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  • 1. Financial Markets and Instruments: An Overview
  • 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. 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. Participants of Financial System SA: Financial Markets and Instruments: An Overview The Government Sector The Household Sector The Business Sector
  • 5. The Household Sector
    • Concerned with investing their savings
    • Interested in a wide array of assets
    • Taxes and risk preferences can lead to a widely varying asset demands
    SA: Financial Markets and Instruments: An Overview
  • 6.
    • Concerned with raising capital
      • Borrow from banks (loan) or households (bonds)
      • Take in new partners (issue equity)
    • Objectives re issuing securities:
      • Get the best possible price
      • Low cost of marketing
    The Business Sector SA: Financial Markets and Instruments: An Overview
  • 7. The Government Sector SA: Financial Markets and Instruments: An Overview
    • Raise funds to finance budget deficits
    • Regulatory roles
  • 8. Implications of Clientele Demands SA: Financial Markets and Instruments: An Overview Investment Banking Financial Intermediation Financial Innovations Responses to Taxation and Regulations
  • 9.
    • Banks – borrowing / lending
    • Investment companies
      • Pooling of resources
      • Achieve diversification in investments
      • Expertise
    • Mutual Funds
      • Arise out of the “smallness problem”
      • Gain the benefit of large scale trading
      • Investment trusts, Unit trusts
    Financial Intermediation SA: Financial Markets and Instruments: An Overview
  • 10. SA: Financial Markets and Instruments: An Overview Investment Banking
    • Specialise in selling securities to public on behalf of firms or governments. 
    • Advisory role
  • 11.
    • A security whose value depends on the value of underlying asset.
      • Commodity futures
      • Derivatives in hedging
    Financial Innovations SA: Financial Markets and Instruments: An Overview
  • 12. SA: Financial Markets and Instruments: An Overview
    • Zero Coupon Bonds
    • Dual Fund:
      • A derivative asset, income and capital shares on a portfolio of stocks are sold separately.
    • Eurodollar market :
      • Regulation-Q: Limits the bank deposit interest rate.
      • Reserve requirement: Foreign branches of the US banks are exempt from reserve requirements.
      • These are considered to be the reasons for the emergence of Eurodollars.
    Responses to Taxation and Regulation
  • 13. Financial Instruments SA: Financial Markets and Instruments: An Overview
    • Money Market Instruments
    • Capital Market Instruments
  • 14.
    • Treasury bills : Issued weekly by government
    • Certificates of deposit : Time deposit with a bank
    • Commercial paper : Well-known companies’ unsecured short-term debt
    • Bankers’ acceptance : Client writes and bank accepts
    • Repos
    • LIBOR market
    SA: Financial Markets and Instruments: An Overview Money market Instruments Short-term, marketable, liquid, low-risk debt securities:
  • 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. 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. 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. SA: Financial Markets and Instruments: An Overview
    • Investor borrows part of purchase price from a broker
    • Interest charge (broker loan rate)
    • Collateral
    • Initial margin and maintenance margin
    Margin Purchase What is meant by buying on margin?
  • 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. 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. SA: Financial Markets and Instruments: An Overview
    • Investor borrows stocks to sell
    • How about dividend?
    • Brokerage firms lend the stocks
    • Deposit of sale proceeds
    • Margin
    Short Selling What is meant by short-selling in stock markets?
  • 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. Investor characteristics
    • Investor should establish an investment policy
    • Objectives regarding return requirements, risk tolerance, liquidity requirements etc. should be documented.
    • Typical issues to be considered include:
      • Investor’s financial situation
      • Available resources
      • Future investable income
      • Future cash-flow needs
      • Risk tolerance of investor
      • Tax status
    SA: Financial Markets and Instruments: An Overview
  • 24. Investment vehicles
    • Securities available for investment purpose include:
      • Money-market securities
      • Bonds
      • Stocks
      • Derivative securities
    • They offer a trade-off between risk and return
    SA: Financial Markets and Instruments: An Overview
  • 25. Strategy development
    • Optimise the investment vehicles and investor characteristics
    • Asset allocation
    • Security selection
    • The strategy developed depends on the investor’s perception re market efficiency
      • Markets are efficient: Design well diversified and immunised portfolio.
      • Markets are not efficient: Search for mispriced securities.
    SA: Financial Markets and Instruments: An Overview
  • 26. Strategy implementation
    • Successful implementation of strategy may lead to complexities due to frequent changes in portfolio.
    • Transaction costs (spread, commission, price concessions) could be barriers.
    SA: Financial Markets and Instruments: An Overview
  • 27. Strategy monitoring
    • The strategies should be re-valued periodically. Changes may be required due to:
      • Changes in market conditions
      • Changes in security regulations
      • Changes in tax laws
      • Suitability of assets allocation strategy
      • Changes in investor’s objectives and constraints
    SA: Financial Markets and Instruments: An Overview
  • 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. Seminar Questions SA: Financial Markets and Instruments: An Overview
    • Discuss how taxes and risk preference of household sector lead to widely varying asset demands.
    • Discuss the justifications for the existence of financial intermediaries.
    • Outline the major features of prominent financial instruments used in money markets.
    • Explain the followings:
        • Margin purchase
        • Short-selling
    • ‘ Managing investment is a dynamic and on going process.’ Comment.