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Financial Market is the market where financial securities like stocks and bonds and commodities like valuable metals are exchanged at efficient market prices. Here, by efficient market prices we mean the unbiased price that reflects belief at collective speculation of all investors about the future prospect. The trading of stocks and bonds in the Financial Market can take place directly between buyers and sellers or by the medium of Stock Exchange. Financial Markets can be domestic or international.
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Financial Institutions Assignment Topic :
Role and Functions of Financial Market
Submitted To:
Waqar Ahsan
Submitted By:
Muhammad Asjad khuram
Registration No:
1652-411036
Financial Market:
Financial Market is the market where financial securities like stocks and bonds and commodities like valuable metals are exchanged at efficient market prices. Here, by efficient market prices we mean the unbiased price that reflects belief at collective speculation of all investors about the future prospect. The trading of stocks and bonds in the Financial Market can take place directly between buyers and sellers or by the medium of Stock Exchange. Financial Markets can be domestic or international.
Different Types of Financial Markets
Capital Market:
Capital Market consists of primary market and secondary market. In primary market newly issued bonds and stocks are exchanged and in secondary market buying and selling of already existing bonds and stocks take place. So, the Capital Market can be divided into Bond market and Stock market. Bond market provides financing by bond issuance and bond trading. Stock market provides financing by shares or stock issuance and by share trading . As a whole capital market facilitates raising of Capital
Money MarketMoney Market facilitates short term debt financing capital.
Derivatives MarketDerivatives Market provides instruments which help in controlling financial risk.
Foreign Exchange MarketForeign Exchange Market facilitates the foreign exchange trading.
Insurance MarketInsurance Market helps in relocation of various risks.
Commodity MarketCommodity Market organizes trading of commodities
Contribution of Financial MarketsFinancial Markets are essential for fund raising. Through Financial Market borrowers can find suitable lenders. Banks also help in the process of financing by working as intermediaries. They use the money , which is saved and deposited by a group of people; for giving loans to another group of people who need it . Generally, banks provide financing in the form of loans and mortgages except banks othe intermediaries in the financial market can be insurance companies and mutual funds. But more complicated transactions of Financial Market take place in stock exchange. In stock exchange, a
company can buy others' company's shares or can sell own shares to raise funds or they can buy their own shares existing in the market.
Basis of financial Market
Basis of financial markets are the borrowers and lenders.Borrowers of the financial market can be individual persons, private companies, public corporations, government and othe local authorities like municipalities. Individual persons generally take short term or long term mortgage loans from banks to buy any property. Private Companies take short term or long term mortgage loans from banks to buy any property. Private companies take short or long term loans for expansion of business or for improvement of the business infrastructure.
Lenders
in the Financial Market are actually the investors. Their invested money is used to finance the requirements of borrowers. So, there are various types of investments which generate lending activities. Some of these types of investments are depositing money in savings bank account, paying premiums to Insurance Companies, investing in shares of different companies, investing in govt. bonds and investing in pension funds and mutual funds.
Financial Market is nothing but a tool which is used to raise capital. Just like any other tool, it can be beneficial and can be harmful too. So, the ultimate outcome solely lies in the hands of the people who use it to serve their purpose
An asset is anything of durable value, that is, anything that acts as a means to store value over time. Real assets are assets in physical form (e.g., land, equipment, houses,...), including "human capital" assets embodied in people (natural abilities, learned skills, knowledge,..). Financial assets are claims against real assets, either directly (e.g., stock share equity claims) or indirectly (e.g., money holdings, or claims to future income streams that originate ultimately from real assets). Securities are financial assets exchanged in auction and over-the-counter markets (see below) whose distribution is subject to legal requirements and restrictions (e.g., information disclosure requirements).
Lenders are people who have available funds in excess of their desired expenditures that they are attempting to loan out, and borrowers are people who have a shortage of funds relative to their desired expenditures who are seeking to obtain loans. Borrowers attempt to obtain funds from lenders by selling to lenders newly issued claims against the borrowers' real assets, i.e., by selling the lenders newly issued financial assets.
A financial market is a market in which financial assets are traded. In addition to enabling exchange of previously issued financial assets, financial markets facilitate borrowing and lending by facilitating the sale by newly issued financial assets. Examples of financial markets include the New York Stock Exchange (resale of previously issued stock shares), the U.S. government bond market (resale of previously issued bonds), and the U.S. Treasury bills auction (sales of newly issued T-bills). A financial institution is an institution whose primary source of profits is through financial asset transactions. Examples of such financial institutions include discount brokers (e.g., Charles Schwab and Associates), banks, insurance companies, and complex multi-function financial institutions such as Merrill Lynch.
Introduction to Financial Markets and Institutions:
Financial markets serve six basic functions. These functions are briefly listed below:
Borrowing and Lending: Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes.
Price Determination: Financial markets provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets.
Information Aggregation and Coordination: Financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers.
Risk Sharing: Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments.
Liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets.
Efficiency: Financial markets reduce transaction costs and information costs.
In attempting to characterize the way financial markets operate, one must consider both the various types of financial institutions that participate in such markets and the various ways in which these markets are structured.
Who are the Major Players in Financial Markets?
By definition, financial institutions are institutions that participate in financial markets, i.e., in the creation and/or exchange of financial assets. At present in the United States, financial institutions can be roughly classified into the following four categories: "brokers;" "dealers;" "investment bankers;" and "financial intermediaries."
Brokers:
A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a seller (or buyer) to complete the desired transaction. A broker does not take a position in the assets he or she trades -- that is, the broker does not maintain inventories in these assets. The profits of brokers are determined by the commissions they charge to the users of their services (either the buyers, the sellers, or both). Examples of brokers include real estate brokers and stock brokers.
Diagrammatic Illustration of a Stock Broker:
Payment ----------------- Payment ------------>| |-------------> Stock | | Stock Buyer | Stock Broker | Seller <-------------|<----------------|<------------- Stock | (Passed Thru) | Stock Shares ----------------- Shares
Dealers:
Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not engage in asset transformation. Unlike brokers, however, a dealer can and does "take positions" (i.e., maintain inventories) in the assets he or she trades that permit the dealer to sell out of inventory rather than always having to locate sellers to match every offer to buy. Also, unlike brokers, dealers do not receive sales commissions. Rather, dealers make profits by buying assets at relatively low prices and reselling them at relatively high prices (buy low - sell high). The price at which a dealer offers to sell an asset (the "asked price") minus the price at which a dealer offers to buy an asset (the "bid price") is called the bid-ask spread and represents the dealer's profit margin on the asset exchange. Real-world examples of dealers include car dealers, dealers in U.S. government bonds, and Nasdaq stock dealers.
Diagrammatic Illustration of a Bond Dealer:
Payment ----------------- Payment ------------>| |-------------> Bond | Dealer | Bond Buyer | | Seller <-------------| Bond Inventory |<------------- Bonds | | Bonds -----------------
Investment Banks:
An investment bank assists in the initial sale of newly issued securities (i.e., in IPOs = Initial Public Offerings) by engaging in a number of different activities:
Advice: Advising corporations on whether they should issue bonds or stock, and, for bond issues, on the particular types of payment schedules these securities should offer;
Underwriting: Guaranteeing corporations a price on the securities they offer, either individually or by having several different investment banks form a syndicate to underwrite the issue jointly;
Sales Assistance: Assisting in the sale of these securities to the public.
Some of the best-known U.S. investment banking firms are Morgan Stanley, Merrill Lynch, Salomon Brothers, First Boston Corporation, and Goldman Sachs.
