Module 2 Market Structures

FINANCIAL MARKETS
MODULE 2 MARKET STRUCTURES
OUR LADY OF FATIMA

UNIVERSITY
MARKET STRUCTURES
 A financial market is simply a market in which one or more financial
assets are traded
 Originally, a financial market was a physical location—an exchange—
where traders met to make agreements to buy or sell certain financial
assets with a high degree of transparency in prices and order sizes
MARKET STRUCTURES
 Preceded by some semi-formal security markets in Italy, the first
known exchange for security trading was established in 1531 in
Antwerp, Belgium, where various forms of bonds were traded. Stock
exchanges were formed in Amsterdam in 1602, London in 1773, and
New York in 1792. Today the trading in most financial markets takes
place via an electronic system in which traders can place orders and see
how prices evolve
MARKET STRUCTURES
 Whether the trading is physical or electronic, an exchange typically
regulates the trading in various ways, for example regarding how
orders are placed, the order sizes allowed, who can trade, and how
deals are settled
MARKET STRUCTURES
 An exchange has an associated clearing house taking care of the
clearing and settlement of the transactions made on the exchange. The
clearing house is formally the counterparty in any trade on the
exchange. A deal between two traders is implemented as two
transactions, one between the buyer and the clearing house and the
other between the seller and the clearing house
MARKET STRUCTURES
 The clearing house guarantees that both traders receive the payments
the deal entitles them to, even if the original counterparty defaults and
cannot make its promised payment. Hence, the traders on an exchange
do generally not have to assess counterparty risk. Typically, the
clearing house requires traders who promise some future payments to
post collateral in form of margin deposits of a certain size. These
deposits are used to cover losses in case of the trader defaulting on his
promise
MARKET STRUCTURES
 Some trading takes place in the less organized over-the-counter
markets or simply OTC markets. (Non-exchange trading venues are
also referred to as Alternative Trading Systems or ATSs.)
 An OTC market is a computer and telecommunications network linking
selected dealers. OTC markets have been much less regulated than
exchanges. OTC trades were usually not run through a central clearing
house, so the seller and the buyer would enter a bilateral contract in
which case an assessment of the counterparty risk becomes relevant
MARKET STRUCTURES
 The aftermath of the recent financial crisis, governments and international
organizations have pushed for more regulation of the OTC markets
 The regulation requires OTC derivative trades to be executed through
exchanges or electronic trading platforms and cleared through central counter
parties (CCPs). Despite the regulatory push for more exchange-based trading,
OTC trading remains prevalent for derivative securities such as futures and
options, especially the more exotic species of derivatives. However, OTC
markets exist for all main types of securities, including securities that are also
traded on organized exchanges
MARKET STRUCTURES
 A significant share of off-exchange security trading takes placed in so
called dark pools
 A dark pool is a private exchange or forum in which investors can trade
certain financial securities with other members of the forum. Many
dark pools are owned and operated by large financial institutions,
others are independent, and some are even owned by companies that
also own traditional exchanges
MARKET STRUCTURES
 When trading on a traditional exchange, an investor generally has to
post how many units of the security she wants to buy or sell and at
which price. This may reveal information to other investors who may
subsequently place orders that will lead the price to move adversely
before the original investor’s order has been executed. Dark pools are
less transparent and orders are not revealed to other potential investors
MARKET STRUCTURES
 This may be advantageous in a given situation, especially for large
investors wanting to trade a larger block of securities. On the other hand,
the lack of transparency leads to prices being less informative about the
true value of the security, so that unwary or unsophisticated investors
may trade at unfair prices. Dark pools were originally reserved for large
institutional investors, but many dark pools now attract other investors,
including retail investors, by allowing smaller trades with faster
processing and lower transaction costs than at traditional exchanges
STOCKS
 A stock is a security issued by a corporation. A common stock entitles its
holder to a share in the ownership of the company, which includes both cash
flow rights and control rights. Cash flow rights mean that the stockholder has
a claim on a share of the dividends and other payouts of the company
 Control rights mean that the stockholder has the right to vote on matters of
corporate policy and in elections for members of the company’s board of
directors. Typically, a company issues a very large number of common stocks
and all the stocks are treated equally in terms of dividends and voting rights
STOCKS
 Some companies further issue a number of preferred stocks. When
paying dividends, the company must pay the preferred stockholders up
to a certain level before it can offer dividends to common stockholders.
On the other hand, preferred stocks do not carry voting rights. When
referring to stocks, we will generally mean common stock, and also use
the terms shares and equity. Likewise, the terms stockholder and
shareholder are used interchangeably
STOCKS
 Shareholders are residual claimants to the assets of the company. The
creditors of the company have first priority. If the company is to be
liquidated, the proceeds from the sale of the company’s assets are first
