FNCE102: Financial Markets and Investments
Lecture 1
Dr Karen Gan
Financial Markets and Institutions
Nature and role of Financial markets and institutions
• Financial markets are arranged groups of institutions that facilitate the
transfer of funds between entities.
Financial institutions are key to an efficient market system:
• Assist in the transfer of funds from surplus units to deficits units.
• Identify potential surplus units to match deficit units.
• From entities who lack investment opportunities to entities who have such
opportunities.
• Efficient allocation of wealth throughout the system.
• Leads to greater efficiency for the economy.
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Financial Intermediation
INDIRECT FINANCE
Financial
Intermediaries
Funds
Funds
Funds
Financial
Markets
Lenders
Funds
FNCE102 FMI:
Finance from the
perspective of
investors.
Borrowers
Funds
DIRECT FINANCE
FNCE201 Corp Finance:
Finance from the
perspective of
companies
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Financial Markets and the Economy
Financial markets play important roles:
 The Informational Role
•
•
•
•
Capital flows to companies with best prospects
The prospects of the company is reflected in their stock prices
When the market is optimistic about the company, its stock price will rise
Hence, stock prices provide information about the potential of a company
 Consumption Timing
• Throughout the lifetime of an individual, you may experience high or low earnings
periods
• In order to “shift” your purchasing power from high to low earnings period, you
should:
- Use securities to store wealth and transfer consumption to the future
- So that in low-earnings period, you can sell these assets for liquidity
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Financial Markets and the Economy
 Allocation of Risk
• A wide variety of securities in the market allows investors to select securities
consistent with their tastes for risk
• This benefits companies who could then issue securities at the best possible prices
 Separation of Ownership and Management
• It is no problem if a business is owned and managed by the same person
• However, due to the large scale that most businesses are now pursuing, most
businesses now employ outsiders to manage their operations
• Agency problems arise when managers start pursuing their own interests instead of
maximizing firm's value
• Some mitigating factors available in the markets include:
• Compensation plans that tie managers’ income to firm success
• Monitoring by the board of directors
• Screening by the external security analysts and large investors
• The threat of takeovers
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Financial Markets and the Economy
 Corporate Governance and Corporate Ethics
•
There will only be efficient allocation of resources if market signals are
accurate and investors are acting on accurate information
•
Eg. Misleading or overly optimistic company reports may lead investors to
make the wrong investment decisions
•
Other examples include:
o Accounting scandals
o Analyst Scandals
•
•
Corporate governance rules help to eliminate such violation of proper rules so
that markets can be a more efficient avenue for capital allocation
Companies should also formulate policies on corporate ethics for every
employee to follow
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The Players
Price of Capital
Financial Intermediaries: Pool and invest funds
• Investment Companies
• Banks
• Insurance companies
Who Supplies Capital?
Who Demands Capital?
Households
Firms
Quantity of Capital
Role of Government?
Can be either borrowers or lenders
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Types of Financial Markets
Fixed Income
Equity
Financial
Markets
Forex
Derivatives
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Fixed income markets
Bonds are also called fixed-income securities based on the following
properties:
• Fixed stream of income periodically - coupon payments
• Fixed par value at maturity
Bonds are categorised by maturity:
•
Short-term:
o T-bills: Issued with maturities in terms of weeks, months, up to 1 year
•
Long-term:
o T-bonds: Issued with maturities of more than 1 year
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Fixed Income
Money Markets
Fixed Income
Capital Markets
Equity
Financial
Markets
Forex
Derivatives
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Money Market
• Where Short term debt instruments are traded
 Maturity ≤ 1 year
• Liquid securities
• Smaller price fluctuations than Long term securities
• Investors use money markets to earn interest on surplus funds
which they hold only temporarily
• Examples of security: Treasury Bills
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Major Components of the Money Market
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Treasury Bills
Short term debt issued by the Government
• Listing of T-Bills: Bank discount method
• Rather than showing the price of each bill, the listing below
shows the yields based on prices.
• Since there are no coupons, the price you pay is a discount from
par value, and the difference implies an “interest” you earn over
the investment period.
• The yields correspond to both bid and ask prices.
