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Financial Institutions and Markets. The markets. Outline of contents. A recap of semester one Money markets Capital markets Bond markets Equity markets Learning outcomes Further work References A starter vocabulary list. The Markets. A recap of semester one.

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Financial institutions and markets

Financial Institutions and Markets

The markets


Outline of contents

Outline of contents

  • A recap of semester one

  • Money markets

  • Capital markets

    • Bond markets

    • Equity markets

  • Learning outcomes

  • Further work

  • References

  • A starter vocabulary list


The markets

The Markets

A recap of semester one


An introduction to markets and institutions

An introduction to markets and institutions

  • The financial system exists to channel funds from those without productive opportunities to those with productive opportunities

    • This can happen directly through financial markets

      • E.g. bond, equity, money, derivatives…

    • Or indirectly through financial institutions / intermediaries

      • E.g. investment banks, pension funds, insurance companies…

  • All economies evolve financial institutions

    • Increased efficiency, since markets are never perfect in real life


Informational problems 1

Informational Problems (1)

  • In a perfect world, information would be symmetric and complete

    • I.e. all parties in a transaction have identical knowledge, which is complete

  • In reality, perfect information does not exist: it may be incomplete and or asymmetric

    • This leads to the problems of adverse selection and moral hazard


Informational problems 2

Informational Problems (2)

Adverse selection: information asymmetry prior to a transaction

  • A price for the good / service is set at a level that is unsatisfactory for the most desirable candidates, who then leave the market

    • The price is adjusted, becoming unsatisfactory to the candidates who are the most desirable of those remaining  they now exit the market

      • This process continues until only the most undesirable candidates remain in the market

  • Note: no-one has “chosen” or “done” adverse selection – individuals act in their own best interests and this leads to adverse selection across the market


Informational problems 3

Informational problems (3)

Moral hazard: asymmetry of information after a transaction

  • This only exists where there is a need but an inability for one party to monitor the counterparty after a transaction occurs

    • Differing incentives of the party and the counterparty exist

      • This leads to the counterparty behaving in a way that would not be approved of by the party

  • Note: no-one has “chosen” moral hazard – individuals act in their own best interests and this leads to a situation that we call moral hazard

  • Note: there is not a choice between adverse selection and moral hazard, they are separate problems of information asymmetry


Financial intermediaries 1

Financial intermediaries (1)

  • Commercial banks & building societies

  • Core functions:

    • Receiving deposits

    • Making loans

    • Providing a payments mechanism

  • These institutions work on a fractional reserve system


Financial intermediaries 2

Financial intermediaries (2)

  • Non-commercial banks

    • Investment banks

      • Services to firms / governments

      • Heavily involved in financial markets

    • Investment and unit trusts

      • Differences, similarities?

    • Insurance companies

      • Types of insurance

      • Reinsurance

    • Pension funds

      • Types of pension

      • Calculation of pension value


The markets1

The Markets

Money markets


On successful completion of the topic

On successful completion of the topic…

  • You should be able to:

    • Understand and explain the money and capital markets, including the instruments involved

    • Understand the process of issuing equity [see Arnold (2012: 357)]

    • Understand the valuation of bonds and equity


What is the money market

What is the money market?

  • Wholesale financial markets in which lending and borrowing on a short-term basis takes place

    • Wholesale: large volumes (millions of pounds) within transactions

    • Short-term: usually for less than one year (most for <120 days)

  • Money markets do not actually trade money

    • Short-term, highly liquid securities are traded

  • There is generally a low default risk on MM instruments


Do we really need the money markets

Do we really need the money markets?

