Overview of Debt Securities and Markets

Hi everyone, welcome to our lecture on topic 4. The topic is the debt securities and markets. We can split the financial markets into two broad categories. The first is money markets and the second is capital markets. The money markets are basically short-term financial markets where we can borrow money or even lend money for a short period of time, usually less than one year. And the capital markets are the financial markets which are more long-term in nature we access capital markets to borrow money for more than one year or also we invest money through capital markets for more than one year as we discussed before the money markets can comprise of primary markets and secondary markets and then we have domestic financial markets and international financial markets both for money markets and capital markets. We first focus on the money market. These are some of the features of the money market. First, money markets do not have any physical location. Therefore, the money market is a worldwide communication network, which is basically a financial network through which transactions are executed. Debt assets are created and traded through this financial network. The money market is also an over-the-counter market, which means there is no central exchange. In a stock market, shares are traded through the stock exchange. For example, we go to the stock exchange and buy shares. We even go to the stock exchange and we sell shares. We do not have this method or this mechanism of trading in money markets. In money markets, we only have Over the counter trading, for example, we have got market participants who interact with other market participants directly. For example, we have one counterparty that completes a transaction with another counterparty at an arm's length. We have a bank, for example, and the bank has got customers. Let's say the customer wants a short-term loan. What the customer will do is the customer will approach the bank and the customer will receive the short-term loan. In this case the bank is going to lend the customer for a short period of time. Now this is a transaction which is occurring in the money market and this is because this loan facility is for a very short period of time. This can be for example an overdraft facility where the customer is a allowed to overdraw money from the customer's business account and this is usually done for a very short period of time for example one month which means the customer will borrow money from the bank for one month and after that one month finishes the customer will repay the money to the bank and this overdrawn facility will then be cleared the majority of the money market transactions are also large in value, usually several million dollars. Therefore, we consider this as a wholesale market. Furthermore, the money market can be used by the government to raise short-term funding. This is a very important market for the government to access if they want to change the level of interest rates in the short run. We discussed that the long run instruments normally have high interest rates because the long term instruments are considered more risky. Therefore, the government can access the short term money market to raise funding, which are basically for short term financial assets that are considered less risky. And therefore, it is cheaper for the government because the rate of return on short term instruments are low. The government can also implement monetary policy by using the money market. As an example, if there is high inflation in an economy, the government would want to increase the interest rates. And the main reason they want to do this is because they want to attract savings by raising interest rates so that people save more money and spend less money. And At the same time, they want to make borrowing more expensive, which ensures corporations or businesses do not borrow too much money and their investment is reduced to a certain extent. All of this will reduce consumption in the economy and therefore inflation is likely to go down. Now, how does accessing the money market help the government achieve these objectives? objectives. A very quick example would be the government would want to reduce the money supply and if the government is able to reduce the money supply in the economy the interest rate will increase. So if you look at the demand and supply curve of money so we have quantity on the x-axis and we have interest rate on the y-axis. So if the government is able to reduce the money supply, the supply curve will shift to the left. And when the supply curve shifts to the left, initially this was the level of interest. And now the interest rate will rise. interest rate was here let's say this is I naught and now the interest rate is going to be I 1 this will help the short term interest rates to rise and therefore the government can make savings more attractive and borrow it more expensive. Clearly this is a short-term strategy and we are basically saying that the short-term rates will increase. What happens when short-term rates increase? The shape of the yield curve can change. If we remember what a yield curve will look like. We have interest rates on the y-axis and on the x-axis we have n which is term to maturity for different types of financial assets. Now when short-term interest rates go up the short-term interest rates will be somewhere here very high and compared to long-term interest rates the short-term interest rates can be much higher. Therefore we can end up with an inverted yield curve. Normally, yield curves are upward sloping. For example, like this, if we have interest rate on the y-axis and term to maturity on the x-axis, in most cases, the yield curves look like this, where short-term rates are lower than long-term rates. But this open market operation can change this shape of the yield curve from being upward sloping to downward sloping and that is why we say that the money market operations can determine the term structure of interest rate or the shape of the yield curve. We have different participants in the money market. For example, we have got commercial banks, investment banks and finance companies. Then we have got corporations, which are basically businesses that require money or sometimes they even invest money or save money. for short term. We have brokers that try to bring together the buyers and sellers. And then we have got the central bank, for example, the government, which participates in open market operations to tweak the monetary policy or to tweak the interest rate such that the financial stability is maintained. Central banks would use the money market to raise short-term funding as I have discussed before If the central bank or the government is able to raise short-term government funding then it may be cheaper for the government because because short term financial instruments are considered less risky in most cases. And therefore, the rate of return that the government has to pay to the buyers will be lowered compared to long term financial instruments. Therefore, the government can. short-term funding at cheaper costs. Furthermore, the central bank can also enter the money market to influence the monetary policies or to implement monetary policies and change the interest rate in the economy, which is mainly done to control inflation or to stimulate economic growth, etc. the brokers are basically like intermediaries they try to match borrowers with lenders and the benefit of using a broker is that the buyers do not have to really know the sellers personally. So the brokers allow for anonymity. The brokers would find buyers and they would basically help buyers buy the financial security that they like without having to to disclose the personal details like names and addresses of the buyer. So the transaction occurs through the broker's account. So money is basically stored or placed or kept in the broker's account. And then that money is used on behalf of the buyer to buy the financial security that the issuer or the seller is trying to sell. The broker offers all these different range of financial services. for a fee or commission, for example, 1% or 2%. percent of the entire deal can go to the broker and that is their main source of income corporations also need to borrow and lend money overnight in the money market and why do they need to lend or borrow money from the money market which is short-term market i'll give you a quick example let's say we have a corporation which needs to purchase stocks which is not financial stocks but basically stock for reselling physical goods so the money needs to come from the money market which is short-term money market for example 30 days why do they need the money only for 30 days this is because when the corporation purchases the stock they will also resell the stock And once they resell the stock, they will recover all the money related to the purchase of the stock, of course. And once they recover the money, that money then can be paid out to the lender of the initial funding. Therefore, the corporations can access money market to meet their short. term liquidity demand another example would be the corporation has to pay salary for a very short period of time or within a short period of time in order to pay the salary the corporation can access the money market and board borrow money for again 30 days. Once the corporation is able to generate revenue by selling their stocks or by collecting the accounts receivables, they can then repay the money that they have borrowed for only 30 days. So there are all these different reasons why corporations would want to borrow money in the short term and therefore they need to access the money market. Corporations generally use overdraft facilities to meet their short-term liquidity. needs. We will discuss more details about this overdraft facility in the next few slides. Corporations can also invest money for short term. For example, they may have a lump sum payment from an accounts receivable and they don't really know what to do with the money because they will need to pay their suppliers but that will be in two months time. So for these two months, the corporation can invest this money in the short term. money market and earn interest. So corporations can also access money market for their short-term investments and obviously they can also access the money market for taking out a short-term loan. Corporations normally issue commercial bills and promissory notes to access the money market meaning they will issue these financial instruments to take a loan for a short period of time. We have a lot more discussion on commercial bills and and promissory notes in the next few slides and we will discuss these in more detail there now we discuss how do participants in the money market make a profit Now the profit is basically related to the interest income. Now interest is basically a rent charged on lending money for a period of time. So the higher the rent, the higher the income. So the higher the rent, the higher the profit as well. That is the main channel through which all intermediaries in the money market are able to make a profit. If we look at this bullet point, what we see that we need a borrower that borrows at a low rate of interest and they lend at a higher rate. So if we consider a bank, the bank is borrowing money from depositors. So the bank has to pay interest expense on this borrowing. And the bank will also lend this money, which will lead to interest income for the bank because of this lending. Eventually, what the bank wants to ensure is that their interest income should exceed interest expense. Therefore, their net interest income is going to be positive. And that is how intermediaries usually make a profit. So borrowing at a