FINANCIAL MARKET

FINANCIAL MARKET

MONEY MARKET

CAPITAL MARKET

PRIMARY MARKET

SECONDARY MARKET

FINANCIAL MARKET
A financial market is a mechanism that allows people and entities to buy and sell (trade) financial securities (such as stocks and bonds),commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect supply and demand.

Stock Exchanges
Stock Exchanges provide a market for the trading of securities to individuals and organizations seeking to invest their saving or excess funds through the purchase of securities. Market Provider Market Facilitator Market Regulator Market Controller

Stock Exchanges

stock exchanges were established for the purpose of facilitating, regulating and controlling the business of buying and selling securities.

MONEY MARKET
The money market is a component of the financial markets for assets involved in shortterm borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit, federal funds, and short-lived mortgage and assetbacked securities.
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Individuals may not be able to raise money from the capital market as they can do in the money market.

CAPITAL MARKET

It is that section of the financial system that is involved in providing medium & long-term funds for productive use. The capital market therefore provides an option for governments and companies to raise investment capital for the construction of waterworks, bridges, schools and factories and purchase of vehicles, facilities and equipment using such financial instruments such as equities and bonds. Capital Market Structure can be broadly divided into four categories:1.

2. 3.

4.

Provider of funds (investors individuals, Unit Trusts/mutual funds, pension funds and other institutional investors) Users of funds (companies and governments and their agencies.) Intermediaries (facilitators stock broking houses, issuing houses, registrars, etc.) Regulators (Government Regulatory Agencies, such as SEC, and the Central Bank and self Regulatory Organization such as The Nigerian Stock Exchange)

As can be seen in the capital market, the providers of funds comprise individuals and corporate bodies, the users of funds (issuer of securities) are expected to be only companies and governments.

Type of capital market

1. Primary Market 2. Secondary Market

Primary Market:In the primary market, new instruments are sold for cash through investment agents. The funds are then used for capital investment in form of retiring outstanding securities of the company, financing new plant or equipment, secure additional working capital, install modern IT infrastructure, branch expansion etc.

Cash generated goes to the issuing company.

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Secondary Market: Only existing securities are traded. The existence of the secondary market where existing securities can be bought and sold enhances the efficiency of the flow of savings in an economy.

Cash generated goes to the selling investors.

Instruments Traded in the Capital Market
Instruments Fixed Income Securities
(A)Bonds Debentures(Unsecured bonds) Mortgage-Backed Securities (B) Asset-Backed Securities

Variable Income Securities

(A)Equities (B)Preference shares(Equities + Bonds) (C)Derivative Securities

Fixed Income Securities

(A)Bonds:

A bond is a security (similar to *IOU) issued in connection with a borrowing arrangements which obligates the issuer (bond issuing company) to make specific payments (coupon payments) to the holder over a period of time usually semi-annually.

Types of Bond: Government Bonds Corporate Bonds

Government Bonds
Federal Government Bonds State Government Bonds Local Government Bonds Municipal Bonds/Notes Agency Bonds

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CORPORATE BONDS
Debentures(Unsecured bonds) Mortgage-Backed Securities Mini-Coupon and Zero-Coupon Bonds Callable/Non Callable Bonds Bearer Bonds Book-Entry/Bonds General Obligation Bonds Revenue Bonds [content not available ]

FEATURES OF BONDS:PAR VALUE -Amount paid to the stockholder on maturity of the bond. -Discount or premium COUPON INTEREST -Annual/Semi-annual Naira interest paid to the bondholder MATURITY DATE -The date on which the issuer is obligated to pay the bondholder SINKING FUND -Periodical application of money towards redemption of the Bonds before maturity

Why would Investment in Bonds be Appropriate?

Investors seeking steady cash flow. Investors who do not have an immediate need for the sum invested. Bonds are excellent vehicle applicable in portfolio diversification.

