Home Economics Derivative Markets
As a result of the process of financial intermediation, and in order to satisfy the investment requirements of the ultimate lenders and the financial intermediaries (in their capacity as borrowers and lenders), a wide array of financial instruments exist. They can be split into three categories:
• Equity / share instruments.
• Debt instruments, which can be split into:
- Short-term debt instruments (= money market).
- Long-term debt instruments (of which the bond market is a part).
• Deposit instruments (which can be seen as a form of debt instrument; the majority of which are short-term).
The instruments are either non-marketable (e.g. bank overdraft, bank mortgage advance) (called non-marketable debt or NMD), which means that their markets are only primary markets (see next section), or marketable debt (MD), e.g. treasury bills, which means that they are issued in their primary markets and traded in their secondary markets (see next section). The financial instruments (also called securities) that exist in the Local Country's1 financial markets (defined in the next section) are revealed in Figure 2.
Figure 2: financial intermediaries & instruments / securities
Spot financial markets
Spot (also called cash) markets are distinguishable from the derivative markets. Spot means to settle the deal as soon as possible and there are different conventions for the debt, share and forex markets as shown in Figure 3. The derivative markets settle (obligation or option) the underlying (described later) instruments in the future.
This section covers the spot markets under the following headings:
• Primary and secondary markets.
• Debt markets.
• Share / equity market.
• Foreign exchange market.
Figure 3: financial markets: spot & derivatives
Primary and secondary markets
As noted, there exist primary and secondary markets. The former are the markets that exist for the issue of new securities (marketable and non-marketable), while the latter are the markets that exist for the trading (i.e. exchange) of existing marketable securities. It should be evident that in the primary markets the issuers (borrowers) receive money from the lenders (investors), while in the secondary markets the issuers do not; money flows from the buyers to the sellers. This is depicted in Figure 4 and Figure 5 (shares used as example).
Figure 4: exchange of value in primary equity market
Figure 5: exchange of value in secondary equity market
The secondary financial markets evolved to satisfy the needs of lenders (investors) to buy and sell (exchange) securities when the need arose. Some markets naturally exist in a safe (i.e. low risk) environment, while for others a safe environment has been created. The former markets are called over-the-counter (OTC) markets, and the latter the formalised (or exchange-driven) markets. The OTC markets are the foreign exchange and money markets (in some countries partly exchange-driven), which essentially are the domain of the well-capitalised banks, while the exchange-driven markets are the equity / share and bond markets (the latter in some cases). These markets may be depicted as in Figure 6.
Figure 6: financial markets
There are two financial markets: the share market and the debt market. The debt market is the market in which debt instruments are issued (primary market) and exchanged (secondary market). Interest is paid on debt instruments (hence the other name: interest-bearing market), as opposed to dividends that are paid on shares / equities. The debt markets are also called the fixed-interest markets, but this is a misnomer because interest may be floating, i.e. reset at intervals, during the life of the instruments.
The debt market and it can be split into the short-term debt market (STDM) and the long-term debt market (LTDM). The money market can be defined as the short-term marketable securities market or as the market for all short-term debt, marketable and non-marketable. Some scholars also term the market as the market for wholesale debt. Our preference is to define the money market as the market for all short-term debt, marketable and non-marketable - and the reason is that in this market the volume of non-marketable debt (ST-NMD) far outstrips the volume of marketable debt (ST-MD). Also the genesis of money market interest rates takes place in the ST-NMD (specifically the interbank markets - there are three interbank "markets", but we will not cover this detail here).
As seen, the other part of the debt market is the LTDM, which is (obviously) the market for the issue and trading of long-term debt instruments. The trading of long-term debt only applies to the MD securities of the LTDM, and this applies to bonds. Thus the bond market is the market for the issue (primary market) and trading (secondary market) of marketable long-term debt securities.
The money and bond markets are differentiated according to term to maturity: the cut-off maturity is arbitrarily set at one year. Thus, the money market is usually defined as the issue and trading of securities with maturities of less than one year and the bond market as the issue and trading of securities with maturities of longer than one year (called bonds). The bond market is part of the LTDM (the marketable part).
The definition of the bond market is acceptable but the money market is much more than the issue and trading of securities of less than one year. It encompasses:
• The primary markets that bring together the supply of retail and wholesale short-term funds and the demand for wholesale and retail short-term funds.
• The secondary market in which existing marketable short-term instruments are traded.
• The creation of new money (deposits) and the financial assets that lead to this (loans in the form of NMD and MD securities).
• The central bank-to-bank interbank market (cb2b IBM) and the bank-to- central bank interbank market (b2cb IBM) where monetary policy is played out and interest rates have their genesis (i.e. where interest rate policy is implemented).