low price. lower rate which means reducing interest expense and lending at a higher rate which means trying to maximize the interest income and therefore interest income can outweigh interest expense ending up with a profit for a bank Furthermore, the participants can also buy financial assets at a lower price and they can sell the financial assets at a higher price. Now, this is typically how discount securities might work. For example, at T equals zero, the market participants can invest $97. So this negative sign indicates that there is cash outflow from the investors. And at T equals one, the future value. this instrument can be 100 which means the investor will receive a hundred back so initially the investor invests 97 so the cash outflow is 97 and finally the investor is able to receive a hundred by investing 97 at the beginning. Therefore, the investor purchases this financial asset for 97, which is at a certain price, which we will say a lower price. And this is because the investor is able to resell meaning the investor is able to get back a hundred at maturity which is basically a higher price than what they paid initially and that is leading to a profit of 100 minus 97 let's say three units and that is again another channel through which financial intermediaries make a profit We now try and focus on different financial instruments that are traded in the money market. We do have some cash products and then discount securities. Our first focus will be on cash products for now. In terms of cash products, we have got overnight cash, cash for seven days, overdrafts which is usually for a month or 15 days or 20 days. Then we have fixed term deposits and fixed term loans. Cash products include overnight cash for example in short it is sometimes called 11 a.m cash. As the name suggests these are very short-term loans which are made only for one night and then the loan is cleared by 11 a.m of the following day. Interest rates are set daily or updated daily and this is traded in a wholesale market in parcels of five or ten million dollars or units which basically means that a large quantity of money is usually lent or borrowed and also repaid overnight and these are mainly used by banks we will discuss more on this in the repurchase agreement slide but i'll still give you a quick example here let's say Commonwealth Bank needs to pay ANZ Bank because a lot of withdrawals occurred from Commonwealth and a lot of money was then paid to ANZ so at the end of the day when the clearing is done or when the settlement occurs it appears that Commonwealth has to pay ANZ a lot of cash for some reason if Commonwealth does not have enough cash it can borrow money from Westpac for just for one night and then repay the money the next day. By borrowing the money from Westpac for one night Commonwealth can settle the payment owed to ANZ and by the next day all unpaid balances would be cleared. So these overnight cash payments or overnight loan facilities are mainly used by banks and these are usually available to banks as well. 7-day cash products are for usually large corporations and as the name suggests money is borrowed for seven days or even deposits are made for seven days basically money is lent out for seven days in this case and then repaid within seven days as well an interest rate can update every seven days in this case Then we have other types of short-term loans, for example, committed loans and uncommitted loans. Committed loans are basically loan facilities where the amount is specified. Now, sometimes what... corporations can have is a loan amount already sanctioned but they do not withdraw the loan which means they do not use the loan fully so these are not fully drawn balances so the amount is committed meaning the amount is specified for example the corporation is allowed to withdraw a total of 10 million dollars so this is a committed loan but let's say the com for some reason the corporation has only withdrawn two million dollars out of the 10 million dollar limit and they still have 8 million balance which they can withdraw when they need to as opposed to committed loans uncommitted loans are also loan facilities that the bank provides to the different borrowers but the amount is not specified the deal is based basically like the following if a corporation needs money the corporation can reach out to the bank and ask for money from the bank but the amount is not predetermined and the bank does not commit to any specified amount in advance so this is the difference between committed and uncommitted loans and then we also have bank overdrafts which we have discussed before for example a corporation or a business needs money for a short period of time to pay salary or to pay suppliers and they do not have enough cash because maybe their accounts receivables or customers are paying them very late therefore they only need the money for like 30 days and And for those 30 days, they can borrow money from the bank or they can overdraw their account, which means they have withdrawn all the money in their account and their account balance is now zero. And what the bank allows the corporation to do is overdraw further money using that business account, which will lead to their balance to go to the negative domain. And that is only for a short period of time, maybe 30 days. In 30 days time, when the corporation... or the business receives money from the accounts receivables or customers they can repay the money to the bank or they can deposit the money in their business account which will again change the balance from a negative balance to a positive balance so that is how overdrawn accounts work or overdraft facilities work and the interest rate is charged daily because this is a very risky sort of you a loan facility the bank does require the money on demand this is because the bank does not commit to a specified time period the lending is on an ad hoc basis in this case meaning the bank does not say well the corporation has got three years to repay this loan no it doesn't work like that the corporation overdraws the account and anytime the bank wants the bank can call up the corporation and and ask for repayment immediately. And these usually have interest rates which track the market interest rate. So this is the bank bill swap index or BBSW in short. So this is basically a reference rate for short term financial instruments or short term financial lending and even borrowing. Now we talk about discount securities and some common products related to discount securities are bills of exchange, trade bills, promissory notes, treasury notes, cds and repos. We will discuss all of these apart from trade bills because these are different types of financial securities which are out of scope for our topic. In bills of exchange, we have bank accepted bills and bank endorsed bills and non-bank bills where a bank is not involved and our focus will be a lot on these. First, let us try and understand what are discount securities. as the name suggests these are financial securities or financial assets that are sold at a discount i have shared many different examples with you about discount securities before but i will still repeat once here so let's say at t equals zero we lend 97 dollars to a corporation which is an issuer and at t equals one which is basically a year later the corporation repays the buyer a hundred So the value of the discount security is 100 but it is initially sold at 97. In other words the corporation which is raising the money or the funds only get to keep 97. 97 or they're able to raise 97 and at the end of the maturity they repay a hundred to the buyer and this leads to a profit of three dollars for the buyer of the discount security and the issuer is able to use 97 and Run the business operations and probably the issuer is able to recover the cost of money, which is this three dollars Now we look at Bills of exchange or commercial bills. These are basically used to finance international trade or trade bills. And these are also used to raise finance in general. This is the formal definition of bills of exchange, but we will discuss this a bit later on. In terms of bills of exchange, we have got two types. One is commercial bills, which is our main focus, and then we have trade bills. In commercial bills, sometimes banks are involved in issuing this commercial bill, and we have two types. One is bank accepted bills and then bank endorsed bills only, and then we also have bills which are not endorsed or accepted by banks at all. Usually we have three parties. The first is the borrower, which is basically the issuer of the discount security. We have an acceptor or a guarantor, which is usually a bank. And then we have the lender, which basically lends money to the borrower. This is about endorsement, which we will discuss later on after understanding what is a bank accepted bill. This is a nice flow chart which illustrates what a bank accepted bill is and how it operates and how are risks reduced in this transaction or in this issuing of commercial bills. First if we look at the issue date we have the borrower which is the issuer of the bill or the commercial bill we have to understand that this bill is again a discount secure which follows the same definition that I have explained to you a little while ago. Discount security is basically a financial security that is being sold or issued at a discount. So the first thing that we need to understand is on the issue date the amount of money that the borrower is receiving is ninety five thousand and eight hundred and this is usually related to a financial face value of a hundred thousand because these bills are traded in multiples of hundreds or thousands so i can make an assumption that the face value of the discount security in total will be a hundred thousand thousand. The first set of arrows indicate that there is a bill which is the financial instrument or the financial contract. The contract is discounted to the buyer. in other words the contract is forwarded to the buyer and the buyer lends money or the buyer or the lender in this case will lend money of 95 800 to the borrower so inside sum the borrower receives 95,800 and then we have a bank which is an acceptor. What is the role of the acceptor over here? The role of the acceptor is at maturity when the buyer is supposed to receive the money back or get the money back you will notice that the acceptor directly pays the buyer okay so if you follow this arrow the money actually comes from the acceptor which is the bank and goes to the discounter or the lender. The lender that holds the bill which is over here will basically present it to the bank or return it to the bank. And where does the bank recover its money from? The issuer. on the due date will repay the bank. 100,000 plus a small margin for the bank's services. Another thing to note here is the amount that is transferred to the issuer is 100,000. Again, I'm showing this to you. The amount that is transferred to the issuer is 100,000. So in effect, the buyer lends 95,800 and gets back 100,000. The difference is the profit for the buyer or the lender and this is also a classic example of a discount security where a certain amount is lent and at maturity a larger amount usually the face value of the financial security is received. So this is normally how commercial bills or bank accepted bills work. How does it help international trade? It helps an international trade by ensuring that the trade trade is completed successfully. For example, we have a US company that is trying to import some sort of product from South Africa. Now, the South African company does not know the US company. They do not have a pre-existing relationship. So what the South African company will demand is the U.S. banks pay the South African company