CASE CBM2012-00001
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`VERSATA EXHIBIT 2053
`VERSATA EXHIBIT 2053
`SAP v. VERSATA
`SAP v. VERSATA
`CASE CBM2012-00001
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`An Introduction to
`Financial Products
`and Markets
`
`LINDSAY FELL
`
`CONTINUUM
`London and New York
`
`

`

`Continuum
`Wellington House
`125 Strand
`London WC2R OBB
`
`© 2000 Lindsay Fell
`
`370 Lexington Avenue
`New York
`NY 10017-6503
`
`All rights reserved. No part of this publication may be reproduced or transmitted in any
`form or by any means, electronic or mechanical including photocopying, recording or any
`information storage or retrieval system, without prior permission in writing from the pub(cid:173)
`lishers.
`
`First published 2000
`
`British Library Cataloguing-in-Publication Data
`A catalogue record for this book is available from the British Library.
`
`ISBN 0-8264-4886-0
`
`Designed and typeset by Kenneth Burnley at Irby, Wirral, Cheshire
`Printed and bound in Great Britain by Redwood Books, Trowbridge, Wiltshire
`
`

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`Contents
`
`Preface
`
`1 The role of the financial sector within the wider economy
`Learning objectives 1 • Money 2 • Types of money 4 • Measuring
`money 5 •The role of the financial sector 6 •The monetary system 7 •
`The financial system 8 • The nature of financial investment 12 •
`Summary 13
`
`2 An overview of financial products and markets
`Learning objectives 16 • The structure of the financial sector 16 •
`Brokerage and financial intermediation 20 • The role of financial
`markets 26 • An overview of financial products 33 • Summary 37
`
`3 The role of the financial authorities in financial markets
`Learning objectives 40 • An overview of the role of financial authorities
`40 • Monetary policy 42 • The conduct of interest rate management 49
`• Regulation 51 • The division of responsibility between different
`financial authorities 56 • Supranational financial authorities 60 •
`Summary61
`
`4 The market for shares
`Learning objectives 64 • The main characteristics of share capital 64 •
`The importance of share capital in company funding 68 • Data on
`shares in the financial press 69 • The market value of shares and share
`price movements 7 4 • Share issues 77 • The secondary market for
`shares 81 • Stock exchanges 83 • Some issues concerning share
`markets 89 • Summary 92
`
`5 The market for medium· to long-term debt capital
`Learning objectives 96 • Factors to consider when comparing different
`types of debt capital 97 • Types of medium- and long-term debt 101 •
`Bond values, inflation and interest rates 1 07 • Data on medium- and
`long-term debt in the press 107 • Bond pricing 109 • The influence of
`inflation and interest rate expectations on bond prices 111 • Interna-
`tional bonds 115 • Bond markets 11 7 • Summary 120
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`CONTENTS
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`6 Short-term debt capital
`Learning objectives 124 • The main characteristics of short-term debt
`products 124 • Different types of short -term debt 125 • Data on money
`market products and evaluation of different forms of return 130 • The
`role of financial authorities in short-term debt markets 135 • Charac-
`teristics of money markets 136 • International money markets 138 •
`Summary 139
`
`7 The derivatives markets
`Learning objectives 142 • The function of derivatives markets 143 •
`History 143 • Forward contracts 144 • Futures 146 • Options 150 •
`Swaps 160 • The markets in which derivatives are traded 161 •
`Controversy surrounding derivatives 162 • Summary 165
`
`8 The market for foreign exchange
`Learning objectives 169 • Exchange rates 169 • The importance of
`exchange rates 1 71 • Data on exchange rates in the financial press 17 5 •
`The determination of exchange rates 179 •The forex markets 184 •
`Exchange rate systems 189 • Summary 193
`
`9 Areas of change and issues for t he future
`Learning objectives 197 • Change-inducing factors 197 • Areas of
`change 199 • Recent financial sector change 200 • Future trends 206 •
`Some critical issues for the financial sector 212 • Summary 214
`
`Suggested solutions to end-of-chapter questions
`Index
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`123
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`142
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`168
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`197
`
`216
`225
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`

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`AN OVERVIEW OF FINANCIAL PRODUCTS AND MARKETS
`
`33
`
`which arbitrageurs were selling products will have a downward pressure on prices
`because of demand to sell. Overall, a pricing equilibrium should be restored between
`the markets concerned because of the arbitrage trading. Arbitrage, like investment/
`speculation, might be undertaken in any of the financial markets discussed in this text.
