Financial Markets and Institutions

BROKER

in order to facilitate the supply and demand matching.

= is the counter party. The dealer runs more risks and can act when he consider the exchange appropriate, on

DEALER

investors’ solicitation.

= dealer forced to make a price (conclude the exchange) when somebody ask for it, whatever the

MARKET MAKER

market situation is and at the conditions he exposed.

MARKETS

1) BONDS

2) EQUITY

3) FOREIGN EXCHANGE

4) MONEY

5) DERIVATIVES

The basic plain vanilla bond is the model, which has to be

STRAIGHT

1 signifies the most

Plain vanilla

physically produced. It contains: basic or standard version of a

financial instrument. Plain

• NAME of the ISSUER vanilla is the opposite of an

Bonds are issued at (al portatore) which means the buyer can’t be identified.

BEARER BASIS exotic instrument, which alters

• = price that would be paid at maturity the components of a traditional

FACE VALUE financial instrument, resulting in

• = the price at which the bond is sold in the primary market (first emission)

ISSUE PRICE a more complex security.

• = price at which it’s sold in the secondary market

MARKET PRICE = you know the price to enter, the price

• = generally on a 6 months basis FIXED INCOME INVESTMENT

COUPONS to exit and what you receive every 6 months. Rumours on credit

worthiness of the company may determine the price in the secondary

market.

Due to the bearer basis, the problem of taxation arises (if the name isn’t known, who is in charge to pay the tax on this

income?) WITHOLDING TAX = usually bonds are bought from banks which apply on every coupon this tax (12.5% in Italy)

Ex. 50 coupon with 20% tax tax = 10, received by the keeper of the bond = 40

that in 2 years the interest rate increased from 5 to 10% and you’re an investor looking for a single A bond.

Suppose

You can buy from the issuer at 5% or in the secondary market a new one at 10%.

When market interest rates rise, for example, newly issued bonds tend to offer higher coupon payments. This makes

the newer bonds more attractive than older bonds offering lower coupons. As a result, the prices of older bonds will

go down because sellers need to offer prospective buyers some incentive to invest in a bond that pays a lower coupon

than the going market rate.

The reverse dynamic also holds true: when interest rates fall, newly issued bonds offer lower coupon payments and

the prices of existing bonds tend to rise.

http://insights.schwab.com/fixed-income/what-you-need-to-know-now-about-interest-rates-and-bond-prices-0

: The interest is paid on the difference between issue price and maturity price.

ZERO COUPON BONDS

If interest rates rise in the next 10 years and you bought a straight bond it means that every 6 months you can reinvest

coupons at a higher interest rate. Opposite situation: reinvest at a lower rate.

In a zero coupon bond money are implicitly reinvested at the same rate (you don’t receive coupons).

So, if you think that will rise you buy a bond with coupons; in the opposite case you but a zero coupon bond.

i : Sold in the primary market as straight bonds, they contain a clause which gives the

CONVERTIBLE BONDS

investor an option, in a given period of time, to transform the bond in 2 shares (for example).

Ex. From 30/9/20 to 31/12/20 possibility to convert: 1 bond = 2 shares

950 = 600 x 2 investors may convert

950 = 300 x 2 probably investors won’t convert

: Strip of paper attached to the bond that gives right in a future period to buy a certain number of

WARRANTS

shares at a specified price.

Ex. From 30/9/20 to 31/12/20 possibility to buy 2 shares at 400€

CALL or PUT OPTIONS ON BONDS

A option on a bond is a provision that allows the holder of the bond the right to force the issuer to pay back the

put

principal on the bond whenever he wants before maturity for whatever reason. If the bond holder feels that the

prospects of the company are weakening, which could lower its ability to pay off its debts, he can simply force the

issuer to repurchase his bond through the put provision. It also could be a situation in which interest rates have risen

since the bond was initially purchased, and the bond holder feels that he can get a better return now in other

investments. Another benefit to a bond with this provision is that it removes the pricing risk bond holders face when

they attempt to sell the bond into the secondary market, where they may have to sell at a discount. The provision

adds an extra layer of security for bond holders - as it gives them a safe exit strategy. Because this option is favorable

for bond holders, it will be sold at a premium to a comparable bond without the put provision.

A option allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the

call

bond reaches its date of maturity. If interest rates in the market have gone down by the time of the call date, the

issuer will be able to refinance its debt at a cheaper level and so will be incentivized to call the bonds it originally

issued. Also, as interest rates go down, the price of the bonds go up; therefore, it is advantageous to buy the bonds

With a callable bond, investors have the benefit of a higher coupon than they would have had with

back at par value.

a non-callable bond. On the other hand, if interest rates fall, the bonds will likely be called and they can only invest at

the lower rate.

