Chapter 2

Financial Market Structure

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 Chapter contents
 Money markets
 Bond markets
 Mortgage markets
 Stock markets
 Foreign exchange markets
 Derivate securities market

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 2.1 Money markets
 refers to the network of corporations,
financial institutions, investors and
governments which deal with the flow of
short-term capital.
 money markets do not exist in a particular
place or operate according to a single set of
rules. Rather, they are webs of borrowers
and lenders, all linked by telephones and
computers.
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 2.1 Money markets…
 they bring borrowers and investors together
without the comparatively costly
intermediation of banks.
 they help borrowers meet short-run liquidity
needs and deal with irregular cash flows
without resorting to more costly means of
raising money.

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 2.1 Money markets…
 there is an identifiable money market for
each currency, because interest rates vary
from one currency to another.
 they have expanded significantly as a result
of the general outflow of money from the
banking industry, a process referred to as
disintermediation.

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 2.1 Money markets…
What do money markets do?
 help issuers of instruments with cash management
or with financing their portfolios of financial
assets.
 attach a price to liquidity, the availability of
money for immediate investment.
 active/liquid money markets allow borrowers and
investors to engaging in a series of short-term
transactions rather than in longer-term
transactions, keeping down long-term interest
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 2.1 Money markets…
Types of instruments
Commercial paper
 a short-term debt obligation of a private-sector firm or
a government-sponsored corporation
 has maturity of between 90 days and 9 months
 is usually unsecured
 allows financially sound companies to meet their short-
term financing needs at lower rates than could be
obtained by borrowing directly from banks.

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 2.1 Money markets…
Types of instruments
Bankers’ acceptance
 a promissory note issued by a non-financial
firm to a bank in return for a loan
 the bank resells the note in the money
market at a discount and guarantees
payment
 is issued at a discount and has a maturity
of less than six months.
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 2.1 Money markets…
Types of instruments
Bankers’ acceptance…
 is usually tied to the sale or storage of specific
goods, such as an export order for which the
proceeds will be received in two or three months.
 are not issued at all by financial-industry firms
 investors rely on the strength of the guarantor
bank, rather than of the issuing company, for
their security
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 2.1 Money markets…
Types of instruments
Treasury bills
 securities with a maturity of one year or
less, issued by national governments
 treasury bills issued by a government in its
own currency are generally considered the
safest of all possible investments in that
currency
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 2.1 Money markets…
Types of instruments
Treasury bills…
 are used as principal source of financing
where a government is unable to convince
investors to buy its longer-term obligations.
 as countries develop reputations for better
economic and fiscal management, they are
often able to borrow for longer terms
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 2.1 Money markets…
Types of instruments
Treasury bills…
 governments may issue TBs denominated
in foreign currency
 but a sudden decline in the value of the
currency increases the debt burden and may
even cause a debt crises as in Mexico in
1995, Russia in 1998 and Brazil in 1999.
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 2.1 Money markets…
Types of instruments
Interbank loans
 loans extended from one bank to another
with which it has no affiliation
 are used by the borrowing institution to re-
lend to its own customers
 includes overnight loans needed to
maintain the required reserves
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 2.1 Money markets…
Types of instruments
Interbank loans…
 banks extend short-term loans to one another
at agreed upon interest rate.
 it is called LIBOR (London Inter Bank Offer
Rate) in UK, Fed fund rate in the US.
 a lending bank can charge more than LIBOR
if the borrowing bank is not creditworthy.

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 2.1 Money markets…
Types of instruments
Time deposits
 another name for certificates of deposit
(CDs)
 are interest-bearing bank deposits that
cannot be withdrawn without penalty before
a specified date.
 time deposits may last for as long as five
years.
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 2.1 Money markets…
Types of instruments
Repurchase agreement(Repos)
 is a combination of two transactions
1. a securities dealer, such as a bank, sells securities
it owns to an investor, agreeing to repurchase the
securities at a specified higher price at a future
date.
2. days or months later, the repo is unwound as the
dealer buys back the securities from the investor
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 2.1 Money markets…
Types of instruments
Repurchase agreement(Repos)
 amount the investor lends is less than the
market value of the securities, a difference
called the haircut
 in a reverse repo the roles are switched, with
an investor selling securities to a dealer and
subsequently repurchasing them

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 2.1 Money markets…
Types of instruments
Futures
 used for hedging and cash management
 by buying or selling a futures contract on a
short-term interest rate or a short-term debt
security, an investor can profit if the relevant
rate is above or below the chosen level on the
contract’s expiration date.

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2.2 Bond Markets
 the word “bond” means contract,
agreement, or guarantee.
 an investor who purchases a bond is lending
money to the issuer
 a bond represents the issuer’s contractual
promise to pay interest and repay principal
according to specified terms.

