Ch visi En sabl

[Pages:140]LEONARDO DA VINCI Transfer of Innovation

VALDON DARSKUVIEN

Vytautas Magnus University

Financial Markets

Leonardo da Vinci programme project

,,Development and Approbation of Applied Courses Based on the Transfer of Teaching Innovations

in Finance and Management for Further Education of Entrepreneurs and Specialists in Latvia, Lithuania and Bulgaria"

2010

TABLE OF CONTENTS

Table of contents............................................................................................................... 2 Introduction ...................................................................................................................... 5 1. FINANCIAL MARKETS: STRUCTURE AND ROLE IN THE FINANCIAL SYSTEM .......................................................................................................................... 6

1.1. Financial system structure and functions............................................................ 6 1.2. Financial markets and their economic functions................................................. 7 1.3. Financial intermediaries and their functions ....................................................... 9 1.4. Financial markets structure .............................................................................. 11

1.4.1. Financial instruments ............................................................................... 11 1.4.2. Classification of financial markets ........................................................... 13 1.5. Financial market regulation ............................................................................. 14 1.6. Summary ......................................................................................................... 15 Key terms.................................................................................................................... 15 Further readings .......................................................................................................... 16 Review questions and problems .................................................................................. 16 2. INTEREST RATES DETERMINATION AND STRUCTURE ............................... 17 2.1. Interest rate determination ............................................................................... 17 2.1.1. The rate of interest ................................................................................... 17 2.1.2. Interest rate theories: loanable funds theory ............................................. 19 2.1.3. Interest rate theories: liquidity preference theory...................................... 20 2.2. The structure of interest rates........................................................................... 20 2.3. Term structure of interest rates......................................................................... 22 2.4. Theories of term structure of interest rates ....................................................... 22 2.4.1. Expectations theory.................................................................................. 23 2.4.2. Liquidity premium theory ........................................................................ 25 2.4.3. Market segmentation theory..................................................................... 26 2.4.4. The preferred habitat theory ..................................................................... 26 2.5. Forward interest rates and yield curve.............................................................. 26 2.6. Summary ......................................................................................................... 29 Key terms.................................................................................................................... 29 Further readings .......................................................................................................... 30 Relevant websites........................................................................................................ 30 Review questions and problems .................................................................................. 30 3. MONEY MARKETS .............................................................................................. 33 3.1. Money market purpose and structure ............................................................... 33 3.1.1. The role of money markets....................................................................... 33 3.1.2. Money market segments .......................................................................... 34 3.1.3. Money market participants....................................................................... 36 3.2. Money market instruments .............................................................................. 37 3.2.1. Treasury bills and other government securities......................................... 37 3.2.2. The interbank market loans ...................................................................... 42 3.2.3. Commercial papers .................................................................................. 43 3.2.4. Certificates of deposit .............................................................................. 45 3.2.5. Repurchase agreements............................................................................ 46 3.2.6. International money market securities ...................................................... 49 3.3. Money market interest rates and yields ............................................................ 51 3.4. Summary ......................................................................................................... 54 Key terms.................................................................................................................... 54

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Further readings .......................................................................................................... 54 Relevant websites........................................................................................................ 55 Review questions and problems .................................................................................. 55 4. DEBT MARKETS .................................................................................................. 57 4.1. Debt market instrument characteristics ............................................................ 57 4.2. Bond market .................................................................................................... 59

4.2.1. Bond market characteristics ..................................................................... 59 4.2.2. Bond market yields .................................................................................. 60 4.3. Bond valuation ................................................................................................ 61 4.3.1. Discounted models................................................................................... 61 4.3.2. Bond duration and risk............................................................................. 63 4.3.3. Bond price volatility ................................................................................ 63 4.3.4. Behavior of Macaulay's duration ............................................................. 65 4.3.5. Immunization........................................................................................... 65 4.3.6. Bond convexity........................................................................................ 65 4.4. Bond analysis .................................................................................................. 67 4.4.1. Inverse floaters and floating rate notes ..................................................... 67 4.4.2. Callable bonds ......................................................................................... 67 4.4.3. Convertible bonds .................................................................................... 69 4.5. Summary ......................................................................................................... 70 Key terms.................................................................................................................... 71 Further readings .......................................................................................................... 71 Review questions and problems .................................................................................. 71 5. EQUITY MARKET ................................................................................................ 73 5.1. Equity instruments........................................................................................... 74 5.1.1. Common shares ....................................................................................... 74 5.1.2. Preferred shares ....................................................................................... 75 5.1.3. Private equity........................................................................................... 77 5.1.4. Global shares and American Depository Receipts (ADR)......................... 78 5.2. Primary equity market ..................................................................................... 80 5.2.1. Primary public market.............................................................................. 80 5.3. Secondary equity market ................................................................................. 83 5.3.1. Organized exchanges ............................................................................... 84 5.3.2. Over-the-counter (OTC) market ............................................................... 86 5.3.3. Electronic stock markets .......................................................................... 87 5.4. Secondary equity market structure ................................................................... 88 5.4.1. Cash vs forward markets.......................................................................... 89 5.4.2. Continuous markets and auction markets ................................................. 89 5.4.3. Order-driven markets and quote-driven markets....................................... 89 5.4.4. Hybrid markets ........................................................................................ 91 5.5. Equity market transactions............................................................................... 91 5.5.1. Bid-ask spread ......................................................................................... 91 5.5.2. Placing order............................................................................................ 93 5.5.3. Margin trading ......................................................................................... 95 5.5.4. Short selling............................................................................................. 97 5.5.5. Stock trading regulations.......................................................................... 98 5.6. Equity market characteristics ......................................................................... 100 5.6.1. Stock indicators ..................................................................................... 100 5.6.2. Stock market indexes ............................................................................. 100 5.6.3. Stock market indicators.......................................................................... 103 5.6.4. Transaction execution costs.................................................................... 104 5.7. Stock market efficiency ................................................................................. 106

