Financial markets and instruments in financial markets.pptx

Financial markets and instruments. CHAPTER 2

1. Financial markets and instuments Dr. Arifa Saeed

2. Overview Definition of financial market Structure of financial market Instruments traded in financial market Functions of financial market

3. What is a Financial System? A financial system is a network of institutions, markets, instruments, and regulations that facilitate the flow of funds between savers (those with excess funds) and borrowers (those who need funds). It plays a critical role in economic growth by ensuring efficient allocation of resources.

4. Structure of financial system Debt vs. equity market Primary vs. secondary market Exchange vs. over the counter market Money vs. capital market

5. Debt vs equity market The debt market and equity market are two major segments of the financial market, each serving different purposes for investors and companies

6. 1. Debt Market (Bond Market) The debt market is where investors buy and sell fixed-income securities , such as bonds and debentures , which represent loans made to governments or corporations . Key Features of Debt Market: ✔ Ownership: Investors do not own the company but act as lenders. ✔ Returns: Fixed interest (coupon payments) over a period of time. ✔ Risk: Lower risk compared to equity investments. ✔ Maturity: Bonds have a fixed maturity date when the principal is repaid. ✔ Priority in Bankruptcy: Bondholders are paid before shareholders in case of liquidation.

7. Types of Debt Instruments: Government Bonds (Treasury bills, sovereign bonds) Corporate Bonds (Investment-grade, junk bonds) Municipal Bonds (Issued by local governments) Debentures (Unsecured corporate loans)

8. Pros and Cons of Debt Market: Pros Cons Fixed and predictable income Lower returns than stocks Lower risk than equity Inflation can reduce real returns Priority in liquidation No ownership or voting rights

9. 2. Equity Market (Stock Market) The equity market is where investors buy and sell stocks (shares) of companies, representing ownership in a business . Key Features of Equity Market: ✔ Ownership: Shareholders own a part of the company. ✔ Returns: Profits through dividends and capital appreciation (increase in stock price). ✔ Risk: Higher risk, but also higher return potential. ✔ Maturity: No fixed maturity—stocks can be held indefinitely. ✔ Priority in Bankruptcy: Shareholders are paid last after all debts are settled.

10. Types of Equity Instruments : Common Stocks – Voting rights, variable dividends. Preferred Stocks – Fixed dividends, no voting rights . Pros and cons: Pros Cons Higher return potential High market volatility Ownership and voting rights No guaranteed income Can benefit from company growth Last priority in liquidation

11. 3. Key Differences Between Debt and Equity Markets Feature Debt Market (Bonds) Equity Market (Stocks) Nature Loan to a company/government Ownership in a company Risk Level Low to moderate High Returns Fixed interest payments Dividends & capital appreciation Maturity Fixed maturity date No maturity (can hold indefinitely) Priority in Bankruptcy High – Paid before shareholders Low – Paid last Voting Rights No voting rights Voting rights for common stockholders

12. Primary vs. Secondary Market Financial markets are classified into primary markets and secondary markets , each playing a distinct role in capital formation and investment.

13. 1. Primary Market (New Issue Market) The primary market is where financial securities (stocks and bonds) are issued for the first time by companies or governments to raise capital. Investors buy securities directly from the issuer . Key Features of the Primary Market: ✔ New securities: First-time issuance (IPO, bond issuance). ✔ Direct purchase: Investors buy directly from the company. ✔ Capital raising: Helps businesses and governments raise funds. ✔ No trading: Once issued, securities move to the secondary market.

14. Types of Primary Market Issues: Initial Public Offering (IPO): A private company sells shares to the public for the first time. Follow-on Public Offering (FPO): An already listed company issues more shares. Rights Issue: Existing shareholders get the right to buy more shares at a discount. Private Placement: Securities are sold to a select group of investors. Bond Issuance: Governments or companies raise debt capital.