Financial Intermediaries:
Unlike brokers, dealers, and investment banks, financial intermediaries are financial institutions that engage in financial asset transformation. That is, financial intermediaries purchase one kind of financial asset from borrowers -- generally some kind of long-term loan contract whose terms are adapted to the specific circumstances of the borrower (e.g., a mortgage) -- and sell a different kind of financial asset to savers, generally some kind of relatively liquid claim against the financial intermediary (e.g., a deposit account). In addition, unlike brokers and dealers, financial intermediaries typically hold financial assets as part of an investment portfolio rather than as an inventory for resale. In addition to making profits on their investment portfolios, financial intermediaries make profits by charging relatively high interest rates to borrowers and paying relatively low interest rates to savers.
Types of financial intermediaries include: Depository Institutions (commercial banks, savings and loan associations, mutual savings banks, credit unions); Contractual Savings Institutions (life insurance companies, fire and casualty insurance companies, pension funds, government retirement funds); and Investment Intermediaries (finance companies, stock and bond mutual funds, money market mutual funds).
Diagrammatic Example of a Financial Intermediary: A Commercial Bank
Lending by B Borrowing by B
deposited ------- funds ------- funds ------- | |<............. | | <............. | | | F |.............> | B | ..............> | H | ------- loan ------- deposit ------- contracts accounts
Loan contracts Deposit accounts issued by F to B issued by B to H are liabilities of F are liabilities of B and assets of B and assets of H
NOTE: F=Firms, B=Commercial Bank, and H=Households
Important Caution: These four types of financial institutions are simplified idealized classifications, and many actual financial institutions in the fast-changing financial landscape today engage in activities that overlap two or more of these classifications, or even to some extent fall outside these classifications. A prime example is Merrill Lynch, which simultaneously acts as a broker, a dealer (taking positions in certain stocks and bonds it sells), a
financial intermediary (e.g., through its provision of mutual funds and CMA checkable deposit accounts), and an investment banker.
What Types of Financial Market Structures Exist?
The costs of collecting and aggregating information determine, to a large extent, the types of financial market structures that emerge. These structures take four basic forms:
Auction markets conducted through brokers; Over-the-counter (OTC) markets conducted through dealers; Organized Exchanges, such as the New York Stock Exchange, which
combine auction and OTC market features. Specifically, organized exchanges permit buyers and sellers to trade with each other in a centralized location, like an auction. However, securities are traded on the floor of the exchange with the help of specialist traders who combine broker and dealer functions. The specialists broker trades but also stand ready to buy and sell stocks from personal inventories if buy and sell orders do not match up.
Intermediation financial markets conducted through financial intermediaries;
Financial markets taking the first three forms are generally referred to as securities markets. Some financial markets combine features from more than one of these categories, so the categories constitute only rough guidelines.
Auction Markets:
An auction market is some form of centralized facility (or clearing house) by which buyers and sellers, through their commissioned agents (brokers), execute trades in an open and competitive bidding process. The "centralized facility" is not necessarily a place where buyers and sellers physically meet. Rather, it is any institution that provides buyers and sellers with a centralized access to the bidding process. All of the needed information about offers to buy (bid prices) and offers to sell (asked prices) is centralized in one location which is readily accessible to all would-be buyers and sellers, e.g., through a computer network. No private exchanges between individual buyers and sellers are made outside of the centralized facility.
An auction market is typically a public market in the sense that it open to all agents who wish to participate. Auction markets can either be call markets -- such as art auctions -- for which bid and asked prices are all posted at one time, or continuous markets -- such as stock exchanges and real estate markets -- for which bid and asked prices can be posted at any time the market is open and exchanges take place on a continual basis. Experimental economists have devoted a tremendous amount of attention in recent years to auction markets.
Many auction markets trade in relatively homogeneous assets (e.g., Treasury bills, notes, and bonds) to cut down on information costs. Alternatively, some auction markets (e.g., in second-hand jewelry, furniture, paintings etc.) allow would-be buyers to inspect the goods to be sold prior to the opening of the actual bidding process. This inspection can take the form of a warehouse tour, a catalog issued with pictures and descriptions of items to be sold, or (in televised auctions) a time during which assets are simply displayed one by one to viewers prior to bidding.
Auction markets depend on participation for any one type of asset not being too "thin." The costs of collecting information about any one type of asset are sunk costs independent of the volume of trading in that asset. Consequently, auction markets depend on volume to spread these costs over a wide number of participants.
Over-the-Counter Markets:
An over-the-counter market has no centralized mechanism or facility for trading. Instead, the market is a public market consisting of a number of dealers spread across a region, a country, or indeed the world, whomake the market in some type of asset. That is, the dealers themselves post bid and asked prices for this asset and then stand ready to buy or sell units of this asset with anyone who chooses to trade at these posted prices. The dealers provide customers more flexibility in trading than brokers, because dealers can offset imbalances in the demand and supply of assets by trading out of their own accounts. Many well-known common stocks are traded over-the-counter in the United States through NASDAQ (National Association of Securies Dealers' Automated Quotation System).
Intermediation Financial Markets:
An intermediation financial market is a financial market in which financial intermediaries help transfer funds from savers to borrowers by issuing certain types of financial assets to savers and receiving other types of financial assets
from borrowers. The financial assets issued to savers are claims against the financial intermediaries, hence liabilities of the financial intermediaries, whereas the financial assets received from borrowers are claims against the borrowers, hence assets of the financial intermediaries. (See the diagrammatic illustration of a financial intermediary presented earlier in these notes.)
Additional Distinctions Among Securities Markets
Primary versus Secondary Markets:
Primary markets are securities markets in which newly issued securities are offered for sale to buyers. Secondary markets are securities markets in which existing securities that have previously been issued are resold. The initial issuer raises funds only through the primary market.
Debt Versus Equity Markets:
Debt instruments are particular types of securities that require the issuer (the borrower) to pay the holder (the lender) certain fixed dollar amounts at regularly scheduled intervals until a specified time (the maturity date) is reached, regardless of the success or failure of any investment projects for which the borrowed funds are used. A debt instrument holder only participates in the management of the debt instrument issuer if the issuer goes bankrupt. An example of a debt instrument is a 30-year mortgage.
In contrast, an equity is a security that confers on the holder an ownership interest in the issuer.
There are two general categories of equities: "preferred stock" and "common stock."
Common stock shares issued by a corporation are claims to a share of the assets of a corporation as well as to a share of the corporation's net income -- i.e., the corporation's income after subtraction of taxes and other expenses, including the payment of any debt obligations. This implies that the return that holders of common stock receive depends on the economic performance of the issuing corporation.
Holders of a corporation's common stock typically participate in any upside performance of the corporation in two ways: by receiving a share of net income in the form of dividends; and by enjoying an appreciation in the price of their stock shares. However, the payment of dividends is not a contractual or legal requirement. Even if net earnings are positive, a corporation is not obliged to distribute dividends to shareholders. For example, a corporation might instead choose to keep its profits as retained earnings to be used for new capital investment (self-financing of investment rather than debt or equity financing).
On the other hand, corporations cannot charge losses to their common stock shareholders. Consequently, these shareholders at most risk losing the purchase price of their shares, a situation which arises if the market price of their shares declines to zero for any reason. An example of a common stock share is a share of IBM.
In contrast, preferred stock shares are usually issued with a par value (e.g., $100) and pay a fixed dividend expressed as a percentage of par value. Preferred stock is a claim against a corporation's cash flow that is prior to the claims of its common stock holders but is generally subordinate to the claims of its debt holders. In addition, like debt holders but unlike common stock holders, preferred stock holders generally do not participate in the management of issuers through voting or other means unless the issuer is in extreme financial distress (e.g., insolvency). Consequently, preferred stock combines some of the basic attributes of both debt and common stock and is often referred to as a hybrid security.
Money versus Capital Markets:
The money market is the market for shorter-term securities, generally those with one year or less remaining to maturity.
Examples: U.S. Treasury bills; negotiable bank certificates of deposit (CDs); commercial paper, Federal funds; Eurodollars.
