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Book title: Understanding Financial Markets & Instruments
Author: Braam van den Berg 

Chapter 1: Introduction to the Financial Markets

1.1   Introduction 
1.2   Markets in the financial system 
1.3   The development of financial markets and instruments 
1.4   Classification of Financial Markets 
1.5   Risks of Financial Transactions  
1.6   Institutions in the markets 
1.7   The role of the government and the South African Reserve Bank  
1.8   Trading in the markets 
1.9   Factors influencing the financial markets   
1.10 Conclusion  

1.1   Introduction

"Life in abundance" is probably one of the greatest desires of mankind.   In business, people strive to manage their assets (and liabilities for that matter) to obtain maximum advantage, which they believe would eventually lead to true joy.  Even the astronomers look toward the heavens to try and find explanations that would enhance our life on earth.  The business world can almost be described with the same philosophy with which Arno A. Penzias, Novel prize winner in physics, described the universe:   "Astronomy leads us to a unique event, a universe which was created out of nothing, and delicately balanced to provide exactly the conditions required to support life."

The business world of today is also delicately balanced with numerous determinants playing a part in trying to enhance human life.

1.2    Markets in the financial system

People have different needs, and in trying to fulfill these needs, opposite needs are matched.   Where needs are matched on a large scale, markets for those needs develop.   Market forces are thus:

  • the supply of an item or service where there is

  • a demand for that item or service.

Trading of that item or service is created through a price mechanism.  The price is based on the value of the item or service to the traders (buyers and sellers), depending on certain market factors.

There are different markets in a system, such as

  • the services market

  • the products market

  • the financial markets.

A market is not necessarily a physical and geographically identifiable place, and goods traded are not necessarily physical goods.   Trading might take place over the telephone, and goods traded might be knowledge, etc.   Goods traded in markets are traded through a price mechanism which expresses the interaction of demand for and supply of these goods as a value.   So, for instance, the trading of apples uses the price mechanism of a monetary amount, for example R1,20 per apple.

The different markets in the financial system of a country are not isolated markets, but they interact with each other.   With electronic communication and the revolution in computers and computer networks, the markets of the world are busy interacting on a large scale.   In a small country like South Africa, one could sometimes feel lost in this "universe" of supplies and demands.   As astronomer Bernard de Fontenelle (1657-1757) put it:   "Behold a universe so immense, I am lost in it.   I no longer know where I am."

The effect of different markets on each other can, however, clearly be seen in the South African context.   The money supply in South Africa is, inter alia, influenced by the gold price, because South Africa is a net exporter (seller) of gold.   If the gold price should increase, the supply of money in the markets will increase due to more money flowing into the country.   This could lead to a higher demand for products in the product markets because of the availability of money.   A higher demand for products could result in prices of products going up (resulting in inflation), which would dampen the demand for products and money.   This interactive circle of changes is an ongoing process in markets.

1.3    The development of financial markets and instruments

The basic needs in the financial world, are the following:

  • the need to invest excess money (supply)

  • the need to borrow money (demand) where there is a shortage of money.

The government of a country might, for instance, need money for certain projects, while certain private sector companies or individuals might have excess money to invest in profitable investments.   The "price" paid for money is interest paid on the amount borrowed, and the interest rate is thus the price mechanism used in financial markets.

To match different financial needs such as the need to borrow and the need to invest, intermediaries are mostly used, for example:

  • where an institution wants to invest a certain sum of money, for a certain time, giving them a certain yield

  • another institution wants to borrow a certain amount of money for a period at the lowest cost possible, the lender's and the borrower's demands might differ.

An example would be:

  • Eskom needs R100 million for a period of at least 10 years to erect new power lines

  • SCMB has R50 million it wants to invest for 7 years

  • Investec has R50 million it wants to invest for 12 years.

