Topic: Financial markets and exchanges

Lecture overview

• What: instruments• Where: exchanges• How: delivery

Financial instruments

• In order to gain understanding of financial markets first we have to define financial markets and particular instruments which are which are traded on those markets.

• We have to know the basic characteristics of those instruments and which are the basic characteristics of those markets.

Financial Instruments • Financial instruments are special documents which have their particular legal

significant and material value.. • Based on the construct of a particular instruments, they give us rights and

obligations pertaining to the subject of a particular instrument.. • Financial instruments can then be a special document with particular properties: • Ownership (share): to own a share (sometimes called a stock) is to own a portion

of a company.• Debt (bond): to own a bond means to have receivables. To issue a bond means

to be in debt towards another party. • Transaction (bill of exchange): bill of exchange can be used to guarantee a

transaction, a payment between participants in the economy. • Possibility (options): option gives us right to buy or sell a certain asset. In terms

of trading, option gives us a possibility to enter into a position. • Merchandize (futures): using futures contracts we can buy or sell certain goods

right now, but take delivery at some future time.

Financial Instruments • We can split financial instruments based on their importance. This

is not a balance sheet split which is simple: balance sheet and off balance sheet instruments.

• We can differentiate between primary and secondary financial instruments:

• Primary instruments: – Financial assets (bill of exchange)– Financial obligations (debt)– Instruments of ownership (stock)

• Secondary instruments – Financial derivatives

Evaluation• One of the main differences between primary and secondary

instruments is in the way their market value is determined. • Primary instruments are valued through markets through supply

and demand. • Secondary financial instruments are also valued through supply

and demand, but their value also changes when the value of the underlying instrument changes. This is relation is the process of evolution is why those instruments are called derivatives: their value is derived through the value of the underlying instrument.

• Financial derivatives are called derivation because they are created based on another instrument, just like gasoline is derived from oil.

Term• Special classification of financial instruments is base on the term of

financial instruments. This is particular important for investors. • The term definition of financial instruments is:

– Short term: maturity up to 1 year (Treasury bills)– Medium term (Treasury notes, 2-5 years)– Long term (bonds)– perpetual (perpetuities, stocks)

• It is important to know the term implications for a particular instrument.

• We can use the time life of a particular instrument when we perform our risk calculations.

• The longer the time horizon, there is a greater possibility issuer will encounter problems.

Primary markets• Financial instruments have their life cycle: the way they are created and the

way they die. • Based on the way financial instruments are created and live we can create a

following split: • Primary markets

– These are the markets where financial instruments are created. – This is the market where the first transition is made (just the first one) between the

issuer of the instrument and the first buyers of the instruments. This is usually done through the intermediary.

• Secondary markets– These are the markets where transactions and change in ownership between the

investors. – These markets are where all other transaction after the issuance of the instruments

occur. • This however does not hold for the derivatives. The process of primary and

secondary markets is not applicable for derivatives since there is not clear distinction between primary and secondary derivatives markets.

Organization• Market is a „place” where transactions occur. The „place

” does not necessarily has to be physical space or surroundings.

• Organized market implies a clearly defined institution which has a clear rules and conditions regarding participating in the market and market participants.

• Incorporated exchanges are by definition an organized markets.

• Apart from the organized markets there are also markets which are not organized. These markets are called over the counter markets or OTC.

Exchanges in theory• Based on what is being traded on exchanges we can split

them into:

• Effective exchanges (security exchanges),• Foreign currency exchanges FX,• Gold exchanges,• Money market exchanges, (money and short term debt

exchanges)• Diamond exchanges,• Commodity exchanges for services.

Types of exchanges – traded items • Security exchanges deal will all kinds of stock certificates and

hybrid stock instruments. The instruments traded on the exchange are determined through special bylaws and regulation of the exchange.

• Foreign exchange exchanges usually trade convertible currencies. These exchanges sometimes also trade money market instruments and or short term debt.

