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1 slides - overview

  1. 1. Financial Markets and Instruments: An Overview
  2. 2. Objective of this session SA: Financial Markets and Instruments: An Overview To introduce major features of financial markets, market participants, financial securities, and investment process.
  3. 3. Financial Markets SA: Financial Markets and Instruments: An Overview Primary Markets: Deal with Initial Public Offers Versus Secondary Markets: Deal with post IPO securities Money Markets: Deal with short-term securities Versus Capital Markets: Deal with long-term securities
  4. 4. Participants of Financial System SA: Financial Markets and Instruments: An Overview The Government Sector The Household Sector The Business Sector
  5. 5. The Household Sector <ul><li>Concerned with investing their savings </li></ul><ul><li>Interested in a wide array of assets </li></ul><ul><li>Taxes and risk preferences can lead to a widely varying asset demands </li></ul>SA: Financial Markets and Instruments: An Overview
  6. 6. <ul><li>Concerned with raising capital </li></ul><ul><ul><li>Borrow from banks (loan) or households (bonds) </li></ul></ul><ul><ul><li>Take in new partners (issue equity) </li></ul></ul><ul><li>Objectives re issuing securities: </li></ul><ul><ul><li>Get the best possible price </li></ul></ul><ul><ul><li>Low cost of marketing </li></ul></ul>The Business Sector SA: Financial Markets and Instruments: An Overview
  7. 7. The Government Sector SA: Financial Markets and Instruments: An Overview <ul><li>Raise funds to finance budget deficits </li></ul><ul><li>Regulatory roles </li></ul>
  8. 8. Implications of Clientele Demands SA: Financial Markets and Instruments: An Overview Investment Banking Financial Intermediation Financial Innovations Responses to Taxation and Regulations
  9. 9. <ul><li>Banks – borrowing / lending </li></ul><ul><li>Investment companies </li></ul><ul><ul><li>Pooling of resources </li></ul></ul><ul><ul><li>Achieve diversification in investments </li></ul></ul><ul><ul><li>Expertise </li></ul></ul><ul><li>Mutual Funds </li></ul><ul><ul><li>Arise out of the “smallness problem” </li></ul></ul><ul><ul><li>Gain the benefit of large scale trading </li></ul></ul><ul><ul><li>Investment trusts, Unit trusts </li></ul></ul>Financial Intermediation SA: Financial Markets and Instruments: An Overview
  10. 10. SA: Financial Markets and Instruments: An Overview Investment Banking <ul><li>Specialise in selling securities to public on behalf of firms or governments.  </li></ul><ul><li>Advisory role </li></ul>
  11. 11. <ul><li>A security whose value depends on the value of underlying asset. </li></ul><ul><ul><li>Commodity futures </li></ul></ul><ul><ul><li>Derivatives in hedging </li></ul></ul>Financial Innovations SA: Financial Markets and Instruments: An Overview
  12. 12. SA: Financial Markets and Instruments: An Overview <ul><li>Zero Coupon Bonds </li></ul><ul><li>Dual Fund: </li></ul><ul><ul><li>A derivative asset, income and capital shares on a portfolio of stocks are sold separately. </li></ul></ul><ul><li>Eurodollar market : </li></ul><ul><ul><li>Regulation-Q: Limits the bank deposit interest rate. </li></ul></ul><ul><ul><li>Reserve requirement: Foreign branches of the US banks are exempt from reserve requirements. </li></ul></ul><ul><ul><li>These are considered to be the reasons for the emergence of Eurodollars. </li></ul></ul>Responses to Taxation and Regulation
  13. 13. Financial Instruments SA: Financial Markets and Instruments: An Overview <ul><li>Money Market Instruments </li></ul><ul><li>Capital Market Instruments </li></ul>
  14. 14. <ul><li>Treasury bills : Issued weekly by government </li></ul><ul><li>Certificates of deposit : Time deposit with a bank </li></ul><ul><li>Commercial paper : Well-known companies’ unsecured short-term debt </li></ul><ul><li>Bankers’ acceptance : Client writes and bank accepts </li></ul><ul><li>Repos </li></ul><ul><li>LIBOR market </li></ul>SA: Financial Markets and Instruments: An Overview Money market Instruments Short-term, marketable, liquid, low-risk debt securities:
  15. 15. SA: Financial Markets and Instruments: An Overview Capital Market Instruments Longer-term and riskier securities Fixed income market Instruments Instruments for long-term borrowings Government bonds Conventional, Index linked Corporate bonds
  16. 16. SA: Financial Markets and Instruments: An Overview Capital Market Instruments Longer-term and riskier securities Equity market Instruments Ordinary shares Residual claim and limited liability Preference shares Stock market indices Equally weighted / value weighted
  17. 17. SA: Financial Markets and Instruments: An Overview Capital Market Instruments Derivative market Instruments A security whose value depends on the value of another security or asset. Options A security that gives the holder the right to buy (call) or sell (put) an asset at a specified price on or possibly before a specific date. Futures An agreement between two parties to trade a specific asset or security at a future date, with the terms and price agreed upon today.
