Financial Markets & Treasury Function

Question 1

What are capital and money markets and what are their main functions?

Answer 1

Capital and Money Markets are part of the overall Financial system.
They both have the same primary purpose of operating as a mechanism for entities with cash surplus/ cash deficit to be in contact with each other for the purpose of acquiring or providing Finance.

• Money Markets - the provide short term (< 1 year) financing and investment.
• Capital Markets - Consisting of the Stock and Bond markets.

Within these two market types there are also:

• Primary Markets - Dealing in new securities
• Secondary Markets - Dealing in “second hand” securities. And utilised to provide diversification, Risk shifting and hedging.

Security = Generic term for a medium of investment.

Question 2

What is a financial intermediary and what role do they play in the Financial System?

Answer 2

A financial intermediary is a third party through whom a lender and a borrower “meet”, they are commonly Banks, Building societies and serve several functions:

• Reduction of Risk - Lending is spread across a variety of entities reducing the potential for overall loss of assets due to default.
• Maturity Transformation - this is essentially a bridge between the needs of lenders (using short term savings deposits) and the needs of the borrowers who will usually be looking for finance over greater than one year periods.
• Aggregation - In isolation a savings balance or other held by a bank may not be of significant value, however by aggregating the balances of multiple accounts the intermediary has access to a larger pool available for lending purposes and earnings returns.

Question 3

What Functions do the stock and Corporate bond markets provide?

Answer 3

These markets facilitate trade in a variety of stocks, such as Issued shares of Public companies and Corporate bonds, and as part of that trade process:

• Allocate capital to industry
• Determine a fair price for assets traded.
• Through Speculative trading - smooth price fluctuations and ensure shares are readily marketable.

A country may have more than one stock exchange, e.g London:

• London Stock Exchange - main market
• Alternative investment market - for smaller companies
• OfEx (Off Exchange) - trade via specialist brokers.

Question 4

How do the money markets provide short term liquidity and short term trade finance?

Answer 4

Short term liquidity

• Short term borrowing - usually fixed term, may be variable or fixed rate and are quite often secured. Would expect this type of borrowing to relate to the acquisition of a single asset e.g vehicle for business use.
• Overdraft - a lot of business have an overdraft option, usually available at variable rates and unsecured.
• Factoring - primarily where sales are to low risk customers (with recourse would result in claw back due to high risk customers)
• Commercial paper - generally businesses with strong credit ratings would access these as they provide financing at a lower rate than the banks.

Short Term Trade Finance.

Where a business is making a single, large value, trade deal short term trade finance may be used to manage tow issues:

• Risk of default from the customer
• Time delay between cost of sales being incurred and receipt of funds.

These are both managed through the use of a “letter of Credit”

1. Initial trade deal - goods and their sale price are agreed, payment terms also agreed.
2. The buyer agrees terms with their bank, buyer bank then issues sellers bank with a letter of credit detailing the balance to be paid and the terms it will be paid on.
3. Goods are shipped by the seller who provides documentary proof of despatch/delivery of goods to their bank.
4. Sellers bank returns letter of credit to buyers bank, buyers bank then accepts the LOC thus accepting responsibility for payment.
5. The Sellers bank can then either
   
   1. Await payment per agreed terms
   2. Request immediate payment of the LOC, which would occur at a discounted rate.
   3. Sell the LOC (at discounted value) to the money markets.
6. Buyers bank can redeem the LOC once the term has passed making payment to the current holder.

Question 5

How do the money markets help businesses manage exposure to Foreign currency and interest rate risk?

Answer 5

Exposure to risk in the money markets is achieved through the use of Money Market instruments known as derivatives.

A derivative derives it’s value from an underlaying asset, and are contracts that give the right, sometimes obligation, to benefit from the changes in value of the underlaying asset. Types of derivative include:

• FRA’s Forward rate agreements - lock in a future interest rate.
• Caps and Floors - Guarantee a Max/Min interest rate to be paid.
• Interest rate futures and Options - Fix future interest rates or leave exposure to positive changes only.
• Interest rate Swaps - Option to swap interest rates with another party.
  
  • Swaptions - option to swap interest rates.

Question 6

What types of Money market instruments are there and how are they used?

Answer 6

• Coupon Bearing securities - Fixed maturity and specified rate of interest. So low risk with guaranteed returns. These will include
  
  • Certificates of Deposit - Issued by a bank to be accessed at the end of a term. Used to provide proof of funds.
  • Sale & repurchase agreement - Sell a short term security with agreement to buy back later at a higher price.
• Discount Instruments - issued at a discount to redemption/maturity value. Large denomination, Highly liquid, effectively fixed interest. Types of this instrument are:
  
  • Treasuries - Short term Government debt (1-3 years)
  • Commercial Bills - Short term large company debt
  • Commercial Paper - Very short term company borrowing (7-45 days)
  • Bankers acceptance - Short term debt guaranteed by the bank.
• Derivatives - used to manage risk (see other card) most common underlaying are commodities, shares, bonds, currencies and interest rates.

Question 7

With Treasury management what are the benefits of this as a centralised function over decentralised?

Answer 7

The treasury function relates to the management of business liquidity so will deal with areas such as borrowing, cash management, currency issues and dividend policy.

A centralised function provides the following benefits:

• Avoidance of duplication of tasks and skills.
• Economies of Scale - borrowing requirements can be managed in bulk potentially giving access to preferential rates, higher (aggregate) volumes of surplus funds also attract more favourable returns.
• Currency exchange risk - viewed and managed with oversight of the whole business position.
• Transfer prices can be established to manage whole group tax expense.

However decentralisation would provide alternative benefits:

• Autonomy - providing greater motivation and a more focused approach to managing costs.
  
  • Better feel for local conditions.