CapMar Lec5

PPT Week 7-8

Stock Market

• cornerstone of the global financial system

• allows companies to raise capital & investors to own a portion of these companies

• serves as a marketplace where securities (stocks & bonds) are bought & sold

Functions of the Stock MARKET

1. Capital Raising

2. Price Discovery

3. Liquidity

4. Risk Sharing

5. Economic Indicator

Capital Raising

companies can raise capital by issuing stocks or bonds, providing funds for expansion, research, or other business needs

Price Discovery

• stock market provides a platform for determining the price of securities based on supply & demand dynamics

• price discovery mechanism reflects the perceived value of a company & its future prospects

Liquidity

• stock market provides liquidity, allowing investors to quickly buy or sell securities

• this is essential for investor confidence & market efficiency

Risk Sharing

• stock market allows investors to diversify their portfolio & spread risk across different assets

• this function is critical for managing financial risk

Economic Indicator

• stock market performance often reflects the overall economic health of a country

• rising markets typically indicate economic growth, while declining markets may signal economic troubles

Structure of the Stock Market

1. Stock Exchanges

2. OTC

Stock Exchanges

• centralized venues where stocks, bonds, & other securities are traded

• New York Stock Exchange (NYSE)

• National Association of Securities Dealers Automated Quotations (NASDAQ)

• Other Major Exchanges

  • London Stock Exchange (LSE)

  • Tokyo Stock Exchange (TSE)

NYSE

one of the largest & oldest stock exchanges in the world, known for its physical trading floor

NASDAQ

• major electronic exchange that lists many technology companies & operates without a physical trading floor

• founded in 1971 by the National Association of Securities Dealers (NASD), the leading self-regulatory organization for the securities industry in the US at the time

• its branding is Advancing Economic Progress for All where its purpose drives to power stronger economies, create more equitable opportunities, & contribute to a more sustainable world to help our communities, clients, employees, & people of all backgrounds reach their full potential  

PSE

• primarily stock exchange in the PH

• plays crucial role in the country’s financial system by providing a platform for trading securities

• understanding this is essential for grasping the dynamics of the PH capital market & its impact on the economy

• Listed Companies: 278 as of 2024

• Securities: 100-150 approx

• Average Daily Trading Volume: 500 million to 1 billion shares

• Average Daily Trading Value: 5 to 10 billion

OTC

• decentralized markets where trading occurs directly between parties, typically facilitated by dealers or brokers

• handle trading in smaller, less liquid securities not listed on formal exchanges 

Market Participants

1. Retail Investors

2. Institutional Investors

3. Market Makers

4. Regulators

Retail Investors

individual investors buying & selling stocks for personal accounts

Institutional Investors

entities such as mutual funds, pension funds, & insurance companies that invest large sums of money

Market Makers

firms that provide liquidity by buying & selling securities, helping maintain an orderly market

Regulators

bodies like the SEC in the US oversee market operations to ensure fairness & transparency

Instruments Traded in the Stock Market

1. Stocks

2. Bonds

3. Exchange-Traded Funds (ETFs)

4. Derivatives

5. Mutual Funds

6. Convertible Securities

7. Rights & Warrants

Stocks (Equities)

1. Common Stock

2. Preferred Stock

Common Stock

represents ownership in a company with shareholders entitled to vote on corporate matters & receive dividends

Preferred Stock

• represents ownership but typically without voting rights

• receive dividends before common stockholders & have a higher claim on assets in the event of liquidation

Bonds

1. Corporate Bonds

2. Government Bonds

Corporate Bonds

• debt securities issued by companies to raise capital

• investors lend money to the company in exchange for periodic interest payments & the return of principal at maturity

Government Bonds

• issued by governments to finance public spending

• typically lower-risk investments compared to corporate bonds

Exchange-Traded Funds (ETFS)

• investment funds that track the performance of a specific index, sector, or commodity

• traded on exchanges like stocks & offer diversification to investors

Derivatives

1. Options

2. Futures

Options

contracts that give investors the right, but not the obligation, to buy or sell a stock at a predetermined price within a specified timeframe

Futures

agreements to buy or sell a particular asset at a future date & price, often used for hedging or speculations

