Chapter Four

Financial Markets
Content

◦Overview of Financial Markets

◦Functions of Financial Markets
◦Actors in Financial markets
◦Financial Market structure
◦Types of Financial Markets

Financial markets
Overview of Financial
Markets
 A market refers to an institution or
arrangement that facilitates the
purchase and sale of goods and
services.
 In any market buyers and sellers meet

together to exchange & this determines

the price of what is exchanged and the
quantity exchanged.
 Financial markets are no different.

Financial markets
 Cont’d
 In financial markets available funds are
exchanged.
 The sellers of the funds have excess

funds and the buyers need those funds.

 The equilibrium in these markets

determines the price & quantity of

financial instruments.

Financial markets
 Cont’d
 If financial markets work well, then:
◦useful investment occurs,
◦production & economic efficiency
increase, and
◦every one in a given country will be
benefited.

Financial markets
 A financial market is an institution or
arrangement that facilitates the exchange
of financial instruments including deposits
and loans, stocks, bonds, etc.
 It is a market where surplus funds (savings)
of economic units (firms, households, government &
foreign investors) are channeled to those
economic units who have a shortage of
funds (to those who wants to borrow
funds).

Financial markets & institutions

Structure of Markets
a) Factor market
◦ Allocates factors of production(land,
labor & capital)
b) Product market
◦ Includes trading of goods and services
c) Financial market
◦ Flow of funds and financial claims are
affected.

Financial markets
In finance, financial markets
facilitate:
1.The raising of capital (in the
capital markets);
2. The transfer of risk (in the
derivatives markets);
3. International trade (in the
currency markets)

Financial markets
Classifications of Financial
Markets
Financial markets may classify based on different
classification criteria or bases. These are:
1. Classification by type of financial claim:
a) Equity (Stock) Market
b) Debt Market
2. Classification by maturity of claim:
a) Money Market which provide short term debt
financing and investment.
b) Capital Market: the market for debt instruments
with a maturity of greater than one and equity
instruments (Bond Market and Stock Market)

Financial markets
3. Classification by origin/ nature of securities:
a) Primary Market: Markets dealing with financial claim that are
newly issued
b) Secondary Market: markets dealing with previously issued
financial claims.
4. Classification by organizational structure.
a) Auction Market
b) Over the Counter (OCT) Market- market by interconnected
computers.
5. Other markets
a) Commodity markets, which facilitate the trading of commodities.
b) Foreign Exchange Markets, which facilitate the trading of foreign
exchange
c) Insurance Markets, which facilitate the redistribution of various
risk
d) Derivatives Markets, which provide instruments for the
management of financial risk.
e) Open Market
f) Negotiated Market

Financial markets
 Financial Market Structures
 A financial market may or may not have
a particular physical existence.
 Financial market takes three basic
forms:
1. Auction markets
2. Over-the-counter (OTC) markets
3. Organized Exchanges
4. Intermediation Financial Markets
Financial markets
 Cont’d…
1. Auction markets: are markets conducted
through brokers.
 Are
form of centralized facility by which buyers
and sellers execute trades, through their
commissioned agents (brokers) in an open &
competitive bidding process.
 The"centralized facility" is not necessarily a
place where buyers & sellers physically meet.
 Rather,it is any institution that provides
buyers and sellers with a centralized access to
the bidding process.

Financial markets
 Cont’d…

 All of the needed information about

◦ bid prices (offers to buy ) &
◦ asked prices (offers to sell )
is centralized in one location which is
readily accessible to all the would-be
buyers & sellers, such as through
computer network.
◦ No private exchanges b/n individual
buyers & sellers are made outside of the
centralized facility.

Financial markets
 Cont’d…

 An auction market is typically a public

market in the sense that it is open to all
agents who wish to participate.
 Relatively homogeneous assets such as
Treasury bills, notes, & bonds are
traded.

