Financial Institutions and

Derivatives
Financial Markets
• Securities markets
• Money markets
• Foreign exchange markets (Forex)
• Futures and options markets (Derivatives)
Financial markets cont’d
• Securities markets
• Raises new capital (primary market)
• Trades in existing shares and bonds (secondary market)
• Various stock exchanges world-wide – eg
– London
– New York
– Tokyo
– Hong Kong
– Frankfurt

• Money markets
• Highly liquid financial instruments are traded
• Covers bank deposits and short-term securities – eg Treasury bills
Financial markets cont’d
• Foreign exchange markets
• Currencies bought and sold
• Primarily carried out by banks

• Futures and options markets

• Derivatives used to hedge or speculate
• UK main market is the London International Financial Futures and
Options Exchange (LIFFE)
The Stock Exchange
• UK securities market
– Ordinary shares
– Preference shares
– Debentures
– Loan stocks
– Eurobonds
– Gilts
– Local authority bonds

Ordinary shares most important in terms of highest market value

The markets
• UK fully listed securities
• Alternative Investment Market (AIM)
• Overseas securities
• Gilt-edged market (issued by government and
local authorities)
Regulating the Stock Exchange
• Recognised investment exchange under the
Financial Services and Markets Act 2000
• Responsible for ensuring that business takes
place in an orderly manner and investors are
afforded proper protection
• Supervised by the Financial Conduct Authority
(FCA)
Regulating members of the Stock Exchange
(SE)
– Marketmakers and brokers are members of the SE
and therefore have to follow the SE’s rules
• Market makers
– buy and sell shares on their own account
– don’t want to be left with unwanted shares at the end of the day’s
trading, or shortage of shares
– Important influence on share price movements
• Brokers
– Act on their own behalf, but also as agents for client investors
– The SE is particularly interested in trading practices
and professional standards
Regulating transactions and companies
• Regulating transactions
– The price, time and volume of all trades have to be reported soon after
they have occurred
– This means that it is possible to check whether the best execution rules
have been followed, and whether insider dealing may have occurred

• Regulating companies
– A company wishing to have its securities quoted on the SE must meet the
FCA’s requirements for listing
– In addition, quoted companies must fulfil certain requirements. For
example, a quoted company must produce an interim six-monthly report.
Information
• Providing investors with information
– The SE also publishes information which is of
interest to investors
– Much information can be accessed via its website
www.londonstockexchange.com

– The Stock Exchange Daily Official List (SEDOL)

• Shows details such as price and volume of transactions in
all the securities listed on the Stock Exchange
Settlement of trades
• When one investor has agreed to sell (or buy) a security to (or from)
another investor or a market maker, the registrar must be informed
• the share certificate or bond must be transferred, and money needs
to change hands
• These administrative processes are known as settlement
• Share transactions agreed on a particular day will be settled three
working days later
• This is done using a computerised system called CREST which records
the holding of securities and the settlement of trades
Central Banks

