Financial Economics (Econ 3091)

Jemberu L. (PhD)
Assistant Professor of Economics
Department of Economics, Addis Ababa University
 Chapter 4
Financial Markets
 3

Outline
• The Money Markets
• The Stock Market
• The Bond Market
• Derivatives
• The Foreign Exchange Market
• The Mortgage Markets
• Financial Markets Efficiency
 4

4.1. The Money Markets

• The term “money market” is a misnomer. Money

(currency) is not actually traded in the money markets.
• The securities in the money market are short term with
high liquidity; therefore, they are close to being money.
• Money market securities are usually sold in large
denominations.
• They have low default risk and they mature in one year or
less from their issue date, although most mature in less
than 120 days.
• Therefore, money market securities are short-term, low-
risk, and very liquid.
 5

Cont’d

• Money market transactions do not take place in any one

particular location or building.
• Instead, traders usually arrange purchases and sales
between participants over the phone and complete them
electronically.
• Because of this characteristic, money market securities
usually have an active secondary market.
• This means that after the security has been sold initially, it
is relatively easy to find buyers who will purchase it in the
future.
• An active secondary market makes money market
securities very flexible instruments to use to fill short-term
financial needs.
 6

Why Do We Need the Money Markets?

• In theory, the banking industry should handle the needs for

short-term loans and accept short-term deposits.
• Banks also have an information advantage on the credit-
worthiness of participants.
• Banks do mediate between savers and borrowers; however,
they are heavily regulated. This creates a distinct cost
advantage for money markets over banks.
• Reserve requirements create additional expense for banks that
money markets do not have.
• When interest rates rose, depositors moved their money from
banks to money markets to earn a higher interest rate.
• Even today, the cost structure of banks limits their
competitiveness to situations where their informational
advantages outweighs their regulatory costs.
 7

The Purpose of Money Markets

• Investors in Money Market: Provides a place for

warehousing surplus funds for short periods of time.
• Borrowers from money market provide low-cost source of
temporary funds.
• Corporations and governments use these markets
because the timing of cash inflows and outflows are not
well synchronized.
• Money markets provide a way to solve these cash-timing
problems.
 8

Money Market Instruments

• Money Market Instruments includes:

• Treasury Bills
• Government discount bond that have 28-day maturities through 12-month
maturities in the US.
• Inter-bank markets
• Short-term funds transferred (loaned or borrowed) between financial
institutions, usually for a period of one day.
• Repurchase Agreements
• An entity sells Treasury securities, but agrees to buy them back at a certain
date (usually 3–14 days later) for a certain price.
• Negotiable Certificates of Deposit
• A bank-issued security that documents a deposit and specifies the interest
rate and the maturity date.
• Commercial Paper
• Unsecured promissory notes, issued by corporations, that mature in no
more than 270 days.
• Eurodollars
• Eurodollars represent Dollar denominated deposits held in foreign banks.
 9

4.2. The Stock Market

• In general terms, the capital of a company is made up of a

combination of borrowing and the money invested by its
owners.
• The long-term borrowing, or debt, of a company is usually
referred to as bonds, and the money invested by its
owners as shares, stocks or equity.
• Stockholders have claim on all assets
• The market for stocks is undoubtedly the financial market
that receives the most attention and scrutiny.
• Great fortunes are made and lost as investors attempt to
anticipate the market’s ups and downs.
• Shares may comprise ordinary shares and preference
shares.
 10

Ordinary Shares - Common Stock

• Ordinary shares, common shares or common stock, whatever

terminology is used, they all share the same characteristics:
namely, they carry the full risk and reward of investing in a
company.
• As the owners of the company, it is the shareholders who vote
yes or no to each resolution put forward by the company
directors at company meetings - for example, an offer to take
over a company.
• Shareholders share in the profits of the company by receiving
dividends declared by the company.
• Proposed dividend will need to be ratified by the shareholders before it
is formally declared as payable.
• Some shares may be referred to as partly paid or contributing
shares. This means that only part of their nominal value has
been paid up.
 11

Preference Shares - Preferred Stock

• Preference shares are a hybrid security with elements of both

debt and equity.
• Although they are technically a form of equity investment, they also
have characteristics of debt, particularly that they pay a fixed income.
• Preferred stock also tends to have credit ratings and ranks
above equities in the capital structure.
• Are non-voting, except in certain circumstances such as when
their dividends have not been paid.
• Pay a fixed dividend each year, the amount being set when
they are first issued and which has to be paid before dividends
on ordinary shares can be paid.
• Rank ahead of ordinary shares (priority - known as seniority) in
terms of being paid back if the company is wound up.
 12

Cont’d

• Preference shares may be cumulative, non-cumulative

and/or participating – about dividends payment in a
particular year.
• Preference shares may also be convertible or
redeemable.
• Convertible preference shares carry an option to convert
into the ordinary shares of the company at set intervals
and on pre-set terms.
• Redeemable shares, as the name implies, have a date at
which they may be redeemed; that is, the nominal value
of the shares will be paid back to the preference
shareholder and the shares cancelled.
 13

Benefits of Owning Shares

Dividends
• A dividend is the return that an investor gets for providing
the risk capital for a business.
• Potential shareholders will compare the dividend paid on
a company’s shares with alternative investments.
• This involves calculating the dividend yield.
• Example:
 14

Cont’d

• Some companies have a higher than average dividend yield,

which may be because:
• The company is mature and continues to generate healthy levels of
cash, but has limited growth potential
• The company has a low share price for some other reason, perhaps
because it is, or is expected to be, relatively unsuccessful; its
comparatively high current dividend is, therefore, not expected to be
sustained and its share price is not expected to rise.
• In contrast, some companies might have dividend yields that
are relatively low, which may be because:
• The share price is high, because the company is viewed by investors
as having high growth prospects, or
• A large proportion of the profit being generated by the company is
being ploughed back into the business, rather than being paid out as
dividends.
 15