Bonds issued by Italian Government

= 5/9 years, fixed rate coupon

BPT (Treasury multiyear bill) = floating rate, 7 years, every 6 months you receive the same value as a T-bill + 25bp

CCT (Credit Certificate of Treasury) = issued until 1995, possibility to obtain an earlier repayment

CTO (Option Certificate of Treasury)

2 Issued by corporations. Plain vanilla: ORDINARY SHARES

Rights: • participate to the shareholders’ assembly

• one vote per share

Trying to determine how much a company is worth means checking the future cash flow generating capacity.

Problems:

•DISTRIBUTION: banks deal with distribution of bonds for the companies which are responsible towards the future

bondholders. These financial instruments are printed first and then sold (a deposit contract, for

example, is firstly “sold” and then created). limited number of investors, quick procedure, no

1) ISSUER DECISION PRIVATE PLACEMENT:

marketing costs, the counter party has very strong contractual power.

Minority of cases, only for creditworthy companies.

authorization from a regulation agency (CONSOB)

PUBLIC ISSUE:

a group of banks which agrees is put together. They make an announce

2) PLACEMENT (lead bank): with details of the bonds and the list of banks where they

(TOMBSTONE)

can be bought, where investors can make a reservation.

the reservation is only an indication of interest and it’s not binding

N.B.

because the real price of the bond is decided the day before the primary

market starts.

•ADVISORY: first design the issue, then send it to a regulation agency (CONSOB in Italy), then marketing.

the lead bank organize events to advertise and create interest in these bonds.

1) ROAD SHOW:

2) ORIGINATION

•GUARANTEE: banks i.e. provide guarantee to the issuer that all the bonds will be sold.

UNDERWRITE THE SECURITIES

it depends on the regulation of the country. Possibilities:

What happens if demand > supply?

GREENSHOE OPTION allows to increase the amount of securities on sale for a maximum of 20%;

1) put in a position of advantage those who have been the firsts to make reservations leaving out the last ones;

2) DIVISION: if the demand is 5 times the supply, everyone gets 1/5 of the bonds demanded.

3)

On the day of issue the demand could fall due to the pricing of the previous day. If demand is highly > than supply it

means that investors are in too much advantage. If there are only few people on the day of issue and not every bond

has been sold, many mistakes could have been made like a price too high or simply there’s panic/bad rumours in the

financial market.

The portion unsold has to be bought by the underwriting banks. For example if 60% of the bonds are unsold, Intesa

Sanpaolo guaranteed for 10mln, this banks buy 60% of what it promised, so 6mln.

Investors can also decide to buy in the secondary market at a lower price.

However, is the most crucial moment.

pricing on behalf companies already listed in the Stock Exchange. There’s already a track record of

1) SEASONED OFFERING

the past, the issue price takes into account the historical price which has to be very similar to the new one.

on behalf companies established relatively recently. There’s no track record, the

2) INITIAL PUBLIC OFFERING

company has to be checked and then the lead bank fix the issue price. Stock Exchange authorities check that at least

25% of the shares is on the market in order to make sure the company doesn’t belong to a one, big shareholder.

Foreign Exchange is the market for trading currencies. This includes all aspects of buying, selling and

3 exchanging currencies at current or determined prices. Nowadays we have a floating rate system so prices

change. Trade is done between customers and banks, banks and central banks, banks and other banks.

1% of the trade is due to imports and exports, the other 99% are speculations.

•SPOT foreign currencies bought and sold for immediate delivery, outright execution of the deal.

MARKET:

•FORWARD deal today, exchange in a future date; buy and sell for 1, 2, 3, 6, 9, 12 months.

MARKET:

You eliminate uncertainty fixing today the price and the conditions.

Ex. You go in a bank and agree to buy 1000$ for 850€. The deal is done today (07/10/2015) but no money are

exchanged. Delivery on 6/02/2016: you go to the bank and pay 850€ and receive 1000$.

3 kinds of agents: People who want to avoid risks, buy protections.

(from “hedge” = protect against risk)

HEDGERS: seek risks and when they’re right they gain a profit

SPECULATORS: buy something at a certain price to sell it at a higher price in other places.

ARBITRAGEURS:

BUY SELL No risk, don’t care if price of $ increase or decrease

0 0 “BULL”, you hope for the value of dollar to increase in order to make

100 0 LONG POSITION

a profit

0 100 “BEAR”, you hope for a fall in prices

SHORT POSITION

100 100 no risks

SHORT POSITION

Exporters wouldn’t have risks if foreign importers pay immediately so they can go to the bank and exchange money,

but in international trade this never happens, nobody pays cash.

Ex. 6/10/15 sold furniture in Switzerland (I’m an Italian exporter)

6/04/16 credit +1mln Swiss Franks

If the value of SF increases in the meantime with respect to €, I have additional profit; if it falls I’ll face a loss.

To avoid these risks:

1) sell spot on 6/04/16: on that day I go to the bank and they give me the amount of the value on that day. I still have<