Chapter 3 Financial Market Structute

CHAPTER 3
FINANCIAL MARKET
STRUCTURE
1/6/21
Chapter contents
 Money markets
 Bond markets
 Mortgage markets
 Stock markets
 Foreign exchange markets
 Derivative securities market
Capital Market Instructor:Dr. Dagnu L.
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3.1 Money markets

 refers to the network of corporations,
financial institutions, investors and
governments which deal with the flow of
short-term capital.
 money markets do not exist in a particular
place or operate according to a single set of
rules. Rather, they are webs of borrowers
and lenders, all linked by telephones and
computers. Capital Market Instructor:Dr. Dagnu L.
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3.1 Money markets…

 they bring borrowers and investors together
without the comparatively costly
intermediation of banks.
 they help borrowers meet short-run liquidity
needs and deal with irregular cash flows
without resorting to more costly means of
raising money.
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 there is an identifiable money market for
each currency, because interest rates vary
from one currency to another.
 they have expanded significantly as a result
of the general outflow of money from the
banking industry, a process referred to as
disintermediation.
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What do money markets do?
 help issuers of instruments with cash management or
with financing their portfolios of financial assets.
 attach a price to liquidity, the availability of money for
immediate investment.
 active/liquid money markets allow borrowers and
investors to engaging in a series of short-term
transactions rather than in longer-term transactions,
keeping down long-term interest rate.
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Types of instruments
Commercial paper
 a short-term debt obligation of a private-sector firm or
a government-sponsored corporation
 has maturity of between 90 days and 9 months
 is usually unsecured
allows financially sound companies to meet their short-
term financing needs at lower rates than could be
obtained by borrowing directly from banks.
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Bankers’ acceptance
 a promissory note issued by a non-financial firm to a bank in return
for a loan
 the bank resells the note in the money market at a discount and
guarantees payment
 is issued at a discount and has a maturity of less than six months.
 is usually tied to the sale or storage of specific goods, such as an
export order for which the proceeds will be received in two or three
months.
 are not issued at all by financial-industry firms
 investors rely on the strength of the guarantor bank, rather than of
the issuing company, for their security.
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Treasury bills
 securities with a maturity of one year or less, issued by national
governments
 treasury bills issued by a government in its own currency are generally
considered the safest of all possible investments in that currency
 are used as principal source of financing where a government is unable
to convince investors to buy its longer-term obligations.
 as countries develop reputations for better economic and fiscal
management, they are often able to borrow for longer terms
 governments may issue TBs denominated in foreign currency
 but a sudden decline in the value of the currency increases the debt
burden and may even cause a debt crises as in Mexico in 1995, Russia
in 1998 and Brazil in 1999.
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Interbank loans…
 loans extended from one bank to another with which it has no
affiliation
 are used by the borrowing institution to re-lend to its own customers
 includes overnight loans needed to maintain the required reserves
 banks extend short-term loans to one another at agreed upon interest
rate.
 it is called LIBOR (London Inter Bank Offer Rate) in UK, Fed fund
rate in the US.
 a lending bank can charge more than LIBOR if the borrowing bank
is not creditworthy. Capital Market Instructor:Dr. Dagnu L.
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Time deposits
 another name for certificates of deposit (CDs)
 are interest-bearing bank deposits that cannot be withdrawn without penalty
before a specified date.
 time deposits may last for as long as five years.
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Repurchase agreement(Repos)
 is a combination of two transactions
1. a securities dealer, such as a bank, sells securities it
owns to an investor, agreeing to repurchase the securities
at a specified higher price at a future date.
2. days or months later, the repo is unwound as the dealer
buys back the securities from the investor
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Repurchase agreement(Repos)
 amount the investor lends is less than the
market value of the securities, a difference
called the haircut
 in a reverse repo the roles are switched, with
an investor selling securities to a dealer and
subsequently repurchasing them
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Futures
 used for hedging and cash management
 by buying or selling a futures contract on a
short-term interest rate or a short-term debt
security, an investor can profit if the relevant
rate is above or below the chosen level on the
contract’s expiration date.
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3.2 Bond Markets

 the word “bond” means contract,
agreement, or guarantee.
 an investor who purchases a bond is
lending money to the issuer
 a bond represents the issuer’s contractual
promise to pay interest and repay principal
according to specified terms.
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3.2 Bond Markets...

