Welcome to Session C of the Associate PRM Webinar Series

Bob Mark, Presenter Anne Jones, Host

Black Diamond Risk Enterprises Webcast Manager PRMIA

This material is the intellectual property of PRMIA and shall not be reproduced or without the express written permission of PRMIA. www.prmia.org

PRMIA 2016
 Welcome to Session C

An Introduction to Financial Markets

 Learning Objectives

After completing this session, participants will be able to:

Define the overall characteristics of global markets and their common

structures
Define the characteristics and types of instruments of each of the
following:
Money Markets (MM)
Bond Markets (BM)
Stock Markets (SM)
Foreign Exchange Markets (FEM)
Futures Markets (FM)
Over-the-Counter Markets (OTCM)
Commodities Markets (CM)
Energy Markets (EM)

Reading material is the abridged of the PRMIA Guide to Financial Markets.

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 The Original Financial Market

Feed the family

and retain seed
for next year
Surplus

Deficit
The harvest Trade (sell) surplus
for commodities
Borrow (buy) corn to feed or lend surplus
family (shareholders) and the family profits
to plant for next year

Plant (invest) for

next year
Users of markets can be growers (creators/providers), consumers
(manufacturers or financial users), borrowers (creators who have a
commitment to deliver), intermediaries (brokers), service providers,
investors and speculators, or any combination of these.
 Why Do Financial Markets Exist?

They are simply a market place where people can buy and sell
assets easily, at low transaction costs, and at prices reflecting an
efficient market

The most important aspect of financial markets is to improve

liquidity, i.e. ensure there is a buyer for anyone who wants to sell
and vice versa

Financial markets also facilitate:

The raising of capital
The transfer of risk
International trade
They match those who need
capital or commodities against
those who have it
For example, eBay is a non-
financial market, matching
buyers and sellers eBay, the
company, is the broker,
automatically matching buyers
and sellers

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Some Basic Terms in Financial Markets
(Glossary)
Assets The plus side of the balance sheet
Tangible assets such as cash in the bank or stored commodities
That held by others money you loaned, transaction obligations to
pay you (there is risk involved here, hence risk-weighted assets)
mortgages, commercial loans, derivatives, etc.
Liabilities The minus side of the balance sheet
What you hold but belongs to someone else, i.e. shareholder funds,
deposits, etc.
Obligations that you have to pay as a result of transactions bonds,
derivatives, margin calls
Margin What you have deposited (capital) in order to have the
right to make a future transaction. The price of the margin rights
may change, but the price of the underlying asset can change much
more, which results in
Leverage The use of financial instruments to enable a profit (or
loss) greater than the normal interest or price change based on the
capital involved it is also the misbalance between loans and assets
(a simple example of leverage is a domestic mortgage)

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 Basel III Leverage Ratio
The leverage ratio is a simple measure of capital that
supplements Basel IIIs risk-based ratios and constrains the
buildup of leverage in the system.
Before the crisis, many banks reported strong tier 1 risk-based
ratios while, at the same time, building up unsustainably high
levels of leverage, both on and off balance sheet.
The leverage ratio is a measure of a banks tier 1 capital as a
percentage of its assets plus the banks off-balance-sheet
exposures and derivative exposures(calculated as an average
over the quarter)
Banks will not be allowed to lower their leverage ratio below 3
percent*.
*Tier1 Capital
Exposure > 3%

See Page 95

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 The History of Markets and Risk
Antiquity Market places offered a venue where commodities could be
exchanged, later on for money rather than other goods
500 BC Temples in Mesopotamia offered deposit services to safeguard
money and commodities credit and payment instructions appear
200 BC Interest on loans and deposits now common although
condemned by religious bodies basic levels of financing appear
500 -1000 AD Islamic banking developed with cheques, promissory notes and
letters of credit paper money appears in China
Il banco Financing reintroduced, driven by the Crusades emergence of
medieval Italy major money lenders the risk was not getting repaid (credit
risk)
1400s the age Money loaned to fund a voyage of discovery periods were long
of investing risk was very high loss could be total profits high
1500s Inflation (market risk) appears shareholders fund voyages
promissory notes appear paper replacing metal; credit
worthiness of issuer now key
18th-19th Banking is primarily to support commercial trading: other risks
Centuries operational, reputational, etc. become issues
19th 20th Investors and depositors at risk on one side inflation, on the
Centuries other, bankruptcies, corruption and insider dealing
1929+ Regulators target market failures (systemic risk)
1980+ Regulators target risk taking and investor protection banks must
set aside capital as first line of defence

