FIN B379F
Risk Management for
Financial Markets and
Products
FIN B379F
Risk Management for Financial Markets and Products
Unit 1
Structures and Functions of
Financial Institutions
Part A
An Overview of Financial System
Indirect Finance
Fund
Fund Financial
s Intermediaries s
Funds
Lenders - Savers Borrowers -
Spenders
1.Households 1.Business firms
2.Business firms 2.Government
3.Government Financial
Fund Fund 3.Households
markets
4.Foreigners s s 4.Foreigners
Direct
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Finance
Source: Mishkin & Eakins (2012) Financial Markets & Institutions,
Importance of Financial System
Producing an efficient allocation of capital
Allow funds to move from people who lack productive investment
opportunities to people who have such opportunities
Allowing consumers to time their purchases better
Provide funds for young people to buy what they need without forcing
them to wait until they have saved the entire purchase price
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Five Parts of Financial System
1. Money
To pay for purchases and store wealth
2. Financial Instruments
To transfer resources from savers to spenders
and to transfer risk to those best equipped to bear it.
3. Financial Markets
To buy and sell financial instruments
4. Financial Institutions
Provide access to financial markets, collect information & provide
services
5. Central Banks
Monitor financial institutions and stabilize the economy
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What are financial markets?
Financial markets include any place or system
that provides buyers and sellers the means to
trade financial instruments, including bonds,
equities, international currencies, and derivatives.
Financial markets facilitate the transfer of fund
from those who have capital to invest (fund
surplus units) to those who need capital (fund
deficit units).
Well functioning financial markets are key
factors in producing high economic growth.
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Financial Market Participants
In general, financial markets participants include:
Individual households
Business units
Investment and security firms
Governments
Government agencies
( e.g. Fannie Mae (Federal National Mortgage Association)
and HKMC (Hong Kong Mortgage Corporation))
International organizations
Regulators (HKMA, Fed etc)
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The 3 Functions of Financial Markets
1. Provide a price discovery process
Allow buyers and sellers to determine the
price or required rate of return (r) of financial
assets.
Investors’ required return determines the
firm’s cost of capital which in turn
determines which projects are acceptable by
the firm
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The 3 Functions of Financial Markets
2. Enhance the liquidity of financial assets
Financial markets provide a mechanism for
investors to trade (buy and sell ) financial
assets easily.
A liquid market allows sellers to convert their
financial assets into cash quickly without
selling at a big discount.
3. Reduce the transaction costs
An efficient financial market help to reduce
search costs and information costs for
investors.
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Classification of financial markets
– seasoning of claim
Financial markets consist of :
1. Primary Market
A primary market is a source of new
securities.
A market where companies,
governments, and other groups go to
obtain financing through debt-based or
equity-based securities.
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Classification of financial markets
– seasoning of claim
2. Secondary Market
The secondary market is where
investors buy and sell securities (e.g.
stocks and bonds) they already own.
The financial assets change ownership
from sellers to buyers.
In secondary markets, investors
exchange with each other rather than
with the issuing entity.
E.g., Hong Kong Stock Exchange, New
York Stock Exchange, NASDAQ,
London Stock Exchange
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Primary Market Operation
( Secondary
Cash
Market )
Investors/Buyers Issuers
(fund surplus units) (fund deficit units)
Financial assets (Shares /Bonds)
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Secondary Market Operation
( Secondary
Cash
Market )
Investors/Buyers Investors/Sellers
Financial assets (Shares /Bonds)
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Classification of financial markets
– instruments
Money Market
Debt Market
Stock Market
Derivative Market
Foreign Exchange Market
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Money Market
• The money market involves the purchase and sale of
large volumes of very short-term debt products,
such as overnight reserves or commercial paper.
• The securities in the money market are short-term
with high liquidity; therefore, they are close to
being money.
• The majority of money market transactions are
privately negotiated bilateral contracts that take
place between financial institutions and companies.
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Money Market
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– basic characteristics
In Money Market, the financial securities have the
following characteristics:
1. Usually sold in large denominations
($1,000,000 or more) (e.g. Exchange Fund Bills
(EFB) is HKD500,000 per unit)
2. Low default risk (because it is usually backed
by government)
3. Mature in one year or less from their issue
date, although most mature in less than 120
days
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Money Market Instruments
Treasury Bills: A Treasury Bill (T-Bill) is a short-term U.S.
government debt obligation backed by the Treasury Department
with a maturity of one year or less.
