Topic: Financial markets
and exchanges
Lecture overview
• What: instruments
• Where: exchanges
• How: delivery
Financial instruments
• In order to gain understanding of financial
markets first we have to define financial
markets and particular instruments which are
which are traded on those markets.
• We have to know the basic characteristics of
those instruments and which are the basic
characteristics of those markets.
Financial Instruments
• Financial instruments are special documents which have their particular
legal significant and material value..
• Based on the construct of a particular instruments, they give us rights and
obligations pertaining to the subject of a particular instrument..
• Financial instruments can then be a special document with particular
properties:
• Ownership (share): to own a share (sometimes called a stock) is to own a
portion of a company.
• Debt (bond): to own a bond means to have receivables. To issue a bond
means to be in debt towards another party.
• Transaction (bill of exchange): bill of exchange can be used to guarantee a
transaction, a payment between participants in the economy.
• Possibility (options): option gives us right to buy or sell a certain asset. In
terms of trading, option gives us a possibility to enter into a position.
• Merchandize (futures): using futures contracts we can buy or sell certain
goods right now, but take delivery at some future time.
Financial Instruments
• We can split financial instruments based on their importance. This
is not a balance sheet split which is simple: balance sheet and off
balance sheet instruments.
• We can differentiate between primary and secondary financial
instruments:
• Primary instruments:
– Financial assets (bill of exchange)
– Financial obligations (debt)
– Instruments of ownership (stock)
• Secondary instruments
– Financial derivatives
Evaluation
• One of the main differences between primary and secondary
instruments is in the way their market value is determined.
• Primary instruments are valued through markets through
supply and demand.
• Secondary financial instruments are also valued through
supply and demand, but their value also changes when the
value of the underlying instrument changes. This is relation is
the process of evolution is why those instruments are called
derivatives: their value is derived through the value of the
underlying instrument.
• Financial derivatives are called derivation because they are
created based on another instrument, just like gasoline is
derived from oil.
Term
• Special classification of financial instruments is base on the term of
financial instruments. This is particular important for investors.
• The term definition of financial instruments is:
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Short term: maturity up to 1 year (Treasury bills)
Medium term (Treasury notes, 2-5 years)
Long term (bonds)
perpetual (perpetuities, stocks)
• It is important to know the term implications for a particular
instrument.
• We can use the time life of a particular instrument when we perform
our risk calculations.
• The longer the time horizon, there is a greater possibility issuer will
encounter problems.
Primary markets
• Financial instruments have their life cycle: the way they are created and the
way they die.
• Based on the way financial instruments are created and live we can create a
following split:
• Primary markets
– These are the markets where financial instruments are created.
– This is the market where the first transition is made (just the first one) between the
issuer of the instrument and the first buyers of the instruments. This is usually done
through the intermediary.
• Secondary markets
– These are the markets where transactions and change in ownership between the
investors.
– These markets are where all other transaction after the issuance of the instruments
occur.
• This however does not hold for the derivatives. The process of primary and
secondary markets is not applicable for derivatives since there is not clear
distinction between primary and secondary derivatives markets.
Organization
• Market is a „place” where transactions occur. The
„place ” does not necessarily has to be physical space or
surroundings.
• Organized market implies a clearly defined institution
which has a clear rules and conditions regarding
participating in the market and market participants.
• Incorporated exchanges are by definition an organized
markets.
• Apart from the organized markets there are also
markets which are not organized. These markets are
called over the counter markets or OTC.
Exchanges in theory
• Based on what is being traded on exchanges we can
split them into:
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Effective exchanges (security exchanges),
Foreign currency exchanges FX,
Gold exchanges,
Money market exchanges, (money and short term
debt exchanges)
• Diamond exchanges,
• Commodity exchanges for services.
Types of exchanges – traded items
• Security exchanges deal will all kinds of stock certificates
and hybrid stock instruments. The instruments traded
on the exchange are determined through special bylaws
and regulation of the exchange.
• Foreign exchange exchanges usually trade convertible
currencies. These exchanges sometimes also trade
money market instruments and or short term debt.