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5.8. Stock valuation .............................................................................................. 109 5.8.1. Fundamental analysis............................................................................. 109 5.8.2. Technical analysis.................................................................................. 110

5.9. Processes of consolidation of stock exchanges ............................................... 114 5.10. Summary ................................................................................................... 115 Key terms.................................................................................................................. 116 Further readings ........................................................................................................ 116 Relevant websites...................................................................................................... 117 Review questions and problems ................................................................................ 118 6. DERIVATIVES MARKETS................................................................................. 120 6.1. Hedging against risk ...................................................................................... 120 6.2. Description of derivatives markets................................................................. 120 6.3. Forward and futures contracts........................................................................ 122

6.3.1. Principles of forward and futures contracts............................................. 122 6.3.2. Forward and futures valuation................................................................ 124 6.3.3. Use of forwards and futures ................................................................... 127 6.3.4. Futures contracts: stock index futures..................................................... 129 6.3.5. Contracts for difference (CFD) .............................................................. 130 6.4. Swaps............................................................................................................ 131 6.5. Options.......................................................................................................... 132 6.5.1. Options definition .................................................................................. 132 6.5.2. Components of the Option Price ............................................................ 135 6.5.3. Determinants of the Option Price ........................................................... 136 6.5.4. Option pricing models............................................................................ 138 6.5.5. Mixed strategies in options trading......................................................... 139 6.6. Summary ....................................................................................................... 139 Key terms.................................................................................................................. 140 Review questions and problems ................................................................................ 140

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INTRODUCTION

Motivation for developing the course

Research by the members of the project consortium Employers' Confederation of Latvia and Bulgarian Chamber of Commerce and Industry indicated the need for further education courses in the field of finance and managerial decision making.

Innovative content of the course

The course has been developed to include the following innovative content: Key concepts of financial markets, which are explained from an applied perspective, including with examples and problems from current financial markets practices from EU integration and development perspective; Analytical techniques to be applied in financial markets provide with understanding and tools to decision makers in the firm; Applied exercises, which cover topics such as money market, debt market, equity market instruments, as well as decision making rules in the financial markets; Summaries are provided at the end of every chapter, which aid revision and control of knowledge acquisition during self-study;

Innovative teaching methods of the course

The course is developed to utilise the following innovative teaching methods: Availability on the electronic platform with interactive learning and interactive evaluation methods; Active use of case studies and participant centred learning; Availability in modular form; Utilising two forms of learning - self-study and tutorial consultations; Availability in several languages simultaneously.

Target audience for the course

The target audience are: entrepreneurs, finance and management specialists from Latvia, Lithuania and Bulgaria and, in the longer term, similar groups in any other European country. The course assumes little prior applied knowledge in the area of financial and operation analysis. The course is intended for 32 academic hours (2 credit points).

Course objective

The objective of the course is to provide entrepreneurs with the knowledge in the area of financial markets, specific financial market instruments, behavior in order to enable them to understand the financial markets processes and their factors, and to make successfully financial decisions on the individual as well as company level.

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1. FINANCIAL MARKETS: STRUCTURE AND ROLE IN THE FINANCIAL SYSTEM

Mini contents

The structure of a financial system Functions of a financial system The structure and key features of financial markets The key features of financial intermediaries Major financial market participants

1.1. Financial system structure and functions

The financial system plays the key role in the economy by stimulating economic growth, influencing economic performance of the actors, affecting economic welfare. This is achieved by financial infrastructure, in which entities with funds allocate those funds to those who have potentially more productive ways to invest those funds. A financial system makes it possible a more efficient transfer of funds. As one party of the transaction may possess superior information than the other party, it can lead to the information asymmetry problem and inefficient allocation of financial resources. By overcoming the information asymmetry problem the financial system facilitates balance between those with funds to invest and those needing funds.

According to the structural approach, the financial system of an economy consists of three main components:

1) financial markets;

2) financial intermediaries (institutions);

3) financial regulators.

Each of the components plays a specific role in the economy.

