ADDIS ABABA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

SCHOOL OF COMMERCE
MARKETING MANAGEMENT DEPARTMENT
MA PROGRAM

FINANCIAL MARKETS
AND INSTRUMENTS

By: Mulugeta Gebremedhin (PhD)

AUGUST 2024 |
Table of Contents

UNIT 1: INTRODUCTION TO FINANCIAL SYSTEMS .................................................................. 1

1. Introduction ................................................................................................................................. 1
1.1 The What and Why of the Financial System ............................................................................ 1
1.2 Key Concepts of the Financial System .................................................................................... 3
1.3 The Roles and Functions of the Financial System in the Economy ........................................ 4
1.4 How the Financial System Functions: The Direct & Indirect Finance ...................................... 7
1.4.1 Direct Finance ........................................................................................................................ 8
1.4.2 Intermediated Finance ........................................................................................................... 9
1.5 Major Components of the Financial System .......................................................................... 12
1.5.1 Financial Institutions ............................................................................................................ 12
1.5.2 Financial Markets................................................................................................................. 13
1.5.3 Financial Instruments........................................................................................................... 14
1.5.4 Regulation of the Financial System ................................................................................. 14
1.5.5Technology and Infrastructure .............................................................................................. 17
1.6 Classification of Financial Institutions..................................................................................... 18
1.6.1 Depository Institutions ......................................................................................................... 19
1.6.2 Non-depository Financial Institutions .................................................................................. 20
1.7 Classification of Financial Markets ......................................................................................... 23
1.8 Classification of Financial Instruments ................................................................................... 28
1.8.1 Money Market Instruments .................................................................................................. 28
1.8.2 Capital Market Instruments.................................................................................................. 30
1.8.3 Derivatives ........................................................................................................................... 34

UNIT 2: MONEY MARKETS ......................................................................................................... 37

2.1 Introduction ............................................................................................................................. 37
2.2 Objectives of Money Market ................................................................................................... 38
2.3 Money Market Securities ........................................................................................................ 38
2.3.1 Treasury Bills .................................................................................................................... 39
2.3.2 Commercial Paper ........................................................................................................... 42
2.3.3 Negotiable Certificates of Deposit ................................................................................... 44
2.3.4 Repurchase Agreement (Repos) ..................................................................................... 45

UNIT 3: BOND MARKETS............................................................................................................ 48

3.1 Background of Bonds ............................................................................................................. 48
3.2 Characteristics of Bond........................................................................................................... 49
3.3 Advantages, Disadvantages, and Risks of Investing in Bonds .............................................. 50
3.3.1 Advantages....................................................................................................................... 50
3.3.2 Disadvantages ................................................................................................................. 50
3.3.3 Risks ................................................................................................................................. 50
3.4 Government and Corporate Bonds ........................................................................................ 51
3.4.1 Government Bonds .......................................................................................................... 51
3.4.2 Corporate Bonds .............................................................................................................. 52
3.4.2.1 Features of Corporate Bonds ....................................................................................... 52

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3.5 Credit Rating Agencies ....................................................................................................... 56
3.6 Yield ........................................................................................................................................ 57
3.6.1 Flat or Running Yield ........................................................................................................ 57
3.6.2 Yield to Maturity (YTM) or Gross Redemption Yield (GRY) ............................................ 58
3.7 Convertible Bonds .................................................................................................................. 59
3.8 Accrued Interest ...................................................................................................................... 60
3.9 Yield Curve .............................................................................................................................. 62
3.10 The Present Value of a Bond................................................................................................ 64
3.11 Inflation-Indexed (Linked) Bonds ............................................................................................. 65

UNIT 4: EQUITY MARKETS......................................................................................................... 67

4.1 Introduction ............................................................................................................................. 68
4.2 Primary and Secondary Markets ............................................................................................ 68
4.2.1 Users of Primary Market ...................................................................................................... 69
4.2.2 Participants or Users of the Secondary Market .................................................................. 69
4.3 Types of Offers ........................................................................................................................ 70
4.3.1 Initial Public Offerings (IPO) ................................................................................................ 70
4.3.2 Follow-on Offering ............................................................................................................... 71
4.4 Methods of Trading: Quote Driven vs Order Driven Trading ................................................. 72
4.5 Types of Equities..................................................................................................................... 72
4.5.1 Ordinary Shares ............................................................................................................... 72
4.5.2 Preference Shares ........................................................................................................... 73
4.6 The Benefits of Share Holding................................................................................................ 75
4.7 The Risk of Owning Shares .................................................................................................... 77
4.8 Corporate Actions ................................................................................................................... 78
4.8.1 Rights Issues ....................................................................................................................... 78
4.8.2 Bonus Issues ....................................................................................................................... 80
4.8.3 Stock Splits and Reverse Stock Splits ................................................................................ 80
4.9 Dividends: Cum and Ex Dividends ......................................................................................... 80
4.10 Stock Market Indices ............................................................................................................ 81
4.11 Computing the Price of Common Stock (Valuation of Equities) ........................................... 83
4.11.1 The One-Period Valuation Model....................................................................................... 83
4.11.2 The Generalized Dividend Valuation Model ...................................................................... 84
4.11.3 The Gordon Growth Model ................................................................................................ 85
4.11.4 Price Earnings Valuation Method ...................................................................................... 86
4.11 Financial Performance Measures of Shares ........................................................................ 86

5. FOREIGN EXCHANGE MARKETS ......................................................................................... 89

5.2 Spot and Forward Transactions ............................................................................................. 90
5.2.1 Interest Rate Parity .............................................................................................................. 91
5.3 Factors Affecting Foreign Exchange Rates ............................................................................ 93
5.3.1 Purchasing Power Parity (PPP) .......................................................................................... 94
5.3.2 Foreign Currency Trading and Speculation ........................................................................ 95
UNIT 6: DERIVATIVE SECURITY MARKETS ............................................................................. 97
6.1 What are Derivatives? ............................................................................................................ 98

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6.2 Market Participants ................................................................................................................. 98
6.2.1 Hedgers ............................................................................................................................ 98
6.2.2 Speculators ...................................................................................................................... 99
6.2.3 Arbitrageurs .................................................................................................................... 100
6.2.4 Traders in the Futures Market........................................................................................ 100
6.3 The Role of the Clearing House ........................................................................................... 101
6.4 Forward Contracts ................................................................................................................ 102
6.5 Futures Contracts ................................................................................................................. 104
6.5.1 Differences between Spot/Cash Markets and Futures Markets ................................... 107
6.5.2 Differences between Futures and Forward Contracts................................................... 107
6.5.3 What Futures Are and What They Are Not? .................................................................. 108
6.5.4 Content of the Futures Contract ..................................................................................... 111
6.5.5 Long and Short Positions ................................................................................................112
6.6 Option Contracts ....................................................................................................................112
6.6.1 Call Option.......................................................................................................................113
6.6.2 Put Option .......................................................................................................................114
6.6.3 European and American Options ....................................................................................114
6.6.4 Option prices and exercise prices ..................................................................................115
6.6.5 Mechanics of Option Trading ..........................................................................................116
6.6.5.1 Call Option: Intrinsic and Time Value ..........................................................................117
6.6.5.2 Put Option: Intrinsic and Time Value .......................................................................... 120
6.5.7 Option Strategies as Risk Management Tools (Hedging) ............................................. 124
6.6 Swaps ................................................................................................................................... 125
6.6.1 Interest Rate Swaps ....................................................................................................... 126
6.6.2 Currency Swaps ............................................................................................................. 127
6.6.3 Credit Swaps .................................................................................................................. 128
6.7 Margining and Marking to the Market ................................................................................... 128

7. TRADING OPERATIONS ....................................................................................................... 133

7.1 Trading Procedure on a Stock Exchange ............................................................................ 133
7.2 Trading Procedure on a Stock Exchange ............................................................................ 133
7.3 Margins ................................................................................................................................. 135
7.4 The Concept of Marking to Market ....................................................................................... 136
7.5 Maintenance Margin and Variation Margin .......................................................................... 139
7.6 The concept of Value at Risk (VaR) ..................................................................................... 141
7.7 Gross Margining vs Net Margining ....................................................................................... 143
7.8 Orders and Exchanges ......................................................................................................... 145
7.8.1 What are orders? ............................................................................................................... 145
7.8.2 Price-Related Condition Orders ........................................................................................ 146
7.8.3 Time-Related Condition Orders ......................................................................................... 157

UNIT 8: FUNDAMENTAL AND TECHNICAL ANALYSIS ........................................................... 162

8.1 Trading Decision ................................................................................................................... 162
8.2 Fundamental Analysis versus Technical Analysis ................................................................ 164

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8.3 Fundamental Analysis Highlights ......................................................................................... 165
8.4 Technical Analysis ................................................................................................................. 171
9.4.1 DOW THEORY .................................................................................................................. 171
8.4.2 What is Technical Analysis ................................................................................................ 173
8.4.3 The 10 Technical Analysis Trading Rules .......................................................................... 175
8.4.4 Charting.............................................................................................................................. 176
8.4.4.1 Line Charts...................................................................................................................... 177
8.4.4.2 Bar Charts ....................................................................................................................... 177
8.4.4.3 Candlestick Charts.......................................................................................................... 178
8.4.4.4 Point-and-Figure Charts ................................................................................................. 180
8.4.5 Reading the Charts ............................................................................................................ 181
8.4.5.1 Continuation Chart Patterns ........................................................................................... 184
8.4.5.2 Reversal Chart Patterns ................................................................................................. 187
8.4.6 Detecting the Trend ........................................................................................................... 191

IV
UNIT 1: INTRODUCTION TO FINANCIAL SYSTEMS

Learning Objectives
Upon completion of this part, a student will be able to:
• Describe the what and why of the financial system
• Identify and explain the key concepts of the financial system
• Discuss the roles and functions of the financial system
• List and describe the five components of the financial system
• Describe how the financial system functions through direct and indirect finance
• List and describe the various types of financial institutions, financial markets, and financial
instruments

Preview
Suppose you want to start a business that locally manufactures a recently invented low-cost car
battery but you have no funds to put this wonderful invention into production. Abdu has plenty of
savings that he has inherited. If you and Abdu could get together so that he could provide you
with the funds, your company’s automotive battery would see the light of day, and you, Abdu, and
the Ethiopian economy would all be better off: Abdu could earn a high return on his investment,
you would get rich from producing the car battery, and customers would have a better choice.
Financial markets (bond and stock markets) and financial intermediaries (banks and insurance
companies) have the basic function of getting people such as you and Abdu together by moving
funds from those who have a surplus of funds (Abdu) to those who have a shortage of funds (you).
More realistically, when a federal or regional government needs to build a dam, road, or hospital,
it may need more funds than taxes provide. Well-functioning financial markets and financial
intermediaries are crucial to our economic health. To study the effects of financial markets and
intermediaries on the economy, we need to understand their general structure and operation.

1. Introduction
The interconnected financial system traces its origins to the introduction of money and the
development of markets to trade goods. Money is a medium of exchange that facilitates
transactions for goods and services. With wealth being accumulated in the form of money,
specialized markets developed to enable the efficient transfer of funds from savers (surplus
entities) to users of funds (deficit entities). The growth of trade and the real economy foster the
growth of the financial system.

This section introduces the what and why of financial systems, the roles of financial systems, the
components of the financial system, and the direct and indirect flow of funds in a financial system.
Besides, this part of the module provides an overview of the types of financial institutions, financial
markets, and financial instruments.

1.1 The What and Why of the Financial System

A financial system comprises financial institutions, financial instruments, and financial markets
that interact to facilitate the flow of funds in the economy. The institutions and markets that

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facilitate this flow of funds develop the financial instruments and techniques that encourage
savings and investment. The financial system also provides the framework through which central
banks and prudential regulators influence the operations of participants in the financial system.
Most importantly, a central bank, through its monetary policy initiatives, affects the level of interest
rates, economic activity, and business performance.

A financial system is essential in facilitating economic growth and future productive capacity in a
country. The provision of finance to businesses allows economic growth to occur, which should
lead to increased productivity, increased employment, and a higher standard of living. A modern,
sound, and efficient financial system encourages the accumulation of savings that are then
available for investment in productive capital within an economy.

Figure 1.1: Financial markets and flow of funds relationship

The financial asset is represented by a financial instrument that states how much has been
borrowed, and when and how much is to be repaid by the borrower. For example, if you invested
money in a term deposit with a bank, the bank would issue a term deposit receipt to you. This is
a financial instrument. The receipt would specify how much you had invested, the rate of interest
to be paid, when interest payments are due, and when the amount invested would be repaid by
the bank. The interest payments and principal repayment are claims to future cash flows.

Buyers of financial instruments are lenders or surplus units that have excess funds today and
want to invest and transfer that purchasing power to the future. The sellers of the instruments are
those deficit units or borrowers that are short of funds today but expect to have a surplus amount
in the future that will enable the repayment of the current borrowing. A principal role of financial
institutions and markets is to bring together providers of funds (surplus units or savers) with users
of funds (deficit units or borrowers). The flow of funds, the relationship between savers and
borrowers, and the place of the financial markets in the flow, are shown in Figure 1.1.

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The expectation of the surplus units (lender or savers) is to earn a positive rate of return.
However, there are other factors that savers should consider in making financial decisions
including:
• return or yield
• risk
• liquidity
• time-pattern of cash flows.

With a real asset such as an investment in a residential apartment, the return is the regular rental
or lease payments received, plus any increase in the value of the property over time (capital
gain). Risk relates to uncertainty and probabilities, such as the failure of the tenant to make rental
payments or the possibility that the property may burn down. The liquidity of the residential unit is
the ease with which it can be sold. Finally, the time pattern of the cash flows will vary depending
on the frequency of the rental payments, the cost of maintenance, and the payment of other
expenses such as insurance and rates.

In the case of a financial asset such as the purchase of shares in a corporation, return consists
of the dividends received and the capital gains or losses made through movements in the share
price on the stock exchange. Note that a dividend is the portion of corporation profits periodically
paid to the shareholder; a stock exchange is where corporation shares are bought and sold. Risk
is measured by the variability of the expected returns and, in the extreme, the possibility that the
corporation may fail. The liquidity of the shares relates to the ease with which they can be sold on
the stock exchange at the current market price. Finally, the time pattern of the cash flows expected
from the shares depends on the profitability and dividend policy of the corporation.

Key points
✓ A financial system comprises a range of financial institutions, financial instruments,
and financial markets to facilitate the flow of funds.
✓ A financial system is essential in facilitating economic growth fostering productivity,
employment, and a higher standard of living.
✓ Financial institutions and markets facilitate financial transactions between the
providers of funds (surplus units) and the users of funds (deficit units or borrowers).
✓ Surplus units (lenders or savers) invest in real assets such as properties or financial
assets such as stocks or bonds depending on the return or yield, risk, liquidity, and time
pattern of cash flows.

1.2 Key Concepts of the Financial System

The four key concepts or principles that underpin how financial institutions, instruments, and
markets work are:
1) risk and reward
2) supply and demand
3) no-arbitrage and
4) the time value of money.

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The returns that investors expect to earn are positively related to the risk they must bear. We
might speak of shareholder returns, bond yields, interest rates, or cash flows from a project. When
the risk is perceived to be greater, the returns that investors demand will be higher. Whatever we
might call them, the rewards from investing depend on the risk that the investor must bear. All
investment returns follow the same rules. If the risk is greater, the expected return is higher.

The price of financial instruments such as shares or bonds depends ultimately on supply and
demand. When the supply of a particular futures or options contract goes up while demand
remains the same (or falls), the price must decline, and vice versa. It can be helpful to remember
that, ultimately, supply and demand are fundamental determinants of the market prices for
everything.

Working alongside supply and demand is a rule that we might call ‘no arbitrage’. A trader cannot
buy a financial instrument in one market at a low price while simultaneously selling that same
thing at a higher price in a different market. If this were possible, the trader could earn infinite
returns at zero risk. That would contradict the risk–reward trade-off.

Finally, have you ever wondered what interest is and why it exists? An interest rate is the cost of
borrowing or the price paid for the rental of funds usually expressed as a percentage. In simple
terms, interest is just the reward for waiting. All of the rates of return that we observe on the
financial markets consist of the pure time value of money, plus a premium for risk, plus a premium
for inflation. Whether it is a shareholder’s return, a bondholder’s bond yield, or a conservative
investor’s term deposit rate, the return is a sum of the pure time value of money, a premium for
risk, and a premium for inflation.

Key points
✓ The returns that investors expect to earn are positively related to the risk they must
bear
✓ The price of financial instruments such as shares, bonds, options, futures or swaps
depends ultimately on supply and demand.
✓ A trader cannot buy a financial instrument in one market at a low price while
simultaneously selling that same thing at a higher price in a different market
✓ An interest rate is the cost of borrowing or the price paid for the rental of funds
usually expressed as a percentage.

1.3 The Roles and Functions of the Financial System in the Economy
As discussed in the previous section, a financial system involves a number of financial institutions
and markets through which funds move between lenders (surplus/saving units) and borrowers
(deficit units). The financial system encourages savings, provides funds for investment, and
facilitates transactions for goods and services. The specific roles and functions of the financial
system are discussed in the following section.

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Roles of the Financial System
The major roles of the financial system are:
• to transfer funds from those who have surplus funds to invest to those who need funds
to invest in tangible assets.
• to transfer funds in such a way as to redistribute the unavoidable risk associated with
the cash flow generated by tangible assets among those seeking and those providing the
funds.
• to discover the price of the traded asset or the required return on a financial asset through
the interactions of buyers and sellers in a financial market. As the inducement of firms to
acquire funds depends on the required return that investors demand, it is this feature of
financial markets that signals how the funds in the economy should be allocated among
financial assets. This is called the price discovery process.
• to provide liquidity to the market and to provide a mechanism for an investor to sell a
financial asset. If there were no liquidity, the owner would be forced to hold a debt
instrument until it matures and an equity instrument until the company is voluntarily or
involuntarily liquidated.
• to reduce the cost of transacting. There are two costs associated with transacting:
search costs and information costs. Search costs represent explicit costs, such as the
money spent to advertise one’s intention to sell or purchase a financial asset, and implicit
costs, such as the value of time spent in locating a counterparty. The presence of some
form of organized financial market reduces search costs. Information costs are associated
with assessing the investment merits of a financial asset, that is, the amount and the
likelihood of the expected cash flow. In an efficient market, prices reflect the aggregate
information collected by all market participants.

Functions of the Financial System

Efficient financial systems are indispensable for speedy economic development. The economic
development of any country depends upon the existence of a well-organized financial system. It
is the financial system that supplies the necessary financial inputs for the production of goods and
services which in turn promotes the well-being and standard of living of the people of a country.
Thus, the ‘financial system’ is a broader term that brings under its fold the financial markets and
the financial institutions which support the system. The responsibility of the financial system is to
mobilize savings in the form of money and monetary assets and invest them in productive
ventures. The efficient functioning of the financial system facilitates the free flow of funds to more
productive activities and thus promotes investment. Thus, the financial system provides the
intermediation between savers and investors which in turn promotes faster economic
development.

The main functions of the capital market are:

1. Resource allocation function
2. Liquidity function
3. Capital formation function

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1. Resource allocation Function: Capital Market allows for the channelization of the saving of
innumerable investors into various productive avenues of investments. Accordingly, the
current savings for a period are allocated amongst the various users and uses. The market
attracts new investors who are willing to make new funds available to businesses. It also
allocates and rations funds through a system of incentives and penalties.

2. The Role of Capital Markets in Resource Allocation

Capital markets play an important role in mobilizing resources and diverting them toward
productive channels. In this way, it facilitates and promotes the process of economic growth
in the country as discussed below:
• Link between Savers and Investors: The capital market functions as a link between
savers and investors. It plays an important role in mobilizing savings and diverting
them into productive investments. In this way, capital markets play a vital role in
transferring financial resources from surplus and wasteful areas to the deficit and
productive areas, thus increasing the productivity and prosperity of the country.
• Encourages Saving: With the development of the capital market, banking and non-
banking institutions provide facilities, which encourage people to save more. In the
less- developed countries, in the absence of a capital market, there is very little
savings.
• Encourages Investment: Capital markets facilitate lending to businessmen and the
government and thus encourage investment. It provides facilities through banks and
nonbank financial institutions. With the development of financial institutions, capital
becomes more mobile, the interest rate falls, and investment increases.
• Promotes Economic Growth: The Capital Market not only reflects the general
condition of the economy but also smoothens and accelerates the process of
economic growth. Various institutions of the capital market, like non-bank financial
intermediaries, allocate the resources rationally in accordance with the development
needs of the country. The proper allocation of resources results in the expansion of
trade and industry in both public and private sectors, thus promoting balanced
economic growth in the country.
• Benefits to Investors: Capital markets help investors, i.e., those who have funds to
invest in long-term financial assets, in many ways:
a) It brings together the buyers and sellers of securities and thus ensures the
marketability of investments.
b) By advertising security prices, the stock exchange enables investors to keep track
of their investments and channel them into the most profitable lines.
c) It safeguards the interests of the investors by compensating them from the stock
exchange’s investor protection fund which is also known as a settlement guarantee
fund in the event of fraud and default.

3. Liquidity Function: Capital Market provides a means by which buyers and sellers can
exchange securities at mutually agreed prices. This allows better liquidity for the securities
that are traded.

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4. Capital Formation
Capital formation is regarded as a key to economic development as it leads to an increase in
the supply of machinery, equipment, plants, and also an increase in human capital. This
increases production and productivity in an economy. This in turn increases employment
opportunities and the standard of living of people. The chart below indicates the capital
formation process.

Increase in saving Mobilization of Investment of

saving saving

Capital formation

Figure 1.1: Stages of capital formation

Key points
✓ The key roles of the financial system are transfer funds from surplus units to
deficit units, efficient price discovery, liquidity, and reduction of transaction
costs.
✓ The key functions of the financial system also include resource allocation
function, liquidity function, and capital formation function.

1.4 How the Financial System Functions: The Direct & Indirect Finance
Financial markets perform the essential economic function of channeling funds from households,
firms, and governments that have saved surplus funds by spending less than their income to
those that have a shortage of funds because they wish to spend more than their income. This
function is shown schematically in Figure 1.2. Those who have saved and are lending funds, the
lender-savers, are at the left and those who must borrow funds to finance their spending, the
borrower-spenders, are at the right. The principal lender-savers are households, but business
enterprises and the government (particularly state and local government), as well as foreigners
and their governments, sometimes also find themselves with excess funds and so lend them out.

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Figure 1.2: Direct and indirect financial flow

1.4.1 Direct Finance

In direct finance, borrowers borrow funds directly from lenders in financial markets by selling them
securities (also called financial instruments), which are claims on the borrower’s future income or
assets. Securities are assets for the person who buys them, but they are liabilities for the individual
or firm that sells (issues) them. For example, if Marathon Motors needs to borrow funds to pay for
a new factory to manufacture electric cars, it might borrow the funds from savers by selling them
a bond, a debt security that promises to make payments periodically for a specified period of time,
or a stock, a security that entitles the owner to a share of the company’s profits and assets.

Why is this channeling of funds from savers to spenders so important to the economy? The
answer is that the people who save are frequently not the same people who have profitable
investment opportunities available to them, the entrepreneurs. Financial markets are critical for
producing an efficient allocation of capital (wealth, either financial or physical, that is employed to
produce more wealth), which contributes to higher production and efficiency for the overall
economy. Examples of direct financing include share issues, corporate bonds, and government
securities. These securities are discussed further in successive parts of the training module.

The Benefits and Disadvantages of Direct Finance

Direct finance is generally available only to corporations and government agencies that have
established a good credit rating. A credit rating is an assessment of the creditworthiness of an
issuer of the security. As the contractual relationship in direct finance is directly between the
provider of funds and the issuer of the security, the risk that the issuer may default is an important
consideration. Therefore, borrowers that do not have an established good credit rating generally
are not able to borrow direct.

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The main advantages of direct finance are as follows:
• It removes the cost of a financial intermediary. If a borrower obtains a loan from a
financial institution through indirect finance, the borrower will pay a profit margin to the
intermediary. Should a corporation or government authority have an investment-grade
credit rating, it may well be able to raise funds directly from the domestic or international
markets at a lower total cost than borrowing through a bank.
• It allows a borrower to diversify funding sources by accessing both the domestic and
international money and capital markets. This reduces the risk of exposure to a single
funding source or market. It enables greater flexibility in the types of funding instruments
used to meet different financing needs. More sophisticated funding strategies may be used
to raise funds. For example, a corporation may obtain a US dollar (USD) loan in the
international capital markets and then use USD export income to repay the loan.
• An organization may enhance its international profile by carrying out transactions in the
international financial markets. An increased profile in the financial markets may be
beneficial in establishing a reputation in the markets for the firm’s goods and services.

There are some disadvantages that may, at times, be associated with direct financing. These
include:
• There can be a problem of matching the preferences of lenders and borrowers. For
example, a lender may have a certain amount of funds available for investment, but this
amount may not be sufficient for the needs of the borrower, who would then need to seek
out and enter into funding arrangements with additional suppliers of funds. There may also
be a mismatch in the maturity structure of the funding as the borrower may need to borrow
for a longer period than the risk-averse investor is willing to lend.
• The liquidity and marketability of a direct finance instrument may be of concern.
How easy is it for the holder of an instrument issued by direct finance to sell at a later
date? Is there a deep and liquid secondary market in that instrument? Not all financial
instruments have an active secondary market through which they may be sold.
• The search and transaction costs associated with a direct issue can be quite high.
These might include advisory fees, the cost of preparing a prospectus, legal fees, taxation
advice, and accounting advice. On very large direct finance transactions the fees and
costs may run into millions of dollars.
• It can be difficult to assess the level of risk of investment in a direct issue, particularly
default risk. Accounting and reporting standards may vary between nation-states, and
information about an issuer may be limited to the prospectus and the issuer’s credit rating.

1.4.2 Intermediated Finance

As shown in Figure 1.2), funds also can move from lenders to borrowers by a second route called
indirect finance because it involves a financial intermediary that stands between the lender-
savers and the borrower-spenders and helps transfer funds from one to the other. A financial
intermediary does this by borrowing funds from the lender-savers and then using these funds to
make loans to borrower-spenders. For example, a bank might acquire funds by issuing a liability
to the public (an asset for the public) in the form of savings deposits. It might then use the funds
to acquire an asset by making a loan to Ethiopian Airline or by buying a government treasury bill.

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The ultimate result is that funds have been transferred from the public (the lender-savers) to
Ethiopian Airlines or the government (the borrower-spender) with the help of the financial
intermediary (the bank).

The process of indirect finance using financial intermediaries, called financial intermediation, is
the primary route for moving funds from lenders to borrowers. Indeed, although the media focus
much of their attention on securities markets, particularly the stock market, financial
intermediaries are a far more important source of financing for corporations than securities
markets are.

The Benefits of Financial Intermediation

Very often the portfolio preferences of savers and borrowers differ. For example, a risk-averse
lender may be prepared to receive a lower rate of return in exchange for maintaining funds at call.
On the other hand, a borrower may be prepared to pay a higher rate of return but may want to
have the funds available for several years. Many savers and borrowers would likely find it difficult
to meet their investment and funding needs if only direct finance was possible. An intermediary is
able to resolve this problem and satisfy the preferences of both parties and at the same time make
a profit.

An intermediary is able to transform short-term deposit funds into longer-term loan funds. An
essential economic role of an intermediary is to resolve the conflicting preferences of surplus units
and deficit units, and thus encourage both savings and productive capital investment. In carrying
out the role of offering instruments with varying financial attributes (risk, return, liquidity, timing of
cash flows), intermediaries perform a range of functions that are important to both savers and
borrowers. These are:
• asset transformation
• maturity transformation
• credit risk diversification and transformation
• liquidity transformation
• economies of scale.

Asset Transformation
Financial intermediaries engage in asset transformation by offering their customers a wide range
of financial products on both sides of the balance sheet, including deposit, investment and loan
products. Without intermediation, surplus units that could generate only small levels of savings
would not have any incentive to save; and users of funds, such as individuals and small
businesses, would find the cost of obtaining loans too high to be worthwhile. Intermediaries
specialize in the gathering of savings and can achieve economies of scale in their operations.
They can profitably receive small amounts from many savers, pool them into larger amounts and
make them available as loans to borrowers. Financial intermediaries provide a range of deposit
products that meet the varying preferences and needs of their customers. These include demand
deposit accounts, current accounts, term deposits, and cash management trusts. At the same
time, financial intermediaries provide a range of loan products, including overdraft facilities, term
loans, mortgage loans, and credit card facilities.

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Maturity Transformation
Most frequently, savers prefer great liquidity in their financial assets, while borrowers tend to prefer
a longer-term commitment in the funds they borrow. By managing the deposits they receive,
intermediaries are able to make loans of a longer-term nature while satisfying savers’ preferences
for shorter-term savings. This is referred to as maturity transformation. Banks provide a good
example of the maturity transformation function of intermediaries. The banks, therefore, have a
mismatch between the terms to maturity of a large proportion of their sources of funds and their
loan liabilities. Financial intermediaries are able to perform such extremes of maturity
transformation for two reasons.
• First, it is unlikely that all savers would choose to withdraw their deposits at the same time.
Deposit withdrawals during any particular period are generally more or less matched by
new deposits.
• Second, financial intermediaries that engage in maturity transformation rely on liability
management. Should a bank’s deposit base (liabilities) begin to decline below the level
necessary to fund its forecast loan portfolio (assets), then the bank may adjust the interest
rates that it offers in order to attract the necessary additional deposits. More probably, the
bank will issue further securities (liabilities) directly into the money or capital markets to
raise the additional funds required.

Credit Risk Diversification and Transformation

Credit risk transformation occurs through the contractual agreements of intermediation. A saver
has an agreement with the financial intermediary, and therefore the credit risk exposure of the
saver is limited to the risk of the intermediary defaulting. The financial intermediary has a separate
loan agreement with the borrower and is exposed to the credit risk of the borrower. Financial
intermediaries have advantages over most individual savers in managing investments.
Intermediaries specialize in making loans and therefore develop expertise in assessing the risk
of potential borrowers. This expertise comes from the technical skills of the employees and
systems in assessing and monitoring loan applications, and also from the information that is
acquired through prior dealings with the borrower.

Liquidity Transformation
Savers generally prefer liquidity in their investments. One reason for this is that the timing of a
saver’s income and expenditure flows will not perfectly coincide. There are times when income is
higher than expenditure and savings are available for investment purposes. On the other hand,
there are times when expenditure exceeds income. To try and manage this timing problem, savers
will tend to hold at least some of their financial assets in a very liquid form that can easily be
converted to cash. Liquidity transformation is measured by the ability to convert financial assets
into cash at something close to the current market price of the financial instrument. Banks have
further extended liquidity arrangements by adopting systems such as electronic networks:
automatic teller machines (ATMs) and electronic funds transfer at point of sale (EFTPOS)
arrangements.

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Economies of Scale
Financial intermediaries gain considerable economies of scale due to their size and the volume
of business transacted and therefore have the resources to develop cost-efficient distribution
systems. Banks maintain extensive branch networks as their primary distribution mechanism. At
the same time, they also provide extensive technology-based distribution systems such as ATMs,
EFTPOS, telephone banking, and Internet banking. Intermediaries also obtain cost advantages
through effective knowledge management and the accumulation of financial, economic, and legal
expertise. In a competitive market, financial intermediaries should pass on efficiency gains in the
form of reduced interest margins and fees.

1.5 Major Components of the Financial System

The major components of any financial system are:
1) Financial institutions
2) Financial markets
3) Financial instruments
4) Regulation of the financial system
5) Technology and financial infrastructure

1.5.1 Financial Institutions

Financial institutions (e.g., commercial and savings banks, credit unions, insurance companies,
mutual funds) perform the essential function of channeling funds from those with surplus funds
(suppliers of funds) to those with shortages of funds (users of funds). Because financial markets
are imperfect, securities buyers and sellers do not have full access to information. Individuals with
available funds are not normally capable of identifying credit-worthy borrowers to whom they could
lend those funds. In addition, they do not have the expertise to assess the creditworthiness of
potential borrowers. Financial institutions involve different types of depository and non-depository
institutions which will be discussed in section 1.6.

Activity 1
Try to identify the most important services provided by financial institutions or
financial enterprises.
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________

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Reflection
Financial enterprises, more popularly referred to as financial institutions, provide
services related to one or more of the following:
1. Transforming financial assets acquired through the market and constituting
them into a different, and more widely preferable, type of asset—which
becomes their liability. This is the function performed by financial
intermediaries, the most important type of financial institution.
2. exchanging of financial assets on behalf of customers
3. exchanging of financial assets for their own accounts
4. assisting in the creation of financial assets for their customers, and then selling
those financial assets to other market participants
5. providing investment advice to other market participants
6. managing the portfolios of other market participants

1.5.2 Financial Markets

A financial market is a market in which financial assets (securities) such as stocks and bonds can
be purchased or sold. Funds are transferred in financial markets when one party purchases
financial assets previously held by another party. Financial markets facilitate the flow of funds and
thereby allow financing and investing by households, firms, and government agencies. Financial
markets
are classified into primary vs secondary markets, bond market vs equity market, money market
vs capital market, cash or spot market vs futures market, exchange traded market vs over-the-
counter (OTC) market. Details of these markets will be presented in section 1.7.

Activity 2
How do financial markets promote economic efficiency and economic growth?
___________________________________________________________________
___________________________________________________________________

Reflection
In financial markets, funds are transferred from surplus units who have an excess of
available funds to deficit units who have a shortage. Financial markets, such as bond
and stock markets, are crucial to promoting greater economic efficiency by channeling
funds from people who do not have a productive use for them to those who do. Indeed,
well-functioning financial markets are a key factor in producing high economic
growth, and poorly performing financial markets are one reason that many countries
in the world remain desperately poor. Activities in financial markets also have direct
effects on personal wealth, the behavior of businesses and consumers, and the cyclical
performance of the economy.
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1.5.3 Financial Instruments
Financial instruments are also known as financial securities, financial claims, or financial assets.
Financial instruments are claims on future assets or earnings. A financial instrument is issued by
a party raising funds, acknowledging a financial commitment, and entitling the holder to specified
future cash flows. For the holder, a financial instrument is an asset and for the issuer, a financial
instrument is a liability. However, if it represents equity, it will appear as part of shareholder funds
(capital). A financial instrument acknowledges a financial commitment and represents an
entitlement to future cash flows. The different types of financial instruments namely money market
securities, capital market securities, and derivatives will be discussed in section 1.8.

Activity 3
Define financial assets or instruments and describe the difference between
financial assets and tangible assets. Besides, show the common characteristics
and links between financial assets and tangible assets
______________________________________________________________
______________________________________________________________
______________________________________________________________

Reflection
An asset, broadly speaking, is any possession that has value in an exchange. Assets can be
classified as tangible or intangible. A tangible asset is one whose value depends on particular
physical properties—examples are buildings, land, or machinery. Intangible assets, by contrast,
represent legal claims to some future benefit. Their value bears no relation to the form, physical
or otherwise, in which these claims are recorded. Financial assets are intangible assets. For
financial assets, the typical benefit or value is a claim to future cash. This section deals with the
various types of financial assets, the markets where they are traded, and the principles for valuing
them. Throughout this training module, we use the terms financial asset, financial instrument,
and security interchangeably. The entity that has agreed to make future cash payments is called
the issuer of the financial asset; the owner of the financial asset is referred to as the investor.
A tangible asset such as a plant or equipment purchased by a business entity shares at least one
characteristic with a financial asset: Both are expected to generate future cash flow for their
owner. For example, suppose Ethiopian Airlines purchases a fleet of aircraft for $500 million.
With its purchase of the aircraft, the airline expects to realize cash flow from passenger travel.
Financial assets and tangible assets are linked. Ownership of tangible assets is financed by the
issuance of some type of financial asset—either debt instruments or equity instruments. For
example, in the case of the airline, suppose that a debt instrument is issued to raise the $500
million to purchase the fleet of aircraft. The cash flow from passenger travel will be used to
service the payments on the debt instrument. Ultimately, therefore, the cash flow for a financial
asset Regulation
1.5.4 is generated of
bythe
some tangible System
Financial asset.

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The financial system is among the most heavily regulated sectors of the economy. The standard
explanation or justification for governmental regulation of a market is that the market, left to itself,
will not produce its particular goods or services in an efficient manner and at the lowest possible
cost. Of course, efficiency and low-cost production are hallmarks of a perfectly competitive
market. Thus, a market unable to produce efficiently must be one that is not competitive at the
time, and that will not gain that status by itself in the foreseeable future. Of course, it is also
possible that governments may regulate markets that are viewed as competitive currently but
unable to sustain competition, and thus low-cost production, over the long run. A version of this
justification for regulation is that the government controls a feature of the economy that the market
mechanisms of competition and pricing could not manage without help. A shorthand expression
economists use to describe the reasons for regulation is market failure. A market is said to fail if
it cannot, by itself, maintain all the requirements for a competitive situation.

The government regulates financial markets for two main reasons: to increase the information
available to investors and to ensure the soundness of the financial system.

1. Increasing Information Available to Investors

Asymmetric information in financial markets means that investors may be subject to adverse
selection and moral hazard problems that may hinder the efficient operation of financial
markets. Risky firms may be the most eager to sell securities to unwary investors and the
resulting adverse selection problem may keep investors out of financial markets. Furthermore,
once an investor has bought a security, thereby lending money to a firm, the borrower may
have incentives to engage in risky activities or to commit outright fraud. The presence of this
moral hazard problem may also keep investors away from financial markets. Government
regulation can reduce adverse selection and moral hazard problems in financial markets and
enhance the efficiency of the markets by increasing the amount of information available to
investors.

Regulators require corporations issuing securities to disclose certain information about their
sales, assets, and earnings to the public and restrict trading by the largest stockholders
(known as insiders) in the corporation. By requiring disclosure of this information and by
discouraging insider trading, which could be used to manipulate security prices, the regulator
hopes that investors will be better informed and protected from some of the abuses in financial
markets.

2. Ensuring the Soundness of Financial Intermediaries

Asymmetric information can lead to the widespread collapse of financial intermediaries,
referred to as a financial panic. Because providers of funds to financial intermediaries may
not be able to assess whether the institutions holding their funds are sound, if they have
doubts about the overall health of financial intermediaries, they may want to pull their funds
out of both sound and unsound institutions. The possible outcome is a financial panic that
produces large losses for the public and causes serious damage to the economy.

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Governments in most developed economies have created elaborate systems of regulation for
financial markets, in part because the markets themselves are complex and in part because
financial markets are so important to the general economies in which they operate. The numerous
rules and regulations are designed to serve several purposes, which fall into the following
categories:
1. to prevent issuers of securities from defrauding investors by concealing relevant
information
2. to promote competition and fairness in the trading of financial securities
3. to promote the stability of financial institutions
4. to restrict entry
5. to insure depositors
6. to restrict the activities of foreign concerns in domestic markets and institutions
7. to control the level of economic activity

Corresponding to each of these categories is an important form of regulation. We discuss each

form in turn.

1. Disclosure regulation is the form of regulation that requires issuers of securities to make
public a large amount of financial information to actual and potential investors. The
standard justification for disclosure rules is that the managers of the issuing firm have
more information about the financial health and future of the firm than investors who own
or are considering the purchase of the firm’s securities. The cause of market failure here,
if indeed it occurs, is commonly described as asymmetric information, which means
investors and managers have uneven access to or uneven possession of information. This
is referred to as the agency problem, in the sense that the firm’s managers, who act as
agents for investors, may act in their own interests to the disadvantage of the investors.
The advocates of disclosure rules say that, in the absence of the rules, the investors’
comparatively limited knowledge about the firm would allow the agents to engage in such
practices.

2. Financial activity regulation consists of rules about traders of securities and trading on
financial markets. A prime example of this form of regulation is the set of rules against
trading by corporate insiders who are corporate officers and others in positions to know
more about a firm’s prospects than the general investing public. Insider trading is another
problem posed by asymmetric information, which is of course inconsistent with a
competitive market. A second example of this type of regulation would be rules regarding
the structure and operations of exchanges where securities are traded so as to minimize
the risk of defrauding the general investing public.

3. Restrictions on Entry - Individuals or groups that want to establish a financial

intermediary, such as a bank or an insurance company, must obtain a license from the
central bank or the regulatory agency. Only if they appear to be upstanding citizens with
impeccable credentials and a large number of initial funds will they be given a license.

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4. Restrictions of financial institutions on Assets and Activities is the form of
government monitoring that restricts these institutions’ activities in the vital areas of
lending, borrowing, and funding. Financial intermediaries are restricted in what they are
allowed to do and what assets they can hold. Before you put funds into a bank or some
other such institution, you would want to know that your funds are safe and that the bank
or other financial intermediary will be able to meet its obligations to you. One way of doing
this is to restrict the financial intermediary from engaging in certain risky activities. Another
way to limit a financial intermediary’s risky behavior is to restrict it from holding certain
risky assets, or at least from holding a greater quantity of these risky assets than is
prudent. For example, commercial banks and other depository institutions are not allowed
to hold common stock because stock prices experience substantial fluctuations. Insurance
companies are allowed to hold common stock, but their holdings cannot exceed a certain
fraction of their total assets.

5. Deposit Insurance - The government can insure people’s deposits so that they do not
suffer great financial loss if the financial intermediary that holds these deposits should fail.
The licensed insurance company can insure each depositor at a commercial bank, savings
and loan association, or mutual savings bank up to a certain loss amount per account.

6. Regulation of foreign participants is the form of governmental activity that limits the
roles foreign firms can have in domestic markets and their ownership or control of financial
institutions.

7. Authorities use banking and monetary regulation to try to control changes in a country’s
money supply, which is thought to control the level of economic activity. There are
countries with regulations to set maximum interest rates that banks could pay on savings
deposits. These regulations were instituted because of the widespread belief that
unrestricted interest-rate competition had contributed to bank failures.

1.5.5Technology and Infrastructure

Historically, financial markets had physical locations where buyers and sellers (or their agents)
met and negotiated the price of a security. Today, information technology has removed the
necessity for a physical location and allowed the creation of a virtual marketplace. Electronic
trading of stocks, bonds, and derivatives continues to replace physical markets. Today most
exchanges are demutualized entities based on the electronic trading model. One of the biggest
drivers of this change has been the adoption of technology which is the primary engine for every
component of the trade cycle.
The basic story of the transformation of exchanges from floor trading to screen trading is a story
of Schumpeter’s “creative destruction” in which new, more efficient, more transparent systems
are taking their place over old systems and old ways of doing things. The clerks, runners, and
price reporters are no longer needed to manage the flow of customer orders as the orders shift
from voice to keyboard and as the bids and offers are automatically matched and captured. The
staff of both exchanges and brokerage firms are shifting from those who took care of order entry,

17
trade matching, and trade and price reporting on a physical trading floor to those who take care
of the hardware and software of screen-based systems.

From their humble beginnings as a place for buyers and sellers to gather to trade goods,
exchanges have grown into complex organizations critical to the domestic and global economy.
The introduction of exchanges marked the beginning of the modern financial market structure.
The exchange was a novel idea introduced to address some of the inefficiencies in early trading
and to protect the interest of market actors and the public at large. Through electronic systems,
the markets have seen new levels of transparency, speed, and anonymity that would not have
been possible in floor trading. Traders have access to more markets and products in real-time
than they ever did in the past. A new wave of innovative applications is helping the trading
community use the flood of data to develop new strategies, trade a larger range of products and
manage greater volume. Transparency in the marketplace has also helped regulators and risk
managers track markets and trading activity more efficiently and accurately.

The transition from floor trading to online trading will help exchanges to provide traders, floor
representatives, and clients with the most efficient and transparent trading environment in terms
of market access, trade execution, market integrity, and data dissemination.

Key points
✓ The major components of any financial system are financial institutions, financial
markets, financial instruments, regulation, and technology and financial infrastructure.
✓ Financial institutions channel funds from those with surplus funds (suppliers of funds)
to those with shortages of funds (users of funds).
✓ A financial market is the platform where financial assets (securities) such as stocks and
bonds are traded.
✓ Financial instruments are also known as financial securities, financial claims, or
financial assets are claims on future assets or earnings.
✓ Regulation of financial markets is needed to prevent market failures by improving
efficiency, reducing costs, and fostering competition.
✓ Information technology improves the efficiency of financial markets where electronic
trading of stocks, bonds, and derivatives continues to replace physical markets.

1.6 Classification of Financial Institutions

Financial institutions are needed to resolve the limitations caused by market imperfections. They
accept funds from surplus units and channel the funds to deficit units. Without financial
institutions, the information and transaction costs of financial market transactions would be
excessive.

Financial institutions can be classified as:

1. depository institutions
2. non-depository institutions.

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1.6.1 Depository Institutions
Depository institutions accept deposits from surplus units and provide credit to deficit units
through loans and purchases of securities. They are popular financial institutions for the following
reasons.
• They offer deposit accounts that can accommodate the amount and liquidity
characteristics desired by most surplus units.
• They repackage funds received from deposits to provide loans of the size and maturity
desired by deficit units.
• They accept the risk on loans provided.
• They have more expertise than individual surplus units in evaluating the creditworthiness
of deficit units.
• They diversify their loans among numerous deficit units and therefore can absorb
defaulted loans better than individual surplus units could.

To appreciate these advantages, consider the flow of funds from surplus units to deficit units if
depository institutions did not exist. Each surplus unit would have to identify a deficit unit desiring
to borrow the precise amount of funds available for the precise time period in which funds would
be available. Furthermore, each surplus unit would have to perform the credit evaluation and incur
the risk of default. Under these conditions, many surplus units would likely hold their funds rather
than channel them to deficit units. Hence, the flow of funds from surplus units to deficit units would
be disrupted.

