Structure of Financial

Markets
Lecture 3
Key terms
• derivative: A financial instrument whose value depends on the
valuation of an underlying asset; such as a warrant, an option, etc.
• maturity: Date when payment is due.
• capital: Money and wealth; the means to acquire goods and services,
especially in a non-barter system.
• exchange: A place for conducting trading.
• liquidity: Availability of cash over short term: ability to service short-
term debt.
Functions of the financial Markets
1. Financial markets perform the function of channelling funds, from
households, firms, and governments who have saved surplus funds by
spending less than their income to those who have a shortage of funds
because they wish to spend more than they earn. The term “financial
markets” is often used to refer solely to the markets that are used to
raise finance: for long-term finance, capital markets are used; for short-
term finance (maturity up to one year), money markets are used.
2. One of the main functions of financial markets is to allocate capital.
Capital markets especially facilitate the raising of capital while money
markets facilitate the transfer of liquidity, in both cases matching those
who have capital to those who need it.
Functions of the financial Markets
3. Additionally, financial markets provide a mechanism for managing
risks. Various financial assets traded in financial markets provide
different payment patterns, and this redistributes and reallocates the
risk associated with the future cash flows among issuers and investors.
4. Financial markets also offer liquidity by providing a mechanism for
investors to sell or purchase financial assets. The presence of organized
financial markets reduces the search and information costs of
transactions, such as the money spent to advertise the desire to sell or
purchase a financial asset. In an efficient market, the market price
reflects the aggregate input of all market participants (Fabozzi and
Modigliani 2003).
Types of players in the Financial Markets
Financial markets comprise five key components: the debt market, the equity
market, the foreign-exchange market, the mortgage market, and the derivative
market.
1. Debt instruments are traded in the debt market, the bond market. The debt
market is important to economic activities because it provides an important
channel for corporations and governments to finance their operations.
Interactions between investors and borrowers in the bond market determine
interest rates.
2. Equity instruments are traded in the equity market, also known as the stock
market. It is important because fluctuations in stock prices affect
investors’ wealth and hence their saving and consumption behavior, as well as
the amount of funds that can be raised by selling newly issued stocks to finance
investment spending.
Types of players in the Financial Markets
3. Foreign-exchange markets are where currencies are converted so that funds can be
moved from one country to another. Activities in the foreign-exchange market
determine the foreign-exchange rate, the price of one currency in terms of another.
4. A mortgage is a long-term loan secured by a pledge of real estate. Mortgage-
backed securities (securitized mortgages) are securities issued to sell mortgages
directly to investors. The securities are secured by many mortgages packaged into a
mortgage pool. The most common type of mortgage-backed security is a mortgage
pass-through, a security that promises to distribute to investors the cash flows from
mortgage payments made by borrowers in the underlying mortgage pool. A 1980s
innovation in the mortgage-backed security market has been the collateralized-
mortgage obligation (CMO), a security created by redistributing the cash flows of the
underlying mortgage pool into different bond classes. Mortgage-backed securities
have been a very important development in financial markets in the 1980s and 1990s.
Types of players in the Financial Markets
5. Financial derivatives are contracts that derive their values from the
underlying financial assets. Derivative instruments include options
contracts, futures contracts, forward contracts, swap agreements, and
cap and floor agreements. These instruments allow market players to
achieve financial goals and manage financial risks more efficiently. Since
the introduction of financial derivatives in the 1970s, markets for them
have been developing rapidly.
CLASSIFICATION OF FINANCIAL
MARKETS
• Financial markets can be categorized in different several ways, revealing features of various market
segments. One popular way to classify financial markets is by the maturity of the financial assets traded.
The money market is a financial market in which only short-term debt instruments (original maturity of
less than one year) are traded. The capital market is a market in which longer-term debt (original maturity
of one year or greater) and equity instruments are traded. In general, money-market securities are more
widely traded and tend to be more liquid.