Cont’d

Capital Gains
• Capital gains can be made on shares if their prices
increase over time.
• If the shareholder doesn’t sell the share, then the gain is
described as being unrealized.
• Whereas dividends need to be reinvested in order to
accumulate wealth, capital gains simply build up.
 16

Cont’d

Pre-Emptive Rights: Right to Subscribe for New Shares

• If a company were able to issue new shares to anyone,
then existing shareholders could lose control of the
company, or at least see their share of ownership diluted.
• Pre-emption rights give existing shareholders in
companies the right to subscribe for new shares.
• In many cases they receive some compensation if they
decide not to do so.
• Pre-emption rights depend on countries regulations (in
US, pre-emption rights for public companies are not
common).
 17

Cont’d

Right to Vote
• Ordinary shareholders have the right to vote on matters
presented to them at company meetings.
• This would include the right to vote on proposed dividends and
other matters, such as the appointment, or reappointment, of
directors.
• The votes are normally allocated on the basis of one share = one vote.
• The votes are cast in one of two ways:
• The individual shareholder can attend the company meeting and vote.
• The individual shareholder can appoint someone else to vote on
his/her behalf – this is commonly referred to as voting by proxy.
• However, some companies issue different share classes, for
some of which voting rights are restricted or non-existent. This
allows some shareholders to control the company while only
holding a smaller proportion of the shares.
 18

The Risks of Owning Shares

Price and Market Risk

• Price risk is the risk that share prices in general might fall.
• Even though the company involved might maintain dividend
payments, investors could face a loss of capital.
• Any single company can experience dramatic falls in its share price
when it discloses bad news, such as the loss of a major contract.
• Market-wide falls in equity prices occurs - risks associated with equity
investment from general price collapses.
• Worldwide equities fell by nearly 20% on 19 October 1987
• By early 2000, reality started to settle in and the ‘dot.com’ bubble was firmly burst
• World stock markets in 2008 during the financial crisis
• Price risk varies between companies: volatile shares, such as shares
in companies highly exposed to global economic trends, tend to
exhibit more price risk than ‘defensive’ shares, such as those of utility
companies.
 19

Cont’d

Liquidity Risk
• Liquidity risk is the risk that shares may be difficult to sell
at a reasonable price.
• This typically occurs in respect of shares in ‘thinly traded’
companies – smaller companies, or those in which there
is not much trading activity.
• It can also be a risk in shares traded on smaller securities
exchanges where there is little trading activity each day.
 20

Cont’d

Issuer Risk
• This is the risk that the issuer collapses and the ordinary
shares become worthless.
• In general, it is unlikely that larger, well-established
companies would collapse, and the risk could be seen,
therefore, as insignificant.
• Events such as the collapse of Enron and Lehman Brothers,
however, show that the risk is a real and present one and cannot
be ignored.
• Shares in new companies, which have not yet managed
to report profits, may have a substantial issuer risk.
 21

Cont’d

Foreign Exchange Risk

• This is the risk that currency price movements will have a
negative effect on the value of an investment.
• Currency movements can therefore wipe out or reduce a
gain, but equally can enhance a gain if the currency
movement is in the opposite direction.
• Example:
 22

How Stocks Are Sold

• When a company decides to seek a listing for its shares, the

process is described in a number of ways, including:
• Becoming listed or quoted
• Floating on the stock market
• Going public
• Making an initial public offering (IPO).
• The term primary market refers to the marketing of new shares
in a company to investors for the first time.
• Once they have acquired shares, the investors may at some
point wish to dispose of some or all of their shares and will
generally do this through a stock exchange.
• This latter process is referred to as dealing on the secondary
market (either an organized exchange or over the counter).
 23

Computing the Price of Common Stock

• If you require a 15% return to compensate you for the risk

of owning stock, you expect company XYZ to pay $.15 in
dividends this year, and expect the company to sell for
$30 at the end of the year, how much would you be willing
to pay for the company today?
• Suppose you decide the stock is more risky than you
originally thought. How does this affect the price you are
willing to pay?
• Valuing common stock is, in theory, no different from
valuing debt securities: determine the future cash flows
and discount them to the present at an appropriate
discount rate.
 24

The One-Period Valuation Model

• This assumes that you buy the stock, hold it for one
period to get a dividend, then sell the stock. We call this
the one-period valuation model.
• Basic Principle of Finance
• Value of Investment = Present Value of Future Cash Flows
• To value the stock today, you need to find the present
discounted value of the expected cash flows (future
payments): the expected dividend and price over the next
year.
•
 25

Cont’d

Example: Suppose that want to buy an Intel stock which is

currently selling for $50 per share and pays $0.16 per year in
dividends. The analyst on Wall Street Week predicts that the
stock will be selling for $60 in one year. Assume that after careful
consideration you decide that you would be satisfied to earn
12% on the investment. Should you buy this stock?
 26

The Generalized Dividend Valuation Model

• The one-period dividend valuation model can be extended

to any number of periods. The concept remains the same.
• The value of stock is the present value of all future cash
flows. The generalized formula for stock can be written as
in Equation 2.

• To estimate the value the stock today, you will have to

estimate its value at some point in the future.
• In other words, you must find Pn in order to find P0.
• However, if Pn is far in the future, it will not affect P0.
 27

Cont’d

• For example, the present value of a share of stock that

sells for $50 seventy-five years from now using a 12%
discount rate is just one cent
• This means that the current value of a share of stock can
be found as simply the present value of the future
dividend stream.
• The generalized dividend model is rewritten in Equation 3
without the final sales price.
 28

Cont’d

• The generalized dividend model says that the price of

stock is determined only by the present value of the
dividends and that nothing else matters.
• Exercise: Many stocks do not pay dividends, so how is it
that these stocks have value?
• The generalized dividend valuation model requires that
we compute the present value of an infinite stream of
dividends, a process that could be difficult.
• Therefore, simplified models have been developed to
make the calculations easier.
• One such model is the Gordon growth model that
assumes constant dividend growth.
 29

The Gordon Growth Model

• Many firms strive to increase their dividends at a constant

rate each year. Equation 4 rewrites Equation 3 to reflect
this constant growth in dividends.

