Financial Markets

The financial markets can be segmented into the money market and the capital market. Financial securities consist of securities that are issued by corporate bodies, the government, through the Central bank, local authorities, as well as semi-government bodies, such as Air Zimbabwe, The Grain Marketing Board, and ZESA.

The Financial Market.

The money market Highly marketable securities having short terms until they mature and involving little or no risk of default are said to possess moneyness and are called money market securities. Are the easiest of all securities to trade, except cash.

Characteristics of Money Market The instruments that are traded on the money market have the following characteristics : Short-term Marketable. Low risk ( risk-free ) Highly liquid.

Large corporation investors typically use money market securities as a place to invest cash that they may not need for a few weeks or months.

Money Market Instruments You must note that only debt securities are traded on the money market. Because of their high liquidity, money market instruments are sometimes called near-cash or cash equivalents. Examples of the instruments that are traded on the money market include: Treasury Bills ( T-bills ). Certificates of Deposit. Commercial Paper, Bankers' Acceptances, Repurchase Agreements ( Repos ).

Treasury Bill Treasury Bills- (T-bills) are the most marketable of all the money market securities. They are issued by the government to the public through the Central Bank as a means of borrowing from the public. They are also used to control the money supply. The bill will have a stated maturity value of, say $10 000 and a maturity date of 91 or 182 days. When you buy the bill, you buy it at a discount to the stated maturity value and when it matures you receive an amount which is equal to the maturity value ( face value ).

pay interest to the investor by selling at a discount from their face value (Maturity value). For e.g. A 90-day T-ill with a face value of $10 000 might be sold at $9800. The buyer can hold the T-bill for 90 days and sell the bill or can sell the bill at any time before it matures. The difference between the maturity value of $100 and the discounted value of $9800 is the interest income paid to the T-bill investor.

Negotiable Certificates of Deposit- Is a time deposit with a bank, that is a deposit which may not be withdrawn on demand. It can also be regarded as a receipt from an insured commercial bank for a deposit with certain provisions attached. A firm may find that it has excess cash that it may not require within the short-term period but may not be certain as to when exactly the cash will be required. The firm may therefore deposit the money in an NCD.

The bank issuing the CD is said to have bought deposits by selling CDs with high interest rate in order to induce big depositors to make cash deposits. One of the written legal provisions covering every CD is that deposit not be withdrawn from the bank before some specific maturity date.

Since it is negotiable, the firm can sell the NCD on the market at any time before the maturity date. The value that the firm obtains when it sells the NCD will depend on the number of days left to maturity and the discount rate at that time.

Bankers acceptances Are securities which arises from an order by a client firm to its bank to pay a sum of money at a future date ( which is similar to a post-dated cheque ). The bank then " accepts " the order by endorsing it and then assuming responsibility for payment to the holder of the acceptance. the securities normally arises in foreign trade when the seller is reluctant to grant credit to an unfamiliar foreign buyer.

The buyer (importer) applies to a well-known international bank for a banker’s acceptance to overcome the seller’s (exporter) fear. It is thus a borrower’s written promise to repay borrowed funds that allow the exporter to obtain collection from the importer’s bank.

Acceptances are used widely in exports and imports because the creditworthiness of the partners to the trade is difficult to establish in international trade. The buyer’s bank is said to accept the banker’s acceptance when the importer’s bank pays the fearful exporter.

The acceptance is also a negotiable instrument because its holder can trade it on the secondary market at a discount from the face value. If the importer’s bank wants to recoup the money it has invested in the loan before the loan expires, the bank sells the written promise to repay the loan (BA) to another investor. BA can be resold to any number of new investors before the loan comes due and repaid.

Commercial Paper- Are short-term, unsecured debt notes issued by large, reputable companies instead of borrowing directly from banks. Thus, they are short term promissory notes issued by large, old and safe corporations. The firm must have a bank line of credit which it can use to support the issue. The bank line of credit gives the borrower access to cash to pay off the notes at maturity.

