Capital Market PrimerFinancial Markets
A financial market is a mechanism that allows people to trade (buy and sell) financial instruments (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect efficient markets.
Financial markets are the economy’s central nervous system.
These markets promote economic efficiency:
They ensure resources are available to those who put them to their best use.
They keep transactions costs low.
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Liquidity:
Keeps transactions costs low.
Risk sharing:
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Financial Markets Structure
Distinguish between markets where new financial instruments are sold and where they are resold or traded: primary or secondary markets.
Categorize by the way they trade: centralized exchange or not.
Group based on the type of instrument they trade
Group by their primary purpose
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Where are financial securities traded?
The Primary market is the market where investors purchase newly issued securities.
Primary market is closely associated with public offering:
Public offering is the offering of securities of a company or a similar corporation to the public.
Initial Public Offering (IPO) is one type of public offering – it occurs when a company offers stock (not other securities) for sale to the public for the first time.
Gray area side note: HSBC definition: An initial public offering (IPO) is a company's first sale of stocks, bonds or certificates of deposit to raise funds for the issuer.
The Secondary market is the market where investors trade previously issued securities. An investor can trade:
Directly with other investors.
Indirectly through a broker who arranges transactions for others.
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Exchange – trading is done on regulated, organized and formalized markets
Centralized exchanges - buyers and sellers meet in a central, physical location.
Over the counter (OTC) – trading is done on an informal (albeit often well-organized) basis between buyers and sellers. Informal trading can take place over a counter, by telephone or even electronically via computer systems. Also known as off-exchange trading.
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Financial markets facilitate:
The raising of capital (in the capital and money markets)
The transfer of risk (in the derivatives and commodity markets)
International trade (in the foreign exchange markets)
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Financial Markets - Categories
Stock Market – a market where the shares of companies and related instruments such as equity derivatives are traded publicly.
Bond Market – comprises of long-term loans. A capital market through which the instruments (called bonds) trade.
Money Market – comprises of short-term loans and investments in short term debt instruments. These instruments do not trade through an exchange, but rather OTC (over-the-counter)
Foreign Exchange Market – foreign currencies can be bought and sold through this market. No formalized exchange exists and currencies are traded on an OTC basis directly between authorized dealers.
Derivative Market – a derivative instrument traded on a derivatives market derives its value from an underlying instrument. This market gives the investor the opportunity to hedge against the risk of dramatic price fluctuations. Numerous instruments known as derivatives trade in this market on an OTC basis. , except for futures and options which trade on the exchange.
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What are stocks?
A stock is a share in the ownership of a company. Stock represents a claim on the company’s assets and earnings.
As an owner (common shareholder), you are entitled to your share of the company’s earnings as well as any voting rights attached to the stock.
Why do companies issue stock?
At some point every company needs to raise money. Companies can either borrow it from somebody or raise it by selling part of the company.
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San Beda College Alabang
Common vs. Preferred Stocks
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Market order
Buy at best price available for immediate execution. Value speed over price.
Buy at best price available for immediate execution. Value speed over price.
Limit order
Buys at best price available but not more than the preset limit price. Forgo purchase if limit is not met.
Sell at best price available, but not less than the preset limit price. Forego sale if limit is not met.
Stop order
Convert to a market order to buy when the stock price crosses the stop price from below.
Convert to a market order to sell when the stock price crosses the stop price from above. Also known as “stop-loss” order.
Stop-limit order
Convert to a limit order to buy when the stock price crosses the stop price from below.
Convert to a limit order to sell when the stock price crosses the stop price from above.
FEL109R - Treasury Management
Bond Market
A bond is a debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate.
Bond basics:
Face Value/Par Value - is the amount of money a holder will get back once a bond matures.
Par value is not the price of the bond.
Coupon - the amount the bondholder will receive as interest payments.
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The bond rating system helps investors determine a company's credit risk.
Not all bonds are inherently safer than stocks.
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Money Markets
Money market is the financial market for short-term borrowing and lending. It provides short term liquid funding for the financial system.
Purpose of Money Markets
Investors in Money Market: Provides a place for warehousing surplus funds for short periods of time
Borrowers from money market provide low-cost source of temporary funds
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What influences the money market?
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Foreign Exchange Market
The foreign exchange market is the market where one buys or sells the currency of country A with the currency of country B.
A currency exchange rate is simply the ratio of a unit of currency of country A to a unit of the currency of country B at the time of the buy or sell transaction.
FX market is the world’s biggest financial market.
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Purpose of the FX Market
Currency conversion in the foreign exchange market is necessary to complete private and commercial transactions across borders.
A tourist needs to pay expenses on the road in local currency.
A firm buys/sells goods and services in the other country’s local currency.
Uses the foreign exchange market to invest excess funds.
Is used to speculate on currency movements.
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Done over the counter (OTC)
Spot exchange rates: the day’s rate offered by a dealer/bank
Forward exchange rates: agreed in advance rates to buy/sell a currency on a future date
Usually quoted 30, 90, 120 days in advance
The market is “open” 24 hours…
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Derivatives Market
A derivative is a financial instrument whose value is derived from the value of something else, usually called the underlying(s).
Underlying: a barrel of oil, a financial asset, an interest rate, the temperature at a specified location.
Various names: Derivative, derivative security, derivative asset, derivative instrument, derivative product
Traders:
Hedgers
Speculators
Arbitrageurs
Stock option, such as option on the stock of Google
A stock, such as the stock of Google
Stock index option, such as an option on the S&P 500 index
A portfolio of stocks, such as the portfolio of stocks comprising the S&P 500 index
Treasury bill futures contract
FEL109R - Treasury Management
Derivatives
Objective - derivatives are used to manage risk exposures in interest rates, currencies, commodities, equity markets, the weather.
OTC- and exchange-traded
Swaps
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Forwards
A forward contract is an agreement between two parties, a buyer and a seller, to exchange an asset at a later date for a price agreed to in advance, when the contract is first entered into.
We call this price the delivery price.
Trades in the OTC market.
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Futures
A futures contract is an agreement between two parties, a buyer and a seller, to exchange an asset at a later date for a price agreed to in advance, when the contract is first entered into.
We call this price the futures price.
Trades on a futures exchange.
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Options
An option gives the buyer the right, but not the obligation, to buy/sell the underlying at a later date for a price agreed to in advance, when the contract is first entered into.
We call this price the strike/exercise price.
The option buyer pays the seller a sum of money called the option price or premium.
Trades OTC or on an exchange.
Types of Options:
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Commodity Market
A physical or virtual marketplace for trading raw or prmary products.
Two types:
The price investors receive from dealers
The ask price:
The price investors pay dealers.
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Short – sell
Long – buy
Ex., To do so there are different ways to trade currencies
when an investor goes long on an investment, it means that he or she has bought a security believing its price will rise in the future. Conversely, when an investor goes short, he or she is anticipating a decrease in the security’s price.
The Bull – a bull market is when the economy is doing well, the GDP is growing and stock prices are rising. The bull market charges ahead.
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