Financial markets and the importance of capital market

instruments

Moorad Choudhry
December 2005

© YieldCurve.com 2005
 2

Financial Markets and the importance of capital market instruments

The financial markets can be said to be an integration of market participants, the

trading and regulatory environment (which includes stock and futures exchanges) and
market instruments. These instruments can be further divided into cash securities and
derivatives. Securities are known as cash market instruments (or simply cash)
because they represent actual cash by value. A security product is issued by the party
requiring finance, and such represents a liability to the issuer. Conversely a security is
an asset of the buyer or holder. Contrary to what might be thought given the publicity
and literature emphasis on derivatives, financial markets are first and foremost cash
securities, with the market itself being, in essence a derivative of the wider economy.

Financial market instruments are the vital tools through which market participants
practice intermediation, the bringing together of the providers and users of capital.
Without this intermediation, the global economy could not function, indeed it could
not have developed beyond its state in the Middle Ages. As such, it is vital for all
market participants to:

possess a good understanding of the instruments and their use;

be able to analyse and value efficiently and accurately the instruments

themselves.

Debt capital market securities are defined primarily in terms of their issuer, term to
maturity and currency. They may also be categorised in terms of:

the rights they confer on the holder, such as voting and ownership rights;

whether they are unsecured or secured against fixed or floating assets;

the cash flows they represent;

how liquid they are, that is the ease with which they can be bought and sold in the
secondary market;

their structure, for example if they are hybrid or composite securities, or whether
their return or payoff profile is linked to another security.

The characteristics of any particular security influence the way it is valued and
analysed. Debt securities originally were issued with an annual fixed interest or
coupon liability, stated as a percentage of par value, so that their cash flows were
known with certainty during their lifetime. This is the origin behind the term fixed
income security, although for there many different types of debt security issued that
do not pay a fixed coupon.

2
 3

Capital market financing

A corporate entity can raise finance in a number of ways, and the flow of funds
within an economy, and the factors that influence this flow, play an important part in
the economic environment in which a firm operates. As in any market, pricing factors
are driven by the laws of supply and demand, and price itself manifests itself in the
cost of capital to a firm and the return expected by investors who supply that capital.
Although we speak in terms of a corporate firm, many different entities raise finance
in the capital markets. These include sovereign governments, supranational bodies
such as the World Bank, local authorities and state governments, and public sector
bodies.

The key distinction in financing arrangements is between equity and debt. Equity
finance represents ownership rights in the firm issuing equity, and may be raised
either by means of a share offer or as previous year profits invested as retained
earnings. Equity finance is essentially permanent in nature, as it is rare for firm’s to
repay equity; indeed in most countries there are legal restrictions to so doing.

Debt finance represents a loan of funds to the firm by a creditor. A useful way to
categorise debt is in terms of its maturity. Hence very short-term debt is best
represented by a bank overdraft or short-term loan, and for longer-term debt a firm
can take out a bank loan or raise funds by issuing a bond. Bonds may be secured on
the firm’s assets or unsecured, or they may be issued against incoming cash flows,
which is known as securitisation. The simplest type of bond is known as a plain
vanilla or conventional bond, or in the US markets a bullet bond. Such a bond
features a fixed coupon and fixed term to maturity, so for example a US Treasury
security such as the 6% 2009 pays interest on its nominal or face value of 6% each
year until 15 August 2009, when it is redeemed and principal paid back to
bondholders.

A firm’s financing arrangements are specified in a number of ways, which include:

the term or maturity: financing that is required for less than one year is regarded
as short-term, and money market securities are short-term in this way. Borrowing
between one year and 10 years is considered medium-term, while longer-dated
requirements are regarded as long-term. There is permanent financing, for
example preference shares;

size of funding: the amount of capital required;

3
 4

the risk borne by suppliers of finance and the return demanded by them as the
cost of bearing such risk. The risk of all financial instruments issued by one issuer
is governed by the state of the firm and the economic environment in which it
operates, but specific instruments bear specific risks. Secured creditors are at less
risk of loss compared to unsecured creditors, while the owners of equity
(shareholders) are last in line for repayment of capital in the event of winding-up
of a company. The return achieved by the different forms of finance reflects the
risk exposure each form represents.

A common observation is that although shares and share valuation are viewed as
treated as very important in finance and finance text books, in actual cash terms they
represent a minor source of corporate finance. Statistics indicate that the major
sources of funding are retained earnings and debt.

Derivative instruments

The principal financial derivatives are forwards, futures, swaps and options. The
importance of these instruments in the financial markets, and the contribution they
have made to market efficiency and liquidity, cannot be overstated. Compared to a
cash market security, a derivative is an instrument whose value is linked to that of an
underlying asset. An example would be a crude oil future, the value of which will
track the value of crude oil. Hence the value of the future derives from that of the
underlying crude oil. Financial derivatives are contracts written on financial securities
or instruments, for example equities, bonds or other financial derivatives.

Forward contracts
A forward contract is a tailor-made instrument, traded over-the-counter (OTC)
directly between the counterparties, that is agreed today for expiry at a point in the
future. In the context of the financial markets a forward involves an exchange of an
asset in return for cash or another asset. The price agreed for the exchange is agreed
at the time the contract is written, and is made good on delivery, irrespective of the
value of the underlying asset at the time of contract expiry. Both parties to a forward
are obliged to carry out the terms of the contract when it matures, which makes it
different to an option contract.

