Chapter 4

Financial market
structure

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 Chapter contents
 Money markets
 Bond markets
 Stock markets
 Foreign exchange markets

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 4.1 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.
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 4.1 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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 4.1 Money markets…
 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
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 4.1 Money markets…
What do money markets do?
For most individuals & institutions, inflows &
outflows of cash are rarely in perfect harmony
with each other.
 As cash runs low relative to current expenditure,
such units must once again enter the money
markets as borrowers of funds, issuing short–term
securities attractive to money market investors.
 A surplus cash position – bring such firms in to
the money markets as net lenders of funds.
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 Money markets…
Investors in the money market seek mainly
safety and liquidity plus the opportunity to
earn some interest income
 For this reason, money market investors are
especially sensitive to risk like market risk,
reinvestment risk, default risk, inflation risk ,
currency risk and political risk.
However money market instruments
generally offer more protection against such
risks than most other investments.
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 TypeofRisk Definition
It istherisk that themarket price(value) ofan asset will decline,
MarketRisk resultingin acapital losswhensold. (It issometimesreferred toas
interest raterisk.)

It istherisk that an investor will beforcedtoplaceearnings froma

ReinvestmentRisk loanor securityin toalow-yieldinginvestmentbecauseinterest
rateshavesubsequentlyfallen.

It istheprobability that aborrower will fail tomeet oneor more

DefaultRisk
promisedprincipal or interest paymentsonaloan or security.

It is therisk that increasesin thegeneral pricelevel will reducethe

InflationRisk
purchasingpowerof investor earningsfromaloan or security.

CurrencyRisk T he risk that adverse movements in the price of one national

currency vis-à-vis another will reducethenet rate of return from a
foreign investment. (It issometimescalledexchange-raterisk.)

PoliticalRisk It istheprobability that changesin government lawsor regulations

will reducetheinvestor’sexpectedreturn froman investment.
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 Types of instruments
1. Commercial paper
 Commercial paper is one of the oldest of all
money market instruments.
 commercial paper consists of short term,
unsecured promissory notes issued by well
known companies that are financially strong
and carry high credit ratings.
 Commercial paper is generally issued in
multiples of $1000 and It is traded mainly in
the primary market.
 Opportunities for resale in the secondary
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 Types of Commercial paper
 There are two types of Commercial Paper:
1. Direct Paper: Direct Paper is issued by large
finance companies and bank-holding companies
that deal directly with investors rather than using
a security dealer
2. Dealer (or Industrial) Paper: is issued
mainly by non-financial companies – including
public utilities, manufacturers, retailers,
wholesalers, etc
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2. 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
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 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

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 2. Types of treasury bills
 The major types of Treasury Bills issued
in the money markets:
 Regular-Series Bills - issued routinely
every week or month in competitive auctions.
 The regular series bills comprise: Three-Month
Bills that are auctioned “weekly”. Six-Month Bills
that are auctioned “weekly” and provides the largest
amount of revenue for the treasury. One-Year Bills
that are sold once “each month”.

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 Cont’d
Irregular-Series Bills - issued
only when the treasury has a
special cash need.
Treasury bills do not carry a promised
interest rate, but instead are sold at a discount
from par.
Example: Suppose you purchased a $ 100 basis
(par value) U.S. Government Treasury Bill that
matures in 180 days at the auction price of $97.
What is the discount rate (or DR) on this T-Bill as
per the bank discount method? 14 of 59
Cont’d
DR = Par Value – Purchase Price x 360 Days X 100
Par Value Number of Days to Maturity

DR = (100 – 97) X 360 X 100 = 6% (in Annual Percentage)

100 180

The monetary benefit to be obtained from the bill (in other

words, income from investing in the T-Bill, in this regard,
is:
(100 X 0.06) X 180 = $3
360

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3. 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 dealer
buys back the securities from the
investor at higher price.
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 …
 Thus, Repurchase Agreements are simply
temporary extensions of credit collateralized by
marketable securities.
 Amount the investor or the purchaser pay is
less than the market value of the securities, a
difference called the haircut

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Cont’d
The longer the term, the larger the “hair
cut” will be to protect the lender in case
security prices fall.

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 4. Bankers Acceptances(BA)
BA is time draft or a bill of exchange drawn
on and accepted by a bank with a specified
payment date.
It is used in international trade to facilitate
financing of goods being imported or
exported.
The instrument is called a bankers
acceptance because a bank accepts the
ultimate responsibility to repay a loan to its
holder.