• UK – Bank of England
• Agent of UK government
• Aims
– Maintain the value of money
– Ensure the soundness of the financial system
– Promote the efficiency and competitiveness of
financial markets
Operational responsibilities
• Issues the country's banknotes
• Holds the government’s main accounts
• Holds accounts for other institutions, eg
– Clearing banks
– Investment banks
– Foreign banks
– International Monetary Fund (IMF)
Operational responsibilities cont’d
• Maintains contacts with other central banks and
international financial institutions
• Carries out government economic policy by
interventions in money market
– Aim to influence interest rates
– Provides liquidity needed by the banking
system for settlement of money market
transactions
Operational responsibilities cont’d
• Carries out government economic policy by
interventions in foreign exchange market
– Maintains foreign reserves (gold and foreign
currency)
– If it sells foreign reserves for sterling, supply
of sterling is decreased so price of sterling
increases in terms of other currencies (and
vice versa)
Debt Management Office (DMO)
• Deals with government's debt and cash management activities
• Issues treasury bills
– Used to cover government’s short term needs
– Usually 90 days
• Issues gilts
– Bonds issued by the government
– Pays a fixed amount (coupon) every six months until maturity
Investment banks
• Specialise in giving financial advice to companies and in
fund management
• Roles of a typical investment bank are
– Financial advisers to companies
• give advice on takeover and merger strategies and defences
• give advice on investment projects
• give advice on the best ways to raise capital
• act as issuing houses
• arrange underwriting of new issues
• issue Eurobonds
Investment banks cont’d
– Fund management
• provide management for unit trusts and for
investment trust companies
• manage pension funds and large private
investment portfolios
• organise the Eurobond market
Clearing banks
• Clearing banks carry out a multitude of roles
• Obtain the bulk of their finance from private
individuals through high street outlets
• Provide means for customers to transfer money to
third parties
• Most of a bank’s funds come from current accounts,
deposit accounts and savings accounts
• Banks use some of the money to give bank loans
which may have terms of a few years
Clearing banks cont’d
• Banks will also lend a lot of money on shorter terms
such as overdrafts (in theory recallable immediately)
• Increasing provision by banks of financial services,
selling eg
– Insurance policies
– Unit trusts
– ISAs (saving plans)
– Debt factoring
Building Societies
• The role of building societies is similar to that of
banks, although there are some differences
– have not entered the commercial money markets to
the same extent as banks
– lending is dominated by house-purchase
mortgages
– individually and collectively are smaller, and thus
exert less influence than banks on the markets
 
Money multiplier
• When bank (or building society) receives a
deposit, it retains some in case depositor wants
it back
• Lends the rest of the money to a borrower
• Borrower spends the money on an item
• Seller redeposits the money in a bank
• Cycle continues
Money multiplier cont’d
• Result is that all banks are highly geared
• Substantial % of capital made up of borrowed
funds
• Critical that they lend soundly
• Large credit failure by one (or more) borrowers
could have devastating influence
Northern Rock in 2007
– UK market leader in mortgages
– Funded its mortgages through lending from other banks
– US sub-prime market led to interbank markets freezing
– NR faced increasing costs to continue borrowing
– Had to ask Bank of England for assistance
– Next day NR Customers queued to withdraw their deposits
– NR share price plummeted
– Chancellor of the Exchequer forced to announce the
government would guarantee all deposits held at the bank
– NR so badly damaged it was soon after nationalised
 Investment trusts
• An investment trust is a company
• Most investment trusts are listed on the Stock
Exchange
• Raise equity and debt capital
• The money raised is often invested in the shares of
other UK companies
• Some investment trusts buy other assets such as
gilts, property and overseas equities
Investment trusts cont’d
• Provide the opportunity for small investors to own a share of
a big, well diversified, and professionally managed portfolio
• The main parties in an investment trust are:
– Board of directors, who are responsible for the policy of
the company
– Investment managers, who manage the investments for
the investment trust
– Shareholders, who buy and sell the shares in the
investment trust company in the same way as they would
in any other company
Investment trusts cont’d
• When investors sell a share, they do so to
another investor
• The total number of shares in issue for an
investment trust does not change (unless the
company has a rights issue)
• For this reason, an investment trust is
sometimes called a closed-end fund.
Unit Trusts
• Unit trusts are trusts in the legal sense
• Set up and run by a management company
• Unit trusts are not companies
• They are not quoted on the Stock Exchange
• Units are bought from and sold to the management
company, not from other investors
• The only money that unit trusts raise is the money that
investors pay for units
• They do not raise equity or debt capital
Unit Trusts cont’d
• Unit trusts allow small investors to invest in a
professionally managed portfolio of shares with
a specific investment objective
• More restrictions on what an authorised unit
trust can invest in than for an investment trust
• Consequently, almost all invest only in quoted
shares
Unit Trusts cont’d
• The main parties involved are:
– The management company, which runs the trust. They set up
the trust, get authorisation from the FSA, advertise the trust,
carry out all necessary administration and control the
investment of the funds
– Trustees, who are responsible for checking that the trust is run
according to the terms of the trust deed. The trustee will be a
company such as a clearing bank or an investment bank that is
independent of the management company
– Investors, who buy units in the trust.
Investment management companies
• Often referred to as fund managers
• Perform a range of activities centred around the core
service of investing client assets
• This includes buying and selling investments, cash
management and transaction processing and settlement
• The industry is also, typically, very concentrated with a
small number of firms dominating the market
• Short-term fund performance is often a key factor in
attracting and retaining clients.
Self-administered pension funds
• Many employers set up pension schemes as part of the benefits
provided for their workforce
• The aim of the pension fund is to provide pensions for the
workforce when they retire
• A self-administered pension scheme is one that is responsible for
its own investment strategy
• Pension funds are largest investors in the UK in shares and gilts
• Private sector schemes are funded by the employer (and usually
employees too) making contributions over the working lives of
members
 