to cover as much as possible of the creditors’ claims
STOCKS
 The stockholders will only get something if the assets are
worth more than the creditors’ claims. On the other,
shareholders have limited liability, which means that they
can never lose more than their original investment
STOCKS
 If the company is being liquidated and it turns out the assets are not
valuable enough to cover the claims of the creditors, the shareholders
are not forced or even expected to pay the difference out of their own
pockets. They are not personally liable for the obligations made by the
company
STOCKS
 Companies can issue stocks through an initial public offering
(IPO) where the new stocks are sold following some sort of
auction process. The investors pay by cash that enters the
company, so a stock issuance is a way for companies to raise
money for investment projects. Subsequently, the stocks are
typically listed and traded on an exchange, which enables an easy
transfer of partial ownership of the company among investors
STOCKS
 In some situations, stocks are issued through private arrangements,
where the company offers a large equity position to one or a few private
investors, again in return for cash. This is referred to as private equity.
Often these private investors also obtain seats on the board of directors
with the purpose of substantially changing the management, operations,
or strategy of the company. Sometimes the private equity investor buys
a majority share of the equity to obtain full control of the company in
order to implement a certain turnaround
STOCKS
 The investor hopes that after a period of 5-10 years the company is
much more valuable, and then the private equity investor may sell off
his equity position maybe through an initial public offering of stocks in
the company and cash in a substantial profit. Private equity
investments are often made by specialized institutional investors who,
in addition to the cash invested, also have the human resources and
skills necessary to improve the company’s performance
STOCK MARKETS
 Stock markets are huge in terms of the number of listed
companies, the number of shares traded, and the market
capitalization, i.e., the market value of the listed shares. Based on
2015 data published by the World Bank, the U.S. stock markets
are by far the largest in the world with a total market
capitalization of 25.1 trillion USD, followed by China (8.2 trillion
USD), Japan, the United Kingdom, Hong Kong, France, Germany,
Canada, Switzerland, India, the Republic of Korea, and Australia
STOCK INDICES
 The stock markets around the world offer an abundance of
investment opportunities. Keeping track of so many
individual stocks is impossible for any investor. To get an
indication of the overall performance of the stock market or a
certain section of the stock market, investors follow stock
indices
STOCK INDICES
 For example, the MSCI All Country World Index includes
2,483 stocks from 23 developed countries and 23 emerging
countries (as of June 30, 2015), whereas the MSCI World
index includes 1,643 stocks from 23 developed countries.5
The overall performance of the stocks traded in a certain
country, on a certain exchange, or in a certain industry can be
measured by a stock market index for that subset of stocks
STOCK INDICES
 For most countries, one or more stock indices attempt to capture
the overall stock market in that country. For the U.S., a leading
stock index is the Standard & Poors 500 index—or simply the
S&P500—which is based on 500 large stocks listed on either
NYSE or NASDAQ. Another popular U.S. stock index is the
Dow Jones Industrial Average or simply the Dow Jones, which is
based on 30 large listed companies, and thus a much more
narrow index than the S&P500
INVESTING IN STOCK VIA FUNDS
 You cannot directly invest in a stock index. In principle, you
could invest in shares of all the companies according to the
weights they are given when computing the index, but this would
be tedious and involve substantial transaction costs. Furthermore,
you would need to have a significant amount of cash to purchase
just one share in each of the companies, and to match the relative
index weights you need to buy many shares in the large
companies
 For many indices there is a simpler solution. You can invest in an exchange-
traded fund, or simply ETF, mimicking the index. An exchange-traded fund
is an investment fund which owns certain assets, and the ownership of the
fund itself is divided into shares that are traded on an exchange, just as the
stocks of any individual company. An ETF tracking an index can do so by
actually holding the portfolio of stocks that constitutes the index and, of
course, rebalancing the portfolio along with changes in the weights of the
index. With many investors in the ETF, the fund will have sufficient capital
to purchase stocks in all the companies in the correct proportions
 Exchange-traded funds were introduced in the U.S. in 1993,
and the ETF market has grown substantially in recent years,
especially in the U.S. Many of the ETFs are “sponsored”
(constructed and managed) by a few financial companies,
namely BlackRock, State Street Corporation, or Vanguard.
The largest stock index ETF is the so-called Spider (traded
under the ticker name SPY), which tracks the S&P 500 index
 As of June 2015, the market cap of the fund was around 135 billion
USD. Other popular ETFs track the Dow Jones Industrial Average
index (ticker name DIA, called diamonds), and the NASDAQ 100
(ticker QQQ, called cubes). Other ETFs track indices covering
specific industry sectors or stocks with particular characteristics
related to the size of the issuing company (large-cap, small-cap),
their dividend payments, or the ratio of their current stock price to
the book value of equity (value stocks, growth stocks)
BONDS AND OTHER DEBT-RELATED SECURITIES
 BONDS TYPES AND ISSUERS
 Both governments, companies, and households occasionally seek to

