Book title: Understanding
Financial Markets & Instruments
Chapter 1: Introduction to the Financial Markets
"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
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:
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
There are different markets in a system,
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.
The development of financial markets and instruments
The basic needs in the financial world, are the following:
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:
An example would be:
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:
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.
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
(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.)
in a certificate giving me 11% interest per year indefinitely 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.
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:
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.
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.
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
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.
Risks of Financial Transactions
Borrowing and lending of money create certain
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:
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."
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
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:
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 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:
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
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:
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
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:
1.10 ConclusionThe 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.