the due amount. So the South African company can trust a large U.S. bank because everyone knows these banks and they are trustworthy and people have confidence in the banking system. So this will ensure that when the South African company finally dispatches the goods they are guaranteed that their payment will be completed by the US bank. In most cases, the payment is sent through and only then the goods are shipped. So this ensures that international trade runs smoothly. For the US bank, this is also a safe sort of a transaction because the US bank can collect the required amount or the amount that the borrower has collected easily from the borrower. and and these are secured loans if the borrower does not pay the bank the bank can foreclose the assets of the borrower and by borrower i basically refer to the drawer over here so this is how bank accepted bills work we have another variation of this which is bank endorsed bills now in bank endorsed bills the banks do not pay the buy buyer or the lender directly the bank only endorses the bill meaning the bank only provides some sort of commitment or guarantee that if the drawer who is supposed to pay the lender directly does not pay the bank will step in and the bank will complete the payment so the bank only provides a guarantee and the and they don't really participate in paying out the lender lender. So that is how a bank endorsement bill works. And this bills can also be traded in the secondary market. So when that happens, bank endorsement is necessary to improve the credit rating of the bill or the credit worthiness of the bill. And that can also incur a contingent liability, meaning the drawer has to secure the bill in some form. for example by pledging an asset or pledging some sort of security to the bank and to the ultimate owners or the buyers of these bills. And if we then go back to the original definition of bills of exchange, it basically says that a certain amount has to be paid to specify person at a determined future time period. And this has to be paid to a certain amount of money. has to be also signed and in writing. So the idea is the same as we discussed, where a discount security is issued, and a certain amount is promised to be repaid to the lender at maturity. And in exchange for that, the lender will initially lend out some money to the drawer or the issuer of the bill in the first instance. Some features of the commercial bills include these. So the terms are usually between 7 and 180 days, which is up to 6 months. The interest rates can vary and these are also traded in the wholesale market where the amounts that are traded are usually large. There is a two-way pricing model here so there is usually a bid rate and that is related to the interest rate and an ask rate which is also related to the interest rate. We will discuss the two way pricing model in more detail in the tutorial because this is a large section which requires a more detailed discussion and it is important even for other topics. Therefore, we will dedicate a lot of time on this area in the tutorial. So leave this out for now. Just for now, I try and understand that there is a bid rate related to the interest rate, which banks. its code and they also have an ask rate which banks code and those are used to understand the price of commercial bill or the interest rate that the buyers will receive and the same interest rate which the sellers or the issuers of the drawers in this case have to pay and then there are some extra fees which apply to borrowers because of different transactions that they are participating in so these are basically the service fees of the transaction fees if you like then we have got promissory notes which are again commercial papers remember these are discount securities they operate in the same way a certain amount is lent and at maturity a larger amount is received in other words in this borrowing time period or lending time period there is no other payment there is no interest paid to the lender the only payment that the lender receives is a lump sum amount at maturity so if the lender lends money for six months in these six months after lending there will be no interest payment there will be no cash inflow for the lender so that is how discount securities work so you pay 97 today in six months you receive 100 back and that's it then these are uh also called IOUs IOU literally what the full form of IOU here is which is IOU and the issuer or the the drawer will owe the money to the lender and there are usually no liabilities here meaning there is no security related to these issues so the issuer does not pledge any collateral or asset against these instruments therefore these are considered more risky than bank accepted bills and therefore the yields are also higher because they're considered more risky than bank accepted bills and also this is one reason why only large companies with very good credit rating or credit quality or credit worthiness are able to issue such bills that are unsecured smaller companies naturally will not be able to do this because their credit ratings are likely to be not that high and therefore promissory notes which are unsecured financial instruments or discount securities are normally issued by large companies. and then we have treasury notes these are the safest form of commercial papers or bills because these are issued by the government so treasury notes in or even treasury bonds basically refer to government issued financial securities they have a very active secondary market at trading which means these treasury notes are extremely liquid instruments instruments. So if if you buy a US government issued Treasury bond, you can resell it at any point of time because there is always very high demand for these government issued bonds. These are also used to improve the asset to liability ratio of different companies. For example, if I as a company buy Treasury notes, my asset ratio will improve by large amounts. The reason for that is These assets are very good quality assets, very liquid. Therefore, the quality of asset is considered quite high relative to other assets. And therefore, the prime asset ratio or the asset to liability ratio improves a lot in the eyes of the investors. These treasury notes are directly. Sold and also bought by the central bank, but we as investors would normally buy it from secondary market and these have lower yields due to Being less risky as these notes are issued by the government and therefore The rate of interest or the yield is lower than bank accepted bills. In other words these Treasury notes are safer than even bank accepted bills we also have certificates of deposits now these are instruments which are again discount securities issued by banks for 90 or 180 days sometimes banks need urgent cash for example during festivals like christmas etc the banks have to pay a lot of money that customers have used on their credit card normally credit card holders will have a certain time period to repay the bank so in the interim period or in this time period the bank has to pay the suppliers or the bank has to pay the stores so they need excess cash to collect this excess cash or raise this amount of fund for a short period of time they can issue promissory notes and these are usually repaid within in a short time frame. And then we have repurchase agreements, which I have discussed before with you. The repurchase agreements are basically overnight loans, if you like. And in these overnight loans, one bank can borrow money from another bank or a Certain bank can borrow money from the central bank The way it works is let's say CBA requires additional funds So what CBA will do is they will provide some collateral or some financial security that they hold for example CBA holds a lot of US government Treasury bonds so what these are assets for CBA and these will be then forwarded to RBA which is the central bank so the central bank will hold these assets or financial securities as collateral or as security and rba will lend money to cba just for one night and the reason why these are called repurchase agreements is because just the following day This transaction will be reversed. In other words, CBA will repurchase the financial securities. In other words, CBA will get back their financial securities because CBA will return the money to RBA. So it is a repurchase agreement between CBA, which is Commonwealth Bank and Reserve Bank of Australia, which is a part of the government. some terms here which will also be useful during the tutorial what does buying a repo mean buying a repo in this case means lending cash so RBA is buying a repo in this case so they are lending cash to CBA and selling a repo would mean to borrow cash so CBA in the first instance is selling a repurchase agreement to RBA the following day these instruments are repurchased by CBA therefore repurchase agreement so CBA gets their financial securities back because they repay the money another important point here is that the title is actually transferred so it's basically sold meaning the financial securities are actually sold and the title is transferred for a short period of time so initially the owner of the financial securities or US Treasury notes would have been the CBA and after selling the repo to RBA the owner of the financial securities will be RBA and the next day when these agreements are repurchased then the ownership will go back to the way they were before which is CBA will be the owner of the financial security and RBA will receive their money back so that ownership will again be transferred from RBA to CBA so this is a pre agreed term so in a repurchase agreement but what's important here is that the title is actually transferred from the seller of the financial security to the buyer. Now we focus on capital markets or debt capital markets, which are the long-term financial markets. In long-term debt, we have corporations here and they can raise funding internally. For example, they can use their reserved earnings or retained earnings or they can use external capital, meaning they can go out in the market and raise funding. So short-term funding is here and then we have long-term funding, which includes Good debt financing and equity financing. So corporations can sell shares and raise money or they can raise money through debt capital, which is by issuing debt securities. Remember, this is part of long term financing. So the debt securities that they will be issuing will be long term debt securities. They can use direct finance, which is by selling. corporate bonds which is what we will discuss at this point so the corporations will sell corporate bonds or even governments can sell corporate bonds and they will receive money directly in other words they do not have to go to a bank and collect a loan which is eventually financed by the depositors of a bank so the bank is the intermediary here therefore this form of financing which is taking a loan from bank is considered indirect finance As opposed to this, direct finance is where the corporations directly issue bonds into the financial markets and investors or buyers effectively lend money to the corporation for a certain period of time, for example, five years. The bonds are usually debenture type in financial instruments and these are also type of notes but long-term notes. These are considered fixed income securities which means every period there will be an interest payment and normally they're fixed by contract so the interest rate will be announced and predetermined. There are two types of bond market in Australia, corporate bond market and government bond market. This slide shows how the Australian bond markets work. Traditionally, we see that the Australian government did not issue bonds more than the non-government