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The investment ecosystem

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The investment ecosystem

Nithisha CHALLA

In this article, Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023) explains the investment ecosystem in financial markets.

Introduction

In the investment ecosystem, there are several blocks to understand: market participants, market products, and market organization.

Market participants

Market participants are individuals, companies, financial institutions, and governments. Some of these participants may issue assets like companies (stocks, commercial paper, and bonds) and governments (bonds). Some of these participants may invest in these assets like individuals or pension funds.

Based on the amount they invest, market participants are segregated as big players and small players. Big players are mostly institutional investors which collect the funds and then invest them. Few examples of institutional investors are mutual funds, pension funds, hedge funds, trusts, charities etc. Big players may also be wealthy individuals (high net worth individuals or HNWI) or family offices. Small players are other individual investors.

Corporates run businesses, including manufacturing, service, and technology firms, and they need capital to expand and maintain their operations. On the other side, we have institutions that consist of fund managers that could be institutional investors but also retail investors as well. These are the people that have capital so the capital flows from the institutions or investment managers who have the money to the corporations that need that money to grow and run their business. The cycle between the two parties is completed when the firms issue back to the investor’s bonds, which are classified as debt, or shares, which are classified as equity.

In the middle of these two groups sit the investment banks they are often referred to as the sell side and they have contacts on both sides of these players. They have corporate clients, and they have institutional investor clients, their job is to match up the institutional investors with the corporates based on risk and return assessments and expectations and investment style to get the deal done. In addition, we have public accounting firms which are the fourth player in the market.

Market Products

Assets

What are assets? In financial language, an asset is that which has some economic value. And assuming that its value increases in the future market participants buy them and that is how it is a part of the investment ecosystem. Few examples for assets are fixed deposit, land, gold, stock, etc.

Asset classes are made up of those investments or securities whose characteristics are the same. Few major asset classes are equity, bonds (fixed income), commodities, and real estate.

Instruments

What are Instruments? Instruments are the ways through which we can invest in different asset classes.

Some of the major instruments we see in markets are direct investing, mutual funds, and exchange-traded funds (ETFs).

  • Direct investing is nothing but investing cash physically in different asset classes or we can digitally buy assets through our accounts
  • Mutual funds are the funds collected by multiple investors and then those are invested in different asset classes. To manage these mutual funds, we have fund managers who will invest on behalf of investors.
  • ETFs are nothing but a basket of securities just like mutual funds, but the only difference is they are traded on stock exchanges.

Market organization

Primary and secondary markets

The primary markets: the initial issuance of assets

The primary market is where new securities, including stocks, bonds, and other financial assets, are first issued by governments or corporations. The primary market is also referred to as the market for new issues.

Companies and governments raise money in the primary market by offering their securities to retail or institutional investors. The securities may be sold through a private placement or an initial public offering (IPO).

There are four main players in the primary market mainly for issuance of securities.
1) Corporates
2) Investors: institutional investors and individual investors
3) Corporate banks
4) Public accounting firms

The secondary markets: the exchange of assets

In the secondary market, fund managers and banks collaborate to trade securities between investors after they have already been issued. On one side, a fund manager may want to purchase securities of a public company, while on the other, a different fund manager may wish to sell those same securities. Investment bankers come between these clients to help facilitate these trades, and this trade is facilitated over the stock exchange. They provide equity research coverage to help fund managers make decisions about buying and selling those securities. And this secondary market trading makes markets liquid. This is what allows you to get in and out of security very easily.

Market infrastructure

Infrastructure providers are the companies which enable the transactions and functioning of different instruments. It means all the digital and physical infrastructure required for the investor is provided by the infrastructure provider. The few common examples of an infrastructure provider are the stock exchange, depositories, and registrar and transfer of agents.

  • Stock exchange: It is the platform where you can sell and buy securities. Here, with the help of a broker and the stock exchange two investors can buy and sell stocks without knowing each other. For example, The TSE is the largest stock exchange in Asia by market capitalization. It is located in Tokyo, Japan and has over 3,500 listed companies.
  • Depositories: These are the companies that store the stocks we buy in electronic form. We can store these stocks through our demat accounts. Depositories help you transfer stock and various other functions like checking the statements, portfolio holdings and transaction information etc. Generally investors directly do not interact with depositories but they approach through a broker who would invest on their behalf. For example: The DTC is one of the largest depositories in the world. It is located in New York City and holds over 3.5 million securities worth trillions of dollars.
  • Registrar and Transfer of Agents (RTA): just like depositories in case of stocks, RTA’s in case of mutual funds. All trades of mutual funds like subscription, redemption, and transfer, are recorded by an RTA. An RTA also helps mutual fund investors in providing their portfolio and statements to them.

