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
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
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
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.
4.3. Capital Markets
Finance is the study of trade-offs between the present and the future. For an individual investor,
an investment in the debt or equity markets means giving up something today to gain something
in the future. To grow and prosper by virtue of wise investments in factories, machinery,
advertising campaigns, and so forth, most firms require access to capital markets. Capital
markets are an arena in which firms and other institutions that require funds to finance their
operations come together with individuals and institutions that have money to invest. To invest
wisely, both individuals and firms must have a thorough understanding of these capital markets.
Capital markets have grown in complexity and importance over the past 25 years. As a result, the
level of sophistication required by corporate financial mangers has also grown. The amount of
capital raised in external markets has increased dramatically, with an ever-increasing variety of
available financial instruments. Moreover, the financial markets have become truly global, with
thousands of securities trading around the clock throughout the world. Capital markets can be
divided into two debt market and equity market.

4.3.1. Debt Market

The most frequently used source of external financing is debt. Corporate managers, whose firms
finance their operations by issuing debt, and the investors who buy corporate debt need to have a
thorough understanding of debt instruments and the institutional features of debt markets.
Debt instruments, also called fixed-income investments, are contracts containing a promise to
pay a future stream of cash to the investors who hold the contracts. The debt contracts can be
negotiable, a feature specified in the contract that permits its sale to another investor, or
nonnegotiable, which prohibits sale to another party. The common forms of debt contracts that
corporations employ to finance their operations include:
 Treasury notes. Issued by U.S. government, no default risk, but price will decline if
interest rate rises. The maturity ranges from 2 to 20 years.
 Mortgages. Borrowings from commercial banks and S&Ls by individuals and
businesses. The risk associated with this is variable and the maturity ranges up to 30
years.
 Leases. Similar to debt in those firms can lease assets rather than borrow and then buy
the assets. The r`1isk
 Bonds are one of the most important types of securities. While bonds are often viewed as
relatively safe investments, one can certainly lose money on them. However, it is also
possible to rack up impressive gains in the bond market.
A bond is a long-term contract under which a borrower agrees to make payments of interest and
principal, on specific dates, to the holders of the bond.
A. Classification of Bonds
Investors have many choices when investing in bonds, but bonds are classified into four main
types: Treasury, corporate, municipal, and foreign. Each type differs with respect to expected
return and degree of risk.
Treasury bonds, sometimes referred to as government bonds, are issued by the federal
government. It is reasonable to assume that the federal government will make good on its
promised payments, so these bonds have no default risk. However, Treasury bonds prices decline
when interest rates rise, so, they are not free of all risks.
Corporate bonds, as the name implies, are issued by corporations. Unlike Treasury bonds,
corporate bonds are exposed to default risk- if issuing company gets into trouble, it may be
unable to make the promised interest and principal payments. Different corporate bonds have
different levels of default risk, depending on the issuing company’s characteristics and on the
terms of the specific bond. Default risk is often referred to as “credit risk,” and the larger the
default or credit risk, the higher the interest rate the issuer must pay.
Municipal bonds, or “munis,” are issued by state and local governments. Like corporate
bonds, munis have default risk. However, munis offer one major advantage over all other bonds:
the interest earned on most municipal bonds is exempt from federal taxes, and also from state
taxes if the holder is a resident of the issuing state. Consequently, municipal bonds carry interest
rates that are considerably lower than those on corporate bonds with the same default risk.
Foreign bonds are issued by foreign governments or foreign corporations. Foreign corporate
bonds are, of course, exposed to default risk, and so are some foreign government bonds. An
additional risk exists if the bonds are denominated in a currency other than that of the investor’s
home currency. For example, if you purchase corporate bonds denominated in Japanese yen, you
will lose money – even if the company does not default on its bonds- if the Japanese yen falls
relative to the dollar.
B. 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
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.
C. Bond Markets
Corporate bonds are traded primarily in the over-the –counter market. Most bonds are owned by
and traded among the large financial institutions (for example, life insurance companies, mutual
funds, and pension funds, all of which deal in very large blocks of securities), and it is relatively
easy for the over-the-counter bond dealers to arrange the transfer of large blocks of bonds among
the relatively few holders of the bonds. Is would be much more difficult to conduct similar
operations in the stock market among the literally millions of large and small stockholders, so a
higher percentage of stock trades occur on the exchanges.
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.
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.
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.
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
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
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
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
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.
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.