What is a Financial Security? Financial securities of all types including foreign exchange and money are traded in the financial markets. A financial security is a contract between the buyer and seller of the security. This contract specifies future cash flows of the security, in terms of the amount (fixed or variable), timing, how long the contract lasts (maturity) and the price the buyer pays the seller. In many cases, it is obvious who the buyer and who the seller is. However, for certain types of financial securities, for example, swaps, the market determines the buyer and seller roles by convention – for example, the buyer in a fixed-for-floating interest rate swap is the fixed rate payer.
Over-the-Counter (OTC) and Exchange Traded (ET) Markets There are two main types of financial market: + Exchanges: where standard products are traded and where the exchange is responsible for administration, clearing, settlement, some regulation and price dissemination. + Over-the-counter: where products traded tend be non-standard and are designed to satisfy a particular financial need of one of the counterparties, for example, a client who requests a broken date FRA.
Who are the participants in the Financial Markets? In general, participants in the financial markets are the buyers and sellers which can be sub-divided into various roles. There are also indirect participants (who facilitate but do not buy or sell) such as regulators, clearers information providers and intermediaries. The main group of intermediaries are called brokers – whose main business is to bring buyers and sellers together for commission.
Types of Instruments
Instruments can be classified as: + equity, debt, or commodity + over the counter or exchange traded + cash or derivative + domestic or global electronic or physical
Equity
An Equity Security can be defined as “A security that represents ownership in a company and the right to receive a share in the profits of that company.”
Debt
A debt involves the lending of money for a given “price” which is the interest rate. The party that puts forward the money is the lender and he receives interest plus principal from the borrower for the risk he is taking. There is a wide variety of debt instruments, for example money market deposits, company bonds, government bonds and Mortgages.
Commodity
The commodities market is where products such as metals, grains and softs are traded. Although some commodities are traded spot, the main market for commodities is the futures market, the largest of which is the Chicago Board of Trade (CBOT).
Over The Counter or Exchange Traded
General Attributes of Instruments Instruments which are traded directly between counterparties are said to be over the counter (OTC) traded and instruments which trade on an exchange are said to be exchange traded. Exchange trading matches buyers and sellers, either electronically or physically. An OTC instrument is tailored to the buyer or seller. They can be traded in various denominations, amounts and maturities. This in contrast to Exchange traded instruments which tend to be standardized, although there is a move by exchanges to trade OTC-like products in order to compete with OTC markets.
Cash or Derivative
Derivatives can be defined as “instruments derived from existing instruments in the cash market.” The source of the derivative is called the underlying cash instrument. Derivative and cash markets tend to be quite distinct, with different players – although the current trend within security houses is towards integration of cash and derivative operations. A derivative can have more than one underlying instrument, for example, an equity convertible bond. Theoretically, it is possible to have a derivative of a derivative, for example, a compound option, although these instruments are not directly traded. The value of a derivative depends on the price and other market characteristics, such as volatility or correlation, of the underlying instruments.
Domestic or Global
With the expansion of global financial markets, a number of instruments are traded internationally. This makes geographical boundaries between markets more or less irrelevant as trading books are often passed from one time zone to another as the markets close in one and open in the other. The largest example of a truly global market is the foreign exchange cash market which effectively runs 24 hours a day. There are also instruments which are issued in one currency and traded in another, for example, Japanese warrants issued in Yen but traded in Swiss Francs or US dollars.
Electronic or Physical
Financial markets have historically been associated with physical trading – buyers and sellers meet face to face or over the telephone. Increasingly though, technology is creating electronic ‘places’ where instruments can be traded over computer networks. The first major market was in Foreign Exchange with Reuters Dealing 2000-1. It’s OTC-nature leant itself to screen-based trading. Electronic trading, of one form or another, is now possible in equities, bonds and commodities as well as Foreign Exchange. Even exchanges, which had long been associated with physical trading are now launching electronic systems.
Types of Markets
Markets use instruments to exchange assets. A brief introduction to each of the following main markets in the financial sector is given below: + Foreign Exchange + Fixed Income + Equities and Equity Linked + Commodities Instruments traded by these markets are defined in Types of Instrument.
