Financial Markets by Coach Brenda Palad

7/28/2019 Financial Markets by Coach Brenda Palad

1/45

FINANCIALMARKETS

Presented by:

Coach Brenda Palad

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 1


2/45


CHAPTER 1

Introduction


3/45


Learning Objectives What a financial asset is

The distinction between a debt instrument and

an equity instrument The general principles for determining the

price of a financial asset

Ten properties of financial assets The principal economic functions of financial

assets


4/45


Learning Objectives (continued) What a financial market is and the principal

economic functions it performs

The different ways to classify financialmarkets

What is meant by a derivative instrument

The reasons for the globalization of financialmarkets

What is meant by an asset class


5/45


Financial Assets Asset

any possession that has value in an exchange

Tangible asset

The value depends on particular physical properties(e.g. buildings, land, or machinery)

Intangible assets Represent legal claims to some future benefit

Examples include financial assets, financialinstruments, or securities

Investor The owner of the financial asset


6/45


Financial Assets Financial assets include

A bond issued by the U.S. Department of the Treasury

A bond issued by General Electric Corporation A bond issued by the state of California

A bond issued by the government of France

An automobile loan

A hone mortgage loan Common stock issued by Microsoft Corporation

Common stock issued by Honda Motor Company


7/45Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 7

Financial Assets Debt versus Equity Claims

Debt instrument

the claims of the holder of a financial asset is a fixed dollar

amount

Equity claim (residual claim)

obligates the issuer of the financial asset to pay the holder an

amount based on earnings, if any, after holders of debt

instruments have been paid Fixed income instruments

both debt and preferred stock that pays a fixed dollar amount


8/45


Financial Assets The Value of a Financial Asset

Valuation

The process of determining the fair value or price ofa financial asset

Fundamental principle of valuation

The value of any financial asset is the present value

of the cash flow expected


9/45



Estimating the cash flow

Cash flowthe cash that is expected to be receivedeach period from investing in a particular financial

asset

the type of financial asset and the characteristics of

the issuer determine the degree of certainty U.S. government never defaults on the debt instruments

Other debt instrument are not know with certainty


10/45



Estimating the cash flow

Three reasons why cash flow of debt instrumentsis not known:

1. The issuer might default

2. Provisions included in most debt instrumentsgrant the issuer and/or the investor the right to

change how the borrowed funds are repaid3. The interest rate the issuer pays can change over

the time the borrowed funds are outstanding


11/45



The appropriate interest rate for discountingthe cash flow is determined by addressing:

1. What is the minimum interest rate the investorshould require?

The interest rate available in the financial market on adefault-free cash flow

2. How much more than the minimum interest rateshould the investor require? Should reflect the risks associated with realizing the

cash flow expected


12/45


Figure 1-1

Summary of theProcess for

Valuing a

Financial Asset


13/45



Various types of risk include:

Credit risk (Default risk)

the risk that the issuer or borrower will default on the

obligation

Purchasing power risk (Inflation risk)

the risk attached to the potential purchasing power of the cash

flow expected

Foreign exchange risk

the risk that the exchange rate will change adversely


14/45


Financial Assets The Role of Financial Assets

Two principal economic functions:

Financial assets transfer funds from those partieswho have surplus funds to invest to those who need

funds to invest in tangible assets

Financial assets transfer funds in such a way as to

redistribute the unavoidable risk associated with thecash flow generated by tangible assets among those

seeking and those providing the funds


15/45


Financial Assets The Role of Financial Assets

Financial intermediaries

Entities who seek to transform the final liabilitiesinto different financial assets preferred by the

public


16/45


Financial Assets Properties of Financial Assets

1. Moneyness

2. Divisibility and denomination

3. Reversibility4. Term to maturity

5. liquidity

6. Convertibility

7. Currency

8. Cash flow and return predictability

9. Complexity

10. Tax status


17/45



Moneyness

Moneyfinancial assets which act as a medium ofexchange or in settlement of transactions

Near moneyfinancial assets, although not money,

closely approximate money in that they can be

transformed into money at little cost, delay, or risk


18/45



Divisibility and denomination

Divisibilitythe minimum size at which a financialasset can be liquidated and exchanged for money

The smaller the size, the more the financial asset is

divisible


19/45



Reversibility

Reversibility (round-trip cost)the cost ofinvesting in a financial asset and then getting out ofit and back into cash again

Bid-ask spreadthe difference between the price atwhich a market maker is willing to sell a financial

asset and the price at which a market maker iswilling to buy the financial asset

The variability of the price as measured by some measureof dispersion of the relative price over time


20/45



Bid-ask spread can be related to two main

forces:1. The variability of the price as measured by some

measure of dispersion of the relative price over

time

2. Thickness of the marketthe prevailing rate atwhich buying and selling orders reach the market

maker


21/45



Term to maturity

The length of the interval until the date when theinstrument is scheduled to make its final payment,

or the owner is entitled to demand liquidation

Demand instrumentsinstruments for which the

creditor can ask for repayment at any time e.g. checking accounts and many savings accounts

Even a financial asset with a stated maturity may

terminate before its stated maturity.


