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Chapter 2
The Financial Environment
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The Financial Environment
The definition Financial markets
The factors that affect the Security
Expected Returns
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What is a market?
A market is a venue where goods
and services are exchanged.
A financial market is a place where
individuals and organizations
wanting to borrow funds are brought
together with those having a surplus
of funds.
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Financial Markets
In an economy there exist an interaction
between the corporation, financial
intermediaries and lenders and borrowers.
This occurs in the financial markets and is
there for the purpose of facilitating the
raising of capital by corporation and other
businesses, which in turn lead to economic
growth.
Unlike commodity markets where trading of
physical goods is done, Financial Markets
are markets where financial assets,
instruments or securities are traded
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Financial Markets
These instruments facilitate the transfer of
funds between units that need funds and
those that supply funds. The financial
Markets that are found in any financial
System consist of a number
of players. The markets bring together
lenders, borrowers (investors) and financial
intermediaries (financial institutions).
Financial intermediaries are firms such as
commercial banks, stock exchanges,
investment companies, insurance companies
and pension funds. Borrowers and lenders of
funds include both individuals and firms.
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The Function of Financial Markets
FM channel funds from savers to
firms, govt or other individuals
through direct or indirect finance
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How is capital transferred between savers
and borrowers?
In direct finance,
borrowers sell
securities (bonds or
shares) to lenders
Indirect financing
involves
intermediaries
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Why is the channeling function
important?
Markets create value: savers get
interest rate that they can spend later
Markets create value: investors make
profits over and above the interest
payments
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Types of Financial Markets
Financial markets can be categorized
using several important features of
them
Debt and Equity Markets
Primary and Secondary Markets
Exchanges and over-the-counter
markets
Money and capital markets
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Debt and Equity Markets
A firm or an individual can obtain funds in a financial market in two
ways:
A. issue a debt instrument (a bond)
Definition: A bond and its Maturity
A bond is a debt security that promises to make payments
periodically for a specified period of time until a specified date.
The maturity of a debt instrument is the number of years until that
instrument’s expiration date.
B. issue equities, such as stocks
Definition: A stock (equity)
Stocks (equities) are claims to a share in the net income (income
after expenses and taxes) and the assets of a business
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Term Structure of the Debt and Equity
A debt instrument is:
short-term, if its maturity is less than a
year
long-term, if its maturity is ten years or
longer
intermediate-term, if its maturity is
between 1 and 10 years
Equity instruments are only long-term as
they do not have a maturity.
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Primary and Secondary Markets
What is a primary market? Definition:
A primary market is a financial market in
which new issues of a security, such as a
bond or a stock, are sold to initial buyers by
the corporation or government agency who
wants to borrow funds.
What is a secondary market? Definition:
A secondary market is a financial market in
which securities that have been previously
issued can be resold
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Exchanges and Over-the-Counter Markets
(Auction market vs. Dealer market)
Secondary markets are organized in two ways:
Exchanges: where buyers and sellers of
securities meet in one central location to
conduct trades like stock exchange, there is
a physical floor.
Over-the-counter markets: dealers at
different locations who have securities and
stand ready to sell them. They are usually
computer-traded.
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Physical location stock exchanges vs.
Electronic dealer-based markets
Auction market vs. Dealer
market (Exchanges vs. OTC)
Differences are narrow
The main difference is that
that OTC have no physical
floor while as auction markets
have a floor
OTC occur over the phone or
computer
The other difference is that
most trades for OTC are for
unlisted securities
OTC prevalent for the bond
market
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Money and Capital Markets
Money markets: a market where short-term securities are
traded (maturity less than 1 year like T-bills and
Commercial papers) e.g. all treasury bills are traded in the
money markets i.e. TBs 91 days, 182 days, 273 days & 364
days
Capital markets: a market where long-term securities are
traded – bonds and equity with maturity of more than 1
year
Treasury Bills (T-bills): Short-term, non-interest bearing
obligations of the Government issued at a discount and
redeemed at maturity for full face value.
Commercial Paper: Short-term, unsecured promissory notes,
generally issued by large corporation
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Importance of allocation of Funds
Funds will flow to economic units that are willing to
provide the greatest expected return (holding risk
constant). In a rational world, the highest expected
returns will be offered only by those economic units
with the most promising investment opportunities.
Result: Savings tend to be allocated to the most
efficient uses.
The expected return is the return on a risky asset
expected in the future.
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What factors affect the Security
Expected Returns?
Default Risk
Marketability
Maturity
Taxability
Expected
inflation
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What factors affect Security Expected
Returns?
Default Risk is the failure to meet the terms of a
contract.
Marketability is the ability to sell a significant
volume of securities in a short period of time in
the secondary market without significant price
concession.
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What factors affect Security Expected
Returns?
Maturity is concerned with the life of the security; the
amount of time before the principal amount of a security
becomes due.
Taxability considers the expected tax consequences
of the security.
Inflation is a rise in the average level of prices of
goods and services. The greater inflation
expectations, then the greater the expected return.
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What are commodity markets?
A commodities market is an exchange where
various commodities and derivatives products
are traded.
Most commodities markets across the world
trade in agriculture products and othe raw
materials like wheat, barley, sugar, maize, cotton,
cocoa, coffee, milk products, pork bellies, oil,
metals etc. These contracts include spot prices,
forwards, futures and options on futures
Other sophisticated products may include
interest rates, environmental instruments, swaps
or ocean freight contracts
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Example of commodity contracts:
A farmer raising corn can sell a future
contract on his corn, which will not be
harvested for several months, and
guarantee a price he will paid when he
delivers. This protects the farmer from
price drops and the buyer from price rises
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Examples of Commodity Exchanges in
Africa
African Mercantile Exchange, Nairobi, Kenya; for Agriculture
& Energy
Nairobi Coffee Exchange, Kenya; for coffee
Ethiopia Commodity Exchange, Addis Ababa; for agriculture
Agriculture Commodity Exchange for Africa, Lilongwe,
Malawi
Mercantile Exchange of Madagascar, Antananarivo; for
agriculture, metals & energy
Global Board of Trade, Ebene, Mauritius; for metals & forex
SAFEX (JSE), Sandton, SA; for agriculture
Makola Agriculturals Exchange, Accra, Ghana; for agriculture
