Financial markets, money markets and money market instruments

A company that wants ₦5bn for ten years goes to the capital market. The same company that needs ₦200m for ninety days goes to the money market. The first is a market for shares and bonds. The second is a market for short-term loans and paper that matures within a year.

A financial manager has to know which one to use, what each instrument costs and how the price of a bond moves when interest rates change.

This topic covers the capital markets (equity and bonds), government securities, the people and firms that work in the market, the money markets (inter-bank and repo), interest rate benchmarks, money market instruments and a definition of derivatives. The previous topic covered government influence and the financial framework. The next topics cover dividend policy and emerging issues.

Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on this topic, but bond pricing and short-term finance appear inside many questions.

Key terms in plain English

Syllabus check

This topic links syllabus area A and the financing parts of area E. It covers:

• the structure of the financial markets and the role of the main participants;
• government securities and money market instruments;
• the nature of derivatives, which later topics cover in detail.

CAMA 2020 and the markets

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The Investments and Securities Act 2025 regulates the capital market.

The capital markets

Capital markets deal in long-term securities: shares and bonds. There is a primary market, where companies and governments sell new securities to raise cash, and a secondary market, where investors trade existing ones. A good primary market needs a liquid secondary market, because investors buy new shares only if they can sell them at a fair price later.

Functions of a stock exchange

• A regulated system in which shares can be traded.
• Rules of business conduct that make dealing fair.
• An efficient system for giving investors new financial information about companies.
• A record of the prices at which shares are bought and sold, with price information for the market.

In Nigeria a company must obtain a listing and also apply to have its shares traded on the exchange, which is now the Nigerian Exchange (NGX).

Bond markets

Bonds are issued by governments, agencies, international bodies and companies. They usually have a fixed maturity and pay interest at a fixed rate once, twice or four times a year, and can be traded in a secondary market. In Nigeria the bond market is dominated by federal and some state government bonds. Corporate bonds are few and come mostly from banks.

International bond markets are used by governments and very large companies to issue bonds, usually in US dollars or euros, and are organised by international investment banks. They are not open to small companies. Nigeria has issued Eurobonds, the first in January 2011.

Government securities

• Price: issued in units of ₦1,000 nominal value.
• Coupon: fixed, or variable and linked to a benchmark such as the CBN Monetary Policy Rate with a floor and a ceiling. Example: a state bond pays 4½% above an MPR of 10%, to a maximum of 18%, so the floor is 14½% and the ceiling 18%. This protects the investor against interest rate risk but not fully against inflation.
• Yield: the market rate of interest, which drives the price. The higher the yield, the lower the price. If investors want 20% and a bond pays a fixed 10% on ₦1,000 (₦100 a year), the price falls to ₦500, because ₦100 is 20% of ₦500. This is the irredeemable approximation.
• Return:
  R = [I + (P1 − P0)] ÷ P0, interest received plus the change in price, over the opening price.
• Redemption: repayment of the nominal amount on a set date or between dates. Undated bonds may never be repaid. State bonds are often repaid under an Irrevocable Standing Payment Order, a first charge on the state’s allocation.

Advantages of government bonds: security of capital and income, and liquidity because they are quoted. Disadvantages: the price can move, and inflation erodes income and capital.

Participants in the capital market

• Issuing houses: price new issues with the issuer, underwrite, bring issues to market, advise on timing (subject to SEC approval) and give financial advice.
• Stockbrokers: agents who buy and sell for investors and earn brokerage. Only licensed brokers can trade on the exchange.
• Central Bank of Nigeria: mainly in the money market: interest rates, protecting the naira, inflation and financial system stability.
• Registrars: keep the register of members, issue certificates, send dividend warrants and annual reports.
• Fund and portfolio managers: invest on behalf of clients.
• Receiving bankers: hold the proceeds of a public offer until they are released to the issuer.
• Trustees: watch the fund managers for investors, keep custody of trust assets and check compliance.
• Capital market consultants: the solicitor to the company and to the offer, and the reporting accountant who reports on the accounts and forecasts.
• Central Securities Clearing System (CSCS): clears and settles trades and holds dematerialised securities. A clearing house guarantees payment to the seller.
• The Securities and Exchange Commission (SEC) and the exchange, covered in the earlier topic on the regulatory background.

The money markets

The money markets are wholesale markets for short-term lending and borrowing and for short-dated instruments (one year or less when issued). They give short-term liquidity to those who need cash and short-term investment to those with a surplus. Banks are the most active participants. Large companies may deal directly. Smaller ones borrow and deposit through their bank, in smaller amounts.

The markets also give access to short-term finance in foreign currency for international trade. In Nigeria the instruments include Treasury bills, CBN certificates, deposits, certificates of deposit, bankers’ acceptances and commercial paper. The FMDQ exchange, registered in 2012, brings Nigeria’s fixed income and currency markets under one governance structure (now named the FMDQ Securities Exchange).

The inter-bank market

Banks lend large sums to each other, often overnight and up to a year. Rates depend on the term and on the credit rating of the borrowing bank. Reference banks report their rates so that an average can be published.