Remark: Although the maturity on certificates of deposit (CDs) -- i.e., on large time deposits at depository institutions -- can run anywhere from 30 days to
over 5 years, most CDs have a maturity of less than one year. Those with a maturity of more than one year are referred to as term CDs. A CD that can be resold without penalty in a secondary market prior to maturity is known as a negotiableCD.
The capital market is the market for longer-term securities, generally those with more than one year to maturity.
Examples: Corporate stocks; residential mortgages; U.S. government securities (marketable long-term); state and local government bonds; bank commercial loans; consumer loans; commercial and farm mortgages.
Remark: Corporate stocks are conventionally considered to be long-term securities because they have no maturity date.
Domestic Versus Global Financial Markets:
Eurocurrencies are currencies deposited in banks outside the country of issue. For example, eurodollars, a major form of eurocurrency, are U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks. That is, eurodollars are dollar-denominated bank deposits held in banks outside the U.S.
An international bond is a bond available for sale outside the country of its issuer.
Example of an International Bond: a bond issued by a U.S. firm that is available for sale both in the U.S. and abroad.
A foreign bond is an international bond issued by a country that is denominated in a foreign currency and that is for sale exclusively in the country of that foreign currency.
Example of a Foreign Bond: a bond issued by a U.S. firm that is denominated in Japanese yen and that is for sale exclusively in Japan.
A Eurobond is an international bond denominated in a currency other than that of the country in which it is sold. More precisely, it is issued by a
borrower in one country, denominated in the borrower's currency, and sold outside the borrower's country.
Example of a Eurobond: Bonds sold by the U.S. government to Japan that are denominated in U.S. dollars.
Asymmetric Information in Financial Markets
Asymmetric information in a market for goods, services, or assets refers to differences ("asymmetries") between the information available to buyers and the information available to sellers. For example, in markets for financial assets, asymmetric information may arise between lenders (buyers of financial assets) and borrowers (sellers of financial assets).
Problems arising in markets due to asymmetric information are typically divided into two basic types: "adverse selection;" and "moral hazard." This section explains these two types of problems, using financial markets for concrete illustration.
1. Adverse Selection
Adverse selection is a problem that arises for a buyer of goods, services, or assets when the buyer has difficulty assessing the quality of these items in advance of purchase.
Consequently, adverse selection is a problem that arises because of different ("asymmetric") information between a buyer and a seller before any purchase agreement takes place.
An Illustration of Adverse Selection in Loan Markets:
In the context of a loan market, an adverse selection problem arises if the contractual terms that a lender sets in advance in an attempt to protect himself against the consequences of inadvertently lending to high risk borrowers have the perverse effect of encouraging high risk borrowers to self-select into the lender's loan applicant pool while at the same time encouraging low risk borrowers to self-select out of this pool. In this case, the
lender's pool of loan applicants is adversely affected in the sense that the average quality of borrowers in the pool decreases.
2. Moral Hazard
Moral hazard is said to exist in a market if, after the signing of a purchase agreement between the buyer and seller of a good, service, or asset:
the seller changes his or her behavior in such a way that the probabilites (risk calculations) used by the buyer to determine the terms of the purchase agreement are no longer accurate;
the buyer is only imperfectly able to monitor (observe) this change in the seller's behavior.
For example, a moral hazard problem arises if, after a lender purchases a loan contract from a borrower, the borrower increases the risks originally associated with the loan contract by investing his borrowed funds in more risky projects than he originally reported to the lender.
The Concept of Present Value
Suppose someone promises to pay you $100 in some future period T. This amount of money actually has two different values: a nominal value of $100, which is simply a measure of the number of dollars that you will receive in period T; and a present value (sometimes referred to as a present discounted value), roughly defined to be the minimum number of dollars that you would have to give up today in return for receiving $100 in period T.
Stated somewhat differently, the present value of the future $100 payment is the value of this future $100 payment measured in terms of current (or present) dollars.
The concept of present value permits financial assets with different associated payment streams to be compared with each other by calculating the value of these payment streams in terms of a single common unit: namely, current dollars.
A specific procedure for the calculation of present value for future payments will now be developed.
Present Value of Payments One Period Into the Future:
If you save $1 today for a period of one year at an annual interest rate i, the nominal value of your savings after one year will be
(1) V(1) = (1+i)*$1 ,
where the asterisk "*" denotes multiplication.
On the other hand, proceeding in the reverse direction from the future to the present, the present value of the future dollar amount V(1) = (1+i)*$1 is equal to $1. That is, the amount you would have to save today in order to receive back V(1)=(1+i)*$1 in one year's time is $1.
Notice that this calculation of $1 as the present value of V(1)=(1+i)*$1 satisfies the following formula:
V(1)(2) Present Value = -------- . of V(1) (1+i)
Indeed, given any fixed annual interest rate i, and any payment V(1) to be received one year from today, the present value of V(1) is given by formula (2). In effect, then, the payment V(1) to be received one year from now has been discounted back to the present using the annual interest rate i, so that the value of V(1) is now expressed in current dollars.
Present Value of Payments Multiple Periods Into the Future:
If you save $1 today at a fixed annual interest rate i, what will be the value of your savings in one year's time? In two year's time? In n year's time?
If you save $1 at a fixed annual interest rate i, the nominal value of your savings in one year's time will be V(1)=(1+i)*$1. If you then put aside V(1) as savings for an additional year rather than spend it, the nominal value of your savings at the end of the second year will be
(3)
V(2) = (1+i)*V(1) = (1+i)*(1+i)*$1 = (1+i)2*$1 .
And so forth for any number of years n.
(4) START --------------------------------/\/\/\-------->YEAR | 1 2 n |
Nominal 2 nValue of $1 (1+i)*$1 (1+i) *$1 (1+i) * $1Savings:
Now consider the present value of V(n) = (1+i)n*$1 for any year n. By construction, V(n) is the nominal value obtained after n years when a single dollar is saved for n successive years at the fixed annual interest rate i. Consequently, the present value of V(n) is simply equal to $1, regardless of the value of n.
Notice, however, that the present value of V(n) -- namely, $1 -- can be obtained from the following formula:
V(n)(5) Present Value = ------------ . of V(n) n (1+i)
Indeed, given any fixed annual interest rate i, and any nominal amount V(n) to be received n years from today, the present value of V(n) can be calculated by using formula (5).
Present Value of Any Arbitrary Payment Stream:
Now suppose you will be receiving a sequence of three payments over the next three years. The nominal value of the first payment is $100, to be received at the end of the first year; the nominal value of the second payment is $150, to be received at the end of the second year; and the nominal value of the third payment is $200, to be received at the end of the third year.
Given a fixed annual interest rate i, what is the present value of the payment stream ($100,$150,$200) consisting of the three separate payments $100, $150, and $200 to be received over the next three years?
To calculate the present value of the payment stream ($100,$150,$200), use the following two steps:
Step 1: Use formula (5) to separately calculate the present value of each of the individual payments in the payment stream, taking care to note how many years into the future each payment is going to be received.
Step 2: Sum the separate present value calculations obtained in Step 1 to obtain the present value of the payment stream as a whole.
Carrying out Step 1, it follows from formula (5) that the present value of the $100 payment to be received at the end of the first year is $100/(1+i). Similarly, it follows from formula (5) that the present value of the $150 payment to be received at the end of the second year is
$150(6) ---------- 2 (1+i)
Finally, it follows from formula (3) that the present value of the $200 payment to be received at the end of the third year is
$200 ----------(7) 3 (1+i)
Consequently, adding together these three separate present value calculations in accordance with Step 2, the present value PV(i) of the payment stream ($100,$150,$200) is given by
(8)
PV(i) = $100 + $150 + $200
(1 + i)1 (1 + i)2 (1 + i)3
More generally, given any fixed annual interest rate i, and given any payment stream (V1,V2,V3,...,VN) consisting of individual payments to be received over the next N years, the present value of this payment stream can be found by following the two steps outlined above.
