Chapter 12| Financial markets and the treasury function

Introduction – The financial system

The Financial System:
An umbrella term encompassing various components:
Financial markets, including stock exchanges and money markets.
Financial institutions, such as banks, building societies, insurance companies, and pension funds.
Financial securities, which include mortgages, bonds, bills, and equity shares.

Functions of the Financial System:

Channels funds from lenders to borrowers.
Provides mechanisms for payments, such as direct debits and cheque clearing systems.
Creates liquidity and money, with banks contributing to money creation through lending.
Offers financial services like insurance and pensions.
Provides facilities for managing investment portfolios to hedge risk.
Securities:
Securities are mediums of investment, such as shares, corporate bonds, or money market instruments.
Many securities are actively traded on financial markets.
Buyer and Seller in Securities Transactions:
For every security, there is both a buyer (investor providing funds) and a seller (recipient of funds).
Examples include an individual investor buying shares of a listed company or a bank investing in government-issued
treasury bills.
These points summarize the key concepts and functions related to the financial system and securities described in the
provided text.

2 The role of financial markets

Certainly, here are bullet points summarizing the key points from the provided text about the role of financial markets,
primary and secondary markets, and various types of financial markets:

Role of Financial Markets:

Financial markets serve as mechanisms for connecting parties with cash surpluses (surplus units) and those with cash
deficits (deficit units).
Surplus units seek to invest, deposit, or lend funds to earn economic returns.
Deficit units seek to borrow funds to manage liquidity positions.

Types of Financial Markets:

Capital Markets: Include stock markets for shares and bond markets.
Money Markets: Provide short-term (< 1 year) debt financing and investment options.
Commodity Markets: Facilitate the trading of commodities like oil, metals, and agricultural produce.
Derivatives Markets: Offer instruments for managing financial risk, such as options and futures contracts.
Insurance Markets: Facilitate the redistribution of various risks.
Foreign Exchange Markets: Facilitate the trading of foreign exchange.

Primary and Secondary Markets:

Primary Markets: Deal in
Secondary Markets: Allow investors to tradenew securities and
"second-hand" raise newincreasing
securities, finance for
thedeficit units. of surplus units to
willingness
invest.

Functions of Secondary Markets:

Diversification: Enables investors to spread risk across a range of enterprises.
Risk Shifting: Offers various types of securities with different risk-return profiles.
Hedging: Allows participants to reduce risk by using counterbalancing contracts.
Arbitrage: Involves buying low and selling high in different markets to make a profit.

Importance of Secondary Markets:

 Well-developed secondary markets reduce price volatility and encourage investors to supply funds.
Secondary markets fulfill roles for both lenders and borrowers, even though primary markets raise new funds.
Disintermediation and securitization provide alternative means of dealing with cash flow surpluses and deficits.

Division of Sources of Finance:

Sources of finance can be divided based on duration:
Short-term (up to one year).
Medium-term (1–7 years).
Long-term (7 years or more).
The choice of financial market for deficit units and surplus units depends on the duration of funds required or
willingness to invest.

Money Markets:
Money markets deal in short-term funds.
Transactions in money markets are conducted by phone or online.
It consists
Liquidity in money of markets
interconnected
reducedmarkets where
after the 2008 various players
global credit engage
crunch in to
due short-term
increasedtransactions.
suspicion among
participants.

Money Markets Functions:

Providing short-term liquidity to companies, banks, and the public sector.
Supporting short-term trade finance deals.
Companies can use bank borrowing, factoring, or commercial paper markets for short-term financing.
Banks participate in inter-bank markets, such as the London Inter-Bank Offered Rate (LIBOR).

Short-Term Trade Finance:

Firms use banker's acceptances and letters of credit to manage default risk and payment delays in large trade deals.
The process involves issuing a letter of credit, shipping goods, creating a banker's acceptance, and various options for
using it.
Banker's acceptance can be redeemed after a specified period.

Capital Markets:
Capital markets deal in longer-term finance and include stock exchanges.
Major securities traded on capital markets:
Public sector and foreign stocks.
Company securities like shares and corporate bonds.
Eurobonds (international bonds, not necessarily related to Europe or the Euro).