Attraction of Bonds over Equities

They are loans repayable over a relatively long period of time, hence frees the issuer from short term funding problems thereby permitting long term capital investment. The interest charge paid by the issuing firm is deducted as an expense from profits before the computation of corporate taxes (tax deductible). Interest on bonds are typically paid semi-annually while equity holders are risk bearers In the extreme case of liquidation, bondholders are creditors; hence have a claim ahead of equity holders.
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(B)Asset-Backed Securities: These are securities issued by a special purpose

company that holds a package of low-risk assets whose cash flows are sufficient to service the bonds. Hence, instead of borrowing money directly, Companies sometimes bundle up a group of assets and then sell the cash flows from these assets. It is these securities that are known as asset-backed securities. Various assets are used as collateral.

Variable Income Securities

(A)Equities (Ordinary shares/ common stock/ variable income securities)
There are two sources of return to ordinary share investors: Cash Dividend 1. dividend Stock Dividend 2. Capital gains Instead of (and sometimes in addition to) cash dividends, investors are paid stock dividends which translates to more shares. Holders have claims upon the residual profits of a company Holders possess limited liability i.e. A shareholder is not liable for the debts of the company beyond the amount of capital contributed. Unless the shareholder owe the company some unpaid subscription on the shares. Equity holders rank last in the distribution of the companys assets in the event of bankruptcy or liquidation. Holders have rights to vote at meetings.

Benefits of Investing in Equities:An investor derives the following benefits: Participate in the fortunes of the company through dividends- which forms part of the companys profit Growth in portfolio through bonus shares extra shares fully paid out of reserves which are distributed to existing shareholders Growth in portfolio through capital appreciation i.e. as market prices of equities increases Right to attend and vote at shareholders meetings Use of share certificate as collateral for borrowings The feeling of satisfaction in contributing to business and economic growth Equity investments enable people to save with ease. Such savings are automatically put to work for their owners. Avoid the adverse effect of inflation on savings as equities over a long period of time produce compound yields that exceed the rate of inflation
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(B)Preference shares (Combine Feature Of Equities & Bonds)

These are non-voting shares in a company, usually paying a fixed stream of dividends. Popularly known as Preference shares, they have features similar to both equity and bonds. They promise to pay a specified stream of dividends each year. Unlike Bonds, failure to pay the promised dividend does not result in corporate bankruptcy. Instead dividends accumulate but ordinary share holders do not receive any dividends until the preferred stockholders have been paid in full. On liquidation, they rank after bondholders but before ordinary shareholders.

(C)Derivative Securities
A derivative instrument is a contract between two parties that specifies conditions (especially the dates the resulting values of the underlying variables) under which payments, or payoffs, are to be made between the parties. Derivatives are broadly categorized by the relationship between the underlying asset and the derivative contract. UNDERLYING ASSET foreign exchange interest rate derivatives derivatives (one of the largest)

equity derivatives

commodity derivatives

credit derivatives

Other examples of underlying exchangeable are:

Property (mortgage) derivatives Economic derivatives that pay off according to economic reports as measured and reported by national statistical agencies Freight derivatives Inflation derivatives Weather derivatives Insurance derivatives Emissions derivatives DERIVATIVE CONTRACT Future contract Forward contract Option contract Swap contract EXCHANGE TRADE Over-The-Counter Trade

Exchange Trade

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Some common examples of these derivatives are the following:CONTRACT TYPES UNDERLYING Exchange-traded futures Exchange-traded options OTC swap OTC forward OTC option

Equity

DJIA Index future Single-stock future

Option on DJIA Index future Equity swap Single-share option

Back-to-back Repurchase agreement

Stock option Warrant Turbo warrant

Interest rate

Option on Eurodollar Eurodollar future future Interest rate Euribor future Option on Euribor swap future

