Download I. Global Financial Market as a part of Global Financial System

I. Global Financial Market as a part of Global Financial System
The global financial system (GFS) is the financial system which consists of institutions and
regulators that act at the international level. The main players are the global institutions, such as
International Monetary Fund and Bank for International Settlements, national agencies and
government departments, e.g. central banks and finance ministries, private institutions acting on the
global scale, e.g., banks and hedge funds, and regional institutions, e.g., Eurozone.
But GFS it is not only institutions. It conveys (moves) resources from lenders to borrowers,
and transfers risks from those who wish to avoid them to those who are willing to take them. It’s a
complex interactive system. Events in one component may influence others components and can have
significant repercussions elsewhere. There are also complex interactions between financial system and
economy – a malfunction of the financial system can cause a malfunction of the economy, and viceversa. The system is still evolving and developing. To understand it, it’s necessary to know essence
and meaning of elements of financial system.
Functions of GFS

transfer capital from those who own it but do not wish to use it to those who wish to use it but
do not own it.

transfer risk from those who wish to limit their exposure to it, to those who are willing to
accept it.
The main elements of Global Financial System are as follows:
I.
Legal norms (global, national and regional level)
II.
Financial Institutions
III.
Money, Capital
IV.
Financial Markets (essence, role, meaning, importance, function, elements, segments)
V.
VI.
Financial Instruments
Techniques and mechanisms
These elements are related to each other. The link between law and finance is inextricable. It is not
to possible to think of a financial system and financial instruments or services and activity of financial
institutions without a legal system which supports them.
The main participants of the system execute these main functions of financial system using
financial instruments. They can function as issuers of this instruments or as financial intermediaries.
Financial instruments represent many promises (for payment),e.g.

to make fixed payments (which are represented by bonds);

to pay dividends (which are represented by shares;

to provide retirement income (which are represented by pension agreements); to bear some of
the costs of accidents or financial losses (which are represented by insurance policies),

to provide a cash flow, such as mortgage repayments (which are represented by securitised
assets)

and many other less or more sophisticated promises which are represented by derivatives.
The financial system includes specialized markets, that enable trade of financial instruments.
The functioning of particular segments of financial market are regulated by custom, rules and
legislation,
Important institution on global financial markets
1. International institutions:
1.1. The International Monetary Fund keeps account of international balance of payments
accounts of member states. The IMF acts as a lender of last resort for members in financial
difficult situations, e.g., currency crisis, problems in balance of payment and debt default.
Membership is based on quotas, or the amount of money a country provides to the fund
relative to the size of its role in the international trading system;
1.2. The World Bank aims to provide funding, take up credit risk or offer favourable (good) terms
to development projects mostly in developing countries. The other multilateral development
banks and other international financial institutions also play specific regional or functional
roles.
1.3. The Bank for International Settlements, the intergovernmental organization for central
banks worldwide. It has two subsidiary (dependent) bodies - the Basel Committee on
Banking Supervision, and the Financial Stability Board.
1.4. The World Federation of Exchanges, the organization brings together the most developed
stock markets in the world
1.5. The Institute of International Finance, which includes most of the world's largest
commercial banks and investment banks (in private sector).
2. Government institutions:
2.1. Finance Ministries: they pass the laws and regulations for financial markets, and set the tax
burden for private players, e.g., banks, funds and exchanges. They are closely tied (though in
most countries independent) to central banks that issue government debt, set interest rates and
deposit requirements, and intervene in the foreign exchange market.
2.2. Central Banks
The important functions of Central Banks are as follows:

Sole right of bank notes issue. The Central Bank in every country, now, has the sole
authorities to issue bank notes and coins and also special types of bonds.

Bank of the State. The Central Bank is banker to the government. It also acts as financial
agents for the government (eg in the case of purchasing and selling the gold and foreign
exchange).

Bank of banks. The Central Bank acts as a banker to the commercial banks. It is the lender of
the last resort (eg the Central Bank helps commercial banks in times of crisis).