  • Without regulation, there would be no need for MMs

    • The banking system should provide short term loans and accept short term deposits

      • Efficiency in gathering information should remove need for MMs

  • But there is regulation in the real world

    • And banks are more heavily regulated

      than the money markets

    • So if asymmetric information is not severe,

      the money markets can have cost

      advantages for short term funds


Sub divisions of the money market

Sub-divisions of the money market

  • The money market may be split into 6 components:

    • The discount market

    • The interbank market

    • The certificate of deposit market

    • The gilt repo market

    • The local authority market

    • The eurocurrency market

      There will be primary and secondary markets within each category

      Small investors can buy shares in money market funds that investment in these vehicles

Also known as parallel markets


The interbank market

The Interbank market

  • This is where banks lend to one another on a short term basis

    • Wholesale

    • Very short term (normally 1-14 days)

    • Unsecured lending

    • Rates tend to be higher & more volatile than discount rates

    • LIBOR = the rate of interest on these loans

      • 3 month rate is important within the wider economy

      • US– Federal Funds rate, influenced by interbank borrowing to maintain reserves at the Fed.

    • These loans cannot be traded in the money markets

      • No distinction between primary and secondary markets


The eurocurrency market

The eurocurrency market

  • Eurocurrency markets are those which allow borrowing and lending to take place denominated in another (non-domestic) currency

    • Note: this can be ANY currency, not just the Euro

  • A eurocurrency instrument is then simply a financial instrument denominated in any non-domestic currency

  • Used because interest rates and regulation can differ across markets


The discount market bills explained

The discount market: Bills explained

  • A bill is a certificate promising to pay a specified amount of money to the bill holder at a specified time in the future

    • Bills are generally issued by large firms (commercial bills) or government (treasury bills)

  • Bills have some important characteristics:

    • They are issued in very large denominations

    • They are highly liquid

    • The reward to the lender is a capital gain, not interest

    • Bills are fixed-interest securities

    • Market price approaches redemption value as maturity approaches: this is because there is low interest rate risk, so yield is lower


The discount market

The discount market

Price of bills

Supply1

Supply0

PE

Demand0

Demand1

QE

Quantity of bills


The market for certificates of deposit

The market for certificates of deposit

  • A certificate of deposit states that a deposit has been made with a bank for a fixed period of time, at the end of which it will be repaid with interest

  • A CD issuer is the bank which accepts the deposit

    • The CD is a liability for this institution

  • A CD holder is the institution which makes the deposit or purchases the certificate in the secondary market

    • The CD is an asset for this institution


The gilt repo market

The Gilt repo market

  • A repo is short for a repurchase agreement

    • This is an agreement to buy any securities from a seller on the understanding that they will be repurchased at some specified price and time in the future

Now

At a specified time in the future…

Securities

Securities


The local authority market

The local authority market

  • This is the (short-term) market in which funds are loaned to local authorities through bills and deposits

    • The bills are effectively the same as treasury bills

    • Deposits are a larger source of funds

  • Once made, deposits cannot be traded

  • US market: advantage is don’t have to pay federal taxes on them, so effective yields can be higher


General principles

General principles

  • Interest rates on longer term products in the money market are usually higher than for shorter term products– because of extra interest rate risk taken on.

  • The credit rating of the borrower has a big effect on the rates charged.

  • When inflation expectations rise, interest rates rise accordingly, so the price of money market products falls.

  • If institutions need extra money quickly, they will issue more short term securities, which pushes up their supply and drives prices down, yields up.

  • Central banks can intervene to lower interest rates by issuing new securities if they fell it’s necessary (and vice versa during a boom).


The markets2

The Markets

Capital Markets


What are the capital markets

What are the capital markets?