An intermediary would seek to merge these different needs and demands of borrowers and lenders through negotiation and financial instruments.   A certificate would be issued to the lender giving him the right to the interest payments and the redemption amount at expiry of the loan.   These instruments are called securities.

Large financial transactions involving the lending and borrowing of money (such as the example above), which are done through intermediaries or as principal by the lender, are often structured and standardised regarding:

  • the amount of the loan or investment

  • the interest paid and received thereon

  • the term to redemption of the loan.

In order to enhance the marketability and tradability of these securities, these standards created for transactions are incorporated into financial instruments.   A borrowing certificate from a certain institution, where the institution borrows the money and gives the lender (investor) a certificate promising to pay the owner or holder of the certificate R1 million on 1 June 2008 and interest of 11,00% per annum on R1 million up to 1 June 2008 (similarly to the Eskom 168 certificates), is an example of a financial instrument.   A certificate representing the contract between the lender and borrower is issued for the duration of the loan.  Appendix 1 is an example of a bond (capital market instrument) which is a financial instrument.

  • Instruments (certificates) issued by the ultimate borrower are called primary securities.

  • Instruments issued by intermediaries on behalf of the ultimate borrower are called indirect securities.

The market for instruments (also called securities) issued for the first time, is called the primary market.   Because of the standardisation of these instruments, different needs in the markets at different times, and different views of economic factors, these instruments are traded between institutions after they have been issued for the first time.   If a lender needs his money before redemption date of the loan, the lender could trade the loan by selling the certificate to another institution.   The buyer of the instrument pays the seller an amount (the present value of the future cash flows of the loan), and the buyer becomes the new lender.   The market where instruments are traded subsequent to the first issue, is called the secondary market.

The secondary market in some of the securities is a very active market.   Activities in the secondary market have a strong determining influence on issues in the primary market as liquidity, tradability, market rates, scale of demand, etc. of specific instruments are reflected in the secondary market.  The variables of the economy in these markets are expressed through the interest rate (the price mechanism) determined in the secondary market (called the market rate), and this has an influence on the rate and value at which issues can take place in the primary market.   If, for instance, I have R1 million to invest and the market rate is 16% (this means that I can invest my money in the market at 16%); I have the following two choices:

(This example ignores the nominal amount of R1 million that the investor would receive at redemption of the loan.   The influence of this will be discussed in later sections and chapters.)

a) Invest in a certificate giving me 11% interest per year indefinitely on R1 million,
b) Invest in an investment in the market giving me 16% (the market rate) interest per year on R1 million.

The obvious choice is b).   I would only invest in a) if I could get a discount on my investment.   The monetary amount of interest that I would receive from the investment in a) would be 11% on R1 million per year, that is R110 000 per year. 

For this amount to give me a return of 16%, I would only be willing to invest:

R110 000/16% = R687 500

If I could get a discount of (R1 000 000 - R687 500) R312 500 on the certificate in a), and only pay R687 500 for the certificate while still receiving 11% interest on the nominal amount of the certificate (R1 000 000), my yield on the investment would be:

R110 000/687 500 = 16%,

The same as option b).

Thus, if the market rate in the secondary market is 16%, and an institution wants to issue certificates in the primary market, the institution has to pay the market rate on his certificates issued, or issue the certificates at a discount if the rate paid on the certificate (called the coupon rate) is less than the market rate.   Vice versa, if the rate paid on certificates is higher than the market rate, these certificates would be issued and traded at a premium.

The secondary market gives the investor the opportunity to manage his portfolio in terms of risk and return ratios, liquidity, etc.   The return that the investor receives or wants to receive on his investment (called the yield), can be managed within certain parameters, and by using different strategies of buying and selling different instruments and investments in the secondary market.

1.4    Classification of Financial Markets

Markets can be classified into different categories depending on the characteristic of the market or instrument used to create categories.  Securities created by institutions in the markets normally pay an interest on the nominal amount (the amount shown on the certificate or contract).   The interest-bearing securities market is split into the money market and the capital market, based on the term to maturity (the term left to redemption of the debt) of the securities.

