Dr Omar Salman

Markets
 Unit No. (1)

The Financial markets:

An Overview
• 1/ Types of markets in the economy
• 2/ Why Financial Market Emerged ?
• 3/ Developing countries and the financial markets
• 4/ Definitions and Functions of Financial Markets
• 5/ Financial Assets and securities
• 6/ Capial VS. Money markets:
• 6/1 Capital Market
• 6/2 Money Market:
• 6/3 Other Classifications of financial markets
• 7 / The market value of a security
 1/ Types of markets in the economy
• In general markets is the basic entity of any economy. An
economy is working well when markets functioning well in
facilitating transactions and determining the value or the price
of the exchanged goods and services between participants.

• Transactions takes place in two types of flows:

 Physical flows which reflect the exchange of productive
resources and different kinds of final and semifinal goods
produced in the economy.

 Monetary flows which reflect the role of money in

facilitating physical transactions by using money to
separate between the buying and selling processes in the
circle.
2/ Emergence and Development of the Financial
Market
• Practically, financial markets play an increasing role in the modern
economies.

• financial markets emerge from the need of the economy.

• In the real world, the monetary side of the economy developed to
make the monetary circle in an economy plays more sophisticated
roles and delivers more services to make the economy perform
effectively.

• From this point of view, the role of money in the economy does not
stand for only facilitating transaction, but also creates their own
business and operations. Money now is a question of doing
business for his own sake far from any physical transactions.
2/ Emergence and Development of the Financial Market

• A variety of needs called for the creation and

introduction of financial markets in the economy:

• The needs for finance business and operations,

• To serve as channel for functioning surpluses of
funds

• To provide a mechanism for transferring money

from surplus units to deficit units, and

• To create additional money to finance growing

needs of deficit units.
3/ developing countries and the financial markets

 Developing countries are in urgent need to introduce

legislations, policies and systems that insure the emergence
of an efficient financial market.
 financial markets facilitating the process of transformation
and reforming national economies in line with economic
development goals.
 Therefore, governments interests in the organizing financial
markets must be through promoting liberal economic policies
and market strengthening.
 Emerging financial markets nowadays represent a great
component of international financial markets and facilitate the
merge of developing market economies in the global
economy.
3/ developing countries and the financial markets

 Emerging financial markets nowadays represent a great

component of international financial markets and facilitate the
merge of developing market economies in the global
economy.
 The basic developments in the emerging market economies
(EMEs) take place as follows:
- Foreign exchange markets are fully liberalized and developed.
- Capital market regulations and structures are modernized and
opened up for foreign investors.
- Derivative markets have been established with introducing a
variety of contracts.
- Stock exchange trading systems are developed, and volume of
daily trading is of great amounts.
4/ Definitions and Functions of Financial Markets

• we can list more than one definition as follows:

• A financial market is a market for the creation and

exchange of financial assets.
• It is an Institutional arrangement for dealing in financial
assets of different types of securities.
• A market for transfering funds from surplus units to dficeit
units in the economy.
• It is the channel through which money demanders meets
money suplliers.
4/ Definitions and Functions of Financial Markets