  • The capital markets refers to markets for long term financing

    • Bond markets

    • Equity markets

  • The capital market is used for long-term financing

    • In contrast to money markets for warehousing or covering temporary shortfalls

  • Main issuers: firms and government

  • Main purchasers: households (through FIs)


The markets3

The markets

Capital Markets

Bonds


Bonds

Bonds

  • Bonds are securities representing debt owed by the issuer to the investor with specified payments on specific dates


The markets4

The markets

Capital Markets

Bonds: Government


Government securities

Government securities

  • Governments may borrow money by issuing bills in the money market or notes and bonds in the capital market


Risk and rates on government securities

Risk and rates on government securities

  • There is a very low risk of default

    • This leads to low interest rates (often considered the “risk-free” rate of return)

Rate (%)


Innovation in government securities

Innovation in government securities

  • Index-linked gilts

    • First issued in the UK in 1981 due to high and variable inflation

    • Par value and coupon are adjusted based on RPI

      • Generally held to maturity so secondary trading is limited

  • Inflation risk is therefore reduced for these bonds


The markets5

The markets

Capital Markets

Bonds: Local authority / Municipal


Local authority municipal bonds

Local authority / municipal bonds

  • These are issued by governments at sub-national levels

    • E.g. states, cities…

  • They are similar to Treasury bonds but are higher risk

    • Issuers cannot print money and may not be able to raise taxes

    • Bond insurance is frequently used in the US and EU to guarantee that the bond will be serviced on time

      • Reduces risk and therefore borrowing cost

  • Municipal bonds tend to be tax exempt in the US


The markets6

The markets

Capital Markets

Bonds: Corporate


Corporate bonds

Corporate bonds

  • Many corporate bonds are listed on exchanges

    • But most trading is OTC

  • Minimum value is typically £1,000 or £50,000 (depending on type of bond and trade)

  • Risk is typically higher for corporate than government issued bonds

    • Risk varies across bonds for same issuer as well

      • This affects the coupon rate


Variations in corporate bonds

Variations in corporate bonds

  • Straight, plain vanilla and bullet bonds are ordinary

    • Regular, fixed coupons and a specified redemption date

    • Exotic bonds are those with more unusual characteristics

  • There is a huge degree of variation in the types of bonds available

    • We will consider:


Restrictive covenants

Restrictive covenants

  • These restrict the actions and rights of the borrower until the debt has been repaid in full

    • In order to reduce risk for the lender

  • Some examples include:

    • Limits on further debt issuance

    • Dividend level

    • Limits on the disposal of assets

    • Financial ratios


Recap

RECAP

  • What is the capital market? (what types of securities, length of maturity, who borrows & why etc).

  • Restrictive covenants for corporate bonds:

  • Some examples include:

    • Limits on further debt issuance

    • Dividend level

    • Limits on the disposal of assets

    • Financial ratios


Foreign bonds

Foreign bonds

  • Foreign bonds are corporate bonds issued within the country of denomination by a firm based outside that country

A bond (in £)

U.S. firm

UK Markets


Eurobonds

Eurobonds

  • Eurobonds are corporate bonds issued in a country other than that of denomination

A bond (in $)

U.S. firm

UK Markets


Euro bonds

Euro bonds

  • Euro bonds are denominated in Euros

    • Please note that eurobonds and Euro bonds are different financial instruments

      • It is also possible to have a Euro eurobond!

A bond (in €)

EZ firm

U.S. markets


Strips

Strips

  • Stripping is the breaking up of a bond into its component coupon payments and its redemption value

    • Each strip is then sold as a zero coupon bond

      • This is at a discount to its redemption value

  • Essentially, these are long term bills


Secured bonds

Secured bonds

  • Secured bonds have collateral attached

    • Mortgage bonds are backed by property

    • Equipment trust certificates are secured by tangible non-real-estate property

  • The existence of collateral reduces risk to the lender

    • Secured bonds pay lower interest than comparable unsecured bonds


Unsecured bonds

Unsecured bonds

  • Unsecured bonds may also be termed debentures

  • Debentures are backed only by the general creditworthiness of the issuer

    • They have lower priority than secured bonds if the company defaults


Junk bonds

Junk Bonds

  • These are debt instruments offering a high return with a high risk

    • Rated below Ba or BBB

  • These may have started as lower risk instruments and become more risky over time

    • Fallen angels

  • Or they may be specifically issued risky bonds

    • Typically issued when limits of bank borrowing are reached and the firm cannot / will not issue more equity