• Money market exchanges usually trade liquid currency in various time buckets, but mostly shot with short term maturity. Sometimes these exchanges will also trade short term highly liquid papers or money equivalents like: repos, T-Bills, certificates of deposit.

Types of exchanges – traded items • On gold exchanges the main object of trading and gold bullion or

ingots and on diamond exchanges the main object of trading are diamonds..

• Commodity exchanges are specific exchange which specialize in trading of actual goods. The main point of exchange traded goods is that the goods traded have to have a certain quality and uniformity.

• In case of commodity exchanges, the actual object of trade is usually on physically present in the market. In case of forward markets the goods do not have to exist at the time of the transaction.

• On commodity exchanges we can usually find basic goods or commodities in their raw form. We can split them: – Agricultural products: gains, cocoa, sugar, lumber and so on. – Mining products like base metals (copper, led, tin) and other commodities

obtained through mining like oil or natural gas.

Exchanges for services• Exchanges for services are highly specialized exchanges – markets for

certain types of services.• The term „exchange” here is just a nominal term since these types of

exchanges function more like places where supply and demand for certain corporate services meet. And the exchange serves more as a go-between, not a real exchange. – Transport capacity exchanges, these exchanges organize supply and demand for

tanker, railroad and air transports. – Transport and storage insurance exchanges exist in places known for large

international trade and significant amount of transport (London, Hamburg, Rotterdam et al.) where participants by and sell insurance for goods transported or stored. This is mostly done for goods which are transported though sea.

– Cooperative exchange where participants can find cooperators and offer cooperative services for companies with similar business activities.

Geographical separation• Based on exchange importance and their relative impact we can use

geographical split:• Local, these are regional exchanges where goods and participants

come from a particular region. • National: these exchanges work on a national level and their impact

is within just one nation. Most of their participants and objects traded are national.

• Regional exchanges have participants from several local countries and objects of trading come from several different countries.

• International, exchanges are the largest exchanges with international and or global impact. Most of these work as large exchange groups which own several exchanges on different continents like ICE or CME.

Exchanges and time

• One of the most important characteristic of exchanges is time. Here we have to main types of exchanges:

• Spot exchanges: are exchanges where trading is

immediate and the exchange of goods is right after trade or in a short period of time.

• Future or forward exchanges are exchanges where trade occurs at the present price, but the delivery occurs at some predefined future time as defined by the contract.

Index• Different exchanges trade different instruments. • For most participants in the economy it is often important to know

what is happening with the values of certain instruments or with a value of a group of instruments. – What has been the overall trend of stocks in recent time (a year)?– What were the changes in the values of tech stocks?– What is the recent trend in the value of gold?

• Precisely since it is important for lots of economic participants to know what is going on with values of certrain instruments the exchanges have to communicate the changes in values with the general public.

• The easiest way to establish such communication is through an index.

Index• In order to be able to answer the investor’s questions the

exchanges usually create and index which reflects the average values of certain instruments or goods.

• For the index we could say it represents the sum of the values of instruments or goods traded on the exchange.

• The best classification of indices is based on the types and characteristics of the instruments which can be found in the index: – Stocks– Bonds– Commodities– Gold– Oil

Types of indecies

• We can split indices into two basic types: – Linear index: this type of index is just a summation of the value

of instruments in the index– Weighted index: to each particular instrument a value is added.

This gives the creator an ability to adjust the significance of a particular instrument or security.

• Linear index is just a summation of particular values, regardless of the importance of stock. On the other hand weighted index gives a more precise picture of the overall changes since individual weights allow to particular value adjustments within the index.

Impotance

• As mentioned the indices are often in media. • The best know indices are: Nasdaq, S&P 500, Dow Jones.• A well known commodity index is: Dow Jones-UBS Commodity

Index.• Most exchanges have their own index: CAC, DAX, MIB, CROBEX.• Large and important exchanges also have smaller indices which

cover a particular sector of the economy. • Indices are also important for mutual funds, because there are any

funds which try to mimic in their composition the value of the index. • When investing in index funds the investor has the equivalent or

purchasing all securities in the index, but for smaller amount of money and with less transaction costs.