• Equation 4 has been simplified using algebra to obtain Equation 5.

 30

Cont’d

• This model is useful for finding the value of stock, given a

few assumptions:
1. Dividends are assumed to continue growing at a
constant rate forever.
• The model should yield reasonable results. This is because errors about
distant cash flows become small when discounted to the present.
2. The growth rate is assumed to be less than the required
return on equity, ke.
This is a reasonable assumption. In theory, if the growth rate were faster
than the rate demanded by holders of the firm’s equity, in the long run the
firm would grow impossibly large.
 31

Cont’d

• Example: Stock Valuation - Gordon Growth Model

 32

Calculating Dividend Growth

• One difficulty in applying these stock valuation models is

that we need some estimate of the long term growth of
dividends, g.
• One simplistic approach is to use the average compound
annual growth rate over a reasonably long period of time.
•
 33

Cont’d
 34

Price Earnings Valuation Method

• Theoretically, the best method of stock valuation is the

dividend valuation approach.
• Sometimes, however, it is difficult to apply. If a firm is not
paying dividends or has a very erratic growth rate, the
results may not be satisfactory.
• Other approaches to stock valuation are sometimes
applied. Among the more popular is the price/earnings
multiple.
• The price earnings ratio (PE) is a widely watched
measure of how much the market is willing to pay for $1
of earnings from a firm.
 35

Cont’d

A high PE has two interpretations.

1. A higher-than-average PE may mean that the market expects
earnings to rise in the future. This would return the PE to a more
normal level.
2. A high PE may alternatively indicate that the market feels the firm’s
earnings are very low risk and is therefore willing to pay a premium
for them.

• Firms in the same industry are expected to have similar PE ratios in

the long run. The value of a firm’s stock can be found by multiplying
the average industry PE times the expected earnings per share.
 36

Cont’d

• Example: If Stock A is trading at $30 and Stock B at $20, Stock A is not necessarily
more expensive. The P/E ratio can help us determine, from a valuation perspective,
which of the two is cheaper.
• If the sector’s average P/E is 15, Stock A has a P/E = 15 and Stock B has a P/E = 30,
stock A is cheaper despite having a higher absolute price than Stock B because you
pay less for every $1 of current earnings. However, Stock B has a higher ratio than
both its competitor and the sector. This might mean that investors will expect higher
earnings growth in the future relative to the market. The P/E ratio is just one of the
many valuation measures and financial analysis tools that we use to guide us in our
investment decision, and it shouldn’t be the only one.
 37

Errors in Valuation

• There are many opportunities for errors in applying the

models. These include problems estimating growth,
estimating risk, and forecasting dividends.
Problems with Estimating Growth
• The constant growth model requires the analyst to
estimate the constant rate of growth the firm will
experience.
• You may estimate future growth by computing the
historical growth rate in dividends, sales, or net profits.
• This approach fails to consider any changes in the firm or
economy that may affect the growth rate.
 38

Cont’d

Problems with Estimating Risk

• The dividend valuation model requires the analyst to
estimate the required return for the firm’s equity.
• Stock price is highly dependent on the required return,
despite our uncertainty regarding how it is found.
Problems with Forecasting Dividends
• Many factors can influence the dividend payout ratio.
These will include the firm’s future growth opportunities
and management’s concern over future cash flows.
 39

Cont’d

• Putting all of these concerns together, we see that stock

analysts are seldom very certain that their stock price
projections are accurate.
• This is why stock prices fluctuate so widely on news reports.
• For example, information that the economy is slowing can
cause analysts to revise their growth expectations. When this
happens across a broad spectrum of stocks, major market
indexes can change.
• Does all this mean that you should not invest in the market?
• No, it only means that short-term fluctuations in stock prices
are expected and natural.
• Over the long term, the stock price will adjust to reflect the true
earnings of the firm.
 40

Stock Market Indices

Most stock market indices have the following four uses:

• To act as a market barometer: Most equity indices provide
a comprehensive record of historic price movements,
thereby facilitating the assessment of trends.
• To assist in performance measurement: Most equity
indices can be used as performance benchmarks against
which portfolio performance can be judged.
• To act as the basis for index tracker funds, exchange-
traded funds (ETFs), index derivatives and other index-
related products.
• To support portfolio management research and asset
allocation decisions.
 41

Cont’d

• As well as considering which market they are tracking, it

is important to also understand how the index has been
calculated.
• Early indices, such as the Dow Jones Industrial Average
(DJIA), are price-weighted so that it is only the price of
each stock within the index that is considered when
calculating the index.
• This means that no account is taken of the relative size of
a company contained within an index, and the share price
movement of one can have a disproportionate effect on
the index.
 42

Cont’d

• Following on from these earlier indices, broader-based

indices were calculated based on a greater range of
shares, and which also took into account the relative
market capitalization of each stock in the index to give a
more accurate indication of how the market was moving.
• This development process is ongoing, and most market
capitalization-weighted indices have a further refinement
in that they now take account of the free-float
capitalization of their constituents.
• This float-adjusted calculation aims to exclude
shareholdings held by large investors and governments
that are not readily available for trading.
 43

Cont’d
• There are now over 3,000 equity indices worldwide, some of which track the fortunes of a single market while others
cover a particular region, sector or a range of markets, such as the FTSE ASEA Pan Africa index series. Some of the
main indices that are regularly quoted in the financial press are shown below.
 44

4.3. The Bond Market

• Bonds are like money market instruments, but they have

maturities that exceed one year (are longer-term securities).
• These include Treasury bonds, corporate bonds, mortgages,
and the like.
• Although bonds do not often generate as much media attention
as shares, they are the larger market of the two in terms of
global investment value.
• Bonds are roughly equally split between government and
corporate bonds.
• Government bonds are issued by national governments and by
supranational agencies such as the European Investment Bank
and the World Bank and the African Development Bank.
• Corporate bonds are issued by companies, such as large
banks and other large corporate listed companies, as well as
by state-owned enterprises, such as electricity utilities or road-
building companies.
 45

Cont’d

• A bond is, very simply, a loan.