The Central Bank acts as a clearing house. It enables the realization of settlements of mutual
obligations among different commercial banks.


Stabilizing and control functions of CB:

Regulation of the amount of money in circulation and credit

Regulation of the financial system and the capital market

Creating employment in the country,

Care about a favorable inflation,

Care about the achievement of a favorable balance of payment.
Many External functions
 participating and operation with foreign or international financial
bodies,
 contract all kinds of credits abroad,

issuing securities and place them abroad,
 granting credits to international or foreign states, central banks, banks
and financial institutions,
 managing and disposition of its foreign currency reserves in the
country or abroad.

The Statistical functions. The Central Bank has to publish the main national macroeconomic
data, (concerning monetary policy, banking system, currency, balance of payments, national
accounts...
3. Private participants:

Commercial banks

Hedge funds and Private Equity

Pension funds

Insurance companies – restore loss, spread risk

Mutual funds
Commercial banks functions:

Acceptance of Deposits

Types of deposits: times deposits (e.g. fixed deposits, Recurring Deposits, Cash
Certificates), demand deposits called also current deposits, saving deposits.
They are passive banking operations - through which banks form a financial resource
for future and use it in an active banking operations

Making loans (granting loans) and advances. The forms of lending money:

Cash credit. In this type of credit scheme, banks advance loans to its customers
on the basis of bonds, inventories and other approved securities,

Overdrafts - Banks advance loans to its customer’s up to a certain amount
through over-drafts, if there are no deposits in the current account. For these
banks demand a security from the customers and charge very high rate of interest.

Discounting of Bills. This is the most prevalent and important method of
advancing loans to the traders for short-term purposes. Under this system, banks
advance loans to the traders and business firms by discounting their bills. In this
way, businessmen get loans on the basis of their bills of exchange before the time
of their maturity.
They are active banking operations - through which banks place their available financial resources

Intermediate operations. Clearing operatio ns, settlements. Performance of individual
customers' orders for a fee - the commission.

Investment of Funds.
The banks invest their surplus funds in many types of securities - e.g. Government
securities (treasury bills, national savings certificate etc.) and other securities.

Additional operations - Banks can:

collect cheques, drafts, bills

make payment for their clients and at times accept the bills of exchange,

pay insurance premium of their customers,

purchase and sell securities,


arrange to send money from one place to another.
Additional operations - Banks can

rent the lockers for the safe custody of valuable assets of their customers such as
gold, silver, legal documents ,etc.,

give reference for their customers,

collect necessary and useful statistics relating to trade and industry.

