Lecture 2

Introduction to Financial
Systems (Part 2)

What are you expected to learn?

2

To explain the type and features of financial securities (i.e. bonds, notes, bills and stocks) traded
on financial markets.

To discuss the theories related to the shape of the yield curve.

To explain the structure of financial markets in the USA and the world (e.g. UK, France and
Germany).

Essential Readings
3

M. Buckle, E. Beccalli (2012) Principles of Banking and Finance Subject Guide,

Chapter 2: Introduction to Financial Systems

Allen, F. and D. Gale, Comparing Financial Systems,

Chapter 3, Institutions and Markets

Mishkin, F. and S. Eakins, Financial Markets and Institutions

Chapter 1 : Why Study Financial Markets and Institutions?

Chapter 2 : Overview of the Financial System

Chapter 10 : Conduct of Monetary Policy

Nature of Financial Instruments (Securities)

4

2 types of financial instruments: (1) debt instruments (2) equity instruments

(1) Debt instruments

a)
b)
c)

promise the payment of given sums to the investor.

Short term - bills (<1 year)

Medium term - notes (1~ 10 years)
Long term - bonds (10 ~20 years)

Bonds
5

Debt owed by the issuer to the investor.

Claims that pay periodic interest (coupon payments) until the maturity date & pay back the par value
(face value) to the investor at the maturity date.

Coupon payments (%) are usually at a fixed interest rate.

Coupon interest is the cost of borrowing or price paid for the rental of funds.

Bonds can be (i) zero coupon bonds or (ii) coupon bonds.

Zero Coupon Bonds

6

Borrower (i.e. the issuer) promises to pay the lender (i.e. bondholder) one specified face value
($1,000) at a specified future date (i.e. maturity).

Borrower receives the bond price which is lower than the face value of $1000 (i.e. discount bonds)
at the current date.

Coupon Bonds
7

Borrowers (i.e. issuers) make regular constant payments (i.e. coupons interest) until a specified date
(i.e. maturity date), when the amount borrowed (principal) is repaid.

2 cash flows to the bondholder:

(i)

Face value; and

(ii)

Coupon interest payments.

Coupon Bonds
8

Face value (par value or principal)

the issuer repays the face value of the bond to the bondholder at the end of the bonds
lifetime (i.e. maturity).

() Coupon interest payments:

regular (example: annually or semi-annual) interest payments to the bondholder.
Is a fixed fraction (%) of the face value, i.e. the cost of borrowing or the price paid for the
rental of funds.

Other Types of Bonds

9

Perpetual Bonds

The borrower simply pay coupons of a specified amount forever.

Floating Rate Bonds

Bonds with coupon rates which vary over the bonds lifetime.
Floating coupon rate is a premium over market interest rate
(e.g LIBOR or US T-bill rate) and is reset on a pre-specified basis.

Example of Perpetual Securities

10

Other Types of Bonds

11

Index-linked bonds

coupons and principal grow in line with inflation.

first issued in the UK.
increasingly & frequently issued by governments as real, risk-free securities.
(Difference between real and monetary/nominal return Fishers Effect)

Whats the benefit of buying an index-linked bond?

Bonds with Embedded Options

12

Callable bonds

Can be repaid early (i.e. before maturity) by the issuer if he/she so chooses. Why would the issuer ask
to repay earlier?
Early repayment might be restricted to a specified date (European style bond) or may be allowed at
any time prior to maturity (American style bond).
Puttable bonds

Redemption date is under the control of the holder of the bond (i.e. the investor/buyer).
Opposite to the callable bond.

Bonds with Embedded Options

13

Convertible bonds

Bonds which can be converted into a share in the firms equity (either at a specific date or at any
time).
Allows bondholders and shareholders to participate in upside gains of a corporation.

Example of Convertible Bond Issue

14

OSIM Share Price Chart

15

Conversion Price = $2.025

Launched 5YCB in Jun11 at S$1.62

Closing Price on 21 Sep = $1.445

Foreign Bonds
16

Issued by a borrower in a country different from that borrowers country of origin (i.e. the borrower is
selling debt abroad).
Denominated in the currency of the country in which it is sold.
E.g. a Russian firm sells Sterling denominated debt in the UK.
Sterling denominated foreign bonds are colloquially known as bulldog bonds.
E.g. Samurai bond in Japan, Matador bond in Mexico.

Eurobonds
17

Bonds denominated in the currency of one country but

actually sold or traded in another, different country.

E.g. a Eurosterling bond denominated in Sterling but sold outside the UK.
Coupons on Eurobonds are paid on an annual basis.
London is one of the major Eurobond markets.

Treasury Bills
18

Part of government debt instruments.

Money market securities (maturity <1 year).

Do not pay interest (a zero coupon bond or pure discount loan).

Issued at discount from their par value (i.e. less than the par
value).

Repay the par value ($1000) at the maturity date.

Yield to the investor = issue value - par value.

Government Notes and Bonds

19

Issued by the government to finance national debt.