• A company or government that needs to raise money to finance
an investment could borrow money from its bank or,
alternatively, it could issue a bond to raise the funds it needs by
borrowing from the investing public.
• With a bond, an investor lends in return for the promise to have
the loan repaid on a fixed date and (usually) a series of interest
payments.
• Bonds are commonly referred to as loan stock, debt or (in the
case of those which pay fixed income) fixed-interest securities.
• The feature that distinguishes a bond from most loans is that a
bond is tradable. Investors can buy and sell bonds without the
need to refer to the original borrower.
 46

Cont’d

• Characteristics of a bond: an example of a US government

bond.
• Let’s assume that an investor has purchased a holding of
US$10,000 7.5% Treasury bond 2024 as shown in the table
above.
 47

Cont’d

1. Nominal – this is the amount of stock purchased and should

not be confused with the amount invested or the cost of
purchase. This is the amount on which interest will be paid
and the amount that will eventually be repaid. It is also
known as the ‘par’ or ‘face’ value of the bond.
2. Stock – the name given to identify the stock and the
borrower, which in this case is the US government. The term
‘Treasury bond’ represents US government bonds issued
with relatively long periods to maturity. However, the term is
also used to describe bonds issued by many other countries.
3. Coupon – this is the amount of interest paid per year,
expressed as a percentage of the face value of the bond.
The bond issuer will pay the coupon to the bondholder. The
rate is quoted gross and will normally be paid in two separate
and equal half-yearly interest payments.
 48

Cont’d

4. Redemption date (‘maturity date’) – this is the date at which

the issue expires and the borrower will repay the lender the
sum borrowed. Repayment of principal will take place at the
same time that the final interest payment is made.
5. Price – this stock can be freely traded at any time on the
New York Stock Exchange (NYSE) and it is quoted at
US$146.80. The convention in most international bond
markets is to quote stock per US$100 nominal of stock. In
this example, the price quoted is US$146.80 and so each
US$100 nominal of stock purchased will cost US$146.80
before any brokerage costs.
6. Value – the value of the stock is calculated by multiplying the
nominal amount of stock by the current price. Comparing the
nominal value of the stock of US$10,000 to the current
market value of US$14,680 (US$10,000 ÷ US$100 x
US$146.80).
 49

Advantages, Disadvantages and Risks of Investing in Bonds

Advantages
• For fixed interest bonds, a regular and certain flow of
income
• For most bonds, a fixed maturity date (but there are bonds
which have no redemption date, and others which may be
repaid on either of two dates or between two dates –
some at the investor’s option and some at the issuer’s
option)
• A range of income yields to suit different investment and
tax situations
• Relative security of capital for more highly rated bonds.
 50

Cont’d

Disadvantages
• The real value of the income flow is eroded by the effects
of inflation (except in the case of index-linked bonds)
• Bonds carry elements of risk
Risks
• Default risk: the issuer might be a company that could go
out of business and/or will not repay the capital at the
maturity date. Government bonds generally have low or
no default risk.
• Price risk: prices of bonds may fall
• Price (or market) risk is of particular concern to bondholders who
are open to the effect of movements in general interest rates, which
can have a significant impact on the value of their holdings.
 51

Cont’d

• Example: Interest rates are approximately 5%, and the

government issues a bond with a coupon rate of 5%
interest. Three months later interest rates have doubled to
10%. What will happen to the value of the bond?
• The value of the bond will fall substantially. Its 5% interest is no
longer attractive, so its resale price will fall to compensate, and to
make the return it offers more competitive.
• There is an inverse relationship between interest rates
and bond prices:
• If interest rates increase, bond prices will decrease.
• If interest rates decrease, bond prices will increase.
 52

Cont’d

• Early redemption: the risk that the issuer may invoke a call
provision and redeem the bond early (if the bond is callable).
• Seniority risk: this relates to the seniority with which corporate
debt is ranked in the event of the issuer’s liquidation. If a bond
is entitled to be repaid before the existing bonds, then the
bonds have suffered from seniority risk.
• Inflation risk: the risk of inflation rising unexpectedly and
eroding the real value of the bond’s coupon and redemption
payment.
• Liquidity risk: liquidity is the ease with which a security can be
converted into cash. Some bonds are more easily sold at a fair
market price than others.
• Exchange rate risk: bonds denominated in a currency different
from that of the investor’s home currency are potentially subject
to adverse exchange rate movements.
 53

Types of Bonds

• Major types of bonds include

• Long-term government bonds (T-bonds)
• Governments issue bonds to finance their spending and investment
plans and to bridge the gap between their actual spending and the tax
and other forms of income that they receive.
• Municipal bonds
• A bond that is issued by municipals.
• Corporate bonds
• A bond that is issued by a company, as the name suggests.
• Eurobonds
• They are denominated in a currency different from that of the financial
center or centers from which they are issued.
 54

Credit Rating Agencies

• The credit risk, or probability of an issuer defaulting on

their payment obligations, and the extent of the resulting
loss, can be assessed by reference to the independent
credit ratings given to most bond issues.
• There are more than 70 agencies throughout the world,
and preferred agencies vary from country to country.
• The three most prominent credit rating agencies are:
• Standard & Poor’s (S&P)
• Moody’s
• Fitch Ratings.
• The table below shows the credit ratings available from
the three companies.
55
 56

4.4. Derivatives

• Derivatives are not a new concept – they have been around for
hundreds of years.
• Their origins can be traced back to agricultural markets, where
farmers needed a mechanism to guard against price
fluctuations caused by surpluses of produce, and merchants
wanted to guard against shortages that might arise from
periods of drought.
• So, in order to fix the price of agricultural produce in advance of
harvest time, farmers and merchants would enter into forward
contracts.
• These set the price at which a stated amount of a commodity
would be delivered between a farmer and a merchant (termed
the ‘counterparties’ to the trade) at a pre-specified future date.
 57