borrow money. Governments often finance a budget deficit by
issuing bonds in return for cash. The government then commits to
deliver a cash flow stream to the owner of the bond in the form of
regular interest payments and a repayment of the borrowed amount
(the face value of the bond) according to some specified amortization
schedule
 The maturity date of the bond is when the last payment is

due. The bonds are typically listed on an exchange and thus
tradeable. Most governments issue bonds with a number of
different maturities, typically ranging from around one
month and up to 30 years
 In the United States, the government bonds are issued by the Department of
the Treasury and are divided into four types. Treasury bills (or T-bills) are
issued with a maturity of up to one year, with the most common maturities
being one month, three months, six months, and one year. The T-bills have no
intermediate interest payments, but only a payment of the face value at the
maturity date; bonds with this feature are called zero-coupon bonds. Since T-
bills are typically issued at a price below the face value, investors in T-bills
still earn a profit
 Treasury notes (or T-notes) are issued with a maturity between

two and ten years. They promise semi-annual interest payments,
typically referred to as coupon payments, and they are bullet
bonds meaning that the entire face value is paid back at the
maturity date. Treasury bonds (or T-bonds) are issued with longer
maturities, currently up to 30 years, and are also bullet bonds
 The abovementioned bonds are all nominal bonds in the

sense that they promise a pre-specified dollar payment
stream. But since consumer prices vary, nominal bonds do
not guarantee a certain purchasing power
 The U.S. Treasury also issues inflation-indexed bonds called

Treasury Inflation-Protected Securities (TIPS, in short) of
different maturities, currently 5, 10, and 30 years. The face
value of these bonds is regularly adjusted to reflect changes in
the Consumer Price Index. In the United States and some other
countries, local governments (municipalities) also issue bonds
 Companies may issue bonds to finance current operations or

new investment projects. Such bonds are called corporate
bonds. In countries like the United States and the United
Kingdom, this is a common way for corporations to obtain
loans, whereas companies in other countries tend to rely
more heavily on bank loans
 RELATED SECURITIES
 Some large corporations regularly issue commercial papers,

which are short-term (up to nine months, but often only one
or a few weeks) contracts similar to zero-coupon bonds.
Some commercial papers are asset backed in the sense that
the issuer puts up collateral to ensure the promised future
payment
 Financial institutions may also issue bonds to

finance their operations. Commercial banks take
deposits from companies and households with
excess capital, and can then lend out the money to
capital-demanding entities
 Banks sometimes issue certificates of deposits (often

abbreviated CD), which are contracts formalizing a fixed-
period deposit at a pre-determined interest rate. The buyer
effectively lends the money to the bank for a fixed period of
time, which typically ranges from one month up to several
years. Some CDs are tradeable after issuance
 An interbank market exists in which major banks, other large

financial institutions, and some large non-financial corporations
negotiate short-term unsecured loan agreements among each
other, mainly to manage day-to-day liquidity needs. Most loans
in this market are simply overnight loans. The market is centered
in London and referred to as the London interbank market
 The interest rates set on such loans are called LIBOR rates, where
LIBOR is an acronym for London InterBank Offered Rate. LIBOR
rates are published for selected maturities ranging from overnight to
one year and for loans in the major currencies (US Dollars, Euros,
British Pounds, Japanese Yen, and Swiss Francs). The LIBOR rates
are frequently used benchmarks in other debt contracts as the banks’
financing costs spill over to the rates they offer to customers
 London is also a center for an international bond market in which
various corporations, governments, and international institutions issue
bonds to attract international investors. The bonds can be denominated in
any of the major currencies and even a currency different from that of
the home country of the issuer
 For example, a Japanese corporation may issue bonds denominated in
US dollars in London
 Financial institutions often engage in repurchase agreements, or
simply repos. Party A sells a security to party B and commits to buy
back the same security at a pre-specified price and point in time
 For party A this is a repo, for party B it is called a reverse repo.
Effectively, a repo constitutes a secured loan, in which the security
serves as the collateral. The security is often a government bond, and
the maturity of the repo is often only one to seven days
 A mortgage is a loan offered to the owner of real estate, where the

