CHAPTER - 4

Financial Markets In The Financial System

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 Financial Markets

• Financial market is a system or an institution where financial

assets or instruments are created and exchanged by market
participants.
The major participants of financial Markets can be grouped
into two:
 Lenders (Surplus Units) that include individuals, households
and some corporation.
 Borrowers (Deficit Units) that include Individuals, Companies,
Central Government, Municipalities, Public corporations.
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 Major Functions of Financial Market
 Financial markets facilitate the transfer of savings

from savers to investors

 It provides liquidity to financial assets

 A Financial market provides a pricing information

 It helps to save money, time and efforts of both buyers

and sellers

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 Classification of Financial Market
The flow of funds through these markets may

be divided in to different markets segments

depending upon the characteristics of
financial claims being traded and the needs of
market participants.

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 1. Classification by type of financial claim:
• Equity (Stock) market
• Debt market
2. Classification by maturity of claim:
− Money Market- which provide short term debt
financing and investment.
− Capital Market- the market for debt and equity
instruments with a maturity of greater than one
year (Bond and Stock Markets).
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 3.Classification by origin:
− Primary Market- markets dealing with financial
claim that are newly issued.
− Secondary Market- markets dealing with
previously issued financial claims.
4. Classification by organizational structure.
• Exchange market- physical location where
transactions are carried out on a trading center.
Traders may enter verbal bids and offers
simultaneously. Example, New York Stock
exchange, AMX
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 • Over The Counter (OTC) market- In which dealers at

different locations who have an inventory of securities stand

ready to buy and sell securities ―over the counter‖ to anyone

who comes to them and is willing to accept their prices.

………Over-the-counter dealers are in computer contact.

Composed of a network of computers where trades made

electronically via traders. Example, NASDAQ

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 Over The Counter (OTC) Market

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 5. Other Classifications:
• Commodity markets- which facilitate the trading
of commodities (such as ECX of Ethiopia).
• Foreign exchange markets- which facilitate the
trading of foreign exchange.
• Derivatives markets- which provide instruments
for the management of financial risk.

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 →The Money Market is designed for short-term

(one year or less) loans.

→The money market is where short-term
obligations (money market instruments) such
as Treasury bills, commercial paper and
bankers' acceptances are bought and sold.
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 £ Participants borrow and lend for short

periods of time, typically up to one year.

£ The MM is the mechanism through which

holders of temporary cash surpluses meet

holders of temporary cash deficits.

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  The money market arises because for most

individuals and institutions, cash inflows and

outflows are rarely in perfect harmony with
each other,
…….and again the holding of idle surplus
cash is expensive.
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 Money market investors seek mainly safety and
liquidity, plus the opportunity to earn some interest
income.

…Because funds invested in the money market represent

only temporary cash surpluses and are usually needed in
the near future, money market investors are especially
sensitive to risk.
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 Money market instruments generally offer more
protection against many types of investment risks.
− Prices are stable as compared to long-term securities.

− Such securities are actively traded (superior liquidity).

− Do not offer significant capital gains for the investor.

− Do not entail substantial capital losses as well.

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 Default risk is minimal in the money market.
Money market instruments also provide some
hedge against political risk.
–Fewer changes in government policy &
regulations are likely expected in the short run.

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  Treasury bills are

− Securities issued to meet the short-term

financial needs of the government.

− Are government IOUs.

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 − T-Bills are generally regarded to be risk free

instruments since the government guarantees

to pay their face value upon maturity.
− They are highly liquid

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 A treasury bill is a discount security,
that is, upon issue the security is sold at
a discount to its face value. Since a bill
makes no coupon payments, the holder
expects to gain from capital
appreciation.
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 

 CPs are unsecured promissory notes issued by

companies with strong credit rating to raise short-term
cash often to finance working capital requirement
− has a fixed maturity;

− usually sold at a discount from face;

− Issuer pays the face value to holders of the security at

maturity.

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 
− Acceptances is a vehicle created to facilitate trade
transactions.
− Acceptances is a time draft payable to the seller of
goods with payment guaranteed by bank.
− Acceptances are used in international trade because
most exporters are uncertain of the credit standing of
their importers.
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  The capital market is designed to finance the

long-term investments by businesses,

governments, and households. The
transactions taking place in this market will
be for periods over a year

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 The capital market comprises:
• Long-term debt market
• Corporate stock (equity) market

− Funds raised in the capital markets makes possible

the construction of factories, highways, and the like.

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  Debt obligation is a financial instrument whereby

the borrower promises to:

− Repay the face amount of the obligation by the

maturity date.
− Make periodic interest payments to the holder of the debt

obligation (lender).

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 • Debt securities include:
− Bonds
− Notes
 Distinction between notes and bonds:
• A note has an original maturity of five years or less, while a
bond carries an original maturity of more than five years.
• Both securities promise the investor an amount equal to
the security’s par value at maturity plus interest payments
at specified intervals.