Financial markets and financial instruments

• We have explained financial exchanges.• Now we can get to know financial instruments

and their properties • We will get to know basic security and derivative

instruments. • First we will cover balance sheet instruments,

then we can move onto derivative instruments.

Stock exchanges• First we have to address the word capital. When we are talking

about capital markets we are not necessarily talking about the accounting (capital in the balance sheet). Capital element of the balance sheet contains other items apart from the stockholder’s equity.

• The stock exchanges usually trade just stock holder’s equity. However this balance sheet distinction is particularly important.

• Capital in the balance sheet is on the side of the liabilities, therefore is it an obligation towards the owner of the company.

• Trading shares is a process which changes the ownership structure of the company. Increasing the amount of shares owned, increases the overall ownership of the company.

Why did the stock markets develop?

• The reason why the stock markets have been created has simple and fundamental logic of supply and demand.

• There were two sides, one side had too much funds and wanted to utilize those funds, on the other side there was a need for funds.

• Equilibrium of supply and demand resulted in the creation of capital markets.

• The best way for us to fully understand why capital markets have developed is to look at two simple examples.

Example 1• If one person owns 100% of shares, that means the corporation is

under control of only one individual. • The whole corporation lies on only one set of shoulders. The

ownership of the corporation represents property, but this property is not liquid.

• The fact that only one individual owns a company means that individual can get all the dividends, but it also means that only one individual has to increase the capital if there is a need for more capital.

• The problem of liquidity, ownership, sources of new capital in this particular case all represent constraints for the corporation.

• To be your own boss sounds good, but if the corporation does not have enough capital, it can not grow.

Example 2

• Let us now look at another alternative example. • Let us say that someone has a great business

idea, but does not have enough funds to bring the idea into fruition.

• One of the ways to obtain funding for the development of the idea is through the capital markets.

• Investors who concur on the idea can invest in business plan and share in the profits.

Implications of examples• From the two examples we can see how the capital markets have developed.

• The first examples gives us an owner who whishes to obtain liquidity from its property by selling a portion of ownership on the stock exchange.

• The second examples shows how investors with extra funds (savings) gave their extra savings to participants in the economy which needed funds. Of course this is based on assumption the investment will eventually be profitable.

• Ultimately you should always keep in mind the supply and demand which exist on the capital markets. Those who have extra funds invest by purchasing ownership. To have ownership implies to have a portion of responsibility, but also a right to partake in profits.

• Successful investors can differentiate goods investments from bad and maintain long term profitability. This basically boils down to knowing when to invest and when to hold off investments.

Stock• Stocks represent ownership.• In terms of voting rights there are two types of stocks:

– With voting rights– Without voting rings

• We can also split shares based on dividends– Preferred: shares have preferences in terms of dividends. Dividends are

first paid out to the owners of preferred shares, then to the owners of the regular shares. This is the reason these types of shears are called preferred: the dividend first goes to them.

– Regular: dividends are paid out of there is enough net income.• If a share exists, that does not mean it is publically traded. • Shares can be exchange listed, or they can be traded OTC.

Debt exchanges• Debt is traded through a clearly defined instruments.

• We have to point this out since on exchanges is not possible to trade all forms of debt. However there exists a market for trading financial obligations.

• One of the best examples of a debt which is not treaded on exchange is a loan. Loan is just like a bond in most of its properties, but it is not treaded on exchanges. That does not mean a bank can not sell their loans, but it does not make sense to list a trade a particular loan. That is why the loans get converted into bonds and then they are treaded.

• The best known „prepackaged” loans are mortgage-backed securities by government agencies like Fredie mac or Fannie mea.

Debt instruments• Debt instruments are usually separated based on the term and issuer:

– Short term 3m – 2y: Treasury bills (government), commercial papers (corporation).

– Medium term 2y – 10y: notes– Long term: bonds

• Based on the interest paid over the life of the bonds we have: – Coupon: interest is paid over time in form of a coupon– No coupon: interest is not paid over time.