• Money market exchanges usually trade liquid currency
in various time buckets, but mostly shot with short term
maturity. Sometimes these exchanges will also trade
short term highly liquid papers or money equivalents
like: repos, T-Bills, certificates of deposit.
Types of exchanges – traded items
• On gold exchanges the main object of trading and gold bullion or
ingots and on diamond exchanges the main object of trading are
diamonds..
• Commodity exchanges are specific exchange which specialize in
trading of actual goods. The main point of exchange traded goods is
that the goods traded have to have a certain quality and uniformity.
• In case of commodity exchanges, the actual object of trade is usually
on physically present in the market. In case of forward markets the
goods do not have to exist at the time of the transaction.
• On commodity exchanges we can usually find basic goods or
commodities in their raw form. We can split them:
– Agricultural products: gains, cocoa, sugar, lumber and so on.
– Mining products like base metals (copper, led, tin) and other commodities
obtained through mining like oil or natural gas.
Exchanges for services
• Exchanges for services are highly specialized exchanges – markets
for certain types of services.
• The term „exchange” here is just a nominal term since these types
of exchanges function more like places where supply and demand
for certain corporate services meet. And the exchange serves more
as a go-between, not a real exchange.
– Transport capacity exchanges, these exchanges organize supply and
demand for tanker, railroad and air transports.
– Transport and storage insurance exchanges exist in places known for
large international trade and significant amount of transport (London,
Hamburg, Rotterdam et al.) where participants by and sell insurance for
goods transported or stored. This is mostly done for goods which are
transported though sea.
– Cooperative exchange where participants can find cooperators and offer
cooperative services for companies with similar business activities.
Geographical separation
• Based on exchange importance and their relative impact we can use
geographical split:
• Local, these are regional exchanges where goods and participants
come from a particular region.
• National: these exchanges work on a national level and their impact
is within just one nation. Most of their participants and objects
traded are national.
• Regional exchanges have participants from several local countries
and objects of trading come from several different countries.
• International, exchanges are the largest exchanges with international
and or global impact. Most of these work as large exchange groups
which own several exchanges on different continents like ICE or CME.
Exchanges and time
• One of the most important characteristic of
exchanges is time. Here we have to main types of
exchanges:
• Spot exchanges: are exchanges where trading is
immediate and the exchange of goods is right
after trade or in a short period of time.
• Future or forward exchanges are exchanges
where trade occurs at the present price, but the
delivery occurs at some predefined future time
as defined by the contract.
Index
• Different exchanges trade different instruments.
• For most participants in the economy it is often important to
know what is happening with the values of certain
instruments or with a value of a group of instruments.
– What has been the overall trend of stocks in recent time (a year)?
– What were the changes in the values of tech stocks?
– What is the recent trend in the value of gold?
• Precisely since it is important for lots of economic
participants to know what is going on with values of certrain
instruments the exchanges have to communicate the changes
in values with the general public.
• The easiest way to establish such communication is through
an index.
Index
• In order to be able to answer the investor’s questions the
exchanges usually create and index which reflects the average
values of certain instruments or goods.
• For the index we could say it represents the sum of the values
of instruments or goods traded on the exchange.
• The best classification of indices is based on the types and
characteristics of the instruments which can be found in the
index:
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Stocks
Bonds
Commodities
Gold
Oil
Types of indecies
• We can split indices into two basic types:
– Linear index: this type of index is just a summation of the
value of instruments in the index
– Weighted index: to each particular instrument a value is
added. This gives the creator an ability to adjust the
significance of a particular instrument or security.
• Linear index is just a summation of particular
values, regardless of the importance of stock. On
the other hand weighted index gives a more precise
picture of the overall changes since individual
weights allow to particular value adjustments
within the index.
Impotance
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As mentioned the indices are often in media.
The best know indices are: Nasdaq, S&P 500, Dow Jones.
A well known commodity index is: Dow Jones-UBS Commodity Index.
Most exchanges have their own index: CAC, DAX, MIB, CROBEX.
Large and important exchanges also have smaller indices which cover
a particular sector of the economy.
• Indices are also important for mutual funds, because there are any
funds which try to mimic in their composition the value of the index.