Cont’d

• These early derivative contracts introduced an element of

certainty into commerce and gained immense popularity.
• They led to the opening of the world’s first derivatives
exchange in 1848, the Chicago Board of Trade (CBOT).
• A derivative is a financial instrument whose price is based on
the price of another asset, known as the ‘underlying’.
• The underlying could be a financial asset, a commodity, a
currency or an index.
• Examples of financial assets include bonds and shares, and
commodities include oil, gold, silver, corn and wheat.
• The trading of derivatives can take place either directly
between counterparties (OTC) or on an organized exchange
such as the Chicago Mercantile Exchange (CME).
 58

Uses of Derivatives

• Hedging: this is a technique employed by portfolio

managers to reduce portfolio risk, such as the impact of
adverse price movements on a portfolio’s value.
• This could be achieved by buying or selling futures
contracts, buying put options or selling call options.
• Anticipating future cash flows: if a portfolio manager
expects to receive a large inflow of cash to be invested in
a particular asset, then futures can be used to fix the price
at which it will be bought and offset the risk that prices will
have risen by the time the cash flow is received.
• Speculation: involves assuming additional risk (betting) in
an effort to make, or increase, profits in the portfolio.
 59

Cont’d

• Asset allocation changes: changes to the asset allocation of a

fund, whether to take advantage of anticipated short-term
directional market movements or to implement a change in
strategy, can be made more swiftly and less expensively using
derivatives such as futures than by actually buying and selling
securities within the underlying portfolio.
• Arbitrage: the process of deriving a risk-free profit from
simultaneously buying and selling the same asset in two
different markets, when a price difference between the two
exists.
• If the price of a derivative and its underlying asset are
mismatched, then the portfolio manager may be able to profit
from this pricing anomaly.
• The vast majority of derivatives take one of four forms:
forwards, futures, options or swaps.
 60

Cont’d

Definitions
• Open: the initial trade (opening a long position or a short
position).
• Close: the physical assets underlying most futures that are
opened do not end up being delivered: they are closed-out
instead.
• Long position: an asset which is purchased or owned
• Short position: an asset which must be delivered to a third
party as a future date, or an asset which is borrowed and sold,
but must be replaced in the future
• Hedging risk involves engaging in a financial transaction that
offsets a long position by taking an additional short position, or
offsets a short position by taking an additional long position.
 61

i. Forwards

• Forward contracts are agreements by two parties to

engage in a financial transaction at a future (forward)
point in time.
• One example of forward contracts that are linked to debt
instruments, called interest-rate forward contracts.
Interest-Rate Forward Contracts
• Interest-rate forward contracts involve the future sale or
purchase of a debt instrument and have several
dimensions:
• Specification of the actual debt instrument that will be delivered at a
future date
• Amount of the debt instrument to be delivered
 62

Cont’d

• Price (interest rate) on the debt instrument when it is delivered, and

• Date on which delivery will take place.
• Example: an agreement for A Bank to sell to an Insurance
Company, one year from today, $5 million face value of the 6s
of 2029 Treasury bonds (coupon bonds with a 6% coupon rate
that mature in 2029) at a price that yields the same interest rate
on these bonds as today’s, say, 6%.
• The Insurance Company will buy the securities at a future date,
it has taken a long position, while the Bank, which will sell the
securities, has taken a short position.
• Why the Bank might want to enter into this forward contract?
• Because these are long-term bonds, the bank is exposed to
substantial interest-rate risk and if interest rates rise in the future, the
price of these bonds will fall.
 63

Cont’d

• Why would the Insurance Company want to enter into the

forward contract with the Bank?
• It expects to receive premiums of $5 million in one year’s time that
it will want to invest in the 6s of 2029 but worries that interest rates
on these bonds will decline between now and next year. By using
the forward contract, it is able to lock in the 6% interest rate on the
Treasury bonds.
 64

Pros and Cons of Forward Contracts

• The advantage of forward contracts is that they can be as

flexible as the parties involved want them to be.
Cons
• The first is that it may be very hard for an institution like
the Bank to find another party (called a counterparty) to
make the contract with.
• There are brokers to facilitate the matching up of parties but seller
may not get as high a price as it wants. (Liquidity problem)
• Default risk
• May be because the buyer can now buy the bonds at a price lower
than the agreed price in the forward contract or it have gone bust.
• Checking each other could be a solution
 65

ii. Futures Markets

• Given the default risk and liquidity problems in the

interest-rate forward market, another solution to hedging
interest-rate risk was needed.
• This solution was provided by the development of
financial futures contracts by the Chicago Board of Trade
starting in 1975.
• A financial futures contract is similar to an interest-rate
forward contract in that it specifies that a financial
instrument must be delivered by one party to another on a
stated future date.
• However, it differs from an interest-rate forward contract in
several ways that overcome some of the liquidity and
default problems of forward markets.
 66

Cont’d

Example: Hedging Interest Rate Risk

• A manager has a long position in Treasury bonds. She
wishes to hedge against interest rate increases, and uses
T-bond futures to do this:
• Her portfolio is worth $5,000,000
• Futures contracts have an underlying value of $100,000, so she
must short 50 contracts.
• As interest rates increase over the next 12 months, the value of the
bond portfolio drops by almost $1,000,000.
• However, the T-bond contract also dropped almost $1,000,000 in
value, and the short position means the contact pays off that
amount.
• Losses in the spot T-bond market are offset by gains in the T-bond
futures market.
 67

Cont’d

Success of Futures Over Forwards

1. Futures are more liquid: standardized contracts that can
be traded
• The quantities delivered and the delivery dates of futures contracts are
standardized, making it more likely that different parties can be matched
up in the futures market.
• The futures contract has been bought or sold, it can be traded (bought
or sold) again at any time until the delivery date.
• Not just one specific type of Treasury bond is deliverable on the delivery
date, as in a forward contract. Instead, any Treasury bond that matures
in more than 15 years and is not callable for 15 years is eligible for
delivery.
• Allowing continuous trading also increases the liquidity of the futures
market.
 68

