The development of financial markets and instruments

The basic needs in the financial world, are the following:

i)  the need to invest excess money (supply)

ii) the need to borrow money (demand) where there is a shortage of money.

The government of a country might, for instance, need money for certain projects, while certain private sector companies or individuals might have excess money to invest in profitable investments. The “price” paid for money is interest paid on the amount borrowed, and the interest rate is thus the price mechanism used in financial markets.

To match different financial needs such as the need to borrow and the need to invest, intermediaries are mostly used, for example:

where an institution wants to invest a certain sum of money, for a certain time, giving them a certain yield
another institution wants to borrow a certain amount of money for a period at the lowest cost possible, the lender’s and the borrower’s demands might differ.

An example would be:

Eskom needs R100 million for a period of at least 10 years to erect new power lines

SCMB has R50 million it wants to invest for 7 years

Investec has R50 million it wants to invest for 12 years.

An intermediary would seek to merge these different needs and demands of borrowers and lenders through negotiation and financial instruments. A certificate would be issued to the lender giving him the right to the interest payments and the redemption amount at expiry of the loan. These instruments are called securities.

Large financial transactions involving the lending and borrowing of money (such as the example above), which are done through intermediaries or as principal by the lender, are often structured and standardised regarding:

the amount of the loan or investment

the interest paid and received thereon

the term to redemption of the loan.

In order to enhance the marketability and tradability of these securities, these standards created for transactions are incorporated into financial instruments. A borrowing certificate from a certain institution, where the institution borrows the money and gives the lender (investor) a certificate promising to pay the owner or holder of the certificate R1 million on 1 June 2008 and interest of 11,00% per annum on R1 million up to 1 June 2008 (similarly to the Eskom 168 certificates), is an example of a financial instrument. A certificate representing the contract between the lender and borrower is issued for the duration of the loan. Appendix 1 is an example of a bond (capital market instrument) which is a financial instrument.

Instruments (certificates) issued by the ultimate borrower are called primary securities.

Instruments issued by intermediaries on behalf of the ultimate borrower are called indirect securities.

The market for instruments (also called securities) issued for the first time, is called the primary market. Because of the standardisation of these instruments, different needs in the markets at different times, and different views of economic factors, these instruments are traded between institutions after they have been issued for the first time. If a lender needs his money before redemption date of the loan, the lender could trade the loan by selling the certificate to another institution. The buyer of the instrument pays the seller an amount (the present value of the future cash flows of the loan), and the buyer becomes the new lender. The market where instruments are traded subsequent to the first issue, is called the secondary market.

The secondary market in some of the securities is a very active market. Activities in the secondary market have a strong determining influence on issues in the primary market as liquidity, tradability, market rates, scale of demand, etc. of specific instruments are reflected in the secondary market. The variables of the economy in these markets are expressed through the interest rate (the price mechanism) determined in the secondary market (called the market rate), and this has an influence on the rate and value at which issues can take place in the primary market. If, for instance, I have R1 million to invest and the market rate is 16% (this means that I can invest my money in the market at 16%); I have the following two choices:

(This example ignores the nominal amount of R1 million that the investor would receive at redemption of the loan. The influence of this will be discussed in later sections and chapters.)

a) Invest in a certificate giving me 11% interest per year indefinitely on R1 million,
b) Invest in an investment in the market giving me 16% (the market rate) interest per year on R1 million.

The obvious choice is b). I would only invest in a) if I could get a discount on my investment. The monetary amount of interest that I would receive from the investment in a) would be 11% on R1 million per year, that is R110 000 per year.

For this amount to give me a return of 16%, I would only be willing to invest:

R110 000/16% = R687 500

If I could get a discount of (R1 000 000 – R687 500) R312 500 on the certificate in a), and only pay R687 500 for the certificate while still receiving 11% interest on the nominal amount of the certificate (R1 000 000), my yield on the investment would be:

R110 000/687 500 = 16%,

The same as option b).

Thus, if the market rate in the secondary market is 16%, and an institution wants to issue certificates in the primary market, the institution has to pay the market rate on his certificates issued, or issue the certificates at a discount if the rate paid on the certificate (called the coupon rate) is less than the market rate. Vice versa, if the rate paid on certificates is higher than the market rate, these certificates would be issued and traded at a premium.

The secondary market gives the investor the opportunity to manage his portfolio in terms of risk and return ratios, liquidity, etc. The return that the investor receives or wants to receive on his investment (called the yield), can be managed within certain parameters, and by using different strategies of buying and selling different instruments and investments in the secondary market.