• The b2b IBM where the central bank's key lending interest rate (KIR2) has its secondary impact, i.e. on the interbank rate.
• The money market derivative markets (= an addendum).
It is in the money market that money (= bank deposits of the non-bank private sector3) is created by the banks by simply lending (= bank assets). It does not appear proper that the banks are able to do so, but it is so because the general public accepts bank deposits as a means of payment (= the definition of money apart from bank notes and coins), assuming a low inflation environment.
Because of this unique ability of the banks, a referee is required to ensure that the money stock does not grow too rapidly (since high money growth is related to inflation). The referee is the central bank and its weapon is the KIR.
The central bank operates in the debt and foreign exchange (forex) markets through buying and selling debt instruments and forex (called open market operations) with a specific purpose: to ensure that the banks borrow from it at all times. This is called the "liquidity shortage" but it is simply loans to the banks at a rate of interest called the KIR. (This happens in the so-called interbank market.)
The ultimate outcome of the level of the KIR is the level of bank lending rates. This is monetary policy which can be summarised as follows:
• Borrowings from the central bank at all times means that the KIR affects the banks' deposit rates.
• The banks endeavor to maintain a healthy margin (because they are profit-maximises) between what they pay for deposits and what they charge for loans (the high profile loan rate is the prime rate).
• Thus if the KIR affects the banks' deposit rates it affects the banks' lending rates via a "static" margin.
• The level of the banks' prime rates (which are the same) (and their other lending rates which are benchmarked on prime rate) affects the demand for bank loans (= bank credit).
• The demand for credit by the household sector, the corporate sector and the government sector, when satisfied by the banks (which they happily do if the creditworthiness of the borrower is sound), "creates" bank deposits.
• Bank deposit growth is money stock growth, and the "cause" is bank loan growth.
• The money stock growth rate generally reflects the demand for goods and services.
• If the demand for goods (as largely reflected in the bank credit / money stock growth rate) is high and the economy cannot expand quickly enough to satisfy the demand, inflation makes its menacing appearance.
• Thus the job of the central bank is to ensure that the money stock (bank deposits) does not grow beyond the economy's capacity to satisfy the demand (that underlies it).
• This it executes via the one weapon it has: the KIR and the ability to ensure that the banks borrow from it at all times.
• Inflation, if high and sustained, ultimately impairs economic growth because economic agents (individuals and business - the household and corporate sector) devote their attention to hedging their wealth. The foreign sector's involvement in the local economy is also affected.
• A change in money market rates has an almost immediate impact on the pricing / valuation of assets (bonds, equities and property), and therefore on the perception of wealth (which has an effect on expenditure, the main driver of economic growth).
The reason for this exposition is the significance interest rates. They have their genesis in the money market in the form of the KIR. This rate (essentially one-day rate) should be seen as having a direct effect on the one-day interbank rate and therefore on the one-day deposit rate; this rate radiates to all other longer-term rates (deposit and borrowing). The money market rates are a vital input in the pricing of derivative instruments.
Share / equity market
The share market is the market for the issue and trading of shares. The term equity refers to the capital of a company; it is made up of three parts:
• Ordinary shares. These shares are permanent capital in the sense that they represent a share in the ownership of a company
• Preference shares. These shares are long-term capital if they have a maturity date (they usually do), or permanent capital if they are perpetual, i.e. have no maturity date.
• Retained profits.
Ordinary and preferences shares are marketable, whereas retained profits are not. Preference shareholders have preference over ordinary shareholders, and creditors (e.g. bonds, bank loans) enjoy preference over preference shares, in the event of the liquidation of the company.
Foreign exchange market
The forex market, strictly speaking, is not a financial market. However, since residents (ignoring exchange controls for a moment) are able to borrow or lend offshore, and foreigners are able to lend to or borrow from local institutions, the forex market (which allows these transactions to take place) has a domestic and foreign lending or borrowing dimension, and can be viewed as being closely allied to the domestic financial market.
When we focus on the ultimate lenders and borrowers in our depiction of the financial system shown earlier, we observe that these sectors include the foreign sector. This is where the foreign exchange market fits in. The foreign sector is able to supply funds locally, domestic institutions are able to lend to the foreign sector, and the foreign sector is able to borrow funds in the local market (i.e. issue securities in the local market). The unbound forex markets of the world allow this to take place. As indicated above, the forex market should be seen as a conduit for foreigners to the local financial and goods / services markets and for locals to the foreign financial and goods / services markets.
It will be apparent that in order for a forex market to function there needs to be a demand for and a supply of forex. Demand is the demand for, say, US dollars, the counterpart of which is the supply of rand. This cannot be satisfied without a supply of forex (say US dollars), the counterpart of which is a demand for rand. The forex market brings these demanders and suppliers together.
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