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International Financial Tools 4 Folder of Exercises and Case Studies EXERCISES Exercise 1. Financial markets and their participants With globalization, financial markets have multiplied and become more complex. Overview of the main participants. "The markets think the crisis is over", "The markets have decided not to buy any more Greek public debt", These are the phrases that have been heard or read recently in the media. But who are these financial markets with such formidable intelligence and power? The answer is both simple and complicated. Simple, because markets basically correspond to the actors who trade on them. But the answer is actually more complicated because there are several types of financial markets, organised in different ways. In particular, the role of the authorities and the mode of regulation differ significantly from one market to another and from one country to another. The Stock Exchange, an organized market: Basic intermediaries, brokerage firms, often subsidiaries of banking institutions, are responsible for trading and listing securities. But the real protagonists of these exchanges are three: the issuers that offer the new securities on the primary market, institutional investors and banks, which carry out the bulk of the transactions in the securities (purchases and sales). Two other categories of actors play an essential role in the evaluation and control of stock exchanges. First and foremost, financial analysts, who monitor developments in corporate and government finances, and especially the rating agencies, which are responsible for assessing and rating the ability of issuers of securities to repay, and whose influence on market equilibrium has become considerable. Secondly, there are the market authorities, which are of two types: on the one hand, the private authorities, which run the stock exchanges through public limited companies. Thus, Euronext is a public limited company under Dutch law with a supervisory board and a management board that defines the operating rules of this pan-European market. Above the private authorities are the public authorities, present at the national level - in France, the Autorité des marchés financiers - and at the European level (the European Securities Market Authority (ESMA). The role of these public authorities is to set market rules and monitor their application; they have the power to impose sanctions. Over-the-counter markets: Alongside exchanges such as Euronext, which are "organised" markets controlled by the authorities, over-the-counter markets have developed on which transactions are carried out between operators who define the terms of their exchange directly between themselves. These markets are totally opaque and are therefore very different from stock exchanges. They have grown considerably since the early 2000s and are present in different segments of the financial industry. They now capture the bulk of securities transactions. They are known as "dark pools", markets where transactions are carried out "in the shadows", thus escaping the scrutiny of public authorities. These markets are reserved for large investors, not least because the packages of shares traded amount to millions or even billions of euros. Dark pools constitute a real "black hole" in the current system of stock market regulation. The public authorities have a share of responsibility in this worrying situation: dark pools developed following a 2007 European directive (Markets in Financial Instruments Directive, MiFID) that sought to break the monopoly of stock exchanges by promoting these "alternative" forms of trading, encouraging financial players to create their own exchanges outside organised markets. Over-the-counter markets also account for more than 90% of transactions in derivatives, sophisticated financial products that are used both to hedge against International Financial Tools 5 Folder of Exercises and Case Studies unexpected changes in financial assets (exchange rates, equities, commodities, etc.) and to speculate on these changes. The foreign exchange market, a global market: In addition to the securities markets discussed above, the foreign exchange markets are the place where currencies are exchanged, leading to the determination of exchange rates. This global currency market is by far the largest of all markets: according to the recent triennial survey of the Bank for International Settlements (BIS), daily trading in this market will amount to $4 trillion in 2010, which is ten times that of equities and four times that of bonds. This market is highly concentrated: 85% of transactions are in dollars; more than 50% of transactions are carried out in two financial centres, the United Kingdom (36.7%) and the United States (17.9%). Another feature is that most transactions are again over-the-counter, most often using automated electronic systems that can handle thousands of orders per minute. The latest BIS survey reveals an important change: interbank transactions have been overtaken for the first time by non-bank financial institutions, such as institutional investors, but especially hedge funds and central banks. This change corresponds to a twofold evolution. The speculative dimension of the foreign exchange market has become predominant, as shown by the growing role of hedge funds. In other words, whereas foreign exchange market transactions were directly linked to trade in the early 1970s, they are now linked to international financial transactions, most of which are purely financial transactions of a speculative nature. H. Lopin, Alternatives Economiques, 01/01/2011 Question 1: Explain the difference between an OTC market and an organised market and show, based on the text, the growing importance of the former for market participants. Question 2: Explain the relationships between the main players in the financial markets: issuers, institutional investors, banks, financial analysts and rating agencies. Question 3. What are the differences between private and public regulators? International Financial Tools 6 Folder of Exercises and Case Studies Exercise 2. Which stock market index should you trust? Criticized, the major traditional indices are competing with newcomers. The CAC 40 regularly finds itself criticized. Like all indices, it measures the weight of the stocks that make up the index according to their market capitalization. Because the more fashionable a stock is, the higher its price, the more its capitalization increases... and the more its weight in the index increases. Most major stock market indices, built on this model, therefore have the unfortunate reputation of passing on all bubbles. Or to overemphasize the star stocks of the moment, like Total, which represented up to 15% of the CAC 40. Some indices, such as the Dow Jones in the United States or the Nikkei in Japan, escape this shortcoming because they give equal weight to the selected stocks. But professionals criticize them for not being representative of the market, and for exhibiting greater volatility and turnover than traditional indices. This debate is not new. But today's savers are more concerned about this. For them, indices have become investment vehicles (listed index funds) and no longer just market indicators. "It's paradoxical. Investors who rely on indices often think they are limiting risk, whereas, by construction, indices can be quite risky," notes David Gagnozzi, Managing Director of Fidelity Gestion. So some people are looking for the parade. "There is now a demand for alternative indices and other ways of weighting stocks," observes Lars Hamich, CEO of Stoxx Ltd. This index provider first introduced indices that weight values based on dividends paid over the past five years. Others had the same idea: to compose indices where values would be weighted by fundamental criteria. These relate to the significance of cash flows, sales, profits and book values over the past year or the past five years. Will these newcomers perform better? Less volatile, they should be less sensitive to bubbles than their elders, their promoter promises. But already some criticisms have been made. "These clues aren't really clues. No economic theory justifies the choice of these fundamental criteria. This amounts to making a systematic but active selection of securities," says Noël Amenc, professor of finance at Edhec. The main virtue of these newcomers will therefore perhaps be to make investors aware that, in one zone, choosing one index over another is a real management choice. "There are no good clues. Everyone has a bias. It is likely that in time we will find that these new clues have one too. And that the most important thing for the investor is to know which bias and which risks he is prepared to take," emphasises Jean-Pierre Grimaud, Investment Director at Swiss Life. A. Bodescot, Le Figaro, 3 March 2007 Question 1: Explain any reservations about the relevance of stock market indices. Can you bring counterarguments to these same reservations? Question 2. What is the use of stock market indices and for whom are they useful? Question 3. Justify, with example, the existence of several stock market indices for the same stock market.