Why should I be interested in this post?

As a student and prospective business management graduate, I think it is important to know the investment ecosystem. Firstly, investments play a vital role in the growth and success of companies. Companies need investments to fund their operations, expand their businesses, and create value for their shareholders. Therefore, understanding the investment ecosystem will enable management students to make informed decisions regarding investments that can help drive the growth of the companies they work for or manage in the future.

Related posts on the SimTrade blog

▶ All posts about financial techniques

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Useful resources

McKinsey (2017) Capital Markets Infrastructure: An Industry Reinventing Itself

Black rock The Investment Stewardship Ecosystem

About the author

The article was written in March 2023 by Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023).

Why do governments issue debt?

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Why do governments issue debt?

Rodolphe Chollat-Namy

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) gives the reasons why governments issue debt.

In normal times, governments use debt (bills, notes and bonds) to cover expenses and finance investments that will create new wealth, which will make it possible to repay the debt. This is what companies do when they use credit to buy new machinery for example. It is also what public authorities do when they build schools, hospitals or roads that will increase the productive capacity of the country and improve the living conditions of its inhabitants. However, the interest for a state to go into debt could not be limited to this. What are the other reasons to go into debt?

Public debt allows the mobilization of private savings

The level of savings directly influences investment in the economy and, therefore, the level of consumption. However, there are many factors that can push savings away from their optimal level, i.e. the level that maximizes consumption. It is therefore necessary for a government to find solutions to adjust this level of savings. Recourse to debt is one of the solutions.

Indeed, recourse to debt is a means of mobilizing, in return for remuneration, the savings of individuals, and in particular those of households with sufficiently high incomes to save. Today, there are not enough borrowers who issue good quality assets. The proof is that interest rates are very low on public debt. Savers are competing with each other and accepting lower and lower yields for this type of savings medium. Thus, in a world of asset shortages, it is the state that will provide sufficient savings vehicles. The state is then faced with a dilemma: to provide adequate and safe savings vehicles and to increase taxes in order to pay the interest on new public debt.

Public debt helps limit fluctuations in production levels

As we have seen with the Covid-19 crisis, an economy can be confronted with one or more shocks that temporarily push the level of production away from its potential level. Such fluctuations represent a cost. Indeed, a higher volatility in the level of output translates into a lower growth rate. In addition, a temporary fall in output from its potential level can lead to the failure of long-term viable businesses.

Investments financed by debt can be used to limit the magnitude of changes in the level of output. Changes in government spending or tax obligations significantly affect the level of output. An increase in expenditure usually results in an increase in output. Thus, public debt is an effective way of stabilizing output. This is what happened during the 1980s and 1990s. Governments around the world used massive debt to support their economic activity. During the Covid-19 crisis, the “whatever it takes” approach saved many companies. However, it has also kept unprofitable companies on life support, which should have disappeared, due to a lack of hindsight.

Public debt is a redistribution within the present generations

Public debt is often presented as a burden to be borne by future generations. However, this statement is far from obvious. Indeed, it is very difficult to measure the extent of transfers between generations. Future generations will also benefit from part of the money borrowed today that will have been invested and distributed to households that will be able to save it and then pass it on to their children. Thus, it is difficult to assess the real burden of the debt for future generations.

What is more certain, however, is that the public debt is primarily a transfer within the households at the present time. The State borrows from an agent X to redistribute to an agent Y or to make an investment that will benefit an agent Z. Thus, from this point of view, the use of debt is a good tool for redistribution among households.

Related posts on the SimTrade blog

   ▶ Rodolphe CHOLLAT-NAMY Government debt

   ▶ Rodolphe CHOLLAT-NAMY Bond valuation

   ▶ Rodolphe CHOLLAT-NAMY Bond markets

   ▶ Bijal GANDHI Credit Rating

   ▶ Jayati WALIA Credit risk

Useful resources

Rating agencies

S&P

Moody’s

Fitch Rating

About the author

Article written in July 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Government debt

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Government debt

Rodolphe Chollat-Namy

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, i>Grande Ecole – Master in Management, 2019-2023) introduces you to government debt.

A government debt is a debt issued and guaranteed by a government. It is then owed in the form of bonds bought by investors (institutional investors, individual investors, other governments, etc.).

According to the OECD: “Debt is calculated as the sum of the following liability categories (as applicable): currency and deposits; debt securities, loans; insurance, pensions and standardized guarantee schemes, and other accounts payable.”