`It will be particularly relevant where the same financial assets are traded in more than
`one market around the world, e.g. currency and some shares and bonds. Arbitrage
`between markets for different products arises especially in connection with derivative
`products, where there is a logical connection between the value of these assets and
`other assets, such as shares, on which they are based. Derivatives are outlined more
`generally below.
`
`Activity 5
`
`The US$/£ exchange rate is US$1.70/£1 in New York but US$1.69/£1 in London.
`What arbitraging strategy would you undertake to make a profit out of the discrep(cid:173)
`ancy between the two markets?
`
`You would want to buy pounds for dollars in London and sell them back for dollars
`in New York. You would make a profit of a cent on every pound transacted in this
`way. An alternative transaction would be to buy dollars for pounds in New York and
`sell them back into pounds in London.
`
`An overview of financial products
`
`In Chapters 4 to 8 of this book we are going to study individually the main
`types of financial products which may be used by different sectors in an economy to
`balance their financial needs. Below is a brief overview of those products to give you
`a preliminary idea of what is available and of the main differences between alternative
`types of finance. The overview includes both financial products issued by institutions,
`such as banks, and financial products sold through markets. The latter products are
`often referred to as 'financial securities'. This means they are saleable financial prod(cid:173)
`ucts which are normally evidenced by some form of certificate or by an entry on a reg(cid:173)
`ister of holders of the products.
`
`Shares
`
`Shares are the longest-term financial securities available, in that they are gen(cid:173)
`erally irredeemable, i.e. they are issued without a repayment date. An investor earns
`part of his or her return on shares through receiving a dividend from the issuing com(cid:173)
`pany. Although dividends are generally paid once or twice a year, companies have no
`legal obligation to pay dividends, and indeed, if they have cumulative losses, may be
`legally prevented from doing so. A share is thus quite a risky investment, in that divi(cid:173)
`dends may be low or even non-existent if a company does badly; on the other hand,
`dividends can rise without limit if a company does particularly well.
`Although an investor in shares cannot expect a repayment of his or her investment
`from the issuing company because most shares are irredeemable, shares can often be
`sold to other investors through a recognized stock exchange. In recent years, compa(cid:173)
`nies have also bought back their own shares on occasion. When an investor sells on
`shares, there is the possibility of a 'capital gain' or 'capital loss', these being the dif-
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`34
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`AN INTRODUCTION TO FINANCIAL PRODUCTS AND MARKETS
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`ference between the investor's selling price and his or her original buying price. The
`capital gain/loss is the other part of the investor's return on shares and, like dividends,
`is risky because it is not known in advance.
`Another aspect of share capital is that in most cases it confers ownership of the enter(cid:173)
`prise that issues the shares. Thus, if you buy a share in a company, you become part
`owner of the company and will often get the right to vote on the company's affairs
`through annual meetings.
`Share capital and the stock markets through which it is traded are discussed in more
`detail in Chapter 4.
`
`Medium- to long-term debt
`
`This is borrowing which is originally arranged to last for more than a year. It
`can take several forms, from loans, hire purchase or lease finance arranged through an
`institution, such as a bank, to bonds, which are market traded debt securities. In all
`cases a stream of payments to be made by the borrower will be agreed upon in
`advance, and these will incorporate repayment of the original amount lent plus some
`return to the lender. As the payments by the borrower are agreed in advance and as
`the lender can sue for these payments should they not be made, lending to supply
`funds to someone is generally less risky than providing the finance as share capital in
`the way described above.
`You will probably be familiar with loans. They come in a variety of forms, but nor(cid:173)
`mally involve the payment of interest on the outstanding debt and the repayment of
`the amount lent, called 'the capital' or 'the principal', either in a lump sum at the end
`of the loan period or in instalments over the life of the loan.
`Lease and hire purchase finance are types of funding normally reserved for financing
`equipment. The borrower pays a series of rentals which repay the amount lent to
`acquire the equipment and provide a return to the lender.
`Bonds are long-term borrowing securities. They are effectively pieces of paper certi(cid:173)
`fying that a long-term loan has been made and setting out the main terms of.the loan,
`such as the rate of interest and the timing and amount of loan repayment. The differ(cid:173)
`ence between, say, a long-term bank loan and a bond is that the bond is tradable,
`whereas the bank loan is not. Thus an investor who buys a bond on issue from a com(cid:173)
`pany can sell the bond on to another investor before the bond comes up for repay(cid:173)
`ment. As with shares, the value of the bond on early sale is uncertain and so the
`investor may make a capital gain or a capital loss.