sector. However, over time, specifically since 2018 or 2019, we see that the Australian government bonds have overtaken the non-government bonds in terms of the total value. In addition to that, we also see that the state governments have also increased their bond issuance. So overall, we see that the financial markets are now relying more on issuing bonds to raise capital. Traditional corporate bonds are dominated by financial corporations. So financial corporations would issue these bonds and even non-financial corporations would also issue bonds. But financial corporations would then buy these bonds up. And we also have bonds that are issued by foreign companies. For example, kangaroo bonds. These are bonds issued in Australia. and in AUD, but by a foreign company. So kangaroo bonds are issued by non-residents, which basically means a foreign company, but in AUD and in Australia. So there are many different foreign companies that operate in Australia. And if they want to collect money in AUD, they can do that. So kangaroo bonds are issued by non-residents, which basically means a foreign company, but in AUD and in Australia. So there are many different foreign companies that operate in Australia. And if they want to collect money in AUD, they can do that. or if they want to raise AUD they can sell these kangaroo bonds. Then we have also non-financial companies who issue long-term bonds in large amounts. So it's traditionally financial corporations participated in this bond market and these days corporations also participate in long-term bond funding. If you look at the breakdown of the non-government bonds that are issued, we would see that mostly the financials have issued bonds. For example, banks and other financial institutions would be issuing bonds to collect their deposits which they then give out as loans. Then we also have non-financial corporations and non-resident bonds. So these are closely aligned with each other but these are not greater in value compared to the financials and then we also have asset-backed securities which are basically packaged loans or financial assets that banks sell we will discuss these later however there is quite a bit of asset-backed securities in 2007 and 8 however because of their risky nature more regulations let to a decrease in the value of asset-backed securities being circulated. however in the recent years these asset-backed securities are also picking up in terms of the volume of their issuance um 85 percent of government debt is raised through issue of bonds so the bonds are issued by the central bank to the public and these investors would buy up these long-term bonds and the money will flow from the investors to the central bank or the government now these bonds are not directly sold to the investors these are usually sold through the bank and investors who are interested to buy these bonds can buy these bonds from the bank but in most cases banks are the ones who would buy up these treasury bonds and corporations can also do which are basically institutional investors for banks treasury bonds are considered very liquid because these are treasury bonds in other words these bonds are issued by the government and therefore the credit quality is very good so there is always very high demand for buying up this treasury bond so if you hold the treasury bond and you want to sell it to someone else it will be sold almost immediately because these are bonds which are very liquid and can be sold to someone else very quickly because these are very high quality bonds. They have very little risk that they will default meaning if you buy treasury bonds there is very little risk that 30 years later you will not receive your money back. Such risks are very little when it comes to treasury bonds. Again, treasury bonds have very high credit ratings. So these are very low risk bonds generally. And these are issued by the federal government and even state government. So if you can see here, the credit ratings are very high. Triple A is like the highest credit rating possible. So yeah, credit rating is very high for treasury bonds in general. Treasury bonds are actively traded. Again, these are traded through the financial network and dealers would offer bid prices and ask prices which are related to interest rates for the bond. These are large investments so each parcel size is like 10 million and the phase value of each treasury bond is 1000 and the settlement is also done through the financial network. which is stated over here. The phase value is the amount which is usually repaid at maturity and the coupon rate is the rate of interest which is paid periodically. Then there is a maturity date on the bond which is predetermined which is also related to the term to maturity. The price of the bond is set at the beginning and then when it traded in the secondary market the price can vary and then we also have an effective rate of return or the market yield or the yield to maturity which is also the rate of return relate to the bond now this is where I want to discuss a little bit more in detail so how does a bond work so we have understood what a bond is it's a long-term debt instrument but what are the pay related to this we know the phase value of a bond is usually $1,000 so let's say phase value is 1000 and we have a rate which is the interest rate per year so the coupon rate is based on the phase value if you can see over here as an example the coupon rate is 10% and the term to maturity so the bond has been issued for five years in total so if we look at the time period 0 1 2 3 4 & 5 So these are years and every year we will receive 10% and Remember the interest is calculated on the face value So 10% of the face value which is 1000 which is 100 so every year we will receive 100 on top of that at maturity as we have seen in the slide we will receive the phase value this is the payout structure so we pay a certain amount today and we receive 100 for the next five years and 1000. In this case, what we will pay is 1000 and we will receive a 1000 back. So overall our annual income or rate of return is 10%. What I need you to understand here is our focus on is the coupon rate is fixed which is 10 and the coupon rate is 10 of the phase value which is normally 1000 so the coupon rate does not change but this coupon rate is actually quite different to the yield now i want to explain to you what the yield is the yield is the rate of return if the bond is held to maturity so The yield is effective rate of return or the effective interest rate that we earn by purchasing this bond. This can be slightly different to the coupon rate. The promise is that the coupon rate is going to be 10% and we will earn 10% every year. The fun part is it can actually be more than 10% if you calculate and if you invest a smaller amount. Let's say for the same bond that required you to invest 1000 at the beginning is sold at a discount. Instead of paying 1000 we pay just 900. Remember this 100 income does not change. You still receive 100 every year for the next 5 years. And the reason for that is the coupon rate is fixed. This is how bonds work. So the coupon rate has been determined to be 10% and therefore you will receive 10% of a thousand, which is 100. For some reason, you receive a discount. Let's say the company. needs money urgently therefore where you're supposed to pay 1000 the company is happy for you to pay 900 and there are many companies like this that require money and they will provide a discount in fact the market forces would lead to these discounts organically so basically the company will provide some sort of discount so you do not invest 1000 you instead of investing 1000 just invest 900 so if you calculate the effective return for one year you're receiving a hundred and you're investing 900 so your return is approximately 11% this 11% is basically the effective return or rate of return which is actually greater than 10% so to summarize your coupon rate is 10% but your effective rate of return is more than the coupon rate and the reason for that That is, you were able to buy the bond at a discount compared to what you are supposed to pay as face value. Generally, you pay face value. the end of the maturity of the bond you receive the phase value back and periodically you receive the coupon but in this case given that you're able to buy the bond at a discount you make more than the coupon rate so that is what the yield is we have a formal formula to calculate the yield which is again not entirely in the scope of this topic but i've given you a broad idea of How the yield to maturity is calculated? Roughly and that this yield to maturity is actually a very different thing than what the coupon rate is. So This is some food for thought Next we have floating rate bonds or nodes. So these are floating rate bonds whose coupon rates vary with the market interest rate. So if the market interest rates go up, the floating rate nodes rates will go up and vice versa. We also have zero coupon nodes. These are again like discount securities where no coupon is paid every period so a certain amount is paid today in other words a certain amount is lent today and after a time period the phase value is repaid to the lender so these are zero coupon bonds and then we have deferred coupon bonds where in the first few time periods we do not have any coupon payments and the fixed coupons will start after that time elapses convertible bonds so sometimes when we buy bonds at maturity we can negotiate with the seller or the corporation that we do not want cash or face value instead of that we want want shares. The benefit of that is we can become owners of the company. So these are called convertible bonds which already have a predetermined term that at maturity instead of paying out the phase value in cash shares can be issued to the lender or to the buyer of the bond. Then we also have bonds with embedded options. For example, a bond can be sold back to the issuer or the issuer can have the right to recall the bond or pay back the lender before the end of the maturity. So these are callable bonds. we also have foreign bonds as i've explained to you one example kangaroo bonds where foreign companies issue bonds in australian dollars in australia similarly we have samurai bonds foreign companies can sell japanese yen bonds in japan and yankee bonds where foreign companies sell us dollar bonds in the us We also have euro bonds. Now I need you to understand one thing here. Euro bond has got nothing to do with the currency euro as such. These are basically bonds issued in a currency other than the currency of the country where the bond is issued for example if we have a new zealand company operating in australia and issuing bonds in usd that it will be considered a euro bond In other words, the bond issued in a country does not use the local currency of the country where the bond is being issued. And in most cases, the Euro bonds will be issued in USD by different corporations operating in a particular country. However, if a corporation issues bonds in USD in the US, obviously that will not be considered. a euro bond. The rest of the details are very similar to what we have discussed. These are also listed on exchanges and these can be traded through dealers. USD is the dominant currency in which all these euro bonds are issued in most cases and outside US. We also have floating rate notes where the rates can vary even for Euro bonds. And we also have dual currency bonds where funds are raised in one currency and coupon and face values are paid in another currency. So maybe you'll be raising bonds in AUD, but the periodic payments are made in USD. Obviously, you don't get any excess. The currencies are converted on the payment. date and the payments are made as per the agreed amounts.