real estate is used as a collateral for the loan. Traditional mortgages
are issued as annuity loans (equal payments) with long maturities,
say, 30 years. In some countries mortgages are offered by banks, but
in other countries specialized mortgage institutions exist. These
institutions offer mortgages to a large number of households (and
companies) and finance the mortgages by issuing bonds
 These bonds are backed by a certain pool of the mortgages in

the sense that the payments flowing to the bond owners
depend on the borrowers’ actual payments on their mortgages.
The actual payments may differ from the promised payments
due to the borrower defaulting on the loan or deciding to pay
back the loan pre-maturely (maybe to refinance)
DEBT MARKETS
 The markets for bonds and other debt-related contracts are often split into a
money market and a fixed-income market. The money market consists of
the short-term debt instruments maturing in at most one year, which
therefore includes Treasury bills, some certificates of deposit, commercial
papers, interbank loans, and repos. The fixed-income market consists of the
longer-term debt instruments such as Treasury notes and bonds, TIPS,
mortgage-backed bonds, municipal bonds, and corporate bonds
DEBT MARKETS
 According to the Bank of International Settlements, BIS, the
total amount outstanding for debt securities issued by U.S.-based
entities is 35.8 trillion USD (December 2014) of which 15.5
trillion was issued by the government, 15.0 trillion by financial
corporations, and 5.1 trillion by non-financial corporations.
Japan is second in the statistics with a total of 11.1 trillion USD
issued of which 8.2 trillion is government debt
DEBT MARKETS
 BOND INDICES AND FUNDS
 As for stocks, various bond market indices are also published and used as benchmarks
for bond investment performance. However, indices are less relevant for bonds than
for stocks. Even within the same country or industry, the stocks of different countries
may perform very differently. The performance of bonds is less diverse. The prices of,
and thus the rates of return on, the bonds issued by the U.S. government follow each
other quite closely. Of course, the returns vary somewhat with the maturity of the
bond, but by looking at just a few key maturities investors obtain a good impression of
the performance of government bonds with different maturities
DEBT MARKETS
 BOND INDICES AND FUNDS
 Hence, an index averaging all U.S. government bonds does not

provide much additional information. The diversity among corporate
bonds is bigger as their performance to some extent depend on the
profitability of the issuing corporations, so corporate bond indices
can be relevant. Similarly, for bond investments across a group of
different countries, such as the emerging market countries
DERIVATIVE SECURITIES
 MAIN TYPES OF DERIVATIVES
 A derivative security or simply a derivative is an asset

whose dividend(s) and price are derived from the price of
another asset, the underlying asset, or the value of some
other variable such as an interest rate. The four main types of
derivatives are forwards, futures, swaps, and options
 A forward contract or simply a forward is a binding

agreement between two parties to transact a given asset at a
pre-specified future point in time and at a pre-specified price.
If you know that you have to purchase or have to sell a
specific asset at a future date, you can use a forward on that
asset to lock in the purchasing or selling price already today
 You eliminate the risk of an adverse move in the asset price,

but you also give up the chance of a price move in your
favor. Forward contracts thus have obvious application for
risk management. On the other hand, forwards can also be
used for speculation in the future price of the underlying
asset
 The profits and losses from an investment in a forward

contract are settled at its maturity date. Futures contracts are
similar to forwards, but with the profits and losses being
settled on a daily basis throughout the life of the contract—
the so-called markingto-market mechanism
 This feature allows futures contracts to be traded on organized

exchanges, whereas forward contracts are traded over the counter.
Futures on stock indices, individual stocks, government bonds, and
foreign currency are traded on a large scale on many exchanges
around the world. There are also large markets for futures on many
different commodities, such as oil, gold, aluminum, electricity, soy
bean oil, frozen concentrated orange juice, and live cattle.
 A swap refers to an agreement to exchange two specified streams of

payments. For example, an interest rate swap is the exchange of two streams
of interest rate payments on a certain face value, where typically one stream
is calculated using a fixed, known interest rate, whereas the other depends on
how a certain market interest rate evolves over the life of the contract.
Another example is a currency swap where the two payment streams are
denominated in different currencies and thus involve an exchange rate
 An option is an asset giving the owner the right, but not the obligation, to
perform a certain transaction in the future at terms specified today. Typically
this transaction is to purchase or sell a given underlying asset at a pre-set price
at or before a given future date. Call options give their owner the right to buy
the underlying, put options give the right to sell the underlying. Options on
stock indices, individual stocks, bonds, interest rates, and exchange rates are
traded in many markets. Sometimes the underlying asset itself is a derivative.
For example, you can trade options on futures on many commodities
ALTERNATIVE ASSETS CLASSES
 Commodities are by many institutional investors nowadays seen
as an asset class. As an investor you can get exposure to
commodities through certain financial securities without ever
owning the commodities physically. One possibility is to buy or
sell commodity futures or even options on such commodity
futures. The profits from such investments are purely determined
by the evolution in the price of the underlying commodity
 REAL ESTATE
 is an important asset class in terms of its total value. For example,

