Financial Markets and Instruments
Domain 1: Financial markets and instruments
This domain tests how markets are organised and how the main instrument families behave. Questions focus on market participants, primary versus secondary activity, settlement mechanics, and the risk and return features of cash, bonds, equities and derivatives.
Market structure
- Primary markets raise new capital through IPOs, rights issues and bond issuance; secondary markets provide liquidity and price discovery.
- Participants include issuers, investors, market makers, brokers, exchanges, clearing houses and custodians. Clearing manages counterparty risk; settlement transfers cash and securities.
- UK equities normally settle T+2, and the UK has announced a move to T+1; check the current implementation date rather than assuming it has already happened.
- Exchange-traded versus OTC: OTC derivatives are bilateral and carry counterparty risk, while exchange-traded contracts are standardised and centrally cleared.
Instrument features
- Money market instruments such as T-bills, commercial paper and CDs are short-dated and priced on a discount or yield basis.
- Bonds pay coupons and return principal; prices move inversely with yields. Duration measures price sensitivity to yield changes.
- Equities are residual claims with limited liability, voting rights and discretionary dividends.
- Derivatives derive value from an underlying and can hedge or leverage exposure; futures and options have different loss profiles.
Worked example
A 91-day UK T-bill is quoted at a discount rate of 4.75% on £1,000,000 face value. Price = £1,000,000 × [1 − (0.0475 × 91/365)] = £988,157.53. The discount is £11,842.47. Holding-period return = 11,842.47/988,157.53 = 1.198%. Annualised simple return = 1.198% × 365/91 = 4.81%. The quoted discount rate is not the return earned, because return is calculated on the price paid, not on face value.
Traps
- Confusing primary issuance with secondary trading, or treating a listing as capital raising.
- Mixing cum-dividend and ex-dividend prices, or ignoring the 30-day bed-and-ISA rule.
- Assuming a bond’s coupon equals its yield; only a par bond has coupon equal to yield to maturity.
- Forgetting that futures can produce losses beyond the initial margin, while a long option’s loss is limited to premium.
Key points
- Primary markets raise capital; secondary markets provide liquidity and price discovery.
- T-bills are discount instruments; the discount rate understates the investor’s return.
- Bond prices and yields move inversely; duration measures sensitivity.
- Equities are residual claims with discretionary dividends.
- OTC derivatives carry counterparty risk; exchange-traded contracts are centrally cleared.