  • The capital market is the market for the issue and trade of long-term securities.
  • The money market is that of short-term securities.

When goods such as financial instruments are traded in a market, there are certain differences between transactions done in these markets.   The differences in transactions in the financial markets can be categorised in different categories, two of which are the following:

  • The timing difference between the closing of the transaction and the delivering of the goods or settlement of the transaction

  • The difference in certainty that the other party will honour the transaction.

In the spot market, the closing of the transaction and the delivery of the goods take place simultaneously or within a short-term time span prescribed by the specific market.   Uncertainty about delivery from the other party is very limited, otherwise no transaction would take place.

The forward market is the market where a transaction is closed in the present, and the settlement of the transaction and the delivery of goods are in the future.   The delivery date and the price are determined at the closing of the transaction.   Because of the time lapse between the closing and the settlement of the transaction, the risk that one of the parties might not be able to deliver at the settlement date is higher than in the spot market.

The futures market is similar to the forward market, except that in the futures market, the risks of settlement and quality of the product are addressed.  The same transaction as in the forward market would be closed, with the addition of the standardisation of the amount of goods, the quality of the goods and guarantee (by an exchange) of the payment of the price and delivery of goods or cash settlement of the difference.

1.5    Risks of Financial Transactions

Borrowing and lending of money create certain risks, namely

  • That the borrower will not be able to repay the money

  • That the lender is receiving a fixed rate on his investment while market rates fluctuate in such a way that the yield on his initial investment is now below current market related rates

  • That the value of the capital invested could decrease due to movements in the market.

To lower the risk of a financial transaction, the risk can be sold to people or institutions that are willing to take on that risk without immediately taking over the effects of the transaction.   The institution willing to buy the risk associated with the transaction would have to be compensated for taking on the risk.   In monetary terms, the compensation for taking on the risk would, however, be less than the possible maximum loss associated with the risk.   The trading of these risks associated with financial instruments resulted in the development of derivative products.

To hedge a position means to reduce the risk associated with a financial transaction or position, by selling the risk or by taking an opposite financial position, with the effect that a market movement would not result in substantial financial loss.   A financial position which is not hedged, is called an open position.

The trading of risks created a market for the hedging of risks involved in financial transactions, which is a market derived from the original financial transaction.   Contracts are drawn up for these kinds of transactions and because these contracts are derived from the original financial transaction, they are called derivatives.   In a publication by Paul Eloff of the South African Futures Exchange, the following description of derivatives is given:

"Derivatives such as future contracts and options, are instruments whereby price risks are reallocated from those not willing to accept the risk and placed with those who are willing to accept the risk."

1.6     Institutions in the markets

A sophisticated financial services sector consisting of lenders, borrowers, financial intermediaries, financial instruments and financial markets, has different institutions participating in these markets.

Certain intermediaries in the financial markets take on deposits as principal.  These intermediaries are called deposit-taking intermediaries.   Examples of such intermediaries are:

  • South African Reserve Bank (SARB) (deposits from selected clients)

  • Private banks

  • Land and Agricultural Bank

  • SA Post Office Limited.

There are other intermediaries operating in the market, who only manage funds on behalf of clients as an agent for the client.   They do not take on deposits, but bring together the borrower and lender with similar needs regarding amount, term and rate of the transaction.  Such an intermediary is called a non-deposit-taking intermediary.   Examples of these intermediaries are:

  • Unit trusts

  • Insurers

  • Pension and provident funds

  • Finance companies.

Other institutions and interest groups in the market do not participate in the trading of instruments as principal traders but perform functions such as supervision of activities, regulation of the markets, provision of trading facilities, etc.   Examples of these institutions and groups are:

  • The Johannesburg Stock Exchange

  • The South African Futures Exchange

  • The Bond Exchange of South Africa

  • The Supervision Department of the SARB

  • The Financial Services Board.