Financial markets
 Cont’d…

2. Over-the-counter (OTC) : is market

conducted through dealers;
 An OTC market has no centralized

mechanism or facility for trading.

 It is a public market consisting of a number
of dealers spread across a region, a country,
or the world, who make the market in some
type of asset. i.e.,
◦ the dealers themselves post bid & asked
prices of the assets, &
◦ stand ready to buy or sell the asset with
anyone who chooses to trade at the posted
prices.
Financial markets
 Cont’d
 The dealers provide customers more
flexibility in trading than brokers,
because dealers can offset imbalances
in the demand & supply of assets by
trading out of their own accounts.
 Many well-known common stocks are traded
over-the-counter in the United States
through NASDAQ
(National Association of Securities Dealers' A
utomated Quotation System)
.
Financial markets
 Cont’d
3. Organized Exchanges: combine
auction and OTC market features.
 organized exchanges permit buyers &
sellers to trade with each other in a
centralized location, like an auction.
 Securities
are traded on the floor of the
exchange with the help of specialist
traders who combine broker and
dealer functions.

Financial markets
 Cont’d
 The specialists broker trades but also
stand ready to buy and sell stocks from
personal inventories if buy and sell
orders do not match up.

 such as the NYSE (New York Stock

Exchange), which combine auction and
OTC market features.

Financial markets
 Cont’d
4. Intermediation Financial
Markets
 Is a FM in which financial intermediaries
help transfer funds from savers to
borrowers by issuing financial assets to
savers and receiving other type of
financial assets from borrowers.

Financial markets
Functions of Financial Markets

Financial markets serve six basic functions:

1. Borrowing and Lending
2. Price Determination
3. Information Aggregation &
Coordination
4. Risk Sharing
5. Liquidity
6. Efficiency
Financial markets
Major Participants in Financial Markets

◦ Brokers
◦ Dealers
◦ Investment Banks
◦ Financial Intermediaries
◦ Governments
◦ Companies
◦ Individuals

Financial markets
Types of Financial Market
 Financial markets include:
1. Primary market
2. Secondary market
3. Money market
4. Capital market
5. Foreign exchange markets
6. Derivative market

Financial markets
1. Primary Markets
 Primary market is a market in which
newly issued securities are sold to initial
buyers by the corporation or
government in raising the funds.
 Securities available for the first time are

offered through the primary market.

 That is, In the primary market,

companies interact with investors

directly while in the secondary market
investors interact with themselves.
Financial markets
 Cont’d
 The securities offered may be a new type
for the issuer or additional amounts of a
security used frequently in the past.
 The traditional middleman in the primary
market is called an investment banker.
 Investment banking firms play an
important role in many primary market
transactions by underwriting securities.

Financial markets
 Cont’d
 That is, they buy the new issue from the
issuer at an agreed upon price and hope to
resell it to the investing public at a higher
price.
 Usually, a group of investment bankers joins

to underwrite a security offering and form

what is called an underwriting syndicate.
 Companies raise new capital in the primary

market through:
i. Public issues
ii. Right issue
iii. Private placement
Financial markets
 Cont’d
i. In public offering: the will be
established companies sell new
securities to the public. i.e., to all
individuals and institutions.
ii. In right issue: offering of securities
may be made only to the existing
shareholders.
 when securities are offered only to the
company’s existing shareholders, it is
called right issue.

Financial markets
 Cont’d
iii. Private placement: instead of public
issue of securities, a company may
offer securities privately only to a few
investors. This is referred to as private
placement.
 The investment bankers may act as a
finder, i.e., they locate the
institutional buyer for a fee.

Financial markets
2. Secondary Market
 Secondary market is a market where
already issued or existing or outstanding
financial assets are traded among
investors.
 Unlike primary market, in the secondary

market the issuer of the asset does not

receive funds from the buyer.
 Rather the existing issue changes hands

and funds flow from the buyer of the

asset to the seller in the secondary
market.
Financial markets
 Cont’d

 The primary market provides a

direct link between the prospective
savers and the issuing company,
while
 Secondary market provides an

indirect link between the savers

and the company.

