The first three topics in this unit built the fixed-income world — risk-free government bonds, credit-sensitive corporate debt, and the term structure of interest rates. This topic widens the picture to three more asset classes that appear constantly as the underlyings of the derivative contracts covered in Topics 5–7:
Equities are ownership stakes in firms. Unlike bonds, equities have no contractual cash-flow schedule: dividends are discretionary, capital gains are uncertain, and the equity holder is last in the capital structure in default. Their return in excess of the risk-free rate — the equity risk premium — is the main reward for bearing systematic (market) risk. Stock indices aggregate many equities into a single tradable benchmark, and index futures are among the most liquid instruments in the world.
Money markets are the short-end of the fixed-income universe: instruments with maturities of one year or less (T-bills, commercial paper, certificates of deposit, and repo). The repo market is where financial institutions fund positions overnight using collateral, and the overnight repo rate — now anchored to the secured overnight financing rate (SOFR) in the US — has replaced LIBOR as the standard risk-free rate benchmark underpinning derivative pricing.
Foreign exchange is the largest financial market in the world, with over $7 trillion in daily turnover. The spot exchange rate links two money markets; the forward exchange rate links the spot rate to the two countries' interest rates through covered interest rate parity (CIP), which is the most important no-arbitrage condition in international finance.
By the end of this topic you should be able to:
- distinguish common from preferred shares and describe how dividends, index construction, and the equity risk premium work;
- identify the main money-market instruments and explain how repo provides collateralised overnight funding;
- explain why the OIS rate (now SOFR) has replaced LIBOR as the standard risk-free benchmark;
- state covered interest rate parity: , and prove it by no-arbitrage;
- describe how the FX spot market is structured (bid-ask, price vs. volume quotation conventions).
In this lesson
- Contents
- The big picture
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