In particular, then, given any fixed annual interest rate, and given any payment stream paid out on a yearly basis to the owner of some financial asset, the present (current dollar) value of this payment stream can be found by following Steps 1 and 2 outlined above. Consequently, regardless how different the payment streams associated with different financial assets might be, one can calculate the present values for these payment streams in current dollar terms and hence have a way to compare them.
Measuring Interest Rates by Yield to Maturity
By definition, the current annual yield to maturity for a financial asset is the particular fixed annual interest rate i which, when used to calculate the present value of the financial asset's future stream of payments to the financial asset's owner, yields a present value equal to the current market value of the financial asset.
Below we illustrate this calculation for coupon bonds.
Yield to Maturity for Coupon Bonds:
The basic contractual terms of a coupon bond are as follows:
Seller Purchase Receives: Price Pb | MATURITY START |_______________________ /\/\/\ _____ DATE | | | | | | Coupon Coupon ... Coupon Buyer Payment C Payment C Payment C Receives: + Face Value F
Consider a coupon bond whose purchase price is Pb=$94, whose face value is F = $100, whose annual coupon payment is C = $10, and whose maturity is 10 years.
The payment stream to the buyer (new owner) generated by this coupon bond is given by
(9)
( $10, $10, $10, $10, $10, $10, $10, $10, $10, [$10 + $100] ).
For any given fixed annual interest rate i, the present value PV(i) of the payment stream (9) is given by the sum of the separate present value calculations for each of the annual payments in this payment stream as determined by formula (5). That is,
(10)
PV(i) = $10/(1+i) + $10/(1+i)2 + ... + $10/(1+i)10 + $100/(1+i)10 .
The current value of the coupon bond is its current purchase price Pb = $94. It then follows by definition that the yield to maturity for this coupon bond is found by solving the following equation for i:
(11)
Pb = PV(i) .
The calculation of the yield to maturity i from formula (11) can be difficult, but tables have been published that permit one to read off the yield to maturity i for a coupon bond once the purchase price, the face value, the coupon rate, and the maturity are known.
More generally, given any coupon bond with purchase price Pb, face value F, coupon payment C, and maturity N, the yield to maturity i is found by means of the following formula:
(12a)
Pb = PV(i) ,
where the present value PV(i) of the coupon bond is given by
(12b)
PV(i) = C/(1+i) + C/(1+i)2 + ... + C/(1+i)N + F/(1+i)N .
Interest Rates vs. Return Rates
Given any asset A held over any given time period T, the return to A over the holding period T is, by definition:
the sum of all payments (rents, coupon payments, dividends, etc.) generated by A during period T, assumed paid out at the end of the period,
PLUS the capital gain (+) or loss (-) in the market value of A over period T, measured as the market value of A at the end of period T minus the market value of A at the beginning of period T.
The return rate on asset A over the holding period T is then defined to be the return on A over period T divided by the market value of A at the beginning of period T.
More precisely, suppose that an asset A is held over a time period that starts at some time t and ends at time t+1. Let the market value of A at time t be denoted by P(t) and the market value of A at time t+1 be denoted by P(t+1). Finally, let V(t,t+1) denote the sum of all payments accruing to the holder of asset A from t to t+1, assumed to be paid out at time t+1.
Then, by definition, the return rate on asset A from t to t+1 is given by the following formula:
(13) Return Rate on V(t,t+1) + P(t+1) - P(t) Asset A From = --------------------------- time t to t+1 P(t)
V(t,t+1) P(t+1) - P(t) = --------- + ------------- P(t) P(t)
= payments + Capital Gain (if +) received as or Loss (if -) as percentage percentage of P(t) of P(t)
Formula (13) holds for any asset A, whether physical or financial. The question then arises: For financial assets, what is the connection between the return rate defined by formula (13) and the interest rate on the financial asset defined by the yield to maturity?
The return rate on a financial asset is not necessarily equal to the yield to maturity on the financial asset. Starting at any current time t, the return rate is calculated for some specified holding period from t to t', whether or not this holding period coincides with the maturity of the financial asset. Moreover, the return rate takes into account any capital gains or losses that occur during this holding period, in addition to any payments received from the financial asset during this holding period. In contrast, starting at any current time t, the yield to maturity takes into account the payment stream generated by the financial asset over its entire remaining maturity, plus the overall anticipated capital gain or loss that will be incurred when the financial asset is held to maturity.
Real vs. Nominal Interest Rates
The yield to maturity measure of an interest rate, as examined to date, has been "nominal" in the sense that it has not been adjusted for expected changes in prices. What actually concerns a "rational" saver considering the purchase of a financial asset is not the nominal payment stream he or she expects to earn in future periods but rather the command over purchasing power that this nominal payment stream is expected to entail. This purchasing power depends on the behavior of prices.
Let infe(t) denote the expected inflation rate at time t, and let i(t) denote the (nominal) yield to maturity for some financial asset at time t. Then the real interest rate associated with i(t) is defined by the following "Fisher equation:"
An asset is anything of durable value, that is, anything that acts as a means to store value over time. Real assets are assets in physical form (e.g., land, equipment, houses,...), including "human capital" assets embodied in people (natural abilities, learned skills, knowledge,..). Financial assets are claims against real assets, either directly (e.g., stock share equity claims) or indirectly (e.g., money holdings, or claims to future income streams that originate ultimately from real assets). Securities are financial assets exchanged in auction and over-the-counter markets (see below) whose distribution is subject to legal requirements and restrictions (e.g., information disclosure requirements).
Lenders are people who have available funds in excess of their desired expenditures that they are attempting to loan out, and borrowers are people who have a shortage of funds relative to their desired expenditures who are seeking to obtain loans.
Borrowers attempt to obtain funds from lenders by selling to lenders newly issued claims against the borrowers' real assets, i.e., by selling the lenders newly issued financial assets.
A financial market is a market in which financial assets are traded. In addition to enabling exchange of previously issued financial assets, financial markets facilitate borrowing and lending by facilitating the sale by newly issued financial assets. Examples of financial markets include the New York Stock Exchange (resale of previously issued stock shares), the U.S. government bond market (resale of previously issued bonds), and the U.S. Treasury bills auction (sales of newly issued T-bills). A financial institution is an institution whose primary source of profits is through financial asset transactions. Examples of such financial institutions include discount brokers (e.g., Charles Schwab and Associates), banks, insurance companies, and complex multi-function financial institutions such as Merrill Lynch.
Introduction to Financial Markets and Institutions:
Financial markets serve six basic functions. These functions are briefly listed below:
Borrowing and Lending: Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes.
Price Determination: Financial markets provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets.
Information Aggregation and Coordination: Financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers.
Risk Sharing: Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments.
Liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets.
Efficiency: Financial markets reduce transaction costs and information costs.
In attempting to characterize the way financial markets operate, one must consider both the various types of financial institutions that participate in such markets and the various ways in which these markets are structured.
Who are the Major Players in Financial Markets?
By definition, financial institutions are institutions that participate in financial markets, i.e., in the creation and/or exchange of financial assets. At present in the United States, financial institutions can be roughly classified into the following four categories: "brokers;" "dealers;" "investment bankers;" and "financial intermediaries."
Brokers:
A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a seller (or buyer) to complete the desired transaction. A broker does not take a position in the assets he or she trades -- that is, the broker does not maintain inventories in these assets. The profits of brokers are determined by the commissions they charge to the users of their services (either the buyers, the sellers, or both). Examples of brokers include real estate brokers and stock brokers.
Diagrammatic Illustration of a Stock Broker:
Payment ----------------- Payment ------------>| |-------------> Stock | | Stock Buyer | Stock Broker | Seller <-------------|<----------------|<------------- Stock | (Passed Thru) | Stock Shares ----------------- Shares
Dealers:
Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not engage in asset transformation. Unlike brokers, however, a dealer can and does "take positions" (i.e., maintain inventories) in the assets he or she trades that permit the dealer to sell out of inventory rather than always having to locate sellers to match every offer to buy. Also, unlike brokers, dealers do not receive sales commissions. Rather, dealers make profits by buying assets at relatively low prices and reselling them at relatively high prices (buy low - sell high). The price at which a dealer offers to sell an asset (the "asked price") minus the price at which a dealer offers to buy an asset (the "bid price") is called the bid-ask spread and represents the dealer's profit margin on the asset exchange. Real-world examples of dealers include car dealers, dealers in U.S. government bonds, and Nasdaq stock dealers.