1.7    The role of the government and the South African Reserve Bank

The government of a country, being the ruling body, has to manage and supervise the economy, resources and people of the country.   In order to manage the economy and related resources, economic policies concerning markets and trade in a country are used.   The monetary policy concerning the money markets and money transactions of a country.   This has a strong influence on imports and exports and the payment system of a country.   Fiscal policy is the policy of the government concerning the collection of money through taxes, issuing of financial instruments, etc. to fund the level of expenditure they decide on regarding, for example, education, infrastructure, etc.   A guideline of this policy is given each year in the government's budget.  

One of the functions of the SARB is to co-operate with the Ministry of Finance in formulating and implementing monetary and exchange rate policy.   The SARB also acts as banker to the government and other banks and thus plays an important role in the markets as decisions concerning interest rates of the SARB affect all institutions in the market.

Other important functions of the SARB include:

  • Issuing of bank notes and coins

  • Supervising the country's gold and foreign exchange reserves.  In this function it plays an important role in maintaining a stable exchange rate

  • Supervising registered banks

  • Settlement of claims and payments between banks

  • Lender of last resort for the banks.

1.8    Trading in the markets

Trading can take place in a market when information about prices are exchanged.   The mechanism of price measurement in the money markets is the interest rate, because the interest that the borrower pays is the price that he has to pay for the privilege of using the money for a certain time.

Financial instruments are quoted at interest rates, from which the transaction amount or the amount that the buyer which the transaction amount or the amount that the buyer (lender) has to pay to the seller (borrower), also called the consideration or settlement amount, is then calculated.

Price in monetary values (the consideration paid for an instrument) and interest rate movements are opposites.   Fixed interest rate securities are traded at a discount on the nominal value if the market interest rate is higher than the interest rate on the instrument (called the coupon rate).   Consider the following example:

An instrument with a term to maturity of one year, a nominal amount of R1 million with a coupon rate of 12% will probably trade at the following prices at the beginning of the year:

If the market rate is 15%, the investor could invest his money at 15% in the market.  He would want to buy the instrument giving only a yield of 12% at a discount, so that the money he invested would earn an effective yield of at least 15%.   The cash flow that he would receive at the end of the year if the interest is paid at the end of the period, is:

Interest:   12% of R1 000 000 = R    120 000
Capital amount: R1 000 000  
Total   R1 120 000  

The total cash flow discounted at the required yield of 15% for one year gives R973 913.   For the investor to earn 15% on his investment, he would be willing to pay only R973 913 for the instrument.

If the market rate and yield required by the investor drops to 14% the instrument (using the same calculation methods) would trade at R982 456.   Thus, it is clear that with a fixed interest and redemption payment, a lower monetary amount (consideration) would be offered for an instrument if the yield goes up, because the investor would want to earn more on his investment.   The interest rate at which the instrument is eventually traded, is called the yield and could differ from the market rate because of differing views, costs, etc.

For trading to take place, a buyer and a seller must get together and negotiate.   This could take place on a specifically allocated floor, or by means of a communication system using computer networks and telephones, for instance, the South African Futures Exchange and the JSE.  Where a transaction takes place without making use of an organised exchange, the transaction is called an "over-the-counter" (commonly known as OTC) transaction.     The Futures Exchange and the JSE have in recent years implemented fully automated electronic trading systems, which eliminate telephone calls between buyers and sellers or buying and selling agents to a large degree.   Although transactions are closed in numerous ways, the exchange of money and products such as contracts, certificates, etc. still takes place between the parties of a transaction, and this is called the settlement of a transaction.   Settlement of the transaction can take place at a later date than the date of the transaction.

Owning a financial instrument is called a long position.   A short position is the selling of a financial instrument without being the owner thereof.   Because the settlement date could be after the transaction date, a seller could sell something he doesn't own and buy it before the settlement date, to be able to deliver it to the buyer.