Before the Covid-19 crisis, the government debt of all countries in the world was estimated at $53 trillion. According to the IMF, it is expected to rise from 83% to 96% of world GDP as a result of the crisis.

In order to better understand debt, it is necessary to go back to several points. How does a government issue debt? Who holds government debt? How is government debt measured?

How does a government issue debt?

There are two principal ways to issue bonds: syndication and auction.

Syndication

Syndication is the most common way to issue debt. It is when several financial institutions join together to ensure the placement of a bond with investors in order to reduce their risk exposure. However, since the 1980’s, governments tend to use the auction method.

Auction

The auction can be “open”, i.e. all direct participants in public securities auctions (credit institutions, management and intermediation companies, etc.) have the possibility of acquiring part of the security put up for auction. It can also be “targeted”, i.e. the issue is reserved only for the primary dealers – banks or other financial institutions that has been approved to trade securities – of the issuing State.

A few days before the planned date of an auction, the State makes an announcement, confirming, postponing or cancelling the operation. It also gives the characteristics of the securities to be issued, i.e. the type of securities, the maturity and the amount it wishes to raise. Buyers can then submit several bids, each specifying the desired quantity and price. The issue lines are then auctioned to the highest bidders. The higher the demand is, the lower the issue rate is.

Auction is used because it provides investors, among other things, with transparency and free competition on an investment product with an attractive benefit in relation to a low risk level.

Each country that issues bonds uses different terms for them. UK government bonds, for example, are referred to as gilts. In the US, they are referred to as treasuries: T-bills (that expire in less than one year), T-notes (that expire in one to ten years) and T-bonds (that expire in more than ten years). In France, the government issues short-term liabilities (“Bons du Trésor”) and long-term liabilities (“OAT for “Obligations Assimilables du Trésor”) with maturity between 2 and 50 years.

Who holds government debt?

Government debt can be broken down into domestic and external debt depending on whether the creditors are residents or non-residents.

Domestic debt

Domestic debt refers to all claims held by economic agents (households, companies, financial institutions) resident in a sovereign state on that state. It is mostly denominated in the national currency. A government can call for savings, but savings used to finance the deficit can no longer be used to finance private activity and in particular productive investment. This is known as the crowding-out effect. A government must therefore deal with this limit.

External debt

External debt refers to all debts owed to foreign lenders. A distinction must be made between gross external debt (what a country borrows from abroad) and net external debt (the difference between what a country borrows from abroad and what it lends abroad). A level of debt that is too high can be dangerous for a country. In the event of fluctuations in the national currency, the interest and principal amounts of the external debt, if denominated in foreign currency, can quickly become a burden leading to default.

The case of France

In France, non-residents are the main holders of French public debt. They hold 64% of the bonds issued by the government. They are institutional investors, but also sovereign investment funds, banks and even hedge funds. In addition, as regards domestic debt, French insurance companies hold nearly 20% of French securities. They are used for life insurance investments. Finally, French banks and French mutual funds hold 10% and 2% respectively.

How to measure government debt?

While the French debt has risen from 2000 billion euros in 2014 to 2700 billion in 2021, the debt burden has fallen from 40 billion to 30 billion. What do these two ways of looking at a country’s debt mean?

In the European Union, the current measure of public debt is the one adopted by the Maastricht Treaty. It takes into account the nominal amount borrowed. This is a relevant criterion for measuring the government’s budgetary misalignments, i.e. its financing needs. It also makes it possible to introduce debt rules: the debt must be less than 60% of GDP.

Another way of measuring debt is to take into account the interest charges on public debt. This criterion makes it possible to account for the cost of the debt and not its amount. It is this criterion that must be considered in order to anticipate future financing needs, to plan taxes and interest charges in the government budget.

Useful resources

Rating agencies

S&P

Moody’s

Fitch Rating

Related posts on the SimTrade blog

   ▶ Rodolphe CHOLLAT-NAMY Why do governments issue debt?

   ▶ Rodolphe CHOLLAT-NAMY Bond valuation

   ▶ Rodolphe CHOLLAT-NAMY Bond markets

   ▶ Bijal GANDHI Credit Rating

   ▶ Jayati WALIA Credit risk

About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, i>Grande Ecole – Master in Management, 2019-2023).

Bond risks

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Bond risks

Rodolphe Chollat-Namy

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) introduces you to bond risks.

Holding bonds exposes you to fluctuations in its price, both up and down. Nevertheless, bonds offer the guarantee of a coupon regularly paid during for a fixed period. Investing in bonds has long been considered one of the safest investments, especially if the securities are held to maturity. Nevertheless, a number of risks exist. What are these risks? How are they defined?