Diagrammatic Illustration of a Bond Dealer:
Payment ----------------- Payment ------------>| |-------------> Bond | Dealer | Bond Buyer | | Seller <-------------| Bond Inventory |<------------- Bonds | | Bonds -----------------
Investment Banks:
An investment bank assists in the initial sale of newly issued securities (i.e., in IPOs = Initial Public Offerings) by engaging in a number of different activities:
Advice: Advising corporations on whether they should issue bonds or stock, and, for bond issues, on the particular types of payment schedules these securities should offer;
Underwriting: Guaranteeing corporations a price on the securities they offer, either individually or by having several different investment banks form a syndicate to underwrite the issue jointly;
Sales Assistance: Assisting in the sale of these securities to the public.
Some of the best-known U.S. investment banking firms are Morgan Stanley, Merrill Lynch, Salomon Brothers, First Boston Corporation, and Goldman Sachs.
Financial Intermediaries:
Unlike brokers, dealers, and investment banks, financial intermediaries are financial institutions that engage in financial asset transformation. That is, financial intermediaries purchase one kind of financial asset from borrowers -- generally some kind of long-term loan contract whose terms are adapted to the specific circumstances of the borrower (e.g., a mortgage) -- and sell a different kind of financial asset to savers, generally some kind of relatively liquid claim against the financial intermediary (e.g., a deposit account). In addition, unlike brokers and dealers, financial intermediaries typically hold financial assets as part of an investment portfolio rather than as an inventory for resale. In addition to making profits on their investment portfolios, financial intermediaries make profits by charging relatively high interest rates to borrowers and paying relatively low interest rates to savers.
Types of financial intermediaries include: Depository Institutions (commercial banks, savings and loan associations, mutual savings banks, credit unions); Contractual Savings Institutions (life insurance companies, fire and casualty insurance companies,
pension funds, government retirement funds); and Investment Intermediaries (finance companies, stock and bond mutual funds, money market mutual funds).
Diagrammatic Example of a Financial Intermediary: A Commercial Bank
Lending by B Borrowing by B
deposited ------- funds ------- funds ------- | |<............. | | <............. | | | F |.............> | B | ..............> | H | ------- loan ------- deposit ------- contracts accounts
Loan contracts Deposit accounts issued by F to B issued by B to H are liabilities of F are liabilities of B and assets of B and assets of H
NOTE: F=Firms, B=Commercial Bank, and H=Households
Important Caution: These four types of financial institutions are simplified idealized classifications, and many actual financial institutions in the fast-changing financial landscape today engage in activities that overlap two or more of these classifications, or even to some extent fall outside these classifications. A prime example is Merrill Lynch, which simultaneously acts as a broker, a dealer (taking positions in certain stocks and bonds it sells), a financial intermediary (e.g., through its provision of mutual funds and CMA checkable deposit accounts), and an investment banker.
What Types of Financial Market Structures Exist?
The costs of collecting and aggregating information determine, to a large extent, the types of financial market structures that emerge. These structures take four basic forms:
Auction markets conducted through brokers; Over-the-counter (OTC) markets conducted through dealers; Organized Exchanges, such as the New York Stock Exchange, which
combine auction and OTC market features. Specifically, organized exchanges permit buyers and sellers to trade with each other in a centralized location, like an auction. However, securities are traded on the floor of the exchange with the help of specialist traders who
combine broker and dealer functions. The specialists broker trades but also stand ready to buy and sell stocks from personal inventories if buy and sell orders do not match up.
Intermediation financial markets conducted through financial intermediaries;
Financial markets taking the first three forms are generally referred to as securities markets. Some financial markets combine features from more than one of these categories, so the categories constitute only rough guidelines.
Auction Markets:
An auction market is some form of centralized facility (or clearing house) by which buyers and sellers, through their commissioned agents (brokers), execute trades in an open and competitive bidding process. The "centralized facility" is not necessarily a place where buyers and sellers physically meet. Rather, it is any institution that provides buyers and sellers with a centralized access to the bidding process. All of the needed information about offers to buy (bid prices) and offers to sell (asked prices) is centralized in one location which is readily accessible to all would-be buyers and sellers, e.g., through a computer network. No private exchanges between individual buyers and sellers are made outside of the centralized facility.
An auction market is typically a public market in the sense that it open to all agents who wish to participate. Auction markets can either be call markets -- such as art auctions -- for which bid and asked prices are all posted at one time, or continuous markets -- such as stock exchanges and real estate markets -- for which bid and asked prices can be posted at any time the market is open and exchanges take place on a continual basis. Experimental economists have devoted a tremendous amount of attention in recent years to auction markets.
Many auction markets trade in relatively homogeneous assets (e.g., Treasury bills, notes, and bonds) to cut down on information costs. Alternatively, some auction markets (e.g., in second-hand jewelry, furniture, paintings etc.) allow would-be buyers to inspect the goods to be sold prior to the opening of the actual bidding process. This inspection can take the form of a warehouse tour, a catalog issued with pictures and descriptions of items to be sold, or (in televised auctions) a time during which assets are simply displayed one by one to viewers prior to bidding.
Auction markets depend on participation for any one type of asset not being too "thin." The costs of collecting information about any one type of asset are sunk costs independent of the volume of trading in that asset. Consequently, auction markets depend on volume to spread these costs over a wide number of participants.
Over-the-Counter Markets:
An over-the-counter market has no centralized mechanism or facility for trading. Instead, the market is a public market consisting of a number of dealers spread across a region, a country, or indeed the world, whomake the market in some type of asset. That is, the dealers themselves post bid and asked prices for this asset and then stand ready to buy or sell units of this asset with anyone who chooses to trade at these posted prices. The dealers provide customers more flexibility in trading than brokers, because dealers can offset imbalances in the demand and supply of assets by trading out of their own accounts. Many well-known common stocks are traded over-the-counter in the United States through NASDAQ (National Association of Securies Dealers' Automated Quotation System).
Intermediation Financial Markets:
An intermediation financial market is a financial market in which financial intermediaries help transfer funds from savers to borrowers by issuing certain types of financial assets to savers and receiving other types of financial assets from borrowers. The financial assets issued to savers are claims against the financial intermediaries, hence liabilities of the financial intermediaries, whereas the financial assets received from borrowers are claims against the borrowers, hence assets of the financial intermediaries. (See the diagrammatic illustration of a financial intermediary presented earlier in these notes.)
Additional Distinctions Among Securities Markets
Primary versus Secondary Markets:
Primary markets are securities markets in which newly issued securities are offered for sale to buyers. Secondary markets are securities markets in which existing securities that have previously been issued are resold. The initial issuer raises funds only through the primary market.
Debt Versus Equity Markets:
Debt instruments are particular types of securities that require the issuer (the borrower) to pay the holder (the lender) certain fixed dollar amounts at regularly scheduled intervals until a specified time (the maturity date) is reached, regardless of the success or failure of any investment projects for which the borrowed funds are used. A debt instrument holder only participates in the management of the debt instrument issuer if the issuer goes bankrupt. An example of a debt instrument is a 30-year mortgage.
In contrast, an equity is a security that confers on the holder an ownership interest in the issuer.
There are two general categories of equities: "preferred stock" and "common stock."
Common stock shares issued by a corporation are claims to a share of the assets of a corporation as well as to a share of the corporation's net income -- i.e., the corporation's income after subtraction of taxes and other expenses, including the payment of any debt obligations. This implies that the return that holders of common stock receive depends on the economic performance of the issuing corporation.