housing wealth constitutes a large share of household assets. In 2010
the value of residential property owned by US households was 36%
of total household wealth, and for middle income households the
share is even larger.10 At the end of 2013, the value of all homes in
the United States was estimated at 25.7 trillion USD.11 Commercial
real estate has to be added to that
 REAL ESTATE
 Even as a small investor (home owner or renter) you can obtain an investment exposure
to real estate markets without physically buying real estate. You can invest in the shares
of real estate investment trusts, the so-called REITs. These are investment companies
dedicated to investing in more or less specialized real estate or in mortgages. Typically, a
REIT is established and managed by a bank or another financial institution, but the
shares of the REIT are traded on stock exchanges just as the stocks of other companies.
In the United States you can even purchase REIT ETFs, that is, shares of an exchange-
traded fund holding a basket of stocks in real estate investment trusts
 PENSION FUNDS
 Pension funds and other large institutional investors (and some

relatively wealthy individual investors) have been actively investing
in real estate for many years. They own various buildings, rent them
out to corporations or households, and cash in the rents. In addition,
they may hope to resell the real estate later at a profit. Many
households own the home they live in which, in addition to
providing shelter and pleasure, is also a major investment
 Long-term institutional investors, such as pension funds, are
sometimes investing in infrastructure, i.e. roads, bridges,
tunnels, etc., often in corporation with the local government.
The pension fund finances the construction costs and
receives a long-term payment stream in return
MAIN PLAYERS
 Firms are primarily demanding capital to finance
investments. They can do so by issuing stocks or corporate
bonds or both. They can use derivatives to manage mostly
short-term risks. Short-term deposits and loans facilitate
corporate liquidity management
MAIN PLAYERS
 Households or individuals are primarily supplying capital. In
order to smooth consumption over the life-cycle, young and
middle-aged individuals typically save part of their income for
financing consumption in retirement. Much of the retirement
savings are invested in stocks and bonds. Individuals may also
save temporarily to finance large future expenditures such as
the down payment on a house or an apartment
MAIN PLAYERS
 Since individuals tend to dislike risk and uncertainty, many individuals
maintain some buffer of savings for a rainy day, e.g., to finance some
consumption even in times of unemployment or bad health. On the other
hand, households are often borrowing money to partially finance larger
expenditures such as residential real estate. It is important for
households to consider their financial assets and liabilities in connection
with the other assets they hold, e.g., the real estate they may own and
the human capital they hold in form of their ability to earn labor income
MAIN PLAYERS
 Many governments are primarily demanding capital since they run budget
deficits which they finance by issuing bonds and similar securities. However,
several countries have set up Sovereign Wealth Funds and some of these funds are
among the largest investors in the world. An example is the Norwegian
Government Pension Fund, which was established in 1990 and until 2006 was
known as the Petroleum Fund. The fund is financed by the government’s profits
from the oil and natural gas sector and thus not really a pension fund (which is
financed by contributions of pension savers), but at the discretion of the
government the fund can contribute to the future financing of the public pensions
paid by the government to the citizens of Norway
MAIN PLAYERS
 The fund currently (September 2015) holds assets worth
around 7,000 billion Norwegian Kroner, equivalent to
roughly 800 billion USD. The capital is invested in equity
(62.8%), fixed income (34.5%), and real estate (2.7%)
MAIN PLAYERS
 The central bank of a country controls the country’s supply of money,
which is of key importance for the interest rates and the inflation rate of
the country as well as the exchange rates between the currency of the
country and other currencies. The central bank can increase the money
supply by offering commercial banks to borrow money at a low interest
rate in the central bank. Subsequently, this allows the commercial banks to
lend money to corporations and households at fairly low interest rates,
which could then stimulate consumption and investment throughout the
economy.
MAIN PLAYERS
 The central bank can decrease the money supply by offering
commercial banks to deposit money at a high interest rate in the
central bank. The high interest rate then spills over to the loans
commercial banks offer consumers and corporations, which tends
to lower consumption and investment in the economy. Similarly,
central banks can provide or reduce liquidity in the financial
market by buying or selling government bonds of various
maturities
MAIN PLAYERS
 Central banks can also affect financial markets by setting the
reserve requirements for commercial banks that force them
to hold deposits of a given size in the central bank.
Furthermore, most central banks have the authority to
supervise and regulate financial markets in other manners in
order to maintain a sound banking system
MAIN PLAYERS
 After the financial crisis that peaked in 2007-2008, central banks have
taken a prime role in the attempt to stabilize the financial system and to
push economic growth. Several key central banks lowered their target
interest rates to very low levels, in some cases even to zero or negative
levels. They further engaged in so called quantitative easing whereby
the central banks spend huge sums on buying various financial assets
from financial institutions, including assets that are substantially riskier
than the government bonds central banks traditionally trade
MAIN PLAYERS
 Financial intermediaries include commercial banks, investment banks,
investment companies (including pension funds, mutual funds, and
hedge funds), mortgage institutions, and brokers. The prime role of
some financial intermediaries is to act on behalf of a group of
households/individuals. Other intermediaries try to bring lenders and
borrowers together and equate supply and demand. Other again just
facilitate financial transactions, and finally some intermediaries focus
on providing advice to other market participants
MAIN PLAYERS
 Pension Funds or Retirement Funds invest the savings of their
members to provide retirement income. These funds are
established or controlled by the government, labor market
organizations, or each employer. Many pension funds are very
large investors in financial markets. For example, the Japanese
Government Pension Fund—the pension fund for Japanese
public sector employees—has a capitalization of 1,143 billion
US dollars (end of 2014)
MAIN PLAYERS
 Hedge funds are investment companies that are organized as
private partnerships and are thus less regulated than other
investment companies. They are typically open to wealthy or
institutional investors, and investors have to lock up their
investments in the fund for some period
MAIN PLAYERS
 Hedge funds are known to follow more “extreme”
investment strategies than other funds, strategies that
sometimes resemble bets that certain macroeconomic or
political events will happen or that some apparent mispricing
in financial markets will be corrected. Hedge funds take large
management fees from investors, for example, a flat fee of
2% of the invested amount plus 20% of the returns earned
MAIN PLAYERS
 Foundations and endowments, such as university
endowment funds
FUNCTIONS OF FINANCIAL SYSTEMS
 What does the financial system do?
 Its prime role is to bring suppliers of capital and users of capital

