Brokers Awareness

8/4/2019 Brokers Awareness

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Brokers Awareness program

Dr. Mounther Barakat

Securities and Commodities Authority


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.


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Introduction

It has been noticed that traders and entry

level brokers may be

1- from backgrounds other than finance,or

2- little finance background, or

3- of finance background that needs tobe refreshed

If you are none of the above, this isnot for you


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What is this program about?

Introduction to the field of finance Financial risk and return Demand on financial assets

Structure of interest rates Financial markets efficiency Economic policies and the role of the central bank Capital, money, commodity, derivatives, mortgage, foreign

exchange markets Organization of markets and its operations Introduction to financial analysis Conflict of interest and financial crises Financial institutions: Investment companies, securities firms,

banks, insurance companies, finance companies, pensions, ...


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What is Finance?

Finance deals with: efficient allocation

of resources by using pricing systemsthat are based on the riskness ofassets.

Three areas of finance:

Financial markets and Institutions Intermediation

Corporate finance

Investments


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Definitions from Finance perspective

Asset Real asset Vs. Financial asset Primary asset Vs. Secondary asset Intermediary Vs. broker Vs. dealer Market Financial market Balance sheet

Income statement Statement of cash flow Cash Vs. profit Surplus Vs. Deficit Units


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The financial System

Types of financial Systems

Religious

Socialism

Capitalism

Mixed

The financial system in the UAE is the freemarket system with considerations specific tothe UAE (e.g. Islamic and Arab culture, )


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The financial system

Participants

Governments

Businesses Individuals

Foreigners

The financial sector

Financial markets Financial institutions

Money and Interest rates


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The Financial System

Financial System

I/M Fin. Sec. Participants

- Government.

- Businesses

- Individuals

- Foreigners

- Financial Markets

- Financial Institutions

- Interest rates

- Money Supply


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The Financial Sector

Financial Sector

Financial InstitutionsFinancial Markets

Long Term

Equity

Debt

Short Term

Money

FOREX

Non-depositories

Investment Companies

Securities firms

Contractualfinancing

Depositories

Banks

Credits Unions


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Interest Rates and Money Supply

Interest is the rent of money

Equal to the real growth rate of GDP plus the expected

inflation rate plus a premium to compensate for theriskness of the company being analyzed.

Money supply is the amount of liquidity that is beingallowed by the UAE central bank. The company beinganalyzed benefits if the amount of liquidity is near the

healthy level. Both interest rates and money supply have a great

effect on the performance and value of the companyand need to be taken into consideration in any financial

analysis.


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Function of Financial Markets and Institutions

Allows transfers of funds from person orbusiness without investment opportunities

(i.e., Lender-Savers) to one who has them(i.e., Borrower-Spenders)

Improves economic efficiency


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Segments of Financial Markets1. Direct Finance

Borrowers borrow directly from lenders in financialmarkets by selling financial instruments which are

claims on the borrowers future income or assets

2. Indirect Finance

Borrowers borrow indirectly from lenders via financial

intermediaries (established to source both loanablefunds and loan opportunities) by issuing financialinstruments which are claims on the borrowers futureincome or assets


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Importance of Financial

Markets Financial markets are critical for producing an

efficient allocation of capital, which contributes tohigher production and efficiency for the overalleconomy, as well as economic security for thecitizenry as a whole

Financial markets also improve the lot of individual

participants by providing investment returns tolender-savers and profit and/or use opportunities toborrower-spenders


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FlowofFunds Through the Financial System

Function of Financial Markets


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Classifications of Financial Markets

1. Primary Market New security issues sold to initial buyers

2. Secondary Market Securities previously issued are bought

and sold


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3. Exchanges )(

Trades conducted in central locations

(e.g., ADSM, DFM, .)

4. Over-the-Counter Markets

Dealers at different locations buy and sell


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Long term (Capital Markets)

Debt

Equity

Short term (Money Markets)

Foreign Exchange

Money markets


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1. Debt Markets

Short-Term (maturity < 1 year) MoneyMarket

Long-Term (maturity > 1 year) CapitalMarket

2. Equity Markets Common Stock


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Characteristics of Debt Markets Instruments

Debt instruments

Buyers of debt instruments are suppliers (of

capital) to the firm, not owners of the firm

Debt instruments have a finite life or maturity date

Advantage is that the debt instrument is acontractual promise to pay with legal rights to

enforce repayment

Disadvantage is that return/profit is fixed orlimited


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Characteristics of Equity Markets Instruments

Equity instruments (common stock is mostprevalent equity instrument)

Buyers of common stock are owners of the firm

Common stock has no finite life or maturity date

Advantage of common stock is potential high

income since return is not fixed or limited Disadvantage is that debt payments must be

made before equity payments can be made


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Characteristics of Financial Markets

1. Debt Markets Although less well-known by the average

person, debt markets are much larger in totaldollars than equity markets, due to greaternumber of participant classes (households,businesses, government, and foreigners) andsize of individual participants (businesses, and

government) This is not the case in the UAE; debt market is

mostly bank loans and informal or off balancesheet lending.


