FINANCIAL MARKETS & INSTRUMENTSSuperior University Lahore

Introduction of Financial MarketsFinancial Assets are assets which contain a coinciding financial liability on the other part of it. These are also termed as financial instruments and securities.

The Entity that agrees to make future payments is called the issuer of financial asset and the owner of the financial asset is called an Investor. Examples include the loans granted by the financial institutions and Bonds/Certificates Issued by Financial Institutions.

Financial AssetsFinancial Assets Basically are of two types:

Debt Instruments: In this case the holder has a fixed amount claim on the assets of the issuer.

Equity Instruments: In this case the holder has varying or residual amount claim on the assets of the issuer.

Financial Assets There are certain types of instruments that fall under both categories. The examples are Preferred Stocks/Shares which carry fixed amount payments. Another example is Convertible Bonds which carry the holder the right to covert debt into equity under certain circumstances.

Debt and preferred stock that pay fixed dollar amounts are also called fixed-income instruments.

Notional Classification of Financial Markets On the Basis of Nature of Claims:Debt Markets: Deal with Securities without ownership rightsEquity Markets: Deal with Securities with ownership rights

On the Basis of Maturity of ClaimsMoney Markets: Market for short term securities Capital Markets: Market for long term securities

Notional Classification of Financial MarketsOn the Basis of Seasoning of ClaimsPrimary Markets: These deal with newly issued securitiesSecondary Markets: These deal with previously issued securitiesOn the Basis of Immediate or Future DeliveryCash or Spot Markets: Where assets are traded for immediate deliveryDerivative Markets: These provide the right to buy securities at some future date.

Notional Classification of Financial MarketsOn the Basis of Organizational StructureAuction Market: A market where trade is conducted by seeking bids from the buyers and sellers.Over-the-counter Markets: It is an unregulated market whereby geographically traders interact via some communication Channels.Intermediated Markets: Where an Intermediary agent facilitates the interaction of buyers and sellers.

Characteristics of Financial MarketsLiquidity: It is the ease with which the trading can be conducted.Transparency: It is the availability of prompt and complete information about the trade and prices.Reliability: The assurance that the trade is completed with agreed terms.Legal Procedures: The rules about the settlement of disputes.Suitable Investor Protection Regulations.Low Transaction Costs.

Functions of Financial MarketsPrice Setting: It matches demand of an asset with its supply for price discovery process.

Asset Valuations: After an asset has been purchased the market price help in determining the asset values at any future time.

Arbitrage: This occurs in countries with poor market structures where the markets are not integrated and the investors try to benefit from different prices in different markets.

Bonds MarketsAdjustable Bonds: On such Bonds interest rates can be changed based on specific circumstances. Inflations Protected Bonds and Base Rate based bonds are the examples.The Bonds which have options attached to them are also called structured securities. Examples include, callable and putable bonds.

Functions of Financial MarketsRaising Capital: By Issuing Shares Bonds etc., the companies can meet additional capital requirements for expansion.Commercial Transactions: Financial Markets provide liquidity to its customers to meet sometimes the working capital requirements.Investing: The Markets provide an opportunity to the investors to earn return on funds that might not be possible otherwise.

Cross Border MeasuresGlobalization leads to the following additional types of Financial Markets:Internal Markets, this has further two types:Domestic Markets: Where only the local residents issue and deal in securities.Foreign Markets: Where the securities of the issuers not domiciled in the country are traded.

Cross Border MeasuresExternal/Offshore or Euromarkets: These allow two distinguishing features to the issuers of securities:Securities are issued in more than One Countries at the same time.They are issued outside the jurisdiction of any single country.

The sourcing of Raising funds internationally has changed. More Corporations are raising funds through equities as compared with debts before.

Reasons for Increase in the use of Financial MarketsInflation: Financial Markets provide an opportunity to the investors to protect the reduction in the values of their assets. Because the returns in the market often adjusts to the inflation rates through pricing mechanism.

Stock and Bond Market Performance: markets provide pricing, risk management etc., mechanisms due to which the use of markets has increased.

Types of InvestorsDriving Force behind financial markets is the desire to earn a return on investors. The return has two components:YieldCapital Gains

The investors are of the following types:Individuals InvestorsInstitutional Investors

Types of InvestorsInstitutional Investors are of the following types:Mutual FundsHedge FundsInsurance CompaniesPension FundsFinancial Institutions

FOREIGN EXCHANGE MARKETS

Foreign Exchange MarketsPrices are always expressed in terms of currencies.

Such currencies are issued by the Central Bank of the relevant countries.

The choice of the currency depends on the ease of the masses using the currency.

