Brokers Awareness program

Dr. Mounther Barakat Securities and Commodities Authority

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Introduction
It has been noticed that traders and entry level brokers may be 1- from backgrounds other than finance, or 2- little finance background, or 3- of finance background that needs to be refreshed If you are none of the above, this is not for you
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What is this program about?

          

Introduction to the field of finance Financial risk and return Demand on financial assets Structure of interest rates Financial markets efficiency Economic policies and the role of the central bank Capital, money, commodity, derivatives, mortgage, foreign exchange markets Organization of markets and its operations Introduction to financial analysis Conflict of interest and financial crises Financial institutions: Investment companies, securities firms, banks, insurance companies, finance companies, pensions, ...
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What is Finance?


Finance deals with: efficient allocation of resources by using pricing systems that are based on the riskness of assets. Three areas of finance:


 

Financial markets and Institutions Intermediation Corporate finance Investments

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Definitions from Finance perspective

          

Asset Real asset Vs. Financial asset Primary asset Vs. Secondary asset Intermediary Vs. broker Vs. dealer Market Financial market Balance sheet Income statement Statement of cash flow Cash Vs. profit Surplus Vs. Deficit Units
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The financial System



Types of financial Systems

   

Religious Socialism Capitalism Mixed

The financial system in the UAE is the free market system with considerations specific to the UAE (e.g. Islamic and Arab culture, )
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The financial system



Participants
   

Governments Businesses Individuals Foreigners Financial markets Financial institutions

The financial sector

 

Money and Interest rates

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The Financial System

Financial System

I/M
- Interest rates - Money Supply

Fin. Sec.
- Financial Markets - Financial Institutions

Participants
- Government. - Businesses - Individuals - Foreigners 1-9

The Financial Sector

Financial Sector

Financial Markets

Financial Institutions

Long Term Equity Debt

Short Term Money FOREX Depositories

Banks Credits Unions

Non-depositories
Investment Companies Securities firms Contractual financing

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Interest Rates and Money Supply

 

Interest is the rent of money Equal to the real growth rate of GDP plus the expected inflation rate plus a premium to compensate for the riskness of the company being analyzed. Money supply is the amount of liquidity that is being allowed by the UAE central bank. The company being analyzed benefits if the amount of liquidity is near the healthy level. Both interest rates and money supply have a great effect on the performance and value of the company and need to be taken into consideration in any financial analysis.
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Function of Financial Markets and Institutions Allows transfers of funds from person or business without investment opportunities (i.e., Lender-Savers ) to one who has them (i.e., Borrower-Spenders )
 

Improves economic efficiency



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Segments of Financial Markets

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Direct Finance Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrower s future income or assets

2.

Indirect Finance Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower s future income or assets

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Importance of Financial Markets



Financial markets are critical for producing an efficient allocation of capital, which contributes to higher production and efficiency for the overall economy, as well as economic security for the citizenry as a whole


Financial markets also improve the lot of individual participants by providing investment returns to lender-savers and profit and/or use opportunities to borrower-spenders


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Function of Financial Markets

Flow of Funds Through the Financial System

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Classifications of Financial Markets

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Primary Market


New security issues sold to initial buyers

2.

Secondary Market


Securities previously issued are bought and sold

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Classifications of Financial Markets

Exchanges ( )  Trades conducted in central locations (e.g., ADSM, DFM, .) Over-the-Counter Markets  Dealers at different locations buy and sell

3.

4.

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Classifications of Financial Markets



Long term (Capital Markets)

 

Debt Equity Foreign Exchange Money markets

Short term (Money Markets)

 

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Classifications of Financial Markets

Debt Markets


1.

Short-Term (maturity < 1 year) Money Market Long-Term (maturity > 1 year) Capital Market

2.

Equity Markets


Common Stock
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Characteristics of Debt Markets Instruments



Debt instruments


Buyers of debt instruments are suppliers (of capital) to the firm, not owners of the firm Debt instruments have a finite life or maturity date Advantage is that the debt instrument is a contractual promise to pay with legal rights to enforce repayment Disadvantage is that return/profit is fixed or limited
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Characteristics of Equity Markets Instruments Equity instruments (common stock is most prevalent equity instrument)
  

Buyers of common stock are owners of the firm Common stock has no finite life or maturity date Advantage of common stock is potential high income since return is not fixed or limited Disadvantage is that debt payments must be made before equity payments can be made
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Characteristics of Financial Markets

1.