22/45



Liquidity

Serves an important and widely used function,although no uniformly accepted definition is

presently available

Liquidity closely related to whether a market is

thick or thin. Thinness always increases the round-trip cost, even of a liquid financial asset


23/45



Convertibility

The timing, costs, and conditions for conversion areclearly spelled out in the legal descriptions of the

convertible security at the time of issuance


24/45



Cash flow and return predictability

The predictability of the expected return depends onthe predictability of the cash flow

Nominal expected returnthe dollars expected tobe received but does not adjust those dollars to takeinto consideration changes in their purchasing

power Real expect returnthe nominal expected return

after adjustment for the loss of purchasing power ofthe financial asset as a result of inflation


25/45



Complexity

Combination of two or more simpler assets To find the true value one must decompose the

asset into its component parts and price each

component separately


26/45



Tax Status

Tax rates differ from: Year to year

Country to county

Among municipal units within a country

Financial asset to financial asset


27/45


Financial Markets Financial market

Where financial assets are exchanged

In most economies financial assets are createdand subsequently traded in some type of

organized financial market structure


28/45


Financial Markets The Role of Financial Markets

3 additional economic functions:

Price discovery process - the interactions of buyersand sellers in a financial market determine the price

of the traded asset

Provide a mechanism for an investor to sell a

financial asset Reduces the search and information costs of

transacting


29/45


Financial Markets The Role of Financial Markets

Search costs

Represent explicit costsInformation costs

Incurred in assessing the investment merits of a

financial assets


30/45


Financial Markets Classification of Financial Markets

Types of financial claims

Debt market Equity market


31/45


Figure 1-2 Classification of Financial

Markets by Type of Claim


32/45


Financial Markets Classification of Financial Markets

Maturity of the claims

Money market - a financial market for short-termfinancial assets (< 1 year)

Capital market - the financial market for longer

maturity financial assets (> 1 year)


33/45


Figure 1-3 Classification of Financial

Markets by Maturity of Claim


34/45


Financial Markets

Classification of Financial Markets

Whether the financial claims are newly issued

Primary market - the market for newly issuedfinancial assets

Secondary market - the market, where after a

certain period of time, the financial asset is bought

and sold among investors


35/45


Financial Markets

Globalization of Financial Markets

The integration of financial markets throughout

the world into an international financial market


36/45


Financial Markets


Factors contributing to the integration of

financial markets Deregulation or liberalization of markets and the

activities of market participants in key financial

centers of the world

Technological advances for monitoring worldmarkets, executing orders, and analyzing financial

opportunities

Increased institutionalization of financial markets


37/45


Financial Markets


Institutionalization of financial markets

The shifting of the financial markets in the U.S. andother major industrialized countries from

dominance by retail investors to institutional

investors

Emerging markets Participation in the financial markets of developing

economies


38/45


Figure 1-4 Classification of Global

Financial Markets


39/45


Derivative Markets

Derivative instruments

Some contracts give the contract holder either the

obligation or the choice to buy or sell a financial

asset

Such contracts derive their value from the price of

the underlying financial asset

Options contracts

Futures contracts

Forward contracts swap agreements

Cap and floor agreements


40/45


Asset Classes

Four major asset classes:

Common stocks

BondsCash equivalents

Real estate


41/45


Asset Classes

Asset classes expanded by separating foreign

securities U.S. securities:

U.S. common stocksNon-U.S. (or foreign) common stocks

U.S. bonds

Non-U.S. (or foreign) bondsCash equivalents

Real estate


42/45


Asset Classes

U.S. common stocks classified as assetclasses:

Large capitalization stocks

Mid capitalization stocks

Small capitalization stocks

Growth stocks

Value stocks*market capitalization = total market value of its common

stock outstanding


43/45


Asset Classes

U.S. bonds classified as asset classes:

U.S. government bonds

Investment-grade corporate bondsHigh-yield corporate bonds

U.S. municipal bonds

Mortgage-backed securitiesAsset-backed securities


44/45


Asset Classes

Non-U.S. stocks and bonds classified as asset

classes:

Developed market foreign stocksDeveloped market foreign bonds

Emerging market foreign stocks

Emerging market foreign bonds


45/45

Asset Classes

Characteristics of emerging markets:

Have economies that are in transition but havestarted implementing political, economic, and

financial markets reforms in order toparticipate in global capital market

May expose investors to significant pricevolatility attributable to political risk and theunstable value of their currency

Have a short period over which their financialmarkets have operated

Documents

Financial Markets by Coach Brenda Palad