Trading in the markets

Trading can take place in a market when information about prices are exchanged. The mechanism of price measurement in the money markets is the interest rate, because the interest that the borrower pays is the price that he has to pay for the privilege of using the money for a certain time.

Financial instruments are quoted at interest rates, from which the transaction amount or the amount that the buyer which the transaction amount or the amount that the buyer (lender) has to pay to the seller (borrower), also called the consideration or settlement amount, is then calculated.

Price in monetary values (the consideration paid for an instrument) and interest rate movements are opposites. Fixed interest rate securities are traded at a discount on the nominal value if the market interest rate is higher than the interest rate on the instrument (called the coupon rate). Consider the following example:

An instrument with a term to maturity of one year, a nominal amount of R1 million with a coupon rate of 12% will probably trade at the following prices at the beginning of the year:

If the market rate is 15%, the investor could invest his money at 15% in the market. He would want to buy the instrument giving only a yield of 12% at a discount, so that the money he invested would earn an effective yield of at least 15%. The cash flow that he would receive at the end of the year if the interest is paid at the end of the period, is: Interest: 12% of R1 000 000 = R 120 000

Capital amount: R1 000 000

Total R1 120 000

The total cash flow discounted at the required yield of 15% for one year gives R973 913. For the investor to earn 15% on his investment, he would be willing to pay only R973 913 for the instrument.

If the market rate and yield required by the investor drops to 14% the instrument (using the same calculation methods) would trade at R982 456. Thus, it is clear that with a fixed interest and redemption payment, a lower monetary amount (consideration) would be offered for an instrument if the yield goes up, because the investor would want to earn more on his investment. The interest rate at which the instrument is eventually traded, is called the yield and could differ from the market rate because of differing views, costs, etc.

For trading to take place, a buyer and a seller must get together and negotiate. This could take place on a specifically allocated floor, or by means of a communication system using computer networks and telephones, for instance, the South African Futures Exchange and the JSE. Where a transaction takes place without making use of an organised exchange, the transaction is called an “over-the-counter” (commonly known as OTC) transaction. The Futures Exchange and the JSE have in recent years implemented fully automated electronic trading systems, which eliminate telephone calls between buyers and sellers or buying and selling agents to a large degree. Although transactions are closed in numerous ways, the exchange of money and products such as contracts, certificates, etc. still takes place between the parties of a transaction, and this is called the settlement of a transaction. Settlement of the transaction can take place at a later date than the date of the transaction.

Owning a financial instrument is called a long position. A short position is the selling of a financial instrument without being the owner thereof. Because the settlement date could be after the transaction date, a seller could sell something he doesn’t own and buy it before the settlement date, to be able to deliver it to the buyer.