Financial System: What does it means and what such a
INTERNATIONAL CAPITAL MARKETS (MSc)
Introduction. The Role of Financial Markets Set of markets, individuals and institutions which trade in those markets and
the supervisory bodies responsible for their regulation
The end users of the system are people and firms whose desire is o lend and
October, 2nd 2008
Three different approaches for the end-users of most of Financial System
Channels funds from lenders to borrowers
Deal directly with one another (costly, risky inefficient and,
consequently, not very likely) Creates liquidity and money
Provides a payments mechanism
Use one of many organised markets. If the liability is newly issued,
the issuer receives funds directly from the lender. More frequent, buy an Provides financial services such as insurance and pensions
existing liability, secondary transaction (eg. stock exchanges London, Offers portfolio adjustment facilities
New York, Tokyo, etc).
Deal via institutions or “intermediaries”. Lenders have an asset which
cannot be traded but can only be returned to the intermediary
Function of Financial Markets Debt and Equity Markets
In direct Finance (route at the bottom of Figure 1), borrowers borrow funds directly from Firm or individual can obtain funds in two ways:
lenders in financial markets by selling them securities (also called financial instruments),
which are claims on the borrower’s future income or assets Issue a debt instrument (bond or mortgage, which is a contractual agreement by the
borrower to pay the holder of the instrument fixed dollar amounts at regular intervals –
Flows of Funds through the Financial System interest and principal payments – until a specified date - the maturity date – when a final
payment is made.
Short-term, maturity less than a year
Financial Long-term, ten years or longer
Issue equity, such a common stock, which are claims to share in the net income
Lender-Savers Financial Borrower-Spenders
1.Households Funds Markets
Funds 1.Business Firms
2.Business Firms 2. Government
3. Government 3. Households
4. Foreigner 4. Foreigners the the
DIRECT FINANCE UNIVERSITY UNIVERSITY
Primary and Secondary Markets Exchanges and Over-the-Counter Markets
Primary Market: financial market in which new issues of a security, such as a bond or a Secondary markets can be organized in two ways:
stock, are sold to initial buyers by the corporation or government agency borrowing funds Organized exchanges, where buyers and sellers of securities (or their agents or
Secondary Market: financial market in which securities that have been previously issued brokers) meet in one central location to conduct trades.
can be resold. Over-the-Counter (OTC) market, in which dealers at different locations have an
Two main functions: inventory of securities and stand ready to buy and sell securities “over the counter” to
anyone who comes to them and is willing to accept their prices.
Make financial instruments more liquid;
Determine the price of the security that the issuing firm sells in the
Brokers: are agents of investors who match buyers with sellers of securities.
Dealers: Link buyers and sellers by buying and selling securities at stated price
Internationalization of Financial Markets Function of Financial Intermediaries
Funds can move from lenders to borrowers by a second route (see previous figure), called
The traditional instrument in the international bond market are known as foreign bonds Indirect Finance, because it involves a financial intermediary that stands between the
lender-savers and the borrower-spenders and helps transfer funds from one to the other.
Eurobond: a bond denominated in a currency other than that of the country in which it is
sold, eg. A bond denominated in US dollars sold in London These process is called financial intermediation.
Eurocurrencies: foreign currencies that are deposited in banks outside of the home
country. Why are financial intermediaries and indirect finance so important in financial markets?
Eurodollars: US dollars deposited in foreign banks outside of the United States or in Transaction costs, time and money spent in carrying out financial transactions are a
foreign branches of US banks. Similar to short term Eurobonds. major problem/concern for people who have excess funds to lend. Financial intermediaries
can reduce transaction costs because of economies of scale.
Another benefit made by low transaction costs is to reduce the exposure of investors to risk
(uncertainty about the returns investors will earn). FI do this through risk sharing (asset
transformation), creating and selling assets with risk characteristics that people are
Function of Financial Intermediaries (2) Primary Assets and Liabilities of Financial Intermediaries
Asymmetric Information: Adverse Selection and Moral Hazard
Type of Intermediary Primary Liabilities Primary Assets
Source of Funds (Uses of Funds)
In financial markets, one party often does not know enough about the other party to make Depository Institutions
accurate decisions, called asymmetric information (Banks)
Adverse selection, problem created by asymmetric information before the transaction
costs. Commercial Banks Deposits Business and consumer
Adverse Selection in Financial Markets occurs when the potential borrowers who are the loans, mortgages, US
most likely to produce an undesirable (adverse) outcome- -the bad credit risks- are the government securities and
ones who most actively seek out a loan and thus most likely to be selected municipal bonds
Savings and loan Deposits Mortgages
Moral Hazard, problem created by asymmetric information after the transaction costs. Mutual savings banks Deposits Mortgages
Moral Hazard in financial markets is the risk (hazard) that the borrower might engage in
activities that are undesirable (immoral) from the lender’s point of view because they Credit Unions Deposits Consumer loans
make it less likely that the loan will be paid back.