The common types of depository institutions are:

1. Commercial banks
2. Saving or thrift institutions
3. Credit unions

A more specific description of each depository institution’s role in the financial markets follows.

Commercial Banks
In aggregate, commercial banks are the most dominant depository institution. They serve surplus
units by offering a wide variety of deposit accounts, and they transfer deposited funds to deficit
units by providing direct loans or purchasing debt securities. Commercial bank operations are
exposed to risk because their loans and many of their investments in debt securities are subject
to the risk of default by the borrowers.

Commercial banks serve both the private and public sectors; their deposit and lending services
are utilized by households, businesses, and government agencies. The federal funds market
facilitates the flow of funds between depository institutions (including banks). A bank that has
excess funds can lend to a bank with deficient funds for a short-term period, such as one to five
days. In this way, the federal funds market facilitates the flow of funds from banks that have excess
funds to banks that are in need of funds.

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Savings/Thrit Institutions
Savings institutions, which are sometimes referred to as thrift institutions, are another type of
depository institution. Savings institutions include savings and loan associations (S&Ls) and
savings banks. Like commercial banks, savings institutions offer deposit accounts to surplus units
and then channel these deposits to deficit units. They are typically jointly owned by the individuals
that have deposited or borrowed money from them – the members. It is for this reason that such
savings organizations are often described as ‘mutual societies. Whereas commercial banks
concentrate on commercial (business) loans, savings institutions concentrate on residential
mortgage loans. Normally, mortgage loans are perceived to exhibit a relatively low level of risk,
but many mortgages also defaulted. This led to the credit crisis and caused financial problems for
many savings institutions.

Credit Unions
Credit unions differ from commercial banks and savings institutions in that they:
• are nonprofit and
• restrict their business to credit union members, who share a common bond (such as a
common employer or union).

Like savings institutions, they are sometimes classified as thrift institutions in order to distinguish
them from commercial banks. Because of the “common bond” characteristic, credit unions tend
to be much smaller than other depository institutions. They use most of their funds to provide
loans to their members.

1.6.2 Non-depository Financial Institutions

Non-depository institutions generate funds from sources other than deposits but also play a major
role in financial intermediation. The major types of non-depository institutions are:
1. Finance companies 4. Insurance companies
2. Mutual funds 5. Pension funds
3. Security firms

Finance Companies
Most finance companies obtain funds by issuing securities and then lending the funds to
individuals and small businesses. The functions of finance companies and depository institutions
overlap, although each type of institution concentrates on a particular segment of the financial
markets.

Mutual Funds
Mutual funds sell shares to surplus units and use the funds received to purchase a portfolio of
securities. They are the dominant non-depository financial institution when measured in total
assets. Some mutual funds concentrate their investment in capital market securities, such as
stocks or bonds. Others, known as money market mutual funds, concentrate in money market
securities. Typically, mutual funds purchase securities in minimum denominations that are larger
than the savings of an individual surplus unit. By purchasing shares of mutual funds and money

20
market mutual funds, small savers are able to invest in a diversified portfolio of securities with a
relatively small amount of funds.

Securities Firms
Securities firms provide a wide variety of functions in financial markets. The major types of security
firms are:

• Brokers
• Agents
• Investment banks

Brokers
Brokers are securities firms engaged in executing securities transactions between two parties.
The broker fee for executing a transaction is reflected in the difference (or spread) between the
bid quote and the ask quote. The markup as a percentage of the transaction amount will likely be
higher for less common transactions since more time is needed to match up buyers and sellers.
The markup will also likely be higher for transactions involving relatively small amounts so that
the broker will be adequately compensated for the time required to execute the transaction.

Dealers
Dealers are security firms that are market makers of specific securities by maintaining an
inventory of securities. Although a broker’s income is mostly based on the markup, the dealer’s
income is influenced by the performance of the security portfolio maintained. Some dealers also
provide brokerage services and therefore earn income from both types of activities.

Investment Banks
In addition to brokerage and dealer services, securities firms also provide underwriting and
advising services. The underwriting and advising services are commonly referred to as
investment banking, and the securities firms that specialize in these services are sometimes
referred to as investment banks. When securities firms underwrite newly issued securities, they
may sell the securities for a client at a guaranteed price or may simply sell the securities at the
best price they can get for their client. Some securities firms offer advisory services on mergers
and other forms of corporate restructuring. In addition to helping a company plan its restructuring,
the securities firm also executes the change in the client’s capital structure by placing the
securities issued by the company.

Insurance Companies
Insurance companies provide individuals and firms with insurance policies that reduce the
financial burden associated with death, illness, and damage to property. These companies charge
premiums in exchange for the insurance that they provide. They invest the funds received in the
form of premiums until the funds are needed to cover insurance claims. Insurance companies
commonly invest these funds in stocks or bonds issued by corporations or in bonds issued by the
government. In this way, they finance the needs of deficit units and thus serve as important
financial intermediaries.

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Pension Funds
Many corporations and government agencies offer pension plans to their employees. The
employees and their employers (or both) periodically contribute funds to the plan. Pension funds
provide an efficient way for individuals to save for their retirement. The pension funds manage the
money until the individuals withdraw the funds from their retirement accounts. The money that is
contributed to individual retirement accounts is commonly invested by pension funds in stocks or
bonds issued by corporations or in bonds issued by the government. Thus, pension funds are
important financial intermediaries that finance the needs of deficit units.

Summary of institutional sources and use of funds

Financial Main Sources of Funds Main Uses of Funds
Institutions

Commercial Deposits from households, Purchases of government and

Banks businesses, and corporate securities; loans to
government agencies businesses and households

Saving Deposits from households, Purchases of government and

institutions businesses, and corporate securities; mortgages and
government agencies other loans to households; some loans
to businesses

Credit Unions Deposits from credit union Loans to credit union members
members

Finance Securities sold to households Loans to households and businesses

Companies and businesses

Mutual Funds Shares sold to households, Purchases of long-term government

businesses, and government and corporate securities
agencies

Insurance Insurance premiums and Purchases of long-term government

companies earnings from investments and corporate securities

Pension funds Employer/employee Purchases of long-term government

contributions and corporate securities

Activity 4
Try to identify the most important services provided by financial institutions or
financial enterprises
____________________________________________________________________
____________________________________________________________________
____________________________________________________________________

22
Reflection
Financial enterprises, more popularly referred to as financial institutions, provide
services related to one or more of the following:
1. Transforming financial assets acquired through the market and constituting
them into a different, and more widely preferable, type of asset—which
becomes their liability. This is the function performed by financial
intermediaries, the most important type of financial institution.
2. exchanging of financial assets on behalf of customers
3. exchanging of financial assets for their own accounts
4. assisting in the creation of financial assets for their customers, and then selling
those financial assets to other market participants
5. providing investment advice to other market participants
6. managing the portfolios of other market participants

1.7 Classification of Financial Markets

The key function of financial markets is the transfer of funds from those who have excess funds
to those who need funds. Many households and businesses with excess funds are willing to
supply funds to financial markets because they earn a return on their investment. Those
participants who receive more money than they spend are referred to as surplus units (or
investors). They provide their net savings to the financial markets. Those participants who spend
more money than they receive are referred to as deficit units. They access funds from financial
markets so that they can spend more money than they receive.

Financial markets play the following two roles.

1. Accommodating corporate finance needs
• A key role of financial markets is to accommodate corporate finance activity and
• The financial markets serve as the mechanism whereby corporations (acting as deficit
units) can obtain funds from investors (acting as surplus units).

2. Accommodating investment needs

• Another key role of financial markets is accommodating surplus units who want to
invest in either debt or equity securities. Investment management involves decisions
by investors regarding how to invest their funds.
• The financial markets offer investors access to a wide variety of investment
opportunities, including securities issued by the Treasury and government agencies
as well as securities issued by corporations.

Activity 5
How do deficit units (borrowers) finance their need using debt and equity securities?
____________________________________________________________________

23
Reflection
Related to accommodating finance needs, many deficit units such as firms and government
agencies access funds from financial markets by issuing securities, which represent a claim
on the issuer. Debt securities represent debt (also called credit, or borrowed funds) incurred
by the issuer. Deficit units that issue the debt securities are borrowers. The surplus units
that purchase debt securities are creditors, and they receive interest on a periodic basis (such
as every six months). Debt securities have a maturity date, at which time the surplus units
can redeem the securities in order to receive the principal (face value) from the deficit units
that issued them. Equity securities (also called stocks) represent equity or ownership in the
firm. Some large businesses prefer to issue equity securities rather than debt securities when
they need funds.

Classification of Financial Markets

Financial markets can be classified in different ways. The most common classification of financial
markets is into primary and secondary markets using the seasoning of claim criterion. However,
the structure of financial markets can also be classified into different categories by the nature of
the claim (debt market and equity market), by the maturity claim (money and capital market), by
the timing of delivery (cash or spot and futures market), and the organizational structure
(exchange traded vs OTC market).

Primary and Secondary Markets

Primary markets facilitate the issuance of new securities. Secondary markets facilitate the trading
of existing securities, which allows for a change in the ownership of the securities. Many types of
debt securities have a secondary market, so investors who initially purchased them in the primary
market do not have to hold them until maturity. Primary market transactions provide funds to the
initial issuer of securities; secondary market transactions do not.

An important characteristic of securities that are traded in secondary markets is liquidity, which
is the degree to which securities can easily be liquidated (sold) without a loss of value. Some
securities have an active secondary market, meaning that there are many willing buyers and
sellers of the security at a given moment in time. Investors prefer liquid securities so that they can
easily sell the securities whenever they want (without a loss in value).

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Financial Markets

By maturity of By timing of By organizational

By nature of claim
claim delivery structure

Debt market Money market Cash/spot market Exchange traded

market

Equity market Capital market Future market Over the counter

(OTC) market

Figure 1.2: Structure of financial markets

Debt and Equity Markets

A firm or an individual can obtain funds in a financial market in two ways. The most common
method is to issue a debt instrument, such as a bond or a mortgage, which is a contractual
agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular
intervals (interest and principal payments) until a specified date (the maturity date) when the final
payment is made. The maturity of a debt instrument is the number of years (term) until that
instrument’s expiration date. A debt instrument is short-term if its maturity is less than a year and
long-term if its maturity is 10 years or longer. Debt instruments with a maturity between one and
10 years are said to be intermediate-term.

The second method of raising funds is by issuing equities, such as common stock, which are
claims to share in the net income (income after expenses and taxes) and the assets of a business.
If you own one share of common stock in a company that has issued one million shares, you are
entitled to 1 one-millionth of the firm’s net income and 1 one-millionth of the firm’s assets. Equities
often make periodic payments (dividends) to their holders and are considered long-term securities
because they have no maturity date. In addition, owning stock means that you own a portion of
the firm and thus have the right to vote on issues important to the firm and to elect its directors.

Activity 6
What are the financial assets that have a fixed amount vis-à-vis financial assets with
residual or varying amount? Besides, discuss the reason why the payment structure
varies as fixed and residual?
____________________________________________________________________
____________________________________________________________________

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Reflection
The claim that the holder of a financial asset has may be either a fixed dollar amount or a
varying, or residual, amount. In the former case, the financial asset is referred to as a debt
instrument. The bank loan and the treasury bill are examples of debt instruments requiring fixed
dollar payments. An equity instrument (also called a residual claim) obligates the issuer of the
financial asset to pay the holder an amount based on earnings if any after holders of debt
instruments have been paid. Common stock is an example of an equity instrument. A
partnership share in a business is another example. Some securities fall into both categories.
Preferred stock, for example, is an equity instrument that entitles the investor to receive a fixed
dollar amount. This payment is contingent, however, and is due only after payments to debt
instrument holders are made. Another "combination "instrument is a convertible bond, which
allows the investor to convert debt into equity under certain circumstances. Both debt and
preferred stock that pay fixed dollar amounts are called fixed-income instruments.

Money Markets Vs Capital Markets

The money market is a financial market in which only short-term debt instruments (generally those
with an original maturity of less than one year) are traded. The capital market is the market in
which longer-term debt (generally with an original maturity of one year or greater) and equity
instruments are traded. Money market securities are usually more widely traded than longer-term
securities and so tend to be more liquid. Short-term securities have smaller fluctuations in prices
than long-term securities, making them safer investments. As a result, corporations and banks
actively use the money market to earn interest on surplus funds that are available only temporarily.
Capital market securities, such as stocks and long-term bonds, are often held by financial
intermediaries such as insurance companies and pension funds, which have little uncertainty
about the amount of funds they will have available in the future.

The money markets bring together institutional investors that have a surplus of funds and those
with a short-term shortage of funds. The money markets are attractive to institutional investors for
short-term financing arrangements as the markets are (normally) highly liquid and the securities
issued in the market are standardized and have well-developed secondary markets. The money
markets allow institutional investors, such as commercial banks, insurance offices, investment
banks, fund managers, finance companies, other finance institutions, government authorities and
large corporations to manage their short-term financing needs. For example, a large retail sales
store may accumulate surplus funds from sales. In order to gain a return, the store needs to invest
the surplus funds. However, the store may need to use the funds in a few days to buy more stock.
The store knows that it is able to purchase short-term securities in the money markets today that
can easily be sold again in a few days when the cash is needed.

From the point of view of borrowers, one of the principal functions of the money markets is to
enable them to bridge the mismatch between their cash expenditures and their cash receipts. A
large corporation may need to raise short-term funds to cover its forecast working-capital

26
requirements over the next three months. The corporation could borrow the funds from a bank,
but it may also find that it is able to borrow at a lower yield by issuing short-term securities directly
into the money markets. The securities issued may be repaid as the company generates income
from its products or services.

The money markets have no specific trading location. Money-market transactions are conducted
from the business offices of the market participants using computer networks.

Capital markets channel savings to finance the longer-term investment plans of businesses,
individuals and governments. Therefore, financial instruments are defined as capital-market
instruments if they have an original term to maturity in excess of one year. Capital-market
instruments include both debt instruments and equity. The capital markets are extremely large
and offer a wide range of products to meet the needs of both lenders and borrowers. For example,
loans may be obtained through direct or intermediated finance for periods ranging up to 30 years.
Loans may be secured or unsecured, have a fixed interest rate or a variable interest rate, and
have different repayment structures and timing of cash flows. The development of domestic
capital markets is extremely important for economic growth as they provide the long-term funds
necessary for productive investment.

Cash or Spot Markets Vs Futures Markets

In cash or spot transaction, as soon as a deal is struck between the buyer and the seller, the
buyer has to pay for the asset to the seller, who in turn transfers the rights to the asset to the
buyer. However, in the case of a futures contract, the actual transaction does not take place when
an agreement is reached between a buyer and a seller. In such cases, at the time of negotiating
a deal, the two parties merely agree on the terms on which they will transact at a future point in
time, including the price to be paid per unit of the underlying asset. Thus, the actual transaction
per se occurs only at a future date that is decided at the outset. Consequently, unlike in the case
of a cash transaction, no money changes hands when two parties enter into a futures contract.
However, both have an obligation to go ahead with the transaction on the predetermined date.

Exchanges and Over-the-Counter Markets

Secondary markets can be organized in two ways. One method is to organize exchanges, where
buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct
trades. The New York and American Stock Exchanges for stocks and the Ethiopia Commodity
Exchange (ECX) and the Chicago Board of Trade for commodities are examples of organized
exchanges. The other method of organizing a secondary market is to have an over-the-counter
(OTC) market, in which dealers at different locations who have an inventory of securities stand
ready to buy and sell securities “over the counter” to anyone who comes to them and is willing to
accept their prices. Because over-the-counter dealers are in contact via computers and know the
prices set by one another, the OTC market is very competitive and not very different from a market
with an organized exchange. Many common stocks are traded over the counter, although a
majority of the largest corporations have their shares traded at organized stock exchanges. The
U.S. government bond market or the Ethiopia government treasury bill by contrast, are set up as
an over-the-counter market. Other over-the-counter markets include those that trade other types

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of financial instruments such as negotiable certificates of deposit, federal funds, banker’s
acceptances, and foreign exchange.

1.8 Classification of Financial Instruments

Financial instruments of securities can be divided into:
1. Money market securities
2. Capital market securities
3. Derivatives

1.8.1 Money Market Instruments

Money market securities are debt securities with a maturity of one year or less.
Money market securities are commonly purchased by households, corporations (including
financial institutions), and government agencies that have funds available for a short-term period.
Because money market securities have a short-term maturity and can typically be sold in the
secondary market, they provide liquidity to investors. Money market securities tend to have a low
expected return but also a low degree of credit (default) risk. Most firms and financial institutions
maintain some holdings of money market securities for this reason.

The most popular money market securities are:

• Treasury bills (T-bills)
• Commercial paper
• Negotiable certificates of deposit
• Repurchase agreements (Repos)

Treasury Bills (T-Bills)

When governments need to borrow funds, they frequently issue short-term securities known as
Treasury bills. The Treasury issues T-bills with 4-week, 13-week, and 26-week maturities on a
weekly basis. It periodically issues T-bills with terms shorter than four weeks, which are called
cash management bills. It also issues T-bills with a one-year maturity on a monthly basis. Treasury
bills were formerly issued in paper form but are now maintained electronically.

Depository institutions commonly invest in T-bills so that they can retain a portion of their funds in
assets that can easily be liquidated if they suddenly need to accommodate deposit withdrawals.
Other financial institutions also invest in T-bills in the event that they need cash because cash
outflows exceed cash inflows. Individuals with substantial savings invest in T-bills for liquidity
purposes. Many individuals invest in T-bills indirectly by investing in money market funds, which
in turn purchase large amounts of T-bills. Corporations invest in T-bills so that they have easy
access to funding if they suddenly incur unanticipated expenses.

Treasury bills are attractive to investors because they are backed by the federal government and
are therefore virtually free of credit (default) risk. This is a very desirable feature because investors
do not have to use their time to assess the risk of the issuer, as they do with other issuers of debt
securities. Another attractive feature of T-bills is their liquidity, which is due to their short maturity

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and strong secondary market. At any given time, many institutional investors are participating in
the secondary market by purchasing or selling existing

Commercial Paper
Commercial paper is a short-term debt instrument issued only by well-known, credit-worthy firms.
It is normally issued to provide liquidity or to finance a firm’s investment in inventory and accounts
receivable. The issuance of commercial paper is an alternative to short-term bank loans. Some
large firms prefer to issue commercial paper rather than borrow from a bank because it is usually
a cheaper source of funds. Nevertheless, even the large creditworthy firms that are able to issue
commercial paper normally obtain some short-term loans from commercial banks in order to
maintain a business relationship with them. Financial institutions such as finance companies and
bank holding companies are major issuers of commercial paper.

Because commercial paper is issued by corporations that are susceptible to business failure,
commercial paper is subject to credit risk. The risk of default is affected by the issuer’s financial
condition and cash flow. Investors can attempt to assess the probability that commercial paper
will default by monitoring the issuer’s financial condition. The focus is on the issuer’s ability to
repay its debt over the short term because the payments must be completed within a short-term
period. Some firms place commercial paper directly with investors. Other firms rely on commercial
paper dealers to sell their commercial paper at a low transaction cost.

Negotiable Certificates of Deposit

Negotiable certificates of deposit (NCDs) are certificates issued by large commercial banks and
other depository institutions as a short-term source of funds. Non-financial corporations often
purchase NCDs. Although NCD denominations are typically too large for individual investors, they
are sometimes purchased by money market funds that have pooled individual investors’ funds.
Thus, money market funds allow individuals to be indirect investors in NCDs, creating a more
active NCD market. Maturities on NCDs normally range from two weeks to one year. A secondary
market for NCDs exists, providing investors with some liquidity. However, institutions prefer not to
have their newly issued NCDs compete with their previously issued NCDs being resold in the
secondary market. Some issuers place their NCDs directly; others use a correspondent institution
that specializes in placing NCDs. Another alternative is to sell NCDs to securities dealers who in
turn resell them.

Repurchase Agreements
With a repurchase agreement (or repo), one party sells securities to another with an agreement
to repurchase the securities at a specified date and price. In essence, the repo transaction
represents a loan backed by securities. If the borrower defaults on the loan, the lender has
claim to the securities. Most repo transactions use government securities, although some involve
other securities such as commercial paper or NCDs.

A reverse repo refers to the purchase of securities by one party from another with an agreement
to sell them. Thus, a repo and a reverse repo refer to the same transaction but from different
perspectives. These two terms are sometimes used interchangeably, so a transaction described

29
as a repo may actually be a reverse repo. Financial institutions such as banks, savings and loan
associations, and money market funds often participate in repurchase agreements. Many
nonfinancial institutions are also active participants.

The most common maturities are from 1 to 15 days and for one, three, and six months. A
secondary market for repos does not exist. Some firms in need of funds will set the maturity on a
repo to be the minimum time period for which they need temporary financing. If they still need
funds when the repo is about to mature, they will borrow additional funds through new repos and
use these funds to fulfill their obligation on maturing repos.

Activity 7
Identify the issuer/s or deficit units and the investors or surplus units for each
of the four types of money market securities discussed above.
______________________________________________________________
______________________________________________________________
______________________________________________________________

Table 1.1: Money-market participants and instruments

Securities Issued By Common Investors Common Market
Maturities Activities
Treasury bills Federal government Households, firms, 13 weeks, 26 High
and financial weeks, 1 year
institutions
Negotiable Large banks and Firms 2 weeks to 1 Moderate
certificates of savings institutions year
deposit (NCDs)
Commercial Bank holding Firms 1 day to 270 Low
paper companies, finance days
companies, and other
companies
Repurchase Firms and financial Firms and financial 1 day to 15 Nonexistent
agreements institutions institutions days

1.8.2 Capital Market Instruments

Financial instruments are defined as capital-market instruments if they have an original term to
maturity in excess of one year. Capital-market instruments include both debt instruments and
equity and encompass both the domestic and international markets. The capital markets are
extremely large and offer a wide range of products to meet the needs of both lenders and
borrowers. For example, loans may be obtained through direct or intermediated finance for
periods ranging up to 30 years. Loans may be secured or unsecured, have a fixed interest rate

30
or a variable interest rate, and have different repayment structures and timing of cash flows. The
development of domestic capital markets is extremely important for economic growth as they
provide the long-term funds necessary for productive investment. The major types of capital
market instruments are:
• Equity
• Bond
• Foreign exchange

Equity or Stock
When a firm goes public, it issues stock in the primary market in exchange for cash. This changes
the firm’s ownership structure by increasing the number of owners. It changes the firm’s capital
structure by increasing the equity investment in the firm, which allows the firm to pay off some of
its debt. It also enables corporations to finance their growth. A stock is a certificate representing
partial ownership in the firm. Like debt securities, common stock is issued by firms in the primary
market to obtain long-term funds. Yet the purchaser of stock becomes a part owner of the firm,
rather than a creditor. This ownership feature attracts many investors who want to have an equity
interest in a firm but do not necessarily want to manage their own firm.

The stock markets are like other financial markets in that they link the surplus units (that have
excess funds) with deficit units (that need funds). Within the context of a corporation, the main
form of security issued is the ordinary share, sometimes referred to as common stock. The other
type of stock is known as preferred stock. The shareholder has an entitlement to participate in the
profits of the business, by way of receiving either dividend payments or capital gains (losses) in
the value of the shareholding. From the perspective of the business, equity provides a source
of long-term funding that does not have to be repaid. Equity is available to:
• finance physical infrastructure such as buildings and equipment
• provide creditor confidence in dealing with the firm
• ensure the availability of funds to absorb abnormal losses
• improve the liquidity of the business.

Stock issued by corporations may be purchased directly by households. Alternatively, households

may invest in shares of stock mutual funds; the managers of these funds use the proceeds to
invest in stocks. Other institutional investors such as pension funds and insurance companies
also purchase stocks. In addition to the primary market, which facilitates new financing for
corporations, there is also a secondary market that allows investors to sell the stock they
previously purchased to other investors who want to buy it. Thus, the secondary market creates
liquidity for investors who invest in stocks. In addition to realizing potential gains when they sell
their stock, investors may also receive dividends on a quarterly basis from the corporations in
which they invest. Some corporations distribute a portion of their earnings to shareholders in the
form of dividends, but others reinvest all of their earnings so that they can achieve greater growth.

The ownership of common stock entitles shareholders to a number of rights not available to
other individuals. Normally only the owners of common stock are permitted to vote on certain key
matters concerning the firm, such as the election of the board of directors, authorization to issue

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new shares of common stock, approval of amendments to the corporate charter, and adoption of
bylaws. Many investors assign their vote to management through the use of a proxy, and many
other shareholders do not bother to vote. As a result, management normally receives the majority
of the votes and can elect its own candidates as directors.
Preferred stock represents an equity interest in a firm that usually does not allow for significant
voting rights. Preferred shareholders technically share the ownership of the firm with common
shareholders and are therefore compensated only when earnings have been generated. Thus, if
the firm does not have sufficient earnings from which to pay the preferred stock dividends, it may
omit the dividend without fear of being forced into bankruptcy. A cumulative provision on most
preferred stock prevents dividends from being paid on the common stock until all preferred stock
dividends (both current and those previously omitted) have been paid. The owners of preferred
stock normally do not participate in the profits of the firm beyond the stated fixed annual dividend.
All profits above

Bonds
Bonds are long-term debt securities that are issued by government agencies or corporations. The
issuer of a bond is obligated to pay interest (or coupon) payments periodically (such as annually
or semiannually) and the par value (principal) at maturity. An issuer must be able to show that its
future cash flows will be sufficient to enable it to make its coupon and principal payments to
bondholders. Investors will consider buying bonds for which the repayment is questionable only
if the expected return from investing in the bonds is sufficient to compensate for the risk.

Bonds are often classified according to the type of issuer. Treasury bonds are issued by
government agencies, municipal bonds are issued by state and local governments, and corporate
bonds are issued by corporations. Most bonds have maturities of between 10 and 30 years. Bonds
are classified by the ownership structure as either bearer bonds or registered bonds. Bearer
bonds require the owner to clip coupons attached to the bonds and send them to the issuer to
receive coupon payments. Registered bonds require the issuer to maintain records of who owns
the bond and automatically send coupon payments to the owners.

Foreign Exchanges
The fundamental fact of international finance is that different countries issue different currencies,
and the relative values of those currencies may change quickly, substantially, and without warning.
As a result, the risk that a currency’s value may change adversely, which is called foreign-
exchange risk or currency risk, is an important consideration for all participants in the international
financial markets. Investors who purchase securities denominated in a currency different from
their own must worry about the return from those securities after adjusting for changes in the
exchange rate.

A foreign exchange rate is the price at which one currency (e.g., the U.S. dollar) can be exchanged
for another currency (e.g., the ETB) in the foreign exchange markets. These transactions expose
Ethiopian corporations and exporters to foreign exchange risk as the cash flows are converted
into and out of ETB. Thus, in addition to understanding the operations of domestic financial

32
markets, financial managers and investors must also understand the operations of foreign
exchange markets and foreign capital markets.

As firms and investors increase the volume of transactions in foreign currencies, hedging foreign
exchange risk has become a more important activity. Financial managers therefore must
understand how events in other countries in which they operate affect cash flows received from
or paid to other countries and thus their company’s profitability. Foreign exchange markets are
the markets in which traders of foreign currencies transact most efficiently and at the lowest cost.
As a result, foreign exchange markets facilitate foreign trade, the raising of capital in foreign
markets, the transfer of risk between participants, and speculation on currency values.

The actual amount of ETB received on a foreign transaction depends on the (foreign) exchange
rate between ETB and USD or Euro. If ETB declines (or depreciates) 1 in value relative to the
U.S. dollar or Euro over time, the Birr value of the cash flows received will fall. If ETB rises (or
appreciates) in value relative to the U.S. dollar or Euro, the Birr value of the cash flows received
increases.

Key points
✓ Within the context of financial markets, primary markets are those markets where new
financial instruments are issued.
✓ Secondary markets are those markets where existing securities are bought and sold.
✓ Direct finance occurs when a provider of funds contracts with a user of funds. Benefits
can include lower cost of funds, access to diverse funding sources, and greater
financing flexibility. Disadvantages involve matching funding preferences, liquidity and
marketability of instruments issued, search and transaction costs, and risk assessment.
✓ Intermediated finance occurs when the provider of funds contracts with a financial
intermediary, such as a commercial bank, and the financial intermediary contracts
separately with the user of funds (borrower). Benefits include asset transformation,
maturity transformation, credit risk diversification and transformation, liquidity
transformation, and economies of scale.
✓ Money markets are direct finance wholesale markets for the issue of discount securities
such as bills of exchange, promissory notes (commercial paper), and negotiable
certificates of deposit. These short-term markets allow participants to manage their day-
to-day liquidity requirements.
✓ The capital markets provide long-term finance, including equity, corporate debt, and
government debt. The capital markets are supported by the foreign exchange market
and the derivatives markets.

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1.8.3 Derivatives
So far, we have focused on the cash market for financial assets. With some contracts, the contract
holder has either the obligation or the choice to buy or sell a financial asset at some future time.
The price of any such contract derives its value from the value of the underlying financial asset,
financial index, or interest rate. Consequently, these contracts are called derivative instruments.

Derivatives are financial contracts whose values are derived from the values of underlying assets.
They are widely used to speculate on future expectations or to reduce a security portfolio’s risk.
Derivative instruments are different from equity and debt in that they do not provide actual funds
for the issuer. Funds need to be raised in either the equity or debt markets. Risks associated with
equity or debt issues may be managed using derivative contracts. For example, an investor might
be concerned that the value of shares held in an investment portfolio might fall. The investor might
enter into a derivative contract that gives the investor the option to sell shares at a specified date
at a price that is agreed upon today. If the share price does fall, the investor will exercise the
option and sell at the agreed higher price.

Derivatives provide a range of risk management products that are available to borrowers to
manage risks associated with capital-market transactions. The principal risks to be managed
include interest rate risk, foreign exchange risk, and price risk. For example, a borrower with an
existing loan that has a variable interest rate might be concerned that the rate will increase in the
future. The borrower might use a derivative product to manage that risk. The same principles
apply for the risk that the exchange rate might change or that share prices may rise or fall.

Derivative instruments include:

• futures
• forwards
• options
• Swaps

Futures
A financial futures contract is a standardized agreement to deliver or receive a specified amount
of a specified financial instrument at a specified price and date. The buyer of a financial futures
contract buys the financial instrument, and the seller of a financial futures contract delivers the
instrument for the specified price. Futures contracts are standardized contracts that are traded
through a futures exchange.

Forwards
A forward contract is similar to a futures contract but is typically more flexible and is negotiated
over the counter with a commercial bank or investment bank. A forward foreign exchange contract
establishes a foreign currency exchange rate that will apply at a specified date. A forward rate
agreement is used to lock in an interest rate today that will apply at a specified date.
Option
An option contract gives the buyer of the option the right—but not an obligation—to buy (or sell)
the designated asset at a specified date or within a specified period during the life of the contract,

34
at a predetermined price. The fact that the buyer is not obliged to proceed with the contract is
valuable, and therefore the buyer must pay a premium to the writer of the option.

Swap
A swap contract is an arrangement to exchange specified future cash flows. With an interest rate
swap, there is an exchange (swap) of future interest payments based on a notional principal
amount. A currency swap is denominated in a foreign currency and fixes the exchange rate at
which the initial and final principal amounts are swapped.

Risk management through the use of derivative contracts is a complex area of finance and will
represent a challenging part of your later learning.

Activity 8
Do derivatives have an underlying value like stocks and bonds? What are the
key differences between derivatives and securities?
______________________________________________________________
______________________________________________________________
______________________________________________________________

Reflection
Derivatives do not have their own underlying value like stocks or bonds. They
are financial contracts whose values are derived from the values of underlying
assets. They are widely used to speculate on future expectations or to reduce a
security portfolio’s risk. Derivative instruments are different from equity and
debt in that they do not provide actual funds for the issuer. Funds need to be
raised in either the equity or debt markets. Risks associated with equity or debt
issues may be managed using derivative contracts.

Summary
The financial system primarily involves financial institutions, financial markets, and financial
instruments or securities. The basic function of financial markets is to channel funds from savers
(surplus units or lenders) who have an excess of funds to spenders (deficit units or borrowers)
who have a shortage of funds. Financial markets can do this either through direct finance, in which
borrowers borrow funds directly from lenders by selling them securities, or through indirect
finance, which involves a financial intermediary that stands between the lender-savers and the
borrower-spenders and helps transfer funds from one to the other. Because they allow funds to
move from people who have no productive investment opportunities to those who have such
opportunities, financial markets contribute to economic efficiency. In addition, channeling of funds
directly benefits consumers by allowing them to make purchases when they need them most.

35
Financial institutions can be classified into depository and non-depository institutions. Depository
and non-depository financial institutions help to finance the needs of deficit units. The main
depository institutions are commercial banks, savings institutions, and credit unions. The main
non-depository institutions are finance companies, mutual funds, security firms, pension funds,
and insurance companies.

Financial markets can be classified as debt and equity markets, primary and secondary markets,
exchanges and over-the-counter markets, spot and futures markets, and money and capital
markets. Securities can be classified as money market (short-term) securities, capital market
(long-term) securities, and derivatives. The major money market instruments are treasury bills,
commercial papers, negotiable certificates of deposits, and repurchase agreements. The major
capital market securities include stocks or equity, bonds, and foreign exchange. Key derivative
instruments are futures, forwards, options, and swaps.

Self-Assessment Questions
1. Explain the functions of a modern financial system and categorize the main types of
financial institutions.
2. The concepts of risk, reward, supply and demand underlie the complexity of financial
instruments. How could we use these concepts, for example, to explain the rate of return
expected by a shareholder and the price change hands on the stock market?
3. Discuss the key functions and roles of the financial system in the economy.
4. Define the main classes of financial instruments that are issued into the financial system,
that is, equity, debt, and derivatives.
5. Discuss the nature of the flow of funds between savers and borrowers, including direct
finance, and intermediated finance.
6. Distinguish between various financial market structures, including money and capital
markets, debt and equity markets, spot and future markets, and exchange markets and
OTCs.
7. What are the differences between primary market and secondary market financial
transactions? Besides, why is the existence of well-developed secondary markets
important to the functioning of the primary markets within the financial system?

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UNIT 2: MONEY MARKETS

Learning Objectives
Upon completion of this unit, students will be able to:

• Define money market and describe its unique characteristics

• Describe the objectives or purposes of the money market
• Identify the major participants in the money market
• Describe treasury bills and learn how to compute the price of treasury bills.
• Describe commercial paper and show the computation of the commercial paper yield.
• Describe negotiable certificates of deposit and compute the yield of negotiable certificates
• Describe repurchase agreements (Repos) and show how its yield can be determined.

2.1 Introduction
Money market securities are debt securities with a maturity of one year or less. Money markets
facilitate the transfer of short-term funds with a maturity of one year or less from individuals,
corporations, or governments with excess funds to those with deficient funds. Even investors who
focus on long-term securities tend to hold some money market securities. Money markets enable
financial market participants to maintain liquidity. Capital markets serve a similar function for
market participants with excess funds to invest for periods longer than one year and/or who wish
to borrow for periods longer than one year. Market participants who concentrate their investments
in capital market instruments also tend to invest in some money market securities to meet their
short-term liquidity needs. The secondary markets for money market instruments are important
to serve to reallocate the (relatively) fixed amounts of liquid funds available in the market at any
particular time.

Notice, from the description above, that money markets and money market securities or
instruments have three basic characteristics.
1) First, money market instruments are generally sold in large denominations. Most money
market participants want or need to borrow large amounts of cash so that transaction costs
are low relative to the interest paid. The size of these initial transactions prohibits most
individual investors from investing directly in money market securities. Rather, individuals
generally invest in money market securities indirectly, with the help of financial institutions
such as money market mutual funds or short-term funds.

2) Second, money market instruments have low default risk; the risk of late or non-payment
of principal and/or interest is generally small. Since cash lent in the money markets must
be available for a quick return to the lender, money market instruments can generally be
issued only by high-quality borrowers with little risk of default.

3) Finally, money market securities must have an original maturity of one year or less. Recall
that the longer the maturity of a debt security, the greater is its interest rate risk and the
higher its required rate of return. Given that adverse price movements resulting from
interest rate changes are smaller for short-term securities, the short-term maturity of

37
money market instruments helps lower the risk that interest rate changes will significantly
affect the security’s market value and price.

Are money markets wholesale markets or retail markets for individual investors and
why?
money markets are wholesale markets. This means that most transactions are very
large. The size of these transactions prevents most individual investors from
participating directly in the money markets. Instead, dealers and brokers, operating in
the trading rooms of large banks and brokerage houses, bring customers together.

2.2 Objectives of Money Market

Below are the main objectives of the money market:
a) Providing borrowers with short-term funds at a reasonable price. Lenders will also have
the advantage of liquidity as the securities in the money market are short-term.
b) Enabling lenders to turn their idle funds into an effective investment. In this way, both the
lender and borrower are at a benefit.
c) Central bank regulates the money market. Therefore, the money market helps central
banks regulate the liquidity level in the economy.
d) Many organizations are short on their working capital requirements. The money market
helps such organizations to have the necessary funds to meet their working capital
requirements.
e) It is an important source of finance for the government sector for national and international
trade. Hence, it provides an opportunity for banks to park surplus funds.

2.3 Money Market Securities

Money market securities are issued in the primary market through a telecommunications network
by the Treasury, corporations, and financial intermediaries that wish to obtain short-term financing.
How do money markets facilitate the flow of funds?
• Governments issue money market securities (Treasury bills) and use the proceeds to
finance the budget deficit.
• Corporations issue money market securities and use the proceeds to support their existing
operations or to expand their operations.
• Financial institutions issue money market securities and bundle the proceeds to make
loans to households or corporations. Thus, the funds are channeled to support household
purchases, such as cars and homes, and to support corporate investment in buildings and
machinery.
• The Treasury and some corporations commonly pay off their debt from maturing money
market securities with the proceeds from issuing new money market securities. In this way,
they can finance expenditures for long periods even though money market securities have
short-term maturities. Overall, money markets allow households, corporations, and
governments to increase their expenditures; thus, the markets finance economic growth.
What are the major money market participants?

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Because money market securities have a short-term maturity and can typically be sold in the
secondary market, they provide liquidity to investors. Most firms and financial institutions maintain
some holdings of money market securities for this reason.
The more popular money market securities are:
1. Treasury bills (T-bills)
2. Commercial paper
3. Negotiable certificates of deposit
4. Repurchase agreements (Repos)
5. Banker’s acceptances
Each of these instruments is described in turn.

2.3.1 Treasury Bills

When the government needs to borrow funds, the central bank issues short-term securities known
as Treasury bills. The Treasury issues T-bills with 4-week, 13-week, and 26-week maturities
weekly. It periodically issues T-bills with terms shorter than four weeks, which are called
cash management bills. It also issues T-bills with a one-year maturity on a monthly basis.
Treasury bills were formerly issued in paper form but are now maintained electronically.

Key Characteristics of Treasury Bills

• Investors in Treasury Bills: Depository institutions commonly invest in T-bills so that
they can retain a portion of their funds in assets that can easily be liquidated if they
suddenly need to accommodate deposit withdrawals. Other financial institutions also
invest in T-bills if they need cash because cash outflows exceed cash inflows. Individuals
with substantial savings invest in T-bills for liquidity purposes. Many individuals invest in
T-bills indirectly by investing in money market funds, which in turn purchase large amounts
of T-bills. Corporations invest in T-bills so that they have easy access to funding if they
suddenly incur unanticipated expenses.
• Credit Risk: Treasury bills are attractive to investors because they are backed by the

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federal government and are therefore virtually free of credit (default) risk. This is a very
desirable feature because investors do not have to use their time to assess the risk of the
issuer, as they do with other issuers of debt securities.

• Liquidity: Another attractive feature of T-bills is their liquidity, which is due to their short
maturity and strong secondary market. At any given time, many institutional investors are
participating in the secondary market by purchasing or selling existing T-bills. Thus,
investors can easily obtain cash by selling their T-bills in the secondary market.
Government securities dealers serve as intermediaries in the secondary market by buying
existing T-bills from investors who want to sell them or selling them to investors who want
to buy them. These dealers profit by purchasing the bills at a slightly lower price than the
price they sell.

Pricing Treasury Bills: The par value (amount received by investors at maturity) of T-bills is
$1,000 and multiples of $1,000. Since T-bills do not pay interest, they are sold at a discount
from par value, and the gain to the investor holding a T-bill until maturity is the difference between
par value and the price paid.

The price that an investor will pay for a T-bill with a particular maturity depends on the investor’s
required rate of return on that T-bill. That price is determined as the present value of the future
cash flows to be received. The value of a T-bill is the present value of the par value. Thus,
investors are willing to pay a price for a one-year T-bill that ensures that the amount they receive
a year later will generate their desired return.

Example:
If investors require a 4 percent annualized return on a one-year T-bill with a $10,000 par value,
the price that they are willing to pay is
P = $10,000/1.04
= $9,615.38
If the investors require a higher return, they will discount the $10,000 at that higher rate of return,
which will result in a lower price that they are willing to pay today. You can verify this by estimating
the price based on a required return of 5 percent and then on a required return of 6 percent.

To price a T-bill with a maturity shorter than one year, the annualized return can be reduced by a
fraction of the year in which funds will be invested.

If investors require a 4 percent annualized return on a six-month T-bill, this reflects a 2 percent
unannualized return over six months. The price that they will be willing to pay for a T-bill with a
par value of $10,000 is therefore
P = $10,000=1.02
= $9,803.92

Estimating the Treasury Bill Yield

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Because T-bills do not offer coupon payments and are sold at a discount from par value, their
yield is influenced by the difference between the selling price and the purchase price. If an investor
purchases a newly issued T-bill and holds it until maturity, the return is based on the difference
between the par value and the purchase price. If the T-bill is sold before maturity, the return is
based on the difference between the price for which the bill was sold in the secondary market and
the purchase price.

The general calculation for yield on Treasury bills is

For example, in the weekly auction of treasury bills, an average price of Birr 97,912 per Birr
100,000 of face amount for a six-month (182-day) bill produced an annual rate of return on a
discount basis is equal to:

(100,000 – 97,912/100,000) x (360/182) = 4.13%

True Yield
To calculate the true yield of a Treasury bill for comparison with other money market yields,
the discount must be divided by the price and a 365-day year used. In the above example,
the true yield is

(100,000 – 97,912/97,912) x (365/182) = 4.28%

Where treasury bill quotes refer to the discount rate, the discount and the purchase price
(primary market issue price or secondary market sale price) will be calculated as follows:

Discount = Nominal value x discount rate x (Days to maturity/360)

Price = Nominal value – discount OR Nominal value x (1 – discount rate x Days to

maturity/360)

Example: Calculate the discount and the issue price of Treasury bills if the nominal value is
Birr 1 million, the discount rate is 9%, and the maturity is 28 days.

Discount = 1,000,000 x 0.09 x 28/360 =

Birr 6,999.90
Price = 1,000,000 – 6,999.90 = Br 993,000
= 1,000,000 x (1 – 0.09 x 28/360) = Br 993,000

If the quoted bill price is based on the rate of return or market yield (r), the purchase price
(both in the primary and secondary markets) may be determined according to the accepted
for zero-coupon debt securities:
Price = Nominal value ÷ (1 + rate of return x Days to maturity/365)

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The price of Treasury bills in the above example with a 9.19% rate of return would be:

1,000,000/ (1 + 0.092 x 28/365) = Br 993,000

2.3.2 Commercial Paper

Commercial paper is a short-term debt instrument issued only by well-known, credit-worthy firms
that is typically unsecured. It is normally issued to provide liquidity or to finance a firm’s investment
in inventory and accounts receivable. The issuance of commercial paper is an alternative to short-
term bank loans. Some large firms prefer to issue commercial paper rather than borrow from a
bank because it is usually a cheaper source of funds. Nevertheless, even the large creditworthy
firms that are able to issue commercial paper normally obtain some short-term loans from
commercial banks in order to maintain a business relationship with them. Financial institutions
such as finance companies and bank holding companies are major issuers of commercial paper.

Key Characteristics of Commercial Paper

• Denomination: The minimum denomination of commercial paper is usually $100,000,
and typical denominations are in multiples of $1 million. Maturities are normally between
20 and 45 days but can be as short as 1 day or as long as 270 days. Because of the high
minimum denomination, individual investors rarely purchase commercial paper directly,
although they may invest in it indirectly by investing in money market funds that have
pooled the funds of many individuals. Money market funds are major investors in
commercial paper. Although the secondary market for commercial paper is very limited, it
is sometimes possible to sell the paper back to the dealer who initially helped to place it.
However, in most cases, investors hold commercial paper until maturity.

• Credit Risk: Because commercial paper is issued by corporations that are susceptible to
business failure, commercial paper is subject to credit risk. The risk of default is affected
by the issuer’s financial condition and cash flow. Investors can attempt to assess the
probability that commercial paper will default by monitoring the issuer’s financial condition.
The focus is on the issuer’s ability to repay its debt over the short term because the
payments must be completed within a short-term period. Although issuers of commercial
paper are subject to possible default, historically the percentage of issues that have
defaulted is very low, as most issuers of commercial paper are very strong financially. In
addition, the short period of the credit reduces the chance that an issuer will suffer
financial problems before repaying the funds borrowed.

• Credit Risk Ratings: Commercial paper is commonly rated by rating agencies such as
Moody’s Investors Service, Standard & Poor’s Corporation, and Fitch Investor Service.
The possible ratings assigned to commercial paper are shown in the following exhibit. The
rating serves as an indicator of the potential risk of default. Some investors rely heavily
on the rating to assess credit risk, rather than assess the risk of the issuer themselves.