The money markets are basically short-term financial markets where we can borrow money or even lend money for a short period of time, usually less than one year. And the capital markets are the financial markets which are more long-term in nature we access capital markets to borrow money for more than one year or also we invest money through capital markets for more than one year as we discussed before the money markets can comprise of primary markets and secondary markets and then we have domestic financial markets and international financial markets both for money markets and capital markets. We first focus on the money market.

These are some of the features of the money market. First, money markets do not have any physical location. Therefore, the money market is a worldwide communication network, which is basically a financial network through which transactions are executed.

Debt assets are created and traded through this financial network. The money market is also an over-the-counter market, which means there is no central exchange. In a stock market, shares are traded through the stock exchange. For example, we go to the stock exchange and buy shares. We even go to the stock exchange and we sell shares.

We do not have this method or this mechanism of trading in money markets. In money markets, we only have Over the counter trading, for example, we have got market participants who interact with other market participants directly. For example, we have one counterparty that completes a transaction with another counterparty at an arm's length.

We have a bank, for example, and the bank has got customers. Let's say the customer wants a short-term loan. What the customer will do is the customer will approach the bank and the customer will receive the short-term loan.

In this case the bank is going to lend the customer for a short period of time. Now this is a transaction which is occurring in the money market and this is because this loan facility is for a very short period of time. This can be for example an overdraft facility where the customer is a allowed to overdraw money from the customer's business account and this is usually done for a very short period of time for example one month which means the customer will borrow money from the bank for one month and after that one month finishes the customer will repay the money to the bank and this overdrawn facility will then be cleared the majority of the money market transactions are also large in value, usually several million dollars.

Therefore, we consider this as a wholesale market. Furthermore, the money market can be used by the government to raise short-term funding. This is a very important market for the government to access if they want to change the level of interest rates in the short run. We discussed that the long run instruments normally have high interest rates because the long term instruments are considered more risky. Therefore, the government can access the short term money market to raise funding, which are basically for short term financial assets that are considered less risky.

And therefore, it is cheaper for the government because the rate of return on short term instruments are low. The government can also implement monetary policy by using the money market. As an example, if there is high inflation in an economy, the government would want to increase the interest rates.

And the main reason they want to do this is because they want to attract savings by raising interest rates so that people save more money and spend less money. And At the same time, they want to make borrowing more expensive, which ensures corporations or businesses do not borrow too much money and their investment is reduced to a certain extent. All of this will reduce consumption in the economy and therefore inflation is likely to go down. Now, how does accessing the money market help the government achieve these objectives? objectives.

A very quick example would be the government would want to reduce the money supply and if the government is able to reduce the money supply in the economy the interest rate will increase. So if you look at the demand and supply curve of money so we have quantity on the x-axis and we have interest rate on the y-axis. So if the government is able to reduce the money supply, the supply curve will shift to the left.

And when the supply curve shifts to the left, initially this was the level of interest. And now the interest rate will rise. interest rate was here let's say this is I naught and now the interest rate is going to be I 1 this will help the short term interest rates to rise and therefore the government can make savings more attractive and borrow it more expensive.

Clearly this is a short-term strategy and we are basically saying that the short-term rates will increase. What happens when short-term rates increase? The shape of the yield curve can change.

If we remember what a yield curve will look like. We have interest rates on the y-axis and on the x-axis we have n which is term to maturity for different types of financial assets. Now when short-term interest rates go up the short-term interest rates will be somewhere here very high and compared to long-term interest rates the short-term interest rates can be much higher.

Therefore we can end up with an inverted yield curve. Normally, yield curves are upward sloping. For example, like this, if we have interest rate on the y-axis and term to maturity on the x-axis, in most cases, the yield curves look like this, where short-term rates are lower than long-term rates. But this open market operation can change this shape of the yield curve from being upward sloping to downward sloping and that is why we say that the money market operations can determine the term structure of interest rate or the shape of the yield curve. We have different participants in the money market.

For example, we have got commercial banks, investment banks and finance companies. Then we have got corporations, which are basically businesses that require money or sometimes they even invest money or save money. for short term. We have brokers that try to bring together the buyers and sellers. And then we have got the central bank, for example, the government, which participates in open market operations to tweak the monetary policy or to tweak the interest rate such that the financial stability is maintained.

Central banks would use the money market to raise short-term funding as I have discussed before If the central bank or the government is able to raise short-term government funding then it may be cheaper for the government because because short term financial instruments are considered less risky in most cases. And therefore, the rate of return that the government has to pay to the buyers will be lowered compared to long term financial instruments. Therefore, the government can. short-term funding at cheaper costs.

Furthermore, the central bank can also enter the money market to influence the monetary policies or to implement monetary policies and change the interest rate in the economy, which is mainly done to control inflation or to stimulate economic growth, etc. the brokers are basically like intermediaries they try to match borrowers with lenders and the benefit of using a broker is that the buyers do not have to really know the sellers personally. So the brokers allow for anonymity. The brokers would find buyers and they would basically help buyers buy the financial security that they like without having to to disclose the personal details like names and addresses of the buyer.

So the transaction occurs through the broker's account. So money is basically stored or placed or kept in the broker's account. And then that money is used on behalf of the buyer to buy the financial security that the issuer or the seller is trying to sell. The broker offers all these different range of financial services.

for a fee or commission, for example, 1% or 2%. percent of the entire deal can go to the broker and that is their main source of income corporations also need to borrow and lend money overnight in the money market and why do they need to lend or borrow money from the money market which is short-term market i'll give you a quick example let's say we have a corporation which needs to purchase stocks which is not financial stocks but basically stock for reselling physical goods so the money needs to come from the money market which is short-term money market for example 30 days why do they need the money only for 30 days this is because when the corporation purchases the stock they will also resell the stock And once they resell the stock, they will recover all the money related to the purchase of the stock, of course. And once they recover the money, that money then can be paid out to the lender of the initial funding. Therefore, the corporations can access money market to meet their short.

term liquidity demand another example would be the corporation has to pay salary for a very short period of time or within a short period of time in order to pay the salary the corporation can access the money market and board borrow money for again 30 days. Once the corporation is able to generate revenue by selling their stocks or by collecting the accounts receivables, they can then repay the money that they have borrowed for only 30 days. So there are all these different reasons why corporations would want to borrow money in the short term and therefore they need to access the money market. Corporations generally use overdraft facilities to meet their short-term liquidity. needs.

We will discuss more details about this overdraft facility in the next few slides. Corporations can also invest money for short term. For example, they may have a lump sum payment from an accounts receivable and they don't really know what to do with the money because they will need to pay their suppliers but that will be in two months time.

So for these two months, the corporation can invest this money in the short term. money market and earn interest. So corporations can also access money market for their short-term investments and obviously they can also access the money market for taking out a short-term loan. Corporations normally issue commercial bills and promissory notes to access the money market meaning they will issue these financial instruments to take a loan for a short period of time.

We have a lot more discussion on commercial bills and and promissory notes in the next few slides and we will discuss these in more detail there now we discuss how do participants in the money market make a profit Now the profit is basically related to the interest income. Now interest is basically a rent charged on lending money for a period of time. So the higher the rent, the higher the income. So the higher the rent, the higher the profit as well. That is the main channel through which all intermediaries in the money market are able to make a profit.

If we look at this bullet point, what we see that we need a borrower that borrows at a low rate of interest and they lend at a higher rate. So if we consider a bank, the bank is borrowing money from depositors. So the bank has to pay interest expense on this borrowing. And the bank will also lend this money, which will lead to interest income for the bank because of this lending. Eventually, what the bank wants to ensure is that their interest income should exceed interest expense.

Therefore, their net interest income is going to be positive. And that is how intermediaries usually make a profit. So borrowing at a low price.

lower rate which means reducing interest expense and lending at a higher rate which means trying to maximize the interest income and therefore interest income can outweigh interest expense ending up with a profit for a bank Furthermore, the participants can also buy financial assets at a lower price and they can sell the financial assets at a higher price. Now, this is typically how discount securities might work. For example, at T equals zero, the market participants can invest $97. So this negative sign indicates that there is cash outflow from the investors. And at T equals one, the future value.

this instrument can be 100 which means the investor will receive a hundred back so initially the investor invests 97 so the cash outflow is 97 and finally the investor is able to receive a hundred by investing 97 at the beginning. Therefore, the investor purchases this financial asset for 97, which is at a certain price, which we will say a lower price. And this is because the investor is able to resell meaning the investor is able to get back a hundred at maturity which is basically a higher price than what they paid initially and that is leading to a profit of 100 minus 97 let's say three units and that is again another channel through which financial intermediaries make a profit We now try and focus on different financial instruments that are traded in the money market. We do have some cash products and then discount securities.