together. Suppliers of capital currently have excess capital that they
want to save or invest for later use. They can do so, for example, by
depositing the money in a bank, buying bonds and thus lending
money to the issuer, or buying shares of stock in a company. The
suppliers include households saving for retirement and firms with
profits they do not want to distribute to their owners
 Users of capital have a need for capital to finance current
expenditures in excess of current income. This includes
households seeking to purchase residential real estate or simply
having—hopefully, only temporarily—negative net income.
Households typically obtain capital by borrowing from banks,
mortgage institutions (who may then issue bonds financing the
mortgage), and other credit-supplying companies
 Entrepreneurs starting a business often need outside capital
to finance buildings, equipment, and employees. Existing
firms may require outside capital in order to finance
expansions in production capacity. The capital can be raised
by issuing corporate bonds, which means that the company is
effectively borrowing money from the buyers of the bonds
 In some countries, corporate bonds are very rarely issued, and
firms borrow directly from banks and other financial institutions.
Instead of borrowing, firms can issue shares of stock to investors
who, in return for the share price they pay, obtain an ownership
stake in the company. Firms may also have short-term liquidity
needs, which are covered by loans in banks or the money market.
Governments are in many cases also users of capital. A budget
deficit is typically financed by the issuance of government bonds
 The above examples highlight that a key function of
financial markets is to transfer resources through time and
across both countries and industries. By saving for
retirement, a household transfers resources from their active,
income-earning phase of the life cycle to the retirement
phase
 Without the chance to save, the consumption of a household
in any given period would be limited to its income in the
period. The financial markets help households smoothing
their consumption over life. Likewise, financial markets
enable the transfer of capital from countries or industries
with excess capital to other countries or industries in need of
capital
 For example, companies in a highly profitable industry may
invest some of the profits in bonds issued by companies in an
expanding industry. The capital transfer may also involve an
intermediary. One company can deposit excess capital in a
bank, which can then lend it out to another company
demanding capital
 Financial markets are not only facilitating the transfer of resources,
but also ensuring that the capital flows to the most efficient projects
 Suppose company A has plenty of capital for investments, but it can
only make a 2% rate of return on an additional investment in its
own production. On the other hand, company B can obtain a 10%
rate of return on expanding its production capacity, but lacks the
capital to initiate the expansion
 If company B borrows the required capital from company A
at a 5% interest rate, both parties are satisfied, and the more
efficient productive investment can be implemented.
Alternatively, company A could pay out its excess capital to
its owners, who could then invest directly in company B
 The financial system also allows for the transfer of risk between
participants and thus facilitates risk management. By issuing shares and
thus an ownership stake of the company, an entrepreneur obtains capital
required for investments, but also shares the risk with the investors.
Any future profits and losses are split between the entrepreneur and the
investors according to their ownership share. Although the entrepreneur
believes she has a great business case, she might not want to take all the
risk, even if she had the necessary capital herself
 Long-term investors keep track of their exposure to various forms
of risks, such as their exposure to specific industries (through their
ownership of stocks and bonds issued by companies in different
industries), to macroeconomic factors, to interest rates and foreign
exchange rates, etc. They can manage their risks by moving
capital from some financial assets to others, for example from
stocks to bonds, from one country to another country, or from
stocks in one industry to stocks in another industry.
 Pension funds facing predictable future pension payouts to
its members can reduce—maybe completely eliminate—the
risk that they cannot meet the promised payments by
investing in a well-chosen portfolio of bonds
 Derivative securities are ideal for managing the risk of adverse movements in
certain quantities, such as key interest rates, exchange rates, or prices of
commodities, stocks, or bonds. An investor exposed to such a risk can reduce
or eliminate the risk by taking an appropriate position in a carefully selected
derivative security
 The investor can effectively transfer resources between different states of the
world. After significant growth and innovation in the markets for derivative
securities, investor can now manage their exposure to a long list of risk factors
through derivatives
 Some risks are difficult to “securitize”— for example, risks
related to the labor income or health status of a given person
—but often insurance companies can then provide protection
through tailored insurance contracts
 Financial markets also enable investors to take risk. Investors
are generally willing to accept some risks, as long as they are
compensated in terms of higher expected returns. Although
stock investments are generally riskier than bond
investments, most investors participate in the stock market
because average returns are larger for stocks than for bonds
 When selecting their risky investments, some investors do not want to rely
only on the better average performance of risky assets relative to risk-free
assets. Instead, they invest in specific stocks or other assets they believe
will deliver larger-than-average returns. This belief can be due to a
fundamental analysis of the asset and issuer, which indicates that the asset
is currently under-priced. But, sometimes investors are simply making
“bets” based on some gut feeling. Investors take on a lot of risk if they