Exhibit 1: Commercial paper credit rating

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Moody’s Standard and Poor Fitch
Highest P1 A1 F1
High P2 A2 F2
Medium P3 A3 F3
Low NP B or C F4
Default NP D F5

• Placement: Some firms place commercial paper directly with investors. Other firms rely
on commercial paper dealers to sell their commercial paper at a transaction cost of about
one-eighth of 1 percent of the face value. This transaction cost is generally less than it
would cost to establish a department within the firm to place commercial paper directly.
However, companies that frequently issue commercial paper may reduce expenses by
creating such an in-house department. Most nonfinancial companies use commercial
paper dealers rather than in-house resources to place their commercial paper. Their
liquidity needs, and therefore their commercial paper issues, are cyclical, so they would
use an in-house, direct placement department only a few times during the year. Finance
companies typically maintain an in-house department because they frequently borrow in
this manner.

• Backing Commercial Paper: Some commercial paper is backed by assets of the issuer.
Commercial paper that is backed by assets should offer a lower yield than if it were not
secured by assets. However, the issuers of asset-backed commercial paper tend to have
more risk of default than the well-known firms that can successfully issue unsecured
commercial paper, and the value of assets used as collateral may be questionable. Thus,
yields offered on asset-backed commercial paper are often higher than the yields offered
on unsecured commercial paper.

Estimating the Commercial Paper Yield

Like T-bills, commercial paper does not pay interest and is priced at a discount from par value.
At a given point in time, the yield on commercial paper is slightly higher than the yield on a T-bill
with the same maturity because commercial paper carries some credit risk and is less liquid. The
nominal return to investors who retain the paper until maturity is the difference between the price
paid for the paper and the par value. Thus the yield received by a commercial paper investor can
be determined like the T-bill yield, although a 360-day year is usually used.

Example
1. If an investor purchases 30-day commercial paper with a par value of $1,000,000
for a price of $995,000, and holds the commercial paper until maturity, the yield is:
The yield on the commercial papers = (1,00,000 – 995,000/ 995,000) x (365/30) =
6.11%

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2. Tana Corporation issued a 90-day, Birr 2,500,000 commercial paper at a discount
of Birr 60,000. Calculate the true yield on the commercial papers. The paper was
sold 49 days later when the market rate of return was 10.5%. Calculate the price
of the commercial paper on its date of sale.
The yield on the commercial papers = (60,000/2,440,000) x (365/90) = 9.97%

The price 41 days before maturity = 2,500,000 x (1 + 0.105 x 41/365) = Br

2,470,857.47

Suppose an investor purchases 95-day commercial paper with a par value of $1,000,000
for a price of $990,023. The discount yield (d ) on the commercial paper is calculated as follows:
Discounted yield = ($1,000,000 - $990,023/1,000,000) * 360/95
= 0.3702%

The true yield (bond equivalent yield) is:

= ($1,000,000 - $990,023/ $990,023) * 365/95
= 0.3757%

2.3.3 Negotiable Certificates of Deposit

Negotiable certificates of deposit (NCDs) are certificates issued by large commercial banks and
other depository institutions as a short-term source of funds. Nonfinancial corporations often
purchase NCDs. Although NCD denominations are typically too large for individual investors, they
are sometimes purchased by money market funds that have pooled individual investors’ funds.
Thus, money market funds allow individuals to be indirect investors in NCDs, creating a more
active NCD market.

Maturities on NCDs normally range from two weeks to one year. A secondary market for NCDs
exists, providing investors with some liquidity. However, institutions prefer not to have their newly
issued NCDs compete with their previously issued NCDs being resold in the secondary market.
An oversupply of NCDs for sale could force institutions to sell their newly issued NCDs at a lower
price.

Key Characteristics of Negotiable Certificates of Deposit

• Placement: Some issuers place their NCDs directly; others use a correspondent
institution that specializes in placing NCDs. Another alternative is to sell NCDs to
securities dealers who in turn resell them. A portion of unusually large issues is commonly
sold to NCD dealers. Normally, however, NCDs can be sold to investors directly at a higher
price.

• Yield: Negotiable certificates of deposit provide a return in the form of interest along with
the difference between the price at which the NCD is redeemed (or sold in the secondary
market) and the purchase price. Given that an institution issues an NCD at par value, the
annualized yield that it will pay is the annualized interest rate on the NCD. If investors

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purchase this NCD and hold it until maturity, their annualized yield is the interest rate.
However, the annualized yield can differ from the annualized interest rate for investors
who either purchase or sell the NCD in the secondary market instead of holding it from
inception until maturity. Negotiable certificates of deposit must offer a slightly higher yield
above the T-bill yield with the same maturity to compensate for less liquidity and safety.
The premiums are generally higher during recessionary periods, and they reflect the
market’s perception of the financial system’s safety.

Example1. An investor purchased an NCD a year ago in the secondary market for
$990,000. He redeems it today upon maturity and receives $1,000,000. He also receives
interest of $40,000. His annualized yield (YNCD) on this investment is:
= $1,000,000 - $990,000 + $40,000 / $990,000
= 5.05%

Example 2. A bank has issued a six-month, $1 million negotiable CD with a 0.72 percent
quoted annual interest rate. The true yield on the CD is:
= 0.72% (365/360) = 0.73%
Thus, at maturity (in 6 months) the CD holder will receive:
FV = $1million (1 + 0.0073/2) = $1,003,650

Example 3. Assume a $1 million, 90-day CD with a 9% coupon rate. Compute the

redemption value and price of CD with a maturity of 36 days.

Redemption value = 1,000,000 x (1 + 0.09 x 90/360) = Br1,022,500

The price of CDs 36 days before maturity if the short-term interest rate on that date is
10% would be 1,022,500/ (1 + 0.1 x 36/360) = Br1,012,376.24

2.3.4 Repurchase Agreement (Repos)

With a repurchase agreement (or repo), one party sells securities to another with an agreement
to repurchase the securities at a specified date and price. In essence, the repo transaction
represents a loan backed by the securities. If the borrower defaults on the loan, the lender claims
the securities. Most repo transactions use government securities, although some involve other
securities such as commercial paper or NCDs. A reverse repo refers to the purchase of securities
by one party from another with an agreement to sell them. Thus, a repo and a reverse repo refer
to the same transaction but from different perspectives. These two terms are sometimes used
interchangeably, so a transaction described as a repo may actually be a reverse repo.

A secondary market for repos does not exist. Some firms in need of funds will set the maturity on
a repo to be the minimum period for which they need temporary financing. If they still need funds
when the repo is about to mature, they will borrow additional funds through new repos and use
these funds to fulfill their obligation on maturing repos.

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Key Characteristics of Repos
Placement: Repo transactions are negotiated through a telecommunications network. Dealers
and repo brokers act as financial intermediaries to create repos for firms with deficient or excess
funds, receiving a commission for their services. When the borrowing firm can find a counterparty
to the repo transaction, it avoids the transaction fee involved in having a government securities
dealer find the counterparty. Some companies that commonly engage in repo transactions have
an in-house department for finding counterparties and executing the transactions. A company that
borrows through repos may, from time to time, serve as the lender. That is, it may purchase the
government securities and agree to sell them back shortly.

Impact of the Credit Crisis: During the credit crisis in 2008, the values of mortgage securities
declined and so financial institutions participating in the housing market were exposed to more
risk. Consequently, many financial institutions that relied on the repo market for funding were not
able to obtain funds. Investors became more concerned about the securities that were posted as
collateral. Bear Stearns, a large securities firm, relied heavily on repos for funding and used
mortgage securities as collateral. But the valuation of these types of securities was subject to
much uncertainty because of the credit crisis. Consequently, investors were unwilling to provide
funding, and Bear Stearns could not obtain sufficient financing. It avoided bankruptcy only with
the aid of the federal government. The lesson of this example is that repo market funding requires
collateral that is trusted by investors. When economic conditions are weak, some securities may
not serve as adequate collateral to obtain funding.

Estimating the Yield

The repo rate is determined as the difference between the initial selling price of the securities and
the agreed-on repurchase price, annualized to a 360-day year.

An investor initially purchased securities at a price (PP) of $992,000 while agreeing to sell them
back at a price (SP) of $1,000,000 at the end of 60 days. The yield (or repo rate) on this
repurchase agreement is

Repo rate = [($1,000,000 - $992,000)/ $992,000)] x 360 / 60

= 4.84%

Summary
The main money market securities are Treasury bills, commercial paper, NCDs, and repurchase
agreements. These securities vary according to the issuer. Consequently, their perceived degree
of credit risk can vary. They also have different degrees of liquidity. Therefore, the quoted yields
at any given point in time vary among money market securities.

Financial institutions manage their liquidity by participating in money markets. They may issue
money market securities when they experience cash shortages and need a liquidity boost. They
can also sell holdings of money market securities to obtain cash. The value of a money market
security represents the present value of the future cash flows generated by that security. Since

46
money market securities represent debt, their expected cash flows are typically known. However,
the pricing of money market securities changes in response to a shift in the required rate of return
by investors. The required rate of return changes in response to interest rate movements or to a
shift in the security’s credit risk.

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UNIT 3: BOND MARKETS

Learning Objectives
Upon completion of this unit, a student will be able to:
• Define and describe the characteristics of bonds.
• Describe the advantages and disadvantages of bonds.
• Discuss the nature of government and corporate bonds.
• Discuss the different types of corporate bonds.
• Explain the differences between domestic, foreign, and Eurobonds.
• Discuss the basic differences between flat yield and yield to maturity.
• Describe how dirty price can be determined.
• Explain the yield curve and its implications.
• Describe how a bond price can be determined.

3.1 Background of Bonds

a bond is essentially a loan or an I owe you (IOU) issued by an organization (the
borrower, or issuer), in return for money lent to it. i.e., bonds are long-term debt securities
that are issued by government agencies or corporations. The issuer of a bond is obligated
to pay interest (or coupon) payments periodically (such as annually or semiannually) and
the par value (principal) at maturity. An issuer must be able to show that its future cash
flows will be sufficient to enable it to make its coupon and principal payments to
bondholders. Investors will consider buying bonds for which the repayment is
questionable only if the expected return from investing in the bonds is sufficient to
compensate for the risk.

Although less frequently reported on than equity markets, bond markets are larger both
in size and value of trading. As with equities, the major participants include the investors
(particularly the institutions such as the funds run by asset managers and insurers)
generally undertaking deals with the dealers (or traders) at the large banks. However, in
contrast to equities, little dealing is done via stock exchange systems, with the majority
of trades taking place away from the exchanges in OTC trades. Furthermore, the trading
volume is lower, eg, a smaller number of larger trades as most trades tend to be very
large when compared to equity market trades. The amount outstanding on the global
bond market at the end of 2022 was approximately US$133 trillion.

A company that needs to raise money to finance an investment could borrow money from
their bank, or alternatively, they could issue a bond to raise the funds they need. With a
bond, an investor lends in return for the promise to have the loan repaid on a fixed date
plus (usually) a series of interest payments. Bonds are commonly referred to as loan
stock, debt or (in the case of those that pay fixed income) fixed-interest securities.

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3.2 Characteristics of Bond
The feature that distinguishes a bond from most loans is that a bond is tradable and
negotiable instrument. Investors can buy and sell bonds without the need to refer to the
original borrower. Although there are a wide variety of bonds in issue, they all share
similar characteristics. These can be described by looking at an example of a UK
government bond and explaining what each of the terms means. To explain the
terminology associated with bonds, we will assume that an investor has purchased a
holding of £10,000 nominal 10% Treasury stock 2030.

Nominal value, face value, or principal value $10,000

Name/stock Treasury bond
coupon 10%
Redemption or, maturity date 2030
Price 102
Value $12,000

Each of the terms annotated above is explained below:

• Nominal – this is the amount of stock purchased and should not be confused with the
amount invested or the cost of purchase. This is the amount on which interest will be paid
and the amount that will eventually be repaid. It is also known as the par or face value of
the bond.

• Stock – the name given to identify the stock.

• Coupon: this is the nominal interest rate payable on the stock, also known as the coupon.
The rate is quoted gross and will normally be paid in two separate and equal half-yearly
interest payments. The annual amount of interest paid is calculated by multiplying the
nominal amount of stock held by the coupon; that is, in this case, £10,000 times 10%.

• Maturity – this is the year in which the stock will be repaid, known as the redemption date
or maturity date. Repayment will take place at the same time as the final interest payment.
The amount repaid will be the nominal amount of stock held; that is, £10,000.

• Price – the convention in the bond markets is to quote prices per £100 nominal of stock.
So, in this example, the price is £102 for each £100 nominal of stock.

• Value – this is calculated by taking the price per £100 nominal of stock and scaling up
based on the total nominal value held. In this example, the total nominal value is £10,000
and the price per £100 nominal value is £102. The total value is, therefore, £12,0070,
calculated as:
(£10,000/£100) x £102 = £12,000.

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3.3 Advantages, Disadvantages, and Risks of Investing in Bonds
As one of the main asset classes, bonds have a role to play in most portfolios.

3.3.1 Advantages
Their main advantages are:
• for fixed-interest bonds, a regular and certain flow of income
• for most bonds, a fixed maturity date (but there are bonds that have no redemption date
and others which may be repaid on either of two dates or between two dates – some at
the investor’s option and some at the issuer’s option)
• a range of income yields to suit different investment and tax situations, and
• the relative security of capital for more highly rated bonds.

3.3.2 Disadvantages
Their main disadvantages are:
• the ‘real’ value of the income flow is eroded by the effects of inflation (except in the case
of index-linked bonds)
• bonds carry various elements of risk as presented below.

3.3.3 Risks
• Default risk - As can be seen, there are a number of risks attached to holding bonds.
Corporate bonds generally have default risk (the possibility of an issuer defaulting on the
payment of interest or capital, eg, the company could go bust) and price risk. Highly rated
government bonds are said to have only price risk, as there is little or no risk that the
government will fail to pay the interest or repay the capital on the bonds. However, recent
turmoil in government bond markets, such as fears that certain European governments
were unable to meet their obligations on these loans, resulted in the prices of their bonds
falling significantly. Price (or market) risk is of particular concern to bondholders, who are
open to the effect of movements in general interest rates, which can have a significant
impact on the value of their holdings

With both of these examples, remember that it is the current value of the bond that is
changing. Changes in interest rates do not affect the amount payable at maturity, which
will remain as the nominal amount of the stock. As the above examples illustrate, there is
an inverse relationship between interest rates and bond prices:
o If interest rates increase, bond prices will decrease.
o If interest rates decrease, bond prices will increase.

Some of the other main risks associated with holding bonds are:

• Early redemption – the risk that the issuer may invoke a call provision (if the bond is
callable).
• Seniority risk – the seniority with which corporate debt is ranked in the event of the
issuer’s liquidation. Debt with the highest seniority is repaid first in the event of liquidation;
so debt with the highest seniority has a greater chance of being repaid than debt with

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lower seniority. If the company raises more borrowing and it is entitled to be repaid before
the existing bonds, then the bonds have suffered from seniority risk.
• Inflation risk – the risk of inflation rising unexpectedly and eroding the real value of the
bond’s coupon and redemption payment.
• Liquidity risk – liquidity is the ease with which a security can be converted into cash.
Some bonds are more easily sold at a fair market price than others.
• Exchange rate risk/foreign currency risk – bonds or coupon payments denominated in
a currency different from that of the investor’s home currency are potentially subject to
adverse exchange rate movements.

3.4 Government and Corporate Bonds

3.4.1 Government Bonds

Governments issue bonds to finance their spending and investment plans, and to bridge the gap
between their actual spending and the tax alongside other forms of income that they receive.
Issuance of bonds is high when tax revenues are significantly lower than government spending.
Western governments are major borrowers of money, so the volume of government bonds in issue
is very large and forms a major part of the investment portfolio of many institutional investors
(such as pension funds and insurance companies).

There are two main types of bonds in issue – conventional bonds and index-linked bonds.
Conventional government bonds are instruments that carry a fixed coupon and a single
repayment date, such as the example used above of 10% Treasury stock 2030. Conventional
bonds typically represent around 75% of bonds in issue.

The coupon and redemption amount for index-linked bonds are increased by the amount of
inflation over its lifetime. An example is a 10% Treasury index-linked stock 2230. When this stock
was issued, it carried a coupon of 10%, but this is uplifted by the amount of inflation at each
interest payment. Similarly, the amount that will be repaid in 2030 will also be adjusted in line with
inflation. Index-linked bonds are attractive in periods when a government’s control of inflation is
uncertain because they provide extra protection to the investor. They are also attractive as long-
term investments, eg, pension funds. Long-term investors need to invest their funds and know
that the returns will maintain their real value after inflation so that they can meet their obligations
to pay pensions.

Conventional bonds can be stripped into their individual cash flows – that is, the coupon
payments and the bond repayment. ‘Stripping’ a bond refers to breaking it down into its individual
cash flows which can be traded separately as zero coupon bonds. A three-year bond will have
seven individual cash flows: six (semi-annual) coupon payments and the final maturity repayment.
These are known as ‘bond STRIPs’.

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3.4.2 Corporate Bonds
A corporate bond is a bond that is issued by a company, as the name suggests. The term is
usually applied to longer-term debt instruments, with a maturity date of more than 12 months. The
term commercial paper (CP) is used for instruments with a shorter maturity. Only companies with
high credit ratings can issue bonds with a maturity greater than ten years at an acceptable cost.
Most corporate bonds are listed on stock exchanges, but the majority of trading in most developed
markets takes place in the over-the-counter (OTC) market – that is directly between market
counterparties.

3.4.2.1 Features of Corporate Bonds

There is a wide variety of corporate bonds and they can often be differentiated by looking at some
of their key features, such as security, and redemption provisions.

Bond Security
When a company is seeking to raise new funds by way of a bond issue, it will often have to offer
‘security’ to provide the investor with some guarantee for the repayment of the bond. In this
context, security usually means some form of charge over the issuer’s assets (eg, its property or
trade assets) so that, if the issuer defaults, the bondholders have a claim on those assets before
other creditors (and so can regard their borrowings as safer than if there were no security). In
some cases, the security takes the form of a third-party guarantee – for example, a guarantee by
a bank that, if the issuer defaults, the bank will repay the bondholders. The greater the security
offered, the lower the cost of borrowing should be. The security offered may be fixed or floating.

Fixed security implies that specific assets (eg, a building) of the company are charged as security
for the loan. A floating charge means that the general assets of the company are offered as
security for the loan; this might include cash at the bank, trade debtors and stock.

Redemption Provisions: Callable Bond vs Puttable Bond

Callable Bonds
In some cases, a corporate bond will have a call provision, which gives the issuer the option to
buy back all or part of the issue before maturity. This is attractive to the issuer as it gives it the
option to refinance the bond (ie, replace it with one at a lower rate of interest) when interest rates
are lower than the coupon that is being paid. This is a disadvantage to the investor, who will
probably demand a higher yield as compensation. Call provisions can take various forms. For
example, there may be a requirement for the issuer to redeem a specified amount at regular
intervals. This is known as a sinking fund requirement.

Puttable Bond
Some bonds are also issued with put provisions, known as ‘puttable’ bonds. These give the
bondholder the right to require the issuer to redeem early, on a set date, or between specific
dates. This makes the bond attractive to investors and may increase the chances of selling a bond
issue in the first instance; it does, however, increase the issuer’s risk that it will have to refinance
the bond at an inconvenient time.

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3.4.2.2 Types of Corporate Bonds
The development of financial engineering techniques in banks around the world has resulted in a
large variety of corporate debt being issued and traded. Some of the main types are described
below.

Medium-Term Notes (MTNs)

Medium-term notes (MTNs) are standard corporate bonds with maturities of up to five years,
though the term is also applied to instruments with maturities as long as 30 years. Where they
differ from other debt instruments is that they are offered to investors continually over some time
by an agent of the issuer, instead of in a single tranche of one sizeable underwritten issue.

Fixed-Rate Bonds
The key features of fixed-rate bonds have already been described above. Essentially, they have
fixed coupons that are paid either half-yearly or annually and predetermined redemption dates.

Floating Rate Notes (FRNs)

Floating rate notes (FRNs) are usually referred to as FRNs and are bonds that have variable rates
of interest. The rate of interest will be linked to a benchmark rate, such as the Sterling Overnight
Index Average (SONIA) in the UK and Secured Overnight Reference Rate (SOFR) in the US.
SONIA is the rate of interest at which banks will lend to one another in London and is the
replacement for LIBOR, and is now often used as a basis for financial instrument cash flows. An
FRN will usually pay interest at the benchmark rate plus a quoted margin or spread.

Convertible Bonds
Convertible bonds are issued by companies. They give the investor holding the bond two possible
choices:
• to simply collect the interest payments and then the repayment of the bond on maturity, or
• to convert the bond into a predefined number of ordinary shares in the issuing company,
on a set date or dates, or between a range of set dates, before the bond’s maturity.

The attractions to the investor are:

• If the company prospers, its share price will rise, and, if it does so sufficiently, conversion
may lead to capital gains.
• If the company hits problems, the investor can retain the bond – interest will be earned
and, as bond-holder, the investor will rank ahead of existing shareholders if the company
goes bankrupt. Of course, if the company were seriously insolvent and the bond were
unsecured, the bondholder might still not be repaid – but this is a possibility more remote
than that of a full loss as a shareholder.

For the company, relatively cheap finance is acquired. Investors will pay a higher price for a bond
that is convertible because of the possibility of a capital gain. However, the prospect of dilution of

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current shareholder interests, as convertible bondholders exercise their options, has to be borne
in mind.

Zero-Coupon Bonds (ZCBs)

A zero-coupon bond (ZCB) is a bond that pays no interest but is issued at a discount. ‘Coupon’ is
an alternative term for the interest payment on a bond. For example, a two-year $1 million could
be issued at a discounted value of $920,000. The investor pays $920,000 at the time of investment
or purchase and receives $1 million after 2 years upon maturity of the bond.

Domestic and Foreign Bonds

Bonds can be categorized geographically. A domestic bond is issued by a domestic issuer into
the domestic market, for example, an Ethiopian company issuing bonds, denominated in Birr, to
Ethiopian investors. In contrast, a foreign bond is issued by an overseas entity in a domestic
market and is denominated in the domestic currency. Examples of a foreign bond are a German
company issuing a sterling bond to UK investors or a US dollar bond issued in the US by a non-
US company.

Eurobonds
Eurobonds are large international bond issues often made by governments and multinational
companies. The term "Eurobond" refers to a bond that is denominated in a currency other than
the currency of the country where the bond is issued. Some key points about Eurobonds:

1. Currency denomination: Eurobonds are typically denominated in a major global currency

like the U.S. dollar, Euro, British pound, or Japanese yen. This differentiates them from
domestic bonds, which are denominated in the local currency.

2. Issuer and market: Eurobonds are issued and traded in the Eurobond market, which is an
international, over-the-counter bond market located outside the country whose currency
is used for the bond. This allows issuers to raise funds globally.

3. Advantages:
- Allow issuers to tap into a wider pool of investors beyond their home country.
- Provide investors diversification and access to different credit and currency exposures.
- Benefit from lighter regulations compared to domestic bond markets.

Eurobonds are an important instrument in the international debt capital markets, allowing issuers
to raise funds globally while offering investors exposure to diverse credit and currency risks.

Distinguishing Features of Domestic, Foreign, and Eurobonds

Type of Bond Issuer Currency Market

Domestic bond Ethiopia Birr Ethiopia
Foreign bond Ethiopia USD USA
Euro bond USA USD Japan

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Eurobonds are bonds that are issued and sold outside of their home country (the currency of
issue does not need to be the euro). They can be issued in any currency as long as it is different
to the currency of the place from which they are issued. For example, a eurobond issued in the
UK would be in a currency other than pound sterling, such as the euro or the US dollar, and a
eurobond issued in Germany would be in a currency other than the euro, such as the US dollar
or the Japanese yen. Eurobonds provide a way for organizations to issue debt without being
restricted to their domestic market, and provide investors access and an opportunity to invest in
markets and currencies outside their home countries.

Asset-Backed Securities (ABSs)

There is a large group of bonds that trade under the overall heading of asset-backed securities
(ABSs). These are bundled securities, so-called because they are marketable securities that
result from the bundling or packaging together of a set of non-marketable assets. The assets in
this pool, or bundle, range from mortgages and credit card debt to accounts receivable. (‘Accounts
receivable’ is money owed to a company by a customer for goods and services that they have
bought and is usually known as this once an invoice has been issued.) The largest market is for
mortgage-backed securities, whose cash flows are backed by the principal and interest payments
of a set of mortgages.

Mortgage-backed bonds are created by bundling together a set of mortgages and then issuing
bonds that are backed by these assets. These bonds are sold on to investors, who receive interest
payments until they are redeemed. Creating a bond in this way is known as securitization, and
it began in the US in 1970 when the government first issued mortgage certificates, a security
representing ownership of a pool of mortgages. A significant advantage of ABSs is that they bring
together a pool of financial assets that otherwise could not easily be traded in their existing form.
The pooling together of a large portfolio of these illiquid assets converts them into instruments
that may be offered and sold freely on the capital markets.

Covered Bonds
A variation on asset-backed bonds is covered bonds which are widely used in Europe. These are
issued by financial institutions and are corporate bonds that are backed by cash flows from a pool
of mortgages or public sector loans. The pool of assets provides ‘cover’ for the loan, hence the
term ‘covered bond’. They are similar in many ways to asset-backed securities, but the regulatory
framework for covered bonds is designed so that bonds that comply with those requirements are
considered as particularly safe investments. The main differences are:
• They remain on the issuer’s balance sheet.
• The asset pool must provide sufficient collateral to cover bondholder claims throughout
the whole term of the covered bond.
• Bondholders must have priority claim on the cover asset pool in case of default of the
issuer.
Covered bonds are an important part of the financing of the mortgage and public sector markets
in Europe and represent a vital source of term funding for banks. A thriving covered bond market
is seen as essential for the future of the European banking sector and the ability of individuals to
finance house loans at a reasonable rate.

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3.5 Credit Rating Agencies
Credit risk, or the probability of an issuer defaulting on their payment obligations, and the extent
of the resulting loss, can be assessed by reference to the independent credit ratings given to most
bond issues. There are more than 70 agencies throughout the world, and preferred agencies vary
from country to country. The three most prominent credit rating agencies that provide these ratings
are Standard & Poor’s; Moody’s; and Fitch Ratings.

The table below shows the credit ratings available from each. Standard & Poor’s and Fitch Ratings
refine their ratings by adding a plus or minus sign to show relative standing within a category,
while Moody’s does the same by the addition of a 1, 2 or 3.

As can be seen, bond issues, subject to credit ratings, can be divided into two distinct categories:
those accorded an ‘investment grade’ rating, and those categorized as non-investment grade,
or speculative. The latter are also known as ‘high-yield’ or – for the worst-rated – ‘junk’ bonds.
Investment grade issues offer the greatest liquidity and certainty of repayment. Bonds will be
assessed and given a credit rating when they are first issued and then reassessed if
circumstances change, so that their rating can be upgraded or downgraded with a consequent
effect on their price.

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3.6 Yield
Yields are a measure of the returns to be earned on bonds. The coupon reflects the interest rate
payable on the nominal or principal amount. However, an investor will have paid a different
amount to purchase the bond, so a method of calculating the true return is needed. The return,
as a percentage of the cost price, which a bond offers is often referred to as the bond’s yield.
3.6.1 Flat or Running Yield
The interest paid on a bond as a percentage of its market price is referred to as the flat or running
yield. The flat yield is calculated by taking the annual coupon and dividing by the bond’s price and
then multiplying by 100 to obtain a percentage. The bond’s price is typically stated as the price
payable to purchase £100 nominal value. The calculation of the flat yield is as follows:

Flat yield = (annual coupon/price) x 100

This is best illustrated by example:

Example 1: the flat yield on a 5% bond, redeeming in six years and priced at £104.40 is:
(5 / 104.40) x 100 = 4.79%
Examples 2. A bond with a coupon of 1%, issued by XYZ plc, redeemable in 2030, is currently
trading at £100 per £100 nominal. The flat yield is the coupon divided by the price expressed as
a percentage, ie: £1/£100 x 100 = 1%.

Example 3. A bond with a coupon of 1.5%, issued by ABC plc, redeemable in 2030, is currently
trading at £98 per £100 nominal. So, an investor could buy £100 nominal value for £98. The flat
yield is the coupon divided by the price expressed as a percentage, ie, £1.50/£98 x 100 = 1.53%.

Example 4. 0.375% Treasury stock 2030 is priced at £100.70. So an investor could buy £100
nominal value for £100.70. The flat yield on this gilt is the coupon divided by the price, ie:
£0.375/£100.70 x 100 = 0.372%.

Using the flat yield, it is simple to see how a change in interest rates will impact bond prices. If
interest rates increase, investors will want an equivalent increase in the yield on their bonds.
However, because the coupon is fixed for most bonds, the only way that the yield can increase is
for the price to fall. This explains the inverse relationship between interest rates and bond
prices. When interest rates rise, bond prices fall, and vice versa.

The flat yield only considers the coupon and ignores the existence of any capital gain (or loss)
through redemption. As such, it is better suited to short-term investors in the bond, rather than
those investors that might hold the bond through to its maturity and benefit from the gain (or suffer
from the loss) at maturity.

Limitations of Flat Yield

There are three key drawbacks to using flat yield as a robust measure in assessing bond returns:

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• Since it only measures the coupon flows and ignores the redemption flows, it often gives
an incomplete picture of the actual returns from the bond. A bond that has been purchased
at a price that is below the redemption value will be significantly undervalued because the
redemption gain is excluded from the calculation. The opposite is also true when a bond
is purchased at a price above the redemption value.
• The calculation completely ignores the timing of any cash flows and, because there is no
discounted cash flow analysis, the time value of money is completely overlooked.
• If the bond is a floating-rate note (FRN), the return in any one period will vary with interest
rates. If the coupon is not a constant, using a flat-yield basis for measuring returns
becomes an arbitrary matter of selecting which coupon amount is among many possible
values to use for the calculation.

3.6.2 Yield to Maturity (YTM) or Gross Redemption Yield (GRY)

The interest earned on a bond is only one part of its total return, however, as the investor may
also either make a capital gain or a loss on the bond if it is held until redemption. The redemption
yield is a measure that incorporates both the income and capital return – assuming the investor
holds the bond until its maturity – into one figure. This requires computation of yield to maturity or
gross redemption yield.

The YTM or GRY is a fuller measure of yield than the flat yield because it takes both the coupons
and any gain (or loss) through to maturity into account – hence its alternative name ‘yield to
maturity’ or just YTM. Because it considers the gain or loss if the bond is held until it matures, it
presents a more complete picture of the return than the flat yield. However, it does ignore the
impact of any taxation (hence the ‘gross’ in GRY), so this measure of return is especially useful
for non-tax-paying long-term investors such as pension funds and charities.

The calculation of the YTM is the internal rate of return (IRR) of the bond. The IRR is simply the
discount rate that, when applied to the future cash flows of the bond, produces the current price
of that bond.

Example
Assume that there is a US government bond known as a 5% T-note and that it will be repaid in
exactly five years. Its current price is $115, and so if an investor buys $10,000 nominal of the bond
today, it will cost $11,500, excluding brokers’ costs. The annual interest payments will amount to
$500, so its flat yield is:
= [(500/11,500) x 100]
= 4.35%.
In five years, however, the investor is only going to receive $10,000 when the bond is redeemed,
and so, based on a price of $11,500, will make a loss of $1,500 over 5 years. If an investor were
simply to look at the flat yield, it would give a misleading indication of the true return that they
were earning. The true yield needs to take account of this loss to redemption and this is the
purpose of the redemption yield.

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Very simply, the investor needs to write off that loss over the five-year period of the bond, let us
say at the approximate rate of $300 per annum, so the annual return that the investor is receiving
is closer to $200 – the annual interest of $500 less the $300 written off. If you recalculate the flat
yield using this $200 as the interest, the return reduces to 1.74% as computed below.

= [(200/11,500) x 100]
= 1.74%
The YTM, then, gives a more accurate indication of the return that the investor receives, and can
be used to compare the yields from different bonds to identify which is offering the best return.

3.7 Convertible Bonds

Convertible bonds are a type of corporate bond that can be converted into a predetermined
number of the company's equity shares. The key features of convertible bonds are:

1. Conversion Option: Convertible bonds give the holder the option to exchange the bond for
a set number of the issuer's common stock shares, typically at a predetermined conversion
price.
2. Coupon Rate: Convertible bonds pay a lower coupon rate compared to the issuer's regular
corporate bonds, as the conversion option provides additional value to the investor.
3. Call Provision: The issuer typically has the right to call (redeem) the convertible bond
before maturity, forcing conversion.

The main advantages of convertible bonds are:

- Upside Potential: Investors can benefit from the bond's fixed income as well as any
appreciation in the underlying stock price.
- Downside Protection: Convertible bonds provide more downside protection compared
to the company's common stock.
- Lower Coupon: The conversion option allows the issuer to pay a lower coupon rate
compared to a regular corporate bond.

Convertible bonds appeal to investors who want exposure to a company's equity upside with less
risk than holding the common stock directly. They also allow issuers to raise capital with a
potentially lower interest burden compared to a straight debt offering.

Example 1
A convertible bond issued by XYZ Inc. is trading at $142.5. It offers the holder the option of
converting $1,000 nominal into three shares. The shares of XYZ Inc. are currently trading at $380. To
calculate the premium, first work out the share value of the conversion choice.
For $1,000 nominal value, that is $380 x 3 shares = $1,140.
The bond is trading at $142.5 ($1,000 nominal costs $1,425), and so the premium in absolute terms
is:
1,425 – 1,140 = $285 per $1,000 nominal.

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It is more usual to express it as a percentage of the conversion value:
(285 / 1,140) x 100 = 25%
The convertibility feature makes the pricing and valuation of convertible bonds more complex than
regular corporate bonds. Factors like the stock price, volatility, interest rates, and time to maturity
all impact the bond's conversion value.

Example 2
The convertible bonds issued by ABC plc are trading at £110. Each £100 nominal value offers the
holder the option of converting into 15 ordinary ABC shares. The ordinary shares of ABC are
currently trading at £6.40. What is the conversion premium, expressed in percentage terms?

Share value of the conversion option = 15 x $6.4 = $96

Bond value = $110
Premium in absolute terms = $14
Premium percentage = (14/96) x 100 = 14.58%

3.8 Accrued Interest

Listed bond prices do not include accrued interest, and are described as flat prices. The flat price
is alternatively referred to as the clean price. Most bonds pay interest semi-annually. For
settlement dates when interest is paid, the bond price is equal to the flat price. Between payment
dates, however, the actual price paid for the bond will be the flat price plus the accrued interest.

Accrued interest is the interest that has been earned, but not paid, and is calculated by the
following formula:

Accrued interest = Coupon payment x Number of days since last payment

Number of days between payments

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The above graphic shows how the dirty price (ie, the clean price plus accrued interest) of a bond
fluctuates over the lifetime of the bond, in this case, two years.

The assumption made is that the flat price remains constant over the two years; however, in
reality, it will probably fluctuate with interest rates and because of other factors. The flat price is
what is listed in bond tables for prices. The accrued interest must be calculated according to the
formula above. Note that the bond price steadily increases each day until reaching a peak the day
before an interest payment, then drops to a minimum immediately following the payment.
Calculate the purchase price of a bond with accrued interest.

Example
An investor purchases a corporate bond with a settlement date on 15 September with a face value
of $1,000 and a nominal yield of 8%, which has a listed price of 100.25, and which pays interest
semi-annually on 15 February and 15 August. How much should the investor pay for the bond, or
in other words, what is its dirty price?

The semi-annual interest payment is $40 and there were 31 days since the last interest payment
on 15 August. Assuming the settlement date fell on an interest payment date, the bond price would
equal the listed price: 100.25 x $1,000.00 = $100,250.

Since the settlement date was 31 days after the last payment date, accrued interest must be
added. Using the above formula, with 184 days between coupon payments, we find that:

Accrued interest = $40 x (31/184) = $6.74

Therefore, the actual purchase price for the bond will be $1,002.50 + $6.74 = $1,009.24.

Day Count Conventions

Historically, different day count conventions have evolved in calculating accrued interest to take
into account the fact that fixed-income securities have different coupon payment date
characteristics, and to address issues related to the vagaries of the calendar system. The Julian
calendar has uneven-length months and also has leap years, when once every four years there
are 366 days to a year rather than 365. This has given rise to several different ways of counting
the intervals between payments and even the length in days of the year assumed in the
calculations.

There is no central authority defining day count conventions, so there is no standard terminology.
Certain terms, such as 30/360, actual/actual (ACT/ACT), and money market basis must be
understood in the context of the particular market. There has also been a move towards
convergence in the marketplace, which has resulted in the number of conventions in use being
reduced.

In the example just cited, the day count is what can be called actual/actual, since the exact number
of days between coupons and the actual days since the last payment have been used.

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Common day count conventions that affect the accrued interest calculation are as follows:
• ACT/360 (days per month, days per year) – each month is treated normally and the year
is assumed to be 360 days, eg, the period from 1 February 2024 to 1 April 2024 is
considered to be 59 days divided by 360 (even in instances like this one, when the year
is a leap year). ACT/360 counts are used for US Treasury bills and money market
instruments.

• 30/360 – each month is treated as having 30 days, so the period from 1 February 2024 to
1 April 2024 is considered to be 60 days. The year is considered to have 360 days (again,
even in instances when the year is a leap year). This convention is frequently chosen for
ease of calculation: the payments tend to be regular and at predictable amounts. 30/360
counts are used by US agency corporate issuers and eurobonds.

• ACT/365 – each month is treated normally, with the year assumed to be 365 days,
regardless of leap year status. So, despite 2024 being a leap year, the period from 1
February 2024 to 1 April 2024 is still considered to be 59 days. This convention results in
periods having slightly different lengths compared to the 30/360 basis.

2
• ACT/ACT – each month is treated normally, and the year has the actual number of days,
eg, the period from 1 February 2024 to 1 April 2024 is considered to be 60 days and the
year is 366 days in length. In this convention, leap years do affect the final result. If the
period was 1 February 2022 to 1 April 2022, then the period is 59 days (as 2022 is not a
leap year) and the year is 365 days long. ACT/ ACT counts are used by the US Treasury
and for UK gilts.

3.9 Yield Curve

The yield curve refers to the graphical representation of the relationship between bond yields and
their corresponding maturities. It plots the yields of bonds with different maturity dates on the x-
axis against their yield levels on the y-axis.

The main types of yield curves are:

1. Normal (Upward Sloping) Yield Curve:

- Longer-term bond yields are higher than shorter-term bond yields.
- This is the most common shape and reflects the normal state of the bond market.

2. Inverted (Downward Sloping) Yield Curve:

- Longer-term bond yields are lower than shorter-term bond yields.
- This shape is associated with an economic slowdown or recession.
3. Flat Yield Curve:
- Yields across different maturities are approximately the same.
- This can indicate market uncertainty about the economic outlook.

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The shape of the yield curve provides insights into market expectations about future interest rates,
inflation, and economic conditions:
• Upward sloping curve is also known as the normal curve and it suggests expectations of
economic growth and rising interest rates. This is known as the normal yield curve, and
its shape captures the fact that investors have a liquidity preference: they prefer more
rather than less liquidity. As a result of this, they are willing to accept a lower yield on more
liquid, short-dated government bonds, and demand a higher yield on less liquid, longer-
dated government bonds. In other words, given the same coupon rate, the price of a short-
dated government bond will be higher than that of a longer-dated government bond,
resulting in a higher yield for the longer-dated instrument than the equivalent shorter-dated
instrument.

• An inverted curve indicates expectations of an economic slowdown and declining interest

rates. In an inverted yield curve scenario, yields available on short-term government bonds
exceed those available on long-term government bonds. This occurs when there is an
expectation of a significant reduction in interest rates at some stage in the future. The
consequence of this is that, when investing in longer-term instruments that will be
outstanding when the interest rates fall, the investor is willing to accept a lower yield. For
shorter-term instruments that will not be outstanding when the interest rate falls, the
investor is demanding a higher yield. The existence of an inverted yield curve does not
remove any liquidity preference, but the impact of the anticipated interest rate fall
outweighs the effect of the liquidity preference. Because an inverted yield curve implies
the market expects rates to fall (which happens when governments ease monetary
conditions or there is weaker demand for credit), this is often interpreted as a forecast for
slowing economic conditions or an impending recession.

• Flat curve signals uncertainty about the economic trajectory.

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The yield curve is closely monitored by investors, policymakers, and economists as it has
historically been a reliable predictor of recessions when it becomes inverted. Analyzing the yield
curve dynamics can help investors make informed decisions about their bond portfolio allocation
and duration positioning based on their economic outlook and risk preferences.

3.10 The Present Value of a Bond

Money has a time value. That is, money deposited today will attract a rate of interest over the
term it is invested. For example, $100 invested today, at an annual rate of interest of 5%, becomes
$105 in one year’s time. The addition of this interest to the original sum invested acts as
compensation to the depositor for forgoing $100 of consumption for one year.

The time value of money can also be illustrated by expressing the value of a sum receivable in
the future in terms of its value today, again by taking account of the prevailing rate of interest. This
is known as the sum’s present value. So, $100 receivable in one year’s time, given an interest
rate of 5%, will be worth $100/1.05 = $95.24 today, in present value terms. This process of
establishing present values is known as discounting, the interest rate in the calculation acts
as the discount rate. In other words, the value today, or the present value, of a lump sum due to
be received on a specified future date can be established by discounting this amount by the
prevailing rate of interest.

To arrive at the present value of a single sum, receivable after n years, when the prevailing rate
of interest is r, simply multiply the lump sum by the following:

1/(1 + r)n

Referring back to the earlier example, $100 receivable in one year, given an interest rate of 5%,will
have a present value of:

$100 x 1/(1+r)n = $100 x 1/(1+0.05)1 = $100 x 1/1.05 = $100 x 0.9524 = $95.24

If $100 was due to be received in two years, then the present value will be:

$100 x 1/(1+r)2 = $100 x 1/(1.05)2 = $100 x 1/1.1025 = $100 x 0.907 = $90.70

Present value calculations can also be used to derive the price of a bond, given the appropriate rate of
interest and the cash flows.

Example 1
Imagine $1,000 nominal of a two-year bond paying annual coupons of 10%. Given an appropriate rate
of interest, the sum of the present values will provide the logical price for the bond. Using a market
interest rate of 12% per annum, the following present values emerge.

Time Cash flow Discount factor Present value

End of year 1 $100 0.8929 $89.29
End of year 2 $1100 0.7440 $818.40
Sum of the individual present values = price of the bond $907.69

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Example 2

Assume that company ‘X’ recently purchased Treasury bonds in the secondary market with a total
par value of $40 million. The bonds will mature in five years and have an annual coupon rate of 10
percent. The company is attempting to forecast the market value of these bonds two years from now
because it may sell the bonds at that time. Therefore, it must forecast the investor’s required rate of
return and use that as the discount rate to determine the present value of the bonds’ cash flows over
the final three years of their life. The computed present value will represent the forecasted price two
years from now.

Required:

a) Compute the present value or the price of the bond if the company holds the bond until its
maturity assuming that the investor’s required rate of return is 12%. Besides, assume that
interest will be paid annually.
b) Compute the present value of the price of the bond if the company sells the bond by the end
of year 3 assuming that the investor’s required rate of return is 12%. Besides, assume that
interest will be paid annually.
The price of the bond if the investor holds the bond until expiry will be computed as follows.

Year cash flow Discount factor Present value

End of year 1 4,000,000.00 0.8929 3,571,428.57
End of year 2 4,000,000.00 0.7972 3,188,775.51
End of year 3 4,000,000.00 0.7118 2,847,120.99
End of year 4 4,000,000.00 0.6355 2,542,072.31
End of year 5 44,000,000.00 0.5674 24,966,781.65

Sum of the individual present values = price of the bond 37,116,179.04

If the bond is sold by the end of the year, its price will be:

Year cash flow Discount factor Present value

End of year 1 4,000,000.00 0.8929 3,571,428.57
End of year 2 4,000,000.00 0.7972 3,188,775.51
End of year 3 44,000,000.00 0.7118 31,318,330.90

Sum of the individual present values = price of the bond 38,078,534.99

3.11 Inflation-Indexed (Linked) Bonds

Inflation-indexed bonds are issued to provide returns tied to the inflation rate. These bonds, commonly
referred to as TIPS (Treasury Inflation-Protected Securities), are intended for investors who wish to
ensure that the returns on their investments keep up with the increase in prices over time. The coupon
rate offered on TIPS is lower than the rate on typical bonds, but the principal value is increased by the
amount of the inflation rate (as measured by the percentage increase in the consumer price index)
every six months.

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Example
Consider a 10-year, inflation-indexed bond that has a par value of $10,000 and a coupon rate of 4
percent. Assume that, during the first six months since the bond was issued, the inflation rate (as
measured by the consumer price index) was 1 percent, in which case the principal of the bond is
increased by $100 (0.01 × $10,000). Thus the coupon payment after six months will be 2 percent (half
of the yearly coupon rate) of the new par value, or 0.02 × $10,100 ¼ $202. Assume that the inflation
rate over the next six months is 3 percent. Then the principal of the bond is increased by $303 (0.03 ×
$10,100), which results in a new par value of $10,403. The coupon payment at the end of the year is
based on the coupon rate and the new par value, or 0.02 × $10,403 ¼ $208.06. This process is applied
every six months over the life of the bond. If prices double over the 10-year period in which the bond
exists, the par value of the bond will also double and thus will be equal to $20,000 at maturity.

Inflation-indexed government bonds have become popular in many countries. They are especially
desirable in countries where inflation tends to be high.