• Once you engaged in buying or selling a financial asset, you

are participating in the financial markets in one way or the
another.
• Therefor we can summarize basic functions provided by
financial market for investors as well as the economy:
• Facilitate, create, and allocate credit in the economy.
• Serve as intermediary for mobilization of savings
between savers and investors.
• Assist the process of balanced economic growth through
proving finance for deficit units and financial
convenience.
• Respond to various credit needs of the business
communities.
5/ Financial Assets and securities
• Assets – in general - are everything has durable and stable value
and perform the function of store of value over time. Therefore, we
can introduce different definitions, ideas, and concepts related to
assets.
• Generally, assets classified mainly into two types:
- Real assets which take the physical or tangible form such as land,
equipment, buildings, ……
- Financial assets or intangible assets such as securities as
instruments created, issued, and traded in the financial
markets.
• Financial assets defined as claims or obligations on real assets:
o directly as stock/share claims on equity shares, or
o indirectly as our holdings of money or claims on future
income stream like bonds or deposits.
 Financial Securities as a Financial Assets
• Securities are financial assets or instruments traded on
domestic or global financial markets.
• It is the merchandise or the instruments of financial
markets.
• Securities can be classified into three common categories:
• Stocks as share of capital equities or ownership in real
assets.
• Bonds as debt obligation on real assets or income stream of
the issuer.
• Derivatives as forward, futures, and option contracts. It is
derived from the original security for the sake of hedging or
investment.
• Currencies or cash money which represent obligation on the
monetary authorities of country of denomination.
Securities created and traded or exchanged under
two main types:
 Primary securities
o It is issued directly, in the primary market, by ultimate
borrowers of the funds to the ultimate savers or
investors. New stocks and bonds issued in a primary
market by a borrower and purchased by an investor.
 Secondary securities
o Not issued directly by ultimate borrowers. It is issued
by financial intermediaries to ultimate savers. It is an
old security traded in the secondary market. Example:
Using stockbroker to purchase already issued security
for the sake of holding or reselling.
6/ Capital VS. Money markets:

• Traditionally, and in the literature, financial markets

classified into two main types and segments as:
• capital market:
• It is a market for creating, issuing, and marketing
long-term securities, with direct or indirect impact
on capital.
• money markets:
• Money market is the market for short term
instruments or securities.
6/1 Capital Market
• It used to raise long-term funds for economic agents like
governments, banks, and corporations, and other institutions.
The basic functions of Capital market are:
- Allocation of financial resources according to their most
efficient uses.
- Provide means for borrow or invest money for long terms
efficiently and effectively.
- The channel through which money transferred from
surplus units to deficit units in the economy on a long-term
basis.
- The main market for financing long term investment in the
economy.
• Two types of capital market:
• Debt market, and
• Equity market
The Debt Market:

• Debt market is a market for borrow and lend funds

through issuing debt instruments. Through debt market
companies can raise funds by issuing debt
instruments.
• Bonds are the main instrument/ tool for debt financing in
the capital markets.
• Bond is a debt obligation has a face value called
principal and pays a dividend or return for the holder
according to time horizon and maturity date.
• The borrower repays the borrowed money, principal,
usually in a number of installments, plus interest at
agreed date of maturities. Therefore, there are debt
service burdens paid by the issuer in form of return to
the holder.
• there are wo categories of debt markets:

• Primary Debt Market: It is a market for a new issued

debt instruments. Bonds represents the main debt
instrument in the financial markets. Through debt
market business units can get the required finance on
a long-term basis at fixed costs agreed in the issuing
agreement.
• Secondary Debt Market: It is the market for the
exchange of already issued bonds and offered for
sale by the holder. The main function of the
secondary market is to provide liquidity for the
investors or the holder of the det instrument.
• Debt instruments
• Debt instruments is the tools or merchandise of debt
markets.
• It represents a debt obligation upon the issuer or the
debtor.
• It is issued under different conditions. It may be:
• fixed interest rates,
• floating rate or return linked to certain economic factors
such inflation rates or index,
• negotiable,
• convertible,
• or any other conditions.
The Equity Market:
It is a market for financial Instruments that represents a share
or ownership in a business or corporations.
In practice, there are two types of equity markets:
o Primary Equity Market:
It is a market for selling and buying newly issued stocks (shares).
Through primary market, business can issue new stocks (shares) to
get additional capital or participation from additional investors for
financing new business or already existence ones.
The process of issuing new equity called underwriting and takes
place in an underwriting market.
o Secondary Equity Market:
It is a market for exchange and trade the old and already issued stocks
(shares). In this market, investor purchases a stock, through a broker,
from another holder wishes to sell these stocks.
Through secondary equity markets investors can transfer old equity
instruments from less liquid into liquid forms. Therefore, secondary
markets in general can be defined as a liquidity market.
6/2 Money Market:
• It is the market of short-term lending or borrowing of money.
• Money market instruments characterized by the following
advantages:
- highly liquid asset with maturity of one year or less,
- high safety level and low risk,
- low interest rate,
- help central banks in designing effective monetary
policies,
- modernize operation of commercial banks.
- The financial assets traded in this market are of
maturity for one year or less such as:
• Trade Credit:
- provides short term finance for trader at lower cost.
- Trader used money market to get their needs of money
to finance domestic or foreign trade.
• Commercial Paper:
- It drawn by the creditor on debtor.
- The commercial paper or bill of exchange (Draft) can be
discounted by the creditor with a bank or a broker before
maturity and get immediate money.
- The rate of discount depends on a number of factors like
creditworthiness of the debtor, time to maturity,
economic conditions, and a like.
• Certificate of Deposit (CDs):
- CD is a receipt for money deposited with a bank or other
financial institution.
- CDs usually issued as negotiable, in huge amounts, and
at floating rates.
• Treasury Bills (TBs):
- It is a short-term government paper raised to collect
money from money markets to finance government
operations.
- It is one of the safest money market instruments available,
and bear zero risk, relatively low returns.
- It issued at different maturities of 1 year, 6 months or 3
months.
- In advanced money markets CDs exchanged by primary
and secondary markets.
- It may issue at price lower than their face-value.
-
• In modern financial market there are other variants of money
market instruments such as Banker’s Acceptance, Promissory
Notes, and Repurchase Agreements.
• The main players in money markets are:
- Non-banking finance institutions (NBFCs),
- Commercial banks, and
- Acceptance houses.
- In the modern financial markets, trading in money market
takes place off the exchange, which called Over the
Counter (OTC) between two parties through electronic
networks.
• Modern money markets consist of two segments:
- Organized money market. It subject to close control by the
regulatory authorities in every country. They operate and
manage by authorized and honestly firm based on very strict
rules.
- Unorganized section of money markets used mainly by
borrowers who are not able to get credit from the organized
money market or has a special needs and terms. Unorganized
money market has flexible terms, informal procedures, and
higher interest rate for borrowers etc.
6/3 Other Classifications of financial markets
According to the type of transactions and organization :
 Spot market or the exchange:
It is the market for spot trading. There are many types of securities traded
in the spot markets such as common and preferred stocks and convertible
securities.
 Non-organized markets
It called over the counter market (OTC). Transactions in this market ran
outside the stock exchange and performed by brokerage houses
distributed in many locations. Transaction performed and took place
through strong electronic network of communications based on the
internet.
 The 3rd market
A part of the nonorganized market consists of brokerage houses, not members of
exchange, but has the right to deal on the registered securities in such markets.
It is a continuous market with different sizes of transactions. Members of the
markets are the large investment institutions such as pension funds and small
brokerage houses. These markets provide their clients with higher discounts in
fees.
6/4 Summary layout of different types and classifications
of financial markets
 The
following
diagram
depict
summing
up the
different
approaches
that we
review in
the
previous
sections of
types and
classificatio
ns of
financial
markets:
7 / The market value of a security
 The value of a share, for example, in the financial markets derived from,
and based on the market value of the underlying firm or the issuer of the
stock.
 major factors determine the market value of a
shares or stocks:
- the amount of the expected cash flows to be generated for the
benefit of stockholders: Expected cash flows = net profit after tax +
depreciation. Expected cash flows affected directly by the following
factors:
o Sales volume and value,
o Ability to reduce cost of production and operation,
o Discount rate used in discounting cash flows, and
o Information about the business environment and market conditions.
- the timing of these cash flows.
- the risk of the cash flows.
 8/ Theories of Financial Markets
• Financial economists pave the way for the introducing a very
sophisticated innovations in the financial instruments and risk
aversion models and analysis.
• Starting from M. Markowitz efforts and up to date we can
review in short, the 5 basic building blocks in the financial
market theories and operative models:
• portfolio theory,
• capital asset pricing theory,
• interest rate structure theory,
• capital structure theory,
• agency theory,
• efficient markets theory, and
• option pricing theory.
 Portfolio Theory
• Expected returns and risk were termed as the standard deviation
of the return distribution.
• It is possible to make portfolio decisions, in which the incomplete
correlation between the securities can be exploited for
diversification.
• If an individual investor wants a higher expected return, he must
accept a higher risk.
• Morgan develops a portfolio model to measure and explain the
risks of the firm on a daily basis, based on the daily updates of
spot prices, volatility estimates, and correlation estimates
accessible through the internet.
• Then introduced the concept Value-at-Risk (VaR) as portfolio risk
measure to become the standard for the measurement of portfolio
risk with official endorsement.
• Like all other economic models, portfolio models can never be
more than approximations of the complex real world.
Capital Asset Pricing Theory
• This theory is developed by Sharpe and assuming that:
• There is a link between the returns of individual
securities and the return of a broad market index.
• Investors can lend and borrow at a risk-free interest
rate.
• Transaction costs are zero.
• Investors can borrow at risk-free interest.
• All portfolios will lie on the “Capital Market Line”, and the
slope of this line indicates the price of risk as
determined by the market.
• The model has two measures:
• “betas” as a measures for sensitivity of the individual stock to
movements in the return on the stock market as a whole.
“Sharpe Ratio” = (return of a portfolio over time - the risk-free interest
rate) / the standard deviation of the return on the portfolio.