Our first focus will be on cash products for now. In terms of cash products, we have got overnight cash, cash for seven days, overdrafts which is usually for a month or 15 days or 20 days. Then we have fixed term deposits and fixed term loans.

Cash products include overnight cash for example in short it is sometimes called 11 a.m cash. As the name suggests these are very short-term loans which are made only for one night and then the loan is cleared by 11 a.m of the following day. Interest rates are set daily or updated daily and this is traded in a wholesale market in parcels of five or ten million dollars or units which basically means that a large quantity of money is usually lent or borrowed and also repaid overnight and these are mainly used by banks we will discuss more on this in the repurchase agreement slide but i'll still give you a quick example here let's say Commonwealth Bank needs to pay ANZ Bank because a lot of withdrawals occurred from Commonwealth and a lot of money was then paid to ANZ so at the end of the day when the clearing is done or when the settlement occurs it appears that Commonwealth has to pay ANZ a lot of cash for some reason if Commonwealth does not have enough cash it can borrow money from Westpac for just for one night and then repay the money the next day. By borrowing the money from Westpac for one night Commonwealth can settle the payment owed to ANZ and by the next day all unpaid balances would be cleared.

So these overnight cash payments or overnight loan facilities are mainly used by banks and these are usually available to banks as well. 7-day cash products are for usually large corporations and as the name suggests money is borrowed for seven days or even deposits are made for seven days basically money is lent out for seven days in this case and then repaid within seven days as well an interest rate can update every seven days in this case Then we have other types of short-term loans, for example, committed loans and uncommitted loans. Committed loans are basically loan facilities where the amount is specified. Now, sometimes what... corporations can have is a loan amount already sanctioned but they do not withdraw the loan which means they do not use the loan fully so these are not fully drawn balances so the amount is committed meaning the amount is specified for example the corporation is allowed to withdraw a total of 10 million dollars so this is a committed loan but let's say the com for some reason the corporation has only withdrawn two million dollars out of the 10 million dollar limit and they still have 8 million balance which they can withdraw when they need to as opposed to committed loans uncommitted loans are also loan facilities that the bank provides to the different borrowers but the amount is not specified the deal is based basically like the following if a corporation needs money the corporation can reach out to the bank and ask for money from the bank but the amount is not predetermined and the bank does not commit to any specified amount in advance so this is the difference between committed and uncommitted loans and then we also have bank overdrafts which we have discussed before for example a corporation or a business needs money for a short period of time to pay salary or to pay suppliers and they do not have enough cash because maybe their accounts receivables or customers are paying them very late therefore they only need the money for like 30 days and And for those 30 days, they can borrow money from the bank or they can overdraw their account, which means they have withdrawn all the money in their account and their account balance is now zero.

And what the bank allows the corporation to do is overdraw further money using that business account, which will lead to their balance to go to the negative domain. And that is only for a short period of time, maybe 30 days. In 30 days time, when the corporation...

or the business receives money from the accounts receivables or customers they can repay the money to the bank or they can deposit the money in their business account which will again change the balance from a negative balance to a positive balance so that is how overdrawn accounts work or overdraft facilities work and the interest rate is charged daily because this is a very risky sort of you a loan facility the bank does require the money on demand this is because the bank does not commit to a specified time period the lending is on an ad hoc basis in this case meaning the bank does not say well the corporation has got three years to repay this loan no it doesn't work like that the corporation overdraws the account and anytime the bank wants the bank can call up the corporation and and ask for repayment immediately. And these usually have interest rates which track the market interest rate. So this is the bank bill swap index or BBSW in short. So this is basically a reference rate for short term financial instruments or short term financial lending and even borrowing.

Now we talk about discount securities and some common products related to discount securities are bills of exchange, trade bills, promissory notes, treasury notes, cds and repos. We will discuss all of these apart from trade bills because these are different types of financial securities which are out of scope for our topic. In bills of exchange, we have bank accepted bills and bank endorsed bills and non-bank bills where a bank is not involved and our focus will be a lot on these.

First, let us try and understand what are discount securities. as the name suggests these are financial securities or financial assets that are sold at a discount i have shared many different examples with you about discount securities before but i will still repeat once here so let's say at t equals zero we lend 97 dollars to a corporation which is an issuer and at t equals one which is basically a year later the corporation repays the buyer a hundred So the value of the discount security is 100 but it is initially sold at 97. In other words the corporation which is raising the money or the funds only get to keep 97. 97 or they're able to raise 97 and at the end of the maturity they repay a hundred to the buyer and this leads to a profit of three dollars for the buyer of the discount security and the issuer is able to use 97 and Run the business operations and probably the issuer is able to recover the cost of money, which is this three dollars Now we look at Bills of exchange or commercial bills. These are basically used to finance international trade or trade bills. And these are also used to raise finance in general. This is the formal definition of bills of exchange, but we will discuss this a bit later on.

In terms of bills of exchange, we have got two types. One is commercial bills, which is our main focus, and then we have trade bills. In commercial bills, sometimes banks are involved in issuing this commercial bill, and we have two types. One is bank accepted bills and then bank endorsed bills only, and then we also have bills which are not endorsed or accepted by banks at all.

Usually we have three parties. The first is the borrower, which is basically the issuer of the discount security. We have an acceptor or a guarantor, which is usually a bank. And then we have the lender, which basically lends money to the borrower.

This is about endorsement, which we will discuss later on after understanding what is a bank accepted bill. This is a nice flow chart which illustrates what a bank accepted bill is and how it operates and how are risks reduced in this transaction or in this issuing of commercial bills. First if we look at the issue date we have the borrower which is the issuer of the bill or the commercial bill we have to understand that this bill is again a discount secure which follows the same definition that I have explained to you a little while ago.

Discount security is basically a financial security that is being sold or issued at a discount. So the first thing that we need to understand is on the issue date the amount of money that the borrower is receiving is ninety five thousand and eight hundred and this is usually related to a financial face value of a hundred thousand because these bills are traded in multiples of hundreds or thousands so i can make an assumption that the face value of the discount security in total will be a hundred thousand thousand. The first set of arrows indicate that there is a bill which is the financial instrument or the financial contract. The contract is discounted to the buyer. in other words the contract is forwarded to the buyer and the buyer lends money or the buyer or the lender in this case will lend money of 95 800 to the borrower so inside sum the borrower receives 95,800 and then we have a bank which is an acceptor.

What is the role of the acceptor over here? The role of the acceptor is at maturity when the buyer is supposed to receive the money back or get the money back you will notice that the acceptor directly pays the buyer okay so if you follow this arrow the money actually comes from the acceptor which is the bank and goes to the discounter or the lender. The lender that holds the bill which is over here will basically present it to the bank or return it to the bank. And where does the bank recover its money from? The issuer.

on the due date will repay the bank. 100,000 plus a small margin for the bank's services. Another thing to note here is the amount that is transferred to the issuer is 100,000. Again, I'm showing this to you. The amount that is transferred to the issuer is 100,000.

So in effect, the buyer lends 95,800 and gets back 100,000. The difference is the profit for the buyer or the lender and this is also a classic example of a discount security where a certain amount is lent and at maturity a larger amount usually the face value of the financial security is received. So this is normally how commercial bills or bank accepted bills work. How does it help international trade?

It helps an international trade by ensuring that the trade trade is completed successfully. For example, we have a US company that is trying to import some sort of product from South Africa. Now, the South African company does not know the US company.

They do not have a pre-existing relationship. So what the South African company will demand is the U.S. banks pay the South African company the due amount. So the South African company can trust a large U.S. bank because everyone knows these banks and they are trustworthy and people have confidence in the banking system. So this will ensure that when the South African company finally dispatches the goods they are guaranteed that their payment will be completed by the US bank.