15. Pros and cons of primary market Pros Cons Companies raise capital for growth Risk for investors due to price volatility Investors get shares at the issue price Limited access to small investors Direct purchase without intermediaries No immediate resale option

16. 2. Secondary Market (Stock Exchange or Aftermarket) The secondary market is where previously issued securities are bought and sold among investors through exchanges (e.g., NYSE, NASDAQ) or over-the-counter (OTC) markets . Key Features of the Secondary Market: ✔ Trading of existing securities (stocks, bonds, ETFs). ✔ Investors trade among themselves (company is not involved). ✔ Price determined by market forces (demand and supply). ✔ Liquidity: Investors can buy and sell easily.

17. Types of Secondary Markets: Stock Exchanges: Centralized platforms (NYSE, NASDAQ, LSE). Over-the-Counter (OTC) Market: Decentralized trading (FOREX, derivatives). Bond Market: Trading of government and corporate bonds. Commodities & Derivatives Market: Futures and options trading.

18. Pros and cons Pros Cons High liquidity Prices can be volatile Allows price discovery Subject to speculation Easy entry and exit for investors Transaction costs (brokerage fees)

19. Key difference between primary and secondary markets Feature Primary Market Secondary Market Nature New securities issued Existing securities traded Seller Company/Government Other investors Purpose Raises capital for issuers Provides liquidity to investors Price Determination Fixed by the issuer (e.g., IPO price) Market-driven (demand & supply) Transaction Participants Company and investors Investors trading among themselves Market Examples IPOs, Rights Issues, Bond Issuance Stock Exchanges, OTC Market

20. 4. How Do Primary and Secondary Markets Work Together? A company raises money through an IPO (initial public offering: is the process by which a private company becomes a publicly traded company by offering its shares to the general public for the first time. This allows the company to raise capital from investors in exchange for ownership (equity) in the company. ) in the primary market . After issuance, the shares are traded in the secondary market . Investors buy and sell stocks, setting market prices . Companies can later issue more shares via FPO or rights issues in the primary market .

21. 5. Which Market is Better for Investors? Primary Market – Best for investors who want to buy new shares at the offering price . Secondary Market – Ideal for traders who want liquidity and price flexibility

22. OTC Market vs. Exchange Market Financial markets are classified into Over-the-Counter (OTC) markets and Exchange markets based on how securities are traded. Each has unique characteristics, advantages, and risks.

23. 1. Exchange Market (Organized Market) The exchange market is a centralized marketplace where financial instruments like stocks, bonds, and derivatives are traded under strict regulations. Key Features of Exchange Market: ✔ Centralized platform: Trades occur on formal exchanges (NYSE, NASDAQ, LSE). ✔ Regulated trading: Governed by financial authorities (SEC, SECP). ✔ Transparent pricing: Prices are publicly available and determined by supply and demand. ✔ Standardized contracts: Securities and derivatives follow fixed terms. ✔ High liquidity: Large volumes of buyers and sellers.

24. Examples of Exchange Markets: Stock Exchanges: NYSE, NASDAQ, London Stock Exchange (LSE). Futures & Options Exchanges: Chicago Mercantile Exchange (CME), Intercontinental Exchange (ICE). Commodity Exchanges: New York Mercantile Exchange (NYMEX).

25. Pros Cons High transparency and investor protection High transaction costs (fees, commissions) Standardized contracts and rules Strict regulations can limit flexibility High liquidity Limited access for smaller investors

26. 2. Over-the-Counter (OTC) Market (Decentralized Market) The OTC market is a decentralized network where financial instruments are traded directly between buyers and sellers without a centralized exchange. Key Features of OTC Market: ✔ Decentralized trading: Transactions occur directly between parties via brokers or electronic networks. ✔ Flexible contracts: Customizable terms for securities, derivatives, and forex . ✔ Lower regulation: Less oversight compared to exchanges. ✔ Less transparency: Prices may vary and are not always publicly available. ✔ Liquidity varies: Some OTC markets have high liquidity ( forex ), while others have low liquidity (penny stocks).

27. Examples of OTC Markets: OTC Stocks: Pink Sheets, OTC Bulletin Board (OTCBB). Forex Market: Currency trading occurs over the counter. Bond Market: Corporate and government bonds are often traded OTC. Derivatives: Swaps and forward contracts are mainly OTC instruments.