  18. 18. SA: Financial Markets and Instruments: An Overview <ul><li>Investor borrows part of purchase price from a broker </li></ul><ul><li>Interest charge (broker loan rate) </li></ul><ul><li>Collateral </li></ul><ul><li>Initial margin and maintenance margin </li></ul>Margin Purchase What is meant by buying on margin?
  19. 19. Initial Margin SA: Financial Markets and Instruments: An Overview Initial Margin (IM) is amount required to be deposited with the broker (as % of total value of securities purchased) Actual Margin (AM) = Consider Number of shares purchased (N): 200 Price per share (P): £60 Initial margin requirement (IM): 50% How much the investor could borrow (B)?
  20. 20. Maintenance Margin SA: Financial Markets and Instruments: An Overview Maintenance Margin (MM) is required to minimise the risk of default. When share price declines below certain level MM is called by the broker. Consider N = 200 Purchase price per share: £60 Borrowing: $6000 (initial margin 50%) Maintenance margin: 40% What should be the price for margin call? How much you need to deposit if share price falls to £40?
  21. 21. SA: Financial Markets and Instruments: An Overview <ul><li>Investor borrows stocks to sell </li></ul><ul><li>How about dividend? </li></ul><ul><li>Brokerage firms lend the stocks </li></ul><ul><li>Deposit of sale proceeds </li></ul><ul><li>Margin </li></ul>Short Selling What is meant by short-selling in stock markets?
  22. 22. The Investment Process SA: Financial Markets and Instruments: An Overview Source: Levy and Post (2005). 1. Investor characteristics 2. Investment vehicles 3. Strategy development 4. Strategy implementation 5. Strategy monitoring 5. Strategy monitoring
  23. 23. Investor characteristics <ul><li>Investor should establish an investment policy </li></ul><ul><li>Objectives regarding return requirements, risk tolerance, liquidity requirements etc. should be documented. </li></ul><ul><li>Typical issues to be considered include: </li></ul><ul><ul><li>Investor’s financial situation </li></ul></ul><ul><ul><li>Available resources </li></ul></ul><ul><ul><li>Future investable income </li></ul></ul><ul><ul><li>Future cash-flow needs </li></ul></ul><ul><ul><li>Risk tolerance of investor </li></ul></ul><ul><ul><li>Tax status </li></ul></ul>SA: Financial Markets and Instruments: An Overview
  24. 24. Investment vehicles <ul><li>Securities available for investment purpose include: </li></ul><ul><ul><li>Money-market securities </li></ul></ul><ul><ul><li>Bonds </li></ul></ul><ul><ul><li>Stocks </li></ul></ul><ul><ul><li>Derivative securities </li></ul></ul><ul><li>They offer a trade-off between risk and return </li></ul>SA: Financial Markets and Instruments: An Overview
  25. 25. Strategy development <ul><li>Optimise the investment vehicles and investor characteristics </li></ul><ul><li>Asset allocation </li></ul><ul><li>Security selection </li></ul><ul><li>The strategy developed depends on the investor’s perception re market efficiency </li></ul><ul><ul><li>Markets are efficient: Design well diversified and immunised portfolio. </li></ul></ul><ul><ul><li>Markets are not efficient: Search for mispriced securities. </li></ul></ul>SA: Financial Markets and Instruments: An Overview
  26. 26. Strategy implementation <ul><li>Successful implementation of strategy may lead to complexities due to frequent changes in portfolio. </li></ul><ul><li>Transaction costs (spread, commission, price concessions) could be barriers. </li></ul>SA: Financial Markets and Instruments: An Overview
  27. 27. Strategy monitoring <ul><li>The strategies should be re-valued periodically. Changes may be required due to: </li></ul><ul><ul><li>Changes in market conditions </li></ul></ul><ul><ul><li>Changes in security regulations </li></ul></ul><ul><ul><li>Changes in tax laws </li></ul></ul><ul><ul><li>Suitability of assets allocation strategy </li></ul></ul><ul><ul><li>Changes in investor’s objectives and constraints </li></ul></ul>SA: Financial Markets and Instruments: An Overview
  28. 28. SA: Financial Markets and Instruments: An Overview Z. Bodie, A. Kane and A. J. Marcus, Investments , McGraw-Hill. Chapters: 1,2,3 Levy, H. and T. Post (2005), Investments , FT Prentice Hall. Chapters 1,2 and 3. Essential Readings
  29. 29. Seminar Questions SA: Financial Markets and Instruments: An Overview <ul><li>Discuss how taxes and risk preference of household sector lead to widely varying asset demands. </li></ul><ul><li>Discuss the justifications for the existence of financial intermediaries. </li></ul><ul><li>Outline the major features of prominent financial instruments used in money markets. </li></ul><ul><li>Explain the followings: </li></ul><ul><ul><ul><li>Margin purchase </li></ul></ul></ul><ul><ul><ul><li>Short-selling </li></ul></ul></ul><ul><li>‘ Managing investment is a dynamic and on going process.’ Comment. </li></ul>

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