Summary
Bonds are issued to finance government expenditures, housing, and corporate expenditures. Many
financial institutions, such as commercial banks, issue bonds to finance their operations. In addition,
most types of financial institutions are major investors in bonds. Bonds can be classified in four
categories according to the type of issuer. The issuers are perceived to have different levels of credit
risk. In addition, the bonds have different degrees of liquidity and different provisions. Thus, quoted
yields at a given point in time vary across bonds. Bond yields vary among countries. Investors are
attracted to high bond yields in foreign countries, causing funds to flow to those countries.
Consequently, bond markets have become globally integrated.

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UNIT 4: EQUITY MARKETS

Learning Objectives
Upon completion of this unit, a student will be able to:
• Understand the structure of a corporation and identify the advantages and disadvantages
of being a publicly listed corporation.
• Consider the origins and purpose of a stock exchange.
• Understand the role of primary markets and secondary markets.
• Discuss the different types of offers namely IPOs and follow-on offerings
• Discuss the basic differences between quote-driven markets and order-driven markets.
• Compare and contrast ordinary shares and preference shares.
• Discuss the benefits and risks of owning shares
• Explain the different types of corporate actions and rights issues
• Describe the major global market indexes
• Discuss the various valuation methods of equities

This chapter examines the operation of a stock exchange as a primary market and as a secondary
market for securities issued through the exchange. In facilitating its primary and secondary market
functions, a stock exchange enables the offering of a range of securities, including equity, interest
rate, and hybrid or derivative products. Importantly, stock exchanges facilitate the flow of
information that is essential in an efficient marketplace. This flow of information is crucial to both
investors and companies issuing securities. Finally, to maintain integrity and fairness in the
market, a stock exchange will monitor market participants' behavior and ensure compliance with
the regulatory requirements of the nation-state supervisor.

Following the general discussion of the share market and the corporation, the remaining parts
examine the equity markets, first from the point of view of companies seeking to raise funds in
the equity markets and, second, from the point of view of investors. This part explores the stock
exchange rules that apply to a company seeking to be listed as a public company on a stock
exchange. The chapter also considers various forms of equity funding that may be available to
companies. A distinction is drawn between those companies that are raising equity through the
share market for the first time and those that have already issued shares and are issuing
additional shares to obtain more equity to expand the business.

The next section examines companies listed on a stock exchange from a potential investor’s point
of view. It examines major indicators of the financial structures, risk and profitability of listed
companies. The chapter also analyses issues that affect the price of shares. This section
concludes with a discussion on share market indices.

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4.1 Introduction
A stock exchange is a place where a range of listed financial assets is bought and sold. The share
market refers to that part of a stock exchange where companies are listed on the exchange and
are known as public corporations. The shares of listed public corporations are issued and traded
through the share market. The best-known stock exchange is probably the New York Stock
Exchange (NYSE). Another exchange in the USA, the NASDAQ, lists mainly technology stocks.

A publicly listed corporation is a legal entity formed under the provisions of the corporation
legislation of a nation-state and listed on a formal stock exchange. Listing on a stock exchange
requires the corporation to comply with the rules of that exchange.

A share is a financial asset; that is, a security that entitles a shareholder to share in the net profits
of the company and to vote for the board of directors, and any resolutions put by the board to
shareholders at general meetings. The shares of a publicly listed corporation are listed on a stock
exchange and the main source of equity funding, the ordinary share, is quoted in the share market.

A corporation usually lists its shares on the exchange of its home country, although some large
multinational corporations may choose to list on their home exchange and an international stock
exchange such as the London Stock Exchange and/or the NYSE. This is related to the dual listing
of companies. Dual Listing refers to the practice of a company's shares being listed and traded
on more than one stock exchange. Here are the key points about dual listing:
• Expand the investor base and increase liquidity for the company's stock
• Access to larger capital markets and potential for higher valuations
• Raise the company's profile and visibility among international investors

Today, stock exchanges compete within an international market that is characterized by the rapid
and continuous flow of information to the markets within a regulatory environment that allows
capital to move almost instantaneously around the world. In a globalized market, the principal
functions of a modern and efficient stock exchange are:
• Establishment of markets in a range of financial securities
• Provision of a securities trading system
• Operation of a clearing and settlement system
• Regulation and monitoring of the integrity of the exchange’s markets
• Provision of a well-informed market, to secure the confidence of all participants.

4.2 Primary and Secondary Markets

All stock exchanges provide both a primary and a secondary market. The primary market, or the
new issues market, facilitates new issues of securities. The primary markets exist to enable
issuers of securities, particularly companies, to raise capital, and to enable the surplus funds held
by potential investors to be matched with investment opportunities the issuers offer. It is a crucial
source of funding. The terminology often used when companies raise capital on a stock exchange
is that they access the primary market and float (or ‘list’). The process that the companies go
through when they float is often called the initial public offering (IPO). Companies can use a variety

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of ways to achieve this flotation, such as offers for investors to subscribe to their shares (offers
for subscription).

The primary market role of a stock exchange is to ensure the efficient and orderly sale of new-
issue securities and includes all of the support facilities that are required to enable this to happen.
New companies listed on a stock exchange are referred to as a new float or an initial public
offering (IPO);

Equity capital issued included ordinary shares issued with IPOs, rights issues, placements, and
dividend reinvestment schemes. A rights issue is the issue of additional shares to existing
shareholders on a pro-rata basis of, say, one additional share for every five shares held.
Placements are the issue of new shares to selected institutional investors such as fund managers.

The secondary market is where existing securities are traded between investors. Stock
exchanges and other trading venues, such as multilateral trading facilities (MTFs), provide
systems to assist in this. These systems provide investors with liquidity, giving them the ability to
sell their securities if they wish. Trading activity in the secondary market also results in the ongoing
provision of buy and sell prices to investors via the exchange’s member firms of stockbrokers and
investment banks.

4.2.1 Users of Primary Market

Issuers of new securities, such as corporations engaging in IPOs or follow-on offerings, as well
as the issuers of certain kinds of debt instruments, are the main suppliers of new securities in the
primary markets. The main purchasers of newly issued securities are large institutional investors,
such as pension funds, insurance companies, and collective investment vehicles, including
exchange-traded funds (ETFs) and mutual funds, who buy the securities being offered on behalf
of their clients, who are primarily members of the general public. Individual investors can also buy
shares directly through a brokerage at IPO.

4.2.2 Participants or Users of the Secondary Market

In the secondary market, where existing securities are bought and sold throughout the daily
trading sessions, there will be a variety of participants. In addition to the previously mentioned
institutional investors engaged in the purchase of newly issued securities, these same institutions
will be engaged in selling previously owned securities within their portfolio and, in turn, adding
other securities available on the secondary market. The constant shifting of priorities in portfolio
allocation constitutes a large part of the transactional volume that arises each day, for example,
in the activities of the London Stock Exchange (LSE) and the New York Stock Exchange (NYSE).
The secondary markets will also be used by short-term speculators and traders

The main participants in the secondary stock market are:

• Investors: Individual investors (retail investors) and institutional investors (mutual funds,
pension funds, hedge funds, etc.). These investors buy and sell publicly traded securities
on the stock exchange.

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• Broker-Dealers: Financial institutions that facilitate the buying and selling of securities on
behalf of investors. They execute trades, provide research and investment advice, and
earn commissions on the transactions.

• Market Makers: Financial firms that provide liquidity to the market by quoting both buy
and sell prices (bid and ask prices) for specific securities. They aim to profit from the
spread between the bid and ask prices.

• Stock Exchanges: Organized marketplaces where securities are listed and traded, such
as the New York Stock Exchange (NYSE) and NASDAQ. They provide the trading
platform, listing requirements, and regulatory oversight for the secondary market.

• Regulators: Government agencies that oversee and enforce rules and regulations in the
stock market. Examples include the Ethiopia Capital Market Authority (ECMA), the
Securities and Exchange Commission (SEC) in the U.S., and the Financial Conduct
Authority (FCA) in the UK.

• Clearing Houses: Entities that facilitate the settlement of securities trades by acting as
the central counterparty. They ensure the completion of transactions and manage the
related risks.

• Data Providers: Firms that collect, analyze, and distribute real-time and historical market
data, such as stock prices, trading volumes, and financial information.

These participants work together to facilitate the efficient and orderly functioning of the secondary
stock market, enabling the trading of publicly listed securities and price discovery.

4.3 Types of Offers

4.3.1 Initial Public Offerings (IPO)

The first time a private company sells its shares to the general public and lists its stock on a
public stock exchange. The major purposes of IPO are to raise capital for the company's growth
and expansion plans, to provide an exit opportunity for the company's existing private investors,
and to increase the company's public profile and visibility. The process of initial public offering is
presented below.
- The company hires investment banks as underwriters to manage the IPO process.
- The company files registration documents with the relevant securities regulator.
- After regulatory approval, the company issues new shares to the public through the
stock exchange.

The key advantages of IPOs over other capital- raising methods are that IPOs can raise
substantial sums of capital and create a great deal of publicity for the issuing companies.
Furthermore, because the money raised in the IPO is equity, it is often referred to as risk capital
and the company assets are not encumbered or hypothecated in the same manner as they would
be if the capital were raised from a debt offering.

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An IPO can be underwritten with firm underwriting or best efforts underwriting. Firm Underwriting
and Best efforts Underwriting are two distinct methods of how investment banks structure their
role as underwriters in a public offering:

In a firm underwriting, the investment bank(s) fully guarantee the sale of the entire issue of
securities and commit to purchasing the entire offering from the issuing company. The
underwriter(s) agree to buy all the shares from the issuing company at a discounted price. The
underwriter(s) then resell the shares to investors at the public offering price, earning the difference
as their underwriting spread. Firm underwriting provides certainty of capital raising for the issuing
company whereas the underwriter(s) bear the full risk of unsold shares.

In the best efforts underwriting, the investment bank(s) agree to use their best efforts to sell the
securities to investors but do not guarantee the full sale of the offering. In this case the
underwriter(s) act as agents and try to find investors to purchase the shares. The issuing company
receives proceeds only for the shares that are successfully sold and the underwriter(s) earn a
commission based on the value of shares sold. Best efforts underwriting lower risk for the
underwriter(s) as they do not have to purchase unsold shares and it is suitable for smaller or
riskier offerings where demand is uncertain.

4.3.2 Follow-on Offering

An already listed company looking to raise more capital can choose to go through a follow-on
offering. A follow-on offering is alternatively referred to as a secondary offer. Issuing more shares
in a follow-on offering will only be considered if the equity markets are sufficiently robust. Where
prices are falling in a bear market, there is unlikely to be sufficient demand for the shares at the
price the issuing company wants. A secondary offering will inevitably be quicker, easier and
cheaper than an IPO, simply because the company has been through the stages before in its
IPO.

As with an IPO, the follow-on offering may also be underwritten, with a potential combination of
firm underwriting by the investment bank(s) and best efforts underwriting by other banks and
stockbroking firms.

Key Differences:
- Firm underwriting provides full guarantee, while best efforts underwriting does not.
- Firm underwriting transfers more risk to the underwriter(s), while best efforts underwriting
retain more risk for the issuing company.
- Firm underwriting typically results in higher offering prices, while best efforts underwriting
may have lower pricing.
- Firm underwriting is more common for larger, higher-profile public offerings, while best
efforts is used for smaller or riskier issues.

The choice between firm underwriting and best efforts underwriting depends on the size, risk
profile, and market conditions surrounding the public offering.

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4.4 Methods of Trading: Quote Driven vs Order Driven Trading
Trading systems provided by exchanges around the world can be classified on the basis of the
type of trading they offer. Broadly, systems are either quote-driven or order-driven:

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• Quote-driven systems – market makers agree to buy and sell at least a set minimum
number of shares at quoted prices. The buying price is the bid and the selling price is the
offer. The prime example of a quote-driven equity trading system is Nasdaq in the US.

• Order-driven systems – the investors (or agents acting on their behalf) indicate how
many securities they want to buy or sell, and at what price. The system then simply brings
together the buyers and sellers. Order-driven systems are very common in the equity
markets – the NYSE, the TSE and trading in the shares of the largest companies on the
LSE are all examples of order-driven equity markets.

The presence of market makers on quote-driven systems provides liquidity that might be lacking
on an order-driven system. Market makers are required to quote two-way prices, resulting in an
ability for trades to be executed. In contrast, an order-driven system can lack liquidity, since
transactions can only be matched against other orders – if there are insufficient orders, trades
cannot be matched.

The orders that await matching are included in the so-called ‘order book’. The buy side of the
order book lists orders to buy, and the sell side of the order book lists orders to sell. New sell
orders entered into the system potentially match existing orders on the buy side. New buy orders
potentially match existing sell-side orders in the order book.

4.5 Types of Equities

The capital of a company is made up of a combination of borrowing and the money invested by
its owners. The long-term borrowings, or debt, of a company are usually referred to as bonds,
and the money invested by its owners as shares, stocks or equity. Shares are the equity capital
of a company, hence the reason they are referred to as equities. They may comprise ordinary
shares and preference shares.

4.5.1 Ordinary Shares

Ordinary shares carry the full risk and reward of investing in a company. If a company does well,
its ordinary shareholders should do well. As the shareholders of the company, it is the ordinary
shareholders who vote ‘yes’ or ‘no’ to each resolution put forward by the company directors at
company meetings. For example, an offer to take over a company may be made and the directors
may propose that it is accepted but this will be subject to a vote by shareholders. If the
shareholders vote ‘no’, then the resolution will not be passed.

Ordinary shareholders share in the profits of the company by receiving dividends declared by the
company, which tend to be paid half-yearly or even quarterly. With the final dividend for the
financial year, the company directors will propose a dividend which will need to be ratified by the
ordinary shareholders before it is formally declared as payable. The amount of dividend paid will

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depend on how well the company is doing. However, some companies pay large dividends and
others none as they plough all profits made back into their future growth.

If the company does badly, it is the ordinary shareholders that will suffer. If the company closes
down, often described as the company being ‘wound up’, the ordinary shareholders are paid last,
after everybody else. If there is nothing left, then the ordinary shareholders get nothing. If there is
money left after all creditors and preference shareholders have been paid, it all belongs to the
ordinary shareholders.

Some companies issue more than one class of ordinary shares (perhaps distinguished as A
ordinary shares and B ordinary shares) and one class may have more voting rights than the other.
Occasionally, one class of shares may not have any voting rights at all; these shares are described
as non- voting shares. Alphabete’s classes of ordinary shares are presented below.
• Class A: Held by a regular investor with regular voting rights (GOOGL)
• Class B: Held by the founders, with 10 times the voting power of Class A shares.
• Class C: No voting rights, typically held by employees and some Class A stockholders
(GOOG)

4.5.2 Preference Shares

Some companies have preference shares as well as ordinary shares. The company’s internal
rules set out the specific ways in which the preference shares differ from the ordinary shares.
Preference shares are a hybrid security with elements of both debt and equity. Although they are
technically a form of equity investment, they also have characteristics of debt, particularly in that
they pay a fixed income. Preference shareholders have legal priority (known as seniority) over
ordinary shareholders in respect of earnings and, in the event of bankruptcy, in respect of assets.

Normally, preference shares:

• are non-voting, except in certain special circumstances, such as when their dividends
have not been paid
• pay a fixed dividend each year, the amount being set when they are first issued and which
has to be paid before dividends on ordinary shares can be paid, and
• rank ahead of ordinary shares in terms of being paid back if the company is wound up.

Types of Preference Shares

Preference shares may be:
• Cumulative or non-cumulative: a cumulative preference shareholder will not only be
paid this year’s dividend before any ordinary shareholders’ dividends are paid, but also
any unpaid dividends from previous years. Non-cumulative shares, on the other hand,
would forfeit dividends not paid in the previous period.

• Participating or non-participating: one drawback of preference shares when compared

to ordinary shares is that, if the company starts to generate large profits, the ordinary
shareholders will often see their dividends rise, whereas the preference shareholders still
get a fixed level of dividend. To counter this, some preference shares offer the opportunity

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to participate in higher distributions. Participating shares can also participate in additional
distributions in the event of liquidation. While all preferred shareholders rank above
common shareholders, participating shareholders are entitled to more money if there are
additional funds available after all other preferred shareholders are paid, as if they are
also common shareholders.

• Redeemable: these are preference shares that enable the company to buy back the
shares from the shareholder at an agreed price in the future. The shares, from the
company’s perspective, are similar to debt. The money provided by the preference
shareholders can be repaid, removing any obligation the firm has to them.

• Convertible: in this case, the preference shareholder has the right, but not the obligation,
to convert the preference shares into a predetermined number of ordinary shares, eg,
perhaps one preference share may be converted into two ordinary shares. This is another
method of avoiding the lack of upside potential in the preference shares, compared to
ordinary shares.

• Zero coupon – these are preference shares that pay no dividend, but offer an upside to
the shareholder in that they redeem at a price above that at which they are issued.

Note that any one particular preference share can exhibit more than one of these features. While
they convey certain protections, such as a fixed dividend as long as the company is profitable and
priority in the bankruptcy chain, preferred shares often are less liquid and are not actively
monitored or easily purchasable by investors. This may lead to regular preferred shares (without
some of the enhancements listed above) to underperform ordinary shares in a rising market.

Key differences between ordinary/equity shares and preference shares

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4.6 The Benefits of Share Holding
Holding shares in a company is having an ownership stake in that company. Ownership carries
certain benefits and rights, and ordinary shareholders expect to be the major beneficiaries of a
company’s success. As we will see in section 5, shares carry risks. As a reward for taking this
risk, shareholders hope to benefit from the success of the company. This reward or return can
take one of the following forms.

1) Dividends: A dividend is the return that an investor gets for providing the risk capital for
a business. Companies pay dividends out of their profits, which form part of their
distributable reserves. Distributable reserves are the post-tax profits made over the life
of a company, over dividends paid.

2) Dividend Yield: Potential shareholders will compare the dividend paid on a company’s
shares with the return on other investments. These would include other shares, bonds
and bank deposits. A comparison of returns is facilitated by calculating the dividend
yield, ie, the dividend as a percentage of the current share price.
Example
ABC plc has 1 million ordinary shares, each trading at £100. It pays out a total of £10
million in dividends. Its dividend yield is calculated by expressing the dividend as a
percentage of the total value of the company’s shares (the market capitalization):
Dividend yield = (Dividend /Market capitalization) × 100 %
= (10 million/100 million) x 100%
= 10%
3) Capital Gains: Capital gains can be made on shares if their prices increase over time.
If an investor purchases a share for £3 and two years later that share price has risen to
£5, then the investor has made a £2 capital gain. However, the shares need to be sold to
realize any capital gains. If the investor does not sell the share, then the gain is
described as being unrealized, and they run the risk of the share price falling before they
realize the share and ‘bank’ the profits. Whereas dividends need to be reinvested in
order to accumulate wealth, capital gains simply build up.

4) Shareholder Benefits: Some companies provide perks to shareholders, such as a

telecoms company offering its shareholders a discounted price on their mobile phones or
a shipping company offering cheap ferry tickets. Such benefits can be a pleasant bonus
for small investors but are not normally a big factor in investment decisions.

5) Shareholder Rights: Shareholders rights cover the right to subscribe new

shares and the right to vote.

5.1 Right to Subscribe for New Shares

Rights issues are one method by which a company can raise additional capital, with
existing shareholders having the right to subscribe for new shares. If a company were
able to issue new shares to anyone, then existing shareholders could lose control of the

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company, or at least see their share of ownership diluted. As a result, in most countries
legislations, existing shareholders are given pre-emptive rights to subscribe for new
shares. What this means is that, unless the shareholders agree to permit the company to
issue shares to others, they must be given the option to subscribe for any new share
offering before it is offered to the wider public, and in many cases, they receive some
compensation if they decide not to do so.

Example
An investor, Mr B, holds 20,000 ordinary shares of the 100,000 issued ordinary shares in
ABC plc. He, therefore, owns 20% of ABC plc. If ABC plc planned to increase the
number of issued ordinary shares, by allowing investors to subscribe for 50,000 new
ordinary shares, Mr B would be offered 20% of the new shares, ie, 10,000. This would
enable Mr B to retain his 20% ownership of the enlarged company. In summary:
Before the issue
Mr B = 20,000 (20%)
Other shareholders = 80,000 (80%)
Total = 100,000 (100%)

After the issue

Mr B = 30,000 (20%)
Other shareholders = 20,000 (80%)
Total = 150,000 (100%)

5. 2 Right to Vote
Ordinary shareholders have the right to vote on matters presented to them at company
meetings. This would include the right to vote on proposed dividends and other matters,
such as the appointment, or reappointment, of directors. The votes are normally
allocated on the basis of 'one share = one vote'. The votes are cast in one of two ways:
The individual shareholder can attend the company meeting and vote.
The individual shareholder can appoint someone else to vote on their behalf – this is
commonly referred to as voting by proxy.
However, some companies issue different share classes, for some of which voting rights
are restricted or non-existent. This allows some shareholders to control the company
while only holding a small proportion of the shares. For example, Alphabete’s share
classes are as follows.

In practice, most shares these days are held in electronic form in stockbrokers’ or
investment managers’ nominee accounts operated by nominee companies – these
companies are used solely for holding and administering shares and other investments.
It does not trade, and so is described as ‘bankruptcy remote’ as the chances of it going
into liquidation are low. It is the nominee’s name that appears on the record of ownership
of the shares and so, if the shareholder wishes to vote, they will need to arrange for the
operator of the nominee account to vote on their behalf.

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4.7 The Risk of Owning Shares
Shares are relatively high risk but have the potential for relatively high returns when a company
is successful. The main risks associated with holding shares can be classified under the following
headings.

1) Market and Price Risk: Market risk is the risk that share prices in general might fall. Even
though the company involved might maintain dividend payments, investors could face a
loss of capital. Market-wide falls in equity prices occur, unfortunately, on a fairly frequent
basis. One example is when worldwide equities fell by nearly 20% on 19 October 1987,
with some shares falling by even more than this. That day is generally referred to as Black
Monday when the Dow Jones index fell by 22.3%, wiping US$500 billion off share prices.

2) Liquidity Risk: Liquidity risk is the risk that shares may be difficult to sell at a reasonable
price or traded quickly enough in the market to prevent a loss. It essentially occurs when
there is difficulty in finding a counterparty who is willing to trade in a share. This typically
occurs in respect of shares in ‘thinly traded’ companies – private companies, or those in
which there is not much trading activity. It can also happen, to a lesser degree, if share
prices in general are falling, in which case the spread between the bid price (the price at
which dealers will buy shares) and the offer price (the price at which dealers will sell
shares) may widen.

3) Issuer Risk: This is the risk that the issuing company collapses and the ordinary shares
become worthless. In general, it is very unlikely that larger, well-established companies
would collapse, and the risk could be seen, therefore, as insignificant. Shares in new
companies, which have not yet managed to report profits, may have substantial issuer
risk.

4) Foreign Exchange Risk: Foreign exchange risk for investors can be indirect or direct.
Indirect relates to investing in a company that has earnings and operations overseas.
Investors will be exposed to the risks associated with changes in earnings as a result of
this. The company itself may engage in hedging its exposure to foreign currency risk.
Direct foreign exchange risk for the investor relates to investing in shares denominated in
foreign currency. Because the relative value of currencies fluctuates, the sterling value of
an equity investment denominated in a foreign currency is subject to constant fluctuations.
For example, a UK investor holding US shares would see the sterling value of their holding
fall if the dollar were to weaken against the pound.

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4.8 Corporate Actions
A corporate action occurs when a company does something that affects its shareholders or
bondholders. For example, most companies pay dividends to their shareholders twice a year.
Corporate actions can be classified into three types:
1) A mandatory corporate action is one mandated by the company, not requiring any
intervention from the shareholders or bondholders. The most obvious example of a
mandatory corporate action is the payment of a dividend, since all qualifying shareholders
automatically receive the dividend.
2) A mandatory corporate action with options is an action that has some sort of default
option that will occur if the shareholder does not intervene. However, until the date at which
the default option occurs, the individual shareholders are given the choice to select
another option. An example of a mandatory with options corporate action is a rights issue
(detailed below).
3) A voluntary corporate action is an action that requires the shareholder to make a
decision. An example is a takeover bid – if the company is being bid for, each individual
shareholder will need to choose whether to accept the offer or not.

This classification is the one that is used throughout Europe and by the international central
securities depositories Euroclear and Clearstream. It should be noted that, in the US, corporate
actions are simply divided into two classifications: voluntary and mandatory. The major difference
between the two is therefore the existence of the category of mandatory events with options. In
the US, these types of events are split into two or more different events that have to be processed.

4.8.1 Rights Issues

A company may wish to raise additional finance by issuing new shares. This might be to provide
funds for expansion, or to repay bank loans or bond finance. In such circumstances, a company
may approach its existing shareholders with a ‘cash call’ – they have already bought some shares
in the company, so would they like to buy some more? Most country's legislations give a series of
protections to existing shareholders. As already stated, they have pre-emptive rights – the right
to buy shares so that their proportionate holding is not diluted. A rights issue can be defined as
an offer of new shares to existing shareholders, pro rata to their initial holding. Since it is an offer
and the shareholders have a choice, rights issues are examples of a ‘mandatory with options’
type of corporate action. As an example of a rights issue, the company might offer shareholders
the right that for every two shares owned, they can buy one more at a specified price that is at a
discount to the current market price.

The initial response to the announcement of a planned rights issue will reflect the market’s view
of the scheme. If it is to finance expansion, and the strategy makes sense to the investors, the
share price could well rise. If investors have a very negative view of why a rights issue is being
made (eg, to fund activities that investors view negatively) and of what it says for the future of the
company, the share price can fall substantially. The company and their investment banking
advisers will, therefore, have to consider the numbers carefully. If the price at which new shares
are offered is too high, the cash call might flop. This would be embarrassing – and potentially
costly for any institution that has underwritten the issue. (Underwriters of a share issue agree, for

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a fee, to buy any portion of the issue not taken up by shareholders at the issue price. The
underwriters then sell the shares they have bought when market conditions seem opportune to
them, and may make a gain or a loss on this sale. The underwriters agree to buy the shares if no
one else will, and the company’s investment bank will probably underwrite some of the issue
itself.)

Example
ABC plc has 100 million shares in issue, currently trading at £4.00 each. To raise finance for
expansion, it decides to offer its existing shareholders the right to buy one new share for every
four previously held. This would be described as a 1 for 4 rights issue which can also be described
as 5:4 in USA. The price of the rights would be set at a discount to the prevailing market price at,
say, £2.00. Each shareholder is given choices as to how to proceed following a rights issue.

For an individual holding four shares in ABC plc, they could do the following:
• Take up the rights, by paying the £2.00 and increasing their holding in ABC plc to five
shares.
• Sell the rights to another investor. The rights entitlement is transferable (often described
as renounceable) and will have value because it enables the purchase of a share at the
discounted price of £2.00.
• Do nothing. If the investor chooses this option, the company’s advisers will sell the rights
at the best available price and pass on the proceeds (after charges) to the shareholder.
• Alternatively, the investor could sell sufficient rights to raise cash and use this to take up
the rest.

As an example, if an investor had a holding of, say, 4,000 shares then they would have the right
to buy 1,000. They could sell sufficient of the rights to raise cash and use this cash to take up the
rest. The share price of the investor’s existing shares will also adjust to reflect the additional
shares that are being issued. So, if the investor originally had four shares priced at £4 each, worth
£16, and they can acquire one new share at £2.00, on taking the rights up, the investor will have
five shares worth £18 or £3.60 each.

The share price will, therefore, change to reflect the effect of the rights issue once the shares go
ex-rights (this is the point at which the shares and the rights are traded as two separate
instruments). The adjusted share price of £3.60 is known as the theoretical ex-rights price
(TERP) – theoretical because the actual price will also be determined by demand and supply. The
rights can be sold, and the price is known as the premium.

In the example above, if the theoretical ex-rights price is £3.60 and a new share can be acquired
for £2.00, then the right to acquire one has a value. That value is the premium and would be
£1.60, although again the actual price would depend upon demand and supply.

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4.8.2 Bonus Issues
A bonus issue (also known as a scrip or capitalization issue) is a corporate action when the
company gives existing shareholders extra shares without their having to subscribe any further
funds. The company is simply increasing the number of shares held by each shareholder, and
‘capitalizes’ earnings by transfer to shareholders’ funds. It is a mandatory corporate action. The
reason for making a bonus issue is to increase the liquidity of the company’s shares in the market
and to bring about a lower share price. The logic is that, if a company’s share price becomes too
high, it may be unattractive to investors.

Example
XYZ plc’s shares currently trade at £15.00 each. The company decided to make a 1 for 2 (1:2)
bonus issue, giving each shareholder an additional share for every two shares they currently hold.
The result is that a single shareholder who held two shares worth £30.00 now has three shares
worth the same amount in total. As the number of shares has increased, the share price decreases
to £10.00.

4.8.3 Stock Splits and Reverse Stock Splits

Similar to a capitalization issue as described above, a stock split does not raise extra cash. It
simply involves the division of existing shares into smaller denominations, making the share
capital more marketable. For example, a company whose shares have a nominal value of £100
each but a market value of £500 each may decide to split each £100 share into 5 shares of £20
each. The market value of each share then becomes £25. The reverse might be appropriate
where the market value of a company’s share is very low. This is known as consolidation of shares
or a reverse stock split.

4.9 Dividends: Cum and Ex Dividends

Dividends are an example of a mandatory corporate action and represent the part of a company’s
profit that is passed to its shareholders. Dividends for many large companies are paid annually
based BoDs decision after approval by shareholders at the company’s AGM, held after the end
of the company’s financial year, and is referred to as the final dividend for the year. The amount
paid per share depends on factors such as the overall profitability of the company and any plans
it might have for future expansion.

A practical difficulty, especially in a large company, where shares change hands frequently, is
determining who is the correct person to receive dividends. Exchanges need to have procedures
to minimize the extent people receive dividends they are not entitled to, or fail to receive the
dividends to which they are entitled. The shares are bought and sold with the right to receive the
next declared dividend up to a date shortly before the dividend payment is made. Up to that point,
the shares are described as cum-dividend. If the shares are purchased cum-dividend, the
purchaser will receive the declared dividend. At a certain point between the declaration date and
the dividend payment date, the shares go ex-dividend (xd). Buyers of shares when they are ex-
dividend are not entitled to the declared dividend.
In October 2014, the standard settlement period across Europe for equity trades changed to T+2;
this means that a trade is settled two business days after it is executed so, for example, a trade

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executed on Monday would settle on Wednesday. As a result, the dividend timetable also changed
as the following example illustrates.

The following diagram shows the dividend time table.

Example
The sequence of events for a company listed on the Exchange might be as follows:
ABC plc calculates its interim profits (for the six months to 30 June) and decides to pay a dividend
of 8p per share. It announces (‘declares’) the dividend on 2 September and states that it will be
due to those shareholders who are entered on the shareholders’ register on Friday 4 October.
(The actual payment of the dividend will then be made to those shareholders at a later specified
date.) This latter date (always on a Friday) is variously known as the:
• record date
• register date, or
• books closed date.

Given the record date of Friday 4 October, the Exchange sets the ex-dividend date as Thursday
3 October and the cum-dividend date will be 2 October. Shareholders who buy the stock on or
before October 2 will be entitled to collect the dividend. Those who buy the stock from 3 October
onwards will not be entitled to receive the dividend and the seller has the right to collect the
dividend. On 3 October, the shares will go ex-dividend and should fall in price by 8p. This is
because new buyers of ABC plc’s shares will not be entitled to the dividend. Mistakes can happen.
If an investor bought shares in ABC plc on 2 October, and for some reason the trade did not settle
on Friday 4 October, they would not receive the dividend. A dividend claim would be made, and
the buyer’s broker would then recover the money via the seller’s broker.

4.10 Stock Market Indices

A stock market index is a method of measuring the performance of a section of the stock market
which is segmented to represent a particular group. The group might be the largest companies
listed on the market, or perhaps a group of companies that all operate in a similar industry. Many
indices are cited by news or specialized financial services firms and are used as benchmarks to

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measure the performance of portfolios and to provide the general public with an easy overview of
the state of equity investments.

The major global market indexes are presented in the following table.
Index name Geographical scope Composition

DJIA (Dow US-domiciled 30 large US companies selected by a

Jones multinationals committee that includes the managing editor
Industrial of the Wall Street Journal
Average)
S&P 500 US-traded stocks Standard & Poor’s manages the composition
multinational companies of the index. The 500 constituents are
selected by S&P from the largest cap stocks
traded in the US
Nasdaq Since both US and non- Covers issues listed on the Nasdaq stock
Composite US companies are listed market, with over 3,000 components, of
on the Nasdaq stock which around 300 are non-US stocks. It is an
market, the index is not indicator of the performance of stocks of
exclusively a US index technology companies and growth
companies
FTSE 100 UK and multinationals Largest 100 UK companies listed on the LSE
as measured by market capitalization.
Deutscher Germany The DAX includes the 40 major German
Aktien IndeX companies trading on the Frankfurt Stock
(DAX) Exchange
Nikkei Stock Japanese corporations 225 large and regularly traded Japanese
225 companies traded on the Tokyo Stock
Exchange (TSE)
More than 60 companies listed on the Hong
Hang Seng Hong Kong/China Kong Stock Exchange selected on the basis
of market value, turnover and financial
performance
FTS Eurofirst 300 European-domiciled Around 300 of the largest listed companies by
corporations marketcapitalization from across Europe

The method of construction can vary according to the method of weighting used. Most are
capitalization-weighted, although some older indices are price-weighted. ‘Capitalization-
weighted’ refers to the importance of the constituents being based on their market capitalization,
which is the number of shares in issue multiplied by the price per share. ‘Price-weighted’ simply
weights the constituents based on their per share prices.

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4.11 Computing the Price of Common Stock (Valuation of Equities)
One basic principle of finance is that the value of any investment is found by com putting the value
today of all cash flows the investment will generate over its life. For example, a commercial
building will sell for a price that reflects the net cash flows (rents minus expenses) it is projected
to have over its useful life. Similarly, we value common stock as the value in today’s dollars of all
future cash flows. The cash flows a stockholder may earn from stock are dividends, the sales
price, or both. To develop the theory of stock valuation, we begin with the simplest possible
scenario. This assumes that you buy the stock, hold it for one period to get a dividend, then sell
the stock. We call this the one-period valuation model. It is useful for building an understanding
of how stock is valued.

4.11.1 The One-Period Valuation Model

Suppose that you have some extra money to invest for one year. After a year you will need to sell
your investment to pay tuition. You want to buy Intel Corp. stock and you call your broker and find
that Intel is currently selling for $50 per share and pays $0.16 per year in dividends. The analyst
on Wall Street Week predicts that the stock will be selling for $60 in one year. Should you buy this
stock?

To answer this question, you need to determine whether the current price accurately reflects the
analyst’s forecast. To value the stock today, you need to find the present discounted value of the
expected cash flows (future payments). The discount factor used to discount the cash flows is the
required return on investments in equity. The cash flows consist of one dividend payment plus a
final sales price, which, when discounted back to the present, leads to the following equation that
computes the current price of the stock.

P0 = [D1/(1 + ke)] + [P1/(1 + ke)]

Where,
P0 = the current price of the stock. The zero subscript refers to time period zero, or the
present.
D1 = the dividend paid at the end of year 1.
ke = the required return on equity investments.
P1 = the price at the end of the first year. This is the assumed sales price of the stock.

Example
Find the value of the Intel stock given the figures reported above. You will need to know
the required return on equity to find the present value of the cash flows. Since a stock is
more risky than a bond, you will require a higher return than that offered in the bond
market. Assume that after careful consideration you decide that you would be satisfied to
earn 12% on the investment. Solution Putting the numbers into the equation yields the
following:
P0 = [.16 / 1 + 0.12] + [$60 /1 + 0.12]
= $.14 + $53.57
= $53.71

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Based on your analysis, you find that the stock is worth $53.71. Since the stock is currently
available for $50 per share, you would choose to buy it. Why is the stock selling for less
than $53.71? It may be because other investors place a different risk on the cash flows or
estimate the cash flows to be less than you do.

4.11.2 The Generalized Dividend Valuation Model

The one-period dividend valuation model can be extended to any number of periods. The concept
remains the same. The value of stock is the present value of all future cash flows. The only cash
flows that an investor will receive are dividends and a final sales price when the stock is ultimately
sold. The generalized formula for stock can be written in the following equation.

P0 = [D1 / (1 + ke)1] + [D2 / (1 + ke)2] + …. + [Dn / (1 + ke)n] + [Pn / (1 + ke)n]

If you were to attempt to use the above equation to find the value of a share of stock, you would
soon realize that you must first estimate the value the stock will have at some point in the future
before you can estimate its value today. In other words, you must find Pn in order to find P0.
However, if Pn is far in the future, it will not affect P0. For example, the present value of a share
of stock that sells for $50 seventy-five years from now using a 12% discount rate is just one cent.

[$50 / (1.1275) = $0.014.

This means that the current value of a share of stock can be found as simply the present value of
the future dividend stream. The generalized dividend model is rewritten in the following equation
without the final sales price.

P0 = Σ [ Dt / (1 + ke) t]

Consider the implications of the above equation for a moment. The generalized dividend model
says that the price of stock is determined only by the present value of the dividends and that
nothing else matters. Many stocks do not pay dividends, so how is it that these stocks have value?

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Buyers of the stock expect that the firm will pay dividends someday. Most of the time a firm
institutes dividend as soon as it has completed the rapid growth phase of its life cycle. The stock
price increases as the time approaches for the dividend stream to begin.

The generalized dividend valuation model requires that we compute the present value of an
infinite stream of dividends, a process that could be difficult, to say the least. Therefore, simplified
models have been developed to make the calculations easier. One such model is the Gordon
growth model, which assumes constant dividend growth.

4.11.3 The Gordon Growth Model

Many firms strive to increase their dividends at a constant rate each year. The following equation
rewrites the generalized dividend valuation equation to reflect this constant growth in dividends.

This model is useful for finding the value of stock, given a few assumptions:
1. Dividends are assumed to continue growing at a constant rate forever. Actually, as long
as they are expected to grow at a constant rate for an extended period of time (even if not
forever), the model should yield reason able results. This is because errors about distant
cash flows become small when discounted to the present.
2. The growth rate is assumed to be less than the required return on equity, ke. Myron
Gordon, in his development of the model, demonstrated that this is a reasonable
assumption. In theory, if the growth rate were faster than the rate demanded by holders of
the firm’s equity, in the long run the firm would grow impossibly large.
Example
Find the current market price of Coca-Cola stock, assuming dividends grow at a constant rate of
10.95%, D0 = $1.00, and the required return is 13%.
P0 = [D0 x (1 + g)] / (ke- g)
P0 = [$1.00 x (1.1095)] /(.13- .1095)]
P0 = $1.1095 / 0.0205 = $54.12
Coca-Cola stock should sell for $54.12 if the assumptions regarding the constant growth rate and
required return are correct.

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4.11.4 Price Earnings Valuation Method
Theoretically, the best method of stock valuation is the dividend valuation approach. Sometimes,
however, it is difficult to apply. If a firm is not paying dividends or has a very erratic growth rate,
the results may not be satisfactory. Other approaches to stock valuation are sometimes applied.
Among the more popular is the price/earnings multiple. The price earnings ratio (PE) is a widely
watched measure of how much the market is willing to pay for $1 of earnings from a firm. The PE
ratio can be used to estimate the value of a firm’s stock. Note that algebraically the product of the
PE ratio times expected earnings is the firm’s stock price.
P = (P / E) x E =
Firms in the same industry are expected to have similar PE ratios in the long run. The value of a
firm’s stock can be found by multiplying the average industry PE times the expected earnings per
share. A high PE has two interpretations.
1. A higher-than-average PE may mean that the market expects earnings to rise in the future.
This would return the PE to a more normal level.
2. A high PE may alternatively indicate that the market feels the firm’s earnings are very low
risk and is therefore willing to pay a premium for them.

Example
The average industry PE ratio for restaurants is 23. What is the current price if earnings per share
are projected to be $1.13?
P0 = (P / E) * E
P0 = 23 * $1.13 = $26
The PE ratio approach is especially useful for valuing privately held firms and firms that do not
pay dividends. The weakness of the PE approach to valuation is that by using an industry average
PE ratio, firm-specific factors that might contribute to a long-term PE ratio above or below the
average are ignored in the analysis. A skilled analyst will adjust the PE ratio up or down to reflect
the unique characteristics of a firm when estimating its stock price.

4.11 Financial Performance Measures of Shares

When discussing a company's shareholding performance, there are several key financial
measures that are typically reviewed:

1. Share Price:
- The current market price of the company's shares.
- Tracking the share price over time provides insights into the company's valuation.

2. Earnings per Share (EPS):

- The portion of the company's profit allocated to each outstanding share.
- EPS reflects the company's profitability and is a key metric for valuing the stock.
- EPS = Net Income / Number of Outstanding Shares
- Example: Company XYZ reported a net income of $10 million and has 2 million
outstanding shares.
EPS = $10 million / 2 million = $5 per share.

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3. Dividend per Share (DPS):
- The amount of dividend paid out to shareholders per outstanding share.
- DPS indicates the company's dividend payout policy and shareholder return.
- DPS = Total Dividends Paid / Number of Outstanding Shares
- Example: Company XYZ paid a total of $2 million in dividends and has 1 million
outstanding shares.
DPS = $2 million / 1 million = $2 per share.

4. Price-to-Earnings (P/E) Ratio:

- The ratio of the company's share price to its EPS.
- P/E ratio provides a measure of the company's valuation relative to its earnings.
- P/E Ratio = Share Price / Earnings per Share
- Example: Company ABC's share price is $50 and its EPS is $5.
P/E Ratio = $50 / $5 = 10.

5. Dividend Yield:
- The ratio of the company's annual dividend per share to its current share price.
- Dividend yield indicates the return shareholders receive from the company's dividends.
- Dividend Yield = Dividend per Share / Share Price
- Example: Company XYZ has a DPS of $2 and a share price of $40.
Dividend Yield = $2 / $40 = 5%.

6. Total Shareholder Return (TSR):

- The overall return to shareholders, including both capital appreciation and dividends.
- TSR combines the share price performance and dividend payments to give a
comprehensive measure of shareholder value creation.
- TSR = (Change in Share Price + Dividends Paid) / Beginning Share Price
- Example: Company PQR's share price increased from $20 to $25 and it paid $1 per
share in dividends. TSR = ($25 - $20 + $1) / $20 = 30%.

7. Market Capitalization:
- The total value of the company's outstanding shares.
- Market cap reflects the overall size and scale of the company.
- Market Capitalization = Share Price × Number of Outstanding Shares
- Example: Company ABC has a share price of $50 and 1 million outstanding shares.
Market Capitalization = $50 × 1 million = $50 million.

Analyzing these financial metrics can provide valuable insights into the company's financial
performance, shareholder value creation, and investment attractiveness. Tracking the trends in
these measures over time and benchmarking against industry peers or the broader market can
help inform investment decisions and strategic planning.

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Summary
Going public changes, the firm’s ownership structure by increasing the number of owners, and it
changes the firm’s capital structure by increasing the equity investment in the firm. Stock market
participants include individual investors as well as institutional investors such as stock mutual
funds, pension funds, and insurance companies. Upon the release of new information about a
firm, some investors respond by either selling their stock holdings or buying more stock. Their
actions affect the supply and demand conditions for the stock and thus influence the equilibrium
stock price.

An initial public offering (IPO) is a first-time offering of shares by a specific firm to the public. Many
firms engage in an IPO to obtain funding for additional expansion and to give the founders and
venture capital funds a way to cash out their investments. A firm that engages in an IPO must
develop a prospectus that is filed with the regulator, and it typically uses a road show to
promote its offering. The firm hires an underwriter to help with the prospectus and road show
and to place the shares with investors.

A secondary stock offering is an offering of shares by a firm that already has publicly traded stock.
Firms engage in secondary offerings when they need more equity funding to support additional
expansion.

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UNIT 5: FOREIGN EXCHANGE (FX)

Learning Objective
Upon completion of this unit, a student will be able to:
• Describe the principal features and uses of spot, forward, and cross rates: quotation as
bid-offer spreads; forwards quoted as bid-offer margins against the spot; quotation of cross
rates
• Be able to calculate spot and forward settlement prices using: adding or subtracting
forward
• Explain the factors that affect foreign exchange rates: freely floating exchange rates;
purchasing power parity; currency demand and supply
• Discuss the factors that affect foreign exchange trading and speculation

5.1 Introduction
The foreign exchange (‘forex’ or ‘FX’) market is the collective way of describing all the transactions
in which one currency is exchanged for another, anywhere in the world. There is no physical
exchange for the currency market in London; it is purely OTC and dominated by banks.

There are two types of transactions conducted on the FX market:

1. Spot transactions are immediate currency deals that are settled within two working days.
2. A forward transaction involves currency deals that are agreed for a future date at a rate of
exchange fixed now.
Both spot and forward rates are quoted by dealers in the form of a buying rate (the bid) and a
selling rate (the offer). The spread between these two prices enables the FX dealer to make a
profit.

The users of the FX market fall into two broad camps.

• First, FX transactions are driven by international trade. If a Japanese company sells goods
to a US customer, it might invoice the transaction in US dollars. These dollars will need to
be exchanged for Japanese yen by the Japanese company and this is the FX transaction.
The Japanese company may not be expecting to receive the dollars for a month after the
submission of the invoice. This gives it two choices: 1. It can wait until it receives the
dollars and then execute a spot transaction. 2. It can enter into a forward transaction to
sell the dollars for yen in a month. This will provide it with certainty as to the amount of
yen it will receive and assist in its budgeting efforts.
• The second reason for FX transactions is speculation. If an investor feels that the US
dollar is likely to weaken against the euro, they can buy euros in either the spot or forward
market to profit if they are right.