Cont’d

2. Delivery of range of securities reduces the chance that

a trader can corner the market
• To corner the market, someone buys up all the deliverable securities so
that investors with a short position cannot obtain from anyone else the
securities that they contractually must deliver on the delivery date.
3. Mark to market daily: avoids default risk
• Trading in the futures market has been organized differently from
trading in forward markets to overcome the default risk problems arising
in forward contracts.
• The buyer and seller of a futures contract make their contract not with
each other but with the clearinghouse associated with the futures
exchange.
• This setup means that the buyer of the futures contract does not need to
worry about the financial health or trustworthiness of the seller, or vice
versa, as in the forward market.
 69

Cont’d

• As long as the clearinghouse is financially solid, buyers and sellers

of futures contracts do not have to worry about default risk.
• To make sure that the clearinghouse is financially sound and does
not run into financial difficulties that might jeopardize its contracts,
buyers or sellers of futures contracts must put an initial deposit,
called a margin requirement.
• Futures contracts are then marked to market every day.
• What this means is that at the end of every trading day, the change
in the value of the futures contract is added to or subtracted from
the margin account.
 70

Cont’d

4. Don't have to deliver: cash netting of positions

• A trader who sold a futures contract is allowed to avoid delivery on
the expiration date by making an offsetting purchase of a futures
contract.
• Because the simultaneous holding of the long and short positions
means that the trader would in effect be delivering the bonds to
itself, under the exchange rules the trader is allowed to cancel both
contracts.
• Allowing traders to cancel their contracts in this way lowers the cost
of conducting trades in the futures market relative to the forward
market in that a futures trader can avoid the costs of physical
delivery, which is not so easy with forward contracts.
 71

Cont’d

Example: Hedging FX Risk

• A US manufacturer expects to be paid 10 million euros in
two months for the sale of equipment in Europe. Currently,
1 euro = $1, and the manufacturer would like to lock-in
that exchange rate.
• The manufacturer can use the FX futures market to
accomplish this:
• The manufacturer sells 10 million euros of futures contracts.
Assuming that 1 contract is for $125,000 in euros, the manufacturer
takes as short position in 80 contracts.
• The exchange will require the manufacturer to deposit cash into a
margin account. For example, the exchange may require $2,000
per contract, or $160,000.
 72

Cont’d

• As the exchange rate fluctuates during the two months, the value of
the margin account will fluctuate. If the value in the margin account
falls too low, additional funds may be required. This is how the
market is marked to market. If additional funds are not deposited
when required, the position will be closed by the exchange.
• Assume that actual exchange rate is 1 euro = $0.96 at the end of
the two months. The manufacturer receives the 10 million euros
and exchanges them in the spot market for $9,600,000.
• The manufacturer also closes the margin account, which has
$560,000 in it-$400,000 for the changes in exchange rates plus the
original $160,000 required by the exchange (assumes no margin
calls).
• In the end, the manufacturer has the $10,000,000 desired from the
sale.
 73

Cont’d

Stock Index Futures

• Financial institution managers, particularly those that
manage mutual funds, pension funds, and insurance
companies, also need to assess their stock market risk,
the risk that occurs due to fluctuations in equity market
prices.
• One instrument to hedge this risk is stock index futures.
• Stock index futures are a contract to buy or sell a
particular stock index, starting at a given level. Contacts
exist for most major indexes, including the S&P500, Dow
Jones Industrials, Russell 2000, etc.
 74

Cont’d

• The “best” stock futures contract to use is generally

determined by the highest correlation between returns to
a portfolio and returns to a particular index.
• Example: Stock Index Futures
• Rock Solid has a stock portfolio worth $100 million, which
tracks closely with the S&P 500. The portfolio manager
fears that a decline is coming and wants to completely
hedge the value of the portfolio over the next year. If the
S&P is currently at 1,000, how is this accomplished?
 75

Cont’d

• Value of the S&P 500 Futures Contract = 250  index

• Currently 250 x 1,000 = $250,000
• To hedge $100 million of stocks that move 1 for 1 (perfect
correlation) with S&P currently selling at 1000, you would:
• Sell $100 million of index futures = 400 contracts
• Suppose after the year, the S&P 500 is at 900 and the
portfolio is worth $90 million.
• Futures position is up $10 million
 76

Cont’d

• If instead, the S&P 500 is at 1100 and the portfolio is

worth $110 million.
• Futures position is down $10 million
• Either way, net position is $100 million
• Note that the portfolio is protected from downside risk, the
risk that the value in the portfolio will fall. However, to
accomplish this, the manager has also eliminated any
upside potential.
• Now we will examine a hedging strategy that protects
again downside risk, but does not sacrifice the upside. Of
course, this comes at a price!
 77

iii. Options

Definitions
• An option gives a buyer the right, but not the obligation, to
buy or sell a specified quantity of an underlying asset at a
pre-agreed exercise price, on or before a pre-specified
future date or between two specified dates.
• The seller, in exchange for the payment of a premium,
grants the option to the buyer.
• A key difference between a future and an option is,
therefore, that the option gives the right to buy or sell,
whereas a future is a legally binding obligation between
the counterparties.
 78

Cont’d

• When options are traded on an exchange, they will be in

standardized sizes and terms.
• On occasion, however, investors may wish to trade an
option that is outside these standardized terms, and they
will do so in the OTC market.
• Options can, therefore, also be traded off-exchange, or
OTC, where the contract specification determined by the
parties is bespoke.
• A call option: is when the buyer has the right to buy the
asset at the exercise price, if they choose to. The seller is
obliged to deliver if the buyer exercises the option.
 79

Cont’d

• A put option: is when the buyer has the right to sell the
underlying asset at the exercise price. The seller of the put
option is obliged to take delivery and pay the exercise price, if
the buyer exercises the option.
Options Contract
• Right to buy (call option) or sell (put option) an instrument at
the exercise (strike) price up until expiration date (American) or
on expiration date (European).
• The buyers of options are the owners of those options. They are also
referred to as holders.
• The sellers of options are referred to as the writers of those options.
• Options are available on a number of financial instruments,
including individual stocks, stock indexes, etc.
 80