Futures contracts
Futures contracts or simply futures are exchange-traded instruments that are
standardised contracts; this is the primary difference between futures and forwards.
The first organised futures exchange was the Chicago Board of Trade, which opened
for futures trading in 1861. The basic model of futures trading established in Chicago
has been adopted around the world.

4
 5

Essentially futures contracts are standardised, that means each contract represents the
same quantity and type of underlying. The terms under which delivery into an expired
contract is undertaken is also specified by the exchange. Traditionally futures were
traded on an exchange’s floor (in the “pit”) but this has been increasingly supplanted
by electronic screen trading, so much so that by January 2001 the only trading floor
still in use in London was that of the International Petroleum Exchange. The financial
futures exchange, LIFFE, now traded exclusively on screen. Needless to say, the two
exchanges in Chicago, the other being the Chicago Board Options Exchange, retained
pit trading.

Swap contracts
Swap contracts are derivatives that exchange one set of cash flows for another. The
most common swaps are interest-rate swaps, which exchange (for a period of time)
fixed-rate payments for floating-rate payments, or floating-rate payments of one basis
for floating payments of another basis.

Swaps are OTC contracts and so can be tailor-made to suit specific requirements.
These requirements can be in regard to nominal amount, maturity or level of interest
rate. The first swaps were traded in 1981 and the market is now well developed and
liquid. Interest-rate swaps are so common as to be considered “plain vanilla”
products, similar to the way fixed-coupon bonds are viewed.

Option contracts
The fourth type of derivative instrument is fundamentally different from the other
three products we have just introduced. This is because its payoff profile is unlike
those of the other instruments, due to the optionality element inherent in the
instrument. The history of options also goes back a long way, however practical use
of financial options is generally thought of as dating from after the introduction of the
acclaimed Black-Scholes pricing model for options, which was first presented by its
authors in 1973.

The basic definition of option contracts is well known. A call option entitles its
holder to buy the underlying asset at a price and time specified in the contract terms,
the price specified being known as the strike or exercise price, while a put option
entitles its holder to sell the underlying asset. A European option can only be
exercised on maturity, while an American option may be exercised by its holder at
any time from the time it is purchased to its expiry. The party that has sold the option
is known as the writer and its only income is the price or premium that it charges for
the option. This premium should in theory compensate the writer for the risk
exposure it is taking on when it sells the option. The buyer of the option has a risk
exposure limited to the premium he paid. If a call option strike price is below that of
the underlying asset price on expiry it is said to be in-the-money, otherwise it is out-
of-the-money. When they are first written or struck option strike prices are often set at
the current underlying price, which is known as at-the-money.

5
 6

Connecting debt financial market instruments

Financial market participants generally all use the same class of instruments and
hence there is a close relationship between all of them, and their application. This
relationship and interaction is a central theme of the “Choudhry” series of books on
debt capital markets.

The main financial market participants are banks, insurance companies, fund
managers, investment banks and hedge funds. The all transact business using the
following products.

The money markets: the market in short-term debt, vital for all institutions to enable
them to raise short-term working capital in an efficient manner. The market is made
up of banks and other financial firms borrowing and lending cash, and managing risk
exposure of this business using derivatives. A key segment of the money market is
that in secured cash borrowing and lending, known as the repo market. The repo
market enables banks to maintain liquidity, since by using repo firms can finance
asset positions and also make good delivery on “short” sales.

The efficient management of the money market operation in any firm is known as
asset-liability management. This is the practice of structuring a firm’s assets and
liabilities in the most efficient manner to maximise income and minimise risk, and is
practised by all financial firms.

The global fixed income markets oversee all this activity. It is comprised of a
diverse range of products, and market trading conventions. It is vital for a ll
participants to be familiar with market mechanics and analytics, to facilitate efficient
use of the products. The fastest-growing sector of the fixed income market is that in
credit derivatives and structured credit products. The credit derivatives market
has grown spectacularly, in a relatively short time, to become a key component of the
capital markets and one which embraces a wide range of participants. At the same
time, so-called synthetic securitisation structures have grown in size such that they
match, in nominal terms, the size of the cash-based securitisation market.

A key risk run by investors in bonds or loans is credit risk, the risk that the bond or
loan issuer will default on the debt. To meet the need of investors to hedge this risk,
the market uses credit derivatives. These are financial instruments originally
introduced to protect banks and other institutions against losses arising from default.
As such they are instruments designed to lay off or take on credit risk. Since their
inception, they have been used by banks, portfolio managers and corporate treasurers
to enhance returns, to trade credit, for speculative purposes and as hedging
instruments.

6
 7

The use of credit derivatives assists banks and other financial institutions with re-
structuring their businesses, because they allow banks to repackage and parcel out
credit risk, while retaining assets on balance sheet (when required) and thus maintain
client relationships. As the instruments isolate certain aspects of credit risk from the
underlying loan or bond, it becomes possible to separate the ownership of credit risk
from the other features of ownership associated with the credit-risky assets in
question; in other words, we can isolate credit as an asset in its own right. It is this
flexibility that has given rise to the market in structured credit products such as
synthetic CDOs, which exist in many varieties. Both these products, in their plain
vanilla credit derivative form and their more structured CDO form, are a positive
development for market participants and an advancement for the capital markets, as
they have simply furthered the process of disintermediation that began originally with
the establishment of capital markets, bringing the lenders and borrowers of capital
closer together. And this, we can all agree, is a good thing.

Finally, all financial markets are concerned with the level of interest rates, this being
the cost of money. The yield curve is the key financial indicator, it is continually
analysed used as a snapshot of the health of the economy overall.

* * *