1.9     Factors influencing the financial markets

Each effective market has a supply of a certain commodity, and a demand for that commodity.   Savings (investments) represent the supply side in the money markets, and financing needs, as the demand side.   Because of the interaction between the various financial commodities, money and service markets in a country, the simple theory of supply and demand determining prices cannot be applied in its basic form in these markets.

The theoretical system would determine that the rate (price for money) would drop if there is a surplus savings (supply) in the market, but if there are savings in the market which are not utilised to finance income-making activities, the national income will eventually decline, probably bringing about a decline in the rate of savings which could work against the fall in interest rates.

Another factor influencing the financial markets is expectations; for instance, if rates are high, with the expectation that the rates are going to decline in the future, the demand for securities and thus the supply of money will be high, pushing interest rates down, and security prices up.

Expectations of higher inflation could push up interest rates.   Prices of goods are expected to go up, so consumers tend to buy now rather than later, which pushes up the demand for cash balances and hikes interest rates.   Interest rates in turn has an effect on inflation.   The level of savings and spending is to a significant extent determined by prevailing interest rates.

Fiscal policy decisions by the government also affect the financial markets.   The decisions by the government also affect the financial markets.   The decision on how to finance the government's deficits will affect the supply and demand for cash balances, short and long-term deposits (M3 money supply), and thus influence interest rates.   If the government decides to finance its monetary needs with the issuing of short-term securities such as treasury bills, the demand for money in the short-term market increases, exerting upward pressure on interest rates.

Examples of other factors affecting local financial markets are the following:

  • The local market seems to overreact on information and expectations.   During 1994/95 the expectation of higher inflation was one of the reasons for long-term interest rates going up by more than 5 percentage points  

  • The level of government spending has an adverse effect on inflation and interest rate movements  

  • South Africa had a two-tier exchange rate system (the financial and commercial rand) up to March 1995.   Some restraining foreign exchange regulations are still in place.   The exchange rate determines what a country pays for imports, and what that country gets for exports in terms of its own currency, for example, the rand proceeds of gold exports.   These import and export payments have an effect on the foreign reserves have an effect on the foreign reserves that South Africa holds and the amount of money in circulation in the economy.   Foreign trade and the resulting foreign exchange rate affect the local economic parameters influencing the financial markets.  
  • The integrity of the payments system in the financial markets.   Trust in the South African system was affected by the credit rating that South Africa received from overseas institutions
  • High labour costs, excessive political violence and significant political uncertainties in the country have tended to keep away foreign investors.   Because of the local political factors, foreign investors want a premium on their investment yield to compensate for the risk and uncertainty associated with investing in South Africa
  • Liquidity in the markets is low, and pooling of funds needs to be done to improve liquidity

  • Domestic funds, such as pension funds, tend to invest in shares rather than capital market instruments because of risk and return factors and uncertainties about interest rates and volatility.   The demand for capital market instruments is thus lower, pushing up interest rates.  Previously, funds were forced to invest in certain government capital market instruments as a certain percentage of their total portfolios
  • Financial disclosure concerning transactions, positions and risk involving financial markets is not in line with generally accepted standards world-side.
  • Capital adequacy and interest rate risk

  • The general approach is that financial positions, which are exposed to interest rate fluctuations, should not be more than a certain percentage of the primary capital of a company.  Internationally accepted levels are much lower than the levels in South Africa.

1.10   Conclusion

The financial markets play a very important part in the well-being of every person.   They interact with other markets and have an influence on issues such as wealth, inflation and stability in a country.   The financial markets have their own characteristics and to operate in them, it is important to comprehend these characteristics.

 

Courses and training in Financial Markets, Instruments, Investments and Derivatives are supplied by the Academy of Financial Markets.  They can be contacted on info@academyfm.co.za or via their web site.  New developments in the Financial Markets are incorporated in updates (see index) of this book and can be obtained from The Academy of Financial Markets.