Cont’d

Example: Hedging with Options

• Rock Solid has a stock portfolio worth $100 million, which
tracks closely with the S&P 500. The portfolio manager fears
that a decline is coming and what to completely hedge the
value of the portfolio against any downside risk. If the S&P is
currently at 1,000, how is this accomplished?
• Value of the S&P 500 Option Contract = 250  index
• Currently 250 x 1,000 = $250,000
• To hedge $100 million of stocks that move 1 for 1 (perfect
correlation) with S&P currently selling at 1000, you would:
• Buy $100 million of S&P put options = 400 contracts
 81

Cont’d

• The premium would depend on the strike price. For

example, a strike price of 950 might have a premium of
$200 / contract, while a strike price of 900 might have a
premium of only $100.
• Let’s assume Rock Solid chooses a strike price of 950.
Then Rock Solid must pay $80,000 for the position. This
is non-refundable and comes out of the portfolio value
(now only $99.92 million).
 82

Cont’d

• Suppose after the year, the S&P 500 is at 900 and the portfolio is
worth $89.92 million.
• Options position is up $5 million (since 950 strike price)
• In net, portfolio is worth $94.92 million

• If instead, the S&P 500 is at 1100 and the portfolio is worth $109.92
million.
• Options position expires worthless, and portfolio is worth
$109.92 million
• Note that the portfolio is protected from any downside risk (the risk
that the value in the portfolio will fall ) in excess of $5 million.
• However, to accomplish this, the manager has to pay a premium
upfront of $80,000.
 83

iv. Swaps

• A swap is an agreement to exchange one set of cash flows for

another.
• Swaps are a form of OTC derivative and are negotiated
between the parties to meet their different needs, so each
tends to be unique.
• Swaps are financial contracts that obligate each party to the
contract to exchange (swap) a set of payments it owns for
another set of payments owned by another party.
• There are two basic kinds of swaps:
• Currency swaps involve the exchange of a set of payments in one
currency for a set of payments in another currency.
• Interest-rate swaps involve the exchange of one set of interest
payments for another set of interest payments, all denominated in the
same currency. Interest rate swaps are the most common form of
swaps.
 84

Interest-Rate Swaps

• They involve an exchange of interest payments and are

usually constructed whereby one leg of the swap is a
payment of a fixed rate of interest and the other leg is a
payment of a floating rate of interest.
• The most common type of interest-rate swap (called the
plain vanilla swap) specifies
• The interest rate on the payments that are being exchanged;
• The type of interest payments (variable or fixed rate);
• The amount of notional principal, which is the amount on which the
interest is being paid; and
• The time period over which the exchanges continue to be made.
• There are many other more complicated versions of
swaps, including forward swaps and swap options (called
swaptions).
 85

Cont’d

• Example: an interest-rate swap between the Midwest

Savings Bank and the Friendly Finance Company.
• Midwest Savings agrees to pay Friendly Finance a fixed rate of 5%
on $1 million of notional principal for the next 10 years, and
Friendly Finance agrees to pay Midwest Savings the one-year
Treasury bill rate plus 1% on $1 million of notional principal for the
same period. Thus, as shown in Figure 24.2, every year, the
Midwest Savings Bank would be paying the Friendly Finance
Company 5% on $1 million while Friendly Finance would be paying
Midwest Savings the one-year T-bill rate plus 1% on $1 million.
 86

Cont’d
 87

Cont’d

Hedging with Interest-Rate Swaps

• Why the managers of the two financial institutions find it
advantageous to enter into this swap agreement.
• The answer is that it may help both of them hedge interest-rate risk.
• Suppose that the Midwest Savings Bank, which tends to
borrow short term and then lend long term in the
mortgage market, has $1 million less of rate-sensitive
assets than it has of rate-sensitive liabilities.
• This situation means that as interest rates rise, the rise in
the cost of funds (liabilities) is greater than the rise in
interest payments it receives on its assets, many of which
are fixed rate.
 88

Cont’d

• The result of rising interest rates is thus a shrinking of

Midwest Savings’ net interest margin and a decline in its
profitability.
• To avoid this interest-rate risk, the manager of the
Midwest Savings would like to convert $1 million of its
fixed-rate assets into $1 million of rate-sensitive assets, in
effect making rate-sensitive assets equal to rate-sensitive
liabilities, thereby eliminating the gap.
• This is exactly what happens when she engages in the
interest-rate swap.
 89

Cont’d

• The manager of the Friendly Finance Company, which

issues long-term bonds to raise funds and uses them to
make short-term loans, finds that he is in exactly the
opposite situation to Midwest Savings:
• He has $1 million more of rate-sensitive assets than of rate-
sensitive liabilities. He is therefore concerned that a fall in interest
rates, which will result in a larger drop in income from its assets
than the decline in the cost of funds on its liabilities, will cause a
decline in profits.
• By doing the interest-rate swap, the manager eliminates
this interest-rate risk because he has converted $1 million
of rate-sensitive income into $1 million of fixed-rate
income.
 90

Cont’d

Advantages of swaps
• Reduce risk, no change in balance-sheet
• Longer term than futures or options
Disadvantages of swaps
• Lack of liquidity
• Subject to default risk
• Financial intermediaries help reduce disadvantages of
swaps (but at a cost!)
 91

Credit Swaps

• Credit derivatives are a relatively new derivative offering

payoffs based on changes in credit conditions along a
variety of dimensions.
• Almost nonexistent twenty years ago, the notional amount
of credit derivatives today is in the trillions.
• Credit derivatives can be generally categorized as credit
options, credit swaps, and credit-linked notes.
• Let’s the credit swaps here
• Suppose you manage Bank A, which specializes in
lending to oil drilling companies. Another bank, Bank B,
specializes in lending to potato farmers. Both bank A and
B have a problem because their loan portfolios are not
sufficiently diversified.
 92

Cont’d

• To protect bank A against a collapse in the oil market,

which would result in defaults on most of its loans made
to oil drillers, you could reach an agreement to have the
loan payments on, say, $100 million worth of your loans to
oil drillers paid to the bank B in exchange for bank B
paying you the loan payments on $100 million of its loans
to potato farmers.
• Such a transaction, in which risky payments on loans are
swapped for each other, is called a credit swap.
• As a result of this swap, bank A and B have increased
their diversification and lowered the overall risk of their
loan portfolios because some of the loan payments to
each bank are now coming from a different type of loan.
 93

4.5. The Foreign Exchange Market

• The FX market refers to the trading of one currency for another.