Federal Funds: Short-term funds transferred (loaned or
borrowed) between financial institutions, usually for a period of
one day.
Repurchase Agreements: A firm 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
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Money Market Instruments
Commercial Paper: Commercial paper is an unsecured,
short-term debt instrument issued by corporations. It is
typically used to the finance short-term liabilities such as
payroll, accounts payable, and inventories.
Banker’s Acceptance: An order to pay a specified amount to
the bearer on a given date if specified conditions have been met,
usually delivery of promised goods.
Eurodollars: Eurodollars represent US dollar denominated
deposits held in foreign banks. The market is essential since
many foreign contracts call for payment is US dollars due to the
stability of the dollar, relative to other currencies.
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Money Market Securities and Their Markets
Money Market Issuer Buyer Usual Secondary
Security Maturity Market
Treasury bills U.S. Consumers and 4, 13, 26, and 52 Excellent
government companies weeks
Federal funds Banks Banks 1 to 7 days None
Repurchase Businesses and Businesses and 1 to 15 days Good
agreements banks banks
Negotiable CDs Large money Businesses 14 to 120 days Good
center banks
Commercial paper Finance Businesses 1 to 270 days Poor
companies and
businesses
Banker’s Banks Businesses 30 to 180 days Good
acceptances
Eurodollar Non-U.S. banks Businesses, 1 day to 1 year Poor
deposits governments, and
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Debt Market
Debt instruments are assets that require a fixed
payment to the holder, usually with interest. Debt
instruments include bonds and mortgages.
o Debt instrument provides a major source of
long-term financing to corporations and
governments.
o It also provides a lower cost of external fund
than equity financing (i.e. issue shares) to
corporations.
o Interest expense is tax deductible to the firm
(tax-shield effect)
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Types of debt instruments
Nowadays, investors can trade the following debt securities in
Hong Kong. They are listing on HKEX or trading OTC;
denominated in HKD or non-HKD and issued within or outside
the Hong Kong boundary:
These debt instruments include:
1. Corporate bond
2. Convertible bond
3. Government, Supranational/MDB issues
4. Asset-backed and revenue-backed securities
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Types of debt instruments
1. Corporate Bond (both fixed and floating rate papers)
These are debt securities issued by private and
public corporations, e.g. listed companies such as
Sun Hung Kai Properties, CLP Power, Li & Fung and
Swire Pacific etc.
The bond issuing company (the issuer) promises to
provide fixed or floating coupon interest to bond
holders periodically (e.g. semi-annually). At the end
(maturity), the issuer will return the principal to them.
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Types of debt instruments
2. Convertible Bond (CB)
CB has the characteristics of both debt and
equity securities.
Same as ordinary bond, CB is a debt securities
which investors are entitled to receive fixed
interest income and the principal upon maturity.
More than that, CB gives investors the right to
convert the bond into shares of the issuing
corporation with predetermined terms.
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Types of debt instruments
2. Convertible Bond (CB) continue
CB gives investors possible capital appreciation
through the right to convert the bonds into shares.
When underlying share price of the CB increase,
the option to convert into shares becomes more
valuable, the price of the CB itself also increase.
Due to the convertible feature which is a benefit to
investors, CB has a lower coupon rate then non-
convertible bond with same investment quality.
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Types of debt instruments
3. Government/ Supranational/ Multinational
Development Bank (MDBs) bonds
These are debt securities issued by governments
or supranational organizations such as:
The Hong Kong SAR (government)
The People’s Republic of China (government)
The Ministry of Finance of the PRC
(government)
China Development Bank (government)
The World Bank (supranational)
The Asian Development Bank (MDB)
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Types of debt instruments
4.a. Asset-backed Securities (ABS)
Asset-backed securities (ABS) are financial
securities backed by income-generating assets such
as home equity loans, student loans, and auto loans.
ABSs are created when a company sells its loans or
other debts to an issuer, a financial institution that
then packages them into a portfolio to sell to
investors.
Pooling assets into an ABS is a process called
securitization. ABSs appeal to income-oriented
investors, as they pay a steady stream of interest,
like bonds.
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Types of debt instruments
4.a. Asset-backed Securities (ABS)
For ABS backing by mortgage loan, it is called
mortgage-backed securities (MBS).
MBS is a popular debt instrument trading
internationally before the 2008 financial crisis.
One important development of the local
securitization market is the presence of the
Hong Kong Mortgage Corporation (HKMC)
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