Not in syllabus for general explanation

 Market Features

Formal exchanges vs. overthecounter markets

Exchange listing rules vs. strength of participants
Exchange prices vs. pooled competing dealer quotes
Margin requirements vs. credit status of participants
Standard contracts vs. made to measure contracts

FX markets use inter-dealer brokers but most markets now use

electronic order books
Sale and repurchase (repo) markets reduce credit risk and increase
liquidity (and offer leverage)
Post trade processing compare and confirm, possible netting,
delivery and payment (settlement)
Retail vs. wholesale trading
Why have brokers if you also have exchanges?

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 The Trade Process
(simplified!)

Indication Execute
Order
of Trade
Interest Processing (T)

Compare/
Clearing/ Settlement
Confirm
Netting (T+?)
Trade

T+3 reducing to an eventual objective of T+0

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PRMIA 2011
 Question #1

Q Which of the following processes is not considered to be

part of post-trade processing?

a) Comparison and confirmation

b) Netting
c) Process Order
d) Settlement

The answer is:

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 Question #1

Q Which of the following processes is not considered to be

part of post-trade processing?

a) Comparison and confirmation this is incorrect because

this is part of post-trade processing
b) Netting this is incorrect because netting is a procedure
effected after the trade was closed
c) Process Order this is correct because Process Order
happens before post-trade processing
d) Settlement this is incorrect because settlement is a post-
trade processing feature

The answer is:

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 Liquidity in Financial Markets

Liquidity The ability to sell or buy a commodity or service at a

fair market value (Nobel prize winner James Tobin)
Markets are liquidity facilitators bringing together buyers and
sellers, reducing their risks
Liquidity will tend to concentrate markets many players reduces
the bid/ask spread
Higher risk of default on an instrument (the credit risk) will make
these less attractive (lower rated) so less liquid and result in a
higher spread
Funding issues will also drive attractiveness and so liquidity i.e.
cash instruments vs. derivatives
Risk managers must understand liquidity driven by individual
impact (i.e. rating) or market impact (i.e. external news, links to
other markets)

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PRMIA 2011
 Question #2

Q Liquidity is the ability to sell or buy a commodity at fair

market value. Liquidity risk is:

a) An unexpectedly high bid/ask price difference

b) The risk of a failure in the order-entry, price-matching
systems
c) A sovereign default of the benchmark government bond
d) An unexpected fall in market volumes in a specific
instrument, or a group of instruments

The answer is:

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 Answer to Question #2

Q Liquidity is the ability to sell or buy a commodity at fair

market value. Liquidity risk is:

a) An unexpectedly high bid/ask price difference can be the

result of a drop in liquidity, but it is not liquidity risk
b) The risk of a failure in the order entry price-matching
systems would be an operational risk
c) A sovereign default of the benchmark government bond is
an, albeit major, credit risk
d) Liquidity risk is that there is an unexpected fall in
market volumes in a specific instrument, or a group
of instruments, which makes transactions harder to
execute at the listed prices

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 What is a Derivative?

A derivative is a financial instrument that is derived from an

asset (the underlying asset), or a measurable future index, event
or value
There is a derivative contract to exchange cash or assets at a
future date based on the underlying asset price (or index, event
or value) at that time
Derivative payments are based on margin, thus giving
opportunities for leverage
Derivatives include:
Forwards and future contracts
Options, index and interest rate contracts
Swaps
Contracts for difference, spread contracts, etc.

and combinations of all the above (derivatives of derivatives!)

