Superior University Lahore

FINANCIAL MARKETS & INSTRUMENTS

Introduction of Financial Markets

Financial

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 Assets
Financial 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 rights Equity Markets: Deal with Securities with ownership rights On the Basis of Maturity of Claims Money Markets: Market for short term securities Capital Markets: Market for long term securities

Notional Classification of Financial Markets

On the Basis of Seasoning of Claims Primary Markets: These deal with newly issued securities Secondary Markets: These deal with previously issued securities On the Basis of Immediate or Future Delivery Cash or Spot Markets: Where assets are traded for immediate delivery Derivative Markets: These provide the right to buy securities at some future date.

Notional Classification of Financial Markets

On the Basis of Organizational Structure Auction 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 Markets

Liquidity: 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 Markets

Price 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 Markets
Adjustable 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 Markets

Raising 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 Measures

Globalization 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 Measures

External/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 Markets

Inflation: 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 Investors
Driving Force behind financial markets is the desire

to earn a return on investors. The return has two components:

Yield Capital Gains

The investors are of the following types: Individuals Investors Institutional Investors

Types of Investors
Institutional Investors are of the following types: Mutual Funds Hedge Funds Insurance Companies Pension Funds Financial Institutions

FOREIGN EXCHANGE MARKETS

Foreign Exchange Markets

Prices 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 Markets

If 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 exchange As a Commodity

Foreign Exchange Markets

The 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 Markets

The

participants markets:
Importers Investors Speculators Governments

of

foreign

currency

and Exporters

Foreign Exchange Markets

Settlement:

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 Markets
The term money market refers to the network of

corporations, financial institutions, investors and governments which deal with the flow of short term capital.

Money Markets
When 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 Markets
Intermediation:

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 Market
Properties 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 Market
Reversibility: 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 Market
Convertibility: 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 Market
Return 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 Markets
Capital

Markets are following dimensions:

Bonds

discussed

in

the

Markets Equity Markets

Bonds Markets
The 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 Markets
Types 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 Markets
Perpetual 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 Markets
Properties of Bonds: Maturity Coupon Current Yield= Annual Coupon interest/Current Price Yield 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.