4th, 5TH and 6th SESSION
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Financial Markets
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Few Key Terms
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Assets
Types of Assets: Tangible and Intangible
Lender/Saver/Investor
Borrower/Seller of financial assets
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Markets
• Definition
• Function of Markets: ‘move money’
• People are not satisfied with their existing
cash flow stream, financial markets serve to
reengineer their existing cash flow streams
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Financial Markets and their Functions
• Financial Markets
– Markets (bond and stock market for instance)
where financial securities are bought and sold.
• Two main functions
1. Moving funds from people having surplus funds to those
in need of funds.
2. Financial markets promote greater economic efficiency.
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Structure of Financial Markets
– Several ways for classifying the financial markets
– Key terms to describe financial markets:
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Public offering vs. Private placement
Primary vs. Secondary market
Debt vs. Equity market
Money vs. Capital market
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A. Classification of financial market on the basis
Public or private placement of securities
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1. Public Placement of Securities
• In a public offering equity shares or other
financial instruments are offered for sale to
the public.
• Investment banking firm
– Underwriting
– Underwriter
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1. Private Placement of Securities
• Also called ‘Direct Placement’
• Securities are offered and sold directly to a
limited number of investors
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B. Classification of financial market on the basis
of the security issue
– Primary market (new issues of security)
– Secondary market (previously issued)
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1. Primary Market
• New issues of a security as opposed to previously
issued securities are traded.
• If Google issues a new batch of securities it would
be called a primary market transaction.
• Works like a new car market.
• IPO
– The first time a company issues stock to the public.
• SEO
– Sale of additional shares by a company whose shares
are already publicly traded.
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2. Secondary Market
• Previously issued securities are bought and sold.
• Used car market.
• New York Stock Exchange (NYSE), Karachi Stock
Exchange (KSE) and NASDAQ etc.
• Important to remember:
– When an individual buys securities in the secondary
market, the person selling the security gets the money
and the issuing corporation gets no new funds.
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Secondary
Market
Broker
Market
Dealer
Market
Stock
Exchange
OTC
• Broker Market
– Broker
• Broker matches ‘buy order’ of person A with ‘sell order’
of person B and charges a commission for that.
• Broker acts as an ‘agent’ of the buyer and seller of the
security.
– Stock Exchanges
• Dealer Market
– Dealer
• Dealer trades for himself acting as a principal not an agent.
• 2 separate trades are made.
• Dealer buys securities from person A (at ‘bid price’ - low)
and sells to person B (at ‘ask price’ - high).
• Bid Ask Spread – Difference between ask price and bid price
(dealer’s profit).
• Example: Dealer will offer $599 bid price for 100 shares of
Google’s stock and will sell them at an ask price of $600
keeping the $1.
– OTC
C. Classification of financial market on basis of the
nature of claim
– Debt market
– Equity market
Claim is to ‘demand anything as a right’. If I hold
a debt instrument it means I hold the right to
demand periodic interest payments and
principal upon maturity, similarly if I hold a stock
I can demand dividend as my right.
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1. Debt Market
• Most common method used to raise funds.
• The debt market is the market where debt
instruments (govt. bonds, corporate bonds) are
traded.
• Debt instruments are assets that require a fixed
payment to the holder, usually in the form of
interest payments and a final payment at
maturity.
• Examples of debt instruments include
government bonds and corporate bonds.
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• The maturity of a debt instrument is the
number of years (term) until that instrument’s
expiration date.
– A debt instrument is short-term if its maturity is
less than a year (T-bills).
– Debt instruments are called long-term if their
maturity is ten years or longer (T-bonds).
– Debt instruments with a maturity between one
and ten years are said to be intermediate-term (TNotes).
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2. Equity Market
• The equity market (often referred to as the
stock market) is the market for trading equity
instruments.
• The second method of raising funds is by
issuing equities, such as common stock.
• A common stock is a document which serves
as legal evidence of ownership in a company.