Gilt: UK government bonds

Treasuries: USA government bonds
Bunds: Germany government bonds
Singapore Government bonds to finance national debt?

Government Notes and Bonds

20

Notes : maturity of 1-10 years.

Bonds: maturity of 10-20 years.
Free of default risk.
Issuer (the government) can print money to pay off the debt if necessary (example: QE1, QE2 & QE3)
Inject liquidity to jumpstart the economy and facilitate consumption and employment.
Government bonds pay lower interest rates than corporate bonds (risk-return relationship).

SG Government Notes
21

Municipal Bonds
22

debt instruments issued by US local, county or state governments to finance public interest projects.
not default-free and are not as liquid as Treasury bonds.
secured on their own revenues and not guaranteed by central government.
pay lower interest rates than Treasury bonds (exempt from federal taxation).
an implicit (indirectly) increase in the actual interest rates received by investors.

Corporate Bonds
23

Issued by large corporations when they need long-term

financing.

Usually pay coupon interest semi-annually.

Not risk-free.

Higher risk & higher return than government & municipal bonds.

The risk depend on the nature of the corporations activities

(e.g. contrast utilities with biotech firms).

Bondholders have senior claims on corporate assets in the

event of bankruptcy.

Default Risk and Bond Ratings

24

Bond is in default if the borrower is unable to meet the financial obligations (i.e. to repay the coupon
interest or/and principal) at specified dates.
Bondholder has a senior claim on the borrowers assets.
The likelihood of a borrower defaulting will affect the terms of the bond.
(Ki = RF + RP; where RP = CPI + Default Risk + Term Structure of Interest
Rate Risk)
[RF = Risk Free, RP = Risk Premium]

A bond with higher possibility of default (and will have a lower credit rating) will have a higher coupon
interest rate (i.e. default risk premium).

Default Risk and Bond Ratings

25

Term Structure of Interest Rates

26

How do interest rates fare across different time periods?

Yield curve is usually constructed from (risk-free) government securities.

Pattern of Yield curve:-

Upward sloping : long term rates > short term rates

Inverted (or downward sloping) : long term rates < short term rates

Flat : long term rates = short term rates

Yield Curve Types

27

Singapore Government Yield Curve

28

Singapore Government Yield

29

Term Structure of Interest Rates

30

3 theories to explain the term structure of interest rates:

(a) Expectation Theory;

(b) Liquidity Premium Theory / Preferred Habitat Theory; and
(c) Segmented Market Theory.

Expectations Theory
31

The theory states that in equilibrium, long-term rate is a geometric average of todays short-term rate
& expected short-term rates in the future.

The theory requires an implicit relationship between current bond yields & forward rates.

Expectations Theory
32

Forward rate of interest

= interest rate payable on funds beginning at some future date.

2
(1 + R) = (1 + r1) x (1 + r2)

Where

R : annual yield on a 2-year bond,

r1: annual return from a 1-year bond, and
r2: 1-year forward rate beginning in 1 years time

Expectations Theory
33

An investor who invests will receive the same return from either
(i) $1,000 in either a 2-year bond; or

(ii) a 1-year bond subsequently reinvesting the proceeds from the 1st year into another 1-year bond.

The existence of arbitrageurs in bond markets ensures that this relationship holds. Both securities with
different maturities are perfect substitutes.

Expectations Theory - Example

34

Yield on a 2-year government bond, R=9% p.a.

Yield on an equivalent 1-year bond, r1 =8% p.a.

Yield implied on a 1-year bond held during Year 2 of the two year bonds life, r2, is given as:

(1 + R)

= (1 + r1) x (1 + r2)

$1,000 x (1.09) x (1.09) = $1,188.10 = $1,000 x (1.08) x (1 + r2)

r2 = 10.01%
nd

r2 is the 2

Upward sloping yield curve :

year forward rate, or equivalently, the expected rate in the 2

Yield on 1-year bond < Yield of 2-year bond

nd

year.

Expectations Theory - Example

35

Expectations Theory
36

Normally, the yield curve is upward sloping.

(i) current long rate (after 3 years) > current short rate
so the short-term rates must be expected to rise in the future
upward sloping yield curve
(ii) Current long rate < current short rate
then short-term rates are expected to decline in the future
downward sloping yield curve
(iii) If no change is expected in short-term rates
current long rate = current short rate
flat yield curve

In summary, expectations of future interest rates determine the shape of the yield curve.

Liquidity Premium Theory or Preferred Habitat Theory (securities are not

perfect substitutes)
37

In a world of uncertainty, investors/lenders prefer to hold assets which can be converted into cash
quickly.
Therefore, investors/lenders demand a liquidity premium for holding long term debt.
Uncertainty also causes borrowers to prefer to borrow for a longer period at a rate which is certain now.
Therefore, borrowers will be willing to pay a liquidity premium, i.e. a higher rate of interest on a longerterm debt.