Holders of a corporation's common stock typically participate in any upside performance of the corporation in two ways: by receiving a share of net income in the form of dividends; and by enjoying an appreciation in the price of their stock shares. However, the payment of dividends is not a contractual or legal requirement. Even if net earnings are positive, a corporation is not obliged to distribute dividends to shareholders. For example, a corporation might instead choose to keep its profits as retained earnings to be used for new capital investment (self-financing of investment rather than debt or equity financing).
On the other hand, corporations cannot charge losses to their common stock shareholders. Consequently, these shareholders at most risk losing the purchase price of their shares, a situation which arises if the market price of
their shares declines to zero for any reason. An example of a common stock share is a share of IBM.
In contrast, preferred stock shares are usually issued with a par value (e.g., $100) and pay a fixed dividend expressed as a percentage of par value. Preferred stock is a claim against a corporation's cash flow that is prior to the claims of its common stock holders but is generally subordinate to the claims of its debt holders. In addition, like debt holders but unlike common stock holders, preferred stock holders generally do not participate in the management of issuers through voting or other means unless the issuer is in extreme financial distress (e.g., insolvency). Consequently, preferred stock combines some of the basic attributes of both debt and common stock and is often referred to as a hybrid security.
Money versus Capital Markets:
The money market is the market for shorter-term securities, generally those with one year or less remaining to maturity.
Examples: U.S. Treasury bills; negotiable bank certificates of deposit (CDs); commercial paper, Federal funds; Eurodollars.
Remark: Although the maturity on certificates of deposit (CDs) -- i.e., on large time deposits at depository institutions -- can run anywhere from 30 days to over 5 years, most CDs have a maturity of less than one year. Those with a maturity of more than one year are referred to as term CDs. A CD that can be resold without penalty in a secondary market prior to maturity is known as a negotiableCD.
The capital market is the market for longer-term securities, generally those with more than one year to maturity.
Examples: Corporate stocks; residential mortgages; U.S. government securities (marketable long-term); state and local government bonds; bank commercial loans; consumer loans; commercial and farm mortgages.
Remark: Corporate stocks are conventionally considered to be long-term securities because they have no maturity date.
Domestic Versus Global Financial Markets:
Eurocurrencies are currencies deposited in banks outside the country of issue. For example, eurodollars, a major form of eurocurrency, are U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks. That is, eurodollars are dollar-denominated bank deposits held in banks outside the U.S.
An international bond is a bond available for sale outside the country of its issuer.
Example of an International Bond: a bond issued by a U.S. firm that is available for sale both in the U.S. and abroad.
A foreign bond is an international bond issued by a country that is denominated in a foreign currency and that is for sale exclusively in the country of that foreign currency.
Example of a Foreign Bond: a bond issued by a U.S. firm that is denominated in Japanese yen and that is for sale exclusively in Japan.
A Eurobond is an international bond denominated in a currency other than that of the country in which it is sold. More precisely, it is issued by a borrower in one country, denominated in the borrower's currency, and sold outside the borrower's country.
Example of a Eurobond: Bonds sold by the U.S. government to Japan that are denominated in U.S. dollars.
Asymmetric Information in Financial Markets
Asymmetric information in a market for goods, services, or assets refers to differences ("asymmetries") between the information available to buyers and the information available to sellers. For example, in markets for financial assets, asymmetric information may arise between lenders (buyers of financial assets) and borrowers (sellers of financial assets).
Problems arising in markets due to asymmetric information are typically divided into two basic types: "adverse selection;" and "moral hazard." This section explains these two types of problems, using financial markets for concrete illustration.
1. Adverse Selection
Adverse selection is a problem that arises for a buyer of goods, services, or assets when the buyer has difficulty assessing the quality of these items in advance of purchase.
Consequently, adverse selection is a problem that arises because of different ("asymmetric") information between a buyer and a seller before any purchase agreement takes place.
An Illustration of Adverse Selection in Loan Markets:
In the context of a loan market, an adverse selection problem arises if the contractual terms that a lender sets in advance in an attempt to protect himself against the consequences of inadvertently lending to high risk borrowers have the perverse effect of encouraging high risk borrowers to self-select into the lender's loan applicant pool while at the same time encouraging low risk borrowers to self-select out of this pool. In this case, the lender's pool of loan applicants is adversely affected in the sense that the average quality of borrowers in the pool decreases.
2. Moral Hazard
Moral hazard is said to exist in a market if, after the signing of a purchase agreement between the buyer and seller of a good, service, or asset:
the seller changes his or her behavior in such a way that the probabilites (risk calculations) used by the buyer to determine the terms of the purchase agreement are no longer accurate;
the buyer is only imperfectly able to monitor (observe) this change in the seller's behavior.
For example, a moral hazard problem arises if, after a lender purchases a loan contract from a borrower, the borrower increases the risks originally associated
with the loan contract by investing his borrowed funds in more risky projects than he originally reported to the lender.
The Concept of Present Value
Suppose someone promises to pay you $100 in some future period T. This amount of money actually has two different values: a nominal value of $100, which is simply a measure of the number of dollars that you will receive in period T; and a present value (sometimes referred to as a present discounted value), roughly defined to be the minimum number of dollars that you would have to give up today in return for receiving $100 in period T.
Stated somewhat differently, the present value of the future $100 payment is the value of this future $100 payment measured in terms of current (or present) dollars.
The concept of present value permits financial assets with different associated payment streams to be compared with each other by calculating the value of these payment streams in terms of a single common unit: namely, current dollars.
A specific procedure for the calculation of present value for future payments will now be developed.
Present Value of Payments One Period Into the Future:
If you save $1 today for a period of one year at an annual interest rate i, the nominal value of your savings after one year will be
(1) V(1) = (1+i)*$1 ,
where the asterisk "*" denotes multiplication.
On the other hand, proceeding in the reverse direction from the future to the present, the present value of the future dollar amount V(1) = (1+i)*$1 is equal to $1. That is, the amount you would have to save today in order to receive back V(1)=(1+i)*$1 in one year's time is $1.
Notice that this calculation of $1 as the present value of V(1)=(1+i)*$1 satisfies the following formula:
V(1)(2) Present Value = -------- . of V(1) (1+i)
Indeed, given any fixed annual interest rate i, and any payment V(1) to be received one year from today, the present value of V(1) is given by formula (2). In effect, then, the payment V(1) to be received one year from now has been discounted back to the present using the annual interest rate i, so that the value of V(1) is now expressed in current dollars.
Present Value of Payments Multiple Periods Into the Future:
If you save $1 today at a fixed annual interest rate i, what will be the value of your savings in one year's time? In two year's time? In n year's time?
If you save $1 at a fixed annual interest rate i, the nominal value of your savings in one year's time will be V(1)=(1+i)*$1. If you then put aside V(1) as savings for an additional year rather than spend it, the nominal value of your savings at the end of the second year will be
(3)
V(2) = (1+i)*V(1) = (1+i)*(1+i)*$1 = (1+i)2*$1 .
And so forth for any number of years n.
(4) START --------------------------------/\/\/\-------->YEAR | 1 2 n |
Nominal 2 nValue of $1 (1+i)*$1 (1+i) *$1 (1+i) * $1Savings:
Now consider the present value of V(n) = (1+i)n*$1 for any year n. By construction, V(n) is the nominal value obtained after n years when a single dollar is saved for n successive years at the fixed annual interest rate i. Consequently, the present value of V(n) is simply equal to $1, regardless of the value of n.
Notice, however, that the present value of V(n) -- namely, $1 -- can be obtained from the following formula:
V(n)(5) Present Value = ------------ . of V(n) n (1+i)
Indeed, given any fixed annual interest rate i, and any nominal amount V(n) to be received n years from today, the present value of V(n) can be calculated by using formula (5).
