Foundations of Financial Markets and Institutions

Chapter 1: Introduction

INTRODUCTION

Two kinds of markets:
1. Product Market: products (manufactured goods and services).
2. Factor Market: factors of production (labour and capital).
Includes the financial market.
FINANCIAL ASSETS

Asset: a possession that has value in an exchange.

Tangible asset: an asset whose value depends on its physical characteristics.

Intangible asset: a legal claim to some future benefit.
Financial asset / financial instrument / security: a claim to future cash.

Issuer: the entity that has agreed to make future cash payments on a financial asset.

Investor: the owner of a financial asset.
Debt Instruments versus Equity Instruments

Debt instrument: a financial instrument whose claim is a fixed dollar amount.

E.g. loans, bonds.

Equity instrument / residual claim: a financial instrument whose claim is a varying, or residual,
amount based on earnings, if any, after holders of debt instruments have been paid off.

E.g. common stock, partnership in a business.

Some securities fall into both categories.

E.g. preferred stock, convertible bonds.
The Price of a Financial Asset and Risk

Price (of a financial asset): equal to the present value of the expected cash flow of the asset,
even if this value is uncertain.

Cash flow: stream of cash payments over time.
E.g. $500/month for 3 years.

Expected return: calculated from expected cash flow and price of a financial asset.

E.g. If price is $100, and cash flow is $105 a year from now, expected return is 5%.

Various categories of risk, including:

Purchasing power risk / inflation risk: attached to the purchasing power of the
expected cash flow.

Credit risk / default risk: risk that the issuer or borrower will default on its obligation.

Foreign-exchange risk (for assets in foreign currencies): risk of an adverse change in
the foreign exchange rate.
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Financial Assets versus Tangible Assets

Both financial and tangible assets are expected to generate some future cash flow for their
owner.

Financial and tangible assets are linked.

Ownership of tangible assets is financed through issuance of financial assets.

Cash flow for a financial asset is ultimately generated by some tangible asset.
The Role of Financial Assets

Two main economic functions of financial assets:
1. To transfer funds from those who have surplus funds to those who need funds to invest
in tangible assets.
2. To redistribute the unavoidable risks associated with the cash flow of tangible assets
among those seeking and those providing funds.
FINANCIAL MARKETS

Financial market: a market in which financial assets are exchanged (i.e. traded).

Spot market / cash market: a market in which financial assets trade for immediate
delivery.
Role of Financial Markets

Three functions of financial markets (in addition to the two functions of financial assets
described above):
1. To facilitate of the price discovery process: process that determines how funds in an
economy should be allocated among financial assets.
Interactions between buyers and sellers in a financial market determine the
price of a traded asset, i.e., the required return on a financial asset.
Inducement for firms to acquire funds depends on the required return that
investors demand.
2. To increase liquidity: the ease with which assets can be sold without altering their price
much (or at all).
Financial markets provide a mechanism for investors to sell assets.
3. To reduce transaction costs: two types:
i. Search costs: includes explicit costs (e.g. money spent to advertise intention
to sell) and implicit costs (e.g. value of time spent locating a counterparty).
ii. Information costs: costs associated with assessing the investment merits of a
financial asset (i.e. the amount and likelihood of expected cash flow).

In an efficient market, prices reflect information collected by all
market participants.
Classification of Financial Markets

By nature of claim:

Debt market: a market in debt instruments.
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Equity market: a market in equity instruments.

By maturity of claim:

Money market: market for short-term debt instruments.

Capital market: market for longer-maturity financial assets.

By seasoning of claim:

Primary market: market for exchanging newly issued financial claims.

Secondary market: market for exchanging previously issued financial claims.

By immediate versus future delivery:

Cash market / spot market: market in which financial assets trade for immediate
delivery.

Derivative market: market for derivatives (assets derived from other forms of assets);
trades for delivery in future.

By organisational structure:

Auction market: a market in which buyers enter competitive bids and sellers enter
competitive offers simultaneously.

Over-the-counter market: a decentralised market (without a central physical location)
in which market participants trade with each other through various communication
mechanisms (e.g. telephone, email, proprietary electronic trading systems).