Liquidity Premium Theory or Preferred Habitat Theory

38

Yield curve will normally be upward sloping, in the absence of any other influences.
In reality, we need to consider the combined effect of expectations together with liquidity preference.
A downward sloping yield curve occur when expectations of an interest rate fall are sufficient to offset the
liquidity premium.

Market Segmentation Theory (securities cannot be substituted)

39

Bond market is actually made up of a number of separate markets distinguished by time to maturity,
each with their own supply & demand.
Different classes of investors and issuers will have a strong preference for certain segments of the
yield curve (different risk-return appetite).
So, the yield curve will not necessarily move up, or down, over its entire range.

Market Segmentation Theory

40

Equity Instruments

Common Stocks
Preferred Stocks

Common Stocks
42

Common stockholders are the owners of the firm.

Common stockholder have the voting right.

Common stockholders

(i)

receive dividends (when distributed, annually or semi-annually); and

(ii)

take capital gains (or losses) when the stock market

price increases (or decreases).

Common Stocks
43

Market Cap = US$656 Billion

Preferred Stocks
44

Represents equity claims but with limited ownership rights (as compared with common stocks);
Preferred stockholder receives fixed and constant preferred dividend:
more similar to bonds with fixed coupon interest;
different to common stocks as common stockholder may not receive dividend.

Preferred Stocks
45

Price of preferred stocks is relatively stable (as preferred dividend is fixed).

Preferred stockholders do not have voting rights (common stockholders have voting rights).
Preferred stockholders have a residual claim on assets and income left over after creditors but before
common stockholders.

Hyflux Preferred Stocks

46

13 April 2011

How are Financial Markets

Structured?

Many ways

Primary vs Secondary Markets

48

Primary market (Investment Bank Operate)

One where newly issued financial securities (both bonds & stocks) are sold to initial buyers.
Primary markets facilitate new financings to corporations.
Secondary market (Security Firms Operate)

Financial market for resale of previously issued securities.

Most of the trading of securities takes place in the secondary (second hand) markets.
Makes financial securities more liquid (an exit strategy for investors) and facilitates price discovery (price
setting) of primary issues of shares.
Manage external market liquidity risk. (Eg: SingTel vs SATs)

Secondary Market Types

49

Financial securities may be traded via

(i)

Exchange market; or

(ii)

Over-the-counter (OTC).

(i) Exchange market traded

() buyers and sellers (through their brokers) transact in one central location to conduct trades.
() Examples: Singapore Exchange (SGX), New York Stock Exchange (NYSE), London Stock Exchange
(LSE).

Secondary Market Types

50

(ii) Over-the-counter (OTC) Dealer markets traded

Dealers at different locations have an inventory of securities and are ready to buy and sell these
securities over-the-counter to anyone willing to accept their price.
OTC markets are competitive as dealers use technology to link prices. OTC is very different from
organised exchanges.
OTC trading is most significant in the USA where listing requirements are quite strict.
Examples : US Government Bond Market, NASDAQ.

Money Market vs Capital Market

51

Money Market

financial markets for short-term debt instruments

Capital Market

Financial markets for long-term securities (e.g.

equity instruments (infinite life), government

(maturity of <1 year).

bonds, corporate bonds (maturity of >=1 year).

are mainly wholesale markets (large transactions)

where firms & financial institutions manage their

Securities are often held by financial

short-term liquidity needs (i.e. to earn interest on

intermediaries (e.g. mutual funds, pension funds

their temporary surplus funds).

& insurance companies).

Trading Intermediation Types

52

1.

Quote-driven dealer markets

A dealer (= market-maker) is on one side of every trade.

A dealer quotes prices & stands ready to buy & sell at these quotes, so they provide liquidity.
Dealers hold an inventory of the security, which fluctuates as they trade.
Dealers profit from charging a bid-ask spread and from speculating.

Trading Intermediation Types

53

2.

Order-driven markets

buyers & sellers trade directly without any intermediation.

Mostly auction markets.
Trading rules formalise the process by which buyers seek the lowest available prices & sellers seek the
highest available prices (price discovery process).

Trading Intermediation Types

54

3.

Brokered markets

) Brokers match the buyers & sellers.

) Brokers find liquidity but do not provide liquidity.
[note: dealers provide liquidity]

) Brokers do not hold inventory as they do not trade themselves. (Market and limit security orders)
) Important for large blocks of stocks and bonds.

(Stock Exchange)

Secondary Markets Around The World

55

Country
Singapore
UK
Japan
Germany
Netherlands,

Stock
Exchange
Singapore
Exchange
London Stock
Exchange
Tokyo Stock
Exchange
Deutsche Borse

Sample Exam Questions

56

1.

What distinguishes stocks from bonds? What are the differences with reference to the risk/return
relationship?

2.

Because corporations do not actually raise any funds in secondary markets, they are less important
to the economy than primary markets. Comment.

Sample Exam Questions

57

3.

With reference to examples, discuss globalisation of the financial markets around the world.

4.

Compare and contrast quote and order driven markets.

5.

Explain the purpose of money markets and give examples of the types of money markets and their
users.