• Another way to classify financial markets is by whether the financial instruments are newly issued. A
primary market is a financial market in which a borrower issues new securities in exchange for cash from
investors. Once securities are sold by the original purchasers, they may be traded in the secondary
market. Secondary markets can be organized in two ways. One is as an organized exchange, which brings
buyers and sellers of securities together (via their representatives) in one central location to conduct
trades. The other is as an over-the-counter (OTC) market, in which over-the-counter dealers located at
different sites but connected with each other through computer networks undertake transactions to buy
and sell securities “over the counter.” Many common stocks are traded over the counter, although shares
of the largest corporations are traded at organized stock exchanges, such as the New York Stock Exchange.
Primary Market
• The primary market is where securities are created, while the
secondary market is where those securities are traded by investors.
• In the primary market, companies sell new stocks and bonds to the
public for the first time, such as with an initial public offering (IPO).
• The primary markets for securities are not well known to the public
because the selling of securities to initial buyers often takes place
behind closed doors. An important financial institution that assists in
the initial sale of securities in the primary market is the investment
bank.
Secondary Market
• The secondary market is basically the stock market and refers to the
New York Stock Exchange, the Nasdaq, and other exchanges worldwide.
• When an individual buys a security in the secondary market, the person
who has sold the security receives money in exchange for the security,
but the corporation that issued the security acquires no new funds.
• A corporation acquires new funds only when its securities are first sold
in the primary market.
• Nonetheless, secondary markets serve two important functions. First,
they make it easier to sell these financial instruments to raise cash; that
is, they make the financial instruments more liquid.
Financial Markets
• Another way of distinguishing between markets is on the basis of the
maturity of the securities traded in each market.
• The money market is a financial market in which only short-term debt
instruments (generally those with original maturity of less than one
year) are traded;
• the capital market is the market in which longer term debt (generally
those with original maturity of one year or greater) and equity
instruments are traded. Money market securities are usually more
widely traded than longer-term securities and so tend to be more
liquid.
Money Market Instruments
• There are many money market instruments but we will discuss 5
1. Treasury bills are the most liquid of all the money market instruments because they are the most
actively traded. They are also the safest of all money market instruments because there is almost
no possibility of default.
2. A certificate of deposit (CD) is a debt instrument sold by a bank to depositors that pays annual
interest of a given amount and at maturity pays back the original purchase price. CDs are often
negotiable. These negotiable CDs are issued in multiples of $100 000 and with maturities of 30 to
365 days, and can be resold in a secondary market, thus offering the purchaser both yield and
liquidity.
3. Commercial paper is an unsecured short-term debt instrument issued by large banks and big
corporations, such as Microsoft. Because commercial paper is unsecured, only the largest and most
creditworthy corporations issue commercial paper. The interest rate the corporation is charged
reflects the firm’s level of risk. The interest rate on commercial paper is low relative to those on
other corporate fixed-income securities and slightly higher than rates on government treasury bills
Money Market Instruments
4. Repurchase agreements/repos: are short-term loans (usually with a maturity of less than
two weeks) for which treasury bills serve as collateral, an asset that the lender receives if the
borrower does not pay back the loan. Repos are made as follows: a large corporation may have
some idle funds in its bank account, say $1 million, which it would like to lend for a week. The
corporation uses this excess $1 million to buy treasury bills from a bank, which agrees to
repurchase them the next week at a price slightly above the corporation’s purchase price. The
effect of this agreement is that the corparation makes a loan of $1 million to the bank and
holds $1 million of the bank s treasury bills until the bank repurchases the bills to pay off the
loan.
5. Overnight funds: are overnight loans by banks to other banks. The overnight funds
designation is somewhat confusing, because these loans are not made by the government or
by the central Bank, but rather by banks to other banks. One reason why a bank might borrow
in the overnight funds market is that it might find it does not have enough settlement deposits
at the Bank of Canada. It can then borrow these balances from another bank with excess
settlement balances.