Financial guarantees for bonds

Financial guarantees for bonds

  • A financial guarantee means the bond holder will be paid the principal and interest if the borrower defaults

    • A form of insurance

      • Risk is transferred

      • Lower interest rate is required to compensate for the risk

  • Credit Default Swaps were created in 1995

    • This type of insurance derivative was de-regulated in the US in 2000

      • Major contributing factor to the financial crisis


Securitisation

Securitisation

  • Securitised products are repackaged debt

  • Lenders collect together the claims held on assets (interest and capital)

    • These claims are then packaged and sold to other investors

      • These packages may be called asset backed securities

        • These may be bonds

  • ABSs may be taken off-balance sheet

    • Covered bonds are similar but stay on-balance sheet


The markets7

The markets

Capital Markets

Bonds: Yields and values


Bonds yields

Bonds: Yields

  • Current yield, running yield or interest yield

    • The return on a bond taking account only of the coupon payments

    • The coupon expressed as a percentage of the market price

  • Redemption yield

    • The return on a bond taking account of the coupon cash flows and the capital gain or loss at redemption

      approx= [(coupon amount / market price)*100] – [{(Market price – nominal value)/market price}*100]


Bond pricing

Bond pricing

  • The price of all financial assets is found in the same way:

    • The present value of all future cash flows

  • The steps involved:

    • Identify cash flows

    • Determine the discount rate required to compensate the investor for holding the security

    • Find the present value of the cash flows

  • See Mishkin and Eakins (2012) pp. 336-338 for numerical examples


The markets8

The markets

Capital Markets

Equities: defining shares


What are shares

What are shares?

  • Shares are the equity capital of a firm

    • Shareholders have a claim to the company’s assets in the form of dividends and residual claims but maintain limited liability


Common versus preference shares

Common versus preference shares

Common / ordinary shares

Preference shares

No voting rights

Dividends are received preferentially and amount is more stable

Comprise less than 25% of stock issues

  • Voting rights

  • Receive dividends

  • Comprise majority of stock issues

Returns higher than for bonds usually, but higher risk


Preference shares from the firm s perspective

Preference shares from the firm’s perspective

  • Advantages

    • Optional dividends versus compulsory interest payments

    • Can alter shareholder capital without affecting firm control

    • Limit on dividend payments even if profitability is very high

    • Useful for gearing / leverage purposes

  • Disadvantages

    • Higher cost of capital than bonds (due to higher risk)

    • Tax deductibility applies to interest but not to dividends so, ceteris paribus, preference shares lower profits compared with bonds


Debt versus equity

Debt versus equity

Debt

Equity

Lower priority in bankruptcy

Dividend payments can be easily changed

Does not mature

Gains can be enormous

E.g. Purchaser of $1000 Google shares in 1999  millionaire

Usually there is a right to vote

Relatively expensive to issue & potential loss of control

  • Higher priority in bankruptcy

  • Interest payments usually fixed

  • Matures

  • Gains are usually relatively small

  • Usually no right to vote

  • Relatively cheap to issue & no loss of control


The markets9

The markets

Capital Markets

Equities: trading shares


How can shares be traded

How can shares be traded?

  • Traditionally, the split in trading method was exchange v. OTC

    • Now, electronic trading is becoming dominant through electronic communications networks (ECNs)


An organised securities exchange

An organised securities exchange

  • The traditional definition: a specified location where buyers and sellers meet to trade using an open outcry model

    • Floor traders specialise in a particular stocks and oversee trades

    • Technology has led to some changes to this model – see ECNs

  • To list on an exchange, a company must meet specified requirements

    • This often excludes small firms

    • A company may also list on more than one exchange


The 20 largest stock exchanges in the world

The 20 largest stock exchanges in the world


What is sold on the lse

What is sold on the LSE?