International Capital Markets:

International financial markets involve the supply of domestic funds to foreign users or vice versa.
Key international markets include the Euromarkets and foreign bond markets.
Eurocurrency refers to money deposited with a bank outside its country of origin, e.g., Eurodollars.

Euromarkets:
Euromarkets involve the use of foreign currencies in international financial transactions.
Eurodeposits are held with banks outside their country of origin.
Eurodeposits are often lent to other customers, creating a Euromarket in that currency.
Eurocurrency Market:
It involves short- to medium-term borrowing and lending of Eurocurrencies.
Various types of deposits and loans are available with durations ranging from overnight to five years.
Deposits can be straight-term or in the form of negotiable Certificates of Deposit (CDs).
Eurocurrency loans can include straight bank loans, lines of credit, and revolving commitments.
Business in the Eurocurrency market includes interbank transactions as well as governments, local authorities, and
multinational companies.
 Excellent credit standing and the need for large sums of money are prerequisites for firms wishing to use the market.

Eurobond Market:
Eurobonds are bonds issued simultaneously in multiple countries, denominated in a currency other than the issuer's
national currency.
Eurobonds represent the long-term segment of the Euromarket.
They may run for periods of 3 to 20 years and can be fixed or floating rate.
Convertible Eurobonds and Option Eurobonds are also utilized.
Major borrowers include large companies, international institutions like the World Bank, and the European Commission.

Stock Markets and Corporate Bond Markets:

Stock markets facilitate the trade of various securities, including shares of public companies, corporate bonds,
government bonds, and local authority loans.
They play a crucial role in allocating capital to industry and determining fair asset prices.
Speculative trading helps smooth price fluctuations and ensures marketability.
Market-makers maintain stocks of securities, quote buying and selling prices (bid and offer prices), and profit from the
spread.
In the UK, there are three stock markets: London Stock Exchange (main market), Alternative Investment Market (AIM)
for smaller companies, and Ofex (off exchange) for trade through specialist brokers.

Role of Speculation:
Speculation can have several functions, including:
Smoothing price fluctuations by anticipating market movements.
Ensuring that shares remain readily marketable.
Assisting in the determination of fair asset prices.

Buying and Selling Securities:

Investors market-makers,
Brokers may act as agents, contacting contact brokersor
toact
buyasand sell securities.
principals (broker-dealers) trading on their own
account.
Market-makers quote bid and offer prices and generate income from the spread.
Stock prices are influenced by supply and demand dynamics and can be impacted by the future return/risk profile of
shares.

Types of Stock Markets:

A country may have multiple securities markets.
In the UK, examples include:
London Stock Exchange (main market) for large public companies.
AIM for smaller companies with lower entry and reporting requirements.
Ofex for trading shares in some public companies through specialist brokers.

3 The role of financial institutions

Certainly, here are bullet points summarizing the key points from the provided text about the role of financial
institutions and various types of financial intermediaries:
Role of Financial Institutions:
Financial intermediation involves the process of connecting lenders and borrowers through intermediaries.
It provides an efficient way to manage risks, aggregate funds, and transform maturities.
Financial intermediaries serve as intermediaries between lenders and borrowers, offering various financial products.
Financial Intermediaries - What They Do:
Risk Reduction:
By lending to a variety of individuals and businesses, financial intermediaries reduce the risk of total loss due to a single
default.
Aggregation:
Financial intermediaries pool small deposits to make larger advances, allowing them to serve more borrowers
effectively.
Maturity Transformation:
They match long-term borrowers with short-term savers, bridging the gap between the two.
Financial Intermediation:
Financial intermediaries connect lenders and borrowers through the process of financial intermediation.