According to the functional approach, financial markets facilitate the flow of funds in order to finance investments by corporations, governments and individuals. Financial institutions are the key players in the financial markets as they perform the function of intermediation and thus determine the flow of funds. The financial regulators perform the role of monitoring and regulating the participants in the financial system.

Firms

Stock market Bond market Short term fixed securities market

Banking sector Governments

Figure 1. The structure of financial system

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Financial markets studies, based on capital market theory, focus on the financial system, the structure of interest rates, and the pricing of financial assets. An asset is any resource that is expected to provide future benefits, and thus possesses economic value. Assets are divided into two categories: tangible assets with physical properties and intangible assets. An intangible asset represents a legal claim to some future economic benefits. The value of an intangible asset bears no relation to the form, physical or otherwise, in which the claims are recorded. Financial assets, often called financial instruments, are intangible assets, which are expected to provide future benefits in the form of a claim to future cash. Some financial instruments are called securities and generally include stocks and bonds. Any transaction related to financial instrument includes at least two parties:

1) the party that has agreed to make future cash payments and is called the issuer; 2) the party that owns the financial instrument, and therefore the right to receive the

payments made by the issuer, is called the investor. Financial assets provide the following key economic functions.

they allow the transfer of funds from those entities, who have surplus funds to invest to those who need funds to invest in tangible assets;

they redistribute the unavoidable risk related to cash generation among deficit and surplus economic units.

The claims held by the final wealth holders generally differ from the liabilities issued by those entities who demand those funds. They role is performed by the specific entities operating in financial systems, called financial intermediaries. The latter ones transform the final liabilities into different financial assets preferred by the public.

1.2. Financial markets and their economic functions A financial market is a market where financial instruments are exchanged or traded. Financial markets provide the following three major economic functions:

1) Price discovery 2) Liquidity 3) Reduction of transaction costs 1) Price discovery function means that transactions between buyers and sellers of financial instruments in a financial market determine the price of the traded asset. At the same time the required return from the investment of funds is determined by the participants in a financial market. The motivation for those seeking funds (deficit units) depends on the required return that investors demand. It is these functions of financial markets that signal how the funds available from those who want to lend or invest funds will be allocated among those needing funds and raise those funds by issuing financial instruments. 2) Liquidity function provides an opportunity for investors to sell a financial instrument, since it is referred to as a measure of the ability to sell an asset at its fair market value at any time. Without liquidity, an investor would be forced to hold a financial instrument until conditions arise to sell it or the issuer is contractually obligated to pay it off. Debt instrument is liquidated when it matures, and equity instrument is until the company is

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either voluntarily or involuntarily liquidated. All financial markets provide some form of liquidity. However, different financial markets are characterized by the degree of liquidity.

3) The function of reduction of transaction costs is performed, when financial market participants are charged and/or bear the costs of trading a financial instrument. In market economies the economic rationale for the existence of institutions and instruments is related to transaction costs, thus the surviving institutions and instruments are those that have the lowest transaction costs.

The key attributes determining transaction costs are

asset specificity,

uncertainty,

frequency of occurrence.

Asset specificity is related to the way transaction is organized and executed. It is lower when an asset can be easily put to alternative use, can be deployed for different tasks without significant costs.

Transactions are also related to uncertainty, which has (1) external sources (when events change beyond control of the contracting parties), and (2) depends on opportunistic behavior of the contracting parties. If changes in external events are readily verifiable, then it is possible to make adaptations to original contracts, taking into account problems caused by external uncertainty. In this case there is a possibility to control transaction costs. However, when circumstances are not easily observable, opportunism creates incentives for contracting parties to review the initial contract and creates moral hazard problems. The higher the uncertainty, the more opportunistic behavior may be observed, and the higher transaction costs may be born.

Frequency of occurrence plays an important role in determining if a transaction should take place within the market or within the firm. A one-time transaction may reduce costs when it is executed in the market. Conversely, frequent transactions require detailed contracting and should take place within a firm in order to reduce the costs.

When assets are specific, transactions are frequent, and there are significant uncertainties intra-firm transactions may be the least costly. And, vice versa, if assets are non-specific, transactions are infrequent, and there are no significant uncertainties least costly may be market transactions.

The mentioned attributes of transactions and the underlying incentive problems are related to behavioural assumptions about the transacting parties. The economists (Coase (1932, 1960, 1988), Williamson (1975, 1985), Akerlof (1971) and others) have contributed to transactions costs economics by analyzing behaviour of the human beings, assumed generally self-serving and rational in their conduct, and also behaving opportunistically. Opportunistic behaviour was understood as involving actions with incomplete and distorted information that may intentionally mislead the other party. This type of behavior requires efforts of ex ante screening of transaction parties, and ex post safeguards as well as mutual restraint among the parties, which leads to specific transaction costs.

Transaction costs are classified into:

1) costs of search and information,

2) costs of contracting and monitoring,

3) costs of incentive problems between buyers and sellers of financial assets.

1) Costs of search and information are defined in the following way:

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