Financial markets
 Cont’d
 By providing liquidity and safety, the
secondary market encourages the
public to subscribe to the new issues.

 The marketability and capital

appreciation provided in the secondary
market are the major factors that
attract the investing public towards the
stock market.

Financial markets
3. Money Market
 The money market is the market for
shorter-term credit instruments/debt
securities, generally those with one
year or less remaining to maturity.
 Because of their short period maturity,
money market investments sometimes
are also known as cash investments.

Financial markets
 Cont’d
 Since money market instruments are
very liquid, & very safe, they offer a
lower return than most other
securities.
 Money market securities are traded in
very high denomination.
◦ Thus, individual investors have limited
access to them as compared to other
market securities.

Financial markets
Characteristics of Money
Market
1. Short term funds are borrowed and
lent
2. No fixed place for conduct of
operation e.g., through phone, etc
3. Dealing may be made with or without
the help of brokers.
4. Funds are traded for a maximum
period of one year.

Financial markets
Importance of money market
 Money markets are important to:
◦ Central government- for controlling the
money supply.
◦ Banks- to meet reserve requirements and
as a place to use excess reserves.
◦ Brokers & dealers- keep the market
moving
◦ Corporations- sources of short term
funding and as a place to invest excess
cash for short period of time.
◦ Other financial institution- a place to
maintain liquidity.
Financial markets
Money Market Instruments
a) Treasury bill (TB):
 It is a short term obligation/promissory
note issued by the government,
 sold at a discount from its face value &
 redeemed of its face value upon
maturity.
 For example, if you buy a 90 day T-Bill
having Br.10,000 face value at Br. 9,800
and held it until maturity, your interest
would be Br. 200(=10,000-9,800).
 For this reason they are also called zero-
coupon rate bonds. Financial markets
 Cont’d
 It is a way that government use to
raise money from the public.
 Is the most marketable money
market securities & considered as
risk-free investment area.
 TBs are issued through the competitive
bidding process at auctions.

Financial markets
 Cont’d
 Futures of TB:
1. Issuer- it issued by the government for
raising short term funds, for filling the
deficit between revenue & expenditure.
2. Liquidity- it enjoys high degree of
liquidity.
3. Tax- Interest exempt from state and local
taxes
4. Monetary management- serve as an
important tool of monetary management
used by the central bank of the country to
influence the economy.

Financial markets
 b) Certificate of Deposits (CDs)

 Negotiable CD is a deposit with a bank

at special interest rate for specified
period of time, which is less than one
year.
 It is issued by commercial banks in any

denomination.
 CDs offer a slightly higher yield than TBs

because of the slightly higher default risk

for a bank, but overall the probability of a
large bank to default is very minimal.

Financial markets
Characteristics of CDs:
 A bank issue time deposit with:
◦ Fixed interest rate and maturity
◦ Terms are negotiable
◦ Common maturities are less than 12
months
◦ They are more certain to banks than
demand deposits that can leave at any
time.
◦ Most CDs are sold directly to investors
who hold to maturity
◦ Investors receive both principal & interest
Financial markets
 c) Commercial Paper (CP)
 CP is Unsecured short-term
promissory note:
◦ Generally issued by corporations or
financial institutions
◦ Sold directly to institutions or through
dealers.
◦ Is the largest (total $ value) of the
money market securities
◦ Funds used to finance working capital
requirements

Financial markets
 Cont’
◦ Usually issued at discount and held to
maturity– no active secondary
market
◦ Issued by high creditworthy & top
rated corporations
◦ Taxed by all levels of government

Financial markets
d) Bankers’ Acceptance (BA)
 BA is a bank draft, a promise of payment
similar to a check, issued by a firm ,
payable at some future date &
guaranteed for by a fee by the bank
that stamps it as “accepted”.
 Or, it is a short term credit investment

created by a non-financial firm and

guaranteed by a bank to make payment.
 The firm issuing the instrument is required

to deposit the necessary funds into the

account to cover the draft.