Present Value of Any Arbitrary Payment Stream:
Now suppose you will be receiving a sequence of three payments over the next three years. The nominal value of the first payment is $100, to be received at the end of the first year; the nominal value of the second payment is $150, to be received at the end of the second year; and the nominal value of the third payment is $200, to be received at the end of the third year.
Given a fixed annual interest rate i, what is the present value of the payment stream ($100,$150,$200) consisting of the three separate payments $100, $150, and $200 to be received over the next three years?
To calculate the present value of the payment stream ($100,$150,$200), use the following two steps:
Step 1: Use formula (5) to separately calculate the present value of each of the individual payments in the payment stream, taking care to note how many years into the future each payment is going to be received.
Step 2: Sum the separate present value calculations obtained in Step 1 to obtain the present value of the payment stream as a whole.
Carrying out Step 1, it follows from formula (5) that the present value of the $100 payment to be received at the end of the first year is $100/(1+i). Similarly, it follows from formula (5) that the present value of the $150 payment to be received at the end of the second year is
$150(6) ---------- 2 (1+i)
Finally, it follows from formula (3) that the present value of the $200 payment to be received at the end of the third year is
$200 ----------(7) 3 (1+i)
Consequently, adding together these three separate present value calculations in accordance with Step 2, the present value PV(i) of the payment stream ($100,$150,$200) is given by
(8)
PV(i) = $100 + $150 + $200
(1 + i)1 (1 + i)2 (1 + i)3
More generally, given any fixed annual interest rate i, and given any payment stream (V1,V2,V3,...,VN) consisting of individual payments to be received over the next N years, the present value of this payment stream can be found by following the two steps outlined above.
In particular, then, given any fixed annual interest rate, and given any payment stream paid out on a yearly basis to the owner of some financial asset, the present (current dollar) value of this payment stream can be found by following Steps 1 and 2 outlined above. Consequently, regardless how different the payment streams associated with different financial assets might be, one can calculate the present values for these payment streams in current dollar terms and hence have a way to compare them.
Measuring Interest Rates by Yield to Maturity
By definition, the current annual yield to maturity for a financial asset is the particular fixed annual interest rate i which, when used to calculate the present value of the financial asset's future stream of payments to the financial asset's owner, yields a present value equal to the current market value of the financial asset.
Below we illustrate this calculation for coupon bonds.
Yield to Maturity for Coupon Bonds:
The basic contractual terms of a coupon bond are as follows:
Seller Purchase Receives: Price Pb | MATURITY START |_______________________ /\/\/\ _____ DATE | | | | | | Coupon Coupon ... Coupon Buyer Payment C Payment C Payment C Receives: + Face Value F
Consider a coupon bond whose purchase price is Pb=$94, whose face value is F = $100, whose annual coupon payment is C = $10, and whose maturity is 10 years.
The payment stream to the buyer (new owner) generated by this coupon bond is given by
(9)
( $10, $10, $10, $10, $10, $10, $10, $10, $10, [$10 + $100] ).
For any given fixed annual interest rate i, the present value PV(i) of the payment stream (9) is given by the sum of the separate present value calculations for each of the annual payments in this payment stream as determined by formula (5). That is,
(10)
PV(i) = $10/(1+i) + $10/(1+i)2 + ... + $10/(1+i)10 + $100/(1+i)10 .
The current value of the coupon bond is its current purchase price Pb = $94. It then follows by definition that the yield to maturity for this coupon bond is found by solving the following equation for i:
(11)
Pb = PV(i) .
The calculation of the yield to maturity i from formula (11) can be difficult, but tables have been published that permit one to read off the yield to maturity i for a coupon bond once the purchase price, the face value, the coupon rate, and the maturity are known.
More generally, given any coupon bond with purchase price Pb, face value F, coupon payment C, and maturity N, the yield to maturity i is found by means of the following formula:
(12a)
Pb = PV(i) ,
where the present value PV(i) of the coupon bond is given by
(12b)
PV(i) = C/(1+i) + C/(1+i)2 + ... + C/(1+i)N + F/(1+i)N .
Interest Rates vs. Return Rates
Given any asset A held over any given time period T, the return to A over the holding period T is, by definition:
the sum of all payments (rents, coupon payments, dividends, etc.) generated by A during period T, assumed paid out at the end of the period,
PLUS the capital gain (+) or loss (-) in the market value of A over period T, measured as the market value of A at the end of period T minus the market value of A at the beginning of period T.
The return rate on asset A over the holding period T is then defined to be the return on A over period T divided by the market value of A at the beginning of period T.
More precisely, suppose that an asset A is held over a time period that starts at some time t and ends at time t+1. Let the market value of A at time t be denoted by P(t) and the market value of A at time t+1 be denoted by P(t+1). Finally, let
V(t,t+1) denote the sum of all payments accruing to the holder of asset A from t to t+1, assumed to be paid out at time t+1.
Then, by definition, the return rate on asset A from t to t+1 is given by the following formula:
(13) Return Rate on V(t,t+1) + P(t+1) - P(t) Asset A From = --------------------------- time t to t+1 P(t)
V(t,t+1) P(t+1) - P(t) = --------- + ------------- P(t) P(t)
= payments + Capital Gain (if +) received as or Loss (if -) as percentage percentage of P(t) of P(t)
Formula (13) holds for any asset A, whether physical or financial. The question then arises: For financial assets, what is the connection between the return rate defined by formula (13) and the interest rate on the financial asset defined by the yield to maturity?
The return rate on a financial asset is not necessarily equal to the yield to maturity on the financial asset. Starting at any current time t, the return rate is calculated for some specified holding period from t to t', whether or not this holding period coincides with the maturity of the financial asset. Moreover, the return rate takes into account any capital gains or losses that occur during this holding period, in addition to any payments received from the financial asset during this holding period. In contrast, starting at any current time t, the yield to maturity takes into account the payment stream generated by the financial asset over its entire remaining maturity, plus the overall anticipated capital gain or loss that will be incurred when the financial asset is held to maturity.
Real vs. Nominal Interest Rates
The yield to maturity measure of an interest rate, as examined to date, has been "nominal" in the sense that it has not been adjusted for expected changes in
prices. What actually concerns a "rational" saver considering the purchase of a financial asset is not the nominal payment stream he or she expects to earn in future periods but rather the command over purchasing power that this nominal payment stream is expected to entail. This purchasing power depends on the behavior of prices.
Let infe(t) denote the expected inflation rate at time t, and let i(t) denote the (nominal) yield to maturity for some financial asset at time t. Then the real interest rate associated with i(t) is defined by the following "Fisher equation:"
The function of financial markets in the economy
A market is a place where supply for a particular good is able to meet demand for it. In the case of financial markets, the good in question is money.
In capital markets, supply agents are those with "positive savings capacity", i.e. mainly households (surprising as that may seem!), and businesses, although the latter generally prefer to reinvest profits or distribute dividends to shareholders. The demand side comes from governments, the modern welfare state having substantial cash requirements, or other companies. Such agents are said to have "financing requirements".
Far from being an abstract entity, often described as both irrational and all-powerful, capital markets are in fact a driving force in the economy since they are places where the fuel, money, is made available to propel the machine forward, in other words generate wealth.
This is the concept, but in practice of course the mechanism is a little more complex.
The first difficulty resides in the fact that an exchange actually needs to take place between agents with savings capacity and agents with financing requirements. For a market to function, it is not enough that a good and its supply and demand exist; agents also have to want to trade it! However, agents with savings capacity, mainly households it should be recalled, are generally deeply averse to risk. An aversion furthermore which can be justified by common sense. Any book on the stock market for budding investors will begin with a warning urging readers to only invest funds in the stock market that will not be needed in the near future. Consequently, the bulk of savings generated by households are held on deposit in demand accounts or savings accounts where money is immediately available.