28. Pros Cons More flexibility in contract terms Higher counterparty risk (risk of default) Lower transaction costs Less transparency in pricing Access to niche or small-cap investments Can have lower liquidity for certain assets

29. 3. Key Differences Between OTC and Exchange Markets Feature Exchange Market OTC Market Structure Centralized, organized platform Decentralized, direct trading Regulation Highly regulated Less regulated Price Transparency Publicly available prices Prices negotiated between parties Liquidity High liquidity Liquidity varies Counterparty Risk Low (exchange guarantees settlement) High (risk of default) Trading Costs Higher due to fees and commissions Lower but may involve hidden costs Contract Standardization Standardized securities and derivatives Customized contracts Examples NYSE, NASDAQ, LSE, CME Forex market, corporate bond market, swaps

30. 4. Which Market is Better? Exchange Market – Best for investors who prefer transparency, security, and liquidity . OTC Market – Suitable for investors and companies needing flexibility and private negotiations.

31. Money and capital market he financial market is divided into two major segments: the money market and the capital market . Both serve different functions in the economy by facilitating the flow of funds between investors, businesses, and governments.

32. 1. Money Market (Short-Term Financial Market) The money market is where short-term financial instruments with maturities of one year or less are traded. It is used for liquidity management by businesses, banks, and governments. Key Features of the Money Market: ✔ Short-term maturity: Instruments mature in less than one year . ✔ Low risk: Instruments are highly liquid and less volatile. ✔ High liquidity: Easily convertible to cash. ✔ Used for short-term borrowing and lending.

33. Types of Money Market Instruments: Treasury Bills (T-Bills): Short-term government securities with a maturity of up to one year. Commercial Paper: Unsecured short-term debt issued by corporations. Certificates of Deposit (CDs): Time deposits issued by banks with fixed interest. Repurchase Agreements (Repos): Short-term borrowing where securities are sold with an agreement to repurchase later. Banker’s Acceptances: Used in international trade financing

34. Pros Cons High liquidity Lower returns than capital market Low risk Limited investment options Helps in short-term financing Not ideal for long-term wealth creation

35. 2. Capital Market (Long-Term Financial Market) The capital market is where long-term financial securities such as stocks and bonds are traded. It helps companies and governments raise funds for investment and expansion. Key Features of the Capital Market: ✔ Long-term securities: Maturities are longer than one year . ✔ Higher risk: Market fluctuations can impact returns. ✔ Higher returns compared to the money market. ✔ Used for long-term capital raising.

36. Types of Capital Market Instruments: Stocks (Equities): Represent ownership in a company, traded on stock exchanges. Bonds: Long-term debt instruments issued by governments or corporations. Mutual Funds: Pools of funds invested in stocks and bonds. Debentures: Unsecured corporate debt with fixed interest payments. Capital Market Segments: Primary Market: Where new securities are issued (e.g., IPOs). Secondary Market: Where existing securities are traded among investors (e.g., stock exchanges).

37. Pros Cons Higher return potential Higher risk Helps in long-term wealth creation Prices can be volatile Essential for economic growth Requires market knowledge

38. Key Differences Between Money Market and Capital Market Feature Money Market Capital Market Nature Short-term Long-term Maturity ≤ 1 year > 1 year Risk Level Low High Liquidity High Moderate to low Returns Low but stable Higher, but volatile Purpose Short-term borrowing/lending Long-term financing & investment Examples T-Bills, Commercial Paper, Repos Stocks, Bonds, Mutual Funds

39. 4. How Do Money and Capital Markets Work Together? Businesses and governments use the money market for short-term funding needs . They use the capital market to raise long-term funds for expansion . Investors use the money market for safe, short-term investments. They invest in the capital market for long-term wealth growth

40. 5. Which Market is Better for Investors? Money Market: Best for risk-averse investors seeking liquidity and stability . Capital Market: Ideal for long-term investors willing to take risks for higher returns .