Forward rate agreement

Interest rate cap and floor Swaption Basis swap Bond option

Credit

Bond future

Option on Bond future

Credit default swap Total return swap

Repurchase agreement

Credit default option

Foreign exchange

Currency future

Option on currency future

Currency swap Currency forward

Currency option

Commodity

WTI crude oil futures

Weather derivatives

Commodity swap

Iron ore forward contract

Gold option

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Over-The-Counter trading: Over-the-counter (OTC) derivatives are derivatives contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge fund Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. According to the Bank for International Settlements, the total outstanding notional amount is US$708 trillion (as of June 2011) Interest rate contracts = 67%, Credit default swaps (CDS) = 8% Foreign exchange contracts = 9%, Commodity contracts = 2%, Equity contracts = 1%, and 12% are other.

Exchange-traded derivative contracts (ETD):

Exchange-traded derivative contracts are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange. A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee. The world's largest derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex(which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and

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the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange). Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.

Derivatives are used by investors for the following:

1. Hedging 2. Speculation 3. Arbitrage Hedging: Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available because of events unspecified by the contract, such as the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counter-party risk.
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From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: the farmer reduces the risk that the price of wheat will fall below the price specified in the contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional income that he could have earned). The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than he otherwise would have) and reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the counter-party is the insurer (risk taker) for another type of risk. Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and can then sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset. Another example: If a stockiest is purchasing gold, the stockiest will simultaneously sell a future contract of an equivalent quantity. This way two contracts will together protect the stockiest from price fluctuation of gold prices go up. The stockiest gains by way of profit on the stock held and if price falls the stockiest gets a profit the future contract sold at the time of buying physical good. A corporation borrows a large sum of money at a specific interest rate. The rate of interest on the loan resets every six months. The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a forward rate agreement (FRA), which is a contract to pay a fixed rate of interest six months after purchases on a notional amount of money. If the interest rate after six months is above the contract rate, the seller will pay the difference to the corporation, or FRA buyer. If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings.

Speculation:
Speculators enter into the market after a deep research of the fluctuation of the market. A Speculator makes profit by the routine market momentum. A market cannot stabilize at the fair price of assets. The market has a tendency to overprize assets when there is the buying frenzy and under prize assets when there is selling pressure. Speculator can calculate a particular assets price has got distorted due to buying frenzy or selling pressure. Speculators ready to bear the risk, they start betting that the party seeking insurance will be wrong about the future value of the underlying asset. Therefore, speculators look to buy an asset in the future at a low price according to a derivative contract when
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the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low.

Arbitrage:
An arbitrage is a trade undertaking to profit from the price difference between the same assets in two different markets. The arbitrage buys from the undervalued market and simultaneously sells in the overvalued market.

DERIVATIVE CONTRACT 1. 2. 3. 4. 5. Forward contract Future contract Option contract Swap contract Warrants contract

Forward contract (Forward contract regulation Act 1952 FCRA [1952])

Over the counter trading Contract between two parties, where payment takes place at a specific time in the future at todays pre-determined price. Gains and losses are based on the performance of some underlying assets. Settlement date is later than 11 days from the date of contract. Settlement of contract occur at the end of the contract. Highly flexible which gives liberty to parties for buying and selling. Negotiable and decided terms and conditions as per the parities mutual convenience or agreements. Forward contract types Repurchase agreement Forward rate agreement

Back-to-back Repurchase agreement

Currency forward

Iron ore forward contract

Future contract (Standardized contract)

Almost same as forward contract because this is not defined separately by FCRA. Its an Exchange-traded contract; therefore, all terms and conditions are pre-specified by the exchange (except price and quantity of assets to be traded). Since exchange is involved therefore no chances that a party may default on its side of agreement.
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 Future contract are mark-to-market which means daily changes are settled day by day until the end of the contract.

DJIA Index future Single-stock future

Future contract types Bond future Currency future WTI crude oil Eurodollar future futures Euribor future

Option contract
Options are contracts that give the owner the right, but not the obligation, to buy (call option) or sell (put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option.

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