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PRMIA 2011
 New Markets

Structured finance
Customised interest products (OTC structured notes) such as interest rate
swaps and floating rate notes
Asset-backed securities
Tranched mortgage-backed securities
Collateralised debt obligations (CDOs)
Collateralised fund obligations
Contingent Convertible Bonds (see Appendix 3.5)*

Syndicated loans
Credit derivatives
Credit default swaps (CDS), Total return swaps, credit default swaptions,
credit spread option, CDS index products, credit linked notes, synthetic
CDOs

Risk managers at firms that deal in these instruments (buy, sell or create) will need to
understand these products

*page 143

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PRMIA 2011
 Money Markets

The interest rate markets (fixed income instruments) derived from loans and
deposits, or from securities
The instruments are composed of all/some of term, principal, interest rate,
marketability/transferability, secured/unsecured obligation, and call/put
features
Players are:
Large corporations, governments and institutions such as the World Bank who
provide funds
Banks, credit unions, trust companies, and some major investment dealers
who are providing services and act as intermediaries
Large/medium businesses requiring services

This is not a physical market and has no location it is a 24-hour market

operating over telephone, the internet and computers

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PRMIA 2011
 Money Market Instruments

Term deposits and loans

Repurchase agreements or repos (term from one day upwards)

Non-domestic loans and deposits (the Eurocurrency Market)

Structured loans (tradable securities one year term)

Treasury bills (government securities)

Commercial paper (short-term corporate similar to T-bills)

Bankers acceptances (as above backed by a bank)

Certificates of deposits (as above but issued by a bank)

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PRMIA 2011
 What is LIBOR?

At 11 a.m. London time each day, the British Bankers Association

(BBA) surveys the rates offered by at least eight banks chosen for
their reputation, scale of activity in the London market, and
perceived expertise in the currency concerned, and giving due
consideration to credit standing

It ranks the quotes from highest to lowest, drops the highest and
lowest to 25%, and takes the average of the remaining 50%

The result is the official BBA London Interbank Offered Rate

(LIBOR) for the specific currency and maturity

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 What is LIBOR?
(continued)

Why is the BBA LIBOR important?

For the U.S. dollar in particular, LIBOR has become the primary
benchmark interest rate for many short-term U.S. dollar loans to
corporations, including those made in the U.S. domestic market
The interest rate on these loans is quoted as a spread above or
below LIBOR, such as three-month LIBOR- X % or six-month
LIBOR + X %
The size of the spread depends primarily on the credit quality of
the customer borrowing the money
While most corporations can only borrow at a spread above LIBOR,
some of the most creditworthy customers can obtain loans at rates
below LIBOR.

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 Bond Markets

Debt instruments to cover the financing needs of governments,

government agencies and corporations

The market consists of borrowers (above), lenders (banks using

deposits, investors) and intermediaries

Bonds can trade nationally or internationally

Bonds are generally long term (capital markets) the primary

market when bonds are issued (bond underwriters), the secondary
market subsequently

Credit risk issues default probability, yield curves and comparisons,

use of credit ratings

Treasury bonds exhibit the risk-free interest rate benchmark used

in CAPM (see Session A)

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 Bonds: Instruments and Trading

Instruments of 1 year + maturity less is considered a money

market instrument

Sovereign or government bonds issued by major national

governments (low risk, highly liquid)

Agency bonds (U.S. government agencies, some privately owned)

Municipal bonds

Corporate bonds (levels of risk and liquidity depend on issuer)

International (or Eurobonds)

Traded on exchanges and OTC

Primary markets (underwriting and flotations), secondary markets

(bid/offer trading) and bond derivatives (futures, options, etc..)

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 Example: Muni Bond

Municipal securities constitute the municipal market, that is, the

market where state and local governments, counties, special
districts, cities and towns raise funds in order to finance projects
for the public good such as schools, highways, hospitals, bridges
and airports.
Typically, bonds issued in this sector are exempt from federal
income taxes, so this sector is referred to as the tax-exempt sector
There are two generic types of municipal bonds: general obligation
bonds and revenue bonds.
General obligation bonds have principal and interest secured by the
full faith and credit of the issuer and are usually supported by
either the issuers unlimited or limited taxing power.
Revenue bonds have principal and interest secured by the revenues
generated by the operating projects financed with the proceeds of
the bond issue. Many of these bonds are issued by special
authorities created for the purpose.

