary monetary policy as
deemed necessary.
 Foreign exchange markets

• The globalisation of financial markets:

‒ Rise of multinational companies:
• For large, multinational companies their:
• capital is almost completely mobile
• approach to financial management is global in
scope and sophisticated in technique.
 Foreign exchange markets

• The globalisation of financial markets:

‒ Technology:
• Breakthroughs in telecommunications and
computer technology have transformed
international finance.
– The US dollar as the ‘new gold standard’:
• Because people wish to trade with stable currencies
that are widely accepted, the US dollar has
benefited.
 Foreign exchange markets

• The globalisation of financial markets:

– The development of the euro:
• Example of the development of a multi-country
standard of value.
 Summary

• The characteristics of money market instruments.

• The role and function of capital markets, and how their
role differs from that of the money markets.
• Treasury bonds, semis and corporate bonds.
• How equity securities are traded in the secondary
markets and how the markets are operated.
• The most common types of derivative contracts.
• How the foreign exchange markets operate and facilitate
international trade.