Intermediated market: a market in which one or more financial institutions stand
between counterparties in a transaction.
Market Participants

Market participants: participants in financial markets that issue and purchase claims. These
include:

Households

Business entities: corporations and partnerships.
Financial enterprises: provide financial products and services.
Nonfinancial enterprises: manufacture products and/or provide non-financial
services.

National governments

National government agencies

State and local governments

Supranationals (e.g. World Bank, European Investment Bank, Asian Development
Bank).

Regulators are also considered market participants.
Globalisation of Financial Markets

Globalisation (of financial markets): integration of financial markets throughout the world into
an international financial market.

Factors leading to globalisation:
1. Deregulation (i.e. liberalisation) of markets and the activities of market participants.
2. Technological advances for monitoring world markets, executing orders, and analysing
financial opportunities.
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3. Increased institutionalisation of financial markets: shift in domination of markets by
retail investors (i.e. individuals) to domination by institutional investors (i.e. financial
institutions).
Classification of Global Financial Markets

Internal market / national market: two parts:
1. Domestic market: where issuers domiciled in the country issue securities and where
these securities are subsequently traded.
2. Foreign market: where securities of issuers not domiciled in the country are sold and
traded.

External market / international market / offshore market / Euromarket: allows trading of
securities with two distinguishing features:
1. At issuance, securities are offered to investors in a number of countries simultaneously.
2. Securities are issued outside of the jurisdiction of any single country.
Motivation for Using Foreign Markets and Euromarkets

Corporations may be unable to raise sufficient funds from the domestic market alone.

Cost of obtaining funds may be lower.

Desire to diversity source of fundingto reduce reliance on domestic investors.
DERIVATIVE MARKETS

Derivative instrument: a contract that enables or obligates the holder to buy or sell a financial
asset at some time in the future.

The price of such a contract derives from the value of the underlying financial asset,
financial index, or interest rate.
Types of Derivative Instruments

Futures contracts and forward contracts: an agreement whereby two parties agree to transact
with respect to some financial asset at a predetermined price at some future date.

One party agrees to buy, the other to sell.

Both parties are obligated to perform.

Neither party charges a fee.

Options contract: gives the owner the right, but not the obligations, to buy (or sell) a financial
asset from (or to) another party.

Option price: fee that the buyer of the contract must pay to the seller.

Two types of options contract:
Call option: grants the owner the right to buy a financial asset from the other
party.
Put option: grants the owner the right to sell a financial asset to the other
party.

Derivative instruments are not limited to financial assets.

There are derivative instruments involving commodities and precious metals.
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There are derivative instruments that are packages of either forward or options
contracts, e.g.:
Swaps: where two counterparties agree to exchange cash flows of one partys
financial instrument for those of the other partys financial instrument.
Caps: where the buyer receives payments at the end of each period in which
the interest rate exceeds an agreed strike price.
Floors: where the buyer receives payments at the end of each period in which
the interest rate is below the agreed strike price.
The Role of Derivative Instruments

Derivative contracts provide issuers and investors with an inexpensive way to mitigate certain
risks, e.g.:

Rises in interest rates.

Declining stock prices.

Adverse changes in exchange rates.

Potential advantages of derivative markets over corresponding cash (spot) market for the same
financial asset:
1. It may cost less to adjust the risk exposure of an investors portfolio to new economic
information.
2. Transactions can typically be accomplished faster.
3. Some derivative markets are more liquid, i.e., they can absorb a greater dollar
transaction without an adverse effect on the price of the derivative investment.
THE ROLE OF GOVERNMENT IN FINANCIAL MARKETS

Governments regulate financial markets in various ways.

Governments, markets, and institutions interact to affect one anothers actions in various ways.
Justification for Regulation

Standard justification: left to itself, the market will not produce goods and services efficiently at
the lowest possible cost.

This occurs when markets fail, i.e., when they are not perfectly competitive.
Competitive market: efficient and low-cost.
Market failure: occurs when a market cannot, by itself, maintain all the
requirements for a competitive situation.