• bonds offer a way for governments to
borrow from many individuals rather than
just a handful of bankers
• are the most widely used of all financial
instruments. For example the total size of
the bond market worldwide was more than
approximately $50 trillion by the end of
2004
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3.2 Bond Markets...

Why issue a bond?
 To diversify sources of funding.
 the issuer can raise far more money without exhausting its
traditional credit lines with direct lenders.
 minimize cost of capital - cost is lower and the funds can be
repaid over a longer period
 matching revenue and expenses-bonds offer a way of linking
the repayment of borrowings for long term projects to
anticipated revenue.
 promoting inter-generational equity-bonds offer a means of
requiring future taxpayers to pay for the benefits they enjoy,
rather than putting the burden on current taxpayers.
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3.2 Bond Markets...

Why issue a bond?
Controlling risk-the obligation to repay a bond

can be tied to a specific project or a
particular government agency, insulating the
parent corporation or government from
responsibility.
avoiding short-term financial constraints-
governments and firms may turn to the bond
markets to avoid financial constraints .
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3.2 Bond Markets...

The issuers
National
 governments
bonds backed by the full faith and credit of national governments are called sovereigns.
are generally considered the most secure type of bond.
Lower
 levels of government
bonds issued by a government at the sub-national level, such as a city, a province or a state,
are called semi-sovereigns.
Corporations
are issued by a business enterprise- owned by private investors or by a government. In
issuing a secured obligation, the firm must pledge specific assets to bondholders.
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3.2 Bond Markets...

Issuing bonds
• each issue is preceded by a lengthy legal document- the offer document or prospectus.
• offer document lays out in detail:
 the financial condition of the issuer

 the purposes for which the debt is being sold
 the schedule for the interest and principal
payments
 the security offered to bondholders in the event
the debt is not serviced as required.
A bond can be issued either through underwriters
& dealers or directly to the Capital
investors.
Market Instructor:Dr. Dagnu L.
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3.2 Bond Markets...

Types of bonds
Straight bonds
 a.k.a debentures
 are the basic fixed-income investment
 owner receives interest payments on specified
dates, usually every six months or every year
following the date of issue.
 the issuer must redeem the bond from the owner at
its face value on a specific date.
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3.2 Bond Markets...

Types of bonds
Callable bonds
 the issuer may reserve the right to call the bonds at particular dates
 the difference between the call price and the current market price is the call
premium.
 a bond that is callable is worth less than an identical bond that is non-
callable
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3.2 Bond Markets...

Types of bonds
Putable bonds
 gives the investor the right to sell the bonds
back to the issuer at par value on designated
dates.
 this benefits the investor if interest rates rise
Perpetual debentures
 a.k.a irredeemable debentures,
 are bonds that will last forever unless the holder
agrees to sell them back toCapital
theMarket
issuer. Instructor:Dr. Dagnu L.
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3.2 Bond Markets...

Types of bonds
Zero-coupon bonds
do not pay periodic interest.
issued at less than par value and are redeemed at par
value
are designed to eliminate reinvestment risk-the loss an
investor suffers if future income or principal
payments from a bond must be invested at lower
rates than those available today.
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3.2 Bond Markets...

Properties of bonds
Maturity
has a date on which the bond issuer will have

repaid all of the principal and will redeem the
bond.
Coupon
the stated annual interest rate as a percentage of

the price at issuance. once a bond has been
issued, its coupon never changes.
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3.2 Bond Markets...

Properties of bonds
Current yield
Has the effective interest rate for a bond at its
current market price. This is calculated by a
simple formula:
=Annual amount of coupon interest/ current price
if the price has fallen since the bond was issued,

the current yield will be greater than the
coupon. Capital Market Instructor:Dr. Dagnu L.
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3.2 Bond Markets...

