Financial Markets, IPOs, and Derivative Instruments

Forward Rate Agreements (FRA)

A Forward Rate Agreement (FRA) is a contract where two parties fix the interest rate today for a future loan without exchanging the principal amount. At settlement, they only exchange the difference between the agreed and market rates, primarily to hedge interest rate risk.

Initial Public Offering (IPO)

An IPO (Initial Public Offering) is the first public offering of a company’s shares. It marks the first time a company sells its shares to the public and becomes listed on a stock exchange. Therefore, an IPO takes place in the primary market, as the shares are offered to investors for the first time.

The IPO process normally includes:

• The decision by the Board and the General Shareholders’ Meeting
• The submission of documentation to the national regulatory authority
• Regulatory approval
• The setting of a price range and a demand survey
• The final price fixing and the sale of the shares

Underpricing occurs when the IPO offer price is set too low compared with the price investors are willing to pay once the shares start trading. It is measured by the first-day return:

Where P₁ is the closing price on the first trading day and P_IPO is the IPO offer price. If this return is positive, there is evidence of underpricing. The main problem is that the firm "leaves money on the table." New investors obtain an immediate gain, but the company could have sold the shares at a higher price and raised more funds. Therefore, underpricing is an indirect cost for the firm and for the original shareholders.

After the IPO, the shares are traded in the secondary market. Investors buy and sell the shares among themselves, and the company does not receive money from these later transactions. The share price is determined by supply and demand in the stock market. One advantage of an IPO is that it gives the firm access to a new source of financing and increases its reputation and visibility. One disadvantage is that it is costly and increases disclosure obligations: the firm must publish financial statements, strategy, investor presentations, and any relevant information affecting its value.

Financial Derivatives and Market Instruments

Financial derivatives are financial instruments whose value derives from another asset, called the underlying asset. The underlying asset can be financial, such as a share, stock index, interest rate, or currency, or non-financial, such as commodities, energy, metals, or agricultural products.

Derivatives usually involve leverage, so their risk may be higher than the risk of the underlying asset. The derivatives market is also a zero-sum market, because one investor’s gain corresponds to another investor’s loss. The main difference between futures and options is that a future creates an obligation, while an option gives a right but not an obligation.

Futures and Options

A future is a standardized contract in which two parties agree today to buy or sell an underlying asset at a future date and at a price fixed today. Both parties are obliged to fulfill the contract. An option gives the holder the right, but not the obligation, to buy or sell an underlying asset at a fixed price. A call option gives the right to buy, while a put option gives the right to sell. The fixed price is the strike price, and the final date is the maturity or expiry date.

Derivatives are mainly used for:

• Hedging: Using derivatives to reduce risk, for example, buying put options to protect a portfolio against a fall in prices.
• Speculation: Using derivatives to profit from expected future price movements, for example, buying a call option if the investor expects the share price to rise.

The main types of derivatives are futures, options, forwards, and swaps. Forwards are similar to futures but are tailor-made and traded Over-The-Counter (OTC). Swaps are agreements to exchange future cash flows, such as fixed interest payments for variable interest payments.

Order-Driven Markets and Order Types

In an order-driven market, orders are introduced into a limit order book and ranked by price priority and then time priority. The main types are:

• Market Order: Has no specific price limit. It is executed immediately at the best available price. It prioritizes execution, but the final price is uncertain.
• Best Price Order: Also known as a market-to-limit order, it has no initial price but becomes limited to the best available price on the opposite side of the book. Unlike a market order, it doesn't execute at several price levels.
• Limit Order: Executed at its limit price or better. A buy limit order is executed at the limit price or lower, and a sell limit order at the limit price or higher.
• Hidden Volume Order: Allows large orders to be placed without showing the full volume to the market, reducing market impact and avoiding moving the price against the investor.

Objectives of the European Central Bank (ECB)

The main objective of the European Central Bank (ECB) is to maintain price stability in the euro area, keeping inflation around 2% over the medium term. The ECB is independent and uses monetary policy to achieve this. Price stability helps economic decisions and supports sustainable growth. The ECB also supports EU economic policies and carries out tasks such as managing monetary policy, foreign exchange operations, reserves, payment systems, banking supervision, and euro banknotes.

Instruments of Monetary Policy

The main monetary policy instruments of the ECB are open market operations, standing facilities, and minimum reserve requirements. They are used to control interest rates, manage liquidity, and implement monetary policy.

• Open Market Operations: The most important tool, used to provide or absorb liquidity.
• Standing Facilities: Manage overnight liquidity through the marginal lending facility and the deposit facility.
• Minimum Reserves: Require banks to hold deposits with the central bank, helping stabilize money market rates.

When conventional tools are not enough, the ECB may use unconventional instruments, especially Quantitative Easing (QE), which involves buying assets to inject money into the economy and lower yields. Other examples include LTROs, TLTROs, APP, and PEPP.

Call and Put Option Payoffs

A call option gives the holder the right, but not the obligation, to buy the underlying asset at a fixed price, called the strike price or exercise price (E). The payoff of a call option at maturity is: max(S_T − E, 0), where S_T is the stock price at maturity. If S_T < E, the investor does not exercise the call because it is cheaper to buy the stock in the market; the payoff is zero. If S_T > E, the investor exercises the call, buys the stock at E, and obtains a gain equal to S_T − E.

A put option gives the holder the right, but not the obligation, to sell the underlying asset at the strike price (E). The payoff of a put option at maturity is: max(E − S_T, 0). If S_T < E, the investor exercises the put because they can sell the stock for E, which is higher than the market price. If S_T > E, the investor does not exercise the put because it is better to sell the stock in the market; the payoff is zero.

Put-Call Parity and No-Arbitrage

In put-call parity, the bond is a risk-free bond that pays the strike price (E) at maturity. The payoff of the bond is E. This payoff is constant and does not depend on the stock price. The bond is included in the parity because the investor needs a certain amount of money today that will grow to E at maturity. Its current value is: E / (1 + r)^T.

The payoff of holding one share is simply the value of the stock at maturity: S_T. If the stock price rises, the payoff rises; if it falls, the payoff falls. Therefore, the stock payoff is a straight upward-sloping line.

Put-call parity is a no-arbitrage relationship between a European put option, a European call option, the underlying stock, and a risk-free bond. The idea is that two portfolios with the same payoff at maturity must have the same price today. Otherwise, there would be an arbitrage opportunity.