Trading of foreign currencies is always done in pairs. These are currency pairs when one
currency is bought and the other is sold, and the prices at which these take place make up the
exchange rate. When the exchange rate is being quoted, the name of the currency is abbreviated

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to a three-character reference. The most commonly quoted currency pairs and their three-
character references are:
• US dollar and Japanese yen (USD/JPY)
• Euro and US dollar (EUR/USD)
• US dollar and Swiss franc (USD/CHF)
• British pound and US dollar (GBP/USD).
When currencies are quoted, the first currency is the base currency and the second is the
counter or quote currency. The base currency is always equal to one unit of that currency, in
other words, one pound, one dollar, or one euro.

For example, say the EUR: USD exchange rate is 1:1.1229, this means that €1 is worth $1.1229.
When currency pairs are quoted, a market maker or foreign exchange trader will quote a bid and
an ask price. Staying with the EUR/USD example, the quote might be 1.1228/30. So if you want
to buy €100,000 then you will need to pay the higher of the two prices and deliver $112,300; if
you want to sell €100,000 then you get the lower of the two prices and receive $112,280.

Generally, exchange rates around the world are quoted against the US dollar. A cross rate is any
foreign currency rate that does not include the US dollar, eg, GBP/JPY is a cross rate,
except GBP and EUR. A cross rate will be of particular interest to companies doing international
business between the constituent countries, eg, a UK company selling goods or services to
Japanese consumers, and receiving payment in yen.

5.2 Spot and Forward Transactions

A typical sterling/dollar spot quote might look something like this: GBP/USD spot rate 1.3055–
1.3145
• Buyer’s rate: £1 buys $1.3055. £1 GBP seller gets $1.30555 USD
• Seller’s rate: $1.3145 buys £1. £1 GBP buyer pays $1.3145 USD

The buyer’s rate and seller’s rate refer to buying and selling dollars respectively. The difference
between the buyer’s and seller’s rates is generally referred to as the bid-offer spread. It enables
the bank to offer deals to make money. How much will an investor receive if the above spot rate
is applied? If the investor wants to sell $50,000 for pounds sterling, they will receive £38,037. This
is based on the seller’s rate of $1.3145: £1.

The forward market is almost exactly the same as the spot market, except that currency deals are
agreed for a future date, but at a rate of exchange fixed now. These rates of exchange are not
directly quoted. Instead, quotes on the forward market state how much must be added to, or
subtracted from the present spot rate.

For example, the three-month GBP/USD quote might be:

spot $1.3055–$1.3145 three-month forward
1.00–0.97c pm. pm stands for premium.

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It is used when the dollar is going to be more expensive relative to sterling in the future. It is
deducted from the quoted spot rate in order to arrive at the forward rate. £1 will buy fewer dollars
in three months’ time and, if you have dollars in three months’ time, the bank will sell you more
sterling per dollar than it will now. The premium is quoted in cents, unlike the spot rate, which is
quoted in dollars. So 1.00 pm is a premium of 1 cent or 0.01 dollars. And 0.97 pm is a premium
of 0.97 cents or 0.0097 dollars. The three-month forward quote is, therefore:
$1.2955–$1.3048.

Alternatively, the three-month forward rate might exhibit a discount, rather than a premium, for
example:
spot 1.3055–1.3145 three-month forward
0.79–0.82c dis

dis stands for discount. The discount is used when the dollar is going to be cheaper relative to
sterling in the future. It needs to be added to the quoted spot rate to arrive at the forward rate. £1
will buy more dollars in three months’ time and, if you have dollars in three months’ time, the bank
will sell you less sterling per dollar than it will now. The three-month forward quote is, therefore:
three-month forward $1.3134–$1.3227
The logic is that the forward rate will always exhibit a wider spread than the spot rate.

5.2.1 Interest Rate Parity

The concept of interest rate parity in determining the exchange rate between currencies arises
from one of the cornerstone ideas in financial theory: rational pricing and the notion of arbitrage.
Rational pricing is the assumption in financial economics that asset prices will reflect the
arbitrage-free price of the asset, as any deviation from this price will be ‘arbitraged away’.
Arbitrage is the practice of taking advantage of a pricing anomaly between securities that are
trading in two (or possibly more) markets. One market can be the physical or underlying market;
the other can often be a derivative market. When a mismatch or anomaly can be exploited (i.e.,
after transaction costs, storage costs, transport costs, and dividends), the arbitrageur ‘locks in’ a
risk-free profit. In general terms, arbitrage ensures that the law of one price will prevail. Interest
rate parity results from recognizing a possible arbitrage condition and arbitraging it away.

Consider the returns from borrowing in one currency, exchanging that currency for another
currency, and investing in interest-bearing instruments of the second currency, while
simultaneously purchasing futures contracts to convert the currency back at the end of the
investment period. Under the assumption of arbitrage, the returns available should be equal to
the returns from purchasing and holding similar interest-bearing instruments of the first currency.
If the returns are different, investors could theoretically arbitrage and make risk-free returns.
Interest rate parity says that the spot and future prices for currency trades incorporate any
interest rate differentials between the two currencies.
A forward exchange contract is an agreement between two parties to either buy or sell foreign
currency at a fixed exchange rate for settlement at a future date. The forward exchange rate is
the exchange rate set today even though the transaction will not settle until some agreed point in
the future, such as in three months’ time. The relationship between the spot exchange rate and

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forward exchange rate for two currencies is simply given by the differential between their
respective nominal interest rates over the term being considered. The relationship is purely
mathematical and has nothing to do with market expectations.

The idea behind this relationship is embodied in the principle of interest rate parity and is
expressed as follows:
Forward rate for GBP/USD = £ Spot rate x (1+US $ Short-term interest rate)
(1+UK £ Short-term interest rate)
Example The GBP/USD spot exchange rate = 1.5220. If the annual interest rate for the UK is
4.88% and for the US, 3.20%, what will the three-month forward exchange rate be?

As the three-month interest rates are quoted on a per-annum basis, they must be divided by four
to obtain the rate of interest that will be payable (%) over three months:
Sterling: 4.88%/4 = 1.22%
Dollar: 3.20%/4 = 0.8%

Applying the interest rate parity formula:

Forward rate for GBP/USD = $1.5220 x (1+0.008) = $1.5157

(1+0.0122)
The forward exchange rate in the example of $1.5157 is lower than the spot exchange rate of
$1.5220. That is, in three months’ time, £1 will buy $1.5157 or $0.0063 fewer dollars than is
available at the spot rate (ie, the difference is 63 pips). If this relationship did not exist, then an
arbitrage opportunity would arise between the spot and forward rates.

It is important to realize that the forward rate calculated under the notion of arbitrage and interest
rate parity is not a forecast of what the rate of exchange will actually be in three months. The
actual rate will vary according to all of the factors that influence exchange rates in the forex (FX)
market. The three-month forward rate in this example is simply a mathematically derived rate
resulting from the interest rate differentials prevailing between the two currencies being
exchanged.

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5.3 Factors Affecting Foreign Exchange Rates

Historically, exchange rates were fixed as part of the 1944 Bretton Woods agreement and were
not subject to market forces. Resetting or changing these exchange rates took place, as it did in
the UK in the 1960s, by a formal devaluation whereby the rates that had been set in 1944 were
modified. The UK Government undertook a devaluation of the pound against the dollar from £1=
$2.80 to £1= $2.40 in 1968.

The era of fixed exchange rates was abandoned in August 1971 as a result of the Smithsonian
Agreement. By 1971, the U.S. dollar was clearly overvalued. That is, its value was maintained
only by central bank intervention. In 1971, an agreement among all major countries (known as
the Smithsonian Agreement) allowed for the devaluation of the dollar. In addition, the Smithsonian
Agreement called for a widening of the boundaries from 1 percent to 2¼ percent around each
currency’s set value. A system with no boundaries and in which exchange rates are market-
determined but still subject to government intervention is called a dirty float. This is to be
distinguished from a freely floating system, in which the foreign exchange market is totally free
from government intervention. Most countries allow their local currency to float but periodically
intervene in the foreign exchange market to influence the value of that currency, as will be
explained shortly.

There are exceptions to floating currencies; for example, some Middle Eastern countries, such as
Saudi Arabia and the UAE, peg their currencies to the US dollar, and China pegs its currency to
a basket of other currencies including the US dollar. A more strict version of a peg is a currency
board, where there are reserve requirements to ensure the peg holds. Hong Kong has such a
system. Other countries that moderately restrict inflows and outflows and where the central bank
plays a key role in allocating the supply of hard currency for imports and other international
transactions often have parallel exchange rates; Nigeria is an example. When the unofficial rate
moves too far away from the official rate, a devaluation can occur.

Questions regarding the determination of the FX rates by the markets come down to several
related issues concerning the demand and supply for individual currencies, monetary and interest
rate policy, issues relating to purchasing power parity (PPP), and speculation.

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5.3.1 Purchasing Power Parity (PPP)
In the short term, it appears that the primary factors affecting the manner in which market
participants decide on the appropriate exchange rates are those of supply and demand and, to
a greater or lesser extent, market sentiment. Purchasing power parity (PPP) theory concerns
the rate at which exchange rates should tend to move over the long term. PPP theory predicts
that amounts of different currencies (at current exchange rates) should have equal purchasing
power.

The concept of PPP can be appreciated by considering an example.

• If a basket of goods costs £100 in London and the same basket of goods costs $200 in
New York, the PPP theory predicts that the exchange rate between the two countries will
be £1 = $2.
• If two economies experience differing rates of inflation then, over time, the exchange rate
will tend to alter in the direction of restoring PPP. If, after a number of years, the basket of
goods now costs £150 in London due to the impact of inflation on UK prices and yet it only
rises to $210 in New York, this suggests that the exchange rate between the two
currencies should now be £1 = $1.40: there should have been a decline in the value of
sterling.
PPP has some plausibility over the long term and gives an underlying theme to the FX markets.
If one economy consistently has an inflation rate in excess of its competitors, then its currency
will deteriorate against its trading partners.

Factors Affecting the Supply and Demand for a Currency

The following is a list of factors that affect the supply and demand for a particular currency, using
the US dollar as an example:

Factors Affecting the Demand for US Dollars

• Overseas operators with a need for US dollars to pay for exports of US goods to
overseas markets now or in the future.
• Overseas investors wanting to invest capital in the US will increase demand,
whereas investors wanting to divest, or reduce their holdings in the US, will
decrease demand.
• Speculation – if the US dollar is expected to increase relative to one or more other
currencies, speculators will buy US dollars ahead of the increase.
• Currency rate management activities of central banks, including the Federal
Reserve.
• Demand will be downward-sloping with respect to price – less demand for exports
and less interest from overseas investors as the US dollar advances relative to
other currencies.

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Factors Affecting the Supply of US Dollars
• When US importers purchase overseas currencies to pay for imported goods
arriving in the US, they are increasing the supply of US dollars into the markets.
• US residents wishing to invest in overseas assets will have to sell US dollars to
buy overseas currency.
• Speculation – if the US dollar is expected to decrease relative to one or more other
currencies, speculators will sell US dollars.
• The Federal Reserve may sell the domestic currency to purchase additional
overseas currency reserves in order to influence the exchange rate as part of
macroeconomic policy.
• Supply will be upward-sloping with respect to price.

5.3.2 Foreign Currency Trading and Speculation

While the previous discussion has focused on the underlying economic and fundamental factors
that influence exchange rates, there is no question that the FX market is also one where there is
a huge amount of speculative trading activity. Much of this trading is conducted by the large banks,
which are the dominant players in the OTC market for FX. The volume of transactions has been
estimated by the Bank for International Settlements (BIS) at approximately $7 trillion in nominal
amounts traded daily. However, as with derivatives, the nominal amount traded is somewhat
misleading since the speculative activity in FX is focused on the amount that is traded at the
margin. In other words, if someone places an order to sell $1 million to purchase £600,000, but
only holds the position for a few hours or minutes, there is a sense in which the nominal amounts
are not really exchanged; it is the marginal difference which is really being traded or at risk.

According to the BIS, the most widely traded currency pair is the USD/EUR, which represents just
under one-quarter of all trades. The FX market is extremely liquid and, for large deals, it is always
open. There is a great depth of trading and, therefore, narrow spreads between buying and
selling prices for the commonly quoted and frequently traded currencies like the EUR/USD.

FX markets can be extremely volatile at times, especially when the markets in other asset classes
are acting in an erratic manner. There is a fascinating correlation between certain currency pairs
and equity markets and some of this is explicable by reference to the carry trade. In essence, the
carry trade in FX involves the borrowing of funds in a currency where the rate of interest is
relatively low – examples are the Japanese yen and the Swiss franc – and then the purchase of
securities, often government bonds, which have a relatively high yield, such as short-term
instruments available from the Australian government.

The more volatile periods for FX trading are often seen when central bank officials (such as the
Federal Reserve chairman) talk to the press or release minutes of meetings. Any hint of a change
in central bank policy will tend to impact the FX rates. Also important to the sudden movements
of exchange rates are the results of auctions of government securities and any changes in short-
term rates announced by central banks. Currencies of emerging markets countries may also be

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strongly influenced by heightened political risk, for example, around election periods or if one
country is experiencing tensions with its neighbors.

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UNIT 6: DERIVATIVE SECURITY MARKETS

Learning Outcomes
Upon completion of this part, a trainee will be able to:
• Define derivatives and describe their importance
• List and describe the major participants in the derivative markets
• Describe the role of the clearing house
• Discuss the nature and purpose of forward contract
• Explain the key aspects of futures contract
• Discuss the key features and types of option contracts
• Describe the meaning and types of a swap contract
• Discuss the purpose and mechanics of margins and ‘marking to the market’

Introduction
Derivative security markets are the markets in which derivative securities are traded. A derivative
security is a financial security (such as a futures contract, option contract, swap contract, or
mortgage-backed security) whose payoff is linked to another, previously issued security such as
security traded in the capital or foreign exchange markets. Derivative securities generally involve
an agreement between two parties to exchange a standard quantity of an asset or cash flow at a
predetermined price and at a specified date in the future. As the value of the underlying security
to be exchanged changes, the value of the derivative security changes. Derivatives involve the
buying and selling, or transference, of risk. Under normal circumstances, trading in derivatives
should not adversely affect the economic system because it allows individuals who want to bear
the risk to take more risk while allowing individuals who want to avoid risk to transfer that risk
elsewhere.

While derivative securities have been in existence for centuries, the growth in derivative security
markets occurred mainly in the 1990s and 2000s. As major markets, the derivative security
markets are the newest financial security markets. Derivative securities, however, are also
potentially the riskiest of the financial securities. Derivative securities traders can experience large
losses if the price of the underlying asset moves against them significantly.

The first of the modern wave of derivatives to trade were foreign currency futures contracts. These
contracts were introduced by the International Monetary Market (IMM), now a subsidiary of the
CME Group, in response to the introduction of floating exchange rates between currencies of
different countries following the Smithsonian Agreements of 1971 and 1973. The second wave of
derivative security growth was with interest-rate derivative securities. Their growth was mainly in
response to increases in the volatility of interest rates in the late 1970s. A third wave of derivative
security innovations occurred in the 1990s and 2000s with credit derivatives (e.g., credit forwards,
credit risk options, and credit swaps). For example, a credit forward is a forward agreement that
hedges against an increase in default risk on a loan (a decline in the credit quality of a borrower)
after the loan rate is determined and the loan is issued.

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In this part, we present an overview of the derivative securities markets. We look at the markets
for forwards, futures, options, and swaps. We define the various derivative securities and focus
on the markets themselves—their operations and trading processes.

6.1 What are Derivatives?

A derivative is a financial instrument or security whose price (value) is dependent upon or derived
from one or more underlying assets. The derivative itself is merely a contract between two or
more parties. Its value is determined by fluctuations in the price of the underlying asset. The most
common underlying assets include stocks, bonds, commodities, currencies, interest rates and
market indexes. Most derivatives are characterized by high financial leverage.

Derivatives are also defined as financial instruments that transfer risks from one party to another.
They are called derivatives because they derive their value from the value of something else—an
underlying right or interest. Underlying rights or interests include bonds and loans, which involve
interest rate, credit, and currency risks, and commodities and equities, which involve price risks.
Underlying rights or interests can also be groups of assets, such as equity, credit, or commodity
indexes, or relationships between prices, such as the spread between two benchmark oil prices.

The derivatives market is the financial market for derivatives, financial instruments like futures
contracts or options, which are derived from other forms of assets. The market can be divided
into two, that for exchange-traded derivatives and that for over-the-counter derivatives.

The four major categories of derivative securities are:

1. Forward contracts
2. Futures contracts
3. Options contract
4. Swaps
Before proceeding to each the four major types of derivative securities, first let’s address the key
market participants and the role of the clearing house in the derivative transactions.

6.2 Market Participants

The key market participants are hedgers, speculators, and arbitragers. Each of these market
players and the purpose of hedging, speculation, and arbitraging will be discussed in the following
section.

6.2.1 Hedgers
Futures contracts have been used as financial offsets to cash market risk for more than a century.
Hedgers are interested in transferring risk associated with the underlying asset. They use futures
to reduce or limit the price risk of the asset. Hedging is used to avoid or reduce price risks
associated with any kind of futures transaction.

Hedging allows a market participant to lock in prices and margins in advance and reduce the
potential for unanticipated loss or competitive disadvantage. A hedge involves in establishing a
position in the futures market that is equal and opposite to a position in the physical market. The

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principle behind establishing equal and opposite positions in the cash and futures markets is that
a loss in one market should be offset by a gain in the other market. Hedging works because cash
prices and futures prices are expected to move in tandem, converging as the futures contract
reaches expiry. In an efficient futures market, the futures price does move in tandem to the cash
price.

Futures contracts can help people to hedge, irrespective of whether they have a long or a short
position in the underlying asset. Consider a person who owns an asset and fears that he may
subsequently have to sell it at a lower price. Such a person can hedge by taking a short position
in a futures contract. If the price of the underlying asset were to fall subsequently, he can still sell
at the original futures price, since the other party is under an obligation to buy at this price.

6.2.2 Speculators
When supplies of an asset are greater than the present demand or need, prices tend to decline.
If supplies appear to fall short of demand, prices tend to move upward. Estimating market supply
and demand conditions are the challenges faced by market participants. It is generally accepted
that speculators are interested in making fast money by anticipating future price movements. A
speculator accepts the risk that hedgers seek to avoid giving the market the liquidity required to
service hedge participants effectively by providing the market with the necessary bids and offers
for a continuous flow of transactions. Speculation is the opposite of hedging. A speculator
holds not offsetting cash market position and deliberately incurs price risk in order to benefit from
price movements. Hedger efficiently transfers his risk to speculators.

A speculator is an additional buyer of securities whenever it seems that market prices are lower
than they should be. Conversely, when it appears that prices are too high a speculator becomes
an active seller. A speculator makes a market analysis to take a market outlook. The speculator’s
view of the market could be either bullish or bearish. The speculator takes a bullish view if the
price of the asset is expected to rise and a bearish view if the price is expected to fall down. The
speculator takes a long position with a bullish view of the market and a short position when the
market is believed to be bearish.

Activity 1
How do speculators play an important role in the futures market?

Reflection
Active speculation adds depth to a market and makes it more liquid. A market characterized
solely by hedgers will not have the kind of volume required to make it efficient. In practice,
when a hedger seeks to take a position, very often the opposite side of the transaction will
be taken by a speculator. Divergence of views, and a desire to take positions based on those
views, is a sine qua non for making the free-market system a success. Thus speculators,
along with hedgers and arbitrageurs, play a pivotal role in derivative markets.

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6.2.3 Arbitrageurs
Arbitragers are interested in making purchases and sales in different markets at the same time to
profit from price discrepancies between the two markets. So, arbitragers are interested in locking
in a minimum profit by simultaneously entering into transactions in two or more markets. An
arbitrager knows the minimum profit potentials at the time of entering into transactions.
Arbitragers lock in profits when they identify cash and carry arbitrage opportunity or reverse cash
and carry arbitrage opportunity.

Traders who continually watch the markets can see inconsistencies in pricing and can market
relatively low-risk profits by arbitrage in today's financial markets, most arbitrage opportunities
occur either between regions, delivery periods, and types of instruments (such as options on
futures) or across a combination of these conditions.

Arbitrage refers to the ability to make a costless, risk-less profit, by simultaneously transacting in
two or more markets. The key phrase here is ‘cost less and risk less’. Arbitrage opportunities, if
perceived, will be exploited till they vanish. The rationale is as follows. If one has to invest in a
risky asset, he will do so only if the expected return is commensurate with the level of risk. Even
if the investment is riskless, a person will invest only if he is assured of a riskless rate of return.
However, if a person is assured of an opportunity to earn a risk-less return without investing in his
own, he would be irrational not to exploit it. Such opportunities are referred to as arbitrage
opportunities.

6.2.4 Traders in the Futures Market

Only futures exchange members are allowed to transact on futures exchanges.
• Floor broker: Exchange members who place trades from the public. Trades from the
public are placed with a floor broker. When an order is placed, a floor broker may trade
with another floor broker or with a professional trader.
• Professional traders: Exchange members who trade for their own account. Professional
traders are similar to designated market makers on the stock exchanges in that they trade
for their own accounts. Professional traders are also referred to as position traders, day
traders, or scalpers.
o Position traders: Exchange members who take a position in the futures market
based on their expectations about the future direction of the prices of the
underlying assets. Position traders take a position in the futures market based on
their expectations about the future direction of prices of the underlying assets.
o Day traders: Exchange members who take a position within a day and liquidate it
before the day’s end. Day traders generally take a position within a day and
liquidate it before the day’s end. Scalpers take positions for very short periods of
time, sometimes only minutes, in an attempt to profit from this active trading.
o Scalpers: Exchange members who take positions for very short periods of time,
sometimes only minutes, in an attempt to profit from this active trading. Scalpers
do not have an affirmative obligation to provide liquidity to futures markets but do
so in expectation of earning a profit. Scalpers’ profits are related to the bid-ask
spread and the length of time a position is held. Specifically, it has been found that

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scalper trades held longer than three minutes, on average, produce losses to
scalpers. Thus, this need for a quick turnover of a scalper’s position enhances
futures market liquidity and is therefore valuable.

Key points
✓ A derivative is a financial instrument whose value is derived from the
underlying asset.
✓ Derivatives are used for price risk management and profit-making from
speculative and arbitrage trading.
✓ The key market participants in the derivatives market are hedgers,
speculators, and arbitragers.
✓ The key trading executors who take part in the derivatives market are floor
brokers, professional traders, position traders, day traders, and scalpers.

6.3 The Role of the Clearing House

Associated with every futures exchange is a clearinghouse, which performs several functions.
One of these functions is to guarantee that the two parties to the transaction will perform. To see
the importance of this function, consider potential problems in the futures transaction described
earlier from the perspective of the two parties—Bahiru the buyer, and Solomon the seller. Each
must be concerned with the other’s ability to fulfill the obligation at the settlement date. Suppose
that at the settlement date, the price of Asset XYZ in the cash market is $70. Solomon can buy
Asset XYZ for $70 and deliver it to Bahiru, who in turn must pay him $100. If Bahiru does not have
the capacity to pay $100 or refuses to pay, however, Solomon has lost the opportunity to realize
a profit of $30. Suppose, instead, that the price of Asset XYZ in the cash market is $150 at the
settlement date. In this case, Bahiru is ready and willing to accept the delivery of Asset XYZ and
pay the agreed-upon price of $100. If Solomon cannot deliver or refuses to deliver Asset XYZ,
Bahiru has lost the opportunity to realize a profit of $50.

The clearinghouse exists to eliminate this problem. According to the novation principle, when
someone takes a position in the futures market, the clearinghouse will be the central counter
party taking the opposite position and agreeing to satisfy the terms set forth in the contract. After
the initial execution of an order, the relationship between the two parties ends. The clearinghouse
interposes itself as the buyer for every sale and the seller for every purchase. Thus, the two parties
are then free to liquidate their positions without involving the other party in the original contract,
and without worry that the other party may default. This function is referred to as the guarantee
function. Besides its guarantee function, the clearinghouse makes it simple for parties to a
futures contract to unwind their positions prior to the settlement date.

Suppose that Bahiru wants to get out of his futures position. He will not have to seek out Solomon
and work out an agreement with him to terminate the original contract. Instead, Bahiru can unwind
his position by selling an identical futures contract. As far as the clearinghouse is concerned, its
records will show that Bahiru has bought and sold an identical futures contract. At the settlement
date, Solomon will not deliver Asset XYZ to Bahiru but will be instructed by the clearinghouse to

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deliver to someone who bought and still has an open futures position. In the same way, if Solomon
wants to unwind his position prior to the settlement date, he can buy an identical futures contract.

Key points
✓ The novation principle states that the clearing house of the exchange is
the central counterparty (CCP).
✓ The clearing house of the exchange steps into the shoes of the
defaulting party to honor the right and the privilege of the non-defaulting
trader.
✓ The clearing house of the exchange is therefore a performance
guarantor.

6.4 Forward Contracts

A forward contract is a contractual agreement between a buyer and a seller at time 0 to exchange
a prespecified asset for cash at some later date at a price set at time 0. Market participants take
a position in forward contracts because an asset's future (spot) price or interest rate is uncertain.
Rather than risk that the future spot price will move against them—that the asset will become
more expensive to buy in the future—forward traders pay a financial institution a fee to arrange a
forward contract. Such a contract lets the market participant hedge the risk that future spot prices
on an asset will move against him or her by guaranteeing a future price for the asset today.

For example, in a three-month forward contract to deliver $100 face value of 10-year bonds, the
buyer and seller agree on a price and amount today (time 0), but the delivery (or exchange) of
the 10-year bond for cash does not occur until three months into the future. If the forward price
agreed to at time 0 was $98 per $100 of face value, in three months, the seller delivers $100 of
10-year bonds and receives $98 from the buyer. This is the price the buyer must pay and the
seller must accept no matter what happens to the spot price of 10-year bonds during the three
months between the time the contract is entered into and the time the bonds are delivered for
payment (i.e., whether the spot price falls to $97 or below or rises to $99 or above).

forward foreign currency exchange contracts allow market participants to buy or sell a specified
currency for a specified price at a specified date (e.g., one-month, three-month, or six-month
contracts are standard). Forward contracts can also be based on a specified interest rate (e.g.,
LIBOR) rather than a specified asset (called forward rate agreements, or FRAs). The buyer of an
FRA agrees to pay the contract rate based on some notional principal amount (e.g., $1 million)—
he or she buys the notional amount at the stated interest rate. The seller of an FRA agrees to sell
the funds to the buyer at the stated rate.

For example, for a three-month FRA written today with a notional value of $1 million and a contract
rate of 5.70 percent, the buyer of the FRA agrees to pay 5.70 percent (the current three-month
LIBOR rate) to borrow $1 million starting three months from now. The seller of the FRA agrees to
lend $1 million to the buyer at 5.70 percent starting three months from now. If interest rates rise
in the next three months, the FRA buyer benefits from the FRA. He or she can borrow $1 million
at the rate stated on the FRA (5.70 percent) rather than at the higher market rate (say, 7 percent).

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Forward contracts often involve underlying assets that are non-standardized, because the terms
of each contract are negotiated individually between the buyer and the seller (e.g., a contract
between Bank A to buy from Bank B, six months from now, $1 million in 30-year Treasury bonds
with a coupon rate of 6.25 percent). As a result, the buyer and seller involved in a forward contract
must locate and deal directly with each other in the over-the-counter market to set the terms of
the contract rather than transacting the sale in a centralized market (such as a futures market
exchange).

Forward Markets
Commercial banks and investment banks and broker-dealers are the major forward market
participants, acting as both principals and agents. These financial institutions make a profit on the
spread between the price at which they buy and sell the assets underlying the forward contracts.
Each forward contract is originally negotiated between the financial institution and the customer,
and therefore the details of each (e.g., price, expiration, size, delivery date) can be unique. Most
forward contracts are tailor-made contracts that are negotiated between two parties. Thus, there
is a risk of default by either party.

As the forward market has grown over the last decade, however, traders have begun making
secondary markets in some forward contracts, communicating the buy and sell prices on the
contracts over computer networks. The advent of this secondary market trading has increased
the standardization of forward contracts. It has also become increasingly easy to get out of a
forward position by taking an offsetting forward position in the secondary market. Secondary
market activity in forward contracts has made them more attractive to firms and investors that had
previously been reluctant to get locked into a forward contract until expiration. Secondary market
activity has also resulted in a situation in which the differences between forward and futures
contracts have significantly narrowed.

Summing up, forward contracts can be a good way to secure a market outlet at a fixed price.
However, they are most suited to entities with a good reputation that will receive a comparatively
low price because of the "risk premium" that traders will build into the price they offer. Also, forward
contracts do not offer much flexibility.

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Activity 2
List the benefits and limitations of forward contracts.
Reflection
Advantages
• Forward contracts have the advantage of locked-in future prices that permit the
determination of fixed purchasing prices.
• Forward contracts also strengthen the links between a specific seller and buyer.
• Moreover, no cash changes hands until the contract is finally settled; there are no
cash-flow problems linked to the use of forward, contrary to the situation with
futures contracts.
Disadvantages
• Forward contracts lack flexibility; getting out of a transaction is difficult.
• Exposure to counterparty risk. Traders are also exposed to a risk of default when
prices move against the interest of the transacting parties and the trader who
appears to be disadvantaged might be tempted to default. Because of this default
risk, traders often pay a relatively low initial price (advance) on forward contracts.

6.5 Futures Contracts

A futures contract, like a forward contract, is an agreement between a buyer and a seller at time
0 to exchange a standardized, prespecified asset at some later date at a price set at time 0. Thus,
a futures contract is very similar to a forward contract. Futures contracts in a way are standardized
forward contracts. Futures contracts are transferable in nature. For all practical purposes, a
forward contract becomes a futures contract if the quality and quantity are standardized and the
contract is traded on a derivatives exchange. This provides for offsetting deals to square up the
open position.

The following are the objectives of futures contracts:

• Enable hedging with the objective of transferring the risk related to the possession of
assets or securities through any adverse movement of price from hedgers to speculators
and arbitragers. This provides for price-risk management.
• Provide liquidity and price discovery to ensure the base minimum volume in trading
through market information and demand-supply factors that facilitate a regular and
authentic price-discovery mechanism.
• Facilitate price stabilization and balance the demand-supply equation. Futures trading
helps the prediction of prices, which in turn maintains stability in prices, thus safeguarding
against any short-term adverse price movement. Liquidity in the contracts of the securities
traded also ensures that the equilibrium in demand and supply is maintained.
• Facilitate bank financing through characteristics such as flexibility, certainty, and
transparency. As predictability in the prices of securities lends stability to market

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operations, banks can be sure about the limited risks associated with financing such
operations. This makes funding by banks easier and less stringent for the market players.

The basic differences between the futures and forward contracts are the following.
• One difference between forwards and futures is that forward contracts are bilateral
contracts subject to counterparty default risk, but the default risk on futures is
significantly reduced by the futures exchange guaranteeing to indemnify counterparties
against credit or default risk.
• Another difference relates to the contract’s price, where the price in a forward contract is
fixed over the life of the contract (e.g., $98 per $100 of face value for three months to be
paid on the expiration of the forward contract), whereas a futures contract is marked to
market daily. This means that the contract’s price is adjusted each day as the price of the
asset underlying the futures contract changes and as the contract approaches expiration.
Therefore, actual daily cash settlements occur between the buyer and seller in response
to these price changes (this is called marking to market). While the value of a forward
contract can change daily between when the buyer and seller agree on the deal and the
maturity date of the forward contract, cash payment from the buyer to seller occurs only
at the end of the contract period.

Marking futures contracts to market ensures that both parties to the futures contract maintain
sufficient funds in their account to guarantee the eventual payoff when the contract matures. For
the buyers of the futures contract, marking to market can result in unexpected payments from
their account if the price of the futures contract moves against them. In a futures contract, like a
forward contract, a person or firm makes a commitment to deliver an asset (such as a foreign
exchange) at some future date. If a counterparty were to default on a futures contract, however,
the exchange would assume the defaulting party’s position and payment obligations. Thus, unless
a systematic financial market collapse threatens an exchange itself, futures are essentially
default-risk-free.

In addition, the default risk of a futures contract is less than that of a forward contract for at least
four reasons:
1) daily marking to market of futures (so that there is no buildup of losses or gains)
2) margin requirements on futures that act as a security bond should a counterparty default
3) price movement limits that spread extreme price fluctuations over time and
4) default guarantees by the futures exchange itself.

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Activity 3
Discuss the benefits and limitations of futures contracts.

Reflection
Advantages and disadvantages of futures
Futures contracts can be used:
• To avoid the effect of fluctuations in prices.
• To secure a processing margin.
• To "lock in" future prices at an attractive level.
• To improve marketing policies and financial planning and forecasting.
The main disadvantage of using futures contracts is that:
• They freeze up working capital due to margin requirements and mark to
market on a real-time basis with daily settlement.

Futures Markets
Futures trading occurs on organized exchanges—for example, the Chicago Board of Trade
(CBOT) and the New York Mercantile Exchange (NYMEX), both of which are part of the CME
Group. Financial futures market trading was introduced in 1972 with the establishment of foreign
exchange futures contracts on the International Money Market (IMM). By 2013, several major
exchanges existed in the United States as well as abroad.

Counter-party default risk led to the development of the futures market. In futures contracts, all
terms (quantity, quality, and delivery date) are standardized except the price, which is discovered
through the interaction of supply and demand in a centralized marketplace or exchange. As
standardized contracts traded through an exchange, futures contracts can be used to minimize
price risk by means of hedging techniques. Since the exchange standardizes the quality and
quantity parameters and offers complete transparency by using risk management techniques
(such as a margining system with "mark to market" settlement on a real-time basis with daily
settlement), the counterparty default risk has been greatly minimized.

Trading on most of the largest exchanges such as the CBOT has historically taken place in
trading “pits.” A trading pit consists of circular steps leading down to the center of the pit. Traders
for each delivery date on futures contracts informally group together in the trading pit. Futures
trading occurs using an open-outcry auction method where trading is conducted at a trading pit
using hand waving and shouting to convey offers to buy or sell a stated number of futures
contracts at a stated price. In addition to trading at pits on traditional exchanges, the 2000s saw
a rise in derivative trading on electronic exchanges. Today, electronic trading replaces the open-
outcry trading method.

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6.5.1 Differences between Spot/Cash Markets and Futures Markets
Securities can be transacted in both the cash and futures markets. Although the two markets are
separate, they are nevertheless interrelated. Assets are bought or sold on a negotiated basis in
the cash market, which is generally considered the actual market where immediate delivery takes
place. The formulation of a futures contract is very specific regarding the quality of the asset, to
be delivered, and the date for delivery. It does not involve an immediate transfer of ownership of
the asset until the expiry date of the futures contract. Thus, in the futures markets, securities can
be bought or sold irrespective of whether one has possession of the underlying asset or not.

As discussed, futures contracts are forward contracts that are traded through the exchange with
standardized quality and quantity. Forward contracts are essentially party-to-party contracts and
are fulfilled by the seller giving delivery of assets of a specified variety as agreed between the
parties. In case of unforeseen/uncontrolled situations that prevent buyers/sellers from receiving
deliveries, contracts may be mutually settled by cash.

Unlike the spot market, the futures market trades in futures contracts primarily for the purpose of
risk management through hedging. Most of these contracts are squared off before maturity and
rarely end in deliveries. Speculators, who are key players in the futures markets, also use these
contracts to benefit from price movements and are hardly interested in taking or giving delivery of
assets. On the other hand, hedgers efficiently transfer price risk to speculators and arbitragers.

The term "basis" refers to the difference in spot and futures prices of an asset. The spot price is
the real price of the security while the futures price refers to the price of a contract being traded
in the futures market. Although the spot and futures prices are initially different, they have the
tendency to equalize as the maturity date for the contract approaches, irrespective of the market
condition. This process of futures price tending towards the cash price is called "convergence".

6.5.2 Differences between Futures and Forward Contracts

The basic distinction between futures and forward contracts are discussed below.
• Trading place. A futures contract is entered on the centralized trading platform of the
exchange. A forward contract is traded in the OTC market.
• Standardization of the contract. A futures contract is standardized in terms of quantity
as specified by the exchange. The size of the forward contract is customized as per the
terms of an agreement between the buyer and seller.
• Transparency in the contract price. The contract price of a futures contract is
transparent as it is available on the centralized trading screen of the exchange. The
contract price of a forward contract is not transparent as it is not publicly disclosed.
• Transaction cost. In a futures contract, transaction costs are low but indirect costs are
high in the forward contract.
• Valuations of open position and margin requirement. In a futures contract, valuation
of open position is calculated as per the official closing price on daily basis and an MTM
margin is required. In a forward contract, valuation of open position is not calculated on a
daily basis and there is no need for an MTM margin.

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• Liquidity. A futures contract is more liquid as it is traded on the exchange. Forward
contract is less liquid due to its customized nature.
• Counter-party risk. In futures contracts, the clearing house becomes the counterparty to
each transaction, which is called novation. Therefore, counterparty risk is almost
eliminated. In forward contracts, counterparty risk is high due to the customized nature of
the transaction.
• Regulations. Regulatory authority and the exchange regulates futures contracts. Forward
contracts are not regulated by any exchange.

Forward contracts and future contract transactions are depicted using figures as follows:

Forward Contract transactions without involvement of Clearing House

Future Contract transactions

Key points
✓ In a spot transaction, as soon as a deal is struck between the buyer and the seller, the
buyer has to pay for the asset to the seller, who in turn transfers the rights to the asset to
the buyer.
✓ In the case of a forward or a futures contract, the actual transaction does not take place
when an agreement is reached between a buyer and a seller. The actual transaction per
se occurs only at a future date that is decided at the outset.
✓ Forward contracts and futures contracts are similar in the sense that both require the long
to acquire the asset and the short to deliver it, on a future date.
✓ There is one major difference between the two types of contracts. Futures contracts are
standardized, whereas forward contracts are customized. Future contracts are needed to
reduce the counterparty default risks involved in forward contracts.

6.5.3 What Futures Are and What They Are Not?

A futures contract is an obligation to buy or sell an underlying asset at a specific price at a specific
time in the future. We’ll explain each key element of a futures contract as follows

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• “Obligation to Buy or Sell”: The key word is obligation. Unless you offset your original
position before the contract expires you must eventually buy or sell at the agreed-upon
price when the contract expires.
• “Underlying Product”: Futures contracts originally were created for agricultural products
such as maize and coffee. In the 1970s and 1980s, futures contracts on financial
instruments such as treasury bonds and stock indexes became popular. Futures contracts
on individual stocks, called “single-stock futures,” are the latest innovation in this financial
arena. Each futures contract specifies a certain amount (and sometimes quality) of the
underlying product so that the contract terms are standardized for all participants.
• “Specific Price”: Futures contracts are traded in public, government-regulated forums—
exchanges where business is conducted either electronically or in traditional open-outcry
pits on a trading floor. Prices are determined by the orders that come into the market from
buyers and sellers. When an order from a buyer at Birr 1,000 meets an order from a seller
at Birr 1,000, a trade occurs and a futures price of Birr 1,000 is broadcast to the market.
• “Specific Time in the Future”: Futures contracts expire at a certain time in the future. For
example, a December 2011 futures contract will cease to exist sometime during the month
of December in 2023 (depending on rules set by the exchange). As with other elements
of the contract, a standardized expiration date makes it easier for traders and other market
actors to focus on pricing decisions.

What Futures Are Not

Now that you have been introduced to what futures contracts are, let’s explore how they differ
from other financial instruments like stocks, options, and exchange-traded funds.
• Futures Are Not Stocks: It may be too obvious to say that futures are not stocks, but it
is essential to understand the important differences between these two investment
vehicles, summarized in Table 1.1.

Table 1.1 Comparing Instruments

Characteristics Futures Stocks
Contract terms Agreement or promise to Conveys ownership
perform
Type of contract Standardized, no limit on the Shares in a company, limited
number to the number issued
Time factor Contracts expire Continue perpetually
Margin Good-faith deposit to ensure Down payment on ownership
contract performance
Leverage High with minimum margins Limited with a minimum
required generally only 2% - margin of 50% of the share
15% of the contract value price
Short selling Simple, involving the same Complex, requiring an uptick
process with the same margin in share price and borrowing
requirements as going long. shares to sell

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• Agreements or Promise, Not Ownership: A futures contract is an obligation to buy or
sell at some time in the future, at a price agreed upon today. A futures contract does not
convey ownership, as buying a share of stock does; it is only the promise that a buyer
and seller will agree to exchange ownership in the future. Futures contracts are usually
traded on an organized and regulated exchange so the buyers and sellers can find each
other easily. Because futures contracts are standardized and interchangeable, they can
be traded anonymously among people on an exchange, where all that remains to be
negotiated is the price. All futures contracts are settled daily (assigned a final value price).
Based on this settlement price, the values of all positions are marked to the market each
day after the official close. Your account is then either debited or credited based on how
well your positions fared in that day’s trading session. In other words, as long as your
positions remain open, cash will either come into your account or leave your account
based on the change in the settlement price from day to day. This system gives futures
trading a rock-solid reputation for creditworthiness because losses are not allowed to
accumulate without some response being required. It is this mechanism that brings
integrity to the marketplace.

• Contracts, Not Shares: The supply of futures contracts is unlimited. A new futures
contract is created every time a buyer and seller make a trade. Unlike shares of stock,
there is no limit to the supply of futures contracts. Every time a buyer and seller make a
trade, a new contract is created. Because a futures contract is an obligation to buy or sell
at a certain price at a certain future date, there’s no getting around the fact that the
obligation must be fulfilled. In most cases, the obligation is fulfilled by simply making an
offsetting trade (sell if you bought; buy if you sold). Of course, you can choose to carry the
position all the way to the delivery date, when it is fulfilled either by the exchange of the
physical commodity or by a cash settlement to or from your trading account. That
possibility helps to keep futures prices closely aligned with cash prices.

• Contract Expirations, Not Perpetual Assets: Because futures contracts expire on a

specific date in the future, a settlement between the buyer and the seller means the
contract ceases to exist after that date. Shares of stocks, on the other hand, continue to
exist (unless a company dissolves or a stock buyback or some other development reduces
the number of shares). Because of these contract expirations, futures traders sometimes
will maintain a position by rolling from one contract month to the next, taking into
consideration the trading liquidity available.

• Good-Faith Deposit, Not a Down Payment: The word margin means something different
in futures than it does in stocks. In stocks, it means that you’re borrowing money and
paying interest. In futures it simply refers to the amount of money that you need to have
in your account to enter a transaction. The margin required for a futures contract is better
described as a performance bond or good-faith money. The levels are set by the
exchanges based on volatility (market conditions) and can be changed at any time.
Generally, futures margins are much less than the margin required for stocks. The

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performance bond (margin) requirements for most futures contracts range from 2 percent
to 15 percent of the value of the contract.

• Leveraged, Not Paid For in Full: Leverage is what futures markets are all about. As a
futures trader, you can access the full value of a futures contract for a relatively small
amount of capital, typically 2 percent to 15 percent of the contract’s value. For example, if
the margin requirement is 5% for about Birr 10,000 in margin, you can buy or sell a
commodity worth Birr 200,000.

6.5.4 Content of the Futures Contract

The future contract comprises of the underlying unit, deliverable grades, price quote, tick size
(minimum fluctuation), contract months, delivery day, delivery method, etc. An example of contract
terms for 10-year treasury note futures is presented below.
• Underlying unit —One U.S. Treasury note having a face value at maturity of $100,000.
• Deliverable grades —U.S. Treasury notes with a remaining term to maturity of at least
6½ years, but not more than 10 years, from the first day of the delivery month. The invoice
price equals the futures settlement price times a conversion factor, plus accrued interest.
The conversion factor is the price of the delivered note ($1 par value) to yield 6 percent.
• Price quote —Points ($1,000) and halves of 1/32 of a point. For example, 126-16
represents 126 16/32 and 126-165 represents 126 16.5/32. Par is on the basis of 100
points.
• Tick size (minimum fluctuation) —One-half of one thirty-second (1/32) of one point
($15.625, rounded up to the nearest cent per contract), except for inter-month spreads,
where the minimum price fluctuation shall be one-quarter of one thirty-second of one point
($7.8125 per contract).
• Contract months —The first five consecutive contracts in the March, June, September,
and December quarterly cycle.
• Last trading day —Seventh business day preceding the last business day of the delivery
month. Trading in expiring contracts closes at 12:01 p.m. on the last trading day.
• Last delivery day —Last business day of the delivery month.
• Delivery method —Federal Reserve book-entry wire-transfer system.
• Settlement —U.S. Treasury Futures Settlement Procedures.
• Position limits —Current Position Limits.
• Trading hours (all times listed are central time) —Open Outcry Mon.–Fri., 7:20 a.m.–
2:00 p.m. CME Globex Sun.–Fri., 5:30 p.m.– 4:00 p.m.
• Ticker symbol — Open Outcry—TY CME Globex—ZN
• Exchange rule —These contracts are listed with, and subject to, the rules and regulations
of the CBOT.

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6.5.5 Long and Short Positions
When speaking of stocks, futures, and options, analysts and market makers often refer to an
investor having long positions or short positions. The key definitions are presented below.
• With stocks, a long position means an investor has bought and owns shares of stock.
• An investor with a short position owes stock to another person but has not actually bought
them yet.
• With options, buying or holding a call or put option is a long position; the investor owns
the right to buy or sell to the writing investor at a certain price.
• Conversely, selling or writing a call or put option is a short position; the writer must sell
to or buy from the long position holder or buyer of the option.

Long and Short Positions in the Futures Contract

If an investor has long positions, it means that the investor has bought and owns those shares
of stocks. By contrast, if the investor has short positions, it means that the investor owes those
stocks to someone, but does not actually own them yet. For instance, an investor who owns 100
shares ‘X’ stock in their portfolio is said to be long 100 shares. This investor has paid in full the
cost of owning the shares.