sell and purchase foreign exchange.
Players active in the stock-, bond-, foreign exchange-, derivatives- and commodities-markets,
and investment banking
Mutual funds They are very popular type of investments, especially for the passive investor. The
main advantages of mutual funds are: management of money by professionalists, diversification of
portfolio (different financial instruments), risk mitigation, accessibility for many investors, liquidity, ...
Hedge funds and Private Equity They are alternative ways of risky long-term investment which
cannot be correlated with financial market represented by traditional financial instruments. From the
other hand it is a possibility for long term financing for many enterprises (for example new and
modern).
Pension Funds The main function of pension fund is to enable the employed people to live a
comfortable life when they finish their regular work. The pension fund helps the working
employees to save money to keep the same standard of living after their retirement. Pension
funds can invest in hedge funds and in private equity.
II. A. Changes in the value of the capital in the time (of a single amount)
The simple capitalizing the interest or The Simply Interest
This method as the name suggests is quite simple. The result of simple capitalizing is just original
principal and interest on it.
I = Capital x rate% x time
and
Interest (I) is calculated by multiplying Capital times the Rate times the Time
Exercise 1.
100
I=10
110
PV
1 year
FV
What is the annual Interest Rate and annual Discount Rate?
Construction of Interest Rate and Discount Rate
Interest Rate
The annual interest rate is the annual interest divided by the capital (PV). It also can by
calculated on the basis on discount rate as discount rate divided by 100% (or 1) minus the
discount rate (taking into account the time.
Discount Rate
The annual discount rate is the annual interest divided by the capital including that Interest
(FV). It also can be calculated on the basis on the Interest Rate as:
Interest
I = Capital x Interest Rate x time =>
I = PV x r x t
I = FV x d x t
or
Exercise 2.
What simple interest rate is equivalent to the simple discount rate 7.5% in discounting an
amount a) in 12 months, b) in 6 months?
The longer the duration means the greater the difference between the interest rate and
the discount rate.
Futures Value (FV) - Simple Interest
FV = PV + I
I = PV x r x t
PV – principal, Present value amount (e.g. the amount of a single deposit made at the present time, a
present account balance, the present cost of an item, etc.)
FV – amount, Future value amount, the amount that the present value will grow to (e.g. the account
balance in the future)
r - interest rate per period
t - time
(1+rt) – simple accumulation factor
We have four components. If you know any three of these four components, you will be able
to calculate the unknown component. And the transformation of the main formula
Present Value (PV) – Simple Interest (using interest rate r)
PV calculations can show how much money to invest right now in return for given cash
amounts to be received in the future.
PV - principal
FV - amount
r - interest rate
t - time
I - interest earned
Present Value Factor ( also Discount Factor) - Simple Interest
Present Value (PV) – Simple Interest (using discount rate d)
PV = FV(1-dt)
Exercise 3.
You can use deposit as a way to earn money. You want to invest $1500 in deposit and this deposit
earns 6% simple interest per year (on its purchase price). How much will it earn in interest and the
balance of the account after
a) 2 years ?
b) 5 months ?
Exercise 4.
Find the unknown quantity for an account that earns simple interest.
FV = $555
PV = $500