concentrate their investments in a few stocks, if they invest heavily in
derivative securities, or if they use leverage to magnify their investments
 Financial markets provide opportunities for investors to pool
resources by investing in conjunction through funds rather
than investing individually. The fund or investment company
collects capital from many individual investors and invests
the aggregate capital in a certain pool of assets
 If an investor with little capital had to invest directly in
individual stocks, she could only buy few shares of few
companies. By investing the same amount in a stock market
fund, she can obtain (small fractions of) shares in a large
number of companies, and such a diversification across
stocks is generally recommended
 Furthermore, fund investments reduce transaction costs. The
transaction costs of the fund making relatively large trades
on behalf of all its members are smaller than the sum of the
transaction costs the investors would have to pay if they did
their trades individually. In addition, many individual
investors appreciate that the fund handles the paperwork, tax
reporting, etc., that financial market trading generates
 Financial markets also provide information of use when taking certain
decisions. The market price of an asset is set to equate demand and
supply, and thus reflects an average valuation of the asset among the
potential buyers and sellers of the asset. If you need to set a value of an
asset for a certain transaction (e.g., a private trade of the asset), the
market price of the asset would be a fair benchmark value. Similarly,
interest rates set in financial markets are used as fair benchmarks for
interest rates in off-market loan agreements
 Firms may use financial market prices for capital budgeting
decisions. If a firm plans to enter a new industry, the stock prices of
companies already active in that industry may provide useful
information for valuing the project.
 For investment projects involving a commodity, the prices of futures
written on that commodity are relevant inputs to the project
valuation. For example, if a firm considers drilling for oil at a certain
location, it should certainly consider the futures prices for oil
 Financial market prices can also help alleviating potential conflicts
of interest. The manager of a firm may have different incentives
than its owners (the shareholders). Maybe the manager would like
to spend company resources on a private jet or other perks, prefer
to build a corporate empire he can rule over instead of running the
company at its most profitable size, or maybe he discards risky, but
potentially highly profitable, investment projects to reduce the
probability of having to report losses in future financial statements
 The shareholders may find it difficult (or very expensive) to
monitor all the actions of the manager and to judge whether
he is making decisions in their interest. This principal agent
problem can be mitigated by tying the compensation of the
manager to the market determined price of the company’s
stocks, for example by granting the manager company stocks
or call options written on the company stocks
 Finally, various quantities and values fixed in financial
markets are used by governments, central banks, and
financial supervisory authorities. Financial markets are
closely linked to the macroeconomy
 Significant changes in stock prices or interest rates may
reflect that investors have revised their expectations about
future macroeconomic conditions, which might induce
governments or central banks to intervene in various ways to
adjust those expectation
INVESTMENT PRIMER
 What does it mean to invest in a financial asset? How do you do it
in practice?
 1. Buy financial assets, either by investing on your own through a
broker (maybe an online broker) or by investing together with
others through an investment company such as a mutual fund
 2. Enjoy the dividends you receive from the assets while you own
them.
INVESTMENT PRIMER
 3. Either keep the assets until their maturity (if the assets
have a finite maturity date) or resell the assets before
maturity, hopefully with profits
 4. Maybe obtain professional advice or even transfer
investment decisions partly to a portfolio manager
INVESTMENT CYCLE
INVESTMENT CYCLE
 Professional investors and portfolio managers often start by
making a strategic asset allocation decision, which means
that they decide on the relative investments in the different
major asset classes. The asset classes could for example be
domestic stocks, foreign stocks, domestic government bonds,
foreign government bonds, corporate bonds, real estate, and
commodities
INVESTMENT CYCLE
 The strategic asset allocation decision is typically based on
the historical long-term risk-return characteristics of the
different asset classes, but maybe influenced by the
investor’s own expectations about their future performance.
The relative weights of the different asset classes are only
infrequently adjusted
INVESTMENT CYCLE
 The next step is then, within each asset class, to decide on
exactly which assets to invest in. For example, you may have
decided to invest 25% of your wealth in US stocks, but
which of the thousands of stocks do you want to invest in?
INVESTMENT CYCLE
 This is the security selection decision. In particular when it
comes to stocks, many investors spend lots of time and effort on
trying to find mispriced stocks, i.e., to identify the future winners
and losers in the stock market. As we shall discuss in later
chapters, this is not an easy task. If it was easy, a lot of investor
would do that and thus buy the obviously underpriced stocks and
their prices would immediately increase to a point where the
stock is no longer underpriced
INVESTMENT CYCLE
 Some investors try to time the markets by moving large amounts
between major asset classes, sometimes quite frequently. Such
market timing activities are known as tactical asset allocation. If
you can predict that the overall stock market is likely to take a
substantial downturn, you should reduce or completely eliminate
your stock holdings and maybe move your money to government
bonds or other assets that are not going down with the stock
market
REFERENCE
 Munk, Claus, 2015
 Dear students: I am motivating everyone to read, study,