Types of Financial Intermediaries:

Clearing Banks:
Provide payment and cheque clearing services.
Offer various accounts and loans to both businesses and individuals.
Investment Banks (Merchant Banks):
Provide financial advice to businesses, help raise capital, and manage business clients' financial affairs.
Offer services like leasing, factoring, hire-purchase, and general lending.
Play a role in foreign trade by offering services such as marine insurance and credits.
Savings Banks:
Collect funds from small personal savers and mainly invest in government securities.
Building Societies:
Accept deposits from households and lend to individuals for home purchases.
Provide services similar to clearing banks.
Finance Companies:
Include finance houses offering medium-term credit, leasing companies leasing capital equipment, and factoring
companies providing loans secured on trade debtors.
Pension Funds:
Collect funds from employers and employees to provide pensions upon retirement or death.
Invest funds for the long term.
Insurance Companies:
Use premium income to invest in assets like bonds, equities, and property.
Provide long-term and short-term insurance services.
Investment Trusts and Unit Trusts:
Investment trusts are closed-end funds that invest in shares and bonds.
Unit trusts, also investing similarly, vary in fund size based on investor activity.

4 Money market instruments

Coupon Bearing Instruments:
These have fixed maturity and specified interest rates.
Certificates of Deposit (CDs):
Represent a deposit with an issuing bank or building society.
Fully negotiable, offering instant liquidity to depositors.
Provide banks with fixed-rate deposits for a specific period.
Sale and Repurchase Agreements (Repos):
Involve selling securities (e.g., treasury bills) to another party and agreeing to repurchase them later at a higher price.
Functions as a secured short-term loan, with the higher repurchase price reflecting the interest on the loan.
Discount Instruments:
Funds are raised by issuing bills at a discount to their eventual redemption or maturity value.
Bills are issued in large denominations and are highly liquid.
Lenders receive a capital gain as their reward.
Treasury Bills:
Mainly issued by governments via central banks.
 Typically have one- or three-month maturities.
Commercial Bills:
Similar to treasury bills but issued by large corporations.
Commercial Paper:
Has initial maturities typically between seven and forty-five days.
May be unsecured, making credit ratings important.
Banker's Acceptances:
Discussed in detail under trade finance.
Derivatives:
Assets whose value is derived from the behavior of an underlying asset.
Common underlying assets include commodities, shares, bonds, indices, currencies, and interest rates.
Types of derivatives include forwards, futures, options, and swaps.
Derivatives can fix future prices (forwards and futures) or give the right (but not obligation) to fix future prices (options).
Derivatives can be traded on exchanges or over the counter (OTC).
Role of Money Market Instruments for Short-Term Financing:
Cash generators lay off cash on short-term markets or return surplus funds to investors.
Cash consumers, like fast-growing firms, look to borrow short-term funds.

5 The role of the treasury function

The treasury function within a firm encompasses various roles, including:
Long-termShort-term management
wealth maximization of resources,
through activitiessuch as cashlong-term
like raising management andinvestment
finance, currency management.
decisions, and dividend
policy.
Risk management, including assessing risk exposure and managing interest rate and foreign exchange risk.
Larger organizations often have a separate treasury department, while in smaller companies, the treasury function
may be part of the finance team.
Treasury management primarily focuses on liquidity management, crucial for a business's survival and growth.
Reasons for developing separate treasury departments:
The size and
Modern internationalization
business of companies
practices, aided by technologyand financial markets increase
and communication, theopportunities
create complexity offortreasury functions.
profit and cost
minimization.
Most large international corporations have moved towards establishing separate treasury departments.
Treasury departments heavily rely on technology for information and operations.
The treasurer typically reports to the finance director and plays a vital role in borrowing, cash management, currency
management, and various financial strategies.
Treasury departments are not large and are not involved in detailed transaction recording.
In international groups of companies, corporate treasurers face unique challenges, such as setting transfer prices,
managing currency exposure, international cash transfers, and investment strategies.
Companies must decide whether to centralize or decentralize treasury management:
Centralization involves holding minimum cash balances at operating companies and managing surplus funds
centrally (cash pooling).
Decentralization requires each operating company to appoint an officer responsible for its own treasury operations.
Advantages of centralization:
Avoids duplication of treasury skills.
Allows for more favorable borrowing and deposit rates.
Enables more effective management of foreign currency risk.
Eliminates situations where one company borrows at high rates while another has idle cash.
Can operate as a profit center and optimize transfer pricing for tax benefits.
Facilitates quick fund transfers to companies in need of cash.
Advantages of decentralization:
Provides greater autonomy and motivation to individual companies.
Local operating units can respond more quickly to local conditions and developments.