t = 2 years
r=?
Exercise 5.
Find the unknown quantity for an account that earns simple interest.
FV = $6050
PV = $5500
t= ?
r = 5%
Nominal Interest Rates vs. Real Interest Rates
A nominal interest rate has not been adjusted for inflation.
A real interest rate has been adjusted for inflation.
Approximately:
But it is not exact result.
The exact relationship between nominal interest rate, real interest rates and rate of inflation is
represented by formula:
Exercise 6. Find the real interest rate (approximate and exact result).
Year
CPI
i
rnominal
rreal (approximate)
rreal (exact)
0
100
-
-
-
-
1
110
15%
2
120
13%
3
115
8%
II. B. The compound capitalizing the interest or the compound the Interest
The "com" in compound also means a bit more “com”plicated.
The result of compound capitalizing are original principal and interest on principal and also interest
on the accumulated interest.
Calculating future value FV
PV - principal
FV - amount
r - interest rate per period. For example, if interest is to be compounded monthly, then a rate of 6% per
year will be restated to be 0,5% per month
n - number of compounding periods. Number of time periods that interest will be added and
compounded over the life of the deposit
Exercise 1.
A single amount of $10,000 will be deposited into an account for one year. The depositor may select
one of three accounts and each of the accounts pays interest of 4% per year. But these accounts differ
in frequency of interest compounding.
a) Account 1. Interest is compounded annually.
b) Account 2. Interest is compounded semiannually
c) Account 3. Interest is compounded quarterly
What is the future value on each of these accounts.
Number of
PV
r per
period of
year
capitalization
account
number of
r per
number
period in
period
of period
the year
( r)
(n)
accumulation
factor
FV
Account 1
Account 2
Account 3
Try to find FV in the case when amount of $10,000 will be deposited into an account for two
years.
Number of
account
PV
r per
period of
year
capitalization
number of
r per
number
period in
period
of period
the year
( r)
(n)
accumulation
factor
FV
Account 1
Account 2
Account 3
Try to find FV in the case when amount of $10,000 will be deposited into an account for half
year.
Number of
account
Account 1
PV
r per
period of
year
capitalization
number of
r per
number
period in
period
of period
the year
( r)
(n)
accumulation
factor
FV
Account 2
Account 3
Exercise 2.
The bank offers an interest rate of 8% per year on a savings account. A person deposits
$2,000 in the bank. How much money will be in his account at the end of ten year, If
a) the saving account is compounded quarterly ?
b) the saving account is compounded quarterly ?
c) the saving account is compounded monthly ?
d) the saving account is compounded once every two years ?
Calculating parameters PV, r, n
The restate the formula
allows to get following parameters: PV, r, n (Compounded Interest.
And the transformation of formula:
III. Global Financial Market
Financial market is a market in which people and entities can trade financial
instruments, commodities, and other fungible items of value at low transaction costs and at
prices that reflect supply and demand. Securities include stocks and bonds, and commodities
include for example precious metals or agricultural goods.
Markets work by placing many interested buyers and sellers, including households,
firms, and government agencies, in one "place", thus making it easier for them to find each
other. More often it is a virtual space.
(On the margin) In economics, typically, the term market means the aggregate of
possible buyers and sellers of a certain good or service and the transactions between them.
Financial markets facilitate:




The raising of capital (in the capital markets)
The transfer of risk (in the derivatives markets)
Price discovery
The transfer of liquidity (in the money markets) – creating the liquidity of economic
entities
 International trade (in the currency markets)
 Global transactions with integration of financial markets
 and are used to match those who want capital to those who have it.
There are many types of financial market: (characteristics, meaning)
Classifications (and criteria):
1. Maturity term of financial instruments
Money market - short-term instruments maturing within a period of one year are
traded in money market
Capital market - include long term instruments, transactions. Capital market deals
with longer maturity financial assets (and claims)
Table1. The main differences between money market and capital market
Criteria
Money market
Capital market
Maturity period of
Short – term instruments
Long-term instruments
instruments
Main types of instruments
inter-corporate deposits,
Securities, long-term bonds,
certificate of deposits,
mutual funds units
treasury bills, commercial
papers, commercial bills
Typical participants/entities
large institutional investors,
Also small individual
investor
commercial banks, mutual fu
Size of market
Financial Centers
nds, and corporate bodies
Wholesale market
London, NY, Tokyo
Lower value of transactions
NY, London, Tokyo,
Frankfurt, Amsterdam, Paris
Local range: Paris, Milan,
Brussels, Zurich, Frankfurt,
Amsterdam
A. Difference and demarcation between money market and capital market is made
on the basis of maturity period of instruments and claims.
CM include long-term financial instruments having maturity of more than one year
( short-term instruments only).
A. Capital market includes trading in securities, mutual fund units and government
debt instruments. On the other hand money market facilitates dealings in shortterm financial instruments such as inter-corporate deposits, certificate of deposits,
treasury bonds, commercial papers, commercial bills, etc.
B. Money market is a wholesale. On capital market the value of individual
transactions may be lower.
C. The main money markets in the world are London, NY, Tokyo and local range
markets as Paris, Milan, Brussels, Zurich, Frankfurt, Amsterdam. The main capital
markets are NY, London, Tokyo and Frankfurt, Amsterdam, Paris
D. The money market is not institutionalized. There are no stock exchanges on money
market. There are many stock exchanges on capital market.
E. Function:
Functions of Money Market and Capital Market
a. Money Market (MM)
The major functions of Money Market :
MM provides help to Trade and Industry. MM provides adequate finance to trade and
industry. Similarly it also provides facility of discounting bills of exchange for trade and
industry. MM helps in keeping a short-term liquidity in financial institutions and nonfinancial enterprises.
The main function of MM are:
–
Transfer of short-term funds from borrower to lender,
–
Provide a good (satisfactory) return of funds,
–
Create a possibility to manage of liquidity in financial institutions and enterprises.
MM performs also functions to States, governments and monetary authorities (additional
function).
 MM makes it easy to keep a balance between the demand for and supply of money for
short term monetary transactions.
 Money market can do this by making funds available to various units in the economy
such as agriculture, small scale industries, etc.
 It provides a mechanism for an effective implementation of the monetary policy.
 Money market makes available investment possibilities (avenues) for short term
period. It helps in generating savings and investments in the economy.
 It is possible by issuing treasury bills in order to raise short loans. However this does
not lead to increases in the prices.
b. Capital Market
1. Capital market is an important source for mobilizing idle savings from the economy. It
mobilizes funds from people for further investments in the productive channels of economy.
In that sense it activate the ideal monetary resources and puts them in proper investments.
2. Capital market helps in capital accumulation. Capital formation is net addition to the
existing stock of capital in the economy. Through mobilization of ideal resources it generates
savings; the mobilized savings are made available to various segments such as agriculture,
industry, etc. This helps in increasing capital formation.
3. Capital market supplies resources for longer periods of time. Thus it provides an
investment possibilities (avenue) for people who wish to invest resources for a long period of
time. It provides suitable interest rate returns also to investors. Instruments such as bonds,
equities, units of mutual funds, insurance policies, etc. definitely provides diverse investment
avenue for the public.
4. Capital market can increase production and productivity in the national economy. As it
makes funds available for long period of time, the financial requirements of business houses
are met by the capital market. It helps in research and development. This helps in, increasing
production and productivity in economy by generation of employment and development of
infrastructure.
5. Capital markets not only helps in fund mobilization, but it also helps in proper allocation of
these resources. It can have regulation over the resources so that it can direct funds in a
qualitative manner.
6. Capital market provides various types of services. It includes long term and medium term
loans to industry, underwriting services, consultancy services, export finance, etc. These
services help the manufacturing sector in a large spectrum.
7. Capital market is place where the investment avenue is continuously available for long term
investment. This is a liquid market as it makes fund available on continuous basis. Both
buyers and seller can easily buy and sell securities as they are continuously available.
Basically capital market transactions are related to the stock exchanges. Thus marketability in
the capital market becomes easy.
F. Possibilities of investment
Possibilities of investment at money market:
–
direct investment - it can be realized using money market instruments (typically
for institutional investors due to large size of transactions).
–
investment in money market funds - it can be realize indirectly using shares in
funds (e.g. mutual fund units) which specialize in investment in money market