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2.2 Bond Markets...
 bonds offer a way for governments to borrow
from many individuals rather than just a
handful of bankers
 are the most widely used of all financial
instruments.
 the total size of the bond market worldwide
was more than approximately $50 trillion by
the end of 2004

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2.2 Bond Markets...
Why issue a bond?
 diversify sources of funding.
 the issuer can raise far more money
without exhausting its traditional credit
lines with direct lenders.
 minimize cost of capital - cost is lower and
the funds can be repaid over a longer
period
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2.2 Bond Markets...
Why issue a bond?
 matching revenue and expenses-bonds offer
a way of linking the repayment of
borrowings for long term projects to
anticipated revenue.
 promoting inter-generational equity-bonds
offer a means of requiring future taxpayers
to pay for the benefits they enjoy, rather
than putting the burden on current
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2.2 Bond Markets...
Why issue a bond?
 Controlling risk-the obligation to repay a
bond can be tied to a specific project or a
particular government agency, insulating
the parent corporation or government from
responsibility.
 avoiding short-term financial constraints-
governments and firms may turn to the
bond markets to avoid financial constraints.
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2.2 Bond Markets...
The issuers
National governments
 bonds backed by the full faith and
credit of national governments are
called sovereigns.
 are generally considered the most secure
type of bond.

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2.2 Bond Markets...
The issuers
Lower levels of government
bonds issued by a government at the sub-
national level, such as a city, a province or
a state, are called semi-sovereigns.

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2.2 Bond Markets...

The issuers
 Corporations
 are issued by a business enterprise-
owned by private investors or by a
government.
 in issuing a secured obligation, the firm
must pledge specific assets to bondholders.

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2.2 Bond Markets...
Issuing bonds
 each issue is preceded by a lengthy legal document-
the offer document or prospectus.
 offer document lays out in detail
the financial condition of the issuer;
the purposes for which the debt is being sold
the schedule for the interest and principal
payments
the security offered to bondholders in the event
the debt is not serviced as required.
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 2.2 Bond Markets...

Issuing bonds
 a bond can be issued either through
underwriters & dealers or directly to the
investors

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2.2 Bond Markets...
Types of bonds
Straight bonds
 a.k.a debentures
 are the basic fixed-income investment
 owner receives interest payments on specified
dates, usually every six months or every year
following the date of issue.
 the issuer must redeem the bond from the owner
at its face value on a specific date.
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2.2 Bond Markets...
Types of bonds
Callable bonds
 the issuer may reserve the right to call the
bonds at particular dates
 the difference between the call price and the
current market price is the call premium.
 a bond that is callable is worth less than an
identical bond that is non-callable

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2.2 Bond Markets...

Types of bonds
Putable bonds
 gives the investor the right to sell the
bonds back to the issuer at par value on
designated dates.
 this benefits the investor if interest rates
rise

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2.2 Bond Markets...
Types of bonds
Perpetual debentures
 a.k.a irredeemable debentures,
 are bonds that will last forever unless the
holder agrees to sell them back to the
issuer.

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 2.2 Bond Markets...
Types of bonds
Zero-coupon bonds
do not pay periodic interest.
issued at less than par value and are redeemed at par
value
are designed to eliminate reinvestment risk-the loss
an investor suffers if future income or principal
payments from a bond must be invested at lower
rates than those available today.




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2.2 Bond Markets...
Properties of bonds
Maturity
 has a date on which the bond issuer will have repaid
all of the principal and will redeem the bond.
Coupon
 the stated annual interest rate as a percentage of the
price at issuance. once a bond has been issued, its
coupon never changes.

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2.2 Bond Markets...
Properties of bonds
Current yield
 Has the effective interest rate for a bond at its
current market price. This is calculated by a
simple formula:
=Annual amount of coupon interest/ current price
 if the price has fallen since the bond was issued,
the current yield will be greater than the coupon.

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2.2 Bond Markets...
Properties of bonds
Yield to maturity
 this is the annual rate the bondholder will receive
if the bond is held to maturity.
 yield to maturity includes the value of any capital
gain or loss the bondholder will enjoy when the
bond is redeemed.
 is the most widely used figure for comparing
returns on different bonds.
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2.2 Bond Markets...
Properties of bonds
Duration
 a number expressing how quickly the investor
will receive half of the total payment due over
the bond’s remaining life
Example: a zero-coupon bond offers payments
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Financial markets and Institutions Instructor: Ashenafi B(PhD)
2.2 Bond Markets...
Ratings of risk
 bond issuers often seek a rating from one or
more private ratings agencies before they
issue bonds
 the selected agencies investigate the issuer’s
ability to service the bonds, including such
matters as financial strength, the intended use
of the funds, the political and regulatory
environment, and potential economic changes.
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2.2 Bond Markets...
Ratings of risk
 after completing its investigation, an
agency will issue a rating that represents
its estimate of the default risk, the
likelihood that the issuer will fail to service
the bonds as required.
 three well-known companies are Moody’s
Investors Service, Standard & Poor’s,
and Fitch ibca.
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2.2 Bond Markets...