Debt Markets
Although less well-known by the average person, debt markets are much larger in total dollars than equity markets, due to greater number of participant classes (households, businesses, government, and foreigners) and size of individual participants (businesses, and government) This is not the case in the UAE; debt market is mostly bank loans and informal or off balance sheet lending.
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Characteristics of Financial Markets

2.


Equity Markets
Although newly founded and lacks the needed environment to function properly, it proved to have played its role in establishing the elements of the sovereignty of the country and in promoting economic development. To the contrary of most economies including that of the US the equity market in UAE is larger than the debt market, due to the fact that the bond markets are small and illiquid.

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Function of Financial Intermediaries

Financial Intermediaries
1. 2.

Engage in process of indirect finance More important source of finance than securities markets Needed because of transactions costs and asymmetric information

3.

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Function of Financial Intermediaries



Transactions Costs
1.

Financial intermediaries make profits by reducing transactions costs Reduce transactions costs by developing expertise and taking advantage of economies of scale and scope.

2.

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Function of Financial Intermediaries

A financial intermediary s low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions
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Banks provide depositors with checking accounts that enable them to pay their bills easily Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary without having to discontinue and liquidate investments 1-26

2.

Function of Financial Intermediaries



Another benefit made possible by the FI s low transaction costs is that they can help reduce the exposure of investors to risk, through a process known as risk sharing



FIs create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party (e.g. banks) This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors
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Function of Financial Intermediaries



Adverse Selection
1. 2.

Before transaction occurs Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected brokers and financial analysts can prevent that by studying the credit worthiness of the borrowers
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Function of Financial Intermediaries



Moral Hazard
1. 2.

After transaction occurs Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back

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Function of Financial Intermediaries



Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits. How they do this is covered in many of the topics to come.


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Financial Institutions


Depository Institutions (Banks)

   

Commercial banks Savings & Loan Associations (S&Ls) Mutual Savings Banks Credit Unions Life insurance companies Property & casualty insurance companies Pension funds
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Contractual Savings Institutions

  

Financial Institutions


Investment Intermediaries
  

Finance companies Mutual funds Money market mutual funds

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Financial Institutions


Commercial banks


Raise funds primarily by issuing checkable, savings, and time deposits which are used to make commercial, consumer and mortgage loans Collectively, these banks comprise the largest financial intermediary and have the most diversified asset portfolios Around 1 trillion DHS in total assets in the UAE

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Financial Institutions


S&Ls, Mutual Savings Banks and Credit Unions




Raise funds primarily by issuing savings, time, and checkable deposits which are most often used to make mortgage and consumer loans, with commercial loans also becoming more prevalent at S&Ls and Mutual Savings Banks Mutual savings banks and credit unions issue deposits as shares and are owned collectively by their depositors, most of which at credit unions belong to a particular group, e.g., a company s workers

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Financial Institutions


All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements.


Life Insurance Companies receive funds from policy premiums, can invest in less liquid corporate securities and mortgages, since actual benefit pay outs are close to those predicted by actuarial analysis
Fire and Casualty Insurance Companies

receive funds from policy premiums, must invest most in liquid government and corporate securities, since loss events are harder to predict
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Financial Institutions


All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements.


Pension and Government Retirement Funds hosted by corporations and state and local governments acquire funds through employee and employer payroll contributions, invest in corporate securities, and provide retirement income via annuities
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Financial Institutions


Finance Companies sell commercial paper (a short-term debt instrument) and issue bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small businesses for operations

Mutual Funds acquire funds by selling shares to individual investors and use the proceeds to purchase large, diversified portfolios of stocks and bonds we will have a training course on these some time this summer

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Financial Institutions


Money Market Mutual Funds

acquire funds by selling checkable depositlike shares to individual investors and use the proceeds to purchase highly liquid and safe short-term money market instruments Hedge Funds, ETFs and others

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Regulation of Financial Markets



Reasons for Regulation

1. 2. 3.

Increase Information to Investors Protect investors and their investments Ensure the Soundness of Financial Intermediaries Improve Monetary Control
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4.