41. Instruments Traded in the Financial Market

42. Market Type Instrument Description Maturity Risk Level Money Market Treasury Bills (T-Bills) Short-term government securities issued at a discount. ≤ 1 year Low Commercial Paper Unsecured short-term debt issued by corporations. ≤ 270 days Moderate Certificates of Deposit (CDs) Fixed-term deposits issued by banks with interest. Varies, ≤ 1 year Low Repurchase Agreements (Repos) Short-term borrowing where securities are sold with an agreement to repurchase later. ≤ 1 year Low Banker's Acceptances Short-term credit instruments used in trade finance. ≤ 6 months Low to Moderate Capital Market Stocks (Equities) Shares representing ownership in a company. No maturity High Bonds Long-term debt securities issued by governments or corporations. > 1 year Low to Moderate Debentures Unsecured corporate bonds with fixed interest payments. > 1 year Moderate to High Mutual Funds Investment pools that diversify into stocks, bonds, or both. No fixed maturity Moderate to High Exchange-Traded Funds (ETFs) Funds that track an index or sector and trade on exchanges. No fixed maturity Moderate Derivative Market Futures Contracts Agreements to buy/sell assets at a future date at a predetermined price. Varies High Options Contracts Contracts giving the right, but not obligation, to buy/sell an asset at a set price. Varies High Swaps Contracts exchanging cash flows or interest rates between parties. Varies High Foreign Exchange (Forex) Market Currencies (Forex Trading) Buying and selling of different currencies. No maturity High Commodity Market Gold, Silver, Oil, Agricultural Products Trading of physical commodities or commodity futures. Varies Moderate to High

43. Valuing a bond

44. Valuing a Bond The value of a bond is determined by calculating the present value of its future cash flows, which include: Periodic Coupon Payments (if applicable) Face Value (Par Value) at Maturity The valuation depends on discounting future cash flows at an appropriate interest rate (discount rate or required rate of return).

45. 1. Bond Valuation Formula The value (price) of a bond is given by: P=∑C(1+r) t+F (1+r)TP = \sum \ frac {C}{(1 + r)^t} + \ frac {F}{(1 + r)^T}P=∑(1+r) tC ​+(1+r)TF​Where: P = Present value (price) of the bond C = Coupon payment per period r = Discount rate (required rate of return) per period F = Face value (par value) of the bond T = Total number of periods t = Period in which the cash flow occurs

46. Factors Affecting Bond Valuation Interest Rates: If market interest rates rise → Bond prices fall If market interest rates fall → Bond prices rise Time to Maturity: Longer maturity bonds are more sensitive to interest rate changes. Coupon Rate: Higher coupon bonds are less sensitive to interest rate changes. Credit Risk: Higher risk bonds (junk bonds) have higher required returns, reducing their value.

47. Functions of financial markets

48. Capital Formation and Resource Allocation ✔ Financial markets channel savings from individuals and institutions to businesses and governments that need capital for expansion and operations. ✔ Efficient allocation ensures funds go to the most productive investments. Price Determination ✔ Financial markets set the prices of financial instruments (stocks, bonds, currencies, etc.) through supply and demand. ✔ Prices reflect market conditions, company performance, and economic trends. Liquidity Provision ✔ Financial markets provide liquidity , allowing investors to buy or sell assets easily. ✔ More liquid markets reduce transaction costs and risk for investors. Risk Management and Hedging Investors and businesses use derivative markets (futures, options, swaps) to hedge against risks. ✔ Example: Airlines use futures contracts to protect against fuel price fluctuations. Mobilization of Savings ✔ Financial markets encourage savings by offering investment opportunities with varying risk-return profiles. ✔ This contributes to capital accumulation and economic growth .

49. Facilitating Economic Growth ✔ By providing capital to businesses and governments, financial markets fuel economic expansion . ✔ Investment in new projects leads to job creation and higher GDP. Reducing Transaction Costs ✔ Centralized markets reduce the cost of searching for buyers/sellers and negotiating prices. ✔ Standardized contracts (like bonds and stocks) make transactions more efficient . International Capital Flow ✔ Global financial markets enable cross-border investment, allowing capital to flow where it is needed. ✔ This supports economic development in emerging markets. Corporate Governance and Transparency ✔ Public companies in financial markets are required to disclose financial information regularly. ✔ Investors monitor company performance, ensuring accountability and efficiency . Facilitating Monetary Policy Implementation ✔ Central banks use financial markets to regulate money supply through open market operations (OMO) . ✔ Interest rates and inflation are controlled by managing liquidity in financial markets.