Maturity
Days to maturity
Bid (%)
Ask (%)
Feb 12, 2010
10
0.177
0.160
Mar 8, 2010
109
0.298
0.288
Jun 18, 2010
202
0.305
0.299
Aug 2, 2010
329
0.430
0.425
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Treasury Bills
In order to calculate price of the T-bill:
• n = number of days till maturity
• r = prevailing interest rate
• Assuming par value = 100
• Price = 100 - (n x r) / 360
Example
Using the Mar 8, 2010 T-bill;
Bid Price for a $100 par value bill
= 100 – (109 x 0.298)/360 = 100 – 0.09 = $99.91
Bid Price for a $1,000 par value bill
= 99.91 x 10 = $999.10
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The Capital Market
Treasury
Notes
Treasury
Bonds
Corporate
Bonds
Municipal
Bonds
Capital
Markets
International
Bonds
InflationProtected
Securities
Federal
Agency
Debt
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The Capital Market
Subsector of the fixed-income market
• Long-Term
• Liquid
• Low risk (but not as low as the Money Market)
• 2 types:
1. LT Government Bonds
2. Corporate Bonds
1. Treasury Notes and Bonds
• Maturities
• Notes – Maturities up to 10 years
• Bonds – Maturities from 10 to 30 years
• Par Value — $1,000
• Interest paid semiannually
• Quotes — Percentage of par
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Capital Market: Corporate Bonds
2. Corporate Bonds
• Issued by private firms
• Usually semi-annual interest payments
• Larger default risk than government securities
• Secured bonds: backed by collateral
• Unsecured bonds (debentures): no collateral
• Options in corporate bonds
o Callable
o Convertible
• Applicable measurement of yield: Yield to maturity
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Capital Markets: Mortgage Backed Securities
Mortgage-Backed Securities
• Proportional ownership of a mortgage pool or a specified
obligation secured by a pool
• Produced by securitizing mortgages
• Most were issued by Fannie Mae and Freddie Mac in the US
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Mortgage-Backed Securities Outstanding
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Equity
Fixed Income
Common Stock
Equity
Financial
Markets
Preferred Stock
Forex
Derivatives
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Equity Securities
Common stock:
• Ownership
• Residual claim
• Limited liability: all the shareholders will lose is their original
investment
Preferred stock:
• Features similar to both equity and debt
• Fixed dividends: but still at discretion of the company
• Just like a perpetuity
• No voting rights
• Priority over common
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Stock Market Indices
A Stock market index is a good representative of the movement of the
whole stock market in that particular country.
Popular Examples of major stock markets include the following:
• Dow Jones Industrial Average
• Includes 30 large blue-chip corporations
• Computed since 1896
• Price-Weighted Index
• S&P 500
• Broad based index of 500 firms
• Market-Value-Weighted Index
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Other Indices
U.S. Indexes
Indexes outside US
• NYSE Composite
• STI (Singapore)
• NASDAQ Composite
• Nikkei (Japan)
• Wilshire 5000
• FTSE (U.K.; pronounced
“footsie”)
• DAX (Germany),
• Hang Seng (Hong Kong)
• TSX (Canada)
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Example of Trading prices
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Stock Basics
Some popular ratios you evaluate when trading on the stock markets:
• Dividend Yield:
o Yearly Dividends / Purchase Price
• Capital Gains (losses):
o Share Price Increases (Decreases)
• P/E Ratio:
o Price-Earnings Ratio = Price Per Share Divided by Earnings Per Share
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Forex
Fixed Income
Equity
Financial
Markets
Forex
Derivatives
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Exchange rate differences
Exchange rates are always subjected to volatility.
• Today’s exchange rates may be different from yesterday’s.
• Exchange rate fluctuates when different amounts of currencies flow in
and out of countries.
• This is due to changing demand and supply of currencies.
• Adjustments to exchange rates are caused by:
1. Price differences
2. Interest rate differences
 Law of one price
If the law of 1 price holds, Exchange Rates between 2 currencies will adjust
to reflect the changes in the price levels in the 2 countries. Differences in
prices (inflation) drive trade flows and the demand & supply of currencies.
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Law of One Price
Example
• American Burger = US$2
• Japanese Burger = JPY200
Under Law of 1 Price: US$2 = JPY200
US$1 = JPY100
But, if exchange rates were US$1 = JPY200
Japanese Burger = US$1 (cheaper than American Burger)
DD for Japanese Burger will rise leading to excess SS of American
Burger & pushing down prices of American Burger such that Exchange
rate converges to US$1 = JPY100.
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Law of One Price
Example (cont’d)
Now suppose:
• American Burger = US$2
• Now Japanese Burger = JPY250
Under Law of 1 Price: US$2 = JPY250
US$1 = JPY125
Hence, when Japanese prices rise, US$ appreciates & JPY depreciates.