 Capital market instruments
Capital market instruments are debt and equity instruments with maturities of greater than one year.
They have far wider price fluctuations than money market instruments and are risky investments.
1. STOCKS: are equity claims on the net income and assets of a corporation. The amount of new
stock issues in any given year is typically quite small less than 1% of the total value of shares
outstanding. Individuals hold around half of the value of stocks; pension funds, mutual funds, and
insurance companies hold the rest.
2. MORTGAGES: are loans to households or firms to purchase housing, land, or other real
structures, where the structure or land serves as collateral for the loans. The mortgage market is
the largest debt market.
3. CORPORATE BONDS: These are long-term bonds issued by corporations with very strong credit
ratings. The typical corporate bond sends the holder an interest payment twice a year and pays
off the face value when the bond matures. Some corporate bonds, called convertible bonds, have
the additional feature of allowing the holder to convert them into a specified number of shares of
stock at any time up to the maturity date.
Capital market instruments
• GOVERNMENT BONDS: Intermediate-term bonds (those with initial
maturities from 1-10 years) and long-term bonds (those with initial
maturities greater than 10 years) are issued by the government to
finance its deficit. Because they are the most widely traded bonds,
they are the most liquid security traded in the capital market. They
are held by the central bank, banks, households, and foreign
investors.
• CONSUMER AND BANK COMMERCIAL LOANS: These are loans to
consumers and businesses made principally by banks, but in the case
of consumer loans also by finance companies
Botswana Stock Market (BSE)
• The stock market refers to public markets that exist for issuing,
buying, and selling stocks that trade on a stock exchange or over-the-
counter. Stocks or equities, represent fractional ownership in a
company, and the stock market is a place where investors can buy and
sell ownership of such investible assets. An efficiently functioning
stock market is considered critical to economic development, as it
gives companies the ability to quickly access capital from the public.
Functions of BSE
• Economic Barometer: Stock exchange serves as an economic barometer that is indicative of the state
of the economy. It records all the major and minor changes in the share prices. It is rightly said to be
the pulse of the economy, which reflects the state of the economy.
• Valuation of Securities: Stock market helps in the valuation of securities based on the factors of supply
and demand. The securities offered by companies that are profitable and growth-oriented tend to be
valued higher. Valuation of securities helps creditors, investors and government in performing their
respective functions.
• Transactional Safety: Transactional safety is ensured as the securities that are traded in the stock
exchange are listed, and the listing of securities is done after verifying the company’s position. All
companies listed have to adhere to the rules and regulations as laid out by the governing body.
• Contributor to Economic Growth: Stock exchange offers a platform for trading of securities of the
various companies. This process of trading involves continuous disinvestment and reinvestment, which
offers opportunities for capital formation and subsequently, growth of the economy.
• Making the public aware of equity investment: Stock exchange helps in providing information about
investing in equity markets and by rolling out new issues to encourage people to invest in securities.
Functions of BSE
• Offers scope for speculation: By permitting healthy speculation of the traded securities,
the stock exchange ensures demand and supply of securities and liquidity.
• Facilitates liquidity: The most important role of the stock exchange is in ensuring a ready
platform for the sale and purchase of securities. This gives investors the confidence that
the existing investments can be converted into cash, or in other words, stock exchange
offers liquidity in terms of investment.
• Better Capital Allocation: Profit-making companies will have their shares traded actively,
and so such companies are able to raise fresh capital from the equity market. Stock
market helps in better allocation of capital for the investors so that maximum profit can
be earned.
• Encourages investment and savings: Stock market serves as an important source of
investment in various securities which offer greater returns. Investing in the stock
market makes for a better investment option than gold and silver.
Origins of BSE
• Formally established in 1989, the Botswana Stock Exchange (BSE) trace its
humble beginnings to when it was known as Botswana Share Market (BSM).
At that time there was no formal stock exchange in Botswana and the BSM
traded as an informal market with only 5 listed entities and a single broking
firm.