• The CAPM assumptions were amended to cover foreign

exchange risk and called international capital asset pricing
model (ICAPM). Under ICAPM investors are taking risks
based on the followings:
• time value for money.
• the premium market portfolio.
• the exposure to foreign exchange risk.
• the international capital market is integrated.
The term Structure of Interest Rate Theory
• Owners of portfolios are exposed to interest rate risk, inflation risk,
default or credit risk, currency risk and political risk.
• The interest rate structure at a given date reflects the overall
evaluation by the market participants of all types of risk factors.
• The term structure of interest rates is defined as the pattern of
interest rates on bonds with different maturities at a given time.
Forward interest rates = expected short-term interest rates in the
future + an appropriate risk premium.
• If there is no arbitrage pricing, the short-term interest rate is
assumed to follow a stochastic process any derivative can be
replicated by a dynamic trading strategy in the underlying assets
and that the value of the derivative is equal to the replicated
portfolio.
Capital Structure Theory
• There are different approaches for capital structure:
• A trade-off principle assumes that firms keep debt levels
that balance the tax advantages of additional debt against
the costs of possible financial problems.
• Firms tend to borrow instead of issuing new equity if
internal cash flow is not sufficient to finance capital
spending.
• Firms prefer internal finance to avoid being reliant on
creditors or new shareholders.
• According to the free cash flow scenario, capital structure is
governed by conflicts between managers and shareholders.
 Agency Theory
• When shareholders (as principals) use a contract to
delegate to the managers (as agents) the power to
perform on his behalf, an agency relationships problem
arises. The agency problems are a result of separation
between ownership and control.
• In financial markets:
• There is an information asymmetry which leads to an
adverse selection problem since managers know
more about the company than the owners.
• Rating agencies play a role in reducing the problem
by providing investors with information about the
company.
Efficient Market Theory
• According to the “Efficient Market Theory” the prices of
securities in financial markets reflect all available
information to the investors.
• There are three forms of market efficiency:
• Weak-form of efficiency to predict future prices of the
financial asset based on past price data.
• Semi-strong form of efficiency to predict future prices
of the financial asset based on not only past price
data but also with all publicly available information.
• Strong-form to predict future prices of the financial
asset based not only publicly available information
but also insider information.
Option Pricing Theory
• Option Pricing model represents a new era in the
development of financial theory and pave the way for
the dominance of derivatives markets.
• It assumes that the value of a European call option
determines as a function of:
- exercise price,
- market price of the underlying asset,
- time distance to exercise,
- risk-free interest rate, and
- volatility of the underlying asset.