The trading of currencies and banks deposits is what makes up
the foreign exchange market.
• It is by far the largest market in the world - with average daily
turnover in excess of US$5 trillion - 2019.
• Trading in currencies became 24-hour, as it could take place in
the various time zones of Asia, Europe and America.
• FX traded in over-the-counter market - where brokers and
dealers negotiate directly with one another.
• Most trades involve buying and selling bank deposits denominated in
different currencies.
• Trades in the foreign exchange market involve transactions in excess
of $1 million.
• Typical consumers buy foreign currencies from retail dealers, such as
American Express.
 94

Cont’d

• The main participants are large international banks which

continually provide the market with both bid (buy) and ask
(sell) prices.
• Central banks are also major participants in FX markets,
which they use to try to control money supply, inflation,
and interest rates.
• There are several types of transaction undertaken in the
FX market:
• Spot transactions: the spot rate is the rate quoted by a
bank for the exchange of one currency for another with
immediate effect.
• However, the currencies actually change hands and arrive in
recipients’ bank accounts mostly two business days after the
transaction date.
 95

Cont’d

• Forward transactions: in this type of transaction, money

does not actually change hands until some agreed future
date.
• A buyer and seller agree on an exchange rate for any date in the
future, for a fixed sum of money, and the transaction occurs on that
date, regardless of what the market rates are then.
• The duration of the trade can be a few days, months or years.
• Futures: foreign currency futures are standardized
versions of forward transactions that are traded on
derivatives exchanges in standard sizes and maturity
dates.
• The average contract length is roughly three months.
 96

Cont’d

• Swaps: a common type of forward transaction is the

currency swap.
• In a currency swap, two parties exchange currencies for a certain
length of time and agree to reverse the transaction at a later date.
• These are not exchange-traded contracts and, instead, are
negotiated individually between the parties to a swap.

You Will Learn Details In International Economics II (Econ

3082) Course!
 97

4.6. The Mortgage Markets

What Are Mortgages?

• A mortgage is simply a secured loan, with the security taking
the form of a property.
• A mortgage is typically provided to finance the purchase of a
property.
• For most people their main form of borrowing is their mortgage on their
house or flat.
• Mortgages tend to be over a longer term than unsecured loans,
with most mortgages running for 20 or 25 years.
• Mortgage markets are less developed in some African
countries due to factors such as the lack of a long-term yield
curve in the bond market for the pricing of long-term
mortgages, or insufficient regulation on property ownership.
• The total amount of mortgage debt outstanding in the U.S.
during 2006 was roughly $13 trillion outstanding.
 98

Cont’d

Characteristics of the Residential Mortgage

• Mortgages can be roughly classified along the following
three dimensions:
• Mortgage Interest Rates
• Loan Terms
• Mortgage Loan Amortization
 99

Mortgage Interest Rates

• The stated rate on a mortgage loan is determined by

three rates:
• Market Rates: general rates on Treasury bonds
• Term: longer-term mortgages have higher rates
• Discount Points: a lower rates negotiated for cash upfront
• The relationship between mortgage rates and long-term
treasury rates - mortgage rates are typically higher than
Treasury rates, but the spread (difference) between the
two varies considerably.
• A difficult decision when getting a mortgage is whether to
pay points (cash) upfront in exchange for a lower interest
rate on the mortgage.
• Exercise: why do you think?
 100

Loan Terms

• Mortgage loan contracts contain many legal terms that

need to be understood. Most protect the lender from
financial loss.
• Collateral: usually the real estate being finance
• Down payment: a portion of the purchase price paid by
the borrower
• PMI: insurance against default by the borrower
• Qualifications: includes credit history, employment history,
etc., to determine the borrowers ability to repay the
mortgage as specified in the contract.
 101

Loan Amortization

• Mortgage loans are amortized loans.

• This means that a fixed, level payment will pay interest
due plus a portion of the principal each month.
• It is designed so that the balance on the mortgage will be
zero when the last payment is made.
 102

4.7. Financial Markets Efficiency

The Efficient Market Hypothesis

• The efficient-market hypothesis (EMH) is a hypothesis in
financial economics that states that asset prices reflect all
available information.
• A direct implication is that it is impossible to "beat the market"
consistently on a risk-adjusted basis since market prices should only
react to new information.
• According to the EMH, stocks always trade at their fair value on
exchanges, making it impossible for investors to purchase
undervalued stocks or sell stocks for inflated prices.
• Therefore, it should be impossible to outperform the overall
market through expert stock selection or market timing, and the
only way an investor can obtain higher returns is by purchasing
riskier investments.
 103

Evidence on Efficient Market Hypothesis - Favorable Evidence

▪ Favorable Evidence
1. Investment analysts and mutual funds don't beat
the market
2. Stock prices reflect publicly available info:
anticipated announcements don't affect stock price
3. Stock prices and exchange rates close to random
walk
4. Technical analysis does not outperform market
 104

Evidence on Efficient Market Hypothesis - Unfavorable Evidence

▪ Unfavorable Evidence
1. Small-firm effect: small firms have abnormally high returns
2. January effect: high returns in January
3. Market overreaction
4. Excessive volatility
5. Mean reversion
6. New information is not always immediately incorporated into
stock prices