• When investing in index funds the investor has the equivalent or
purchasing all securities in the index, but for smaller amount of
money and with less transaction costs.
Financial markets and financial instruments
• We have explained financial exchanges.
• Now we can get to know financial instruments
and their properties
• We will get to know basic security and derivative
instruments.
• First we will cover balance sheet instruments,
then we can move onto derivative instruments.
Stock exchanges
• First we have to address the word capital. When we are talking
about capital markets we are not necessarily talking about the
accounting (capital in the balance sheet). Capital element of the
balance sheet contains other items apart from the stockholder’s
equity.
• The stock exchanges usually trade just stock holder’s equity. However
this balance sheet distinction is particularly important.
• Capital in the balance sheet is on the side of the liabilities, therefore
is it an obligation towards the owner of the company.
• Trading shares is a process which changes the ownership structure of
the company. Increasing the amount of shares owned, increases the
overall ownership of the company.
Why did the stock markets develop?
• The reason why the stock markets have been
created has simple and fundamental logic of supply
and demand.
• There were two sides, one side had too much
funds and wanted to utilize those funds, on the
other side there was a need for funds.
• Equilibrium of supply and demand resulted in the
creation of capital markets.
• The best way for us to fully understand why capital
markets have developed is to look at two simple
examples.
Example 1
• If one person owns 100% of shares, that means the corporation is
under control of only one individual.
• The whole corporation lies on only one set of shoulders. The
ownership of the corporation represents property, but this property
is not liquid.
• The fact that only one individual owns a company means that
individual can get all the dividends, but it also means that only one
individual has to increase the capital if there is a need for more
capital.
• The problem of liquidity, ownership, sources of new capital in this
particular case all represent constraints for the corporation.
• To be your own boss sounds good, but if the corporation does not
have enough capital, it can not grow.
Example 2
• Let us now look at another alternative example.
• Let us say that someone has a great business
idea, but does not have enough funds to bring
the idea into fruition.
• One of the ways to obtain funding for the
development of the idea is through the capital
markets.
• Investors who concur on the idea can invest in
business plan and share in the profits.
Implications of examples
• From the two examples we can see how the capital markets have
developed.
• The first examples gives us an owner who whishes to obtain liquidity from
its property by selling a portion of ownership on the stock exchange.
• The second examples shows how investors with extra funds (savings) gave
their extra savings to participants in the economy which needed funds. Of
course this is based on assumption the investment will eventually be
profitable.
• Ultimately you should always keep in mind the supply and demand which
exist on the capital markets. Those who have extra funds invest by
purchasing ownership. To have ownership implies to have a portion of
responsibility, but also a right to partake in profits.
• Successful investors can differentiate goods investments from bad and
maintain long term profitability. This basically boils down to knowing
when to invest and when to hold off investments.
Stock
• Stocks represent ownership.
• In terms of voting rights there are two types of stocks:
– With voting rights
– Without voting rings
• We can also split shares based on dividends
– Preferred: shares have preferences in terms of dividends. Dividends
are first paid out to the owners of preferred shares, then to the
owners of the regular shares. This is the reason these types of shears
are called preferred: the dividend first goes to them.
– Regular: dividends are paid out of there is enough net income.
• If a share exists, that does not mean it is publically traded.
• Shares can be exchange listed, or they can be traded OTC.
Debt exchanges
• Debt is traded through a clearly defined instruments.
• We have to point this out since on exchanges is not possible to trade
all forms of debt. However there exists a market for trading financial
obligations.
• One of the best examples of a debt which is not treaded on exchange
is a loan. Loan is just like a bond in most of its properties, but it is not
treaded on exchanges. That does not mean a bank can not sell their
loans, but it does not make sense to list a trade a particular loan. That
is why the loans get converted into bonds and then they are treaded.
• The best known „prepackaged” loans are mortgage-backed securities
by government agencies like Fredie mac or Fannie mea.
Debt instruments
• Debt instruments are usually separated based on the term and issuer:
– Short term 3m – 2y: Treasury bills (government), commercial papers
(corporation).
– Medium term 2y – 10y: notes
– Long term: bonds
• Based on the interest paid over the life of the bonds we have:
– Coupon: interest is paid over time in form of a coupon
– No coupon: interest is not paid over time.