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  Equity is a certificate representing ownership

of a corporation. It grants the right to share in

the firm’s assets and earnings, if any.

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 A stock is a certificate that certifies ownership of a certain
portion of a firm. When a firm issues new shares of stock,
it does not add to its debt. Instead, it brings in additional
―owners‖ who supply it with funds.

It entitles the investor to receive dividends distributed by a

company.

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 Similar to common stock in that it represents an
ownership interest but, like bonds, pays a fixed
periodic dividend.
• Senior to common stock but junior to bonds.

• Generally do not have voting rights.

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 • The primary market is that part of the financial

market that deals with the issuance of new securities

(debt or equity)

• It is the market where the securities are sold for the

first time. It is also called the new issue market (NIM).

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 • The securities are issued by the company directly to

investors.

• The company receives the money.

• Primary issues are used by companies for the

purpose of setting up new business or for expanding

or modernizing the existing business.

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  Methods of raising capital in the primary

market are:
→Initial public offering (IPO);

→Rights issue (for existing companies);

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 • Initial Public offering (IPO), also referred to simply

as a "public offering", is when a company issues

common stock or shares to the public for the first time.
• An IPO is the process by which a private company

transforms itself into a public company

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 • In an IPO the issuer may obtain the assistance of

an underwriting firm. Underwriting firm

(investment banker) is a firm that assists in the
issue of new securities:

− helps the issuer determine what type of security

to issue (common or preferred),

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 − Best offering price and

− Time to bring it to market

− Analyzing the market to determine whether there

is investor demand for such company

− Structuring the offering (Prospectus development)

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 − Deals with legal issues associated with an IPO

− Helps obtain necessary government permissions

 Prospectus is a document that contains information

relating to the various aspects of the issuing company:

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 • The general details of prospectus include:

• The company’s name and address of its registered

office,

• The name and address of the company’s promoters,

managing director, director, company secretary,

legal adviser, auditors of the company etc

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 • The name and address of underwriters,

• Material details regarding the project, i.e, location,

plant and machinery, technology, performance

guarantee, infrastructure, etc,, nature of products,
marketing set-up, past performance, future prospects

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 • Preemptive right is a right of existing

shareholders in which new shares must be

offered to existing shareholders first in such
a way that they can maintain proportional
ownership in the corporation.

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  A rights issue involves selling securities in the

primary market by issuing rights to the existing

shareholders.

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 • The secondary market, is the financial market where

previously issued securities and financial instruments

such as stock, bonds, options, and futures are bought
and sold.

• Trade with old securities.

• Trade is between investors.

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 Functions of Secondary Markets
 Benefit to the Issuers

a. Provide regular information about the value

of the security-
For example: Higher value of shares indicate-
higher goodwill (public image), good
management of funds raised from earlier
primary markets by the firm.

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  Benefits to Investors (buyers) or Security

Holders
 Secondary markets offer them liquidity for their

assets as well as information about their assets

fair market values.

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  Secondary markets brings together many

interested parties and so can reduce the

costs of searching for likely buyers and
sellers of assets.

 However, don't support new investment.

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 The foreign exchange market is the mechanism
by which participants:

• Transfer purchasing power between countries;

• Obtain or provide credit for international

trade transactions.

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 Largest of all financial markets with average daily
turnover of over $2 trillion!

• U.S. dollar involved in 87% of all transactions.

• No central trading location exists;

• No set hours for trading exists; and

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 • No special requirements exist for market participants

in the FX markets.

• Trading conforms to an unwritten code of conduct or

rules among active traders

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 Exchange rates
• A foreign exchange rate is the price of one currency

expressed in terms of another currency.

• The exchange rate is the number of units of a given currency

that can be purchased for one unit of another country’s

currency.

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 • The exchange rate tells us about the relative value of

any two currencies

Birr is the unit of account/unit of value

ETB 30 / $

Dollar is the currency whose price is determined

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 There are two systems of quotation: Direct Quotation and
Indirect Quotation.

Direct Quotation:

◦ The exchange rate quoted in terms of the number of units of the

domestic currency relative to a unit of the foreign currency.

Indirect Quotation:

◦ The exchange rate quoted in terms of the number of units of the

foreign currency relative to a unit of the domestic currency.
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 • Direct Quote: Home Currency per unit of Foreign
Currency (FC).

• Indirect Quote: Foreign Currency (FC) per unit of Home

Currency

• N.B- The reciprocal of a direct quote is an indirect quote

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 • Suppose a U.S. tourist on holiday flies from New York to

London, then to Paris, and finally back to New York.