`Medium- to long-term debt capital and the markets in which debt securities can be
`traded are discussed in more detail in Chapter 5.
`
`Short-term debt
`
`This debt includes institutional funding in the form of overdrafts and short(cid:173)
`term loans (less than a year) and also market based short-term debt, which is in the
`form of inter-bank loans, bills, corporate paper and certificates of deposit.
`Overdafts are loans, normally from banks, which are technically repayable on
`demand. In practice, many overdraft facilities are continually renewed, and so this
`
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`AN OVERVIEW OF FINANCIAL PRODUCTS AND MARKETS
`
`35
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`form of finance takes on the character of rather longer-term debt. Loans are also avail(cid:173)
`able from institutions for a defined term ofless than a year. As with longer-term loans,
`short-term loans will have provisions agreed in advance for the amount of interest to
`be paid and the date for the loan principal to be repaid.
`Some short-term debt products are provided through markets rather than financial
`institutions. The markets are 'wholesale' rather than 'retail'; that is, they are aimed at
`larger borrowers and lenders, with amounts transacted normally being in large
`amounts, in excess of £0.5 million in the UK. Some products issued through markets
`are tradable. Examples of these are bills; these are rather like IOUs, in that they are
`pieces of paper, which can be sold, promising a repayment from a borrower of a cer(cid:173)
`tain amount on a certain date. Other market products are not saleable, such as bank
`deposits arranged between banks.
`The markets in which short-term borrowing securities are traded are called 'money
`markets'. This is rather a misleading term, in that the uninitiated might think that it
`was a description similar to 'financial markets', i.e. covering all markets for funds.
`Money markets do strictly refer to short-term borrowing, however, and we will look
`at them and short-term debt products in general in Chapter 6.
`
`Derivatives
`
`'Derivatives' are financial assets which can be traded in their own right but
`whose value depends on the current or future value of another financial asset, such as
`a share or bond. Derivatives can thus be said to derive their value from other finan(cid:173)
`cial assets, and hence their name. Derivatives include options, futures, forward con(cid:173)
`tracts and swaps.
`Derivatives do not, in most cases, raise money for borrowers; their purpose instead is
`to enable investors to adjust their risk. To give an example, let us consider one type of
`derivative, an option. A share option might give an investor a right to sell a particular
`share in the secondary share market at a set price on a set future date. The option may
`be created and sold by an options trader in the options market; it is not created and
`sold by the company to whose share it relates and does not raise money for that com(cid:173)
`pany for, say, capital projects. The purpose of the option may be to protect the pur(cid:173)
`chasing investor from risk. In the example above, an investor who held a share in a
`company might also want to buy an option to sell it in future for a particular price to
`protect himself or herself from the possibility of the share price falling. This is in fact
`an example of a hedge, as discussed above.
`Derivatives are thus rather different in their function from shares and debt products,
`both of which on their issue raise funds for the issuer and thus solve the problem of a
`funding deficit, as discussed in Chapter 1. The risk management function of deriva(cid:173)
`tives, their other uses and the markets in which they are traded are studied in detail
`in Chapter 7.
`
`Currencies
`
`Currencies and currency markets are again not about fund raising. A curren(cid:173)
`cy is simply the denomination of money used in a geographical area. Markets which
`trade foreign currency, normally referred to as 'foreign exchange' or 'forex' markets,
`
`

`

`36
`
`AN INTRODUCTION TO FINANCIAL PRODUCTS AND MARKETS
`
`are, however, treated as financial markets both in finance textbooks and by individu(cid:173)
`als and institutions managing their affairs in the real world.
`The role of the forex markets is to facilitate the exchange of one currency for another,
`whether the exchange be made in connection with commercial transactions, other
`financial transactions, such as the raising of a loan, or speculation on how the values
`of one currency may change against others in future .
`Foreign exchange markets and related issues are discussed in Chapter 8.
`
`Activity 6
`
`Refer back to Chapter 1, where different sectors of the economy were identified
`and discussed. Note for each sector which of the financial products outlined above
`might be used to finance expenditure deficits.
`
`THE PERSONAL SECTOR
`In Activity 1 of this chapter, you thought about your different requirements for funds
`and the forms your funding might take. Which products have been relevant to you?
`
`The first thing to note is that financial securities, i.e. saleable financial products
`traded through financial markets, are almost wholly irrelevant as a source of funds
`to individuals. Individuals cannot issue shares because they cannot sell off owner(cid:173)
`ship of themselves. Any funding they undertake must therefore be in the form of
`borrowing. Borrowing that individuals undertake is invariably in the form of arrange(cid:173)
`ments with financial institutions rather than securities issued through markets.