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Characteristics of Financial Markets

2. Equity Markets Although newly founded and lacks the needed

environment to function properly, it proved tohave played its role in establishing the elementsof the sovereignty of the country and inpromoting economic development.

To the contrary of most economies including

that of the US the equity market in UAE is largerthan the debt market, due to the fact that thebond markets are small and illiquid.


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Function of Financial Intermediaries

Financial Intermediaries

1. Engage in process of indirect finance2. More important source of finance than

securities markets

3. Needed because of transactions costsand asymmetric information


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Transactions Costs

1. Financial intermediaries make profits byreducing transactions costs

2. Reduce transactions costs by developingexpertise and taking advantage of

economies of scale and scope.

Function of FinancialIntermediaries


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A financial intermediarys low transactioncosts mean that it can provide its customers

withliquidity services, services that make iteasier for customers to conduct transactions

1. Banks provide depositors with checkingaccounts that enable them to pay their bills

easily

2. Depositors can earn interest on checking andsavings accounts and yet still convert them intogoods and services whenever necessary without

having to discontinue and liquidate investments



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Another benefit made possible by the FIs lowtransaction costs is that they can help reducethe exposure of investors to risk, through aprocess known as risk sharing

FIs create and sell assets with lesser risk to one

party in order to buy assets with greater risk from

another party (e.g. banks) This process is referred to as asset

transformation, because in a sense risky assetsare turned into safer assets for investors



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Adverse Selection

1. Before transaction occurs2. Potential borrowers most likely to

produce adverse outcome are ones mostlikely to seek loan and be selected

brokers and financial analysts canprevent that by studying the creditworthiness of the borrowers



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Moral Hazard 1. After transaction occurs

2. Hazard that borrower has incentives toengage in undesirable (immoral)activities making it more likely that won't

pay loan back



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Financial intermediaries reduce adverseselection and moral hazard problems,

enabling them to make profits. Howthey do this is covered in many of thetopics to come.



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Depository Institutions (Banks) Commercial banks

Savings & Loan Associations (S&Ls) Mutual Savings Banks

Credit Unions

Contractual Savings Institutions Life insurance companies Property & casualty insurance companies

Pension funds

Financial Institutions


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InvestmentIntermediaries

Finance companies

Mutual funds

Money market mutual funds



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Commercial banks Raise funds primarily by issuing checkable,

savings, and time deposits which are used tomake commercial, consumer and mortgage loans

Collectively, these banks comprise the largestfinancial intermediary and have the mostdiversified asset portfolios

Around 1 trillion DHS in total assets in the UAE



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S&Ls, Mutual Savings Banks and Credit Unions

Raise funds primarily by issuing savings, time, and

checkable deposits which are most often used to makemortgage and consumer loans, with commercial loans alsobecoming more prevalent at S&Ls and Mutual Savings Banks

Mutual savings banks and credit unions issue deposits asshares and are owned collectively by their depositors, mostof which at credit unions belong to a particular group, e.g.,a companys workers



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All CSIs acquire funds from clients at periodicintervals on a contractual basis and havefairly predictable future payout requirements.

Life Insurance Companies receive funds from policy premiums, can invest inless liquid corporate securities and mortgages,since actual benefit pay outs are close to thosepredicted by actuarial analysis

Fire and Casualty Insurance Companies receive funds from policy premiums, must investmost in liquid government and corporatesecurities, since loss events are harder to predict



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All CSIs acquire funds from clients at periodicintervals on a contractual basis and have

fairly predictable future payout requirements. Pension and Government Retirement Funds

hosted by corporations and state and localgovernments acquire funds through employee and

employer payroll contributions, invest in corporatesecurities, and provide retirement income viaannuities



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Finance Companies

sell commercial paper (a short-term debt

instrument) and issue bonds and stocks to raisefunds to lend to consumers to buy durablegoods, and to small businesses for operations

MutualFunds

acquire funds by selling shares to individualinvestors and use the proceeds to purchaselarge, diversified portfolios of stocks and bonds we will have a training course on these sometime this summer


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Money Market MutualFunds

acquire funds by selling checkable deposit-like shares to individual investors and use theproceeds to purchase highly liquid and safe

short-term money market instrumentsHedge Funds, ETFs and others


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Regulation of Financial

Markets Reasons for Regulation

1. Increase

Information to

Investors

2. Protect investors and their investments

3. Ensure the Soundness of Financial

Intermediaries4. Improve Monetary Control


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Regulation Reason:Increase Investor Information

Asymmetric information in financial markets means

that investors may be subject to adverse selectionand moral hazard problems that may hinder the

efficient operation of financial markets and may alsokeep investors away from financial markets

The Securities and Commodities Authority (SCA)requires corporations issuing securities to disclose

certain information about their sales, assets, andearnings to the public and restricts trading by thelargest stockholders (known as insiders) in thecorporation.