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Example of Forex Quotes
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Example of Forex Chart
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Derivatives
Fixed Income
Equity
Financial
Markets
Forex
Futures
Derivatives
Forwards
FNCE 102
Options
FNCE 101
Swaps
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Derivatives
A derivative is a security that gets its value from the value of another
asset, such as commodity prices, bond and stock prices, or market
index values.
Many assets can be traded under derivatives:
• Equities
• Bonds
• Currencies
• Interest rates
• Commodities
• Credit Risk
• Weather
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Uses of Derivatives
Derivatives can be used by:
• Hedgers
• Speculators
• Arbitrageurs
FNCE102 focuses on this: from the
investor’s perspective for managing risks
Use of Derivatives for
Risk Management
Stock price risks
• Futures (FNCE102)
• Options (FNCE101)
Interest rate risks
• Futures (FNCE102)
Forex risks
• Futures (FNCE102)
• Forwards (FNCE102)
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Example of Derivatives Prices
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Derivatives Trading
Derivatives are traded in major exchanges in the world.
CME group is the world’s major derivatives exchange and trades a wide
variety of derivatives products.
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Derivatives Trading
There is growing competition among exchanges in terms of the range of products
and the fees charged.
Other famous derivatives exchanges include:
• Eurex and Nasdaq
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Derivatives Trading
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The Financial System
We have learnt about the components of the whole financial system.
To summarise: A financial system comprises:
• Investors (companies and individuals)
• Financial institutions
o
o
o
o
Banks (eg. commercial banks, private banks)
Stock-broking firms
Investment companies (eg. mutual funds, hedge funds)
Insurance companies
• Financial markets
o
o
o
o
Fixed Income
Equity
Foreign Exchange
Derivatives
 Next, we move on to understand the
Investment Process
within the Financial System.
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Multifactor
Models
Optimal
Risky
Portfolios
Asset
Allocation
CAPM
The
Investment
Process
Asset
Pricing
Anomalies
Security
Selection
Smart
Beta
Investing
Mutual
funds &
Hedge
funds
Managing
Bond
Portfolios
Risk
Management
with
Derivatives
Behavioural
Finance
Portfolio
Performance
Evaluation
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The Investment Process
 Asset allocation
• Choice among broad asset classes
 Security selection
• Choice of securities within each asset class
• Most important decisions in the Investment Process
• An investor must decide how to divide his wealth across all the
available asset classes in the financial markets
• Even the smartest and most experienced investor may be confused
given the wide variety of financial securities available
• Therefore, it is necessary to grasp the following topics in order to
understand the complete Investment Process.
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The Investment Process
 Optimal Risky Portfolios
• Every asset class and financial security has different levels of risk.
• We need to understand the risk-return trade-off for every financial
security.
• Investor’s utility levels and degree of risk aversion will determine
the types of financial securities that are included in the investment
portfolio.
• An optimal portfolio can then be constructed.
 Equity valuation
• Capital Asset Pricing Model and Multi-factor models are used to
evaluate the expected return that is commensurate with the risk of
equities available in the markets.
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The Investment Process
 Asset Pricing Anomalies & Behavioural Finance
• Investors behave differently and react to market movements in a
different way.
• This irrationality is based on behavioural biases and psychological
differences.
• This is in contrast to conventional portfolio theory which follows
the efficient market hypothesis.
 Mutual funds and Hedge funds
• Funds are pools of investment money from investors that are
placed into a variety of assets.
• Funds follow different investment policies and aim to deliver
attractive returns for their investor clients.
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The Investment Process
 Managing Bond Portfolios
• Valuation of fixed-income portfolios.
• Determine interest rate sensitivity and bond duration for the
investor to manage this asset class.
 Portfolio Performance Evaluation
• As part of the investment process, we need to evaluate the
performance of the investment portfolio.
• Not only must we consider returns, we must also take into account
the risks of the investment portfolio.
• We will explore the common performance evaluation ratios in this
lecture.
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The Investment Process
 Risk Management
• Vital to the investment process is proper risk management.
• Before we decide on the tools to manage risks, it is important to
firstly understand and evaluate the types of risks involved.
• Risk monitoring is also essential so that we can understand the
effectiveness of the risk management tools that are in place.
 Futures
• From the perspective of the investor, futures are one of the many
methods for hedging risks.
• Through hedging, the investor’s position is protected.
• The types of risks common to most investors are forex and interest
rate risks.
• We will investigate the methods using futures for hedging such
risks with examples.
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In the following lectures, we will explore in detail, each topic in the
Investment Process
within the Financial System.
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