Kinds of regulation and their corresponding purposes:
1. Disclosure regulation: requires issuers of securities to disclose large amounts of
financial information to actual and potential investors.
Purpose: to prevent issuers of securities from defrauding their investors by
concealing relevant information.
Asymmetric information: when managers of issuing firms have greater access
to and possession of information than actual and potential investors.
Agency problem: in absence of disclosure regulation, managers, who act as
agents of investors, may act in their own interest at the expense of investors.
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2. Financial activity regulation: consists of rules about traders of securities and trading
on financial markets.
Purpose: to promote competition and fairness in the trading of financial
securities.
E.g. rules against insider trading: trading by corporate insiders, e.g. corporate
officers and others with more information about a firms prospects than the
general investing public.
E.g. rules regarding structure and operations of exchanges where securities are
traded so as to minimise the risk of defrauding the general investing public.
3. Regulation of financial institutions: a form of governmental monitoring that restricts
the activities of financial institutions in vital areas of lending, borrowing, and funding.
Purpose: to promote the stability of financial institutions.
The justification for regulation is that these institutions have a special
importance in the modern economy; their failure would be devastating.
4. Regulation of foreign participants: limits the roles foreign firms can have in domestic
markets and their ownership or control of financial institutions.
Purpose: to restrict the activities of foreign concerns in domestic markets and
institutions.
5. Banking and monetary regulation: controls changes in a countrys money supply.
Purpose: to control the level of economic activity.
Regulation in the United States

US regulatory structure is largely the result of various financial crises, especially the stock
market crash of 1929 and the Great Depression of the 1930s.

There is a complex array of industry- and market-focused regulators.

Blueprint for Regulatory Reform: a proposal by the US Department of Treasury that would
replace the complex array of regulators with a regulatory system based on functions:

Three proposed regulators:
1. Market stability regulator: would take on responsibility of the Federal Reserve
by giving it the power and authority to ensure overall financial market stability.
2. Prudential regulator: charged with safety and soundness of firms with federal
guarantees.
3. Business conduct regulator: would regulate business conduct across all types
of financial firms, taking on most of the roles of the Securities and Exchange
Commission and the Commodity Futures Trading Commission.
FINANCIAL INNOVATION

There has been a surge in significant financial innovations since the 1960s.
Categorisations of Financial Innovation

Three examples of systems for classifying financial innovation:

Economic Council of Canadas classification system:
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1. Market-broadening instruments: increase liquidity and availability of funds
by attracting new investors and offering new opportunities for borrowers.
2. Risk-management instruments: reallocate financial risks to those who are
less averse to them, or who have offsetting exposure and are thus better able
to shoulder financial risks.
3. Arbitraging instruments and processes: enable investors and borrowers to
take advantage of differences in costs and returns between markets, reflecting
differences in perception of risks, as well as in information, taxation, and
regulations.

Bank for International Settlements classification system:
1. Price-risk-transferring innovations: provide market participants with more
efficient means for dealing with price or exchange-rate risk.
2. Credit-risk-transferring instruments: reallocate the risk of default.
3. Liquidity-generating innovations: three functions:
i. Increase liquidity of the market.
ii. Allow borrowers to draw upon new sources of funds.
iii. Allow market participants to circumvent capital constraints imposed
by regulators.
4. Credit-generating instruments: increase the amount of debt funds available
to borrowers.
5. Equity-generating instruments: increase the capital base of financial and
nonfinancial institutions.

Stephen Rosss classification system:
1. New financial products (financial assets and derivative instruments) better
suited to the circumstances of the time (e.g. to inflation) and to the markets in
which they trade.
2. New strategies that primarily use these financial products.
Motivation for Financial Innovation

Two opposing views:
1. Impetus for innovation is the endeavour to circumvent (or arbitrage) regulations and
find loopholes in tax rules.
Arbitrage: the practice of taking advantage of a price difference between two
or more markets.
2. Essence of innovation is the introduction of financial instruments that are more
efficient for redistributing risks among market participants.

Important causes of financial innovation:
1. Increased volatility of interest rates, inflation, equity prices, and exchange rates.
2. Advances in computer and telecommunication technologies.
3. Greater sophistication and educational training among professional market
participants.
4. Financial intermediary competition.
5. Incentives to circumvent existing regulation and tax laws.
6. Changing global patterns of financial wealth.