Foreign Exchange MarketsIf in a country the currency of a country not issued by the central bank of that country is used for payment of prices, then the determination of the price of that other currency also becomes a question:In this way the currencies perform two functions:

As a medium of exchangeAs a Commodity

Foreign Exchange MarketsThe following are the types of currency markets:

Spot Market: Where currencies are traded for immediate delivery.

Forward Markets: Where market participants allow the currencies to be traded at a specified rate in future.

Foreign Exchange MarketsThe participants of foreign currency markets:Importers and ExportersInvestorsSpeculatorsGovernments

Foreign Exchange MarketsSettlement: The actual delivery of currencies between trading parties is called settlement. This settlement might be through physical delivery or through the transfer of value via banks.

Herstatt Risk: In modern times the greatest risk arises from the fact that the trading occurs different times. Such risk is called Herstatt Risk.

MONEY MARKETS

Money MarketsThe term money market refers to the network of corporations, financial institutions, investors and governments which deal with the flow of short term capital.

Money MarketsWhen a business needs cash for a couple of months until a big payment arrives, or when a bank wants to invest money that depositors may withdraw at any moment, or when a government tries to meet its payroll in the face of seasonal fluctuations in tax receipts, the short term liquidity transactions occur in the money markets.

Money MarketsIntermediation: Financial Intermediaries play the basic role of transforming financial assets that are less desirable for a large part of the public into other financial assets which are more widely preferred by the public. Which eventually becomes their liabilities.

Money MarketProperties of Financial Assets: Moneyness: The ability of the Financial Assets to be accepted as Medium of Exchange in settlement of Assets. In Pakistan money consists of currency and all kinds of interest bearing deposits maturing upto 1 year.Divisibility and Denomination: It means a minimum size into which a Financial Assets is Divisible. Like minimum share price is Rs. 10 and minimum Bond Price is Rs. 1,000/= in Pakistan.

Money MarketReversibility: It means the cost of investing to a Financial Asset and then getting back out of it into Cash Again.Cash Flows: It consists of any income that will flow to the Investor and the Principal that will be recovered at the end of the term.Term of Maturity: It is the length of the period at the end of which the instrument will make its final payment.

Money MarketConvertibility: It is the ability of the Financial Assets to convert into some other asset. Like some Bonds are convertible into Shares and vice versa.Currency: These are certain types of Financial Assets that deal in different countries. Like Islamic Bonds Issued by Government of Pakistan that Pay Interest in Dollars although such Bonds are issued in Pakistan.Liquidity: This is the loss an investor has to suffer if he wishes to sell financial asset immediately.

Money MarketReturn Predictability: This is the uncertainty associated with Future Return flowing to the investor.Complexity: Complexity refers to a characteristic where a Financial Asset has more than one characteristic at the same time. For example, callable bond which gives the issuer the right to call back the bond at any time during the life of the Bond at a certain price.

CAPITAL MARKETS

Capital MarketsCapital Markets are discussed in the following dimensions:

Bonds MarketsEquity Markets

Bonds MarketsThe word Bond means contract, agreement or guarantee.

An investor who purchases bonds is in fact lending money to the issuer of bonds.The issuer in return promises a to pay fixed amount of money as interest on the money lent alongwith the principal sum on decided payment terms.

Bonds MarketsTypes of Bonds: Straight Bonds also known as debentures where the investor receives periodical interest payments, and principal sum at the maturity of Bonds.Callable Bonds: The issue has the right to call the Bond at any time during its life.Non-refundable Bonds: Prohibit the issuer from issuing new Bonds for retiring old Bonds. Accordingly such Bonds can be retired only if the issuer is able to generate the funds internally like from taxes or sales.Putable Bonds: Give the investor right to sell the Bond back to the issuer on a specific date at a specific price.

Bonds MarketsPerpetual Debentures: These are such Bonds that will last forever unless the holder agrees to sell them back to the issuer.Zero-coupon Bonds: These do not pay periodic interest. Rather total interest earned is paid to the investor on the maturity alongwith the principal.Convertible Bonds: Such Bonds have the option to be converted into equity shares under specific circumstances with the mutual agreement of the issuer and investor.

Bonds MarketsProperties of Bonds:Maturity CouponCurrent Yield= Annual Coupon interest/Current PriceYield to Maturity: This is the annual rate Bond Holder will receive if the bond is held till maturity.Duration: Duration is a number expressing how much quickly the investor will receive half of the total payment due over the remaining life of the Bond.Ratings of Risk: It is mandatory for every private issuer of Bond to get its bond rated before every issue in terms of Default. This is done by rating agencies.