Over the counter trade

Over the counter trade

  • Trade is not centralised, as with an “organised” exchange

  • Dealers are market makers – they set bid and ask prices

    • They hold an inventory and adjust it based on what investors want to do

  • OTC trading can be through a very large network, e.g. NASDAQ, or it may be on a much smaller scale


Electronic communication networks

Electronic communication networks

  • These allow trade without the middleman of an exchange

  • 24-7 market

  • A number of advantages exist:

    • Transparency: more information– traders see all unfilled orders, can judge supply & demand better

    • Cost reduction

    • Faster execution

    • After-hours trading


Vocab check

Vocab check

  • Restrictive covenant

  • Discount bill

  • Par value

  • Certificate of deposit

  • Gilt

  • Eurocurrency account

  • Basis point

  • Redemption

  • Preference shares


The markets10

The markets

Capital Markets

Equities: valuing shares


How to value a share

How to value a share

  • Remember that valuing any financial product is a matter of discounting all future cash flows back to present value terms

  • There are several methods for this regarding shares

    • One period valuation model

    • Generalised dividend valuation model

    • Gordon growth model

    • Price-earnings valuation model


One period valuation model

One-period valuation model

  • This is the simplest model

    • Use the expected dividend and price next year

  • It may, however, be a little too simple!

  • K is the required rate of return on equity


The generalised dividend valuation model

The generalised dividend valuation model

  • This is the most general model

  • There may, however, be computational problems with a sum to infinity


The dividend growth model

The dividend growth model

  • This is the same as the previous model, but assumes that dividends grow at a constant rate, g


Price earnings valuation

Price-earnings valuation

  • The price earnings ratio (PE) is a widely watched measure of how much the market is willing to pay for £1.00 of earnings from the firms.


General problems with valuation

General problems with valuation

  • The Gordon growth model is conceptually straightforward, however, it is problematic in reality

    • Estimating the growth rate, g

    • Estimating risk, which impacts ke

    • Forecasting future dividends

  • The growth rate is particularly problematic since a change has both a direct and an indirect effect


Effects of a change in the growth rate

Effects of a change in the growth rate


Case the 2007 2009 financial crisis and the stock market

Case: The 2007–2009 Financial Crisis and the Stock Market

  • The financial crisis, which started in August 2007, was the start of one of the worst bear markets.

  • The crisis lowered “g” in the Gordon Growth model—driving down prices.

  • Also impacts ke—higher uncertainty increases this value, again lowering prices.

  • The expectations were still optimistic at the start of the crisis. But, as the reality of the severity of the crisis was understood, prices plummeted.


Case 9 11 enron and the market

Case: 9/11, Enron and the Market

  • Both 9/11 and the Enron scandal were events in 2001.

  • Both should lower “g” in the Gordon Growth model—driving down prices.

  • Also impacts ke—higher uncertainty increases this value, again lowering prices.

  • We did observe in both cases that prices in the market fell. And subsequently rebounded as confidence in US markets returned.


The markets11

The Markets

Learning Outcomes


On successful completion of the topic1

On successful completion of the topic…

  • You should be able to:

    • Understand and explain the money and capital markets, including the instruments involved

    • Understand the process of issuing equity [see Arnold (2012: 357)]

    • Understand the valuation of bonds and equity


Vocab concept check

VOCAB & concept CHECK

  • Debt versus equity

  • Eurobonds

  • US federal versus local authority bonds

  • Debenture

  • Securitisation

  • Financial guarantee


The markets12

The Markets

Further Work


Next steps for you

Next steps for you…

  • Complete your vocabulary list and learn it

  • Compulsory reading

    • Arnold (2012) – chapters 5, 6, 8 and 9

    • Howells and Bain (2007) – chapters 5 and 6

    • Mishkin and Eakins (2012) – chapters 11, 12 and 13

  • Additional reading

    • Arnold (2012) – chapters 10, 11 and 12

    • See the reference list


The markets13

The Markets

Reference List


References 1

References (1)

  • Arnold, G. (2012) Modern Financial Markets and Institutions: A practical perspective, Essex: Pearson Education.