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 ...
Bankers acceptances are sold on a discounted
basis just as treasury bills and commercial
paper. The major investors in bankers
acceptances are money market mutual funds
and municipal entities.
 Investing in bankers acceptances exposes
the investor to credit risk.
 This is the risk that neither the borrower nor
the accepting bank will be able to pay the
principal due at the maturity date.
 The market interest rates that acceptances
offer investors reflect this risk bankers
acceptances have higher yields than treasury
bills.
 The higher yield relative to treasury bills also
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 5. Certificate of Deposits (CDs)
 A certificate of deposit (CD) is a
financial asset issued by a bank or thrift
that indicates a specified sum of money
has been deposited at the issuing
depository institution.
 CDs are issued by banks and thrifts to
raise funds for financing their business
activities.
 A C D bears a maturity date and a
specified interest rate and can be issued
in any denomination. 22 of 59
 ...

 If the depositor chooses to withdraw funds

prior to the maturity date, an early withdrawal
penalty is imposed.
 In contrast, a negotiable C D allows the initial
depositor (or any subsequent owner of the CD)
to sell the C D in the open market prior to the
maturity date.
 Unlike treasury bills, commercial paper , and
bankers acceptances, yields on CDs are quoted
on an interest bearing basis.
 CDs with a maturity of one year or less pay
interest at maturity . 23 of 59
4.2 Capital Market

1. Liquidity:
2. Risk and return:
3. Regulation:
4. Efficiency
5. Diversification:
6. Information transparency:
etc
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1 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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...

 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.
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...
Why issue a bond?
 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
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...
Why issue a bond?
 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
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...
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 29 of 59
...
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.
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...
The issuers
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.
The issuers
 Corporations
 are issued by a business enterprise-
owned by private investors or by a
government.
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...
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.
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 Bond Markets...

Issuing bonds
 a bond can be issued either
through underwriters & dealers or
directly to the investors

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Types of bonds
1.Straight bonds
 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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...
2. Callable bonds
 the issuer may reserve the right to call the
bonds at particular dates
 a bond that is callable is worth less than an
identical bond that is non-callable
3. 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
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...
4. Perpetual debentures
 irredeemable debentures,
 are bonds that will last forever
unless the holder agrees to sell
them back to the issuer.

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 ...
5. 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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4.3 Stock Markets

 where equity claims are traded

 common(ordinary) stock and
preferred stock
 Includes both primary market and
secondary market
 primary market is where IPO( initial
public offering) are issued and also
where seasoned offerings are made
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4.3 Stock Markets
Secondary markets
where stocks once issued are
traded
include floor-based
exchange(NYSE) and electronic-
based exchange.

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4.3 Stock Markets

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4.4 Foreign Exchange
Markets
 Apart from money and capital markets, the
foreign exchange markets are important
category of markets operating in the
financial system.
 markets where currencies of
different countries are traded

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 Exchange Rate
Quotations
Foreign Exchange Rates are prices of
foreign currencies expressed in terms of other
currencies.
In other words, the relationship between the
values of two currencies is called an exchange
rate.

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Cont’d
There are two forms of exchange rate
quotations.
Direct Quotation:
The number of U.S. Dollar required for
purchasing one unit of other currency. E.g. (How
money dollar was required to acquire one birr or
1b= ?$)
Indirect Quotation: The number of foreign
currency that can be purchased for one U.S.
Dollar. ($1=?birr) 43 of 59
 Cont’d
Example 1
If the current exchange rate of Dollar per Pound is
$1.5054/£, then what is the exchange rate of British Pound
per U.S. Dollar?
In this regard, we may determine the exchange rate of Pound
per Dollar as follows:
If $1.5054 = £1(Direct quotation)
Then, $1 = ? £(Indirect quotation)
We can just cross multiply the above values and hence,
obtain the following:
= $1 X £1
$1.5054
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 Types of foreign exchange
There are three markets for foreign
market
exchange of currencies:
1. Spot Market: Forex markets that deal
in currency for immediate delivery.
2. Forward Market: Forex markets that
involve future delivery of foreign currency.
3. Currency Futures Market: Forex
markets that deal in contracts to hedge
against future changes in Forex rates.
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Factors Affecting Foreign Exchange Rates
1. Balance of Payments Position
2. Speculation: expectation about future
currency values.
3. Domestic Economic and Political Conditions
 like Wars & revolutions , Inflation, Recession, and
Labor strikes which have negative impact and
 Rapid economic growth and Industrial
development which have positive impact.
4. Central Bank Intervention
5. Market Forces of Demand and Supply
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End of chapter four

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