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2.3 Mortgage Markets
What is mortgage?
 a pledge of property to secure payment of
a debt
 involves two parties: mortgagor(home
owner) and mortgagee(lender)
 real estate that can be pledged as a
mortgage are divided into two as
residential and non-residential property
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 2.3 Mortgage Markets
Originators
 commercial banks, thrift(S&Ls), and
mortgage banks
 generate income from origination fee,
application fee and profit from selling a
mortgage at a higher price

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2.3 Mortgage Markets
Origination process
1. homeowner applies for a mortgage loan
2. mortgage originator performs credit
evaluation of the applicant based on Loan-
to-Value ratio(LTV) and Payment to
Income ratio(PTI)
3. contract signed

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2.3 Mortgage Markets
Originators can
1. keep mortgage in their portifolios
2. sell to an investor such as Fannie Mae
3. use it as a collateral for issuance of a
security

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2.3 Mortgage Markets
Mortgage-backed securities
 involves securities issued with mortgages
used as a collateral
 THREE types:
1. Pass through securities
2. Collateralized mortgage obligation(CMO)
3. Mortgage backed bond

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 2.3 Mortgage Markets

Mortgage-backed securities
1. Pass through securities
a security created by pooling mortgages
and selling shares/participation
certificates in the pool.
gives the investors a pro rata share of
the principal and interest on the pool
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2.3 Mortgage Markets

Mortgage-backed securities ...

1. Pass through securities...
the pool may consist several
thousands or just a few
help investors eliminate the
unsystematic risk

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2.3 Mortgage Markets

Mortgage-backed securities
2. Collateralized Mortgage Obligation
a multi-class pass through with a number of
bond holder classes
each bond holder has a different
guaranteed coupon paid semiannually

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2.3 Mortgage Markets

Mortgage-backed securities
3. Mortgage-backed bonds
bonds in which mortgages are used as a
collateral
is more a collateralization than
securitization

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2.4 Stock Markets

 where equity claims are traded

 common(ordinary) stock and preferred stock
 Includes both primary market and secondary
market
 primary market is where IPOs are issued and
also where seasoned offerings are made
 Seasoned offering have rights offerings

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2.4 Stock Markets
Secondary markets
where stocks once issued are traded
include floor-based exchange(NYSE) and
electronic-based exchange (NASDAQ)

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2.4 Stock Markets

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2.4 Stock Markets

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2.4 Stock Markets
Stock Market Indexes
is a composite value of a group of
secondary market traded stocks.

Example: Dow Johns Industrial

Average(DJIA), S&P 500,NASDAQ
composit-industrials,banks,& insurance
companies, DAX

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 2.5 Foreign Exchange Markets

 markets where currencies of different countries are

traded
 spot rate and forward rate
 Determinants of Exchange Rate
 relative inflation rates
 relative interest rates
 relative income levels
 government controls
 expectations

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2.5 Foreign Exchange Markets
Government influence on exchange rates
1) Direct intervention
 by exchanging foreign currency with
local currency
 can be sterilized or non-sterilized
intervention

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2.5 Foreign Exchange Markets
Sterilized intervention
 the government buys or sells local
currency(in the forex market) to
manipulate the exchange rate and at the
same time undertakes an offseting
transaction in the money market to keep
money supply unaffected

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2.5 Foreign Exchange Markets
Non-sterilized intervention
 the the government buys or sells local
currency to manipulate its value
 no offseting transaction is undertaken in
the money market to keep money supply
unaffected

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 2.7 Derivative Securities Markets
 financial instruments the value of which is
derived from the prices of securities, commodities,
money or other external variables.
 are created to manage price volatility
 although many, they fall into two basic
categories:
(1) Forwards are contracts that set a price for
something to be delivered in the future.
(2) Options are contracts that allow, but do not
require, one or both parties to obtain certain
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2.7 Derivative Securities Markets
Options
Characteristics
 Option premium-upfront fee
 Exercise/strike price
 American Vs European options
 In the money/out of the money
 A zero sum game

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2.7 Derivative Securities Markets
Forward contract
agreement between buyer and seller to
trade securities for cash on a specific date
Future contract
similar to forward contract, except that it is
traded in an organized exchange
asset standardized and indeminity is
available in case of default
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2.7 Derivative Securities Markets
Swaps
agreement to exchange specified
periodic cash flows in the future based on
some underlying instrument or price
Example:interest rate swaps

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 End of Chapter 2

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