Mutual Funds

• pooled investments vehicles managed by professional fund managers, investing in a diversified portfolio of stocks, bonds, or other securties

• provide investors with diversification & professional management

Convertible Securities

bonds or preferred stocks that can be converted into common stock

Rights & Warrants

instruments that allow shareholders to purchase additional shares, often at a discount

Types of Financial Risks in Global Markets

1. Currency Risk (Exchange Rate Risk)

2. Interest Rate Risk

3. Credit Risk

4. Political Risk

5. Liquidity Risk

6. Operational Risk

Currency Risk (Exchange Rate Risk)

• risk of financial loss due to fluctuations in foreign exchange rates affecting the value of cross-border transactions or assets

• can lead to reduced revenue or increased costs for businesses dealing in multiple currencies.

Interest Rate Risk

• risk of financial loss due to changes in interest rates affecting the cost of borrowing or the value of interest-bearing assets

• affects debt servicing costs & investment returns, especially for firms with large debt exposure

Credit Risk

• risk that a counterparty will default on its obligations, leading to financial losses

• higher in global markets due to varying credit standards and economic conditions across countries

Political Risk

• risk of financial loss due to changes in political conditions or government policies (expropriation, currency controls, changes in tax laws)

• can disrupt operations, lead to asset losses, or increase costs for multinational businesses

Liquidity Risk

• risk that a firm will not be able to meet its short-term financial obligations due to an inability to convert assets into cash

• more pronounced in global markets where access to liquidity may be restricted by cross-border regulations or market conditions

Operational Risk

• risk of financial loss due to failures in internal processes, systems, or controls, or due to external events (natural disasters)

• amplified in a global environment where firms operate across diverse regulatory, cultural, and economic landscapes.

Strategies for Managing Currency & Interest Rate Risks

1. Currency Risk Management

2. Interest Rate Risk Management

Currency Risk Management

1. Natural Hedging

2. Forward Contracts

3. Currency Options

4. Currency Swaps

Natural Hedging

matching currency inflows & outflows by operating in the same currency as much as possible

Forward Contracts

agreements to exchange currencies at a predetermined rate on a specific future date, locking in exchange rates & protecting against adverse currency movements

Currency Options

contracts that give the right, but not the obligation, to exchange currencies at a specified rate before a certain date, providing flexibility & protection

Currency Swaps

agreements between two parties to exchange cash flows in different currencies, allowing firms to manage currency exposure & access foreign capital

Interest Rate Risk Management

1. Interest Rate Swaps

2. Forward Rate Agreements (FRAs)

3. Caps, Floors, & Collars

4. Debt Restructuring

Interest Rate Swaps

agreements to exchange fixed-rate payments for floating-rate payments (or vice versa), helping firms manage interest rate exposure on debt

Forward Rate Agreements (FRAs)

contracts that fix the interest rate for a future period, protecting against future interest rate volatility

Caps, Floors, and Collars

derivative instruments that limit the maximum (cap), minimum (floor), or both (collar) interest rates that a firm will pay or receive, offering protection against adverse rate movements

Debt Restructuring

adjusting the composition or terms of existing debt to better align with expected interest rate conditions, reducing interest rate exposure

Derivatives

• financial instruments whose value is derived from underlying assets such as currencies, interest rates, or commodities

• widely used for hedging & managing financial risks

• Forwards & Futures

• Options

• Swaps

• Credit Derivatives

Forwards & Futures

standardized contracts obligating the purchase or sale of an asset at a future date, used to lock in prices and mitigate the risk of price fluctuations

Options

contracts that give the right, but not the obligation, to buy or sell an asset at a predetermined price, providing flexibility while managing risk

Swaps

contracts where two parties exchange financial obligations, such as interest payments or currencies, to manage exposure to interest rate or currency fluctuations

Credit Derivatives

instruments like credit default swaps (CDS) that provide protection against credit risk, allowing firms to transfer the risk of default

Role of Derivatives in Risk Management

1. Risk Mitigation

2. Flexibility & Customization

3. Cost Efficiency

Risk Mitigation

derivatives allow firms to hedge against adverse movements in currencies, interest rates, & other market variables, reducing potential losses