Continuing the example, an investor who has sold 100 shares of ‘X’ stock without yet owning
those shares is said to be short 100 shares. The short investor owes 100 shares at settlement
and must fulfill the obligation by purchasing the shares in the market to deliver. Oftentimes, the
short investor borrows the shares from a brokerage firm in a margin account to make the
delivery. Then, with hopes the stock price will fall, the investor buys the shares at a lower price
to pay back the dealer who loaned them. If the price doesn't fall and keeps going up, the short
seller may be subject to a margin call from their broker.

Long and Short Positions in the Option Contract

When an investor uses options contracts in an account, long and short positions have slightly
different meanings. Buying or holding a call or put option is a long position because the investor
owns the right to buy or sell the security to the writing investor at a specified price. Selling or
writing a call or put option is just the opposite and is a short position because the writer is obligated
to sell the shares to or buy the shares from the long position holder, or buyer of the option.

6.6 Option Contracts

When buying option contracts, the right but not the obligation, to buy or sell a futures contract at
a given price is obtained. When prices move unfavorably, this right will not be exercised by the
buyer (holder) of the option, and therefore the purchase of options provides protection against
unfavorable price movements while permitting to profit from favorable ones. For an option, a
premium has to be paid which is the maximum loss from the option purchase when prices are
unfavorable. However, when prices are favorable, the buyer of an option will make a profit that is
more or less commensurate with the favorable price. The other main advantage of using options
is that only the sellers of options have to pay margins. Also, options are often used to protect
prices in deals with not fully reliable partners. If a fixed price deal with a seller is concluded and
this position is covered with a futures contract, one may be stuck with a loss-making uncovered

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futures contract if the physical leg of the transaction disappears. When options are used, traders'
losses are limited to the upfront premium that they pay.

In the successive sections of this part, the major types of options namely call option, put option,
American option, European option, and Bermudan option will be discussed.

Activity 4
What are option contracts, and how do they differ from forward and futures contracts?

Reflection
In the case of both forward as well as futures contracts; both the long and the short have
an obligation. That is, the long is obliged to take delivery of the underlying asset on the
date that is agreed upon at the outset, while the short is obliged to make delivery on that
date and accept cash in lieu. On the contrary, the buyer of an options contract (who
incidentally is also known as the long), has the right to go ahead with the transaction,
subsequent to entering into an agreement with the seller of the option who is also known
as the short. Option buyers are also referred to as option holders, while option sellers
are referred to as option writers.

The difference between a right and an obligation is that a right need be exercised only if
it is in the interest of its holder, and if he deems it appropriate. Consequently, the long in
the case of an options contract is under no compulsion to go through with the transaction.
However, it must be remembered that the short or the writer in the case of an options
contract always has an obligation. That is, were the long to decide to exercise his right,
the short would have no choice but to carry out his part of the deal.

6.6.1 Call Option

A plain vanilla call option is a contractual agreement, which gives the owner (holder) of the option
the right but not the obligation to purchase a predetermined quality of the underlying asset
(commodities, shares, indices, etc.) at a specified price (called the strike price) on the expiry date.

When a person is given a right to transact in the underlying asset, the right can obviously take on
one of two forms. That is, he may either have the right to buy the underlying asset, or else he may
have the right to sell the underlying asset. An option contract that gives the long the right to acquire
the underlying asset is known as a Call option. In such cases, if and when the long exercises his
right, the short is under an obligation to deliver the asset. On the other hand, an options contract
that gives the holder the right to sell the underlying asset is known as a Put option. If and when
the put holder decides to exercise his option, the put writer is obliged to take delivery of the asset.
The difference between forward and futures contracts and the two types of options contracts can
be illustrated with the help of a simple table.

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Table 1 Comparison of Futures and Forwards, and Options

Instrument Nature of commitment of the Nature of commitment of the

long short
• Forward/futures Obligation to acquire the Obligation to sell the underlying
contract underlying asset asset
• Call options Right to acquire the underlying Obligation to deliver the
asset underlying asset
• Put options Right to sell the underlying asset Obligation to accept delivery of
the underlying asset

6.6.2 Put Option

A plain vanilla put option is a contractual agreement, that gives the owner (holder) of the put option
the right but not the obligation to sell a predetermined quantity of the underlying asset
(commodities, shares, indices, et.) at a specified price (called the strike price) on the expiry date.

6.6.3 European and American Options

As discussed earlier, a holder of an option acquires the right to transact in the underlying asset.
If the option were to be European in nature, then the right can be exercised only on a fixed date
in the future, known at the expiration date of the option. Quite obviously, if an option is not
exercised on that day, then the contract itself will expire. In the case of an American option
however, the option holder has the right to transact at any point in time, between the time of
acquisition of the right and the expiration date of the contract. Quite obviously, the expiration date
is the only point in time at which a European option can be exercised, and the last point in time
at which an American option can be exercised.

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A Bermudan option is a half-way house. It can be exercised on a set number of days before
expiry, such as one day per week. Unlike a forward, an option contract has built-in flexibility
because the holder is not obliged to exercise or take up the option. For this privilege the buyer of
an option has to pay an initial premium to the seller (also known as the writer) of the contract. The
premium is determined by calculating the expected payout, and a key input to establishing this
value is the volatility of the price of the underlying asset. The more volatile the underlying asset,
all other things being equal, the greater the expected payout from an option on that asset, and
the greater the premium charged by the writer.

6.6.4 Option prices and exercise prices

Option price and exercise price differ in their meaning. The term option price or option premium
refers to the amount paid by the buyer of an option to the writer of the option, for permitting him
to acquire the right to transact on a future date. In the case of call options, the term exercise price,
also known as the strike price, represents the amount payable by the option holder per unit of the
underlying asset, if he were to choose to exercise his option on a subsequent date. Equivalently,
it is the amount receivable by the option holder per unit of the underlying asset, were he to
exercise a put option.

As can be seen, the option premium is a sunk cost. Even if the transaction were not to take place
subsequently, the premium cannot be recovered. The exercise price however, enters the picture
only if the option holder chooses to go ahead with transaction. Since he has a right and not an
obligation, he may or may not wish to transact, which means that the exercise price may or may
not be paid/received subsequently.

Illustration
Kemal has taken a long position in a call option with an exercise price of $40, and three months
to maturity. Assume that the options have been written by Martha, who consequently has a short
position. If the spot price at the time of expiration of the contract were to be greater than $40, it
would make sense for Kemal to exercise the option and buy the commodity at $40 each.
Otherwise, he could simply forget the option, and buy the commodity in the spot market at a price,
which by assumption, is lower than the exercise price. As he has a right and not an obligation, he
is under no compulsion to exercise the option. However, if Kemal were to decide to exercise his
right, Martha would have no option but to deliver the commodity for $40. Thus, in the event of the
option holder choosing to exercise his right, options contract always impose a performance
obligation on the writer of the option.

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Activity 5
If a person goes long in a futures contract, does he have to pay an amount at the
outset to the investor who goes short? Why or why not?

Reflection
In the case of an options contract, the buyer is required to pay an option premium to
the writer. This is because the buyer is acquiring a right, whereas the writer is taking
on an obligation to perform if the buyer were to exercise his right. Rights, it must be
understood, are never free and one has to pay to acquire them. Consequently, option
holders have to pay option writers to acquire the right to transact.

Futures and forward contracts are different, for they impose an equivalent obligation
on both the long as well as the short. As we will see subsequently, the futures price,
which is the price at which the long will acquire the asset on a future date, will be set
in such a way that from the standpoint of both the long as well as the short, the value
of the futures contract at inception is zero. In other words, the two equivalent and
opposite obligations ensure that neither party has to pay the other at the outset.

6.6.5 Mechanics of Option Trading

Options for commodities such as rice, oil, and grain have been in existence for many years.
Options on financial assets are more recent although activity has expanded rapidly since the
introduction of listed contracts on exchanges such as the Chicago Board Options Exchange
(CBOE), LIFFE, and Eurex. The buyer of a European-style option contract has the right but not
the obligation to buy (call option) or sell (put option) an agreed amount of a specified asset, called
the underlying; at a specified price, called the exercise or strike price; on a future date, called the
expiry or expiration date.

Consider the example of a one-year European call struck at $100. The holder of the option has
the right but not the obligation to purchase the share for $100 after one year. If the price of the
share is highly volatile this increases the chance that it will be substantially above the strike at
expiry. The greater the value of the underlying asset at expiry, the greater will be the profit
achieved by the owner of the call. Of course, a high level of volatility also increases the chance
that the share price at expiry will be below the $100 strike of the call. However, the holder of the
option is not obliged to exercise the contract. The loss is limited to the initial premium paid.

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Table 2 Long call option contract

Type of option: Long call

Underlying asset: XYZ stock
Spot price: $100
Number of the contract: 100
Exercise price: $100 per share
Exercise style: American
Expiry: 1 year
Premium: $10 per contract

6.6.5.1 Call Option: Intrinsic and Time Value

A call option is a right but not the obligation to buy a commodity or a financial asset at a fixed
strike or exercise price. Table 2 gives details of an equity call option contract purchased by a
trader. The option is American-style, so it can be exercised on any business day up to and
including expiry, in one year. The underlying asset is trading at $100 in the cash or spot market
and the exercise price of the call is also $100. The premium charged by the writer of the contract
is $10 per share or $1000 on 100 contracts. The holder of the call has the right to purchase each
contract for $100. The intrinsic value of an option is defined as any money that can be realized
through immediately exercising the contract. In this case the asset is trading at $100 in the cash
market and the strike is also $100, so the holder cannot realize any value by immediate exercise.
That means the option has zero intrinsic value.

Since the strike price is exactly the same as the spot price, the call is said to be at-the-money.
Imagine, however, that sometime after the option is purchased the spot price of the commodity
jumps to $120. The option is now in-the-money since the owner has the right to buy a share for
$100 that is worth $120. The option contract now has $20 intrinsic value per share. Note that this
is not the net profit the holder would achieve by actually exercising the call. To establish this value
the initial $10 premium has to be deducted from the intrinsic value.

Table 3Intrinsic value of $100 strike call for a range of spot prices

New price Intrinsic value now Option is now . . .

$80 $0 Out-of-the-money
$90 $0 Out-of-the-money
$100 $0 At-the-money
$110 $10 In-the-money
$120 $20 In-the-money

Table 3 calculates the option’s intrinsic value if the spot price of the asset moves to a range of
different possible levels. Notice that intrinsic value is never negative because the owner of an
option is never obliged to exercise an out-of-the-money contract. More formally, the intrinsic value
of an American-style call option can be defined as the spot price of the underlying asset minus
the strike, or zero, whichever is the greater of the two. This definition is commonly also applied to

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European options, although the profit from exercise can only be realized at expiry. Any money
paid for an option in addition to its intrinsic value is called time value.

In the contract shown in Table 3 above, the buyer pays $10 per share in premium, even though
the option has no intrinsic value at all. The $10 consists of time value, and the buyer is obliged to
pay this money because there is some chance or probability that the share price might rise above
the strike before expiry. This possibility provides profit opportunities for the buyer of the contract
and serious risks for the writer. If the contract is exercised the writer is obliged to deliver a share
at a fixed price of $100, whatever its value in the market happens to be at that point in time. The
buyer of the call has to pay for that chance or opportunity and the writer has to be compensated
for that very considerable risk. The two components – intrinsic and time value together make up
the total premium paid for an option.

Option premium = Intrinsic value + Time value

The expression time value derives from the fact that normally, all other things being equal, a
longer-dated option has more time value than a shorter-dated contract. The probability of a share
price doubling in the course of a year is much greater than over the course of a day. This increases
the potential payout to the buyer of a call on the share. It also increases the potential losses to
the writer, who has to charge a higher premium in compensation. Talk of ‘time value’ can be a
little misleading, however, since time to expiry is not the only factor that determines how much a
buyer has to pay for an option over and above its intrinsic value. It is also determined by factors
such as the volatility of the underlying, and the general level of interest rates in the market.

Long call expiry payoff

If an option is at- or out-of-the-money at expiry it has zero intrinsic value. The contract will simply
not be exercised and will be worthless. On the other hand, if the option is in-the-money it will have
positive intrinsic value. This is calculated as the difference between the share price and the strike
price. At expiry an option has zero time value, since the outcome of the contract is no longer in
question.

To illustrate these effects, we return to the bought or ‘long’ call option contract discussed in the
previous sections. The strike is $100 and premium paid is $10 per contract. Table 4 shows the
intrinsic value for a range of different possible share prices at expiry. The break-even point occurs
when the underlying is trading at $110. The owner of the call can realize $10 intrinsic value by
exercising the contract, by purchasing a share for $100 that is worth $110. This exactly offsets
the initial premium, and the net profit and loss per share is zero. (This ignores any transaction
and funding costs.)

The results from Table 4 are presented graphically in Figure 1, which shows the net profit and
loss on the option contract for a range of possible share prices between $50 and $150. The
maximum loss to the buyer of the call is $10 per contract. The maximum profit is unlimited since
the share price (in theory) could rise to any level.

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Table 4 $100 strike call: intrinsic value and net profit and loss (P&L) at expiry per contract

Share price at expiry Call intrinsic value Net profit and loss
50 0 -10
60 0 -10
70 0 -10
80 0 -10
90 0 -10
100 0 -10
110 10 0
120 20 10
130 30 20
140 40 30
150 50 40

Net P&L per contract

50
30
10

50 70 90 110 130 150 Cash price at expiry

-10
-30
-50

Figure 1 Profit and loss on long $100 strike call at expiry

Short call expiry payoff

In the jargon of the market, the buyer of an option contract has limited downside (potential losses)
but unlimited upside (potential profit). Like an insurance policy, the most money that can ever be
lost is the initial premium that was paid. Also, if the option is exchange-traded it can easily be sold
back before expiry, recouping at least some of that initial outlay. However, the position of the
seller or writer of a call option is very different.

Figure 2 illustrates the payoff profile at expiry for the writer of the call option explored in the
previous sections. The maximum profit is the initial premium collected. If the commodity price is
trading above the strike at expiry then the option will be exercised at a profit to the holder and a

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loss to the writer. For example, suppose price is $150. Then the writer will have to deliver the
asset at a fixed price of $100 which costs $150 to buy in the spot market, so losing $50 on
exercise. From this is deducted the initial premium received of $10, leaving a $40 loss per share
on the deal (ignoring funding and transaction costs).

Table 5 Long put option contract

Type of option: Long put
Underlying asset: XYZ stock
Spot share price: $100
Number of shares: 100
Exercise price: $100
Exercise style: American
Expiry: 1 year
Premium: $10 per contract
Net P&L per contract

50
30
10

50 70 90 110 130 150 Cash price at expiry

-10
-30
-50

Figure 2 Profit and loss on short $100 strike call at expiry

The graph in Figure 2 shows the profit and loss profile of a ‘naked’ or unhedged short call. The
position has limited upside gains (limited to the initial premium collected) and potentially unlimited
downside losses. In practice, professional traders do not routinely sell options contracts
unhedged. That would be much too risky. A short or sold call option can be hedged by buying a
quantity of the underlying. If the share price increases, the dealer will lose money on the call but
gain on the hedge. This methodology is known in the market as delta hedging. When a dealer
has sold an option and has traded the appropriate quantity of the underlying to match the risk,
then the overall position is said to be delta neutral.

6.6.5.2 Put Option: Intrinsic and Time Value

A put option is the right but not the obligation to sell the underlying at the strike or exercise price.
Table 5 sets out the terms of a purchased or long put option contract. The strike is $100 per
contract, the time to expiry is one year and the premium is $10 per contract. Buying a put option
is a ‘bear’ position on the underlying. The holder profits from a fall in the share price, although the

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maximum loss is restricted to the initial premium paid. Since the strike and the spot price in this
example are both $100 the option is at-the-money and has zero intrinsic value. It is not possible
to realize any value by immediately exercising the contract.

Table 6 Intrinsic value of $100 strike put for a range of contract prices
New share price Intrinsic value Option is now…
$80 $20 In-the-money
$90 $10 In-the-money
$100 $0 At-the-money
$110 $0 Out-of-the-money
$120 $0 Out-of-the-money

The intrinsic value of a put option is the strike less the spot price of the underlying asset, or zero,
whichever is the greater of the two. In this example the option is at-the-money and its intrinsic
value is zero. Therefore, the premium consists entirely of time value. It is paid on the possibility
that the share price might fall below the strike, in which case the option would move into-the-
money and would acquire positive intrinsic value. Suppose that sometime after the contract was
purchased the share price had fallen to $80. The owner of the put could purchase the share in
the cash market for $80, then exercise the option, thereby selling the share for $100 and earning
$20 (less the premium paid at the outset). The contract would now be in-the-money with $20
intrinsic value. On the other hand, if the share price increased to (say) $120, the option would be
out-of-the-money and the intrinsic value zero. It would not make sense to exercise the contract
and sell for only $100. Table 8.5 calculates the intrinsic value of the put option if the share price
moved to several different levels.

Long put expiry payoff

Table 7 and Figure 3 illustrate the profit and loss profile of the put option discussed in the previous
section at expiry and from the perspective of the buyer of the contract. The values are shown per
share; the strike price is $100; the initial premium paid is $10; and the maximum loss is the
premium. If the underlying is trading below the strike price, the option will have positive intrinsic
value and will be exercised. The intrinsic value measures the gain that can be released by
exercising the contract; the net profit and loss figure subtracts from this the initial premium paid.

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Table 7 $100 strike put option intrinsic value and net profit/loss at expiry

Share price at expiry Intrinsic value Net profit and loss

50 50 40
60 40 30
70 30 20
80 20 10
90 10 0
100 0 -10
110 0 -10
120 0 -10
130 0 -10
140 0 -10
150 0 -10

Net P&L per contract

50
30
10

50 70 90 110 130 150 Cash price at expiry

-10
-30
-50

Figure 3 Profit and loss on long $100 strike put at expiry

Short put expiry payoff

The buyer of a put option has a limited downside (potential loss), restricted to the initial premium
paid. The maximum upside or profit potential is not, in fact, unlimited, since share prices do not
fall below zero, but normally it is still very substantial. The major risk is taken by the writer of the
contract. If it is exercised the writer is obliged to take delivery of the underlying and pay a
predetermined price – the strike – whatever the actual value of the share happens to be in the
cash market.

Figure 4 illustrates the position of the writer of the put option contract at expiry explored in the
previous section. The strike is $100 per share and the premium received is $10. As long as the
commodity is trading at or above the strike the contract will not be exercised. The profit is the
initial premium received. However, if the underlying is trading below the strike then the contract

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will be exercised. The writer will be obliged to pay $100 for an asset that is worth less than that in
the cash market. The break-even point for the writer is reached when the share is trading at $90,
in which case the loss on exercise matches the initial premium received.

Net P&L per contract

50
30
10

50 70 90 110 130 150

-10
-30
-50

Figure 4 Profit and loss on short $100 strike put at expiry

Moneyness of option
The intrinsic value of an option is determined by the difference between the spot price and strike
price, in terms of present value as discussed in the above sections. The moneyness of the call
and put options representing the intrinsic values (pay-offs) of the options are depicted on the table
below.

Moneyness of option
Call Put

ST > E In-the-money Out-of-the-money

ST = E At-the-money At-the-money

ST < E Out-of-the-money In-the-money

ST –current stock price
E - Exercise price

The position illustrated in Figure4 is that of an unhedged or ‘naked’ sold put option. Professional
traders normally try to hedge or cover the bulk of the risks they acquire when selling contracts.
The risk, when selling a put, is that the share price may fall sharply, and one method of hedging
this is to establish a short position in the underlying – that is, to borrow shares and sell them into
the cash market, with a promise to return them later to the original owner. If the underlying
commodity falls in price the option writer can then buy them back cheaply and return them to the
original owner. The profit achieved by doing this will help to offset losses on the put option. This

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is an example of a delta hedge and of establishing a position that is delta neutral – one that is not
exposed to small changes in the value of the underlying asset.

6.5.7 Option Strategies as Risk Management Tools (Hedging)

Options are primarily used to offset or reduce the price risk resulting from exposure to an
underlying asset. Options are also used by speculators and arbitrages to make money. Some of
the hedging strategies using options are:
1. Covered Call- a strategy involving the sale of a call option to supplement a long position
in underlying assets. If the call is unexercised, then the call writer keeps the premium and
still has the stock, for which he can still receive any dividends. If the call is exercised, then
the call writer gets the exercise price for his stock in addition to the premium, but he
foregoes the stock profit above the strike price.

Illustration
On October 6, 2023, you own 1,000 shares of Microsoft stock, which is currently trading
at $27.87 per share. You write 10 call contracts for Microsoft with a strike price of $30 per
share that expires in January 2024. You receive 0.35 per share for your calls, which equals
$35.00 per contract (one call option contract contains 100 shares) for a total of $350.00.
If Microsoft doesn’t rise above $30, you get to keep the premium as well as the stock. If
Microsoft is above $30 per share at expiration, then you still get $30,000 for your stock,
and you still get to keep the $350 premium.

2. Protective Put- a strategy involving the purchase of a put option as a supplement to a

long position in an underlying asset. A stockholder buys protective puts for stock already
owned (buy stock) to protect his position by minimizing any loss. If the stock rises, then
the put expires worthless, but the stockholder benefits from the rise in the stock price. If
the stock price drops below the strike price of the put, then the put’s value increases by 1
dollar for each dollar drop in the stock price. Thus, the put compensates dollar for dollar
the drop in stock price below the strike price. The net payoff for the protective put position
is the value of the stock and the put, minus the premium paid for the put.

Illustration
Using the same example above for the covered call, you instead buy 10 put contracts at
$0.25 per share, or $25.00 per contract (one put option contract contains 100 shares) for
a total of $250 for the 10 puts with a strike of $25 that expires in January 2016. If Microsoft
drops to $20 a share, your puts are worth $5,000 and your stock is worth $20,000 for a
total of $25,000. No matter how far Microsoft drops, the value of your puts will increase
proportionately, so your position will not be worth less than $25,000 before the expiration
of the puts—thus, the puts protect your position.

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Key points
✓ An option is a contract in which the writer of the option grants the buyer the right, but not
the obligation, to purchase from or sell to the writer something at the exercise (or strike)
price within a specified period of time (until the expiration date).
✓ The price paid by the option buyer is called the option price or option premium.
✓ A call option grants the option buyer the right to buy something from the option writer, and
a put option grants the option buyer the right to sell something to the option writer.
✓ The maximum amount that an option buyer can lose is the option price, while the
maximum profit that the option writer can realize is the option price; the option buyer has
substantial upside return potential, while the option writer has substantial downside risk.
✓ The option contract will specify the exercise style (American, European, Bermuda).
Options may be traded either on an organized exchange or in the OTC market.
✓ There are four basic option positions: buying a call option, selling a call option, buying a
put option, and selling a put option.
✓ The buyer of a call option benefits if the price of the underlying rises; the writer (seller) of
a call option benefits if the price of the underlying is unchanged or falls.
✓ The buyer of a put option benefits if the price of the underlying falls; the writer (seller) of
a put option benefits if the price of the underlying is unchanged or rises.
✓ In determining the payoff from an option, the time value of money as a result of having to
finance the option price must be considered.

6.6 Swaps
A swap is an agreement between two parties (called counterparties) to exchange specified
periodic cash flows in the future based on some underlying instrument or price (e.g., a fixed or
floating rate on a bond or note). Like forward, futures, and option contracts, swaps allow firms to
better manage their interest rate, foreign exchange, and credit risks. However, swaps also can
result in large losses. At the heart of the financial crisis in 2008–2009 were derivative securities,
mainly credit swaps, held by financial institutions. The cash flows that are swapped may be
determined based on interest rates, exchange rates, or the prices of indexes or commodities.

The salient features of swap are that:

• It is a combination of forward contracts and it possesses all the properties of a forward
contract;
• Swap is long-term in nature, while forwards are arranged for a short period only;
• It requires that there is a double coincidence of wants, which is two parties with equal,
opposite but matching needs must come into contact with each other; and
• there may be a need for a financial intermediary to make the two counterparties meet.

The most common types of swaps are interest rate swaps, currency swaps, and credit swaps.

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6.6.1 Interest Rate Swaps
By far the largest segment of the swap market is comprised of interest rate swaps. Conceptually,
an interest rate swap is a succession of forward contracts on interest rates arranged by two
parties. An interest rate swap is an agreement whereby two parties (called counterparties) agree
to exchange periodic interest payments. In a swap contract, the swap buyer agrees to make
several fixed interest rate payments based on a principal contractual amount (called the notional
principal) on periodic settlement dates to the swap seller. This party is referred to as the fixed-rate
payer. The swap seller, in turn, agrees to make floating-rate payments, tied to some interest rate,
to the swap buyer on the same periodic settlement dates. The swap seller is referred to as the
floating-rate payer. In undertaking this transaction, the party that is the fixed-rate payer is seeking
to transform the variable-rate nature of its liabilities into fixed-rate liabilities to better match the
fixed returns earned on its assets.

For example, the deal entered into on March 8, 2023, where Marathon Motors agrees to receive
a 3-month floating rate interest payment & pay a fixed rate of 3% per annum every 3 months for
2 years to CBE on a notional principal of $100 million. The next table illustrates cash flows that
could occur.
Date Floating Rate Floating Fixed Paid Net cash
(%) Received (‘000s) flow
(‘000s) (‘000s)

June 8, 2022 2.20 550 750 -200

Sept 8, 2022 2.60 650 750 -100

Dec. 8, 2022 2.80 700 750 -50

Mar. 8, 2023 3.10 775 750 +25

June 8, 2023 3.30 825 750 +75

Sept 8, 2023 3.40 850 750 +100

Dec 8, 2023 3.60 900 750 +150

Mar 8, 2024 3.80 950 750 +200

Further assume that for the next five years party X agrees to pay party Y 10% per year, while
party Y agrees to pay party X a six-month LIBOR (London Interbank Offered Rate). Party X is a
fixed-rate payer/floating-rate receiver, while Party Y is a floating-rate payer/fixed-rate receiver.
Assume that the notional principal amount is $50 million and that payments are exchanged every
six months for the next five years. This means that every six months, party X (the fixed-rate
payer/floating-rate receiver) will pay party Y $2.5 million (10% times $50 million divided by 2). The
amount that party Y (the floating-rate payer/fixed-rate receiver) will pay party X will be six-month
LIBOR times $50 million divided by 2. For example, if six-month LIBOR is 7%, party Y will pay

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party X $1.75 million (7% times $50 million divided by 2). Note that we divide by two because
one-half year’s interest is being paid.

6.6.2 Currency Swaps

This section considers a simple example of how currency swaps can be used to immunize or
hedge against exchange rate risk when firms mismatch the currencies of their assets and
liabilities. currency swap involves exchanging principal and interest payments at a fixed rate in
one currency for principal and interest payments at a fixed rate in another currency. A currency
swap agreement requires the principal to be specified in each of the two currencies. The principal
amounts in each currency are usually exchanged at the beginning and at the end of the life of the
swap. Usually, the principal amounts are chosen to be approximately equivalent using the
exchange rate at the swap’s initiation. But when they are exchanged at the end of the life of the
swap, their values may be quite different.

Fixed-Fixed Currency Swaps

Consider a U.S. financial institution with all of its fixed-rate assets denominated in dollars. It is
financing its $200 million asset portfolio with a £100 million issue of five-year, medium-term British
pound notes that have a fixed annual coupon of 6 percent. By comparison, a financial institution
in the United Kingdom has all its £100 million assets denominated in pounds. It is funding those
assets with a $200 million issue of five-year, medium-term dollar notes with a fixed annual coupon
of 6 percent. These two financial institutions are exposed to opposing currency risks. The U.S.
institution is exposed to the risk that the dollar will depreciate (decline in value) against the pound
over the next five years, which would make it more costly to cover the annual coupon interest
payments and the principal repayment on its pound-denominated note liabilities. On the other
hand, the U.K. institution is exposed to the risk that the dollar will appreciate against the pound,
making it more difficult to cover the dollar coupon and principal payments on its five-year, $200
million note liabilities. These financial institutions can hedge their exposures off the balance sheet.
Assume that the dollar/pound exchange rate is fixed at $2/£1. The U.K. and U.S. financial
institutions would enter into a currency swap by which the U.K. institution sends annual payments
in pounds to cover the coupon and principal repayments of the U.S. financial institution’s pound
note issue, and the U.S. financial institution sends annual dollar payments to the U.K. financial
institution to cover the interest and principal payments on its dollar note issue.

As a result of the swap, the U.K. financial institution transforms its fixed-rate dollar liabilities into
fixed rate pound liabilities that better match the fixed-rate pound cash flows from its asset portfolio.
Similarly, the U.S. financial institution transforms fixed-rate pound liabilities into fixed-rate dollar
liabilities that better match the fixed-rate dollar cash flows on its asset portfolio.

In undertaking this exchange of cash flows, the two parties normally agree on a fixed exchange
rate for the cash flows at the beginning of the period. In this case, the fixed exchange rate is
$2/£1. Note in the example above that should the exchange rate change from the rate agreed in
the swap ($2/£1), either one or the other side would be losing in the sense that a new swap might
be entered into at a more favorable exchange rate to one party. Specifically, if the dollar were to
appreciate against the pound over the life of the swap, the agreement would become more costly

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for the U.S. financial institution. If, however, the dollar depreciated, the U.K. financial institution
would find the agreement increasingly costly over the swap’s life.

6.6.3 Credit Swaps

In recent years the fastest growing types of swaps have been those developed to better allow
financial institutions to hedge their credit risk, so-called credit swaps or credit default swaps.
Two types of credit swaps are total return swaps and pure credit swaps. A total return swap
involves swapping an obligation to pay interest at a specified fixed or floating rate for payments
representing the total return on a loan (interest and principal value changes) of a specified
amount. While total return swaps can be used to hedge credit risk exposure, they contain an
element of interest rate risk as well as credit risk. For example, if the base rate on the loan
changes, the net cash flows on the total return swap also will change—even though the credit
risks of the underlying loans have not changed.

To strip out the “interest rate”-sensitive element of total return swaps, an alternative swap has
been developed called a pure credit swap. In this case, the financial institution lender will send
(each swap period) a fixed fee or payment (like an insurance premium) to the counterparty. If the
financial institution lender’s loan or loans do not default, it will receive nothing back from the
counterparty. However, if the loan or loans default, the counterparty will cover the default loss by
making a default payment that is often equal to the par value of the original loan minus the
secondary market value of the defaulted loan. Thus, a pure credit swap is like buying credit
insurance and/or multiperiod credit.

6.7 Margining and Marking to the Market

When a position is first taken in a futures contract, the investor must deposit a minimum dollar
amount per contract as specified by the exchange. This amount called the initial margin, is
required as a deposit for the contract. Individual brokerage firms are free to set margin
requirements above the minimum established by the exchange. As the price of the futures
contract fluctuates each trading day, the value of the investor’s equity in the position changes.
The equity in a futures account is the sum of all margins posted and all daily gains less all daily
losses to the account.

At the end of each trading day, the exchange determines the settlement price for the futures
contract. The settlement price is different from the closing price, which many people know from
the stock market and which is the price of the security in the final trade of the day (whenever that
trade occurred during the day). The settlement price by contrast is that value that the exchange
considers to be representative of trading at the end of the day.

The exchange uses the settlement price to mark to market the investor’s position so that any
gain or loss from the position is quickly reflected in the investor’s equity account. The
maintenance margin is the minimum level (specified by the exchange) to which an investor’s
equity position may fall as a result of an unfavorable price movement before the investor is
required to deposit additional margin. The additional margin deposited is called the variation
margin, and it is an amount necessary to bring the equity in the account back to its initial margin

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level. Unlike the initial margin, the variation margin must be in cash rather than interest-bearing
instruments. Any excess margin in the account may be withdrawn by the investor. If a party to a
futures contract who is required to deposit variation margin fails to do so within 24 hours, the
exchange closes the futures position out.

Although there are initial and maintenance margin requirements for buying securities on margin,
the concept of margin differs for securities and futures. When securities are acquired on margin,
the difference between the price of the security and the initial margin is borrowed from the broker.
The security purchased serves as collateral for the loan, and the investor pays interest. For futures
contracts, the initial margin, in effect, serves as good faith money, an indication that the investor
will satisfy the obligation of the contract. Normally, no money is borrowed by the investor who
takes a futures position.

Illustration
To illustrate the mark-to-market procedure, let’s assume the following margin requirements for
Asset XYZ.

Initial margin $7 per contract

Maintenance margin $4 per contract

Let’s assume that Bisrat buys 500 contracts at a futures price of $100, and Senayit sells the same
number of contracts at the same futures price. The initial margin for both Bisrat and Senayit is
$3,500, which is determined by multiplying the initial margin of $7 by the number of contracts,
which is 500. Bisrat and Senayit must put up $3,500 in cash or Treasury bills or other acceptable
collateral. At this time, $3,500 is also called the equity in the account. The maintenance margin
for the two positions is $2,000 (the maintenance margin per contract of $4 multiplied by 500
contracts). The equity in the account may not fall below $2,000. If it does, the party whose equity
falls below the maintenance margin must put up additional margin, which is the variation margin.
There are two things to note here. First, the variation margin must be cash. Second, the amount
of variation margin required is the amount to bring the equity up to the initial margin, not to the
maintenance margin.

Marking to the Market

To illustrate the mark-to-market procedure, we assume the following settlement prices at the end
of several trading days after the transaction was entered into. Those prices are:

Trading day Settlement

price
1 $99
2 $97
3 $98
4 $95

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First, consider Bisrat’s position. At the end of trading day 1, Bisrat realizes a loss of $1 per contract
or $500 for the 500 contracts he bought. Bisrat’s initial equity of $3,500 is reduced by $500 to
$3,000. No action is taken by the clearinghouse because Bisrat’s equity is still above the
maintenance margin of $2,000. At the end of the second day, Bisrat realizes a further loss as the
price of the futures contract has declined another $2 to $97, resulting in an additional reduction
in his equity position by $1,000. Bisrat’s equity is then $2,000: the equity at the end of trading day
1 of $3,000 minus the loss on trading day 2 of $1,000. Despite the loss, no action is taken by the
clearinghouse, because the equity still meets the $2,000 maintenance requirement. At the end of
trading day 3, Bisrat realizes a profit from the previous trading day of $1 per contract or $500.
Bisrat’s equity increases to $2,500. The drop in price from $98 to $95 at the end of the trading
day 4 resulted in a loss for the 500 contracts of $1,500 and a consequent reduction of Bisrat’s
equity to $1,000. As Bisrat’s equity is now below the $2,000 maintenance margin, Bisrat is
required to put up the additional margin of $2,500 (variation margin) to bring the equity up to the
initial margin of $3,500. If Bisrat cannot put up the variation margin his position will be liquidated.
The following table shows the profit and loss, the equity balance, and the variation margin
requirement.

Trading Settlement Daily gain Account Margin call/

day price or /(loss) balance Variation
Margin
0 100 --- $3,500
1 $99 ($500) $3,000
2 $97 ($1,000) $2,000
3 $98 $500 $2500
4 $95 ($1,500) $1000 $2,500

Now, let’s look at Senayit’s position. Senayit as the seller of the futures contract benefits if the
price of the futures contract declines. As a result, her equity increases at the end of the first two
trading days. In fact, at the end of trading day 1, she realizes a profit of $500, which increases her
equity to $4,000. She is entitled to take out the $500 profit and use these funds elsewhere.
Suppose she does, and her equity, therefore, remains at $3,500 at the end of trading day 1. At
the end of trading day 2, she realizes an additional profit of $1,000 that she also withdraws. At the
end of trading day 3, she realizes a loss of $500 with the increase of the price from $97 to $98.
This resulted in a reduction of her equity to $3,000. Finally, on trading day 4, she realizes a profit
of $1,000, making her equity $4,000. She can withdraw $500.

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Summary
In this part, we introduced the major derivative securities and the markets in which they trade.
Derivative securities (forwards, futures, options, and swaps) are securities whose value depends
on the value of an underlying asset but whose payoff is not guaranteed with cash flows from these
assets. We examined the characteristics of the various securities and the markets in which each
trades.

The purpose of futures markets is to provide an important opportunity to hedge against the risk of
adverse future price movements. Futures contracts are creations of exchanges, which require an
initial margin from parties. Each day positions are marked to market. An additional (variation)
margin is required if the equity in the position falls below the maintenance margin. The
clearinghouse guarantees that the parties to futures contracts will satisfy their obligations. A buyer
(seller) of a futures contract realizes a profit if the futures price increases (decreases). The buyer
(seller) of a futures contract realizes a loss if the futures price decreases (increases). Because
only initial margin is required when an investor takes a futures position, futures markets provide
investors with substantial leverage for the money invested.

A forward contract differs in several important ways from a futures contract. In contrast to a futures
contract, the parties to a forward contract are exposed to the risk that the other party to the
contract will fail to perform. The positions of the parties are not marked to market, so there are no
interim cash flows associated with a forward contract. Finally, unwinding a position in a forward
contract may be difficult.

An option is a contract between two parties, the buyer and the seller (or writer). The buyer pays
a price or premium to the seller for the right (but not the obligation) to buy or sell a certain amount
of a specified item at a set price for a specified period of time. The right to buy is a call option,
and the right to sell is a put option. The set price is the exercise or strike price. The item to which
the option applies is the underlying asset, and its value determines the value of the option. Hence,
options are called derivative instruments. Options differ from futures in several key ways. First,
both parties to a futures contract accept an obligation to transact, but only the writer of an option
has an obligation, and that occurs if the buyer wishes to exercise the option. Second, the option
buyer has a limited, known maximum loss. Third, the risk/return profile of an option position is
asymmetric, while that of a futures position is symmetric.

A swap is an agreement between two parties (called counterparties) to exchange cash flows. An
interest rate swap is an agreement specifying that the parties exchange interest payments at
designated times. In a typical swap, one party will make fixed-rate payments and the other will
make floating-rate payments, with payments based on the notional principal amount. currency
swaps are used to immunize or hedge against exchange rate risk when firms mismatch the
currencies of their assets and liabilities.

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Self-Assessment Questions
1. What are the differences between a spot contract, a forward contract, and a futures
contract?
2. What is the purpose of requiring a margin on a futures or option transaction? What is the
difference between an initial margin and a maintenance margin?
3. When is a future or option trader in a long versus a short position in the derivative contract?
4. What is an option? How does an option differ from a forward or futures contract? What is
the difference between a call option and a put option?
5. What must happen to the price of the underlying stock for the purchaser of a put option on
the stock to make money? How does the writer of the put option make money?
6. What is a swap? What is the difference between an interest rate swap and a currency
swap? Which party is the swap buyer and which is the swap seller in an interest-rate swap
transaction?

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7. TRADING OPERATIONS

Learning Objectives
Upon completion of this unit a students will be able to:
• Identify and describe the various types of trading parameters
• Define margining and explain the meaning of maintenance margin and variation margin
• Describe the concept of marking to the market
• Describe the concept of value at risk (VaR)
• Discuss the methodology for computing the margin amount using VaR
• Explain the nature of market orders and limit orders
• Explain how orders are prioritized through price priority rule and time priority rule.
• Describe the notion of stop loss order and demonstrate how a stop loss price and trigger
price can be determined.

7.1 Trading Procedure on a Stock Exchange

Trading involves buying and selling financial instruments like stocks, bonds, commodities, and
currencies to profit from price changes. Trades operate in various financial markets such as stock
exchanges, commodity exchanges, and forex markets, aiming for short-term gains through rapid
transactions or long-term appreciation.

An exchange is a market that serves as a link between the savers and borrowers by transferring
the capital or money from those who have a surplus amount of money to those who need money
or investment is known as a Financial Market. Simply put, a Financial Market is a market that
creates and exchanges financial assets. In general, the investors are the surplus units and
business enterprises are the deficit units. Hence, a financial market acts as a link between surplus
units and deficit units and brings the borrowers and lenders together.

A stock exchange can be defined as an organization or body of individuals, whether incorporated

or not established to assist, regulate, and control businesses in buying, selling, and dealing in
securities.

7.2 Trading Procedure on a Stock Exchange

Before the companies start selling the securities through the stock exchange, they have to first
get their securities listed on the stock exchange. The company's name is included in listed
securities only when the stock exchange authorities are satisfied with the financial soundness and
various other aspects of the company. Earlier, the buying and selling of securities were done on
the trading floor of the stock exchange. However, in present times, it is done through online trading
systems. Key participants in stock and commodity exchanges include individual investors,
institutional investors (e.g., mutual funds, hedge funds), market makers, and proprietary trading
firms. Each participant has their investment strategies and trading objectives.

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Here's an overview of the key aspects of trading operations in stock or commodity exchanges:

Order Order Trade Clearing and

placement matching execution settlement

1. Placing the Order: Investors and traders place buy or sell orders for different financial
instruments through brokers or directly on the exchange's trading platform. Orders can be
market orders (executed at the current market price) or limit orders (executed at a
specified price or better). The investor can place the order to the broker either personally
or through email, phone, etc. The investor must make sure that the order placed specifies
the range or price (market price or limit price) at which the securities can be sold or
bought.”

2. Order Matching: The broker after receiving an order from the investor will have to then
go online and connect to the main stock exchange to match the share and best price
available. The exchange's matching engine matches buy and sell orders based on factors
like price and time priority. Once a match is found, the trade is executed, and the
transaction details are recorded.

3. Executing Order: When the shares can be bought or sold at the price mentioned by the
investor, it will be communicated to the broker terminal, and then the order will be executed
electronically. Once the order has been executed, the broker will issue a trade
confirmation slip to the investors.

4. Clearing and Settlement: The exchange facilitates the execution of trades and ensures
the timely settlement of transactions. Settlement typically occurs within a few business
days, where the buyer pays for the purchased assets, and the seller delivers the assets.
Clearing houses play a crucial role in managing the risks associated with trading. They
act as a central counterparty, guaranteeing the completion of trades and managing the
collateral (margin) requirements for traders. The payment of securities in cash or delivery
of securities is done on delivery vs payment modality. Usually, settlement takes place on
T+2 basis. For example, if the transaction took place on Tuesday, then the payment must
be done before Thursday, i.e., T+2 days (Transaction plus two more days).

On the T+2 Day, the Stock Exchange will then deliver the share or make payment to the
other broker. This is known as Payout Day. Once the shares have been delivered or
payment has been made, the broker has to make payment to the investor within 24 hours
of the payout day, as he/she has already received payment from the exchange.

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7.3 Margins

What are Margins?

As we have just seen, whenever two parties enter into an agreement to trade at a future date,
there is always the risk of default. In other words, one of the parties may not carry out his part of
the deal as required by the contract. In the case of futures contracts, compliance is ensured by
requiring both the long and the short to deposit collateral in an account known as the Margin
Account. This margin deposit, known as the Initial Margin, is therefore a performance
guarantee.

The amount of collateral is the potential loss that each party is liable to incur. In the case of a
futures contract, since both parties have an obligation, it is necessary to collect collateral from
them both. Once such potential losses are collected, the incentive to default is effectively taken
away. Also even if the party that ends up on the losing side were to default, the collateral collected
from it would be adequate to take care of the interests of the other party.

Activity
What is the meaning of offsetting? How are forward and futures contracts offset?
Commentary
Offsetting essentially means taking a counter position. It means that if a party has
originally gone long, it should subsequently go short, and vice versa. The effect of
offsetting is to cancel an existing long or short position in a contract. Remember, a
forward contract is a customized private contract between two parties. Thus, if a party
to a forward contract wants to cancel the original agreement, he must seek out the
counter-party to the agreement, before it can be canceled.

Cancelling a futures contract is a lot simpler. This is because a futures contract between two
parties, say Yacob and Wassie, to transact coffee at the end of a particular month, will be identical
to a similar contract between two other parties, say Kokebie and Senait, as both the contracts
would have been designed according to the features specified by the exchange. So if Yacob,
who had entered into a long position wants to get out of his position, all he has to do is to go back
to the floor of the exchange and offer to take a short position in a similar contract. This time the
opposite position may be taken by a new party, say Waktola. Thus, by taking a long position
initially with Wassie, and a short position subsequently with Waktola, Yacob can ensure that he
is effectively out of the market and has no further obligations. As far as the clearing house is
concerned, its records will show that Yacob has bought and sold an identical contract and that his
net position is zero. This is the meaning of offsetting.

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The profit or loss for an investor who takes a position in a futures contract and subsequently
offsets it, will be equal to the difference between the futures price prevailing at the time the original
position was taken, and the price at the time the position was offset.

7.4 The Concept of Marking to Market

The reason for collecting margins is to protect both parties against default by the other. To
reiterate, the potential for default arises because a position once opened, can and will invariably
lead to a loss for one of the two parties, if it were to comply with the terms of the contract. This
loss, however, will not arise all of a sudden at the time of expiration of the futures contract. As the
futures price fluctuates in the market from trade to trade, one of the two parties to an existing
futures position will experience a gain, while the other will experience a loss. Thus, the total loss
or gain from the time of getting into a futures position till the time the contract expires or is offset
by taking a counter-position, whichever is earlier, is the sum of these small losses/profits that
correspond to each observed price in the interim.

The term Marking to Market refers to the process of calculating the loss for one party, or
equivalently, the corresponding gain for the other, at specified points in time, with reference to the
futures price that was prevailing at the time the contract was previously marked to market. In
practice, when a futures contract is entered into, it will be marked to market for the first time at
the end of the day. Subsequently, it will be marked to market every day until the position is either
offset or else it itself expires. The party who has incurred a profit will have the amount credited
to his margin account, while the other party, who would have incurred an identical loss, will have
his margin account debited.

We will now illustrate how profits and losses arise in the process of marking to market and will
highlight the corresponding changes to the margin accounts of the respective parties.