Financial markets
 Cont’d
 If the firm fails to do so, the bank’s guarantee
obligate the bank to cover the draft
 These accepted drafts are often resold in a

secondary market at discount similarly as

treasury bill.
 E.g., acceptance set at a discount from the

face value:
◦ Face value of banker’s acceptance … Br. 100,000
◦ Minus 1% commission/discount … … Br. 1000
◦ Amount received by the holder … … Br. 99,000

Financial markets
 Cont’d
◦Banks guarantee payments to secure
orders of goods from manufacturers
◦Are a type of “letter of credit” that
guarantees a payment by the bank on
a specific date
◦Particularly useful between foreign
trading partners where there is a high
level of asymmetric information –
Banks resolve this AI.

Financial markets
e) Interbank mkt loans/Federal
Funds
 Fed funds are bank deposits at a bank’s
district Fed for the purpose of meeting
reserve requirements
 Banks with “excess” reserves at the
Fed loan to those with a shortfall

Financial markets
f. Repurchase agreements/REPO
 REPO is an agreement to buy any
securities from a seller with the agreement
that they will be repurchased at some
specified date & price in the future.
 REPO is a fully collateralized loan in which

the collateral consists of mktable

securities.
 The repurchase price is higher than the

initial sale price: the d/fce is Return to the

lender.

Financial markets
4. Capital Market
 The capital market is the market for
long-term securities, generally those
with more than one year to maturity.
 The primary participants raising funds in
the capital markets are:
◦ Federal, state, & local governments; &

◦ Corporations.
 Securities markets consist of organized
exchanges & OTC markets.
Financial markets
 Cont’d
 Security markets are considered to be
efficient when prices adjust rapidly to
new information.
 Security legislation is intended to
protect investors against fraud,
manipulation, and illegal insider
trading.
 Capital market provides with:
◦ Long-term fixed income (in Debt market), &
◦ Equities (in Equity market)

Financial markets
Capital market Trading
 Capital market trading occurs in either the primary
market or the secondary market.
 The primary market is where new issues of stocks and

bonds are introduced.

 When firms sell securities for the very first time, the

issue is an initial public offering

(IPO).
A secondary market is where the sale of
previously issued securities takes place.
 Secondary markets are critical in capital

markets because most investors plan to sell

long-term bonds at some point before they
mature.
 There are two types of exchanges in the

secondary market for capital securities:

organized exchanges and over-the-counter
exchanges.
Capital market instruments
are:
 Treasury Notes & Bonds
 Municipal Bonds
 Corporate Bonds
 Common stocks
 Preferred stocks

Financial markets
 Cont’d
a) Treasury Bonds and Notes
 Issued by government
 Treasury Notes (mature 1-10 years)
 Bonds (mature 10 – 30 years)
 Quoted as a % of par value
 Semi annual coupon payments
 Denominations of $1,000 or more
 Premium (selling price greater than

face value) and discount bonds (selling

price less than face value )
Financial markets
 Cont’d
b) Municipal Bonds
 Issued by State & Local Government
 Tax Exempt

c) Corporate Bonds
 Issued by corporations
 Semiannual coupon payment
 Interest rate risk
 Default risk exist

Financial markets
Bond Yield Calculations
 Bond yields are quoted using a variety of conventions ,
depending on both the type of issue and the market.
 We will examine the current yield calculation that is

commonly used for long-term debt.

Bond Current Yield Calculation

𝐶
𝑖𝑐 =
𝑃

= current yield
C= annual coupon payment
P= price of the coupon bond
Bond Current Yield Calculation
 What is the current yield for a bond with a face value
of $1,000, a current price of $921.01, and a coupon rate
of 10.95%?
Answer:
= $109.50/921.01= 11.89%
Note: C( Coupon) = 10.95% $1,000 =109.50
Value of Bonds
 Bond Terminology
 Par value—face amount of the bond, which is

paid at maturity date.