understand and comprehend all the learning content of
this lecture for all of these will help you explore
FINANCE. It is very important to gain mastery of the
course
INVESTMENT CYCLE
 Dear students: I am motivating everyone to read, study,
understand and comprehend all the learning content of
this lecture for all of these will help you and understand
Auditing and the role of an Independent Practitioner or
Professional Accountant in all aspects of life. It is very
important to gain mastery of the course

Module 2 Market Structures

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FINANCIAL MARKETS

MODULE 2 MARKET STRUCTURES

OUR LADY OF FATIMA

 BONDS TYPES AND ISSUERS

 Both governments, companies, and households occasionally seek to

 BONDS TYPES AND ISSUERS

 The maturity date of the bond is when the last payment is

 BONDS TYPES AND ISSUERS

 BONDS TYPES AND ISSUERS

 Treasury notes (or T-notes) are issued with a maturity between

 BONDS TYPES AND ISSUERS

 The abovementioned bonds are all nominal bonds in the

 BONDS TYPES AND ISSUERS

 The U.S. Treasury also issues inflation-indexed bonds called

 BONDS TYPES AND ISSUERS

 Companies may issue bonds to finance current operations or

 Some large corporations regularly issue commercial papers,

 Financial institutions may also issue bonds to

 Banks sometimes issue certificates of deposits (often

 An interbank market exists in which major banks, other large

 A mortgage is a loan offered to the owner of real estate, where the

 These bonds are backed by a certain pool of the mortgages in

 Hence, an index averaging all U.S. government bonds does not

 A derivative security or simply a derivative is an asset

 A forward contract or simply a forward is a binding

 You eliminate the risk of an adverse move in the asset price,

 The profits and losses from an investment in a forward

 This feature allows futures contracts to be traded on organized

 A swap refers to an agreement to exchange two specified streams of

 is an important asset class in terms of its total value. For example,

 Pension funds and other large institutional investors (and some

 Its prime role is to bring suppliers of capital and users of capital

 Dear students: I am motivating everyone to read, study,

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