    • (see chapters 5, 6 and 8-12)

  • Howells, P. and Bain, K. (2007) Financial Markets and Institutions, 5th Edition, Essex: Pearson Education.

    • (see chapters 5, 6, 8, 9)

  • Mishkin, F.S. and Eakins, S.G. (2012) Financial Markets and Institutions, 7th Global Edition, Essex: Pearson Education.

    • (see chapters 11-15)


The markets14

The Markets

A starter vocabulary List


Vocabulary a

Vocabulary: A

  • This list is far from complete: it is your responsibility to add to it with any new words

  • It has been provided for this 1st topic of semester 2 but will not be provided for other topics

  • Affirmative covenants: part of the indenture identifying what the borrower should do (e.g. publication of financial statements, etc.)

  • Asset backed securities: repackaged debt


Vocabulary b

Vocabulary: B

  • Basis point: 0.01%

  • Bill: a certificate promising to pay a specified amount of money to the bill holder at a specified time in the future (short-term debt instrument traded in the money market)

  • Bonds: securities that represent debt owed by the issuer to the investor, and typically have specified payments on specific dates

  • Bullet bonds: ordinary, unexciting bonds

    • See also plain vanilla bondsand straight bonds


Vocabulary c

Vocabulary: C

  • Call provision: the right of the issuer to repurchase a bond prior to maturity

  • Certificate of deposit:contract stating that a deposit has been made with a bank for a fixed period of time, at the end of which it will be repaid with interest

  • Commercial bills: bills issued by large corporations

  • Convertible bond: provides the right to exchange a bond for ordinary stock according to a pre-arranged formula at the bondholder’s discretion

  • Coupon: the amount paid in interest on a bond

  • Coupon rate: the interest paid on a bond as a percentage of the face value

  • Current yield: coupon interest payment divided by current market price of a bond


Vocabulary d e

Vocabulary: D-E

  • Debenture: an unsecured bond

  • Equipment trust certificates: bonds using non-real-estate property as collateral

  • Eurobonds: corporate bonds issued in a country other than that of denomination

  • Exotic bonds: have some unusual or atypical characteristics


Vocabulary f g

Vocabulary: F-G

  • Face value: the value of a bond at redemption

    • see also par value

  • Fallen angels: bonds that are low risk when issued but have become high risk

  • Financial guarantees: insurance against bond payment default

    • Fixed interest securities: the return for holding a bill to redemption is known at the time of issue

    • Foreign bonds: corporate bonds issued within the country of denomination by a firm based outside that country

    • Gilt / Gilt-edged security: a UK government bond


Vocabulary i p

Vocabulary: I-P

  • Indenture: the contract of a bond

    • see also trust deed

    • Junk bond: a bond rated below Ba or below BBB

    • Market rate: the interest rate currently in effect in the market for securities of like risk and maturity; used to value bonds

    • Maturity: time until redemption

    • Mortgage bonds: bonds using property as collateral

    • Par value: the value of a bond at redemption

      • See also face value

    • Plain vanilla bonds: ordinary, unexciting bonds

      • See also bullet bonds and straight bonds


Vocabulary r s

Vocabulary: R-S

  • Redemption yield: the return on a bond taking account of the coupon cash flows and the capital gain or loss at redemption

  • Running / interest yield: the coupon expressed as a percentage of the market price

  • Secured bonds: collateral is specified in the indenture

  • Securitisation: the act of repackaging debt

  • Straight bonds: ordinary, unexciting bonds

    • See also bullet bonds and plain vanilla bonds


  • Vocabulary t z

    Vocabulary: T-Z

    • Treasury bills: bills issued by government

    • Trust deed: the contract of a bond

      • See also indenture

    • Yield to maturity: the yield an investor will earn if the bond is purchased at current market price and held until maturity


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