The Foreign Exchange (FX) Market
What is traded on the FX Market? The FX market is an international market which currencies are exchanged for spot or forward delivery. The “prices” of the various currencies are in most cases quotes against the US dollar. When this is not the case, the price is called a cross rate. Further details of the FX market are in Chapter [4].
Fixed Income Market
What is traded on the FI Market? Bonds of different types are traded in the fixed income (FI) market. A bond is a contract of the indebtedness of one organisation to the holder of the bond. The different types of bonds purchased within the fixed income market include: corporate, euro, government and asset-backed bonds which include mortgage bonds. The most important type of bond in the market is usually government bonds because the government is normally the largest organisation that issues bonds, in a given country. Also, government bonds in developed countries are considered risk-free.
Maturity of FI Instruments Maturities in the fixed income market tend to be longer which is a factor that distinguishes the fixed income market from the money market. In general terms, any debt instrument that matures in over 1 year is regarded as a fixed income instrument, or bond. However, the one year boundary is not strictly adhered to, for example, a 12X18 FRA is clearly over 1 year in maturity but is considered a money market instrument.
Equities Market
What is traded on the Equities Market? When a business is an incorporated company, a number of shares are issued which represent part ownership of the company. If a company wishes to raise capital from the public by issuing shares, it often seeks to list its shares on an exchange. In order to list its shares on an exchange, a company must comply with the regulations of that exchange. These regulations usually involve reporting the profits and losses and assets of the company. The exchange provides a means for institutions and the public to buy newly issued shares and to buy and sell previously issued shares. These shares are bought and sold in the equities market and traders in this market must be members of a stock exchange, such as the London Stock Exchange. Membership binds them to the rule of the exchange.
Maturity of Equity Instruments Shares issued by companies last for the lifetime of the company.
Commodities Market
What is traded in the Commodities Market? Physical commodities such as metals, grains and precious metals are traded within the commodities market. The companies which trade in this market are normally members of a commodity exchange such as the LME, where trading takes place.
Physical vs. Cash Delivery Much of the activity in the commodities markets takes place in the form of futures trading, that is, agreements to deliver commodities at a future date for a price agreed today.. However, most of the commodity trading is cash settled, in other words, there is no actual physical delivery involved.
Relationships between Instruments and Markets
Although some markets are characterised by the instruments in which they deal, some instruments may be traded across more than one market. The following table illustrates these inter-relationships.
Markets
Instruments FX Money Fixed Income Equities Commodities
Bill
Bond
CD
Convertibles
CP
Deposits
Equity
EuroCurrency
Forward
FRA
FRN
Futures
MTNs
Options
Preference Share
Repos
Rights
SPOT
SWAPs
Treasury Bills
Warrants
Types of Institutions
The term financial institution describes an organisation involved in some capacity in the financial markets. Care is needed in the use of this term since “institution” is sometimes reserved for the “buy-side” of the market with the term “securities house” generally implying the “sell side”. It is useful to discuss institutions since their business goals and the instruments they trade determine to a large extent the roles of employees of that institution.
International and Domestic Institutions The financial market consists of international and domestic institutions. International institutions deal with international loans, import/export finance, and foreign exchange dealing. Domestic institutions deal with banking and monetary issues in their respective countries (although some domestic institutions are becoming increasingly global). A financial institution such as a bank, uses investors, depositors or its own funds to invest in financial assets such as equities or bonds to make profit. Examples of institutions are: + banks + building societies + broking firms + corporations + local authorities + fund management and insurance companies.
Banks
Most countries have regulations governing the operation of banks. If a company is to operate as a bank, it must have a licence granted by the government and conform to the regulations which apply to banks in that country. For an institution to operate as a bank in the United Kingdom, it must be authorised by The Bank of England. The institution must satisfy the Bank of England that : + it has adequate capital + it has adequate liquidity (that is sufficient funds to meet its obligations when due) + it has a realistic business plan + it has adequate systems and controls + it has made provision for bad or doubtful debts + it’s business is carried out in a prudent manner + its directors, managers and controllers are “fit and proper” Banks are often given an exclusive right to undertake activities that other institutions may not be able to, for example, take deposits or clear cheques. The government usually acts as a guarantor for bank deposits. Because of the advantages given to banks by the government, they often have the largest financial asset base in a country, making them pivotal in the financial market. Most of a bank’s assets are held in loans or other instruments which give a return, this gives the bank a cash flow. The bank also has deposits which are its liabilities and tries to maximise the difference between the money it pays to its depositors and the money it receives from its creditors, or the financial assets it holds.