 Coupon interest rate – stated interest rate

(generally fixed) paid by the issuer.

 Coupon payment – par value coupon interest
rates
 Maturity date—years until the bond must be

repaid
Value of Bond
 YTM – the yield the investor will earn if the bond is
purchased at the current market price and held until
maturity.
 Indenture– the contract that accompanies a bond and

specifies the terms of the loan agreement. It includes

management restrictions, called covenants
Value of Bond
 Bond Value = +

 In short,
Example 1
 XYZ Company has a level –coupon bond
outstanding that pays coupon interest of
$120 per year and has 10 years to maturity.
The face value of bond is $1000. If the yield
for similar bond is currently 14%, what is
the bonds current market value?
PV={120
PV= {120
PV= 625.92+270
PV= $895.92
Example 2:
 For XYZ company bond described in
example1, find the bonds value if the yield for
similar bonds decreases to 12%.
PV = {120
PV= {120
PV= 678+322= $1000
Example 3:
 For XYZ company bond described in example1, find the
bonds value if the yield for similar bonds decreases to
9%.
PV = {120
PV= {120
PV= 770.16+422= $1192.16
Example 4:
 Suppose the XYZ bond paid interest
semi-annually. What would its value
be if the yield is 14%?
 If interest paid semi-annually;

 PV= {60
 PV= {60
 PV= 635.64+258.4 = $894.04
Zero coupon bonds
 A bond that makes no coupon payments, thus, initially
priced at a deep discount.
Summary
◦In example 1 YTM 14% >coupon
interest rate 12%, the bond sold at
discount.
◦In example 2 YTM 12%= coupon
interest rate 12%, the bond sold at
par.
◦In example 3 YTM 9% < coupon
interest rate 12%, the bond sold at
Premium.
 Cont’d
d) Common Stock
 Shares of ownership in a corporation
 Right to residual claims
 Right to vote on corporate matters
 Limited Liability
 Investor Equity Return

= Dividend Yield + % of Price

change

Financial markets
Background on Common Stock

◦ Common stock = certificate representing equity

or partial ownership in a corporation

Issued in primary market by corporations that

need long-term funds

◦ Stock is then traded in the secondary market,

creating liquidity for investors and company
evaluation for managers
Background on Common Stock

Ownership and Voting Rights

◦ Owners of common stock vote on:
 Election of board of directors
 Authorization to issue new shares
 Amendments to corporate charter
 Other major events
◦ Many investor assign their vote to management via a
proxy
◦ Households own about half of all common stock, the
rest is owned by institutional investors
 Cont’d
e) Preferred Stock
 Has debt & Equity Characteristics
 Fixed Dividend Payout
 Corporation pays taxes on preferred
dividends unlike interest
◦(double taxation, just like common
dividends for individual investors)

Financial markets
Background on Preferred Stock
 Represents equity or ownership interest, but
usually no voting rights
 Trade voting rights for stated fixed annual

dividend
 Dividend paid before common if dividends

are declared by board of directors

 Dividend may be omitted

◦ Cumulative provision
◦ If common dividend paid, preferred dividend fixed
 Preferred Stock
•• Preferred
Preferred stock
stock isis aa hybrid
hybrid security
security
that
that has
has characteristics
characteristics of of both
both bonds
bonds
and
and common
common stock
stock
•• Generally has fixed
Generally has fixed dividends
dividends

•• Generally
Generally does
does not
not have
have voting
voting
rights
rights unless
unless dividend
dividend payments
payments are
are
missed
missed

•• Nonparticipating
Nonparticipating versus
versus
participating
participating 8-72
 Stock Returns
•• The
The returns
returns on on aa stockstock over
over one
one period
period
(R
(Rtt)) can
can be
be divided
divided into into capital
capital gains
gains and
and
dividend
dividend returns:
returns:
Pt  Pt  1 Dt
Rt  
Pt  1 Pt  1