instruments.
–
"saving" in money market account - it can be realized by using one of offers of
banks or other financial institutions (e.g. financial unions). This type of account
can be opened as a savings account.
Possibilities of investment at Capital market
2. Geographical range criterion
a. Global market
b. International market (e.g. Regional, Financial Market Group: Asian emerging
markets, BRIC countries Brazil, Russia, India and China)
c. National market
Regardless of the kind of market, each of them can be divided by money market and capital
market, primary market and secondary market, and so on.
3.
Criterion: the seller of financial instrument (the issuer or the investor)
Primary market – the issuer of instrument is the seller
Secondary market – the investor, which purchased the instrument earlier (on primary or
secondary market) is the seller.
Primary Market
The Primary Market is also called the new issue market. It’s market where securities are
created and where firms (the issuer) sell new stocks and bonds to the public for the first time
(Initial Public Offerings - IPO). The transactions in primary markets transactions are carried
out between issuers and investors.
Usually, these securities are sold by investment banks who handle the offering directly to their
customers or to the customers of their selling groups. If the offering is a hot item, then the
investment banks may restrict the sale to their best customers. Generally, the investment
banks (underwriters) determine the initial price of the stocks or bonds (issue price).
The main service functions of primary market are related to issuance of financial instruments:
organization and conducting the new issue.
On the primary market, each security can be sold only once, and the process to create series of
new shares or bonds is often very long due to regulatory requirements.
When securities are sold on the primary market, the main recipient of funds is the company
issuing the securities.
Primary markets act as a source of new funds for the company issuing the stocks or bonds.
Underwriters often reserve for themselves and their important clients a portion of the primary
shares as part of their commission.
Money market (MM) is the market where money and it’s equivalent are traded.
Because money is synonym of liquidity, MM provides liquidity funding for the global
financial system. The money market is component of the financial market for assets
involved in short term borrowing and lending with maturities no longer than one year.
Trading on this market involves: inter-corporate deposits, certificate of deposits, treasury
bills, repurchase agreement, commercial papers, commercial bills. These short-time
financial instruments are commonly called "papers”. On the money market act financial
institutions and dealers who want either to borrow or lend the money (for short time). On
this market financial institutions and governments manage their short term cash needs.
The core of the MM is the interbank market. Banks borrowing and lending to other
participants using short time financial instruments (e.g. commercial papers, repurchase
agreement and similar instruments).
Secondary Market
The secondary market (also called aftermarket) is the financial market in which previously
issued financial instruments such as stock, bonds, options, and futures are bought and sold. It
means, that it is the market in which securities are traded after they are initially offered in the
primary markets. That means, that secondary markets allow investors to buy and sell existing
securities. The transactions in secondary market transactions are carried out among investors.
On the secondary markets, there is no limit on the number of times a security can be traded,
and the process is usually very quick. With the rise of strategies such as high frequency
trading, a single security could in theory be traded thousands of times within a single hour.
The secondary market is where the stocks and bonds and other securities held by investors are
sold, usually through organized stock exchanges or in the over-the-counter market. The prices
of the securities in the secondary market are determined by supply and demand (equalizing
supply with demand).
When a transaction is conducted on the secondary market, the investor (individual or mutual
fund) that owns and sells a security receives the money.
Liquidity is a crucial aspect of securities that are traded in secondary markets. Liquidity refers
to the ease with which a security can be sold without a loss of value. Securities with an active
secondary market mean that there are many buyers and sellers at a given point in time.
Investors benefit from liquid securities because they can sell their assets whenever they want;
an illiquid security may force the seller to get rid of their asset at a large discount.
... Sometimes the classification arises as the result of many criteria
4. Criterion: the specificity of the instrument (and maturity term of financial
instruments)
 Capital markets which consist of:
o Stock markets, which provide financing through the issuance of shares or
common stock, and enable the subsequent trading thereof.
o Bond markets, which provide financing through the issuance of bonds, and
enable the subsequent trading thereof.
 Money markets, which provide short term debt financing and investment.
 Derivatives markets, which provide instruments for the management of financial risk.
 (Future markets, which provide standardized forward contracts for trading products at
some future date; see also forward market)
 Foreign exchange markets, which facilitate the trading of foreign exchange.
It can be also specified:
 Credit Markets, a marketplace for the exchange of debt securities and short-term
commercial paper, for those who do not have access to money market and capital
market
Insurance markets, which facilitate the redistribution of various risks.
 Commodity markets, which facilitate the trading of commodities.
5. Numerous and kinds of items of trade – general market and specialized market
There are both general markets (where many commodities are traded) and specialized
markets (where only one commodity is traded).
IV. Financial Instruments
Classifications:
There are many classifications of financial instruments in the literature. They using
different criteria.
In general financial instruments (securities) could be categorized into:

debt securities (e.g. bonds)
Debt items can be classified by maturity. There are short and long term: short-term
debt is one year or less, long term debt is more than one year. In some classifications
are specified short-term, medium-term and long term maturity. In these cases
medium-term maturity that is, two (sometimes three) years or less, but more than one
year. The next classification of debt instruments divide them also on variable - rate
instruments and fixed-rate instruments. This is the supplementary breakdown.

equity securities (e.g. stocks)
Stocks can be either common stock or preferred stock.

derivative contracts (e.g. forward, futures, options, swaps)
Stocks vs. Bonds
Stocks/shares and bonds are financial instruments for investors to obtain a return and for
companies to raise capital. They both are instruments of capital market. But there are many
differences between them.
STOCKS
Stocks of a company are offered at the time of an IPO (Initial Public Offering) or later
equity sales. IPO is a type of public offering where shares of stock in a company are sold to the
general public, on a securities exchange, for the first time. Stocks can be either common stock or
preferred stock. The value of stocks corresponds to the value of the company and therefore,
stock price fluctuates depending upon how the market values the company. Stocks are
risky instrument.
Types of shares/stocks
Ordinary shares. Most companies have just ordinary shares. They give one vote per share,
are entitled to participate equally in dividends and, if the company is wound up, share in the
assets (proceeds) of the company after all the debts have been paid.
Preference shares. They usually have a preferential right to a fixed amount of dividend.
They may also have a priority on return of capital on a winding up. Preference share are
often non-voting.
Non-voting shares. Non-voting shares carry no rights to attend general meetings or vote.
Such share are widely used to issue to employees so that some of their remuneration can be
paid as dividends, which can be more tax-efficient for the company and the employee. This
type of shares are also sometimes issue for members of the main shareholders' families.
Voting shares, dividend shares, capital shares. Sometimes three classes of shares are
created with class 'A' having all the voting rights, class 'B' having all the dividend rights
and class 'C' having all the capital rights. It is then possible for the different shareholders to
have different percentages of the rights for these purposes.
Management shares. A class of shares carrying extra voting rights so as to retain control of
the company in particular hands.
BONDS
Bonds are loans offered at a fixed interest rate.
Corporate bonds. They are issue when company believes that it can raise capital cheaper by borrowing
money from banks (interest-paying corporate bonds).
Generally bonds are "safer" than stocks because of lower volatility, Additionally, some of them are
zero-risky (Treasury bonds) or very low risky (some municipal bonds). But It should be noted that
there is always a chance that company will be unable to repay bond-holders. In that sense, bonds are
not "risk-free".
Types of Bonds
Treasury bonds (T-Bonds) and treasury notes (T-Notes) vs treasury bills T-Bills). They are
government debt issued by Departments of the Treasury in particular country. All of
treasury securities are often called simply as “Treasuries”. The most important treasury
securities: treasury bills (T-Bills), treasury bonds (T-Bonds), treasury notes (T-Notes) differ
in the length until maturity:

Treasury bills are issued for terms less than a year.

Treasury notes are usually issued for 2, 3, 5, and 10 years.