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 Stock Markets

Stocks (shares or equities) represent ownership in an organisation

for whom they are a way of raising capital and spreading
ownership (and risk)

Stocks are issued and traded on regulated markets

Stockholders last in queue for recovery of investment, hence high

volatility in stock prices

Stocks have a face value and can pay a dividend, and carry
variable ownership (voting) rights

The market consists of the primary market (the initial launch of a

share) and the secondary markets (the subsequent trading in those
shares)

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 The Status of a Stockholder

Simplified balance sheet of a company

Assets Liabilities
Fixed assets Creditors
Debtors (e.g. a loan) Bondholders
Shareholders funds

Pay-out hierarchy on liquidation

First in queue Tax authorities
Secured creditors (mortgagor)
Trade creditors
Senior bond holders
Junior bond holders
Last in queue Stock/share/equity holders
 The Stock Market Players
Execute Trades via:
Exchanges (both physical and electronic)
ECNs (Electronic crossing networks)
Internal matching
Direct (but reported to the exchange)
Retail Research
Investors

Custodian

Professional Buy-side Sell-side

Investors
broker broker

Sales Selling Registrar

Investor
Institutional
Investors Reports to
(Pension or
Mutual Funds)
Exchange and
Regulator
 Stock Market Terms & Instruments

IPOs (public)
Private placements The primary market
OTC
Market makers
The secondary market

Commissions
Bid-Offer spread
Everything and almost
Points and tick size anything can have an
impact on the market
Buying on margin
Leverage
and is part of the risk
Margins and margin calls scenario
Stock borrowing and short selling
Different exchange rules
Changing regulatory scenario

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 Question #3

Q A company issues 100 million shares at 25. Its market

share price is now 150 with a bid/offer spread of 1. The
market cap is:

a) $25 million
b) $150 million
c) $149 million
d) $151 million

The answer is:

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 Answer to Question #3

Q A company issues 100M shares at 25. Its market share

price is now 150 with a bid/offer spread of 1. The
market cap is:

a) $25 million was the market cap when the shares were
first issued and before any trading started
b) $150 million is the number of shares times the
quoted share price
c) $149 million does not take into account the last
transacted share price
d) $151 million would be multiples of the buy or sell spreads

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 Foreign Exchange Market

Trading in foreign exchange markets averaged $5.3 trillion per day

in April 2013 (Source: Triennial Central Bank Survey of Foreign
Exchange and OTC Derivatives Markets Activity*)

The interbank market is OTC decentralised, continuous, open

bid, double auction

Trade can be direct or via a broker, physical or through electronic

trading systems credit officers will set counterparty limits.

FX rates will vary according to:

The economic state of the country (fundamentals)
The balance of payments
Short-term market activity or international events
Liquidity
Central banks intervention

(* The BIS Triennial Survey :$4 trillion in April 2010 & $3.3 trillion in April 2007 )

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 FX Operations
Most rates quoted against the U.S.$:
Directly NNN currency against 1 U.S.$, or
Indirectly NNN U.S.$ against one unit of currency

Crossrates are non-U.S.$ currency vs. non-U.S. $ currency

Currency can be bought spot {(for immediate delivery and settled
1 (e.g. U.S.$/C$) or 2 days after trade date)} or forward (delivery
up to one year in the future)

Forward
Desk
Compliance
Spot Desk Confirmation,
Chief
Settlement, etc.
Trader

------------- Front Office ------------ --- Middle Office --- - Back Office -

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 Futures Markets

Futures are exchange-traded, forward based derivatives which

contract two parties to a future action, i.e. the delivery and
payment of an asset
There is a buyer and seller, a maturity/expiration date, and a future
defined payment they are binding contracts but less than 3%
(CME) run to expiration
Underlying assets can be stocks, commodities, currencies, fixed
income instruments, etc.. Futures can reduce concentration risk in a
portfolio
Margin payments on futures reduce default risk but increase
leverage risk
Managed futures funds are the basis of the commodity trading and
hedge fund industries
Options on futures (derivatives of derivatives) are extremely
popular as they do not have margins but the risks are high