Although banks can be grouped together as a broad type of financial institution, there are different types of bank. These are: + Commercial + Investment + Universal + Central.
Commercial Banks Banks whose principal activities are taking deposits and lending money to individuals and small and medium sized businesses, are often called retail, clearing or commercial banks. These banks have large cash flows and they aim to maximise their profits by getting the largest possible spread between the rate at which they acquire money via deposits or through loans from other institutions, and the rate at which they lend money. A commercial bank participates in the financial markets to manage the flow of cash in and out of the bank and to get the best return on the financial assets of the bank.
Investment Bank An investment bank, or merchant bank as it is sometimes known in the United Kingdom, is a bank which helps large businesses to raise capital, usually by underwriting the issue of shares or bonds. Fees charged for this service provide income for the investment bank. Investment banks also take trading positions using the assets of the company – this is known as proprietary trading. The activities of underwriting and proprietary trading involve some risk which must be managed by the investment bank.
Universal bank A universal bank is one which takes deposits, underwrites securities and offers fund management services. Regulations in different countries may or may not allow universal banks to operate. For example, in the United States, a bank which underwrites securities is forbidden by the Glass-Steagall Act 1933 to take deposits. This act was designed to protect depositors’ funds from the risky activity of underwriting securities. European banks, in particular Swiss and German banks, are not under the same restrictions and can take deposits and underwrite securities. These banks are known as Universal Banks because they encompass all banking activities. Increasing deregulation in the United States and the United Kingdom has resulted in a trend towards banks in these countries either broadening their areas of operation or merging with banks operating in different areas.
Central Banks Governments are involved in financial markets to implement their monetary policy and to raise funds to finance the government’s activities. Most governments participate in the financial markets via a central bank. These banks fulfil a number of functions such as: + issuing bank notes + supervision of banks + management of exchange reserves + issuing Government debt. The central bank in different countries has various names, for example, The United State Federal Reserve System, Deutsche Bundesbank, The Bank of England. The specific responsibilities of the Bank of England as stated in the 1995 Report and Accounts : ” …maintaining the stability of the financial system, both domestic and international; and seeking to ensure the effectiveness of the UK’s financial services sector.” When central banks get involved in financial markets, it is usually to intervene either in the currency market or to implement monetary policy by setting long or short term interest rates. Arguably, the central banks of the major economic powers have the most important influences on world interest rates.
Building Societies
Building Societies (known as Savings and Loans in the United States) are organisations which are set up to pool depositors funds so that they may be lent to other members to purchase real estate. In general they have a far smaller asset base than commercial banks, but they operate in a similar way, that is, they take deposits and make loans. Traditionally they have restricted their lending to mortgages against real-estate. Recently there has been a trend for building societies to merge and/or gain licences to become banks.
Broking Firms
Broking firms provide an intermediary service between buyers and sellers in the financial market. For this service, they charge the buyer and the seller a commission on any deal they broke, and the more deals they broke the greater the profit they make. Brokers are agents working within a broking firm who do not hold a position in the market. They are not principals as they simply provide a matching service between buyers and sellers.
Corporations
Corporate Treasury A company may have large and variable cash flows because of the nature of its business, and they may need to buy or sell goods and services overseas or raise capital for large projects. The management of the cash flow, assets and liabilities of a company is usually performed by the corporate treasury department.
Local Authorities
Local Authorities form part of the government structure, although they often participate in the financial markets independently of central banks. Local authorities have large cash flows and often require short term funding or have a temporary surplus of funds.
Fund Management
Fund Management encompasses pension funds, insurance funds and collective investments such as mutual funds and unit trusts. Fund managers select what instruments to hold positions in for maximum return and minimum risks and manage these investments on a medium to long term basis. In addition to return objectives, fund managers have to operate within trustee requirements. Insurance and pension fund managers also need to structure their portfolios to meet the various claims on the fund, such as insurance or pension claims, a process called “portfolio dedication”.