Global Capital Markets (Module 1)

Chapter 1
Introduction
Financial Assets
Asset: any possession that has value in an exchange
– Tangible asset: The value depends on
particular physical properties
– Intangible assets: Represent legal claims to
some future benefit

Debt versus Equity Claims

– Debt instrument: Fixed amount claim
– Equity claim: Residual Claim

Value of a Financial Asset

Valuation
The process of determining the fair value or price of a
financial asset
Fundamental principle of valuation
The value of any financial asset is the present value of
the cash flow expected
The Value of a Financial Asset
– Estimating the cash flow
– Discount Rate
Three reasons why cash flow of debt instruments is
not known:
1
 • The issuer might default
• Call/Put
• Floating Rate

The Role of Financial Assets

• Transfer Funds
• Spread and transfer risk

Properties of Financial Assets

1. Moneyness
2. Divisibility and denomination
3. Reversibility (bid/ask) (thick/thin)
4. Term to maturity
5. liquidity (Money easily)
6. Convertibility (Another asset)
7. Currency
8. Cash flow and return predictability
9. Complexity
10. Tax status

Financial market
2
 • The Role of Financial Markets
– Search costs
– Information costs
Why do investors go to secondary market?
1. Meet liquidity needs
2. Information

• Classification of Financial Markets

– Maturity of the claims
• Money market - a financial market for
short-term financial assets (< 1 year)
• Capital market - the financial market for
longer maturity financial assets (> 1 year)
• Classification of Financial Markets
– Whether the financial claims are newly
issued
• Primary market - the market for newly
issued financial assets
• Secondary market - the market, where
after a certain period of time, the financial
asset is bought and sold among
investors

Why is the link between company and secondary

market?

3
 • Globalization of Financial Markets
– The integration of financial markets throughout
the world into an international financial market
• Factors influencing Globalization
1. Technology
2. Liberalization
3. Integration

• Globalization of Financial Markets

– Emerging markets
• Participation in the financial markets of
developing economies
• Characteristics of emerging markets:
– Have economies that are in transition but
have started implementing political,
economic, and financial markets reforms in
order to participate in global capital market
– May expose investors to significant price
volatility attributable to political risk and the
unstable value of their currency
– Have a short period over which their financial
markets have operated

Players
• Governments
– Federal government
– Government-sponsored enterprises
4
Housing
 The eleven Federal Home Loan Banks (FHLBanks)
(1932)
 Federal National Mortgage Association (Fannie
Mae) (1938)
 Federal Home Loan Mortgage Corporation (Freddie
Mac) (1970)
Veteran
 National Veteran Business Development
Corporation (1999)
Farming
 Federal Farm Credit Banks (FCBanks) (1916)
 Federal Agricultural Mortgage Corporation (Farmer
Mac) (1987)
Education
 SLM Corporation (Sallie Mae) (1972-1995)

– State governments
– Local governments
• Nonfinancial Corporations
– Microsoft
– Unilever
• Depository Institutions
– Commercial banks
– Savings and loan associations (Thrifts)
– Savings banks

5
 – Credit unions
• Insurance Companies
Life Insurance
Property and Casualty Insurance
• Asset Management Firms
– Pension Funds
– Exchange-traded funds
– Hedge funds
– Private equity Funds
– Venture Capital Funds
– Angel Funds
– Sovereign wealth Funds
– Real estate investment trusts
– Structured finance operating companies
• Investment Banks
– Independent/stand alone
– May be a subsidiary of
• Commercial banks
• Insurance companies
• Nonprofit Organizations
• Commercial enterprises
• Not-for-profit organizations
• Foundations: Single person
• endowments
• Foreign Investors
– Individuals

6
 – Nonfinancial businesses
– Financial entities
– Supranational institutions
Role of Financial Intermediaries
• Transform financial assets and re-constitute them
into different types of assets.
• Exchange financial assets on behalf of customers.
• Exchange financial assets for their own account.
• Assist in the creation of financial assets.
• Provide investment advice to other market
participants.
• Manage the portfolios of other market participants.
• Maturity Intermediation
• Risk Reduction Intermediation
• Denomination Intermediation
• Information Intermediation
• Reducing the Costs of Contracting
• Providing a Payment Mechanism
Overview of Asset/Liability Management for
Financial Institutions
• Type I Liabilities (Amount and Timing of cash outlay
known)
– FDs, Bonds
• Type II Liabilities (Amount known and Timing of
cash outlay unknown)
– Life Insurance Policy

7
 • Type III Liabilities (Amount unknown and Timing of
cash outlay known)
– Certificates of Deposits (CD’s)
• Type IV Liabilities (Amount and Timing of cash
outlay unknown)
- Shares
Regulation of Financial markets
• Justification for Regulation
– efficient manner and at the lowest possible
– financial crises that have occurred at
various times
• Forms of Federal Government Regulation of
Financial Market
– Disclosure Regulation
– Financial Activity Regulation
– Financial Institution Regulation
– Foreign Participant Regulation
Financial Innovation (Financial Engineering)
• Market-broadening instruments: Smaller contract
size in derivatives, Higher interest-bearing current
accounts
• Risk-management instruments: Forwards,
Futures, Options
• Arbitraging instruments and processes: Carry
Trade
• Price-risk-transferring innovations: Futures
• Credit-risk-transferring instruments: Credit
Derivatives

8
 • Liquidity-generating innovations: Factoring
• Credit-generating instruments: Overdraft, Credit
Lines
• Equity-generating instruments: Follow On
Offerings, Rights Issue, Bonus Issue

Motivation for Financial Innovation

– Increased volatility of interest rates, inflation,
equity prices, and exchange rates
– Advances in technologies
– Greater sophistication and educational
training
– Financial intermediary competition
– Incentives to get around existing regulation
and tax laws
– Changing global patterns of financial wealth

Securitization and Financial Innovation

Illiquid assets are made liquid