Default risk

Default risk is the risk that a company, local authority or government fails to pay the coupons or repay the face value of the bonds they issued. This risk can be low, moderate or high. It depends on the quality of the issuer.

For a given product, the default risk is mainly measured by rating agencies. Three agencies share 95% of the world’s rating requests. Moody’s and Standard & Poor’s (S&P) each hold 40% of the market, and Fitch Ratings 14%. The highest rated bonds (from Aaa to Baa3 at Moody’s and from AAA to BBB- at S&P and Fitch) are investment-grade bonds. The lowest rated bonds (Ba1 to Caa3 at Moody’s and BB+ to D at S&P and Fitch) are high yield bonds, otherwise known as junk bonds.

It should be noted that the opinions produced by an agency are advisory and indicative. Moreover, some criticisms have emerged. As agencies rate their clients, questions may be asked about their independence and therefore their impartiality. The analysis done aby rating agencies is most of the time paid by the entities that want their product to be rated.

In addition, companies issuing bonds are increasingly using the technique of “debt subordination”. This technique makes it possible to establish an order of priority between the different types of bonds issued by the same company, in the event that the company is unable to honor all its financial commitments. The order of priority is senior, mezzanine and junior debt. The higher the risk is, the higher the return is. It should also be noted that bonds have priority over equity.

To highlight the level of risk of an issuer, one can compare the yield of its bonds to those of a risk-free issuer. This is called the spread. Theoretically, it is the difference between the yield to maturity of a given bond and that of a zero-coupon bond with similar characteristics. The spread is usually measured in basis points (0.01%).

Liquidity risk

Liquidity risk is the degree of easiness in being able to buy or sell bonds in the secondary market quickly and at the desired price (i.e. with a limited price impact). If the market is illiquid, a bondholder who wishes to sell will have to agree to a substantial discount on the expected price in the best case, and will not be able to sell the bonds at all in the worst case.

The risk depends on the size of the issuance and the existence and functioning of the secondary market for the security. The liquidity of the secondary market varies from one currency to another and changes over time. In addition, a rating downgrade may affect the marketability of a security.

On the other hand, it may be an opportunity for investors who want to keep their illiquid bonds. Indeed, they usually get a better return. This is called the “liquidity premium”. It rewards the risk inherent in the investment and the unavailability of funds during this period.

Interest rate risk

The price of a bond fluctuates with interest rates. The price of a bond is inversely correlated to interest rates (the discount rate used to compute its present value). Indeed, the nominal interest rates follow the key rates. Thus, if rates rise, the coupons offered by new bonds will be higher than those offered by older bonds, issued with lower rates. Investors will therefore prefer the new bonds, which offer a better return, which will automatically lower the price of the older ones.

The interest rate risk is increasing with the maturity of the bond (more precisely its duration). The risk is low for bonds with a life of less than 3 years, moderate for bonds with a life of 3 to 5 years and high for bonds with a life of more than 5 years. However, interest rate risk does not impact investors who hold their bonds to maturity.

Inflation risk

Inflation presents a double risk to bondholders. Firstly, if inflation rises, the value of an investment in bonds will necessarily fall. For example, if an investor purchases a 5% fixed-rate bond, and inflation rises to 10% per year, the bondholder will lose money on the investment because the purchasing power of the proceeds has been greatly diminished. Secondly, high inflation can lead central banks to raise rates in order to tackle it, which, as we can see above, will depreciate the value of the bond.

To protect against this, some bonds, floating-rates bonds, are indexed to inflation. They guarantee their holders a daily readjustment of the value of their investment according to the evolution of inflation. However, these bonds have a cost in terms of return.

As with interest rate risk, the risk increases with the maturity of the bond. Also, the risk rises as the coupon decreases. The risk is therefore very high for zero-coupon bonds.

Currency risk

An investor can buy bonds in a currency other than its own. However, as with any investment in a foreign currency, the return on the bond will depend on the rate of that currency relative to the investor’s own currency.

For example, if an investor holds a $100 US bond. If the EUR/USD exchange rate is 1.30, the price of the bond will be €76.9. If the euro appreciates against the dollar and the exchange rate rises to 1.40, the price of the bond will be €71.4. Thus, the investor will lose money.

Useful resources

Rating agencies

S&P

Moody’s

Fitch Rating

Related posts

   ▶ Rodolphe CHOLLAT-NAMY Bond valuation

   ▶ Rodolphe CHOLLAT-NAMY Bond markets

   ▶ Bijal GANDHI Credit Rating

   ▶ Jayati WALIA Credit risk

About the author

Article written in May 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).