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Characteristics of Equity Securities
• Variable return (dividend, decided by
company’s board of directors)
• Unlimited life of the security
• Voting rights
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Advantages versus disadvantage of owning a
corporation’s equities rather than its debt
ADVANTAGES
DEBT
DISADVANTAGES
1. A corporation has to pay 1. Debt holders interest
all its debt holders
payments are fixed, they do
before it pays its equity
not benefit directly from
holders.
any increases in the
- Less risky (paid first)
corporation’s profitability.
EQUITI 1. Equity holders benefit
ES
directly from any
increase in the
corporation’s
profitability as they are
owners of the
1. An equity holder is a
residual claimant.
- More risky.
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D. Classification of financial market on the basis
of maturities of securities traded
– Money market
– Capital market
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1. Money Market
• Short term (maturity of less than one year)
• Debt instruments
• Money market isn’t a physical place rather a
telephone and computer based market.
• Characteristics
– Highly liquid.
– Active secondary market.
– Wholesale market (usually in excess of $1 million).
2. Capital Market
• Long term (maturity of greater than one year)
• Debt and Equity instruments
Money Market Instruments
1. T-bills:
– Short term debt instruments
– Issued by government at a ‘discount’
– Discount from principal represents interest to
investors
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For example, a 52-week T-Bill with a $1,000 face value might be sold initially for $990. When it
matures, the investor will receive the full $1,000. The extra $10 the investor receives is their
investment return for purchasing the T-Bill.
Default free
Maturity (3, 6 or 12 months)
Liquid Instrument
Balance Sheet (Cash and Cash Equivalent)
2. Certificate of Deposit
• Issued by a bank to certify that the depositor has
deposited a certain sum of money at the bank.
• Characteristics
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Typical Issuer: Commercial bank
Typical Investor: Institutional Investors
Large denominations ($100,000, $1M, $10 M)
Interest payment
Maturity (up to 1 year)
Term security
Bearer Instrument (holder of instrument is owner and
entitled to coupon and principal payment)
Negotiable (can be bought and sold in secondary market)
3. Commercial Paper
• Issued by well-known corporations for short
term financing obligations.
• Characteristics
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Typical issuer: Large well-known corporations
Typical Investor: Institutional investors
Discount Investment
Maturity: Less than 270 days
Unsecured loan
Riskiness (investor can gauge possible riskiness by
looking at the credit rating of the issuing
corporation)
4. Fed Funds
– Reserve requirement
– Loans that bank make to each other in order to
meet the reserve requirement set by the Central
Bank.
– Fed. Fund Rate: Rate at which the loans are lent.
5. Banker’s Acceptance
• Short term debt instrument guaranteed for
payment by a commercial bank.
• Bank ‘accepts’ the responsibility to pay.
• Characteristic
– Typically arises in International trade where the
two companies do not know about each other
(located at different geographical areas).
6. Eurodollar
• Euro means a ‘foreign country’.
• Refers to US dollar deposit in a foreign
country.
7. Repo (Repurchase Agreement)
• Sale of government securities with an
immediate agreement to buy them back on a
future date at a specified price.
• Characteristics
– Secured loan
– Time (Overnight – some are long term)
Capital Market Instruments
1. T-Bonds and T-Notes
– Long term debt security
– Issued by government
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PIB: Pakistan Investment Bond
– Maturity: T-Notes (2-10 years) T-Notes (10-30 years)
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Fixed Interest payment
Principal payment upon maturity
Government is the borrower
Risk (Riskier than T-bills)
2. Corporate Bonds
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Long term debt security
Issued by well-reputed corporations
Maturity (2-30 years)
Fixed interest payment
Risk (credibility)
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AAA rated bond: risk (low) return (low)
B rated bond: risk (high) return (high)
3. Mortgages
– Loan made to purchase real estate with the real
estate serving as collateral for the loan.
4. Common Stock
– Share of ownership
– Dividends
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Variable
5. Preferred Stock
– Hybrid security (characteristics of both bond and
stock instruments)
– Characteristics similar to bond:
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Fixed dividend payment
Paid before common stockholders
– Characteristics similar to stock:
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Generally listed on a stock exchange
No fixed maturity date