Suppose the tourist has $2,000 on hand when she begins
her journey. When she arrives at London’s Airport, she
goes to a bank to check the foreign exchange listing. The
rate she observes for U.S. dollars is $1.4428. How much
British pound (£) would the tourist receive if she decides to
exchange her $2,000 at the prevailing rate?
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 • It means that £1 will cost her $1.4428. Thus, for the
$2,000, she would receive:

• Alternatively, it means that:

• In this regard, the price of one U.S. $ is £0.6931. (Reciprocal

of the price of one £.)
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 • Based on the data given in Table below, indicate

the exchange rates for the ff pair of currencies and

explain what it means (see the 1st as an example):
British Pound/USD: £0.6930 USD/British Pound: $1.4428
Units of British Pound (£) required to buy 1 Units of USD required to buy 1 British Pound (£)
USD
Swiss Franc/USD: _________ USD/Swiss Franc: ________

Japanese Yen/USD: ________ USD/Japanese Yen: _______

Euro/USD: _______________ USD/Euro: ______________

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 i. If the current exchange rate of Dollar per Pound is
$1.5054/£, then what is the exchange rate of British
Pound per USD?

ii. Suppose the exchange rate between the German

Deutsche Mark DM/$ = 2.500 or DM 2.500.What is
the $/DM exchange rate?

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 o In general, the value of a country’s currency
depends on many factors.
Fluctuations in exchange rates occur because of changes in
the supply of and demand for dollars, pounds, Birr, and
other currencies.
• As the demand and supply of countries’ currencies
rises and falls, the exchange rates change if rates are
allowed to ―float.‖
◦ The exchange rates reflect the currencies’ relative
values.
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 When a currency loses value relative to other currencies, we say that
the currency:
− has “depreciated” if the change is due to changes in supply and
demand, or
− has been “devalued” if the change is due to government intervention.

If the currency gains value relative to other currencies, we say that

the currency:
− has “appreciated”, or

− has been “revalued” ~ government intervention.

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 • The Australian dollar was quoted at A$1.8445/US$ on

Aug, 2009, while on March, 2011 it was quoted at

A$1.335/US$. What is the appreciation or depreciation
of the US$?

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 Answer
• The appreciation/depreciation of the US$, relative to
the A$ is:

• Thus, the U.S.$ has depreciated relative to the A$ by

27.6%.

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 • To calculate the appreciation/depreciation of the Australian
dollar, relative to the US dollar, we want the denominator
currency to be the A$:
A$1.8445/US$ = US$0.5422/A$
A$1.335/US$ = US$0.7491/A$
The appreciation/depreciation of the A$, relative to the US$ is:

Thus, the A$ has appreciated relative to the US $ by, 38.2%

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 Important Note!
• The percentage appreciation in one currency is not

equal to the percentage depreciation in the other

currency.

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 • In recent past, the financial market became a riskier place
for the financial institutions, and other participants. As a
result of widened volatilities in the bond, stock markets and
interest rates. Given these developments, market
participants became more concerned with reducing the risk
they faced.
……The instruments, called financial derivatives, have
payoffs that are linked to previously issued securities and
are extremely useful risk reduction tools.

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 o Derivative markets are financial contracts whose

values are derived from the values of underlying assets

(such as bonds, stocks, and other securities).

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  A financial futures contract is standardized agreement

to deliver or receive a specified amount of a specified

financial asset at a specified price and date.

……..The buyer of a financial futures contract agrees

to buy the financial instrument, while the seller of a
financial futures contract agrees to deliver the
instrument for the specified price.

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 Financial futures contracts are traded on organized
exchanges, which establish and enforce rules for such
trading. They clear, settle, and guarantee all
transactions that occur on their exchanges

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  Financial futures are traded either to speculate on
prices of securities or to hedge existing exposure to
security price movements.
− Speculators- in financial futures market take positions
to profit from expected changes in the price of futures
contracts over time.
− Hedgers- take positions to reduce their exposure to
future movements in interest rates or security prices.

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 • An option is a contract in which the option seller grants

the option buyer the right to enter into a transaction with

the seller to either buy or sell an underlying asset at a
specified price on or before a specified date.

• An option is a contract giving its owner the right to

buy or sell an asset at a fixed price

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 o Options are a unique type of financial contract because

they give the buyer the right, but not the obligation, to do
something. The buyer uses the option only if it is
advantageous to do so; otherwise the option can be thrown
away.

o The option seller grants this right in exchange for a certain

amount of money called the option premium or option

price.

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 • The option seller is also known as the option writer,

while the option buyer is the option holder.

• Options are classified as calls and puts.

 A call option grants the owner the right to purchase/buy

a specified financial instrument for a specified price with

in the specified period of time on or before a given date. .

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  A put option grants the owner the right to sell a

specified financial instrument for a specified price with

in the specified period of time.

……As with call option, owners pay a premium to

obtain put options. They can exercise the option at any
time up to the expiration date but are not obligated to
do so.