In most cases, the payment is sent through and only then the goods are shipped. So this ensures that international trade runs smoothly. For the US bank, this is also a safe sort of a transaction because the US bank can collect the required amount or the amount that the borrower has collected easily from the borrower. and and these are secured loans if the borrower does not pay the bank the bank can foreclose the assets of the borrower and by borrower i basically refer to the drawer over here so this is how bank accepted bills work we have another variation of this which is bank endorsed bills now in bank endorsed bills the banks do not pay the buy buyer or the lender directly the bank only endorses the bill meaning the bank only provides some sort of commitment or guarantee that if the drawer who is supposed to pay the lender directly does not pay the bank will step in and the bank will complete the payment so the bank only provides a guarantee and the and they don't really participate in paying out the lender lender.

So that is how a bank endorsement bill works. And this bills can also be traded in the secondary market. So when that happens, bank endorsement is necessary to improve the credit rating of the bill or the credit worthiness of the bill.

And that can also incur a contingent liability, meaning the drawer has to secure the bill in some form. for example by pledging an asset or pledging some sort of security to the bank and to the ultimate owners or the buyers of these bills. And if we then go back to the original definition of bills of exchange, it basically says that a certain amount has to be paid to specify person at a determined future time period.

And this has to be paid to a certain amount of money. has to be also signed and in writing. So the idea is the same as we discussed, where a discount security is issued, and a certain amount is promised to be repaid to the lender at maturity.

And in exchange for that, the lender will initially lend out some money to the drawer or the issuer of the bill in the first instance. Some features of the commercial bills include these. So the terms are usually between 7 and 180 days, which is up to 6 months.

The interest rates can vary and these are also traded in the wholesale market where the amounts that are traded are usually large. There is a two-way pricing model here so there is usually a bid rate and that is related to the interest rate and an ask rate which is also related to the interest rate. We will discuss the two way pricing model in more detail in the tutorial because this is a large section which requires a more detailed discussion and it is important even for other topics. Therefore, we will dedicate a lot of time on this area in the tutorial. So leave this out for now.

Just for now, I try and understand that there is a bid rate related to the interest rate, which banks. its code and they also have an ask rate which banks code and those are used to understand the price of commercial bill or the interest rate that the buyers will receive and the same interest rate which the sellers or the issuers of the drawers in this case have to pay and then there are some extra fees which apply to borrowers because of different transactions that they are participating in so these are basically the service fees of the transaction fees if you like then we have got promissory notes which are again commercial papers remember these are discount securities they operate in the same way a certain amount is lent and at maturity a larger amount is received in other words in this borrowing time period or lending time period there is no other payment there is no interest paid to the lender the only payment that the lender receives is a lump sum amount at maturity so if the lender lends money for six months in these six months after lending there will be no interest payment there will be no cash inflow for the lender so that is how discount securities work so you pay 97 today in six months you receive 100 back and that's it then these are uh also called IOUs IOU literally what the full form of IOU here is which is IOU and the issuer or the the drawer will owe the money to the lender and there are usually no liabilities here meaning there is no security related to these issues so the issuer does not pledge any collateral or asset against these instruments therefore these are considered more risky than bank accepted bills and therefore the yields are also higher because they're considered more risky than bank accepted bills and also this is one reason why only large companies with very good credit rating or credit quality or credit worthiness are able to issue such bills that are unsecured smaller companies naturally will not be able to do this because their credit ratings are likely to be not that high and therefore promissory notes which are unsecured financial instruments or discount securities are normally issued by large companies. and then we have treasury notes these are the safest form of commercial papers or bills because these are issued by the government so treasury notes in or even treasury bonds basically refer to government issued financial securities they have a very active secondary market at trading which means these treasury notes are extremely liquid instruments instruments.

So if if you buy a US government issued Treasury bond, you can resell it at any point of time because there is always very high demand for these government issued bonds. These are also used to improve the asset to liability ratio of different companies. For example, if I as a company buy Treasury notes, my asset ratio will improve by large amounts.

The reason for that is These assets are very good quality assets, very liquid. Therefore, the quality of asset is considered quite high relative to other assets. And therefore, the prime asset ratio or the asset to liability ratio improves a lot in the eyes of the investors.

These treasury notes are directly. Sold and also bought by the central bank, but we as investors would normally buy it from secondary market and these have lower yields due to Being less risky as these notes are issued by the government and therefore The rate of interest or the yield is lower than bank accepted bills. In other words these Treasury notes are safer than even bank accepted bills we also have certificates of deposits now these are instruments which are again discount securities issued by banks for 90 or 180 days sometimes banks need urgent cash for example during festivals like christmas etc the banks have to pay a lot of money that customers have used on their credit card normally credit card holders will have a certain time period to repay the bank so in the interim period or in this time period the bank has to pay the suppliers or the bank has to pay the stores so they need excess cash to collect this excess cash or raise this amount of fund for a short period of time they can issue promissory notes and these are usually repaid within in a short time frame.

And then we have repurchase agreements, which I have discussed before with you. The repurchase agreements are basically overnight loans, if you like. And in these overnight loans, one bank can borrow money from another bank or a Certain bank can borrow money from the central bank The way it works is let's say CBA requires additional funds So what CBA will do is they will provide some collateral or some financial security that they hold for example CBA holds a lot of US government Treasury bonds so what these are assets for CBA and these will be then forwarded to RBA which is the central bank so the central bank will hold these assets or financial securities as collateral or as security and rba will lend money to cba just for one night and the reason why these are called repurchase agreements is because just the following day This transaction will be reversed.

In other words, CBA will repurchase the financial securities. In other words, CBA will get back their financial securities because CBA will return the money to RBA. So it is a repurchase agreement between CBA, which is Commonwealth Bank and Reserve Bank of Australia, which is a part of the government.

some terms here which will also be useful during the tutorial what does buying a repo mean buying a repo in this case means lending cash so RBA is buying a repo in this case so they are lending cash to CBA and selling a repo would mean to borrow cash so CBA in the first instance is selling a repurchase agreement to RBA the following day these instruments are repurchased by CBA therefore repurchase agreement so CBA gets their financial securities back because they repay the money another important point here is that the title is actually transferred so it's basically sold meaning the financial securities are actually sold and the title is transferred for a short period of time so initially the owner of the financial securities or US Treasury notes would have been the CBA and after selling the repo to RBA the owner of the financial securities will be RBA and the next day when these agreements are repurchased then the ownership will go back to the way they were before which is CBA will be the owner of the financial security and RBA will receive their money back so that ownership will again be transferred from RBA to CBA so this is a pre agreed term so in a repurchase agreement but what's important here is that the title is actually transferred from the seller of the financial security to the buyer. Now we focus on capital markets or debt capital markets, which are the long-term financial markets. In long-term debt, we have corporations here and they can raise funding internally. For example, they can use their reserved earnings or retained earnings or they can use external capital, meaning they can go out in the market and raise funding.

So short-term funding is here and then we have long-term funding, which includes Good debt financing and equity financing. So corporations can sell shares and raise money or they can raise money through debt capital, which is by issuing debt securities. Remember, this is part of long term financing. So the debt securities that they will be issuing will be long term debt securities.

They can use direct finance, which is by selling. corporate bonds which is what we will discuss at this point so the corporations will sell corporate bonds or even governments can sell corporate bonds and they will receive money directly in other words they do not have to go to a bank and collect a loan which is eventually financed by the depositors of a bank so the bank is the intermediary here therefore this form of financing which is taking a loan from bank is considered indirect finance As opposed to this, direct finance is where the corporations directly issue bonds into the financial markets and investors or buyers effectively lend money to the corporation for a certain period of time, for example, five years. The bonds are usually debenture type in financial instruments and these are also type of notes but long-term notes. These are considered fixed income securities which means every period there will be an interest payment and normally they're fixed by contract so the interest rate will be announced and predetermined. There are two types of bond market in Australia, corporate bond market and government bond market.

This slide shows how the Australian bond markets work. Traditionally, we see that the Australian government did not issue bonds more than the non-government sector. However, over time, specifically since 2018 or 2019, we see that the Australian government bonds have overtaken the non-government bonds in terms of the total value. In addition to that, we also see that the state governments have also increased their bond issuance.

So overall, we see that the financial markets are now relying more on issuing bonds to raise capital. Traditional corporate bonds are dominated by financial corporations. So financial corporations would issue these bonds and even non-financial corporations would also issue bonds.

But financial corporations would then buy these bonds up. And we also have bonds that are issued by foreign companies. For example, kangaroo bonds.