Primary Assets and Liabilities of Financial Intermediaries (2) What do Interest rates mean and what is their role in valuation?
Type of Intermediary Primary Liabilities Primary Assets
Source of Funds (Uses of Funds)
Contractual Savings Institutions
One of the most closely watched variables in the economy
Daily reports by the news media
Life insurance companies Premiums from policies Corporate bonds and mortgages
Yield to maturity, most accurate measure of interest rates (what financial
Fire and casualty insurance Premiums from policies Municipal bonds, corporate bonds economists mean when they use the term interest rate)
companies and stock, US government
Pension funds, government Employer and employee Corporate bonds and stock Present Value or present discounted value
retirement funds contributions
One dollar of cash flow paid in one year from now is less valuable than a dollar paid today
Allows to figure out today’s value of a credit market instrument at a given simple interest
Financial Companies Commercial paper, stocks, bonds Consumer and business loans rate i just adding up the present value of all the future cash flows received
Mutual Funds Shares Stocks, bonds
Money market mutual funds Shares Money market instruments
Types of Credit Market Instruments
1. Simple loan, lender provides the borrower with a amount of funds, which must be
repaid to the lender at the maturity with an additional payment for the interest
2. Fixed-payment loan (full amortized loan), lender provides the borrower with a
10 amount of funds, which must be repaid by making the same payment every period
(such as a month).
8 5 year
1 Year 3. Coupon bond, pays the owner of the bond a fixed interest payment (coupon
payment) every year until the maturity date, when a specified final amount (face
value or par value) is repaid. Three pieces of information: i) corporation or
government agency that issues the bond; ii) maturity date and iii) coupon rate
4. Discount bond (zero-coupon bond), bought at a price below its face value (at a
2 discount), and the face value is repaid at the maturity date
Simple Present Value Fixed Payment Loan
$100,000 mortgage. Interest rate 7%. What is the yearly payment to the bank to pay off
What is the present value of $250 to be paid in two years if the interest rate is 15%?
the loan in 20 years.
PV = = = $189.04
(1 + i )n (1 + 0.15)2 LV =
+ ... +
1 + i (1 + i )2 (1 + i)n
LV = loan amount = $100,000
X borrows from Y and next year Y wants $110 back from X what is the yield to i = annual interest rate = 0.07
maturity of this loan
n = number of years = 20
FP FP FP
CF $110 $100,000 = + + ... +
PV = ⇔ $100 = = 10% 1 + 0.07 (1 + 0.07)2 (1 + 0.07)20
(1 + i)n (1 + i )
Fixed yearly payment: $9,439.29
Coupon Bond Yield to Maturity
Interest rate that equates the present value of cash flows received from a debt instrument
Find the price of a 10% coupon bond with a face value of $1000, a 12.25% YTM, and 8 with is value today.
years to maturity
C C C C Is the yield promised by the bondholder on the assumption that the bond will be held to
P= + + ... + maturity, that all coupon and principal payments will be made and coupon payments are
1 + i (1 + i )2 (1 + i )3 (1 + i )n reinvested at the bond's promised yield at the same rate as invested. It is a measurement
of the return of the bond. This technique in theory allows investors to calculate the fair
100 100 100 1100 value of different financial instruments. The YTM is almost always given in terms of
P= + + ... +
1 + 0.1225 (1 + 0.1225)2 (1 + i0.1225)3 (1 + 0.1225)8 annual effective rate.
The calculation of YTM is identical to the calculation of internal rate of return.
Price of the bond = $889.20
If a bond's current yield is less than its YTM, then the bond is selling at a discount.
If a bond's current yield is more than its YTM, then the bond is selling at a premium.
If a bond's current yield is equal to its YTM, then the bond is selling at par.
Yields to Maturity on a 10% Coupon rate Bond Maturing in 10 years
(Face Value = $ 1,000)
Variants of Yield to Maturity
Price of Bond (4) Yield to Maturity
Given that many bonds have different characteristics, there are some variants of YTM:
1100 8.48 Yield to Call: when a bond is callable (can be repurchased by the issuer before the
1000 10.00 maturity), the market looks also to the Yield to Call, which is the same calculation of the
YTM, but assumes that the bond will be called, so the cash flow is shortened.
800 13.81 Yield to Put: same as Yield to Call, but when the bond holder has the option to sell the
bond back to the issuer at a fixed price on specified date.