The maturities vary from 5 to 270 days and the denominations are for a specified amount of money e.g. $100 000 or more. These notes are not baked by any collateral, they rely on the high credit rating of issuing corporations.

Repurchase Agreement ( repo ) A repo is a form of short-term borrowing ( usually overnight) used by dealers in T-bills. The dealer sells the T-bills to an investor on an overnight basis. The dealer then agrees to buy back the bills the following day at a slightly higher price. The difference in the price is the interest rate for the night.

In essence, the dealer obtains a one-day loan from the investor, using the T-bills as security for the loan. In a reverse repo an investor locates a dealer with T-bills and negotiates to buy them. The investor then agrees to sell them back to the dealer the following day at a slightly higher price.

Eurodollar loans Eurodollar loans- sometimes called petrodollar loans, or Asian dollar loans or hot money flows. Eurodollar loans are large, short-term international loans that are denominated in dollars. The loans are usually arranged by large international operations.

Capital Markets This is a market where long-term securities are traded. The capital market is made up of fixed-income securities as well as variable income securities issued by both corporate organizations and government. Bonds represent fixed income securities and shares represent variable income securities.

Fixed income capital market The fixed income capital market is composed of longer-term borrowing instruments than those found in the money market. This market includes Treasury bonds, corporate bonds, municipal bonds, and mortgage bonds. The term “fixed income” is applied to these securities because they promise either a fixed stream of income to the investor or a stream of income that is determined according to a specified formula.

Treasury Bonds and Notes Treasury Bonds and Notes are issued by the government for the purposes of long-term borrowing. Treasury notes may have maturity dates of up to 10 years, whereas bonds are issued with maturities of 10 to 30 years. Both are issued in denominations of $100 000 and make semi-annual interest payments called coupon payments.

T-bonds may be callable during the last five years of the bond’s life. The call provision provides Treasury the right to repurchase the bond at par value before maturity.

The long-term securities can either be nonmarketable issues and marketable issues. Non-marketable issues are those which can not be traded in the securities market; they are non-transferable and non-negotiable- they can not be used as collateral for a loan. They can only be purchased from the central bank Treasury e.g. Savings bonds.

Marketable issues make-up about three quarters of the government debt. They are usually purchased from the outstanding supplies through dealer or broker. Holder of marketable government securities stands to gain not only from the interest paid on these bonds but also from price appreciation. The new issue and prices of these securities are published in newspapers.

Municipal Bonds Municipal Bonds are issued by local governments. They are similar to T-bonds in that the income from the bonds is not liable for taxation.

Corporate Bond A Corporate Bond is an instrument issued by a firm in order to borrow money from the investing public. The bond pays a fixed interest rate ( known as the coupon ) on a semi-annual basis, calculated on the amount borrowed ( known as the par value ). If the bond is redeemable, it will have a maturity date on which date the firm will pay back the amount borrowed.

The bondholders will appoint a trustee to look after their interests. The bond may be secured or unsecured through the assets of the firm. If the bond is secured through a floating charge on the assets, it is generally known as a debenture, in which case the general assets of the firm make up the collateral. A bond is usually secured by a fixed charge on the assets, in which case specific assets are identified as security for the amount borrowed.

Some debentures may also be subordinated, that is they will have a lower priority claim to the assets of the firm in the event of bankruptcy. Corporate bonds usually come with options attached. The bonds or debentures may be convertible, that is they give the holder the option to convert them into a specified number of the company's ordinary shares after an agreed period of time.

Yet others may have warrants attached to them. A warrant gives the holder of the bond the option to purchase an agreed number of the firm's ordinary shares within a specified period of time at an agreed price ( the exercise price ). A callable bond gives the firm the option to repurchase the bond from the holder at a stipulated price ( the call price ) or after a stipulated period of time.