P
Ptt =
= stock
stock price
price at time tt
at time
D
Dtt =
= dividends
dividends paid
paid over time tt –– 11 to
over time to tt
(P
(Ptt –– P
Ptt––11)) // P
Ptt––11 = = capital
capital gain
gain over
over
time tt –– 11 to
time to tt
D
Dtt// P
Ptt––11== return
return fromH(PhD) dividends paid 8-73
from
Compiled By Alem
dividends paid
 Estimated Value and Market Price
• By comparing estimates of value and market price, an
analyst can arrive at one of three conclusions: The
security is
– undervalued,
– overvalued, or
– fairly valued in the market place.
• For example,
– if the market price of an asset is $10 and the analyst
estimates intrinsic value at $10, a logical conclusion is that
the security is fairly valued.
– If the security is selling(Mkt price) for $20, the security
would be considered overvalued.
– If the security is selling (Mkt price)for $5, the security would
be considered undervalued
 Intrinsic
Underval value >
Estimated Value and Market
market
Price
ued:
price
Intrinsic
Fairly value =
valued: market
price
Intrinsic
Overvalue value <
d: market
price
 Dealing with Uncertainty
 Analysts must cope with uncertainties related
to model appropriateness and the correct
value of inputs.
◦ An analyst’s final conclusion
depends not only on the comparison
of the estimated value and the
market price but also on the
analyst’s confidence in the estimated
value (i.e., in the model selected and
the inputs used in it).
.
Present value
models
• Dividend discount
models
• Free cash flow models

Multiplier models
• Share price multiples
• Enterprise value
multiples

Asset-based
valuation models
• Adjustments to book
value
Major Categories of Equity Valuation Models
Two major approaches for cost
of equity
 Equilibrium models:

◦Capital asset pricing model (CAPM)

◦Arbitrage pricing theory (APT)

 CAPM
 Expected return is the risk-free rate plus a
risk premium related to the asset’s beta:

E(Ri) = RF + i[E(RM) – RF]

 The beta is i = Cov(Ri,RM)/Var(RM)

 [E(RM) – RF] is the market risk premium or the

equity risk premium
 Preferred Stock Valuation (Non-callable, Non-
Perpetual
convertible Shares)
For example, a $100 par value non-callable perpetual preferred stock
offers an annual dividend of $5.50. If its required rate of return is 6
percent, the value estimate would be $5.50/0.06 = $91.67. Use D/r
Maturity
When the stock has earnings and dividends that are expected to remain
at time foreever. Example: Preferred Stock
constant
period n
F = expected sales price of stock at time N

D0 $5.50
V0   $91.67
r 0.06

n
Dt F
V0   t
 n
t 1 (1  r ) (1  r )
 General Dividend Valuation Model
• The value of common stock is the PV of
the expected dividends to be received
plus the PV of the expected price the
stock is sold for in the future:

d1 d2 dn Pn
P0   ..... 
1  k e  1  k e  1  k e  1  k e n
2 n

• For simplicity we will assume a firm pays

out dividends just once a year.
Constant-Growth Dividend Valuation Model

 If we expect this company to have earnings

of $5 per share in the coming year ,the 7.2%
constant growth rate and with a 40%
dividend payout ratio, we can compute the
common stock value to an investor requiring
a 10% return with the following constant
growth model:

d1
P0 
k e  g 
 Constant-Growth Dividend Valuation Model
 The company’s dividend in the coming year
must be $2.00 per share:

◦ d1 = $5.00 x 40% = $2.00

 And thus the value of the stock is:

$2.00 $2.00
P0   $71.43
10.0% - 7.2%  2.8%
 The Stock Market
 New securities trade in the primary market
while currently outstanding securities trade
in the secondary market.
 The corporation receives money from sale of

its securities only in the primary market.