• In order to encourage foreign investors to botswana, an interim exchange
committee was set up in october 1990 with representatives from the private
and public sector, including the secretary of the Zimbabwe stock exchange.
• In september 1994, the legislation to transform the BSE into a full exchange
was passed by Parliament paving the way for the establishment of the
Botswana Stock Exchange where trading opened in November 1995.
BSE Products
• Equities, bonds, Exchange Trade Products and Commercial Papers are traded on BSE.
1. Venture capital: is a form of private equity financing that is provided by venture capital firms or
funds to startups, early-stage, and emerging companies that have been deemed to have high
growth potential or which have demonstrated high growth
2. Government bonds
3. Corporate bonds
4. Exchange traded funds: a type of investment fund/ exchange-traded product, traded on stock
exchanges. ETFs are similar in many ways to mutual funds, except that ETFs are bought and sold
throughout the day on stock exchanges while mutual funds are bought and sold based on their
price at day's end
5. Quasi-government bonds: National governments establish quasi-government organizations, which
have both public and private sector characteristics. These entities issue quasi-government bonds or
agency bonds. Quasi-government bonds are also rated very high due to extremely low default
rates. These bonds are not guaranteed by national governments, yet investors often perceive an
implicit guarantee.
BSE Products
• Supranational agencies or multilateral agencies could issue bonds that
are often highly rated. Some examples include the World Bank, the
International Monetary Fund (IMF), the European Investment Bank
(EIB), and the African Development Bank (ADB). Supranational bonds
are generally plain vanilla bonds, meaning they pay period coupons
and principal at maturity.
• An over-the-counter (OTC): the market is a decentralized market in
which market participants trade stocks, commodities, currencies, or
other instruments directly between two parties and without a central
exchange or broker. Over-the-counter markets do not have physical
locations; instead, trading is conducted electronically.
OTC listing requirements
• Over-the-counter (OTC) refers to the process of how securities are traded via
a broker-dealer network as opposed to on a centralized exchange. Over-the-
counter trading can involve equities, debt instruments, and derivatives, which
are financial contracts that derive their value from an underlying asset such as
a commodity.
• In some cases, securities might not meet the requirements to have a listing on
a standard market exchange such as the New York Stock Exchange (NYSE).
Instead, these securities can be traded over-the-counter.
• However, over-the-counter trading can include equities that are listed on
exchanges and stocks that are not listed. Stocks that are not listed on an
exchange, and trade via OTC, are typically called over-the-counter equity
securities, or OTC equities.
Automated Trading System
• Automated trading systems — also referred to as mechanical trading systems, algorithmic trading,
automated trading or system trading — allow traders to establish specific rules for both trade entries and
exits that, once programmed, can be automatically executed via a computer. In fact, various platforms report
70% to 80% or more of shares traded on U.S. stock exchanges come from automatic trading systems.
• Traders and investors can turn precise entry, exit, and money management rules into automated trading
systems that allow computers to execute and monitor the trades. One of the biggest attractions of strategy
automation is that it can take some of the emotion out of trading since trades are automatically placed once
certain criteria are met.
• The trade entry and exit rules can be based on simple conditions such as a moving average crossover or they
can be complicated strategies that require a comprehensive understanding of the programming language
specific to the user's trading platform. They can also be based on the expertise of a qualified programmer.
• Automated trading systems typically require the use of software linked to a direct access broker, and any
specific rules must be written in that platform's proprietary language. The Trade Station platform, for
example, uses the Easy Language programming language. On the other hand, the Ninja Trader platform
utilizes Ninja Script.
Central Securities Clearing System Plc

• Central Securities Clearing System Plc (CSCS) operates a computerized

depository, clearing, settlement, and delivery system for transactions
in securities. The Company offers transfer of securities from seller to
buyer, payment settlement, and document conversion to electronic
format. CSCS serves customers in Nigeria.