Ch visi En sabl

LEONARDO DA VINCI Transfer of Innovation

VALDON DARSKUVIEN

Vytautas Magnus University

Financial Markets

Leonardo da Vinci programme project

,,Development and Approbation of Applied Courses Based on the Transfer of Teaching Innovations

in Finance and Management for Further Education of Entrepreneurs and Specialists in Latvia, Lithuania and Bulgaria"

2010

TABLE OF CONTENTS

Table of contents............................................................................................................... 2 Introduction ...................................................................................................................... 5 1. FINANCIAL MARKETS: STRUCTURE AND ROLE IN THE FINANCIAL SYSTEM .......................................................................................................................... 6

1.1. Financial system structure and functions............................................................ 6 1.2. Financial markets and their economic functions................................................. 7 1.3. Financial intermediaries and their functions ....................................................... 9 1.4. Financial markets structure .............................................................................. 11

1.4.1. Financial instruments ............................................................................... 11 1.4.2. Classification of financial markets ........................................................... 13 1.5. Financial market regulation ............................................................................. 14 1.6. Summary ......................................................................................................... 15 Key terms.................................................................................................................... 15 Further readings .......................................................................................................... 16 Review questions and problems .................................................................................. 16 2. INTEREST RATES DETERMINATION AND STRUCTURE ............................... 17 2.1. Interest rate determination ............................................................................... 17 2.1.1. The rate of interest ................................................................................... 17 2.1.2. Interest rate theories: loanable funds theory ............................................. 19 2.1.3. Interest rate theories: liquidity preference theory...................................... 20 2.2. The structure of interest rates........................................................................... 20 2.3. Term structure of interest rates......................................................................... 22 2.4. Theories of term structure of interest rates ....................................................... 22 2.4.1. Expectations theory.................................................................................. 23 2.4.2. Liquidity premium theory ........................................................................ 25 2.4.3. Market segmentation theory..................................................................... 26 2.4.4. The preferred habitat theory ..................................................................... 26 2.5. Forward interest rates and yield curve.............................................................. 26 2.6. Summary ......................................................................................................... 29 Key terms.................................................................................................................... 29 Further readings .......................................................................................................... 30 Relevant websites........................................................................................................ 30 Review questions and problems .................................................................................. 30 3. MONEY MARKETS .............................................................................................. 33 3.1. Money market purpose and structure ............................................................... 33 3.1.1. The role of money markets....................................................................... 33 3.1.2. Money market segments .......................................................................... 34 3.1.3. Money market participants....................................................................... 36 3.2. Money market instruments .............................................................................. 37 3.2.1. Treasury bills and other government securities......................................... 37 3.2.2. The interbank market loans ...................................................................... 42 3.2.3. Commercial papers .................................................................................. 43 3.2.4. Certificates of deposit .............................................................................. 45 3.2.5. Repurchase agreements............................................................................ 46 3.2.6. International money market securities ...................................................... 49 3.3. Money market interest rates and yields ............................................................ 51 3.4. Summary ......................................................................................................... 54 Key terms.................................................................................................................... 54

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Further readings .......................................................................................................... 54 Relevant websites........................................................................................................ 55 Review questions and problems .................................................................................. 55 4. DEBT MARKETS .................................................................................................. 57 4.1. Debt market instrument characteristics ............................................................ 57 4.2. Bond market .................................................................................................... 59