In contrast, agents with financing needs, i.e. businesses, need to find long-term financing for development. The time horizon of agents with savings capacity is typically a few weeks (next pay day) to a few months (next tax payment date ...). The time horizon of agents with financing requirements is several years! This difference makes actual exchange in markets more complex.
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Banks
This is where a third category of economic agents comes in, the banks. Banks are the only agents that have the power to transform very short-term resources (demand deposits i.e. current accounts) into medium and long term resources: bank loans. Banks therefore establish an essential link between households and businesses; they have always played, and indeed still play, a crucial role in the financing of the economy.
Each bank has the right to distribute virtually all of the money deposited by customers on its current accounts (but not all! see below) as loans. However, loans made available in this way by banks do not cancel the deposits that were made, which continue to be available for the customer to use. Banks therefore create money. The loans, granted in the form of demand deposits, increase the cash resources of banks and thus their ability to distribute new loans etc.. Deposits create loans, which themselves create deposits, etc.. This is what is called the "credit multiplier".
Fortunately, the money creation power of banks is not infinite. It is limited firstly by the fact that only part of the loans granted will remain in the form of deposits. The remainder will be converted into cash (notes) through cash withdrawals. Furthermore, to ensure that banks have the capacity to cope with withdrawals, the central bank requires them to lock-up a percentage of their deposits in the form of reserves, not available for lending. The compulsory reserves ratio is one of the instruments used by central banks to control the quantity of money in circulation.
Furthermore, companies cannot finance themselves solely through loans; beyond a certain level of debt, the financial cost has an unsustainable impact on results and banks would no longer be willing to lend. Companies therefore have to find ways of obtaining even longer-term financing, only repayable in the event of dissolution of the company, or debt with very long maturities, for example bonds. The total of the capital and long-term debt of a company constitutes its "equity capital".
Banks, in particular investment banks, are also involved in long-term corporate financing, but it is not their primary purpose which is to ensure that money circulates. To provide companies with equity capital, economic agents ready to lock-up large sums over long periods, obviously with the aim of generating profit, are required: investors.
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Institutional investors
The main investors in capital markets today are "institutional investors" (often referred to simply as "institutionals"), namely insurance companies, fund managers (asset managers), retirement funds and their US equivalent, the pension funds. Institutionals also drain public
savings, but these savings are locked up and cannot be immediately withdrawn in the same way as sums deposited in current accounts. In addition, the institutions in question generally have a regulatory, contractual or legal obligation to build up savings in order to be able to pay, for insurance companies insurance benefits, and for retirement funds retirement benefits to policyholders.
Instead of distributing loans like banks, institutional investors buy securities issued by companies requiring financing. These securities represent either equity capital: shares, or long-term borrowing: bonds. Purchases are made on the primary market, i.e. at the time the securities are issued, or on the secondary market, more commonly referred to as the "Stock Exchange".
Given the needs of companies to obtain financing from the market and institutional investors' needs to invest savings in their care, it is clear that there has to be a way for supply and demand to meet. However for this to happen, the market has to be organised appropriately to facilitate the process; a number of different players contribute to this. In this regard, banks once again play an important role. As account-keepers and liquidity providers, they assume a key intermediation role.
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The issuance of securities
Issuers wishing to raise capital from the market turn to a bank or group of banks (a "bank syndicate") which acts as an agent for the issue. The agent arranges all the economic characteristics of the issue. The agent "underwrites" the issue, in other words undertakes to buy all the securities issued and has a responsibility to find final investors willing to buy the securities issued.
After the issue, and once the securities trade on the market, the paying agent of the issuer (which may be the same as the agent or another institution) will be responsible for ensuring smooth operations throughout the life of the security: payment of coupons for bond issues or dividends for shares, repayments, capital increases etc. Lastly, rating agencies are independent organisations which assess the quality of issuers and assign a rating designed to determine their reliability as debtors.
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Custodians
The agent of the issuer manages the relationship with the central custodian, a key player in securities markets. For each issue it manages, the central custodian keeps up-to-date records in its accounts of the total amount of securities that have been issued and the
amount held by each institution that has a registered account with it (the total amount held by all institutions clearly has to match the total amount of the issue!). In France the central custodian for almost every issue is Euroclear France, formerly SICOVAM.
Each member of Euroclear France is a local custodian. Any investor that does not have a registered account with Euroclear France must open an account with a local custodian in order to be able to hold securities. However, while investors increasingly tend to internationalise their investments, the central custodian practically only manages securities issued in its own country. As a result, the function of "global custodian" has developed. A global custodian is appointed by investors to act as account keeper for all transactions involving the purchase and sale of securities in markets worlwide. To this end, the global custodian works hand-in-hand with local custodians in every market in the world, each one responsible for maintaining relations with the central depository in its country.
To be a global or local custodian, an institution must be authorised not only to keep securities accounts on behalf of investors but also cash accounts. Such institutions are therefore usually banks.
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Market transactions
Investors typically buy securities through a broker. The broker provides a number of services to investors. Financial analysts study markets and issuers and make recommendations. Salesmen pass on the recommendations of analysts to investors and collect their orders. Lastly, traders buy or sell securities in the market.
Trading between brokers is carried out either directly through an "OTC" market or organised market, a stock exchange, or through fast-growing electronic markets.
Once a trade has been completed, the investor turns to a custodian to take charge of "after trade" aspects. For a transaction to be registered correctly, securities provided by the seller have to be exchanged for cash provided by the buyer. This process is referred to as settlement and delivery.
The custodian is also responsible for maintaining the accounts of investor customers to take account of the many transactions that can have an impact on investment portfolios: coupon or dividend payments, repayments, but also exercise of subscription rights, takeover bids, exchange offers etc.
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Trading floors
Market transactions by institutional investors are not limited to the purchase and sale of securities. Given the sums involved and the large number of markets in which investors trade, additional needs arise. An investor may need to obtain foreign currency, hence the necessity to carry out transactions in currency markets. An investor may also require loans, or on the contrary need to invest liquidity on a temporary basis to optimise cash flow. Lastly, he may want to protect a portfolio against market fluctuations, giving rise to the need for derivative products.
Non-financial companies ("corporates") face similar types of need: importers may require foreign currency and processing companies may have to protect themselves against fluctuations in raw material prices. All have special cash management needs and may have to hedge against movements in prices or interest rates.
Banks are able to respond to these needs; at the branch level for small and medium-sized companies or directly via the trading room for the largest customers. Total cumulative positions generated for the various products are processed by traders in the trading rooms. The activity of a trading room reflects the total amount of requests coming from all of the bank’s customers!
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Speculation and arbitrage
Financial institutions and funds dedicated to this type of activity use some of their resources for speculation. This aspect of trading activity, whether or not it be as extensive as many claim, nevertheless remains necessary. Speculation involves taking a position that is contrary to current market trends: it means becoming a seller when you think that prices will fall (and are therefore at their highest!), or becoming a buyer when you think they will rise. By adopting a stance, speculators provide liquidity to the market: they are the sellers for investors who want to buy and the buyers for those who want to sell. It is a risky activity, as, unlike investors or corporates, speculators bet on the future.
Arbitragists also play a harmonising role: they take advantage of price differences between different markets to generate gains. For example, in currency markets they buy dollars in a market where it is cheap and sell in a market where it is most demanded, and therefore more expensive. It is a risk-free activity, since the assets purchased are immediately resold. However, this requires substantial financing as capital gains on each transaction are low. The activity of arbitragists helps eliminate marketing inconsistencies.
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Conclusion
Economic literature, after drawing a sharp distinction between the financing of companies through bank lending (debt financing) and financing through the issuance of securities (market-based economy), now attributes a complementary role to both. Studies suggest that for an economy to grow, there is a need for both an active organised financial market and a reliable banking system.
The purpose of this website is not to discuss the whys and wherefores of financial markets or their beneficial or harmful role. Instead, the content of this site focuses on "how" aspects: who are the players, how do they interact, the financial products that are traded, and the functions that they provide.