Flexibility & Customization

derivatives can be tailored to meet specific risk management needs, providing precise hedging solutions

Cost Efficiency

derivatives often provide a more cost-effective means of managing risk compared to other strategies, such as adjusting physical operations

2008 Financial Crisis & Its Impact on Lehman Brothers

• one of the most prominent victims of 2008 Financial Crisis

• founded in 1850

• grown to become the fourth-largest investment bank in the US, with operations spanning across investment banking, trading, & asset management

• serves as a stark example of how inadequate management of financial risks in a global environment can lead to catastrophic consequences

• this event underscored the importance of robust risk management practices & the need for regulatory oversight to prevent similar crises in the future

Lehman Brothers (Global Financial Risks Involved)

1. Credit Risk

2. Liquidity Risk

3. Market Risk

4. Counterparty Risk

Credit Risk on Lehman Brothers

• significant exposure to subprime mortgages, loans that are given to borrowers with poor credit histories

• widespread default on these mortgages led to substantial losses

Liquidity Risk on Lehman Brothers

as 2008 financial crisis deepened, Lehman Brothers faced a liquidity crunch, unable to secure the short-term funding necessary to maintain its operations

Market Risk on Lehman Brothers

collapse in the housing market caused the value of mortgage-backed securities (MBS) and other financial instruments to plummet, leading to massive write-downs on Lehman's balance sheet

Counterparty Risk on Lehman Brothers

interconnected nature of global financial markets meant that Lehman’s counterparties were also at risk, leading to a loss of confidence and further exacerbating Lehman’s financial difficulties

Impact of 2008 Financial Crisis on Lehman Brothers

1. Loss of Confidence

2. Bankruptcy

3. Global Repercussions

Loss of Confidence

investors and clients lost confidence in Lehman Brothers’ ability to manage its risk exposure, leading to a sharp decline in its stock price and a run on the bank

Bankruptcy

on September 15, 2008, Lehman Brothers filed for Chapter 11 bankruptcy, marking the largest bankruptcy filing in U.S. history with over $600 billion in assets

Global Repercussions

Lehman’s collapse sent shockwaves through the global financial system, leading to a freeze in credit markets, a sharp decline in global stock markets, & and a deepening of the financial crisis

Key Lessons on Lehman Brothers

1. Risk Management Failures

2. Systemic Risk

3. Regulatory Implications

Risk Management Failures

• Lehman Brothers failed to adequately manage its exposure to credit risk & did not have sufficient liquidity to withstand the market downturn

• firm’s reliance on short-term funding and high leverage ratios left it vulnerable to market shocks

Systemic Risk

• collapse of Lehman Brothers highlighted the systemic risks posed by large, interconnected financial institutions

• showed how the failure of one major player could have a domino effect on the global financial system

Regulatory Implications

• aftermath of Lehman’s bankruptcy led to significant regulatory changes aimed at improving risk management practices, enhancing transparency, and reducing systemic risk in the global financial system

Global Financial Crises and Their Impact

• pivotal events that disrupt economies, destabilize financial systems, & affect millions of lives across the world

• marked by sudden collapses in financial markets or institutions, often lead to widespread economic turmoil (recessions, job losses, diminished investor confidence)

• from the Great Depression in 1929 to the 2008 Global Financial Crisis, these events highlight the vulnerabilities of interconnected economies & the far-reaching consequences of financial instability

• impact of global financial crises extends beyond economic

  indicators

  • often exacerbate social inequalities

  • challenge political systems

  • necessitate regulatory reforms to prevent future occurrences

• their ripple effects demonstrate how deeply interconnected & interdependent global markets have become

• understanding the causes and consequences of these crises is essential for policymakers, businesses, & individuals to build resilience & promote sustainable financial systems in an increasingly complex global environment

Financial Crises

• occurs when financial assets or institutions rapidly lose value

• can manifest as banking crises, stock market crashes, currency crises

Types of Financial Crises

1. Banking Crises - collapse of banks due to insolvency or liquidity issue

2. Currency Crises - sudden devaluation of currency

3. Sovereign Debt Crises - government default on their debt

4. Stock Market Crashes - rapid decline in stock prices, eroding investor wealth