• Listed debt instruments are exchange traded (Croatia), others are traded OTC (government bonds USA).

• With bonds it is important to know that price of bonds will change with the changes of supply and demand, but it will also change with the changes of the overall level of the interest rates in the economy.

• Here comes in the bond yield: this is the actual return you get on investing in bonds.

„Places” of trading• Debt instruments are traded on both :

• Organized exchange markets • OTC (over the counter markets)

• Exchanges are organized markets where particular debt is issued. Debt trading is just like trading stocks.

• OTC is a special kind of market, which is not organized in form of corporation, but it is a network of traders using online connection to trade.

Reasons for issuance

• Usually debt instruments will have a clearly defined and stated reason for issue.

• There are three main reasons to issue debt. The reasons depend on the needs of the issuer.

• Short term liquidity• Project finance• Changes in the issuer’s term structure

Reasons for issuance• The first two reasons for issuance are obvious. The debt issued is

using debt to consolidate its cash flow or to use money for an investment activity.

• The third reason is a little more complex. • Corporations just like banks have to control their term structure. In

case a corporation has large amount of short term liabilities and short term liquidity of the corporation is unstable, the corporation should issue long term debt and use proceeds from the debt issuance to pay off short term liabilities.

• Using this the corporation changes the term structure of its debt. • The first reasons for debt issuance have significant effect on the size

for the balance sheet, the third reason for issuance does not.

Characteristics of bonds• Just like any other instruments bonds have also several important

characteristics . • The most important of those are:

• Issuer: who has issued debt instrument: government, corporation, municipality.

• Term: what is the length of the instrument: short term, medium term, long term.

• Payment form: On what form will the repayment occur. • Currency: what is the currency of debt: local or foreign.• Cash flow: what is the way the interest and principals are paid off

over time.

Derivaties

• The process of derivatives creation and the roles of derivatives as instruments is significantly different from stocks and bonds.

• Precisely because of this we have to approach derivatives in a different way from stocks and bonds.

Derivatives• Derivate is a financial instrument whose value and properties are

derived from another usually financial instrument. • Because of this we says derivatives are derived from other

instruments.. • Based on the underlying instrument we have:

– Stock derivatives– Debt derivatives– Derivatives on derivatives (SWAPions, options on futures)

• Derivatives do not have an exact formula for calculation, rather they have models for price prediction. This is why the actual value of the derivative can significantly differ from the value given by model. In case of derivatives, theory and practice rarely coincide.

Forward• Forward is a contract which obliges sides or parties engaged in

forward contract to some future transition. • Forward is a derivative contract, usually between two sides. • Forwards are usually not exchange traded since the terms and

structure of the forward contract can be defined and negotiated between the parties. .

• Because of the way they are traded forwards do not have standardized form.

• The basis for the calculation of the value of the forward contract is a no arbitrage theorem.

• Forwards are mostly based on FX. • It is important to note that forward is a second leg of a FX SWAP.

Futures• Futures contract is a standardized contract where one side

agrees to purchase a certain, clearly defined asset and the other side agrees to sell a certain asset at some point in time.

• Based on their characteristics futures contracts always have two sides: one side which is buying and the other side which is selling.

• Futures are exchange traded instruments. • Exchanges always clearly define the quantity, quality and

characteristics of futures contracts. • In case there is not futures contract for a particular good,

then it is not possible to trade that good on that exchange.

Option• Option is a derivative instrument through which we either buy or sell

a right to purchase or sell a certain underlying instrument: – Call option: right to buy– Put option: right to sell

• Options exist on most financial instruments. The basic options are stock options, but also highly popular are options on futures contracts.

• Options can also be used to create a derivative instrument based on derivative instrument, so you have derivative of a derivative like options on futures or SWAPs.

• Options are traded on exchanges, just like other financial instruments. Options just like futures have their characteristics: time until expiration, clearly defined underlying instrument.

Futures contract example

Contract specification