`Thus, if an individual wanted to borrow short term, he or she might get an overdraft
`from a bank. For longer-term borrowing to buy, say, a car, the individual could
`arrange hire purchase or leasing, also from a bank, and for longer-term borrowing
`still, he or she could get a 15-25-year mortgage from a bank or building society.
`
`Why don't individuals borrow by issuing securities in a market? The costs would be
`too. high in terms of advertising the credit worthiness of the individual, administering
`the issue etc. If we think about it further, it thus only makes sense to use markets
`rather than institutions if you are a sizeable user of funds who can justify the mar(cid:173)
`ket costs which will be incurred.
`
`THE CORPORATE SECTOR
`The corporate sector has probably the widest range of funding possibilities open to
`it. A company can issue shares to raise long-term capital, because in this case
`ownership of the entity can be sold off. As an alternative, a company can use debt
`markets to issue long-term bonds or raise short-term money by selling bills.
`Companies don't have to look just to markets, however, for their funds. Institutional
`lending is available through overdrafts, hire purchase, leasing and longer-term bank
`loans. For smaller companies, institutional lending might, however, be the only
`source of funding available; like individuals, these companies may not be able to
`justify the cost of selling their securities through markets.
`
`THE GOVERNMENT SECTOR
`Share funding is not available to governments because ownership of countries, like
`individuals, cannot be sold. Government funding is thus confined to borrowing. For
`longer-term borrowing, governments sell bonds, which in the UK are called 'gilt
`edged securities' or 'gilts', and for shorter-term funding, governments sell bills,
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`AN OVERVIEW OF FINANCIAL PRODUCTS AND MARKETS
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`3 7
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`which in the UK are called 'Treasury bills'. Governments tend to use markets exclu(cid:173)
`sively for raising funds, rather than borrowing from financial institutions. This is to
`minimize the effect on the country's money supply of government funding. This is
`discussed in more detail in Chapter 3.
`
`Summary
`
`The financial sector consists of financial institutions and financial markets.
`Some financial institutions operate outside formal financial markets and lend funds
`directly to ultimate borrowers. Other institutions, the investing institutions, attract
`funds directly from ultimate savers but channel funds to ultimate borrowers via finan(cid:173)
`cial markets .
`A financial market is a forum through which financial products can be exchanged. It
`will have an information system providing data on prices and volumes transacted and
`a number of professionals active in the processes of the market.
`The financial sector eases the flow of funds between different sectors of the economy
`by providing brokerage and transformation services. Funds are transformed to meet
`the requirements of both savers and borrowers in terms of volume, maturity and risk.
`Financial institutions have traditionally been considered to be the main providers of
`transformation services, but markets also achieve similar results and so are in many
`senses in competition with financial institutions.
`Financial ma~kets can be divided into primary and secondary segments. The primary
`segment of a market is used for issuing new securities, which raise funds for ultimate
`borrowers. The secondary segment of the market allows the exchange of existing
`securities between investors.
`There are three different aspects of market efficiency. Operational efficiency is con(cid:173)
`cerned with the costs involved in operating in the market, pricing efficiency with how
`quickly and accurately information is reflected in market prices and allocational effi(cid:173)
`ciency with how closely funds coming into the market are matched with profitable
`enterprises requiring funds. Operational and pricing efficiency should encourage allo(cid:173)
`cational efficiency, which is important for the overall performance of an economy.
`Three different strategies which could be followed when trading financial securities
`are investment/speculation, hedging and arbitrage. Investment/speculation is acquir(cid:173)
`ing financial assets with a view to making a profit through income or gains generated,
`and will almost always involve risk. Hedging is acquiring financial assets in order to
`reduce risk in an investor's overall financial or commercial holdings. Arbitrage is trad(cid:173)
`ing financial assets in order to exploit pricing discrepancies within or between mar(cid:173)
`kets. Hedging and arbitrage are low risk or risk-reducing activities.
`The principal financial products to be considered are shares, medium- to long-term
`debt, short-term debt, derivatives and currencies. The first three categories raise funds
`for ultimate borrowers on their issue. Derivatives are products which enable people to
`adjust risk, although they can be used for investment in a way similar to assets such
`as shares and debt. Foreign exchange markets are also not primarily concerned with
`fund raising, but instead enable one currency to be exchanged for another. The finan(cid:173)
`cial products which can be used by the personal and government sectors for raising
`money are various types of short- and longer-term debt. The corporate sector also
`uses debt but has the option of issuing shares.
`
`