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 Terms: Options on Futures
Buying an option gives the right but not the obligation to purchase
a specific future transaction at a given date
There is no margin on purchasing options on futures, but there is a
premium paid on purchasing. There is no downside other than
losing the premium
Purchasers of an option contract pay for the right to buy a futures
contract (put, the right to sell, or call, the right to buy) at an agreed
price on or before its expiration date
Sellers of the option contracts receive the premium and have the
obligation to then sell the buyer a futures contract (a CALL option)
or buy one (a PUT option). The seller therefore has an unlimited
liability
If a trader thinks prices will increase, he will buy a call option or sell
a put option
If a trader thinks prices will decrease, he will buy a put option or
sell a call one

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 Futures Markets Players
Exchanges

Clearing houses
Margins, marking-to-market, and delivery
Hedgers

Speculators

Locals or Scalpers

Day Trader

Position Traders

Spreaders

Managed Futures Investors London International Financial

Individuals Futures and Options Exchange (LIFFE)
Funds Now electronic!

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 Commodity Markets

The oldest market spot and forward/future

settlement in physical commodity rather than cash
Four commodity groups metals, softs (sugar, rubber, etc.), grains,
seeds & fibres (wheat, soy bean, cloths, etc.), and livestock & other
(animals and meat products, also orange juice, etc.)
Spot market OTC, on the spot at a sale
Forward tailor-made OTC contract for later delivery
Futures continuous exchange-traded contract, for delivery or for a
cash settlement for the difference
Delivery can be in-store, ex-store, free on board or alongside ship,
transport and insurance may be included, and physical/future swaps
can be built in
Note the special treatment of gold

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 Commodity Trading

Spot to forward pricing relationships:

Forward spot price + storage cost as the commodity will only be
bought in the future
It depends on the (belief in) future supply; if higher than spot the
market is in contango, if below it is in backwardation
Why is backwardation common? Convenience, still time to acquire,
over-supply, optimism about future scarcity, manipulation are all
factors
To control volatility, exchanges set market and trader limits
Commodity trading risk:
Components of risk are the spot price, the forward convenience
variation, the cost of funding (interest rate risk), above-ground stocks
and changes in storage costs
Spot prices can be hedged but it is expensive to hedge interest rates,
and convenience
Careful diversification will reduce overall risk

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 Energy Markets

A specialised commodity market, energy

trading began with oil futures in 1978, now
it is established in both regulated markets
and OTC

Assets traded include crude oil, petroleum, gas, naphtha, electricity,

coal, and lately, emissions, carbon credits and renewable energy
credits

Volumes are low with the ratio of traded derivative volumes to the
physical market (2004) being 3:5 as opposed to 6-20:1 for other
commodities

Mainly specialist exchanges NYMEX (largest), IPE (in London),

Singapore, Shanghai, etc..

A cash market to support the energy market is key

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 Energy Markets

Energy futures markets, pricing (contango and backwardation),

contracts, options, delivery and storage also options on futures

OTC derivatives are customised transactions trading off-exchange,

key centre is Singapore, also Europe and the U.S.

Energy risks are many. They include:

market/pricing
credit/counterparty and cash-flow
liquidity
event and operational
basis (in hedging trades)
legal/regulatory/tax and geopolitical
seasonal and weather

Beau Roffman, New York

Mercantile Exchange (NYMEX)

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 Question #4

Q If a commoditys forward or future price is higher than its

spot price:

a) The spot price is changed to reflect the future price

b) The market is in backwardation
c) The commodity is said to be free on board
d) The market is in contango

The answer is:

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 Answer to Question #4

Q If a commoditys forward or future price is higher than its

spot price:

a) Only the market drives the spot and future prices

b) Backwardation is when the forward or future price is lower
than the spot price
c) Free on Board is a delivery and settlement term and
means the buyer takes the risk on the commodity once it is
on board a ship for delivery
d) The market is in contango because contango is
defined as an upward sloping term structure for a
commodity

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 Thank you for viewing this session!

The next session will be

Session D
Interest Rate Risk and Hedging

Reading material is Chapter 6 from the 2nd Edition of the EoRM

excluding boxes 6-2 (Valuation of a bond and yield to maturity)
and 6-3 (Duration of a bond).

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PRMIA 2016