Equity market The equity market consists of common (ordinary) stock and preferred stock. A shareholder is an investor with an ownership stake in the firm. The return to the investor consists of a dividend, which is a share of the profits after deducting interest and tax from the operating income, as well as a capital gain, that is the difference between the share price when the investor buys the share and the share price when they sell the share.

Ordinary shareholders have a residual claim to the profits after debt holders and holders of preference shares. Preference shareholders receive a preferred dividend, that is they are paid their dividend before the ordinary shareholders. The preference share dividend is fixed in amount, whereas that of the ordinary shareholder may be variable.

Preference shares may also be redeemable, in which case the firm will pay back the capital to the investor at the end of an agreed period of time. Equity shares are issued only by entities incorporated in terms of the Companies Act.

The Derivative Market. Derivatives, such as options and futures, provide pay-offs that depend on the values of other assets such as commodity prices, bond and stock prices, or market index values. Thus, their value is derived from the values of the underlying asset. They represent contingent claims, that is their values are contingent on the values of other assets. Derivatives are commonly used hedging against risk with regards to other securities.

Options. An option gives the holder the right to buy or sell the underlying asset at a given price, called the exercise price or strike price, on or before a specified expiration date. Options are often bought and sold with respect to equity shares. The option need not be exercised. It is exercised only when it is profitable for the holder to do so.

For example, if you buy an option on Delta shares, this gives you the right to buy or sell Delta shares at a later date. Thus, the value of your option depends on what happens to the price of the underlying asset, that is Delta shares, during the time that you hold the option.

American Vs European Options An American option is one that can be exercised at any time during the life of the option. A European option is one that can only be exercised at the end of the agreed period.

Call option A call option gives the holder of the right to purchase the asset at the exercise price. It is profitable to exercise a call option only if the market value of the underlying asset at that time is greater than the exercise price. For example, a call option on Econet with an exercise price of $100 and an expiration date of 30 days will only be exercised if, on the 30th day, the market price of Econet shares is greater than $100.

If the option is not exercised, it will simply expire and no longer has value. Calls therefore represent bullish investment vehicles which provide greater profit when stock prices increase. A bullish market is one in which the investors are generally optimistic about security prices and expect them to go up.

Put Option A put option, on the other hand, gives the holder the right to sell the underlying asset. For example, a put option on Econet with an exercise price of $100 and an expiration date of 30 days will only be exercised if, on the 30th day, the price of Econet shares is lower than $100. Profits on put options increase in a bearish market, that is when share prices decrease. A bearish market is one in which market sentiment is generally pessimistic and investors expect security prices to go down.

Futures Contracts. A futures contract calls for the delivery of an asset at a specified delivery or maturity date for an agreed price, called the futures price, at an agreed date. For example, you may take out a futures contract on sugar, thus promising to deliver the sugar at an agreed price at a future date.

Futures contracts are generally used to hedge against risk arising from changes in the price of the underlying asset. Futures are thus used extensively on the foreign exchange market. For example, an importer of goods from South Africa may want to be protected against the risk that the US dollar may depreciate against the currency of the importer, the South African Rand.

If this happens, the importer may be forced to pay more than anticipated for the goods. The importer may then enter into a futures contract with a local bank in which they undertake to buy South African Rand at a specified exchange rate when the time for payment comes.

In a futures contract there are two parties. The party who undertakes to deliver the asset, for example, South African Rand, and the party who undertakes to purchase the asset. The long position is held by the party who undertakes to purchase the asset on delivery date. The short position is taken by the party who undertakes to deliver the asset.

Difference between Future Contract and Option A futures contract is different from an option in that a futures is a contract which must be fulfilled and an option is only a right which may or may not be exercised. Options must therefore be purchased and futures contracts may be entered into at no cost to the parties. The purchase price of an option is called a premium. It represents the compensation the holder must pay for the ability to exercise the option only when it is profitable to do so.