 There are two types of secondary markets:
Organized exchanges where trading occurs at a
physical location; and
Over-the-counter market where trading occurs
over the telephone or through computer networks.
Organized Exchanges(Physical
exchange)
The New York Stock Exchange (NYSE),
also called the “Big Board,” is the oldest of all
organized exchanges and the largest
organized exchange in the world.

 While the NYSE is considered an organized

exchange because of its physical location, the
majority of its trades are done electronically
without a face-to-face meeting of traders.
 To be listed on the NYSE, a firm must meet
strict requirements dealing with profitability
and market value, and be widely owned.

 Much of the trading on the NYSE is made up

of block trades i.e. transactions involving
American Stock Exchange
 TheAmerican Stock Exchange (AMEX) is
the nation’s second largest, floor-based
exchange. However, in terms of volume, the
AMEX is a distant number two with less than
5% of that on the NYSE.

 AMEX merged with NASDAQ in 1998 but

continues to operate as a separate entity.
Over-the-Counter (OTC) Market
 The over-the-counter market is a
network of dealers that has no listing or
membership requirements. Today, the
OTC market is electronic with Nasdaq
leading the way.
 Not a physical exchange – computer
based quotation system
 OTC listings generally include
companies too new or too small to be
eligible for listing on a major exchange.
 Nasdaq debuted in 1971 and is the
world’s first electronic stock market.
 WhileNasdaq lists more companies
than the NYSE, they are relatively
5. Foreign Exchange Market
 Foreign Exchange: all currencies other
than the domestic currency (in our case,
all currencies other than ‘birr’).
 Foreign exchange market refers to any
and all places where different currencies
are traded for one another.
 Exchange Rate: the price of one
country's currency in terms of another
country's currency;
◦ Is the rate at which two currencies are traded
for another.
Financial markets
Interpreting
Foreign Exchange
Quotations
Direct quotations represent the value of a
foreign currency in dollars, while indirect
quotations represent the number of units of
a foreign currency per dollar.
 Note that exchange rate quotations

sometimes include IMF’s special drawing

rights (SDRs).
 The same currency may also be used by

more than one country.

Interpreting
Foreign Exchange
Quotations
A cross exchange rate reflects the amount
of one foreign currency per unit of another
foreign currency.
 Value of 1 unit of currency A in units of

currency B = value of currency A in $

value of currency B in $
Eurocurrency Market$
 U.S. dollar deposits placed in banks in
Europe and other continents are called
Eurodollars.
 In the 1960s and 70s, the Eurodollar

market, or what is now referred to as the

Eurocurrency market, grew to
accommodate increasing international
business and to bypass stricter U.S.
regulations on banks in the U.S.
Two Types of Currency Markets

1. Spot Market:
- immediate transaction at spot rate
 participants are: commercial banks, brokers,

and customers of commercial and central

banks
2. Forward Market:
- transactions take place at a specified
future date, at forward rate.
 participants are: arbitrageurs, traders,

hedgers, and speculators

 It is the act of reducing exchange rate risk.

Financial markets
Types of Exchange Rates

 Spot versus forward exchange

rates

i. Spot exchange rate: is the rate

existing on the day of the
transaction.

ii. Forward exchange rate: is the

exchange rate fixed today at which
future transaction is exchanged.
Financial markets
Transactions Costs

 Bid-Ask Spread used to calculate the

fee charged by the bank
 Bid = the price at which the bank
is willing to buy

 Ask = the price at which the bank will

sell the currency

Financial markets
 Foreign Exchange
Transactions
 Banks provide foreign exchange services for

a fee: the bank’s bid (buy) quote for a

foreign currency will be less than its ask
(sell) quote. This is the bid/ask spread.
 ask rate – bid rate
bid/ask % spread =
ask rate
 Example: Suppose bid price for £ = $1.52,
ask price = $1.60.
bid/ask % spread = (1.60–1.52)/1.60 = 5%
6. Derivatives Market
 The derivatives market is the financial
market for derivatives.
 Derivative financial instruments are:

◦ Forward contract,
◦ Futures contracts,
◦ Options &
◦ Swap
 which are derived from other forms of
assets.