4.2.1. Bond market characteristics ..................................................................... 59 4.2.2. Bond market yields .................................................................................. 60 4.3. Bond valuation ................................................................................................ 61 4.3.1. Discounted models................................................................................... 61 4.3.2. Bond duration and risk............................................................................. 63 4.3.3. Bond price volatility ................................................................................ 63 4.3.4. Behavior of Macaulay's duration ............................................................. 65 4.3.5. Immunization........................................................................................... 65 4.3.6. Bond convexity........................................................................................ 65 4.4. Bond analysis .................................................................................................. 67 4.4.1. Inverse floaters and floating rate notes ..................................................... 67 4.4.2. Callable bonds ......................................................................................... 67 4.4.3. Convertible bonds .................................................................................... 69 4.5. Summary ......................................................................................................... 70 Key terms.................................................................................................................... 71 Further readings .......................................................................................................... 71 Review questions and problems .................................................................................. 71 5. EQUITY MARKET ................................................................................................ 73 5.1. Equity instruments........................................................................................... 74 5.1.1. Common shares ....................................................................................... 74 5.1.2. Preferred shares ....................................................................................... 75 5.1.3. Private equity........................................................................................... 77 5.1.4. Global shares and American Depository Receipts (ADR)......................... 78 5.2. Primary equity market ..................................................................................... 80 5.2.1. Primary public market.............................................................................. 80 5.3. Secondary equity market ................................................................................. 83 5.3.1. Organized exchanges ............................................................................... 84 5.3.2. Over-the-counter (OTC) market ............................................................... 86 5.3.3. Electronic stock markets .......................................................................... 87 5.4. Secondary equity market structure ................................................................... 88 5.4.1. Cash vs forward markets.......................................................................... 89 5.4.2. Continuous markets and auction markets ................................................. 89 5.4.3. Order-driven markets and quote-driven markets....................................... 89 5.4.4. Hybrid markets ........................................................................................ 91 5.5. Equity market transactions............................................................................... 91 5.5.1. Bid-ask spread ......................................................................................... 91 5.5.2. Placing order............................................................................................ 93 5.5.3. Margin trading ......................................................................................... 95 5.5.4. Short selling............................................................................................. 97 5.5.5. Stock trading regulations.......................................................................... 98 5.6. Equity market characteristics ......................................................................... 100 5.6.1. Stock indicators ..................................................................................... 100 5.6.2. Stock market indexes ............................................................................. 100 5.6.3. Stock market indicators.......................................................................... 103 5.6.4. Transaction execution costs.................................................................... 104 5.7. Stock market efficiency ................................................................................. 106

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5.8. Stock valuation .............................................................................................. 109 5.8.1. Fundamental analysis............................................................................. 109 5.8.2. Technical analysis.................................................................................. 110

5.9. Processes of consolidation of stock exchanges ............................................... 114 5.10. Summary ................................................................................................... 115 Key terms.................................................................................................................. 116 Further readings ........................................................................................................ 116 Relevant websites...................................................................................................... 117 Review questions and problems ................................................................................ 118 6. DERIVATIVES MARKETS................................................................................. 120 6.1. Hedging against risk ...................................................................................... 120 6.2. Description of derivatives markets................................................................. 120 6.3. Forward and futures contracts........................................................................ 122

6.3.1. Principles of forward and futures contracts............................................. 122 6.3.2. Forward and futures valuation................................................................ 124 6.3.3. Use of forwards and futures ................................................................... 127 6.3.4. Futures contracts: stock index futures..................................................... 129 6.3.5. Contracts for difference (CFD) .............................................................. 130 6.4. Swaps............................................................................................................ 131 6.5. Options.......................................................................................................... 132 6.5.1. Options definition .................................................................................. 132 6.5.2. Components of the Option Price ............................................................ 135 6.5.3. Determinants of the Option Price ........................................................... 136 6.5.4. Option pricing models............................................................................ 138 6.5.5. Mixed strategies in options trading......................................................... 139 6.6. Summary ....................................................................................................... 139 Key terms.................................................................................................................. 140 Review questions and problems ................................................................................ 140

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INTRODUCTION

Motivation for developing the course

Research by the members of the project consortium Employers' Confederation of Latvia and Bulgarian Chamber of Commerce and Industry indicated the need for further education courses in the field of finance and managerial decision making.

Innovative content of the course

The course has been developed to include the following innovative content: Key concepts of financial markets, which are explained from an applied perspective, including with examples and problems from current financial markets practices from EU integration and development perspective; Analytical techniques to be applied in financial markets provide with understanding and tools to decision makers in the firm; Applied exercises, which cover topics such as money market, debt market, equity market instruments, as well as decision making rules in the financial markets; Summaries are provided at the end of every chapter, which aid revision and control of knowledge acquisition during self-study;

Innovative teaching methods of the course

The course is developed to utilise the following innovative teaching methods: Availability on the electronic platform with interactive learning and interactive evaluation methods; Active use of case studies and participant centred learning; Availability in modular form; Utilising two forms of learning - self-study and tutorial consultations; Availability in several languages simultaneously.

Target audience for the course

The target audience are: entrepreneurs, finance and management specialists from Latvia, Lithuania and Bulgaria and, in the longer term, similar groups in any other European country. The course assumes little prior applied knowledge in the area of financial and operation analysis. The course is intended for 32 academic hours (2 credit points).

Course objective

The objective of the course is to provide entrepreneurs with the knowledge in the area of financial markets, specific financial market instruments, behavior in order to enable them to understand the financial markets processes and their factors, and to make successfully financial decisions on the individual as well as company level.

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