Let us take the case of Hailu who has gone long in a futures contract with Fikru, expiring five days
hence, at a futures price of Birr 400. Assume that the price at the end of five days is Birr 425 and
that the prices at the end of each day before expiration are as follows.

Table 1.2. End-of-the-Day Futures Prices

Day Futures Price
0 400
1 405
2 395
3 380
4 405
5 425

Note: Day ‘0’ demands the time the contract was entered into, and the corresponding price is the
futures price at which the deal was struck. Day ‘t’ represents the end of that particular day, and
the corresponding price is the prevailing futures at that instant.

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Let us assume that as per the contract Hailu is committed to buying 100 units of the asset, and
that at the time of entering into the contract; both the parties had to deposit Birr 5,000 as collateral
in their margin accounts. The amount of collateral that is deposited when a contract is first entered
into is called the Initial Margin.

At the end of the first day, the futures price is Birr 405. If Hailu were to offset the position that he
had entered into in the morning, he would have to do so by agreeing to sell 100 units at Birr 405
per unit. If so, he would earn a profit of Birr 5 per unit, or Birr 500 in all. While marking Hailu’s
position to market, the broker will act as though he were offsetting. That is, he would calculate
his profit as Birr 500, and credit it to his margin account. However, since he had not expressed a
desire to actually offset, he would act as if he were reentering into a long position at the prevailing
futures price of Birr 405.

At the end of the second day, the prevailing futures price is Birr 395. When the contract is marked
to market, Hailu will make a loss of Birr 1,000. Remember, his contract was re-established the
previous evening at a price of Birr 405. If the broker were to behave now as if he were offsetting
at Birr 395, his loss would be Birr 10 per unit or Birr 1,000 in all. Once again a new long position
would be automatically established, this time at a price of Birr 395.

This process will continue either until the delivery date, when he will actually take possession of
the asset, or until the day that he chooses to offset his position, if that were to happen earlier. As
you can see therefore, rising futures prices lead to profits for the long, whereas falling futures
prices lead to losses.

Now let us consider the situation from Fikru’s perspective. At the end of the first day, when the
futures price is Birr 405, marking to market would mean a loss of Birr 500. That is, his earlier
contract to sell at Birr 400 will effectively be offset by making him buy at Birr 405, and with a new
short position being established for him at Birr 405. Similarly, by the same logic, at the end of the
second day, his margin account will be credited with a profit of Birr 1,000. As you can see, shorts
lose when futures prices rise, and gain when the prices fall.

Thus, the profit/loss for the long is identical to the loss/profit for the short. It is for this reason that
futures contracts are called Zero Sum Games. One man’s gain is another man’s loss. The
following figure indicates how profit for the long is loss for short

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In our illustration, by the time the contract expires, Hailu’s account would have been credited with
Birr 2,500, representing the difference between the terminal futures price and the initial futures
price, multiplied by the number of units of the underlying asset. These funds will have come from
Fikru’s account which would have been debited. Now, if Fikru were to refuse to deliver the asset
at expiration, Hailu would not be at a disadvantage. Since he has already realized a profit of Birr
2,500, he can take delivery in the spot market at the terminal spot price of Birr 425 per unit, in lieu
of taking delivery under the futures contract. Thus, effectively, he will get the asset at a price of
Birr 400 per unit, which is what he had contracted for in the first place.

The Role of the Clearing House in marking to market

The clearinghouse essentially plays the role of a banker. Its task is to debit the margin account of
the broker whose client has suffered a loss, and simultaneously credit the margin account of the
broker whose client has made a profit. Thus, depending upon the movement of the futures price,
the margin accounts maintained with the clearing house are adjusted daily for profit and losses,
in the same way that a broker deals with clients’ margin accounts.

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How does marking to market work?
All open futures positions are marked to market at the end of the day. Any losses incurred by a
party must be paid on the following business day and payouts to parties who have made a profit
will be made on the following business day. On the expiration date, the open positions will be
marked to market for the last time.

Activity

Are forward contracts too marked to market? If not, what are the implications?

Commentary
No, forward contracts are not marked to market. Consequently, both the parties to
the contract are exposed to a credit risk, which is the risk that the other party may
default. Thus, in practice, the parties to a forward contract tend to be large and
well-known, such as banks, financial institutions, corporate houses, and brokerage
firms. Such parties find it easier to enter into forward contracts because, as
compared to individuals, their creditworthiness is easier to appraise.

7.5 Maintenance Margin and Variation Margin

As we have seen, as soon as traders enter into a futures contract, both longs and short have to
deposit a performance bond with their broker known as the Initial Margin. If the markets were to
subsequently move in favor of a party to a futures contract, the balance in his margin account will
increase, else if the market were to move against him, the balance will be depleted. Now, the
broker has to ensure that a client always has adequate funds in his margin account. Otherwise,
the entire purpose of requiring clients to maintain margins can be defeated. Consequently, he
will specify a threshold balance called the Maintenance Margin, which will be less than the
initial margin. If due to adverse price movements, the balance in the margin account were to
decline below the level of the maintenance margin, the client will immediately be asked to deposit
additional funds so as to take the balance back to the level of the initial margin. In futures markets
parlance, we would say that the broker has issued a Margin Call to the client. A margin call is
always bad news, for it is an indication that a client has suffered major losses since the time he
opened the margin account. The additional funds deposited by a client when a margin call is
complied with, are referred to as the Variation Margin.

These concepts can best be explained with the help of an example. Let us reconsider the case
of Hailu, who went long in a contract for 100 units of the asset at a price of Birr 400 per kg, and
deposited Birr 5,000 as collateral for the same. Assume that the broker fixes a maintenance
margin of Birr 4,000. If the contract lasts for a period of five days, and the futures process on the
subsequent days are as shown in table 2, then the impact on the margin account will be as
summarized in Table 3.

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Let us analyze some of the entries in table 3 in detail. As compared to the price at the time the
contract was entered into, the price has now increased by Birr 5 per unit or Birr 500 for 100 units.
Consequently, Hailu who has entered into a long position has gained Birr 500, which will be
credited to his margin account, thus increasing the account balance to Birr 5,500 at the end of the
first day.

Table 3 Changes in the Margin Account over the Course of Time

Day Futures Daily Cumulative Account Margin
Price Gain/Loss Gain/Loss Balance Call
0 400 - - 5,000
1 405 500 500 5,500
2 395 (1,000) (500) 4,500
3 380 (1,500) (2,000) 3,000 2,000
4 405 2,500 500 7,500
5 425 2,000 2,500 9,500

The futures price at the end of the second day is Birr 395, Thus, Hailu has suffered a loss of Birr
10 per unit or Birr 1,000 for 100 units. When this loss is debited to his margin account, the balance
in the account becomes Birr 4,500. The price at the end of the next day is Birr 380, implying that
Hailu has suffered a further loss of Birr 1,500. When this loss is debited to the margin account
the balance becomes Birr 3,000, which is less than the maintenance margin of Birr 4,000. Hence
a margin call is issued for Birr 2,000, this being the amount required to take the balance back to
the initial margin level. Therefore, Hailu has to pay a variation margin or Birr 2,000.

Activity

Does the initial margin necessarily have to be deposited in cash?

What about variation margins?

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Commentary
Initial margins need not always be deposited in the form of cash. Brokers often
accept securities like treasury-bills and equity shares as collateral. However, the
value assigned to these assets will be less than their current market values. This is
because the broker would like to protect himself against a sudden sharp decline in
the value of the collateral. For instance, if the required initial margin is Birr 90, the
broker may ask you to deposit securities having a market value of Birr 100.
Technically speaking, we say that the broker has applied a Haircut of 10%. Variation
margins, however, must always be paid in cash. This is because unlike initial
margins which represent performance guarantees, variation margins are a
manifestation of the actual losses suffered by the client.

7.6 The concept of Value at Risk (VaR)

In the case of futures contracts, it is clear that if the amount of margin or performance bond that
is collected from the parties to the contract is adequately high, the potential for default will be
insignificant. In practice, therefore, the margins specified by the exchange would depend on the
estimate of the potential loss. Value at risk or VaR, is a statistical technique for estimating this
potential loss. A priori, we cannot be sure as to the quantum of loss for either the long or the short
from one day to the next. At best we can say that with a given level of probability, the loss
cannot exceed a specified amount. This is precisely the concept of Value at Risk (VaR).

VaR may be defined as a summary statistical measure of the possible loss of a portfolio of assets
over a pre-specified time horizon. Thus for instance, if we were to say that the 99% VaR of an
asset for a one-day horizon is Birr 1,000, it would mean that there is only a 1% probability that the
loss of value of the asset over a one-day holding period will exceed Birr 1,000. To interpret a VaR
number, it is very important to take cognizance of both the probability level and the holding period
that has been specified. For a given asset, changing one or both parameters can lead to
significantly different estimates of VaR. It must also be remembered that the calculated VaR is
not the maximum possible loss that a portfolio can suffer. For, in principle, the value of a portfolio
can always go to zero, and consequently, the maximum loss that a portfolio can potentially suffer
is its entire current value.

The VaR computational methodology

The initial margin for a futures position should be based on a 99% VaR over a one day horizon.
A technique known as the Exponential Moving Average method can be used for computing the
VaR.

According to this technique, the volatility of the returns on an asset may be computed as
Ϭ2 t = λϬ2t–1 + (1- λ) rt 2
Where Ϭ2t or the variance, is the measure of the volatility of returns on day t, and rt is the return
on the asset on day t.

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rt is defined as (pt/pt-1) where pt is the futures price of the asset on day t.
Assume that 0.94 is the recommended value for λ.

The 99% VaR is then calculated based on a deviation of 3Ϭ. Since short futures positions will
lose if the futures price were to rise, the appropriate limit for a short position is + 3Ϭ so if Ϭ *t is
the calculated value for day t, then the value of pt+1 corresponding to a 99% VaR is given by
(Pt+1/ Pt) = 3Ϭ*t
(Pt+1 / Pt ) = e3Ϭ*t
Pt+1= Pt [1+ e3Ϭ*t -1]

thus, if we know Pt, we can say that in 99% of the cases, over a one day horizon, the percentage
increase in the futures prices will be less than or equal to [e 3Ϭ*t - 1 ]x 100.
For long positions, the calculation ought to be based on a -3Ϭ limit, since declining futures prices
will lead to a loss. So if Ϭ*t is the calculated value for day t, then the value of pt+1 corresponding
to a 99% VaR is given by
ln (Pt+1/Pt)= -3Ϭ*t
(Pt+1 /Pt)= e -3Ϭ*t
pt+1= pt [1+ e-3Ϭ*t -1]

once again, using the same logic, we can say that in 99% of the cases, over a one day horizon,
the percentage decline in the futures price will be less than or equal to
[1- e-3Ϭ*t ] x 100

Numerical illustration

Assume that Ϭt-1 = 0.0247, and that rt = 0.0225. If so, then

Ϭ2t = 0.94 x (0.0247)2 + (1-0.94) x (0.0225)2 = Ϭt = 0.02457

So the percentage margin for a short position will be:

[e3Ϭ*t - 1] x 100 = 7.6495%

whereas that for a long position will be:

[1 - e-3Ϭ*t ] x 100 = 7.1059%.

Let us assume that the futures price of an asset at the end of the day is Birr 1,000 and
that each contract is for 100 units. Therefore, the corresponding initial margin required to
keep a short position open for the following day is

100 x 1,000 x 0.076495 = Birr 7, 649.50

As you can see, the Ϭ for an asset will change from day to day, and consequently so will
the percentage margin.

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7.7 Gross Margining vs Net Margining
Let us assume that a broker has three clients A, B, and C. A has a long position in 100 futures
contracts, B has a long position in 50 futures contracts, and C has a short position in 70 futures
contracts. We will assume that the initial margin is Birr 1 per contract.

The broker will collect Birr 100 from A, Birr 50 from B, and Birr 70 from C. That is in all he will
collect Birr 220. If the clearing house were to collect margins on a gross basis, then the broker
would have to deposit the entire Birr 220 with the clearing house. This is the meaning of gross
margining.

On the other hand, if a net margining system were to be used, the clearing house would calculate
the broker’s position as net 80 long contracts as he has 150 long contracts as well as 70 short
contracts routed through him. Thus, in this case, the broker needs deposit only Birr 80 with the
clearing house.

What are the relative merits and demerits of the two systems? Let us assume that the futures
price goes up by Birr 1. The broker will need Birr 150 to pay parties A and B. Of this, Birr 70
should come from party C, while the balance should come through the clearing house since the
broker has a net long position with it. Assume that party C defaults, that is, it refuses to pay, and
that the broker too has become insolvent. In such a case, if a gross margining system is being
used, the clearing house has the resources to pay both A as well as B, since the broker has
deposited Birr 220 with it.

However, if net margining had been used, and a similar situation were to arise, the clearing house
would only guarantee payment for 80 contracts, since the broker has deposited only Birr 80 with
it. Thus, in the case of net margining, clients need to be more concerned with the financial
strength and integrity of the broker through whom they route their transactions. They cannot bank
on the clearing house to bail them out under all circumstances. But gross margining comes with
an economic price tag. Firstly, clients may not pay adequate attention to the creditworthiness of
their brokers. Secondly, the cost of operations of the clearing house will increase, since it now
has to provide guarantees on a much larger scale.
.

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Activity

What happens if a party defaults, that is, he fails to respond to a margin call?

Commentary

Default can occur at two possible points in time, either before the maturity of the futures
contract, or at the time of maturity. Let us first consider the case where a client defaults
before maturity. We will illustrate it using the data in Table 3.

At the end of the third day, when the balance in the margin account falls to Birr 3,000, a
margin call will be issued for Birr 2,000. If the client fails to pay the variation margin, the
broker will offset his position. In this case, since the client has originally gone long, the
broker will offset his contract by going short at the market price. In our case, the price at
the time of issuance of the margin call was Birr 380. Assume, that by the time the broker
can offset the contract, the price has fallen further to Birr 377. If so, the investor would
have incurred a further loss of Birr 3 per unit or Birr 300 for 100 units. This loss, along with
the transaction costs incurred by the broker, will be deducted from the balance of Birr 3,000
that is available in the margin account. The remaining amount will be refunded to the client.
Similarly, if a broker fails to respond to a margin call from the clearing house, the futures
exchange will close his account at the prevailing market price.

In the case of default at the time of expiration, if the default is on the part of a short, that is,
the short fails to deliver the asset, then the broker will acquire the asset in the spot market
and deliver it to the long. On the other hand, if a long were to default, then the broker would
acquire the asset from the short and sell it in the cash market. In either case, he will deduct
his costs and losses from the balance in the defaulting party’s margin account.

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7.8 Orders and Exchanges

7.8.1 What are orders?

An order is a trade instruction given to a broker or an exchange. In other words, when a trader
wishes to buy or sell an asset, he needs to place an order to indicate what he wishes to
accomplish, and the terms and conditions subject to which he wants his instructions to be carried
out.

What kind of information must an order contain so that it is meaningful?

Firstly, the trader needs to indicate as to whether he wishes to take a long position or a short
position. A desire to go long is communicated by placing a buy order, while a wish to go short is
conveyed by placing a sell order. In addition, he needs to clearly identify the type of derivative or
security that he wants to be bought or sold on his behalf.

The next issue is the number of contracts that we wish to buy. This is called the order size, and
obviously needs to be specified at the outset. Then comes the question of price. Are we prepared
to accept the best price that is currently available in the market? If not, assuming that we wish to
buy, what is the maximum price at which we are willing to buy? Else, if we wish to sell, what
is the minimum price that we are prepared to accept?

Traders who are prepared to accept the best terms available in the market have to place market
orders. Others who wish to place a price ceiling or a price floor, depending on whether they wish
to buy or to sell, place what are called limit orders. The corresponding price ceiling or floor is
called the limit price.

Finally, we need to specify the duration for which we wish our order to remain valid, as there can
be a delay in execution due to the unavailability of a suitable matching order on the other side of
the market. For instance, a trader may specify that his order should either be executed on
submission or else be cancelled. Others may specify a period of time for which they are prepared
to wait if a suitable match were to be currently unavailable. In practice, an exchange will not allow
an order to stay alive indefinitely, and will specify a maximum validity period. If an order were to
fail to get executed within this period, it would automatically stand cancelled.

Let us assume that we place a day order. In such a case, if a suitable match is not found by the
end of the day on which the order is entered, it will automatically be cancelled. We also need to
specify as to whether it is acceptable to partially fill our order. For instance, in our case we have
placed a buy order for 200 contracts. It may so happen that a suitable counter party is found for
100 contracts. The question is, should our order be partially executed and the remaining order for
100 contracts be kept in abeyance until another suitable match is found? If we do not wish this to
happen, we will place an all or nothing or all or none (AON) order. In these cases, an order
must either be filled completely or else remain unexecuted.

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7.8.2 Price-Related Condition Orders

1. Market Order
A market buy order will get executed at the best available price from the standpoint of the trader.
This price will be the lowest of the limit prices specified by all those traders who have placed limit
sell orders prior to the placement of the market order in question, and whose orders have not
been executed so far.

Similarly, when a market sell order is placed, it will be executed at the highest of the limit prices
specified by all those traders who have placed limit buy orders prior to the placement of the market
order in question, and whose orders are still pending.

Activity
How would a market order be executed if there are no trades at that point of time?

Commentary

Will be executed at whatever is the prevailing price on or after submission of such an order
if there are no trades at that point in time, the system takes the last traded price as the
market order and the order remains in the system unexecuted.

For example, if you want your broker to buy two September Silver futures contract at the
prevailing market price, a market order can be placed for the same. The order will be
Priority
executedrules
at the prevailing best-sell price.
There are two priority rules that are used to sort limit orders. The first is called the price priority
rule. According to this, a limit buy order with a higher limit price, ranks higher than all other limit
buy order with a lower limit prices. Similarly, a limit sell order with a lower limit price ranks higher
than all other limit sell orders with higher limit prices. Thus, an incoming market buy order is
guaranteed to get executed at the lowest available price on the buy side of the market.

The next obvious question will pertain to the ranking of two or more buy orders, or sell orders,
with the same limit price. In such cases the time priority rule comes into effect. That is, the
order which comes in first is automatically accorded priority.

These priority rules can of course easily be enforced in a modern electronic or screen-based
system. We will see later, as to how these rules are enforced in the traditional or open-outcry
system of trading, where traders crowd around a trading ring or pit and attempt to have their
orders executed.

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2. Limit Order and a Limit Order Book
A limit Order Book (LOB), at any point in time, contains the details of those limit orders which are
currently valid, but have not been executed thus far due to the unavailability of a suitable match.
A limit order specifies the price at (or better than) which the trade should be executed. Limit orders
are placed to either enter into a new trade or to exit from an existing trade. For a buy order, the
limit is placed below the existing market price and for a sell order the limit is placed above the
existing market price.

Illustration
Assume that today is January 2, 2024 and that March futures contracts have Just commenced
trading. Assume that in the first half-hour of trading, the following 9 orders are placed as shown
in Table 1

Now let us see how the LOB will build up, and examine the changes in it over some time.
At 10.01 a.m., Abrar’s order will enter the system. Since it is the very first order, it obviously cannot
be matched with an existing order on the other side of the market. Being a buy order, it will go to
the top of the buy side of the LOB.

At 10:03 a.m., Bethel’s buy order will enter the system. It too, cannot be matched, for then, there
are no sell orders in the book. So, the order will queue up on the buy side of the LOB.

Table 1 Chronological Sequence of Incoming Orders.

Time a.m. Trader Order Side Order Size Limit Price
10:01 Abrar Buy 100 100
10:03 Bethel Buy 200 120
10:07 Chaltu Sell 200 110
10:10 Dereje Sell 500 125
10:15 Elias Buy 200 100
10:18 Fatuma Buy 400 Market
10:20 Gualu Sell 500 100
10:25 Harerta Sell 200 99
10:30 Lemma Buy 500 90

Since Bethel has specified a limit price of Birr 120, which is higher than the price of Birr 100
specified by Abrar, her order will get priority based on the price priority rule. At 10:07 a.m., Chaltu’s
sell order will enter the system. It has a limit price of Birr 110 indicating that she is prepared to sell
provided she can do so at a price of Birr 110 or more. The system will try and match it with the
best buy order in the LOB, which is Bethel’s. Bethel has given a limit price of Birr 120, indicating
that she is prepared to pay up to Birr 120. Quite obviously, a trade is feasible under these
circumstances.

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Table 2 Snapshot of the LOB at 10.01 a.m.
Buyers Sellers
Trader Order Limit Price Limit price Order size Trader
Size
Abrar 100 100 - - -

Table 3 Snapshot of the LOB at 10.03 a.m.

Buyers Sellers
Trader Order Size Limit Price Limit price Order size Trader
Bethel 200 120 - - -
Abrar 100 100 - - -

Chaltu has sought to sell 200 contracts while Bethel has sought to buy 200 contracts. Therefore,
in the process of execution, both the orders will be filled. One question that remains, however, is
the price at which the trade will be executed. An incoming or active order will get executed at the
price of the existing or passive order with which it is matched. So, in this case, the trade will be
executed at the price of Birr 120 specified by Bethel.

Table 4 Snapshot of the LOB following the Trade

Buyers Sellers
Trader Order Size Limit Price Limit price Order size Trader
Abrar 100 100.00 - - -

At 10:10., Dereje’s sell order will enter the system with a limit price of Birr125. The best, in this
case, the only, buy order has a limit price of Birr 100. Quite obviously a trade is not feasible.
Consequently, Dereje’s order will take its place on the top of the sell side of the book.

At 10:15 a.m., Elias’s buy order for 200 contracts with a limit price of Birr 100 will come in. It
obviously cannot get matched with the best-sell order. In terms of the limit price, it has equal
priority with Abrar’s order. However, Abrar’s order will be accorded greater priority based on the
time priority rule.

Table 5 Snapshot of the LOB at 10:10 a.m.

Buyers Sellers
Trader Order Size Limit Price Limit price Order size Trader
Abrar 100 100 125 500 Dereje

Table 6 Snapshot of the LOB at 10:15 a.m.

Buyers Sellers
Trader Order Size Limit Price Limit price Order size Trader
Abrar 100 100 125 500 Dereje
Elias 200 100 - - -

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At 10:18 a.m., Fatuma’s market buy order for 400 contracts will come in. This kind of order is
assured of execution, provided there are one or more orders on the other side whose cumulative
order size is greater than or equal to the size of the incoming order. In this case, since there is an
order on the sell side for 500 contracts, the incoming order will be filled at a price of Birr125. At
10:20 a.m., Gualu’s sell order for 500 contracts will come in, with a limit price of Birr 100. The
system will try and match it with Abrar’s order and a trade will result. However, Gualu’s order will
not be fully filled in the process, since Abrar’s order is only for 100 contracts. The system will then
try and match the remainder of Gualu’s order with Elias’s. Once again, a trade will result and
Elisas’s order will be filled. However, Gualu’s order will only partially be filled since for the balance
of 200 contracts, there is no possibility of a match. Consequently, the unfilled portion will continue
to stay in the LOB. It will go to the top of the sell side of the LOB since the limit price of Birr 100
specified by Gualu is lower than the price of Birr 125 specified by Dereje.

Table 7 Snapshot of the LOB

Buyers Sellers
Trader Order Size Limit Price Limit Price Order Size Trader
Abrar 100 100 125 100 Dereje
Elias 200 100 - - -

Table 8 Snapshot of the LOB Following the Trade at 10:20

Buyers Sellers
Trader Order Size Limit Price Limit Price Order Size Trader
- - - 100 200 Gualu
- - - 125 100 Dereje

At 10.25 a.m. Harerta’s sell order with a limit price of Birr 99 will enter. Based on the price priority
rule, it will take precedence over Gualu’s order. At 10.30 a.m., Lema’s buy order with a limit price
of Birr 90 will come in. A trade is not feasible as it cannot be matched with Harerta’s order.

Table 9 Snapshot of the LOB at 10:25 a.m.

Buyers Sellers
Trader Order Size Limit Price Limit Price Order Size Trader

- - - 99 200 Harerta
- - - 100 200 Gualu
- - - 125 100 Dereje

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Table 10 Snapshot of the LOB at 10:30 a.m.

Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Lema 500 90 99 200 Harerta
- - - 100 200 Gualu
- - - 125 100 Dereje

Activity 2

What would happen if a market order enters the system and there is no limit order in the queue on
the opposite side of the market?

Commentary
Every exchange has its convention for dealing with this situation. If this kind of situation were to
occur during a business day, then the incoming market order will become a limit order with a limit
price equal to the last recorded trade price.
For instance, assume that the LOB at a particular instant looks as shown in Table 11. Let us assume
that the last recorded trade took place at a price of Birr 98. If a market sell order for 500 contracts
placed by Roman were to enter the system at this point, then quite obviously it would not be possible
to find a suitable match. The order will therefore be converted to a limit sell order with a limit price of
Birr 98, and will consequently take its place at the top of the sell side of the book. The book will then
look as follows (Table 11):

Table 11 Snapshot of the LOB at 10:25 a.m.

Buyers Sellers
Trader Order Size Limit Price Limit Price Order Size Trader

- - - 99 200 Harerta
- - - 100 200 Gualu
- - - 125 100 Dereje
Table 12 Post Submission Snapshot of the LOB

Buyers Sellers
Trader Order Size Limit Price Limit Price Order Size Trader
- - - 98 500 Roman
- - - 99 200 Harerta
- - - 100 200 Gualu
- - - 125 100 Dereje

150
If a market order were to enter the system at the start of trading on a given day, then in the
absence of a limit order on the other side, the incoming order will be converted to a limit order
with a limit price equal to the previous day’s closing price.

Activity 3

Is it true that placing a limit order is more sensible than placing a market order? Limit orders
do seem to give the investor more control over the trade.

Commentary

Yes. Limit orders allow traders to control the price at which their orders will get executed. A limit
buy order will ensure that the buyer will not end up paying more than the limit price specified
by him, whereas a limit sell order will ensure that the seller will not end up getting less than the
limit price specified by him. However, when an investor places a limit order, there is no
guarantee that a suitable match on the other side can be found within a reasonable period of
time. Consider the following LOB (Table 8.13) at a given point in time. The last trade price was
Birr 120.

Table 13 Snapshot of the LOB at the Outset

Buyers Sellers
Trader Order size Limit price Limit price Order size Trader
Abrar 100 100 125 500 Dereje
130 300 Solomon
130 1700 Salah
140 1500 Senai
150 1000 Kemal
150 1000 Sissay

Assume that Elias places a buy order for 200 contracts with a limit price of Birr 100. it cannot be
matched with an existing limit sell order and consequently will have to take its place in the system.
Now assume that Sima places a market buy order for 1,500 contracts. It will be executed
immediately. 500 contracts will be bought at Birr 125 and 1,000 contracts at Birr 130. Therefore,
the last trade price that is reported will be Birr 130.

Once again let us assume that another market buy order is placed immediately thereafter for
1,500 contracts this time by a trader called Roman. It too will get executed. The last reported trade
price will now be Birr 140.

151
Table 14 Snapshot of the LOB after Elias’s Order

Buyers Sellers
Trader Order Size Limit Price Limit Price Order Size Trader

Abrar 100 100.00 125 500 Dereje

Elias 200 100.00 130 300 Solomon

- - - 130 1,700 Salah

- - - 140 1,500 Senay

- - - 150 1,000 Kemal

- - - 150 1,000 Sissay
Table 15 Snapshot of the LOB after Sima’s Order

Buyers Sellers
Trader Order Size Limit Price Limit Price Order Size Trader

Abrar 100 100.00 130 1,000 Salah

Elias 200 100.00 140 1,500 Senai

- - - 150 1,000 Kemal

- - - 150 1,000 Sissay

Table 16 Snapshot of the LOB after Roman’s Order

Buyers Sellers
Trader Order Size Limit Price Limit Price Order Size Trader

Abrar 100 100.00 140 1,000 Senay

Elias 200 100.00 150 1,000 Kemal

- - - 150 1,000 Sissay

Seeing the market price jump from Birr 120 to Birr 140 in a short span of time, other traders who
desire to place buy orders may place limit orders with prices higher than that of the best order on
the buy side. Let us assume that Guta places a buy order for 500 contracts at Birr 110 followed
by Abay who places a buy order for 1,500 contracts at Birr 115. The LOB will then look as shown
in Table 17.

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Table17 Snapshot of the LOB at the End

Buyers Sellers
Trader Order Size Limit Price Limit Price Order Size Trader

Abay 1,500 115 140 1,000 Senai

Guta 500 110 150 1,000 Kemal

Abrar 100 100 150 1,000 Sissay

Elias 200 100

As you can see, Elias’s order has been pushed back in the queue. There is no way of telling as
to when it will get executed or whether it will get executed at all. On the other hand, if Elias had
placed a market order at the outset, it would have immediately been executed at a price of Birr
125.

The advantage with a market order therefore is that execution is guaranteed, provided there
exist enough limit orders on the other side of the market. The problem, however, is that the trader
has no control over the execution price, for the trade will get executed at the limit price of the limit
order with which it is matched.

3. Marketable Limit Order

The odds of a limit order being executed on submission would depend on the limit price that is
specified by the trader. For a buy order, the higher the limit price, the greater is the chance of
early execution. Similarly, for a sell order the lower the limit price the greater the possibility of early
execution. Limit buy orders with high limit prices and limit sell orders with low limit prices are said
to be aggressively priced.

In most cases a limit buy order will be placed at a price that is lower than the best price available
in the market which is the price of the best sell order in the LOB. Similarly a limit sell order will
usually be placed at a price that is higher than the price of the best buy order in the LOB. However,
at times a trader could price his limit order very aggressively.

A marketable limit order by definition is a limit order that can be executed upon submission. Let
us take the case of the following LOB.

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Table 18 Snapshot of an LOB

Buyers Sellers
Trader Order Size Limit Price Limit Price Order Size Trader

Admassu 1,500 100 125 1,300 Paulos

Sherefa 1.000 99 140 1,200 Ahmed

Moges 1,500 90 150 1,500 Kemal

A limit buy order with a limit price of Birr 125 or more will be executed as soon as it enters the
system, as will a limit sell order with a limit price of Birr 100 or less. Thus, the limit price for a
marketable limit buy order must be greater than or equal to the best offer that is available.
Similarly, the limit price of a marketable limit sell order must be less than or equal to the best bid
that is available.

Activity

A marketable limit order seems to be fairly similar to a market order. Why then would a
trader prefer to use such an order instead of a conventional market order?

Commentary

Both market and marketable limit order embody a desire for quick execution on the part
of the trader. However, while in the case of a market order a trader has no control over
the execution price, in the case of a marketable limit order he can prescribe a price
ceiling or a price floor depending upon whether it is a buy or a sell order. The freedom
to specify a floor or a ceiling for the price can acquire significance if circumstances were
Lettous
preclude
go backatomarketable limit
the situation order from
depicted getting
in Table 8.18executed
Assume as planned.
that a trader named Samson issues
a limit buy order with a limit price of Birr 130 for 300 contracts. His expectation at the time of
issuing the order is that it will be matched with the best offer on display, which in this case is at
Birr 125. However, it may so happen that another market order manages to enter the system
before Samson’s order. For instance, let us assume that a large market buy order for 3,000
contracts comes in before Samson’s order. It will push the trade price up to Birr 150. Since
Samson has specified a price limit of Birr 130, his order will not get executed under the
circumstances. Instead, it will go to the top of the buy side as the best bid.

If Samson were to think that although the speed of execution is a major factor, the execution price
is not inconsequential, then issuing a marketable limit order would make sense. For, had he issued
a market order instead in this case, he would have ended up buying 300 contracts at Birr 150, an
outcome that he may not have desired. Thus, the marketable limit order gives the trader control
over the execution price. But there is a corresponding cost because a limit order, whether
marketable or not, always exposes the trader to execution uncertainty.

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4. Stop-Loss order
Stop-loss buy orders are placed above the current market price and stop-loss sell orders are
placed below the current market price. A trigger price is also specified to allow the system to
activate stop loss order once the last traded price breaches the trigger price.

A Stop or a Stop-Loss order will be placed by a trader who has a position in the market and would
like to cut his losses and quit immediately, if conditions were to turn adverse. Such a person may
have no desire to close out his position at the time of placing the order. Stop-loss buy orders are
placed above the current market price and stop-loss sell orders are placed below the current
market price. A trigger price is also specified to allow the system to activate a stop loss order once
the last traded price breaches the trigger price.

For instance, a trader may be long in a particular futures contract and may be expecting that the
futures price will rise. However, in the event of a sudden unanticipated decline in the market, he
may like to ensure that his loss does not exceed an acceptable level. Let us assume that the
threshold loss in his opinion corresponds to a price of p*. In such a case, he can specify a stop
order with an attached trigger price of p*. The stop instruction will prevent the order from getting
activated until and unless the trigger is hit or breached. Once the trigger is hit or penetrated, the
order will get triggered off and will become a market order.

Advantages and disadvantages of Stop Loss orders

The advantage of a stop loss order is that any sudden adverse movement in the market can limit
losses to a great extent. The disadvantage is that the stop price could be activated by a short-
term fluctuation in the price. The solution is to choose a stop loss percentage that factors in a day-
to-day fluctuation while preventing as much downside risk as possible.

Once the trigger price is reached, your stop loss order becomes a market/limit order, the price at
which your sell may be much different from the stop price. This is especially true in a fast-moving
market where prices can change rapidly.

Illustration
Assume that the LOB at a point in time looks as shown in Table 4.19. Petros, a trader has taken
a long position in 800 contracts. He has no desire to offset, for he expects a further rise in the
futures price. However, he has in mind a threshold price of Birr 599.60 and if the market were to
trade at that level or below, he would like to exit it immediately. In this case, Petros can place a
stop sell order with a trigger price of Birr 599.60.

Assume that a market sell order for 4,000 contracts comes in. It will ensure that Abebe’s,
Abdella’s, Araya’s, Aysiha’s and Diguma’s orders are fully filled. The last trade price will be Birr
599.25, which is less than the trigger of Birr 599.60 specified by Petros. This will immediately
cause Petros’s order to get activated and it will enter the system as a market sell order. In this
case it will be executed at Birr 598.00.

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Table 19 Snapshot of a LOB prior to the Placement of a Stop Sell Order

Buyers Sellers
Trader Order Size Limit Price Limit Price Order Size Trader

Abebe 1,200 600.00 600.20 500 Gebre

Abdella 1,000 599.85 600.30 1,000 Mohamed

Araya 500 599.75 600.35 500 Abraham

Aysiha 800 599.55 600.40 700 Mussie

Diguma 500 599.25 600.50 300 Seifu

Eyasu 1,000 598.00 602.00 1,000 Alem

The trigger price specified in the case of a stop sell order will always be less than the best price
that is available at the time of placing the order, which in Petros’s case was Birr 600.

Stop-loss orders can also be placed by traders who wish to take long positions in the event of
adverse market conditions. For instance, assume that Kidane has a short position in 800
contracts. He expects the market to fall further. However, if there were to be a rise in prices and
hit or cross Birr 600.50, he would like to offset and exit the market immediately.

Let us assume that Kidane places a stop-buy order with a trigger price of Birr 600.50. Now
suppose that a large market buy order for 3,000 contracts enters the system. It will ensure that
Gebre’s, Mohamed’s, Abraham’s, Mussie’s, Seifu’s, and Alem’s orders are filled. The last trade
price will be Birr 600.50 which corresponds to the trigger specified by Kidane. His stop order will
immediately get activated and will become a market buy order which in this case will get executed
at a price of Birr 602.00.

Once again Kidane intended to control his losses. However, since he had a short position to start
with, the trigger point in this case Birr 600.50, was greater than the best price available in the
market at the time of placing the order, that is, Birr 600.20. Since such orders enable traders to
control the potential loss in the event of an adverse market movement, they are termed as stop-
loss orders.

What is a trailing stop loss Order?

Stop loss orders can be used to lock in profits, in which case it is sometimes referred to as a
trailing stop. The most basic technique for establishing an appropriate exit point is the trailing stop
technique. Very simply, the trailing stop maintains a stop-loss order at a precise percentage below
the market price (or above in the case of a short position). The stop-loss order is adjusted
continually based on fluctuations in the market price always maintaining the same percentage
below (or above) the market price. The trader is then "guaranteed" to know the exact minimum
profit that his position will garner.

156
Here the stop-loss order is set at a percentage level below not the price at which you bought at
but the current market price. The price of the stop loss is adjusted as the commodity price
fluctuates. Using a trading stop allows you to let profits run while at the sometime guaranteeing
at least some realized capital gain.

Activity 5

Assume that you have an existing open long position of the contract of gold futures
which you had bought at Br 820,000 (each contract is of kg) if you want to limit your
loss to Birr 5,000 what would be your stop-loss sell order and what would be the trigger
price?

A stop-loss sell order would be Birr 8,150 per 10 gm with the trigger price of Birr 8,151
per 10 gm.

Activity 6

How long is an order valid for? What are the different validity instructions that a trader
can specify?

In his quest to find a suitable match, a trader can specify a validity instruction to indicate
the period for which he wishes his order to remain valid. In principle, such instruction
can be specified for any kind of order. They are however particularly important for limit
orders and stop orders. This is because such orders will usually not trade on
submission and many such orders will stay in the system for long periods. Some of
these orders may eventually never trade.
7.8.3 Time-Related Condition Orders

Day Orders (or End of Session Order)

Day orders are available for execution during the current trading session. They remained in the
system until executed or cancelled. All day orders will get cancelled at the end of the trading
session during which such orders were submitted. Every morning therefore, the system will start
with a clean slate with no backlog of orders from the previous day.

Good Till Cancelled Orders (GTC)

Such orders remain in the system until they are explicitly cancelled by the trader. Thus if they are
not executed by the close of trading on a given day, they will automatically be carried forward to
the next business day. However, an order cannot remain in the system forever. Consequently, the
exchange will notify a maximum period of time after which if such order were to remain
unexecuted, they would automatically be cancelled. In order to ensure that a trader does not lose
track of his unexecuted orders, many brokers periodically provide their clients with a list of unfilled
orders. Sometimes, a broker may automatically cancel such an order at the end of a pre-specified

157
time period, without waiting for an explicit instruction to do so from the client. This is done to avoid
the administrative costs involved in constantly monitoring stale orders.

Good Till Date Orders (GTD)

GTD order is available for execution till the end of the date indicated in the order. In such cases,
the trader can specify a period for which he desires the order to remain valid. The implicit
instruction is that the order ought to be cancelled if it is not executed by then. The length of the
period specified by a trader cannot obviously exceed the maximum length of time for which good
till cancelled orders can stay in the system. There are various types of such orders, such as Good-
this-week (GTW) and Good-this-month (GTM) orders.

Immediate or Cancel Orders (IOC)

IOC order has to be executed as soon as it is released into the system, failing which it stands
cancelled. Sometimes, due to the unavailability of a sizeable order on the other side, only a partial
match may be found in which case a part of the incoming order will be executed and the unfilled
portion will be cancelled. In some markets, such orders are known as Fill-or-Kill (FOK) or Good-
on-sight orders.

Spread order
A spread order is essentially a combination of two orders, one to buy an instrument and the other
to simultaneously sell another instrument. For instance, an order to simultaneously go long in
February 2004 futures contracts and short in March 2004 futures contracts on the same company
would constitute a spread order.

A spread order can be a market order or a limit order, the trader has to specify a limit for the
acceptable difference between the two prices. This limit has to be specified as a premium to either
the buy side or to the sell side. For example, if the trader wants to sell a higher priced security
and buy a lower priced security, then the premium will be on the sell side. Such an order can be
filled only if the difference between the sale and purchase prices of the two contracts is greater
than or equal to the specified limit. On the other hand, if the trader wishes to buy a high priced
security and sell a low priced security, then the premium will be on the buy side. Such an order
can be filled only if the difference between the purchase and sale prices of the two contracts is
less than or equal to the specified limit.

Modification and Cancellation of Orders

A Member is permitted to modify or cancel his orders. The order can be modified by effecting
changes in the order input parameters. Time priority for an order modification will not change due
to a decrease in its quantity or a decrease in disclosed quantity. In other circumstances, the time
priority of the order will change. It may be noted that a trade has been executed on behalf of the
client of the member and if the wrong client code has been entered by the member, the client
code of the trade executed can be changed. This is permissible only up to 15 minutes after the
end of the day's trading session.

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Order priority rules in open-outcry systems
The first rule that is expected to be followed by all traders is the open-outcry rule. That is a trader
who wants other people to respond to his intention to trade, must first publicly express his bid or
offer by shouting out aloud. Once a person shouts out an order any trader standing in the pit can
respond to it. Often traders take turns in making bids and counter offers and offers and counter
bids before they ultimately agree upon a price and quantity. The first person who accepts a bid or
an offer gets to trade with the trader who has made the corresponding bid or offer.

The primary order precedence rule is based on price priority. That is a buyer can only accept the
lowest offer and a seller can only accept the highest bid. Such a rule is self-enforcing in practice
since a buyer will always look for the lowest price while a seller will always search for the highest
price.

To prevent inferior quotes from adding to the noise and confusion, most open-outcry systems will
not allow a trader to bid below the best bid that is currently available or offer above the best offer
that is currently available. Consequently, any trader who wishes to acquire priority must either
improve upon the best bid by bidding higher or improve upon the best offer by offering at a lower
price.

In most oral auctions, a floor time preference rule is used. That is priority is given to the trader
who was the first to bid or offer at a given price that improved upon the previous bid or
offer. As long as this trader is enjoying time preference no other trader is allowed to bid or offer
at the same price. Of course, another trader can always gain priority by bidding higher or offering
at a lower price, this rule encourages price competition among traders. For if a trader is
aggressive the only way that he can get ahead of someone who already has time preference is
by improving upon the price.

The time preference rule, unlike the price preference rule, is not self-enforcing. For, from the
standpoint of a potential counter-party, it is immaterial as to whose bid or offer he is accepting, as
long as he is getting the best possible price. Consequently, a trader who has acquired time
preference may have to vocally defend it. That is if someone else were to bid or offer at the same
price, he will have to shout out, “That’s my bid” or “That’s my offer”, to ensure that he continues
to enjoy priority.

The difference between the floor time preference rule and the strict time preference rule followed
by electronic systems is that in an oral auction, once a trade is consummated at a particular price,
anyone may bid or offer at that price, and all orders at that price will have equal priority. In contrast,
the strict time preference criteria rank orders at a given price strictly under the time of submission.
It must also be remembered that in an oral auction a bid or an offer is valid only momentarily. A
trader who wishes to maintain his priority must shout out his order periodically in order to convey
that he continues to be interested in trading. Once a bid or an offer is accepted by a counter-party,
the resulting trade will take place at the price proposed by the trader whose quote was accepted.

159
Summary
This unit covered trading operations focusing on the trading cycle, margining, marking to the
market and orders. Margins are used as a means to risk management to ensure performance of
financial obligations arising out of the transaction and avoid the possibility default. An order is a
trade instruction given to a broker or an exchange. The order can be a market order or a limit
order. A market order will be executed at the best available price from the standpoint of the trader.
A limit order will be executed when a counterparty is willing to trade at the price offered. Two
priority rules are used to sort limit orders. The first is called the price priority rule. According to the
price priority rule, a limit buy order with a higher limit price ranks higher than all other limit buy
orders with a lower limit price. Similarly, a limit sell order with a lower limit price ranks higher than
all other limit sell orders with higher limit prices. According to the time priority rule, when two limit
orders are the same, the order which comes in first is automatically accorded priority. Besides,
this unit addressed the method for determination of stop loss price and trigger price. Stop-loss
buy orders are placed above the current market price and stop-loss sell orders are placed below
the current market price. A trigger price is also specified to allow the system to activate a stop loss
order once the last traded price breaches the trigger price.

Self-Check Exercise Questions

1. Identify the necessary information that an order should consist of.
2. Describe how order matching takes place using the two order priority rules.
3. Identify and describe the different types of time-related condition orders.
4. Assume that you have an existing open short position of a futures contract of gold which
you had sold at Br 8,200 per 10 gm. The total value of one gold futures contract at the
sale price is Br 820,000/kg. What would be the stop-loss buy order and the trigger price if
the maximum loss that the trader is willing to bear is Birr
5. Match the numbers in the Action-Condition matrix below with different orders (Limit buy
order, Limit sell order, stop loss sell order and Stop loss buy order).
Condition
Price below the limit Price above the limit

Sell I II
Action
Buy III IV

160
Summary
This chapter presented a wide range of issues including trading parameters, maintenance margin,
and variation margin, marking to the market, and the methodology for computing the margin
amount using VaR. The chapter discussed the meaning and purpose of margining. Margin is a
collateral deposit used as a performance guarantee just in case a trader defaults. The chapter
also presented the concept of marking to market (MTM). The term Marking to Market refers to the
process of calculating the loss for one party, or equivalently, the corresponding gain for the other,
at specified points in time, with reference to the futures price that was prevailing at the time the
contract was previously marked to market. In practice, when a futures contract is entered into, it
will be marked to market for the first time at the end of the day. Subsequently, it will be marked
to market every day until the position is either offset or else it itself expires. A member has to
deposit an initial margin for the purpose of marking to the market on daily basis. When the initial
margin amount falls below the maintenance margin due to adverse price movement, the member
is expected to deposit a variation margin.

Self-Assessment Questions
1. Who pays the margin? The long or the short trader. Besides, discuss the purpose of
margining.
2. Explain the meaning of marking to the market with its implications.
3. Identify the various types of margins and explain their meaning.