Properties of bonds
Yield to maturity
this is the annual rate the bondholder will receive if
the bond is held to maturity.
yield to maturity includes the value of any capital
gain or loss the bondholder will enjoy when the
bond is redeemed.
is the most widely used figure for comparing returns
on different bonds. Capital Market Instructor:Dr. Dagnu L.
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3.2 Bond Markets...

Properties of bonds
Duration
a number expressing how quickly the investor will

receive half of the total payment due over the
bond’s remaining life
Example: a zero-coupon bond offers payments only at
maturity, so its duration is precisely equal to its term. A
hypothetical ten-year bond yielding 100% annually lets
the owner collect a great deal of money in the early
years of ownership, so its duration is much
Capital Market shorter
Instructor:Dr. than
Dagnu L.
its term. 28 of 59
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3.2 Bond Markets...

Ratings of risk
bond issuers often seek a rating from one or more private ratings agencies before
they issue bonds
the selected agencies investigate the issuer’s ability to service the bonds,
including such matters as financial strength, the intended use of the funds, the
political and regulatory environment, and potential economic changes.
after completing its investigation, an agency will issue a rating that represents its
estimate of the default risk, the likelihood that the issuer will fail to service
the bonds as required.
three well-known companies are Moody’s Investors Service, Standard &
Poor’s, and Fitch ibca.
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3.2 Bond Markets... 1/6/21
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3.3 Mortgage Markets

What is mortgage?
a pledge of property to secure payment of
a debt
involves two parties: mortgagor(home
owner) and mortgagee(lender)
real estate that can be pledged as a
mortgage are divided into two as
residential and non-residential property
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Originators
 commercial banks, thrift(S&Ls), and
mortgage banks
 generate income from origination fee,
application fee and profit from selling a
mortgage at a higher price
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Origination process
1. homeowner applies for a mortgage loan
2. mortgage originator performs credit
evaluation of the applicant based on Loan-
to-Value ratio(LTV) and Payment to
Income ratio(PTI)
3. contract signed
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.3 Mortgage Markets
Originators can
1. keep mortgage in their portifolios
2. sell to an investor such as Fannie Mae
3. use it as a collateral for issuance of a
security
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Mortgage-backed securities
involves securities issued with mortgages
used as a collateral
THREE types:
1. Pass through securities
2. Collateralized mortgage obligation(CMO)
3. Mortgage backed bond
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1. Pass through securities
a security created by pooling mortgages
and selling shares/participation
certificates in the pool.
gives the investors a pro rata share of the
principal and interest on the pool
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Mortgage-backed securities ...

1. Pass through securities...
the pool may consist several thousands
or just a few
help investors eliminate the
unsystematic risk
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2. Collateralized Mortgage Obligation
a multi-class pass through with a number of
bond holder classes
each bond holder has a different guaranteed
coupon paid semiannually
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3. Mortgage-backed bonds
bonds in which mortgages are used as a
collateral
is more a collateralization than securitization
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3.4 Stock Markets
where equity claims are traded

common(ordinary) stock and preferred stock
Includes both primary market and secondary
market
primary market is where IPOs are issued and
also where seasoned offerings are made
Seasoned offering have rights offerings
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3.4 Stock Markets

Secondary markets
where stocks once issued are traded
include floor-based exchange(NYSE) and
electronic-based exchange (NASDAQ)
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3.4 Stock Markets
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3.4 Stock Markets
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3.4 Stock Markets

Stock Market Indexes
is a composite value of a group of
secondary market traded stocks.
Example: Dow Johns Industrial