Financial markets
 Cont’d
 A Derivative is a tradable financial
instrument whose value depends on the
value of the underlying asset.
 Very often, the underlying derivatives

are the price of the traded asset.

 For example, a stock future is a

derivative whose value depends on the

price of the stock.
 Derivative securities provide a number

of useful functions in the area of risk

management and investment.
Financial markets
 Cont’d

 For example,
◦A wheat farmer can fix the price of his
crop before harvest to eliminate price
risk.
◦An importer can fix a foreign
exchange rate before any trade
arrangement to eliminate foreign
exchange risk.

Financial markets
a) Forward contract
 A forward contract: is an agreement
that obligates the holder to buy or sell an
asset at a predetermined delivery
price during a specified future time.
 The buyer of a forward contract agrees to

take delivery of an underlying asset at a

future time, T, at a price agreed upon
today.
 The seller also agrees to delver the

underlying asset at a future time, T, at a

price agreed upon today.

Financial markets
 Cont’d

 A forward contract, therefore, simply

amounts to setting a price today for a
trade that will occur in the future.
 These contracts are traded in over-the-

counter market(OTC) rather than on

exchange market-usually between two
parties.

Financial markets
b) Future contract
 A future contract: is an agreement
that obligates the holder to buy or sell
an asset at a predetermined
delivery price during a specified
future time.
 It is similar to a forward contract except

for some differences.

 Future contracts are traded in an

exchange market.

Financial markets
 Cont’d

 Because of its daily settlement

procedure, intermediate gains or losses
are posted each day during the life of
the future contract. This feature is known
as marking -to -market.
 To make the trade possible, the

exchange specifies certain standardized

futures of the contract, like:
◦ Contract size (number of units delivered in
one contract)
◦ Delivery date
◦ Quality of the underlying asset
Financial markets
 Comparison between forward
contract and future contract
Forward Future
- Private contract b/n -Traded on an
two parties (OTC) exchange
- Not standardized - Standardized
contract
- Settled at the end - settled daily
of contract
- Some default risk - no default risk

Financial markets
c) Option
 It is the right to buy or sell an asset.
 In option the counter parties are:

◦ The maker/writer
◦ The buyer/holder – this will have the
right/option to choose to sell or to buy the
asset.
 There are two types of options:
◦ Call option
◦ Put option

Financial markets
 Cont’d

 Call option: it gives the holder the

option or the right to buy an asset by a
certain date for a certain price.
 Put option: it gives the holder the
option or the right to sell an asset by a
certain date for a certain price.

Financial markets
 Cont’d
 Call Option –
◦ If you buy a call you have limited loss &
unlimited gain
◦ If you sell a call you have limited gain
but unlimited loss if you do not own the
underlying security – naked option)
 Put Option –

◦ If you buy a put you have limited loss

and unlimited gain
◦ If you sell a put you have limited gain
and your loss is limited to the exercise
price of the asset in the contract.

Financial markets
 Cont’d
 The date specified in the contract is known
as the expiration date or maturity
date.
 The price specified in the contract is known

as the exercise price or strike price.

 Options can also be classified in to two

based on the date to exercise the right:

◦ American option: it can be exercised at
any time up to the expiration date.
◦ European option: it can be exercised only
on the expiration date.

Financial markets
d) Swap
 A swap is an agreement between two
parties to exchange cash flows in the
future at the agreed upon (notional)
amount.
 Swap can be:

◦ Interest rate swap

◦ Currency swap
 Interest rate swap: it involves the
exchange of interest payment.
 Currency swap: it involves the

exchange of different currencies

Financial markets
END OF THE CHAPTER! ! !

Financial markets