Self-administered pension funds cont’d
• Two basic types of scheme:
– Defined Benefit schemes: where the member’s pension is
determined by a specific formula (eg 60% of final salary) Members
contribute to the scheme at a set rate and the employers make up
the difference required to finance the benefits
– Defined contribution schemes: where there is a set rate of
employer and member contributions, paid into members’ individual
funds. The pension payable is determined by a) the size of the
fund and b) annuity rates at the date of retirement

– In the UK, defined benefit schemes are now very rare

The main parties involved in a pension
scheme
– Employer, who sets up the pension scheme and makes
contributions
– Employee, who usually makes contributions as well. Will
eventually receive benefits
– Trustees, who are responsible for checking that the trust is run
according to the terms of the trust deed and trust law.
Responsibility to ensure members’ pensions are safeguarded
– Fund managers, needed to invest a scheme’s assets. A typical
fund invests mostly in UK equities, longer dated gilts and company
debt. There may be some investment in overseas securities. A
small proportion of the assets might be invested in property,
money market investments and index-linked gilts
Life insurance companies
• Life insurance is a contract between the policy owner and the
insurer, where the insurer agrees to pay a designated beneficiary a
sum of money upon the occurrence of the insured individual's death
• Legislation requires life companies to maintain an excess of assets
over liabilities
• The need to meet this capital adequacy requirement means that
many companies have to choose assets which match their liabilities
quite closely
• A typical fund invests largely in a mixture of UK equities and fixed
interest securities. It may also invest in overseas securities,
property, money market investments and index-linked bonds.
General insurance companies
• Most insurance companies in the UK are licensed to
carry out general business only (such as motor,
household and commercial insurance)
• There are two key characteristics of general insurance:
– Short term: Almost all policies provide cover for one year, and
most claims are settled within a few months or a year or two
– Variable claim amounts and number: General insurers are
vulnerable to catastrophes (e.g. a hurricane or an oil rig
disaster) which can result in a large number and/or very large
payments.
General insurance companies cont’d
• A general insurer’s liabilities are almost all short term
• General insurers are required to keep an excess of
assets over liabilities
• This, together with the variability of their claims,
means that they do not want to take much investment
risk
• A typical insurer invests mainly in short-dated fixed
interest and money market investments. They may
also invest quite large amounts in UK equities.
Derivatives
• Three main types:
– Financial futures
– Options
– Interest rate and currency swaps
Definition
• A type of financial instrument (= an agreement between
two parties)
• Derive their value from the price or rate of some
underlying item, e.g.:
– commodities
– interest rates
– exchange rates
– stock market indices
• Used by companies to minimise risk of price fluctuations
• Also provide opportunities for speculation
Uses of derivatives
• Hedge against risk by entering into a contract whose
value moves in the opposite direction to their
underlying position and cancels part or all of it out
• Speculate and make a profit if the value of the
underlying asset moves the way they expect (eg
moves in a given direction, stays in or out of a
specified range, reaches a certain level)
• Obtain exposure to the underlying asset where it is
not possible to trade in it (eg weather derivatives);
Transfer of risk
• Derivatives allow risk related to the price of the underlying asset to
be transferred from one party to another
• For example, a wheat farmer and a miller could sign a contract to
exchange a specified amount of cash for a specified amount of
wheat in the future
• Both parties have reduced a future risk:
– for the wheat farmer, the uncertainty of the price,
– for the miller, the availability of wheat.
• However, there is still the risk that no wheat will be available because
of events unspecified by the contract, such as the weather, or that
one party will renege on the contract.
• The farmer and the miller both reduce a risk and acquire a risk when
they sign the contract
• The farmer reduces the risk that the price of wheat will fall below the
price specified in the contract and acquires the risk that the price of
wheat will rise above the price specified in the contract (thereby losing
additional income that he could have earned)
• The miller acquires the risk that the price of wheat will fall (thereby
paying more in the future than he otherwise would have) and reduces
the risk that the price of wheat will rise
• In this sense, one party is the insurer (risk taker) for one type of risk,
and the counter-party is the insurer (risk taker) for another type of risk.
Financial futures
• Contract promising to buy or sell a specified amount of
an asset (eg gold, oranges, oil) on a specified date in
the future