These are bonds issued in Australia. and in AUD, but by a foreign company. So kangaroo bonds are issued by non-residents, which basically means a foreign company, but in AUD and in Australia. So there are many different foreign companies that operate in Australia. And if they want to collect money in AUD, they can do that.

So kangaroo bonds are issued by non-residents, which basically means a foreign company, but in AUD and in Australia. So there are many different foreign companies that operate in Australia. And if they want to collect money in AUD, they can do that.

or if they want to raise AUD they can sell these kangaroo bonds. Then we have also non-financial companies who issue long-term bonds in large amounts. So it's traditionally financial corporations participated in this bond market and these days corporations also participate in long-term bond funding. If you look at the breakdown of the non-government bonds that are issued, we would see that mostly the financials have issued bonds. For example, banks and other financial institutions would be issuing bonds to collect their deposits which they then give out as loans.

Then we also have non-financial corporations and non-resident bonds. So these are closely aligned with each other but these are not greater in value compared to the financials and then we also have asset-backed securities which are basically packaged loans or financial assets that banks sell we will discuss these later however there is quite a bit of asset-backed securities in 2007 and 8 however because of their risky nature more regulations let to a decrease in the value of asset-backed securities being circulated. however in the recent years these asset-backed securities are also picking up in terms of the volume of their issuance um 85 percent of government debt is raised through issue of bonds so the bonds are issued by the central bank to the public and these investors would buy up these long-term bonds and the money will flow from the investors to the central bank or the government now these bonds are not directly sold to the investors these are usually sold through the bank and investors who are interested to buy these bonds can buy these bonds from the bank but in most cases banks are the ones who would buy up these treasury bonds and corporations can also do which are basically institutional investors for banks treasury bonds are considered very liquid because these are treasury bonds in other words these bonds are issued by the government and therefore the credit quality is very good so there is always very high demand for buying up this treasury bond so if you hold the treasury bond and you want to sell it to someone else it will be sold almost immediately because these are bonds which are very liquid and can be sold to someone else very quickly because these are very high quality bonds. They have very little risk that they will default meaning if you buy treasury bonds there is very little risk that 30 years later you will not receive your money back. Such risks are very little when it comes to treasury bonds.

Again, treasury bonds have very high credit ratings. So these are very low risk bonds generally. And these are issued by the federal government and even state government. So if you can see here, the credit ratings are very high. Triple A is like the highest credit rating possible.

So yeah, credit rating is very high for treasury bonds in general. Treasury bonds are actively traded. Again, these are traded through the financial network and dealers would offer bid prices and ask prices which are related to interest rates for the bond. These are large investments so each parcel size is like 10 million and the phase value of each treasury bond is 1000 and the settlement is also done through the financial network.

which is stated over here. The phase value is the amount which is usually repaid at maturity and the coupon rate is the rate of interest which is paid periodically. Then there is a maturity date on the bond which is predetermined which is also related to the term to maturity.

The price of the bond is set at the beginning and then when it traded in the secondary market the price can vary and then we also have an effective rate of return or the market yield or the yield to maturity which is also the rate of return relate to the bond now this is where I want to discuss a little bit more in detail so how does a bond work so we have understood what a bond is it's a long-term debt instrument but what are the pay related to this we know the phase value of a bond is usually $1,000 so let's say phase value is 1000 and we have a rate which is the interest rate per year so the coupon rate is based on the phase value if you can see over here as an example the coupon rate is 10% and the term to maturity so the bond has been issued for five years in total so if we look at the time period 0 1 2 3 4 & 5 So these are years and every year we will receive 10% and Remember the interest is calculated on the face value So 10% of the face value which is 1000 which is 100 so every year we will receive 100 on top of that at maturity as we have seen in the slide we will receive the phase value this is the payout structure so we pay a certain amount today and we receive 100 for the next five years and 1000. In this case, what we will pay is 1000 and we will receive a 1000 back. So overall our annual income or rate of return is 10%. What I need you to understand here is our focus on is the coupon rate is fixed which is 10 and the coupon rate is 10 of the phase value which is normally 1000 so the coupon rate does not change but this coupon rate is actually quite different to the yield now i want to explain to you what the yield is the yield is the rate of return if the bond is held to maturity so The yield is effective rate of return or the effective interest rate that we earn by purchasing this bond.

This can be slightly different to the coupon rate. The promise is that the coupon rate is going to be 10% and we will earn 10% every year. The fun part is it can actually be more than 10% if you calculate and if you invest a smaller amount. Let's say for the same bond that required you to invest 1000 at the beginning is sold at a discount.

Instead of paying 1000 we pay just 900. Remember this 100 income does not change. You still receive 100 every year for the next 5 years. And the reason for that is the coupon rate is fixed. This is how bonds work. So the coupon rate has been determined to be 10% and therefore you will receive 10% of a thousand, which is 100. For some reason, you receive a discount.

Let's say the company. needs money urgently therefore where you're supposed to pay 1000 the company is happy for you to pay 900 and there are many companies like this that require money and they will provide a discount in fact the market forces would lead to these discounts organically so basically the company will provide some sort of discount so you do not invest 1000 you instead of investing 1000 just invest 900 so if you calculate the effective return for one year you're receiving a hundred and you're investing 900 so your return is approximately 11% this 11% is basically the effective return or rate of return which is actually greater than 10% so to summarize your coupon rate is 10% but your effective rate of return is more than the coupon rate and the reason for that That is, you were able to buy the bond at a discount compared to what you are supposed to pay as face value. Generally, you pay face value.

the end of the maturity of the bond you receive the phase value back and periodically you receive the coupon but in this case given that you're able to buy the bond at a discount you make more than the coupon rate so that is what the yield is we have a formal formula to calculate the yield which is again not entirely in the scope of this topic but i've given you a broad idea of How the yield to maturity is calculated? Roughly and that this yield to maturity is actually a very different thing than what the coupon rate is. So This is some food for thought Next we have floating rate bonds or nodes.

So these are floating rate bonds whose coupon rates vary with the market interest rate. So if the market interest rates go up, the floating rate nodes rates will go up and vice versa. We also have zero coupon nodes.

These are again like discount securities where no coupon is paid every period so a certain amount is paid today in other words a certain amount is lent today and after a time period the phase value is repaid to the lender so these are zero coupon bonds and then we have deferred coupon bonds where in the first few time periods we do not have any coupon payments and the fixed coupons will start after that time elapses convertible bonds so sometimes when we buy bonds at maturity we can negotiate with the seller or the corporation that we do not want cash or face value instead of that we want want shares. The benefit of that is we can become owners of the company. So these are called convertible bonds which already have a predetermined term that at maturity instead of paying out the phase value in cash shares can be issued to the lender or to the buyer of the bond.

Then we also have bonds with embedded options. For example, a bond can be sold back to the issuer or the issuer can have the right to recall the bond or pay back the lender before the end of the maturity. So these are callable bonds.

we also have foreign bonds as i've explained to you one example kangaroo bonds where foreign companies issue bonds in australian dollars in australia similarly we have samurai bonds foreign companies can sell japanese yen bonds in japan and yankee bonds where foreign companies sell us dollar bonds in the us We also have euro bonds. Now I need you to understand one thing here. Euro bond has got nothing to do with the currency euro as such.

These are basically bonds issued in a currency other than the currency of the country where the bond is issued for example if we have a new zealand company operating in australia and issuing bonds in usd that it will be considered a euro bond In other words, the bond issued in a country does not use the local currency of the country where the bond is being issued. And in most cases, the Euro bonds will be issued in USD by different corporations operating in a particular country. However, if a corporation issues bonds in USD in the US, obviously that will not be considered.

a euro bond. The rest of the details are very similar to what we have discussed. These are also listed on exchanges and these can be traded through dealers. USD is the dominant currency in which all these euro bonds are issued in most cases and outside US. We also have floating rate notes where the rates can vary even for Euro bonds.

And we also have dual currency bonds where funds are raised in one currency and coupon and face values are paid in another currency. So maybe you'll be raising bonds in AUD, but the periodic payments are made in USD. Obviously, you don't get any excess. The currencies are converted on the payment. date and the payments are made as per the agreed amounts.

Transcript for:Overview of Debt Securities and Markets

Transcript for:
Overview of Debt Securities and Markets