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Regulation Reason:Increase Investor Information

Such government regulation can reduce adverse

selection and moral hazard problems in financialmarkets and increase their efficiency by increasingthe amount of information available to investors


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Regulation Reason: EnsureSoundness of Financial

Intermediaries Because providers of funds to financial

intermediaries may not be able to assess

whether the institutions holding their fundsare sound or not, if they have doubts aboutthe overall health of financial intermediaries,they may want to pull their funds out of bothsound and unsound institutions, with the

possible outcome of a financial panic thatproduces large losses for the public andcauses serious damage to the economy


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Regulation Reason: EnsureSoundness of Financial

Intermediaries To protect the public and the economy from

financial panics, six types of regulations are

needed: Restrictions on Entry - soundness

Disclosure transparency

Restrictions on Assets and Activities no dummies

DepositInsurance peace of mind

Limits on Competition no price wars

Restrictions on Interest Rates no usury


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Regulation: Restriction on

Entry Restrictions on Entry

Very tight regulations as to who is allowed to set

up a financial intermediary Individuals or groups that want to establish a

financial intermediary, such as a bank or aninsurance company, must obtain a charter fromthe government

Only if they are upstanding citizens withimpeccable credentials and a large amount ofinitial funds will they be given a charter.


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Regulation: Disclosure Disclosure Requirements

There are stringent reporting requirementsfor financial intermediaries

Their bookkeeping must follow certain strictprinciples,

Their books are subject to periodic inspection,

They must make certain information available tothe public.


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Regulation: Restriction on Assets

and Activities There are restrictions on what financial

intermediaries are allowed to do and what

assets they can hold

Before you put your funds into a bank orsome other such institution, you would want

to know that your funds are safe and that thebank or other financial intermediary will beable to meet its obligations to you


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Regulation: Restriction on Assets

and Activities One way of doing this is to restrict the

financial intermediary from engaging in

certain risky activitiesAnother way is to restrict financial

intermediaries from holding certain riskyassets, or at least from holding a greater

quantity of these risky assets than isprudent


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Regulation: DepositInsurance

The government can insure people

providing funds to a financial

intermediary from any financial loss ifthe financial intermediary should fail


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Regulation: Past Limits

on Competition Although the evidence that unbridled

competition among financial intermediaries

promotes failures that will harm the public isextremely weak, the government needs toimpose many restrictive regulations

The purpose is to prevent financial

intermediaries from competing to the pointwhere the integrity of the financial system iscompromised.


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Regulation: Past Restrictions

on Interest Rates Competition must also be inhibited by

regulations that impose restrictions on

interest rates that can be paid ondeposits

These regulations need to be instituted

because of the widespread belief thatunrestricted interest-rate competitionhelp encourage bank failures


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Regulation Reason: Improve

Monetary Control Because banks play a very important role in

determining the supply of money (which in turnaffects many aspects of the economy), much

regulation of these financial intermediaries isintended to improve control over the money supply

One such regulation is reserve requirements,which make it obligatory for all depository institutionsto keep a certain fraction of their deposits inaccounts with the central bank

Reserve requirements help the central bank exercisemore precise control over the money supply well,much can be detailed about the UAE monetary policy.


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The cost of money

The price, or cost, of debt capital is the

interest rate.

The price, or cost, of equity capital is therequired return. The required returninvestors expect is composed of

compensation in the form of dividends andcapital gains.


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What four factors affect the cost of money?

Time preferences for consumption (sacrifice)

Expected inflation (loss in purchasing power)

Risk(worry)


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Nominal vs. Real rates

k = represents any nominal rate

k* = represents the real risk-free rate ofinterest, if there was no inflation.Typically ranges from 1% to 4% peryear.

kRF = represents the rate of interest onTreasury securities.


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Determinants of interest rates

)(k = k* + IP + DRP + LP + MRP

k = required return on a debt security

k* = real risk-free rate of interest

IP = inflation premium

DRP = default risk premiumLP = liquidity premium

MRP = maturity risk premium


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Premiums added to k* for different types of debt

IP MRP DRP LP

S-T Treasury

L-T Treasury

S-T Corporate

L-T Corporate


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Yield curve and the term structure of interest rates

Term structure relationship betweeninterest rates (or yields)and maturities.

The yield curve is agraph of the termstructure.


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Hypothetical yield curve

An upward sloping

yield curve.

Upward slope due toan increase inexpected inflation andincreasing maturity

risk premium.

Years to

Maturity

Real risk-free rate

0

5

10

15

1 10 20

Interest

Rate (%)

Maturity risk premium

Inflation premium


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The Yield Curve

Corporate yield curves are higher than thatofTreasury securities, though not

necessarily parallel to the Treasury curve. The spread between corporate and Treasury

yield curves widens as the corporate bond

rating decreases.


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The Yield Curve

0

5

10

15

0 1 5 10 15 20

Years toMaturity

InterestRate (%)

5.2% 5.9%

6.0%Treasury

Yield Curve

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