Average(DJIA), S&P 500,NASDAQ
composit-industrials,banks,& insurance
companies, DAX
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3.5 Foreign Exchange Markets
markets where currencies of different countries are

traded
spot rate and forward rate
Determinants of Exchange Rate
relative inflation rates

relative interest rates
relative income levels
government controls
expectations Capital Market Instructor:Dr. Dagnu L.
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Government influence on exchange rates
1) Direct intervention
by exchanging foreign currency with local
currency
can be sterilized or non-sterilized
intervention
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Sterilized intervention
 the government buys or sells local
currency(in the forex market) to
manipulate the exchange rate and at the
same time undertakes an offseting
transaction in the money market to keep
money supply unaffected
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Non-sterilized intervention
 the the government buys or sells local
currency to manipulate its value
 no offseting transaction is undertaken in
the money market to keep money supply
unaffected
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2) indirect intervention
adjustment of interest rate-increase
interest rate to discourage outflow of
funds
using foreign exchange controls-
restriction on the exchange of the
currency Capital Market Instructor:Dr. Dagnu L.
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3.7 Derivative Securities Markets

financial instruments the value of which is derived from the
prices of securities, commodities, money or other
external variables.
are created to manage price volatility
although many, they fall into two basic categories:
(1) Forwards are contracts that set a price for something
to be delivered in the future.
(2) Options are contracts that allow, but do not require,
one or both parties to obtain certain benefits under
certain conditions.
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Options
Characteristics
Option premium-upfront fee
Exercise/strike price
American Vs European options
In the money/out of the money
A zero sum game
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Forward contract
agreement between buyer and seller to trade
securities for cash on a specific date
Future contract
similar to forward contract, except that it is
traded in an organized exchange
asset standardized and indeminity is
available in case of default
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Swaps
agreement to exchange specified periodic
cash flows in the future based on some
underlying instrument or price
Example:interest rate swaps
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End of Chapter 3
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Chapter 3 Financial Market Structute

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Chapter 3 Financial Market Structute

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CHAPTER 3

Capital Market Instructor:Dr. Dagnu L.

3.1 Money markets

3.1 Money markets…

Capital Market Instructor:Dr. Dagnu L.

3.1 Money markets…

Capital Market Instructor:Dr. Dagnu L.

3.1 Money markets…

3.1 Money markets…

3.1 Money markets…

3.1 Money markets…

3.1 Money markets…

3.1 Money markets…

Capital Market Instructor:Dr. Dagnu L.

3.1 Money markets…

Capital Market Instructor:Dr. Dagnu L.

3.1 Money markets…

3.1 Money markets…

3.2 Bond Markets

Capital Market Instructor:Dr. Dagnu L.

3.2 Bond Markets...

3.2 Bond Markets...

3.2 Bond Markets...

Controlling risk-the obligation to repay a bond

3.2 Bond Markets...

Capital Market Instructor:Dr. Dagnu L.

3.2 Bond Markets...

 the financial condition of the issuer

3.2 Bond Markets...

3.2 Bond Markets...

Capital Market Instructor:Dr. Dagnu L.

3.2 Bond Markets...

3.2 Bond Markets...

3.2 Bond Markets...

has a date on which the bond issuer will have

the stated annual interest rate as a percentage of

3.2 Bond Markets...

if the price has fallen since the bond was issued,

3.2 Bond Markets...

3.2 Bond Markets...

a number expressing how quickly the investor will

3.2 Bond Markets...

Capital Market Instructor:Dr. Dagnu L.

Capital Market Instructor:Dr. Dagnu L.

3.3 Mortgage Markets

3.3 Mortgage Markets

Capital Market Instructor:Dr. Dagnu L.

3.3 Mortgage Markets

Capital Market Instructor:Dr. Dagnu L.

3.3 Mortgage Markets

3.3 Mortgage Markets

3.3 Mortgage Markets

Mortgage-backed securities ...

3.3 Mortgage Markets

3.3 Mortgage Markets

Capital Market Instructor:Dr. Dagnu L.

3.4 Stock Markets

where equity claims are traded

3.4 Stock Markets

Capital Market Instructor:Dr. Dagnu L.

3.4 Stock Markets

Capital Market Instructor:Dr. Dagnu L.

3.4 Stock Markets