1. When the coupon bond is priced at is face value, the YTM equals the coupon rate Yield to Worst: when a bond is callable, "puttable" or has other features, the yield to
worst is the lowest yield of Yield to Maturity, Yield to Call, Yield to Put, and others.
2. The price of a coupon bond and the YTM are negatively related; that is, as the
YTM rises, the price of the bond falls. If the YTM falls, the price of the bond rises
3. The YTM is greater than the coupon rate when the bond price is below its face
Consider a 30-year zero coupon bond with a face value of $100. If the bond is priced at a
Over the remaining 20 years of the bond, the annual rate earned is not 16.26%, but 7%
yield-to-maturity of 10%, it will cost $5.73 today (the present value of this cash flow). Over
the coming 30 years, the price will advance to $100, and the annualized return will be
This can be found by evaluating:
(1 + i ) = (100 25.84)
Suppose that over the first 10 years of the holding period, interest rates decline, and the = 1.07
yield-to-maturity on the bond falls to 7%.
Over the entire 30 year holding period, the original $5.73 invested matured to $100, so
With 20 years remaining to maturity, the price of the bond will be $25.84. 10% annually was made, irrespective of interest rate changes in between
Even though the yield-to-maturity for the remaining life of the bond is just 7%, and the
yield-to-maturity bargained for when the bond was purchased was only 10%, the return
earned over the first 10 years is 16.26%. This can be found by evaluating:
(1 + i ) = (25.84 5.73)
= 1.1626 the the
Real and Nominal Interest rates The Fisher Effect And Expected Inflation
The relationship between nominal and real (inflation-adjusted) interest rates and
Inflation - Rate at which prices as a whole are increasing. expected inflation called the Fisher Effect (or Fisher Equation).
Nominal Interest Rate - Rate at which money invested grows. Nominal rate (r) is approximately equal to real rate of interest (a) plus a premium for
expected inflation (i).
Real Interest Rate - Rate at which the purchasing power of an investment
increases If real rate equals 3% (a = 0.03) and expected inflation equals 2% (i = 0.02):
r ≅ a + i ≅ 0.03 + 0.02 ≅ 0.05 ≅ 5%
1+ nominal interest rate
1 + real interest rate = 1+ inflation rate
True Fisher Effect multiplicative, rather than additive:
Approximation formula (1+r) = (1+a)(1+i) = (1.03)(1.02) = 1.0506; so r = 5.06%
Real int. rate ≈ nominal int. rate - inflation rate
Interest Rates and Returns One-Year Returns on Different-Maturity 10% Coupon Rate Bonds When Interest
Rates Rise from 10% to 20%
Rate of return: payments to the owner plus the change in its value, expressed as a (1) (2) (3) (4) (5) (6)
fraction of its purchase price
Years to Initial Initial Price Price Next Rate of Rate of
Maturity Current ($) Year ($) Capital Return
What would the rate of return be on a bond bought for $1,000 and sold one year later when Bond Yield (%) Gain (%) (2+5)
for $800. The bond has a face value of $1,000 and a coupon rate of 8% is
C + Pt +1 − Pt 30 10 1000 503 -49.7 -39.7
Pt 20 10 1000 516 -48.4 -38.4
Where: R is the rate of return, C the coupon payment, Pt+1price of the bond one year 10 10 1000 597 -40.3 -30.3
later and Pt price of the bond today 5 10 1000 741 -25.9 -15.9
$80 + ($800 − $1,000 )
2 10 1000 917 -8.3 +1.7
R= ⇔ R = - 12% 1 10 1000 1000 0.0 +10.0
Key findings Questions and Quantitative Problems
1. The only bond whose return equals the initial YTM is one whose time to maturity 1. Write down the formula that is used to calculate the yield to maturity on a 10-
is the same as the holding period yaer 8% coupon bond with $1000 face value that sells for $1,200
2. A rise in interest rates is associated with a fall in bond prices, resulting in capital 2. If there is a decline in interest rates, which would you rather be holding, long-
losses on bonds whose terms to maturity are longer than the holding period term bonds or short-term bonds?
3. The more distant a bond’s maturity, the greater the size of the price change 3. “Long-term bonds are a great investment because their interest is over 20%”.
associated with an interest-rate change Is this necessarily right?
4. The more distant a bond’s maturity, the lower the rate of return that occurs as a 4. Calculate the present value of a $1000 zero-coupon bond with 5 years to
result of the increase in the interest rate maturity if the YTM is 6%.
5. Even though a bond has a substantial initial interest rate, its return can turn out 5. You have paid $980.30 for an 8% coupon bond with a face value of $1,000
to be negative if interest rate rises that matures in five years. You plan on holding the bond for one year. If you
want to earn a 9% rate of return on this investment, what price must you sell
the bond? Is this realistic?