• Listed debt instruments are exchange traded (Croatia), others are
traded OTC (government bonds USA).
• With bonds it is important to know that price of bonds will change
with the changes of supply and demand, but it will also change with
the changes of the overall level of the interest rates in the economy.
• Here comes in the bond yield: this is the actual return you get on
investing in bonds.
„Places” of trading
• Debt instruments are traded on both :
• Organized exchange markets
• OTC (over the counter markets)
• Exchanges are organized markets where particular debt
is issued. Debt trading is just like trading stocks.
• OTC is a special kind of market, which is not organized in
form of corporation, but it is a network of traders using
online connection to trade.
Reasons for issuance
• Usually debt instruments will have a clearly
defined and stated reason for issue.
• There are three main reasons to issue debt. The
reasons depend on the needs of the issuer.
• Short term liquidity
• Project finance
• Changes in the issuer’s term structure
Reasons for issuance
• The first two reasons for issuance are obvious. The debt issued is
using debt to consolidate its cash flow or to use money for an
investment activity.
• The third reason is a little more complex.
• Corporations just like banks have to control their term structure. In
case a corporation has large amount of short term liabilities and
short term liquidity of the corporation is unstable, the corporation
should issue long term debt and use proceeds from the debt issuance
to pay off short term liabilities.
• Using this the corporation changes the term structure of its debt.
• The first reasons for debt issuance have significant effect on the size
for the balance sheet, the third reason for issuance does not.
Characteristics of bonds
• Just like any other instruments bonds have also several
important characteristics .
• The most important of those are:
• Issuer: who has issued debt instrument: government,
corporation, municipality.
• Term: what is the length of the instrument: short term,
medium term, long term.
• Payment form: On what form will the repayment occur.
• Currency: what is the currency of debt: local or foreign.
• Cash flow: what is the way the interest and principals are paid
off over time.
Derivaties
• The process of derivatives creation and the
roles of derivatives as instruments is
significantly different from stocks and bonds.
• Precisely because of this we have to approach
derivatives in a different way from stocks and
bonds.
Derivatives
• Derivate is a financial instrument whose value and properties
are derived from another usually financial instrument.
• Because of this we says derivatives are derived from other
instruments..
• Based on the underlying instrument we have:
– Stock derivatives
– Debt derivatives
– Derivatives on derivatives (SWAPions, options on futures)
• Derivatives do not have an exact formula for calculation,
rather they have models for price prediction. This is why the
actual value of the derivative can significantly differ from the
value given by model. In case of derivatives, theory and
practice rarely coincide.
Forward
• Forward is a contract which obliges sides or parties engaged
in forward contract to some future transition.
• Forward is a derivative contract, usually between two sides.
• Forwards are usually not exchange traded since the terms and
structure of the forward contract can be defined and
negotiated between the parties. .
• Because of the way they are traded forwards do not have
standardized form.
• The basis for the calculation of the value of the forward
contract is a no arbitrage theorem.
• Forwards are mostly based on FX.
• It is important to note that forward is a second leg of a FX
SWAP.
Futures
• Futures contract is a standardized contract where one
side agrees to purchase a certain, clearly defined asset
and the other side agrees to sell a certain asset at some
point in time.
• Based on their characteristics futures contracts always
have two sides: one side which is buying and the other
side which is selling.
• Futures are exchange traded instruments.
• Exchanges always clearly define the quantity, quality and
characteristics of futures contracts.
• In case there is not futures contract for a particular
good, then it is not possible to trade that good on that
exchange.
Option
• Option is a derivative instrument through which we either buy or sell
a right to purchase or sell a certain underlying instrument:
– Call option: right to buy
– Put option: right to sell
• Options exist on most financial instruments. The basic options are
stock options, but also highly popular are options on futures
contracts.
• Options can also be used to create a derivative instrument based on
derivative instrument, so you have derivative of a derivative like
options on futures or SWAPs.
• Options are traded on exchanges, just like other financial instruments.
Options just like futures have their characteristics: time until
expiration, clearly defined underlying instrument.
Futures contract example
Contract specification