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UNIT 8: FUNDAMENTAL AND TECHNICAL ANALYSIS

Learning Objectives
Upon completion of this unit, a student will be able to:
• Explain the importance of market analysis for trading decisions
• Discuss the importance of fundamental analysis
• Describe the sources of information needed for fundamental analysis
• Explain the importance of technical analysis
• Describe the four types of charting methods
• Discuss the various tools used for interpreting charts

8.1 Trading Decision

Knowing about the markets and deciding to trade is a big step for an aspiring trader. Every trader
is faced with a greater question: How do I make a trading decision? This chapter presents an
overview of some of the techniques used today to analyze markets so you can make sound
trading decisions. Trading decisions are a function of many factors including time frame, objective
versus subjective trading perspectives, and fundamental versus technical analysis techniques.

Time Frame

Market forecasts can look quite different for different periods. Your final analysis should always
keep this in mind. Consider two points about differences in time frames:

1. In general, shorter time frames will tend to have more random movement, often called “noise.”
Some traders are able to make the noise work to their advantage, while others would rather
focus on the bigger trends. Still others may do well considering both the trees and the forest.
As mentioned before, one of your tasks early on should be to determine which time frames
you are most comfortable trading.

2. Whichever time frame works best for you, you may find value in keeping an eye on other
nearby time frames. A famous phrase in recent years has been the “three-screen method” of
trading. This simply refers to a principle of drilling down the market analysis from broad to
specific, looking at weekly, daily, and hourly charts, for instance. Studying multiple time frames
can give context to the events in any particular time frame.

Subjective versus Objective

In addition to the time frame, central to the matter of making a trading decision is the issue of art
versus science. Different analysts will interpret the same information in different ways. Chart
readers may see and trade the exact same patterns in very different ways. This fact does not
necessarily invalidate the usefulness of forecasting; instead, it points out the influence of
individual subjectivity in analysis.

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The figure bellow shows a basic channel pattern. How might different trading styles approach that
same pattern?
• Momentum traders might buy on strength near each new high and suffer a series of small
losses until the final actual breakout to new highs.
• Range traders, on the other hand, will do just the opposite, selling on rallies to the upper
band because they expect the channel to remain intact.
• Breakout traders will buy as the market moves above the channel (or above previous
highs), betting an upward move is about to begin. Others will count waves within the
channel in an attempt to predict when the market will switch from channel to breakout.
• Trend followers who bought earlier may remain long the entire time with an exit stop
placed below the channel.

Coffee weekly chart: price channel. Different traders approach the same data in different ways.

Activity 1

Do you suggest subjective or objective analysis for a better understanding of the

market? Why or why not?

Commentary

The most that can be said may be that different methods work best at different times.
You shouldn’t be too surprised at the abundance of viewpoints on how to make a
trading decision. After all, the wealth of opinions as to the best course of action is
what makes a market. To get around this subjectiveness, certain traders, called
systems traders, quantify the buy/sell rules and back-test the results. They seek an
objective set of rules that profit over time.

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8.2 Fundamental Analysis versus Technical Analysis
There are two approaches to futures price forecasting. The first involves evaluating the supply of
and demand for the actual commodity, on the premise that a short supply or high demand will
cause prices to rise, and vice versa. This approach is called fundamental analysis. The other
major school of thought is referred to as technical analysis. The pure technical analyst disregards
any information about the supply of and demand for the actual commodity. He focuses his
attention instead on the futures market itself, on the assumption that no matter what the
fundamentals portend, the effects will show up in the behavior of price, trading volume, and open
interest.

The classic description of fundamental analysis is that it examines the supply and demand factors
influencing a market’s price. The classic relationship between supply, demand and price is shown
in the figure below.

Supply

Demand

Price

But those factors differ wildly from market to market. The factors affecting coffee are quite different
from those affecting wheat, pea beans, or sesame. So, as a practical matter, the fundamental
trader becomes an expert in a particular market. For this reason, fundamental analysis is
sometimes considered to be old-school, perhaps because the most learned experts on a given
market are those who have studied it the longest.

Weather is considered a fundamental event and plays an important role, even in markets you may
not suspect would be influenced by weather. For instance, bad weather can depress consumer
spending, and some traders become mini-experts in the severity and timing of weather events
affecting their chosen markets.

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Like weather, other dominant macro fundamentals can affect multiple markets - for example,
economic conditions may dampen overall demand. For the most part, however, fundamental
analysis is concerned with the news and events unique to each market.
In contrast, technical analysis is the study of price action, with no regard given to the news and
events that lead to that movement. The idea is that the best interpretation of underlying news is
already reflected in the price. Unlike fundamental analysis, charting techniques can be applied
across many different markets and tend to be more widely used by traders. Even fundamental
traders will often consider the technical to determine the timing of their trades.

8.3 Fundamental Analysis Highlights

Fundamental analysis is the study of basic, underlying factors that will affect the supply of and
demand for and therefore the price of a commodity. In theory, it is quite simple. When the supply
of a commodity becomes scarce, the price goes up. When it is plentiful, the price goes down.
Unfortunately, it doesn’t always work this way. For example, some of the toughest factors to
accurately quantify are those of supply and demand. How much of a given commodity is enough?
Where is it, and is it in a usable form? Agricultural commodities illustrate this point very well
because most people are familiar with them and because they are very responsive to supply and
demand factors. To make an accurate price projection for maize, for example, here’s what you’d
need to know for a given crop year: existing stocks (on-farm and commercial inventory),
production (projected acres/yields), and usage (food, feed, and seed). This sounds much easier
than it is.

Smart Trader Tip

Every significant commodity price move in the history of commodity trading has been
rooted in fundamental factors. Unless there is a true shortage or surplus of the actual
commodity, unusually low or high prices cannot be maintained.

First, keep in mind you’re doing this on a global basis, and many of the countries from which you
need vital information will be uncooperative. The developed countries may share only the
information that suits their side of the supply-demand equation. If they expect to be maize buyers,
they might provide inflated figures on the supply they have on hand or expect to produce. Their
objective is to drive prices down. Undeveloped countries may do the same thing, or they may not
have an established infrastructure to gather, process, and evaluate what information they have
on their crop.

As you attempt to piece together all the facts on production and usage, you quickly come to the
conclusion that much of the information is unreliable for a variety of reasons. With agricultural
products, the weather is always a major uncertainty. Too much or too little rain, even over a short
time, can drastically impact prices. Other groups of commodities are equally influenced by
seemingly uncontrollable factors that are virtually impossible to predict. It is important to note that
the accuracy of fundamental analysis often hinges on fast-changing information, much of which
is not easily obtained, nor can it always be accurately interpreted.

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Supply is rather straightforward, although it can be subject to frequent revisions. It is the quantity
of a commodity available calculated by combining the stocks carried over from one season (or
one week/month) to the next with new production and, in some cases, imports from overseas.

Supply-Demand Equation
• Existing stocks
• Plus production
• Less usage
• Equals supply

Fundamental analysis is based on an analysis of the comparative strength of the opposing forces
of supply and demand. If supply exceeds demand, prices usually decline. If demand outstrips
supply, prices usually rise.

Smart Trader Tip

The supply of a commodity comprises imports, current production, and any carryover from
previous years. Consumption is the sum of domestic use and exports.

Demand is generally more difficult to quantify. The term used to indicate demand really should be
usage or consumption. Demand may be greater or less than actual consumption. Demand
depends on price: How badly do consumers or the marketplace want the available quantity of this
product at this price?

Smart Trader Tip

The fundamental analyst tries to estimate how much of the commodity will be around in the
coming months and how much demand there will be for it.

Traders rely on some government, corporate, and private events and reports to get a reading on
the key factors that influence prices. Some of the reports are considered to be leading indicators,
some coincidental indicators, and some lagging indicators, depending on the data inputs
necessary to calculate them and how they relate to current conditions.

The following pages provide descriptions of just some of the major news events and reports
watched by fundamental traders. These reports deal primarily with and in addition, the exchanges
sometimes offer extensive background resources for their respective products or links to websites
where you can find more detailed information.

Consumer Confidence Markets are just a reflection of mass psychology, so anything that
provides clues about investor sentiment can be a good indicator of price direction. The readings
on consumer confidence markets may suggest how much money will be spent by consumers,
who account for a large share of the economy, or how likely they will be to invest in the stock
market or housing.

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Retail Sales Comparison figures tell traders how well consumers are doing and how the current
situation relates to previous periods.

Gross Domestic Product This is the broadest measure of all economic activity in a nation and
indicates overall economic growth—or lack of it. How vibrant the economy is will have an effect
on almost all markets.

Employment Situation Nothing provides a better indication of how much consumers might
purchase and how strong the economy is than how many people are working or how many people
are unemployed. Monthly employment reports have become a significant market mover in recent
years as the economy adjusts to trends in outsourcing and downsizing.

Consumer Price Index, Producer Price Index These indexes measure price levels of various
goods and services and generally are considered to be the best gauges of the inflation rate, which
often has a bearing on interest rates. Analysts examine components of these reports to see how
current levels compare with previous levels.

Crop Production updates of production estimates released often set the tone of the market for
the month ahead. Some reports are only projections, but other reports during the growing and
harvesting season provide survey-based estimates of yields and the size of the crop.

Stocks in All Positions In addition to the year-end stocks figures, countries also announce
estimates for the amount of stocks on farms and off farms each quarter. This provides an important
measure of usage as the season progresses.

How Do You Do Fundamental Analysis?

For years, number crunchers have attempted to quantify supply and demand statistics.
Statisticians have tried linear and nonlinear regression analysis, double exponential smoothing,
probability and trigonometric curves, multivariable analysis, and just about every other technique
they could think of. Hopes were raised with the advent of computers. The Wharton School of
Business and Chase Manhattan Bank were two well-known leaders in the field of econometric
modeling. Their models were sophisticated computer programs that attempted to account for just
about every variable affecting price. However, to date, fundamental analysis has not been
particularly successful in day-to-day trading of the futures markets for three reasons:
(1) Projections have been marred by unexpected events.
(2) Variables never seem to be taken into consideration. One or more critical ones always
seem to be missing (or misinterpreted) after the projections are made.
(3) This type of analysis is long-term in nature, while most futures trading tends to be short to
medium-term.

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Activity 2

Evaluate the extent to which fundamental analysis is an effective tool to understand the market.

Commentary

Traders have found fundamental analysis very effective. They often use a particular aspect,
weather, for example, to make projections. These are traders who take long-term approaches
to the market. More often than not, the traders who use it do so by combining it with technical
analysis. Fundamental analysis can provide an overview and the long-term trend. Technical
analysis is used to signal the short-term entry and exit points. Since fundamental analysis
deduces its conclusion from external or underlying factors influencing supply or demand, it is
unique to each commodity.
Smart Trader Tip
You have to be able to make comparisons between today’s situation and prior
situations—to see, for example, where prices were the last time these particular supply
and demand conditions prevailed.

Economic Fundamentals
In the Ethiopia economy, the matters to be considered in the first place are the behavior of the
weather and the performance of agriculture. As agriculture is the mainstay of more than 85% of
the population and contributes large share of the output of the economy, it is important for the
assessment and forecast of industrial performance. If the monsoon is good and agricultural
income rise, the demand for industrial products and services will be good and industry prospers.
Secondly, the public sector plays a vital role in Ethiopia. The Government being the biggest
investor and spender, the trends in public investment and expenditure would indicate the likely
performance of the Ethiopia economy.

Concomitant with this, the government budget policy, tax levies and government borrowing
program along with the extent of deficit financing will have a major influence on the performance
of the Ethiopia economy, as these influence the demand and income of the people. The changes
in excise and customs duties, corporate taxes, etc. are all relevant to assess the trends in the
economy as they have an impact on the industry and the companies.

Thirdly, the monetary policy and trends in money supply which mainly depend on the
government’s budget policy, it’s borrowing from the public and credit from the banks have a major
impact on the industrial growth through the cost and availability of credit, the profit margins of the
companies etc. The monetary situation along with the budgetary policy influences the movement
in price level (inflation) and interest rates. The tight money position, increasing budget deficits and
creation of currency lead to an inflationary spiral. Interest rates in the free markets and the degree
of inflation do have a major influence on the economy and the performance of the industries.
Although a mild inflation is good for business psychology, higher degrees of inflation, particularly
in two digits, will defeat all business planning, lead to cost escalations and squeeze on profit
margins. These will adversely affect the performance of industry and companies.

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Fourthly, the general business conditions in the form of business cycles or the level of business
activity to influence the demand for industrial products and the performance of the industry. In
Ethiopia, it seems business cycles is every 10 years based on weather conditions but outputs do
fluctuate depending upon the state of the economy, performance of agriculture, availability of
power and other infrastructural outputs, imported inputs and a host of other factors. These factors
do influence the costs and profit margins of companies from both demand and supply sides. The
business earnings and profits are affected by such changes in business conditions.

Fifthly, the economic and political stability in the form of stable and long-term economic policies
and a stable political system with no uncertainty would also be necessary for a good performance
of the economy in general and of companies in particular. The Government regulations being all-
pervasive, government policy has to be known in advance in all its aspects and there should be
no uncertainty about the political system as economic and political factors are interlinked. Political
uncertainties and adverse changes in government policy do adversely affect industrial growth.
The foreign exchange position and the balance of payments situation at any time would also
indicate the rigors of government policy with regard to imports, exports, foreign investment and
related matters.

Industry Analysis
At any stage in the economy, there are some industries which are growing while others are
declining. The performance of companies will depend among other things upon the state of the
industry as a whole and the economy. If the industry is prosperous, the companies, within the
industries may also be prosperous although a few may be in a bad shape. At any point to time,
there may be industries which are on the upswing of the cycle called sunshine industries and
those which are on the decline called sunset industries. The industrial position not only depends
upon the economic growth but on the nature of the industry itself. Within the industry the factors
that have to be taken into account are:-

a. Industry Life Cycle: The position of the industry in the life cycle of its growth. Typical industry
life cycle might be described by four stages:
Start-up stage – characterized by extremely rapid growth. At this stage it is difficult to
predict which firm will emerge as industry leaders. Some firms will turn out to be wildly
successful and others will fail altogether. Therefore, there is considerable risk in selecting
one particular firm within the industry.
Consolidation Stage- characterized by growth that is less rapid but still faster than that
of the general economy. After a product becomes established industry leaders begin to
emerge. The survivors from the start stage are more stable, and market share is easier to
predict. Therefore, the performance of the surviving firms will more closely track the
performance of the overall industry.
Maturity stage- characterized by growth no faster than the general economy. Firms at
this stage sometimes are characterized as cash cows, having reasonably stable cash flow,
but offering little opportunity for profitable expansion. The cash flow is best “milked from”
rather than reinvested in the company.

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Minimal or negative growth stage- the industry grows less rapidly than the rest of the
economy or shrinks. This could be due to obsolescence of the product, competition from
new products, or competition from new low-cost suppliers.

b. Business Cycle and industry characteristics

Whether the industry is cyclical, fluctuating or stable, has to be looked into first, as the
prospects for growth will depend on this to an extent. If the demand is seasonal as in the case
of fertilizers, pesticides, etc., their problems may ruin the growth prospects. The nature of the
industry would thus be an important factor for determining the scale of operations and
profitability. The growth prospects would depend on raw materials, and easy access to inputs,
particularly power, transport and other infrastructural facilities.
Some industries move closely with the business cycle, outperforming the average industry in
good times and under-performing it in bad times. Investors in analyzing industries should be
aware of these relationships.

Here are some types of industries based on their responsiveness to changes in the business
cycle:-
Growth industries- earnings are expected to be significantly above the average of all
industries, and such growth may occur regardless of setbacks in the economy.
Defensive industries - Industries least affected by recession and economic adversity
Cyclical industries- are the most volatile-they do unusually well when the economy
prospers and are likely to be hurt more when the economy flatters.
Countercyclical industries - move opposite to the prevailing economic trend.
Interest-sensitive industries- are practically sensitive to expectations about changes in
the interest rates.

c. Industry Competition
The nature of the competitive conditions existing in an industry can provide useful information
in assessing its future. Is the industry protected from the entrance of new competitors as a
result of control over raw materials, the prohibitive cost of building plants, the level of production
needed to operate profitably, and so forth?

d. Raw Material and Inputs

Under this head, we have to look into industries depending on imports of scarce raw materials,
competition from other companies and industries, the barriers to entry of a new company,
protection from foreign competition, import and export restrictions, etc. An industry which has
a limited supply of materials domestically and where imports are restricted, for example, will
have dim growth prospects. Labor is also an input and industries with labor problems may have
difficulties in growth.

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e. Capacity Installed and Utilized
The demand for industrial products in the economy is estimated and the units are given
licensed capacity on the basis of these estimates. If the demand is rising as expected and the
market is good for the products, the utilization of capacity will be higher. If, however, the quality
of the product is poor, competition is high and there are other constraints to the availability of
inputs and there are labor problems, then the capacity utilization will be low and profitability will
be poor.

f. Demand and Market

The demand for the product should be expanding and its price should not be controlled by the
government, if the industry is to have good prospects of profitability. If the demand is income-
elastic and price-elastic, the supplier should be able to sell the goods at a growing rate and the
prospects of growth are good. It is also important that the prices of raw materials and other
input costs like freight, electricity, etc. should not be controlled by the government. The demand
should also be growing and there should be export demand for the product. If the nature of the
product is such as drugs, fertilizers, or other consumer goods, whose price and distribution are
controlled by the government, the growth prospects would be less.

g. Government Policy about Industry

The policy can also be seen from the strategy as laid down in the five-year plans and
importance given to the industry and the expected demand in the economy. The Plan priorities
for the industry, the physical and financial targets of investment and foreign collaboration in
that industry are important variables affecting its fortunes. The government has powers of
control over industry in terms of output, price and distribution of the product and a number of
other aspects. The government policy with regard to granting of clearances, installed capacity
and reservation of the products for small industry, etc. are also factors to be considered for
industrial analysis.

8.4 Technical Analysis

Technical analysts study market indicators and chart patterns to forecast the markets. Technical
analysis is considered to be both an art and a science. This chapter will focus more on the science
part of the story and will leave the art side for you to ponder from your own experiences. Many of
the tenets of technical analysis were first put forward by Charles Dow at the turn of the twentieth
century, and from his general observation, modern-day technical analysis was born.

9.4.1 DOW THEORY

Charles Dow (1850–1902) was the founder of The Dow Jones News Service as well as the first
editor of the Wall Street Journal. As the editor, Mr. Dow wrote articles for the Journal based on his
observations of the stock market. He was the first to use the term “Dow Theory” and William Peter
Hamilton and Robert Rhea formalized Dow’s work into rules that are still in use today as the Stock
Market Barometer.

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Charles Dow built an index that was made up of the major industrial companies of the day. His
thinking was that by following the “right” stocks you could create a barometer of the business
trends. He later developed the Dow Jones Railroad Averages comprised of 20 issues. The
thinking was straightforward and made all the sense in the world. The industrial companies that
he first worked with “made” the goods that ran the economy, but it was the rails that delivered
those goods to the public that enabled the sales to take place. The rail acted as a double check
on the industrials. Therefore, a fully engaged bull market would have both the industrials and the
rails traveling in the same directions and making new highs together. On October 7, 1896, for the
first time The Wall Street Journal began publishing a piece called the “Daily Movement of
Averages” and ran an average price for both the 12 industrials and the 20 railroads.

Dow’s Principles
1. Closing price: Dow had a number of principles, but the most important was that closing
prices reflect the sum total of all investors’ current feelings towards the market. Outside of
the acts of God, like wars or earthquakes, etc., the collective thinking of investors is shown
in today’s closing price. In other words, it is price that gives us knowledge. By the close of
the trading day, everyone who wished to make their feelings and analysis known has had
their opportunity to do so by purchasing or selling shares in the open market. Therefore,
the closing price of an exchange is, in theory, the sum of everyone’s outlook for that
instrument.

2. Stages of the market:

Charles Dow also believed that stocks had three phases of trends
a. Primary bull and bear stage, lasting over a year and setting the general directional
tone of the market
b. An intermediate phase lasting 4–6 months, which acts as contra moves to the longer
term move
c. A short-term phase, which was considered noise lasting a few days to a few weeks

As per Dow Theory, the major trends, namely, bullish or bearish trends have three phases.

The three phases of bullish trend are:

i. Accumulation phase: only select elite of investors who perceive the coming things
first start buying shares.
ii. Big move: the followers of trend notice a distinct uptrend and begin to participate in
the buying and then the mass buying starts.
iii. Excess -the end of the uptrend when the first elite group who initiated the first phase
should dislodge their shares for profit-taking.

The three phases of bearish trend:

i. Distribution phase- only select elite of investors who perceive the coming things
first start selling shares.
ii. Big move- the followers of trend notice a distinct downtrend and begin to participate
in the selling and then the mass selling starts.

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iii. Despair - the end of the downtrend, all hope is lost and stocks are frowned upon.

3. Confirmation: Mr. Dow stated that volume confirms price moves. If we look at this
statement from the standpoint of supply and demand, it is a very same belief found in
every economic textbook. If an asset is in demand by the public because it is felt that the
price will rise, then the volume being bought must increase to reflect that demand. Mr.
Dow felt, therefore, that an expanding volume pattern during a rising price trend was the
confirmation a trader wants to see for a strong product. Just as important, he also noticed
that during periods of normal retrenchments, the volume slowed. Although he looked at
volume as secondary to price, it was still an important part of his theory. He felt that if the
volume was expanded while the stock was in a decline, then that might be an indication
of a major top. He also felt that a rally without volume behind it was suspect. A price rally
would seem to suggest that there is positive thinking about a product, which should in turn
attract buyers. If, however, we witness a product lifting on low volume, we must assume
that the rally might not have a long life. Again, this is the basic rule of economics, which
states that the principle of supply and demand will dominate price action.

8.4.2 What is Technical Analysis

Technical analysts believe that the price of a contract reflects the impact of every single bit of
fundamental information known by anyone who can even remotely affect the price of the
commodity. Every fact that is known about supply, demand, and, most importantly, the psychology
of the public ends up on the price charts. Therefore, price action is the composite opinion of
everyone involved in the markets. The function of technical analysis is to determine through the
analysis of price change the probable strength of demand compared with the pressure of supply
on a product at various price levels and then to predict the direction, length, and velocity of the
next move.

The technical analyst deals with only three pieces of data:

1. price
2. trading volume and
3. open interest (for derivatives markets).
A technical analyst evaluates them to form an opinion on the likely direction of prices over the
next several days.

Smart Trader Tip

The complete analyst looks at the fundamentals to decide whether a significant price movement
is expected, and employs technical analysis to determine the most propitious time to enter the
market.

Exchanges announce four types of prices for each day’s activity in a contract:
1. opening price
2. high price
3. low price and
4. closing or settlement price.

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Of the four, the closing price is generally considered to be the most meaningful, as it represents
the day’s final verdict. In the simplest context, a rise in prices reflects growing demand for the
contract. If the trading volume increases when prices rise, it is a sign that there is interest in the
market—that the price increase is attracting followers. That’s a bullish trend. Rising open interest
would further strengthen the technical picture, as it would indicate that new buyers are entering
the market.

History Repeats Itself in Patterns and Formation

In the commodity markets, history does repeat itself. Past price action can provide clues about
future price action. On commodity price charts and indexes, price movements tend to repeat
themselves with remarkable consistency. You’ll learn that some patterns or formations indicate
that demand is greater than supply. Others suggest the reverse is true. And some imply that
supply and demand will remain indefinitely in balance.

This occurs for two reasons.

• First, technical analysis can be a self-fulfilling prophecy. It is self-fulfilling because so

many professionals use it. They all see the same patterns and often expect the same
results. Therefore, if enough of them act the same way to the same chart signal, the signal
fulfills its promise. This occurs regularly with the most common and widely known signals.

• Second, the market is anticipatory, and you can see price movement first in the charts.
For example, major buyers have been known to buy a commodity before they announce
a big grain deal. They enter the futures market to cover their cash sale. Therefore, the first
alert that something is about to happen often occurs on the futures price charts. Entering
the market causes a price movement before the fundamental facts are known.

Technical analysts are alerted in advance, before the fundamental information is public. Supply
and demand factors are still the prime movers, and yet technical analysis is the earliest indicator
of movement. If you use technical analysis, you don’t have to understand or acquire all the
fundamental information in the world in order to trade. The impact of all the activity affecting price
comes to you in the form of price movement. If you don’t understand what is causing the price
movement, you can exit the market until you do.

Activity 3

Is technical analysis foolproof for understanding the market and projecting price
movement in the future?

Commentary

There is no infallible system—technical or fundamental—for trading commodities in the

market. Chart signals, just like fundamental news, can be misleading. You don’t always
have to be right to enjoy trading commodities, but you need to have structure in your
approach to the markets. Technical analysis can give you that structure highlighting the
basic principles to follow. Since technical analysis is probably the only forecasting
technique an individual investor can utilize, it is important to know the most common
tools and signals. 174
8.4.3 The 10 Technical Analysis Trading Rules
1. When a trend is established, it is likely to continue.
2. The longer term the chart (15 minute, hourly, daily, weekly, monthly), the more reliable the
trend line.
3. The greater the volume of trading when a trend is established, the greater its significance.
4. In up-trending markets, when prices move too far too fast, trading volume decreases and
prices decline.
5. In down-trending markets, volume is higher when prices are declining than when they rally
as shown in the figure below.

6. Markets tend to give warnings before major trend changes occur.

7. If a market is in an uptrend, volume usually drops just prior to it reversing its direction as
shown in the figure bellow.

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8. Volume usually increases in down-trending markets, just before a reversal of trend.
9. Before they plunge through their trend lines, markets tend to test them by making shallow
penetrations. These dips are warnings of impending trend reversals.
10. The steeper the trend, the more unstable it is and the more likely a reversal of trend is
imminent.

The two most widely used and recognized approaches to technical analysis of commodity markets
are:

(1) Price charts

(2) Trend analysis

8.4.4 Charting
Price chart analysis involves finding chart formations or patterns that often repeat themselves,
such as reversals, support-resistance areas, head and shoulders, continuing formations, and
others. Trend analysis includes trend lines and moving averages. Technical analysis is the study
of price action but also includes a number of statistical indicators, as well as data on volume, open
interest, and other factors that relate to tracking prices. Technical analysis is considered to be
both an art and a science. This section will focus more on the science part of the story and will
leave the art side for you to ponder from your own experiences.

Types of Charts
First and foremost, technical analysis means charts, and traders use several different types of
charts, each providing a different view of prices. Which chart type and which technical indicators
you use often depends on the look and feel to which you have become accustomed. Whatever
you use, your chart should help you get some understanding of the market’s price history and
how past price action may provide clues about how prices may unfold in the future. The following

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charts all cover about four months of commodity prices. Note the information conveyed by each
and see which type of chart is most helpful to you.

8.4.4.1 Line Charts

We’ll start first with the line chart, not because it is the most popular but simply because it provides
the easiest explanation of basic chart construction. Figure 2 shows a basic line chart constructed
by connecting just the closing prices for periods without regard to other values for those periods,
such as highs or lows.

Coffee price Line daily chart. The closing value for each period is connected to the next, without
regard to other values for that period, such as the high or low.

8.4.4.2 Bar Charts

Bar charts include quite a bit more information than line charts with only a moderate increase in
the complexity or “busyness” of the chart. While a line chart shows only closing prices, bar charts
include the high and low prices for the period being viewed as well as the opening price and the
closing price. Figure 3 shows a daily bar chart with several sharp spikes up and down at critical
turning points and the channels that formed during trending periods. Each bar is drawn between
the high and low price for the period, and the open and close are indicated with the small hash
marks on the left and right side of the price bar, respectively. Such details were lost on the line
chart.
Again, as with any chart type, bar charts are used for many time frames, from weekly and monthly
down to intraday 60-minute or 1-minute periods. A bar chart can even be drawn based on a
specified number of price ticks, which creates many bars during hectic periods and few bars
during quiet times. Which time frame or number of ticks to choose is up to you and will depend
on how sensitive you want your charts to be.

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Coffee daily bar chart. Each vertical bar is drawn between the high and low for the period, and
the opening and closing prices are indicated with the small hash marks.

8.4.4.3 Candlestick Charts

Moving beyond the bar chart, some traders like a type of chart with a more visual presentation of
price relationships. These are called candlestick charts because the body, representing the
difference between the opening and closing prices, looks like a candle, and the shadows,
representing all the price action above and below the body during the time period depicted, look
like wicks. If the closing price is above the opening price, the body is usually clear, white, or green.
If the closing price is below the opening price, the body is usually solid, black, or red. Candlestick
charts provide a quick visual picture of the relationship between opens and closes and their
relative strengths or weaknesses, especially for extended periods.

Coffee daily candlestick chart. Each candle shows the open / high / low / close price.

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Significance of the colors

Blue candle: close price is higher than the opening price. Sometimes instead of blue, red or
white are used.

High

Close

Open
Low

Red candle: close price is lower than the opening price. Sometimes instead of red, black is used.

High

Open

Close

Low

Figure bellow shows a daily candlestick chart with two of the many candlestick patterns labeled.

• A doji is a candlestick in which the opening and closing prices are about the same,
resulting in a short body, and the high and low prices for the period extend above and
below. It is most useful as a signal when it appears after a run up in prices and may indicate
market uncertainty, which often precedes a turn in the price trend.

• A hammer is a candlestick in which the body is at the upper end of the trading range for
the period with little or no upper shadow; another shadow stretching out below the body
is at least twice as long as the body. It often occurs at the bottom of a downtrend and
indicates a rejection of lows and a reversal higher.

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Hammer

Doji

Coffee daily candlestick chart. Each vertical bar is drawn between the high and low for the period.
The distance between the open and the close is used to form a wider “body”.

8.4.4.4 Point-and-Figure Charts

A lesser-known charting technique is the point-and-figure chart, which is worth mentioning
because of the interesting way it focuses on price action and eliminates reference to time. Point-
and-figure charts appear to have a random series of Xs and Os across a graph instead of a price
bar or candle for each time period. They are popular with floor traders, who find them easy to
create and update even during hectic trading conditions. Figure 5 illustrates the point-and-figure
technique, which was more popular in the past than it is today.

A point-and-figure chart has two essential measurements. The first is the price unit for each box
on a vertical scale; the second is the number of boxes it takes to reverse a column of Xs
representing an up-trending market to a column of Os that represents a downtrend or vice versa.
To keep the illustration simple, this basic point-and-figure chart uses daily closing prices. As long
as prices continue to make new highs, you place an X in a box, building up the X column. Because
there is no entry on the chart for each time period, as there is for other charts, it may take many
periods before the market changes from a column of Xs to Os. Note on the chart that for the whole
month of September there was just one column of Os and one column of Xs. Point-and-figure
charts provide precise price points at which to act—there is less guessing about where a trend
line crosses or what some indicator says.

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Point-and-figure chart. Xs represent upticks and Os show downticks. Each new vertical bar begins
once the market reverses by a predetermined amount, without fixed references to time.

8.4.5 Reading the Charts

We look only at bar charts in this basic introduction to chart analysis and focus first on chart
patterns-those formations on the chart produced by prices themselves.
Identifying the trend is the first goal of the technical analyst, so trend lines are at the heart of
analyzing price action. Trend lines are generally drawn across the successively higher bottoms in
up-trends or progressively lower tops in the case of down-trends. Figure 6 shows examples of
each on a mini-sized contract. If you can spot points that may lead to a trend early in its
development, you have taken a big step forward as an analyst.

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Up-trend lines are drawn along bottoms and function as support. Down trend lines are drawn
across tops and act as resistance.

Trend lines tend to be significant areas on the chart, acting as support below or resistance above.
Prices crossing the trend line may indicate that a change in direction has occurred. Technicians
believe that once violated, support becomes resistance (in a sell-off), and that resistance
becomes support (in a rally).

Analysts sometimes like to draw channels using multiple trend lines off a base trend line. Using
the uptrend line as the lower channel line, a parallel upper channel line can be drawn across the
progressively higher tops of the uptrend. Prices often have a similar range for each bar, so most
of the price activity occurs within the boundaries of the two parallel lines. As with any chart pattern,
these channels can be traded in several ways. Some traders use the channel lines as support
and resistance, selling when prices approach the upper channel line and buying when they
approach the lower channel line, assuming that prices will remain in this channel. Other traders
will trade only the breakout of a channel, assuming that when prices drop below the lower channel
line of an uptrend, for example, the market is reversing its original direction and will continue to
move lower. Some traders who see this breakout wait for the market to make a reaction back to
the channel, as it often does, and then take a position as prices approach the original trend line.
A breakout in the direction of the channel may indicate that prices are becoming overextended,
or conversely may wind up being the beginning of an extended runaway market. Evaluate all price
action in context with other indicators, studies, and time frames to gain clues about the market’s
true situation.

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Support and Resistance lines
Support lines and resistance lines are price levels at which movement should stop and reverse
direction and act as floor and ceiling respectively. The lines are clearly noticed when the prices
are moving in a narrow band for some time. Support Line is price level below the current market
price at which buying interest should be able to overcome selling pressure and thus keep the
price from going any lower.
Resistance Line is price level above the current market price, at which selling pressure should be
strong enough to overcome buying pressure and thus keep the price from going any higher.

When the price pierces the resistance line, this is the first indication of the reversal of the trend in
the upward direction. So also in a bull phase when the price line falls below the support line, a
reversal of the trend is indicated. A break above resistance would be considered bullish where
as the break of the support line would be considered as bearish trend.
Support/Resistance reverse roles once penetrated. Market price falls below a support level, and
then the former support level becomes a resistance level. Market price rise above a resistance
level and the former resistance level becomes a support level. The following graph clearly depicts
the resistance and support lines and the trading and trending patterns.

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Adding a parallel line to a trend line creates a price channel.

How you trade a trend or channel will depend on your own trading style and may vary with your
opinion about market conditions. However, being able to identify a channel and the boundaries
that may contain price action can be very useful for helping you decide where to place your orders
and helping you see the general flow of price action. When prices track sideways for an extended
period, a trading range pattern forms another type of channel, a sideways channel, which may
occur at bottoms or tops until the market makes a decisive move. So how can you tell whether a
trend will continue or it will change?

Analysts use a number of chart patterns to make this decision. Broadly considered, chart patterns
fall into two categories.

1. continuation patterns and

2. reversal patterns.

This section looks at only a few of the better-known examples of each, emphasizing that there is
much more to chart analysis than what you see presented here.

8.4.5.1 Continuation Chart Patterns

Many up-trending charts have areas where prices consolidate for a few periods or even make a
downward correction. Nearly every trend unfolds in that manner several steps forward in the
direction of the main trend and then a step back where the market appears to be assessing its
situation and taking a breather to rest up for the next leg in the direction of the trend. These

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congestion areas are a normal part of trend building and channels and often form patterns that
look like triangles. Analysts identify several different types.

Symmetrical Triangles or Pennants

The pennant pattern typically shows up in the middle of a trend and is formed when price ranges
for each bar become smaller and smaller as highs become lower and lower and lows become
higher and higher (see Figure bellow). As price action tightens as it moves to the apex of the
triangle, it tends to spring out with a sharp move, usually in the direction of the original trend. The
breakout typically occurs about 75 percent of the way to the apex of the triangle. The breakout
that occurs beyond the 80 percent distance to the apex is suspect and may fail to follow through.

Ascending Triangles
These patterns are more likely to appear at market bottoms and feature a series of higher lows
while highs form a relatively flat horizontal line marking the top of the triangle. This indicates a
strengthening market, and a breakout of the topside of the triangle suggests prices will rally.

Pennants and triangles, and a flag. Congestion areas are a normal part of trend building and
often form pennants, triangles, and flags.

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Descending Triangles
This pattern reverses the appearance of the ascending triangle and is formed by a series of lower
highs while lows make a relatively flat horizontal line that marks the bottom of the triangle. This
indicates a weakening situation as traders won’t push prices higher, and a breakout through the
bottom suggests an ongoing downtrend.

Flags
A flag formation is also a congestion area but instead of prices compressing to an apex as in the
triangle, price action is more erratic and appears to be a small countertrend against the main trend
(see Figure 8 and Figure 9). A feature of some flag formations is the flagpole, a sharp move over
one or several periods that stands out on the chart, followed by the congestion area that looks
like a waving flag. Analysts use the length of the flagpole as a measuring tool, taking the length
of the flagpole from its beginning to the point where the congestion starts to form the flag, and
adding it to (or subtracting it from) the point where prices break out of the flag congestion area, in
order to establish targets for a move after the breakout.

Flagpole. The length of the flagpole can be added to the breakout point of the flag to forecast an
objective for the price move.

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8.4.5.2 Reversal Chart Patterns

Channel Breakouts
The breakout of the channel mentioned earlier is one example of a reversal signal. Some traders
may require two closes or three closes below the trend line rather than just an intraday penetration
of the trend line or may require the market to move a specific percentage through the trend line
to confirm the reversal pattern.

M Tops
In this topping pattern, prices run up to a high, drop back to an interim low, rally again to near the
same level as the first high, and then fall back again. When prices fall below the interim low, it’s a
signal to go short as an M top has been confirmed (see Figure bellow). The pattern may look like
a double top or the second high may be a little below the first high. In any case, breaking through
the interim low is the key to this reversal pattern.

M top also called a double top. Prices breaking below the interim low confirm the pattern.

W Bottoms
This bottoming pattern is a mirror of the M top: Prices decline into a low, rally to an interim high,
sink back toward the low, and then rally again. Prices moving above the interim high indicate the
bottom is in place and it’s time to go long (see Figure below). The pattern looks like a double

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bottom although the second low may be a little higher than the first low. Again, breaking above
the interim high is the key to this reversal pattern.

W bottom, also called a double bottom. This pattern is a mirror of the M top.

Head-and-Shoulders Top or Bottom

This formation is an extension of the M top or W bottom. As a topping pattern, the market makes
a high (shoulder), dips to an interim low, rallies again and this time makes a higher high (head),
drops again to another interim low at about the same price level as the previous low, stages
another rally to about the same price level as the first high (shoulder), and then sinks again (see
Figure bellow). A movement below the neckline, preferably close to a horizontal line, signals the
topping pattern is complete and it’s time to go short. Typically, however, there will be some pausing
action that occurs at the neckline before the market continues lower.

Analysts also use the head-and-shoulders pattern to project price targets. Techniques vary for
making this measurement, but one way is to calculate the distance between the top of the head
and the neckline and subtract this distance from the breakout area of the neckline to arrive at a
price objective.

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Head-and-shoulders top. In this classic reversal pattern, prices breaking below the neckline
suggest a sell-off to the objective.

Rounding Bottoms
These are also reversal types of formations, but the signals aren’t as clear as with the other
patterns. A rounding bottom looks like a saucer on a chart as prices edge down in a series of
lower lows and then begin to creep higher with a series of higher lows (see Figure bellow). When
prices on the right side of the chart move above the lip of the saucer formation, it’s a signal to buy.
In some cases, prices reach the lip, then drop lower again before rallying to move above the lip
in what some analysts call a cup-and-saucer formation.

V Tops and V Bottoms

These look just like what the letter describes: Prices make a sharp move and spike to a high or a
low, then immediately turn around to move in the opposite direction (see Figure bellow). This
formation is more evident on a chart in hindsight and doesn’t provide good places to establish a
position. The sudden reversal of trend has few if any areas of consolidation. Some markets, like
meats and currencies, may be more likely than others to form V tops and V bottoms.

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Rounding bottom, also called a saucer bottom. Prices breaking above the saucer lip suggest the
lows may be in place.

V top. Characterized by a sudden reversal of trend, this pattern has within it few if any
consolidation areas.

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8.4.6 Detecting the Trend
A market is trending either upward, downward, or sideways. And the same market may have
different trends in place on different time frames. For example, a 60-minute chart may show
sideways action, while a daily chart of the same market is trending higher. You may be able to
see a trend in a series of price bars or candlesticks, but the longer-term direction may not be so
clear when trading becomes volatile and erratic.

Determining the trend is one of the most important tasks technical analysts have in deciding how
to position themselves to profit from price action. Let’s consider now a technician’s first set of tools
for determining the trend.

Moving Averages
This indicator is probably the simplest and most widely used by traders of all sizes. All you need
to do is add up the prices for a specific number of periods and then divide the total by the number
of periods to get a moving average reading that changes with each new price input. Closing prices
are often used, but you can also incorporate the open, high, or low into the calculation. There are
three main types of moving averages—simple moving average (SMA), weighted moving average
(WMA), and exponential moving average (EMA).

Simple Moving Average (SMA) - This is the most common method used to calculate the moving
average of prices. It simply takes the sum of all of the past closing prices over the time period and
divides the result by the number of prices used in the calculation. For example, in a 10-day moving
average, the last 10 closing prices are added together and then divided by 10. A trader is able to
make the average less responsive to changing prices by increasing the number of periods used
in the calculation. Increasing the number of time periods in the calculation is one of the best ways
to gauge the strength of the long-term trend and the likelihood that it will reverse.

Weighted moving average (WMA):-is calculated by taking the sum of all the closing prices over
a certain time period and multiplying them by the position of the data point and then dividing by
the sum of the number of periods. For example, in a five-day linear weighted average, today's
closing price is multiplied by five; yesterdays by four and so on until the first day in the period
range is reached. These numbers are then added together and divided by the sum of the
multipliers.

Exponential Moving Average (EMA):- This moving average calculation uses a smoothing factor
to place a higher weight on recent data points and is regarded as much more efficient than the
linear weighted average. The most important thing to remember about the exponential moving
average is that it is more responsive to new information relative to the simple moving average.
This responsiveness is one of the key factors of why this is the moving average of choice among
many technical traders.
Whichever type you use, you wind up with a single smoothed line that flows across the chart,
removing much of the noise from the chart (see Figure below).

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Simple moving average. This 10-day SMA is calculated by averaging the previous 10 closing
prices, plotting each point on the chart, and connecting the points to create the smoothed line.

Moving averages can be used in a variety of ways:

• Just look at the slope of the moving average line to determine the trend visually, and
position yourself accordingly.
• Note where the current price is relative to the moving average. If the price is above the
moving average, the trend is up and you should be long; if the price is below the moving
average, the trend is down and you should be short.
• Use the moving average line as a point for potential support or resistance.
• Use several moving averages together to refine your analysis. When the shorter moving
average (which responds quickly) crosses above the longer moving average (which
responds less quickly), the trend may be defined as up. When the shorter moving average
drops below the longer average, the market may be in a downtrend phase (see Figure
below).

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Moving average crossover. The 10-day SMA moves faster than the 20-daySMA. Each crossover
may indicate a new direction in trend.

Analysts use moving averages in a multitude of other ways, but these basic principles should
provide you with a strong foundation on the subject. Following is an introduction to a few other
common methods for determining the trend. The first is actually a fancy manipulation of moving
averages.

Moving Average Convergence/Divergence

Better known as simply MACD, (pronounced “Mac D”), this adaptation of moving averages can
also provide several signals, depending on how early you want to get in on a potential move—or
take the risk that a move will develop. MACD uses three moving averages, often exponential—
two of them based on the number of price periods used and the third an average of the difference
between the two moving averages.

The difference between the readings of the two moving averages is usually shown as a histogram,
while the average of that difference is shown as a moving average line plotted on top of the
histogram (see Figure bellow). When the histogram is above zero, the market may be considered
to be in an uptrend. Below the line, a downtrend may be at hand. You may find earlier indications
of the trend by watching changes in the length of the histogram bars.

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An important part of the analysis involving MACD is how its movements compare with price
movements. When prices make a high and then another high while MACD makes a high and a
lower high, this is divergence—the two are going in different directions. Divergence indicates
underlying weakness in the market (in the case of an uptrend) and a potential market turn, and is
a technique often used with other studies as well.

MACD histogram. The MACD (seen on the bottom portion of the chart) is a plot of the difference
between two moving averages. Values above zero suggest an uptrend and below zero suggest a
downtrend. Divergence (between market prices and the indicators) can foretell a reversal of trend.

The theory of moving averages also lays down the following guidelines for identifying the buy and
sell signals. If the overall price trend of an asset or the market has been down, the moving-average
price line generally would lie above current prices. If prices reverse and break through the moving-
average line from below accompanied by heavy trading volume, signal for a reversal of the
declining trend, it is the right time to buy shares. If the price of an asset had been rising, the
moving average line would also be rising, but it would be below current prices. If current prices
broke through the moving-average line from above accompanied by heavy trading volume, this
would be considered a bearish pattern that would signal a reversal of the long-run rising trend, it
is a signal to sell shares.

Summary
Traders use both fundamental analysis and technical analysis to understand the market and
develop a trade plan. Fundamental analysis is the study of basic and underlying factors that will
affect the supply of and demand for and therefore the price of a futures contract. Fundamental
analysis is based on an analysis of the comparative strength of the opposing forces of supply and
demand. If supply exceeds demand, prices usually decline and if demand outstrips supply, prices
usually rise. A good fundamentalist will be able to forecast a major price move well in advance of
the technician. Fundamentalists better able emotionally to maximize positions because
fundamentals can take a long time to change.

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Technical analysis is concerned with market action only. The technician believes that it is
impossible to know all the fundamentals that affect price at any given time. The technician
believes price is the ultimate fundamental. The price of a futures contract reflects the impact of
every single bit of fundamental information known by anyone who can even remotely affect the
price of the commodity. Every fact that is known about supply, demand, and the psychology of the
public ends up on the price charts. Price action is the composite opinion of everyone involved in
the markets. Technical analysis deals with only three pieces of data to form an opinion on the
likely direction of prices: price, trading volume, and open interest. Traders use four types of
charting methods: line charts, bar charts, candlestick charts, and point and figure charts.

Self-Assessment Questions
1. Discuss the three factors that influence trading decision in an exchange-based commodity
market system.
2. Describe the basic difference between fundamental analysis and technical analysis.
3. Identify and briefly describe Dow’s principles.
4. What are the four types of prices required for developing bar chart and Japanese candle
and stick chart.
5. Identify the assumptions of technical analysis.

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