Treasury bonds are issued for longer than ten years (even for several decades).
All of them are also often referred as "Treasury bonds" (especially T-Notes). They are very
safe financial instrument (zero risk instrument) with not very high return.
Sometimes are also issued Treasury Inflation Protected Securities (TIPS).
Classification:
Marketable bonds – can be transferred through market sales. They are heavily traded on
secondary market and are usually very liquid (e.g. treasury bond).
Non-marketable – are issued to subscribers and cannot be transferred through market
sales (e.g. State and Local Government Series (SLGS), saving bonds)
In today's financial markets, the distinction between stocks and shares has been somewhat
blurred. Generally, these words are used alternately to refer to the pieces of paper that
denote ownership in a particular company, called stock certificates. However, the
difference between the two words comes from the context in which they are used.
For example, "stock" is a general term used to describe the ownership certificates of any
company, in general, and "shares" refers to a the ownership certificates of a particular
company.
Financial Instruments (Derivatives)
Forwards vs. Futures
Because these instruments are the function of an underlying asset, they are considered a
derivative product.
Futures contracts are standardized instruments transacted through brokerage firms on the
exchange to buy or sell a certain underlying instrument at a certain date in the future, at a
specified price. The terms of a futures contract include: delivery places and dates, volume,
technical specifications, and trading and credit procedures and they are standardized for each
type of contract.
They have a form of an agreement between two parties to buy or sell an asset (which can be
of any kind) at a pre-agreed future point in time at a specified price. Forward contracts are not
traded at the stock exchange and are therefore regarded as over-the-counter (OTC)
instruments. Forward contracts are very popular because they are unregulated by the
government, they provide privacy to both the buyer and seller, and they can be customized to
meet both the buyer's and seller's specific needs. In the case of forwards contracts all the
terms of the contract are privately negotiated between parties. They can be keyed to almost
any conceivable underlying asset or measure. The settlement date, notional amount of the
contract and settlement form (cash or physical) are entirely up to the parties to the contract.
Futures
Forwards
Definition
Standardized contract to
buy or sell a certain
underlying instrument at a
certain date in the future,
at a specified price
The agreement between two
parties to buy or sell an asset
(which can be of any kind) at
a pre-agreed future point in
time at a specified price.
Contract Maturity
Future contracts may not
necessarily mature by
delivery of commodity.
Forward contracts generally
mature by delivering the
commodity
Stock -exchanges
OTC
Terms of trade
Standardized delivery places
and dates, volume, technical
specifications, trading and
credit procedures,
standardized for each type of
contract.
All the terms of the
contract are privately
negotiated between
parties.
Structure & Purpose
Standardized. Initial margin
payment required. Usually
used for speculation.
Transaction method
Institutional guarantee
Quoted and traded on the
Exchange
Government regulated
market
Clearing House
Customized to customer
needs. Usually no initial
payment required. Usually
used for hedging.
Negotiated directly by the
buyer and seller
Not regulated
Counterparty risk
Low
Place of trading
(trading venues)
Market regulation
The contracting parties
High
Options
Option is a contract that gives the buyer (the owner) the right, but not the obligation, to buy or sell an
underlying asset or instrument at a specified prices (strike price) on or before a specified date
(expiration date). The seller has the corresponding obligation to fulfill the transaction – that is to sell
or buy – if the buyer (owner) "exercises" the option. The buyer pays a premium to the seller for this
right. An option that conveys to the owner the right to buy something at a specific price is referred to
as a call; an option that conveys the right of the owner to sell something at a specific price is referred
to as a put. Both are commonly traded, but for clarity, the call option is more frequently discussed.
Types of options:
I.


Call option - an agreement that gives an investor the right (but not the obligation) to buy an
specified asset at a specified price (the strike price) within a specific time period (the
expiration date).
Put option - an agreement that gives an investor the right (but not the obligation) to sell an
specified asset at a specified price within a specific time period.

Options
Description
The effect of position/type
of transaction
Premium
Long call
The right (not obligation)
to buy
The obligation to realize
the decision of buyer (sell)
The right to sell
The obligation to realize
the decision of buyer (sell)
Buy
-
Sell
+
Sell
Buy
+
Short call
Long put
Short put
II.


European option – an option that may only be exercised on expiration
American option – an option that may be exercised on any trading day on or before
expiry.
Exercises (Use financial functions)
1. If you plan to save $300 annually for 10 years and the interest rate is 15%,
what is the future value?
2. If you want to buy a bike in 4 years that costs $ 500 and you can save $150
per year, what interest rate would you need?
3. If you invest $1,000 per year in a stock portfolio with a return of 8%, how
much would you expect to have in 7 years?
4. How long would it take you to save $1,000 if you invested $200 per year, and
the interest rate is 10%?
5. If you need $10,000 to pay for your first year of graduate school in 3 years
and you get an interest rate of 9%, how much must you invest each of the next
three years?
6. If 6 years ago you invested $500 and received an interest rate of 4%
(compounded monthly), how much would you now have?
7. You borrowed $100 from a friend, who said you need to pay back $300 in 5
years, what rate are you being charged if it is compounded weekly?
8. How many years would it take you to have $2,500 if you saved $100 each
month at 15%?
9. To have $6000 in 7 years what interest rate would you need if you saved $200
every quarter?
10. If you win a lottery worth $1,000,000 payable in 15 years and the interest
rate is 8% (compounded annually),what is this worth today? Compounded
quarterly? Compounded monthly? Compounded weekly?
A. Compounded annually
B. Compounded quarterly?
C. Compounded monthly?
D. Compounded weekly?