• Used to minimise risk of adverse price movements

affecting future contracts

• A company can use financial futures to “lock in” the

value of assets or liabilities, or to guarantee the value of
receipts and payments
• Example (1)
– UK importer buys goods from Germany
– Contract is to pay in 3 months time in euros at
current prices
– Risk: if £ declines in value against euro,
importer will have to pay more to meet cost
– Limit risk by contracting to buy equivalent
amount of euros in 3 months time, at today’s
exchange rate
• Example (2)
– UK exporter sells goods to US customer at
today’s prices.
– Will receive payment in $ in 2 months time
– Risk: if £ strengthens against $, exporter will
receive less in £s
– Offset risk by contracting to sell equivalent
amount of $ in 2 months, at today’s exchange rate
Characteristics of futures
– Contracts are standardised
– Business is open and prices published
– Contracts can be traded
– Dealings usually through a clearing house, which
guarantees payment to participants
– Each party to a futures contract must deposit a sum of
money known as margin with the clearing house.
– Margin payments act as a cushion against potential losses
which the parties may suffer from future adverse price
movements.
Options
• Give holder right (but not the obligation) to buy or sell an asset at a
pre-agreed price (eg employee share options)
• May be fixed date in future, or range of dates
• Two types
– A call option gives the right to buy a specified asset on a set date in the
future for a specified price
– A put option gives the right to sell a specified asset on a set date in the
future for a specified price.
• Allow a company to protect itself against adverse movements in the
finance environment, and also retain ability to profit from favourable
movements
• Example (1)
– Shareholder owns 10,000 shares in a company
– Risk: price may fall
– Can offset risk by buying a ‘put option’ ie right to
sell the shares at an agreed price (strike price)
– If price goes down, can sell shares at agreed price
– Can also sell the option at a profit (put options rise
in value as price declines)
• Example (2)
– Investor expects a share price to rise, but does not
have the cash to buy now
– Offset risk of losing out by buying a call option
– Gives the right to buy shares at an agreed price on
a future date
– If the price rises, can take up these rights to buy at
a favourable price
– Could alternatively sell the options for a profit
Swaps
• Allow a company to change the characteristics of its underlying
business to manage risk

• Two main types

– Currency swaps
– Interest rate swaps

• Currency swap
– Hedges against the risk of adverse foreign exchange movements
– Usually arranged through a bank as intermediary
Example

Portuguese Company A pays its costs in euros. The majority

of its sales are in the USA, and its income is in US$.
American company B has its costs in US$, but makes the
majority of its sales in Europe.

Companies A and B agree to swap their incomes over the

next year at pre-agreed exchange rates, based on the
current rates and future expectations
Interest Rate Swap
–Hedges against risk of adverse interest rate movements
–Two parties exchange a fixed interest payment for a
floating rate payment, on a notional capital sum
–fixed payments can be thought of as interest payments
on a deposit at a fixed rate, while the variable payments
are the interest on the same deposit at a floating rate
–The deposit is purely a notional one, no exchange of
principal takes place
–Used to limit exposure to fluctuations in interest rates
Example

Company A can only obtain variable interest

rate loans, but expects rates to rise and
wants to minimise its exposure.

Lender

VR
FR
Company A Bank

VR

The two variable cash flows offset each other,

achieving a fixed rate for the company
Summary
• Four key types of financial markets are
– Securities markets
– Money markets
– Foreign exchange markets
– Futures and options markets
• Significant market regulation exists
• Derivatives may be used to reduce risk