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  There is a special terms associated with options. Here are
some important definitions:
1. Exercising the option: The act of buying or selling the
underlying asset via the option contract.
2. Strike or exercising price :The fixed price in the option
contract at which the holder can buy or sell the underlying
asset (specified price ).
3. Expiration date: The maturity date of the option; after this
date, the option is dead (specified date ).

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 4. American and European options: An American option
may be exercised anytime up to the expiration date. A
European option differs from an American option in
that it can be exercised only on the expiration date.

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 ۩ What is the value of a call option contract on common

stock at expiration? The answer depends on the value

of the underlying stock at expiration.

Example
• Assume a call option on IBM stock enables an investor to

buy 100 shares of IBM on or before three months from

now, at an exercise price of $100 per share.

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 Suppose the stock price is $130 at expiration.
The buyer of the call option has the right to buy the
underlying stock at the exercise price of $100. In
other words, he has the right to exercise the call.
Having the right to buy something for $100 when it is
worth $130 is obviously a good thing. The value of
this right is $30 ($130 - $100) on the expiration day
(This is a valuable option).
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 The call would be worth even more if the stock price

were higher on expiration day. For example, if IBM

were selling for $150 on the date of expiration, the
call would be worth $50 ($150 - $100) at that time.
In fact, the call’s value increases $1 for every $1 rise
in the stock price.

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 • If the stock price is greater than the exercise price, we say
that the call is in the money.
• If the value of the common stock will turn out to be less
than the exercise price, in which case we say that the call
is out of the money. The holder will not exercise in this
case.
• It is at the money when security price equals exercise
price.
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  For example, if the stock price at the expiration

date is $90, no rational investor would exercise.

Why pay $100 for stock worth only $90? Because
the option holder has no obligation to exercise the
call, she/he can walk away from the option.

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 • As a consequence, if IBM’s stock price is less than

$100 on the expiration date, the value of the call option

will be $0

If stock price is less If stock price is

than $100 greater than $100

Call option value $0 Stock price - $100

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  Suppose Mr. A, holds a one-year call option on TN common

stock. It is a European call option and can be exercised at

$150. Assume that the expiration date has arrived and If TN is
selling for $200 per share.
i. Mr. A can exercise the option?

ii. What is the value of the TN call option on the expiration date?

iii. What is the value of the TN call on the expiration date, if it is

selling at $100?

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 ۩ Mr. A, can exercise the option—purchase TN at $150—
and then immediately sell the share at $200. Mr. A, will
have made $50 ($200 - $150). Thus, the value of this
call option must be $50 at expiration.
۩ Instead, if TN is selling for $100 per share on the
expiration date. Mr. A, will throw it out. The value of the
TN call on the expiration date will be zero in this case
(never be negative).
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 • A put option can be viewed as the opposite of a call

option. Just as a call gives the holder the right to buy

the stock at a fixed price, a put gives the holder the
right to sell the stock for a fixed exercise price.

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 ۩ Let us assume that the exercise price of the put is $50
and the stock price at expiration is $40.

The holder of this put option has the right to sell the stock.
That is, he can buy the stock at the market price of $40 and
immediately sell it at the exercise price of $50, generating
a profit of $10 ( $50 - $40). Thus, the value of the option at
expiration must be $10.
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 • The profit would be greater still if the stock

price were lower. For example, if the stock

price were only $30, the value of the option
would be $20 ( $50 - $30). In fact, for every
$1 that the stock price declines at expiration,
the value of the put rises by $1.
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  However, suppose that the stock at expiration is

trading at $60—or any price above the exercise price

of $50. The owner of the put would not want to
exercise here. It is a losing plan to sell stock for $50
when it trades in the open market at $60.
If stock price is less If stock price is
than $50 greater than $50
Put option value $50 - stock price $0

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  Ms. B, believes that NT will fall from its current $160 per-

share price. She buys a put. Her put option contract gives her
the right to sell a share of NT stock at $150 one year from
now. If the price of NT is $200 on the expiration date
i. Mr. A can exercise the option?

ii. What is the value of the NT put option on the expiration date?

iii. What is the value of the NT put on the expiration date, if it is

selling for $100?

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 − She will tear up the put option contract because it is worthless.
That is, she will not want to sell stock worth $200 for the
exercise price of $150.
− On the other hand, if it is selling for $100 on the expiration date,
she will exercise the option.
…….In this case she can buy a share of NT in the market for
$100 per share and turn around and sell the share at the exercise
price of $150. Her profit will be $50 ($150 -$100). The value of
the put option on the expiration date therefore will be $50.

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 ۩ Unlike in a futures contract, one party to an option

contract is not obligated to exercise—specifically, the

option buyer/holder/owner has the right but not the
obligation to transact. The option writer does have the
obligation to perform.

……In the case of a futures contract, both buyer and

seller are obligated to perform.
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 ~END~

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