Regulation Reason: Increase Investor Information

Asymmetric information in financial markets means that investors may be subject to adverse selection and moral hazard problems that may hinder the efficient operation of financial markets and may also keep investors away from financial markets The Securities and Commodities Authority (SCA) requires corporations issuing securities to disclose certain information about their sales, assets, and earnings to the public and restricts trading by the largest stockholders (known as insiders) in the corporation.
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Regulation Reason: Increase Investor Information

Such government regulation can reduce adverse selection and moral hazard problems in financial markets and increase their efficiency by increasing the amount of information available to investors

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Regulation Reason: Ensure Soundness of Financial Intermediaries



Because providers of funds to financial intermediaries may not be able to assess whether the institutions holding their funds are sound or not, if they have doubts about the overall health of financial intermediaries, they may want to pull their funds out of both sound and unsound institutions, with the possible outcome of a financial panic that produces large losses for the public and causes serious damage to the economy
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Regulation Reason: Ensure Soundness of Financial Intermediaries



To protect the public and the economy from financial panics, six types of regulations are needed:
     

Restrictions on Entry - soundness Disclosure transparency no dummies peace of mind no price wars no usury
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Restrictions on Assets and Activities Deposit Insurance Limits on Competition

Restrictions on Interest Rates

Regulation: Restriction on Entry



Restrictions on Entry


Very tight regulations as to who is allowed to set up a financial intermediary Individuals or groups that want to establish a financial intermediary, such as a bank or an insurance company, must obtain a charter from the government Only if they are upstanding citizens with impeccable credentials and a large amount of initial funds will they be given a charter.
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Regulation: Disclosure
 

Disclosure Requirements There are stringent reporting requirements for financial intermediaries


 

Their bookkeeping must follow certain strict principles, Their books are subject to periodic inspection, They must make certain information available to the public.

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Regulation: Restriction on Assets and Activities



There are restrictions on what financial intermediaries are allowed to do and what assets they can hold Before you put your funds into a bank or some other such institution, you would want to know that your funds are safe and that the bank or other financial intermediary will be able to meet its obligations to you
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Regulation: Restriction on Assets and Activities



One way of doing this is to restrict the financial intermediary from engaging in certain risky activities Another way is to restrict financial intermediaries from holding certain risky assets, or at least from holding a greater quantity of these risky assets than is prudent
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Regulation: Deposit Insurance



The government can insure people providing funds to a financial intermediary from any financial loss if the financial intermediary should fail

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Regulation: Past Limits on Competition



Although the evidence that unbridled competition among financial intermediaries promotes failures that will harm the public is extremely weak, the government needs to impose many restrictive regulations The purpose is to prevent financial intermediaries from competing to the point where the integrity of the financial system is compromised.
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Regulation: Past Restrictions on Interest Rates



Competition must also be inhibited by regulations that impose restrictions on interest rates that can be paid on deposits These regulations need to be instituted because of the widespread belief that unrestricted interest-rate competition help encourage bank failures
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Regulation Reason: Improve Monetary Control



Because banks play a very important role in determining the supply of money (which in turn affects many aspects of the economy), much regulation of these financial intermediaries is intended to improve control over the money supply One such regulation is reserve requirements, which make it obligatory for all depository institutions to keep a certain fraction of their deposits in accounts with the central bank Reserve requirements help the central bank exercise more precise control over the money supply well, much can be detailed about the UAE monetary policy.
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The cost of money



The price, or cost, of debt capital is the interest rate. The price, or cost, of equity capital is the required return. The required return investors expect is composed of compensation in the form of dividends and capital gains.
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What four factors affect the cost of money?

  

Time preferences for consumption (sacrifice) Expected inflation (loss in purchasing power) Risk (worry)

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Nominal vs. Real rates

k = represents any nominal rate

k* = represents the real risk-free rate of interest, if there was no inflation. Typically ranges from 1% to 4% per year. kRF = represents the rate of interest on Treasury securities.
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Determinants of interest rates ( )

k = k* + IP + DRP + LP + MRP k = k* = IP = DRP = LP = MRP = required return on a debt security real risk-free rate of interest inflation premium default risk premium liquidity premium maturity risk premium
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Premiums added to k* for different types of debt

IP S-T Treasury L-T Treasury S-T Corporate L-T Corporate    

MRP DRP

LP

     
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Yield curve and the term structure of interest rates



Term structure relationship between interest rates (or yields) and maturities. The yield curve is a graph of the term structure.

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Hypothetical yield curve

Interest Rate (%) 15
 Maturity risk premium 

10

Inflation premium

5
Real risk-free rate

An upward sloping yield curve. Upward slope due to an increase in expected inflation and increasing maturity risk premium.

0 1 10

Years to 20 Maturity
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The Yield Curve



Corporate yield curves are higher than that of Treasury securities, though not necessarily parallel to the Treasury curve. The spread between corporate and Treasury yield curves widens as the corporate bond rating decreases.

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The Yield Curve

Interest Rate (%)
15

BB-Rated
10

AAA-Rated 5.9% Treasury 6.0% Yield Curve

5.2%

0 0 1 5 10 15 20

Years to
Maturity
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