In Nigeria this is NIBOR, a trimmed average of quotes from ten reference banks for overnight, 1, 3 and 6 months, used as a benchmark for loans, bonds and derivatives priced as NIBOR plus a spread. The same body publishes NITTY (Treasury bill yields) and NIFEX (foreign exchange fixings). In London the equivalent was LIBOR.

LIBOR has been discontinued and replaced by rates such as the Secured Overnight Financing Rate (SOFR) for the US dollar and the Sterling Overnight Index Average (SONIA) for sterling. The examples keep the LIBOR name because the mechanics are the same.

For the exam, interest on a money market loan = annual rate × months ÷ 12. Only top-rated banks borrow at the benchmark. Others pay a spread above it, for example benchmark plus 0.5% (50 basis points). Many smaller firms borrow at the bank’s own base rate plus a margin, which is set by the bank and is not a market rate.

The repo market

In a repo one party sells short-dated bonds or money market securities and agrees to buy them back on a set date at a higher price. It is a short-term secured loan, and the extra price is the interest. A bank might sell securities for $20m and buy them back after 14 days for $20.046m, so the lender earns $46,000.

Central banks use repos to supply liquidity, and banks use them for secured borrowing. Repo rates are slightly lower than inter-bank rates because repos are secured. A bank with many short-dated bonds borrows by repo. One without them uses the inter-bank market, which is more important for hedging.

Money market instruments

There are two kinds. Coupon-bearing instruments pay interest at a stated rate on a fixed principal, repaid with interest at maturity (certificates of deposit). Discount instruments are issued below face value and repaid at face value (Treasury bills, bills of exchange and commercial paper).

• Treasury bills: government short-term paper, normally 91 days. They are risk-free and can be resold, so they suit a company with a temporary surplus.
• Bills of exchange and bankers’ acceptances: a drawer orders a drawee to pay a sum on a future date. When the drawee accepts it, the bill is an undertaking to pay. A bill accepted by a bank is a bank bill and is traded. Under a BA programme the bank accepts bills drawn on it up to a limit and sells them at a discount for the company. The cost is the discount. With a top-rated bank the rate can be lower than other borrowing.
• Certificates of deposit: issued by a bank for a term deposit. The deposit cannot be withdrawn early but the certificate can be sold.
• Commercial paper: an unsecured promissory note issued through a bank programme by a company with a good credit rating, usually rated by an agency. It is negotiable but buyers mostly hold it to maturity.

Derivatives

IAS 32 describes a derivative as a financial instrument with three features:

• its value changes with a specified underlying (interest rate, commodity price, exchange rate)
• it needs no or little initial investment
• it is settled at a future date

Some are bespoke over-the-counter (OTC) contracts, such as forwards and swaps. Others are standardised and traded, such as futures and options (OTC options are also important).

The small outlay gives exposure to price moves on large volumes, which can be used to speculate or to hedge. Speculation can bring huge losses and has caused corporate collapses. Later topics cover hedging in full.

The rules in more depth

Why bond prices fall when yields rise

A bond pays a fixed cash amount. If new bonds pay more, nobody will pay full price for the old one, so its price falls until its yield matches the market.

Why only some companies issue commercial paper

The paper is unsecured and so relies on the credit of the issuer.

Why repos cost less than inter-bank loans

The lender holds securities as security, so its risk is lower.

Why money market rates move with the central bank

The central bank sets the rate at which banks borrow from it. Banks reprice their own lending at once.

Effect on analysis

In a question, choose the cheapest source for the period and size, and compare the annualised cost of each, adding fees where given.

Worked examples

1. If MPR is 12%, the coupon is 15%, within the range.
2. If MPR is 20%, MPR + 3% = 23%, but the ceiling caps it at 22%.
3. If MPR is 8%, MPR + 3% = 11%, but the floor lifts it to 14%.

1. Price = 80 ÷ 0.16 = ₦500.
2. A year later the price is ₦520 and the holder has received ₦80.
   Return = [80 + (520 − 500)] ÷ 500 = 100 ÷ 500 = 20%.

1. Discount = 1,000,000 − 985,222 = ₦14,778.
2. Rate for three months.
   14,778 ÷ 985,222 = 1.5%.
3. Annualised = 1.5% × 12 ÷ 3 = 6.0%.

1. Rate for three months.
   6.2% × 3 ÷ 12 = 1.55%.
2. Proceeds = 40m ÷ 1.0155 = ₦39,389,463.
3. Interest = 40,000,000 − 39,389,463 = ₦610,537.

1. Rate = 18.5%.
   Three-month rate = 18.5% × 3 ÷ 12 = 4.625%.
2. Interest = 500 × 4.625% = ₦23.125m.

How to score full marks

• Separate capital market from money market by term.
• State whether the instrument is discount or coupon-bearing before calculating.
• Annualise each cost so that you can compare sources.
• Remember that price moves opposite to yield.
• Name the participant and its role precisely.
• Link the choice to size, term and credit rating.

Common mistakes in the exam

• Using the discount as a percentage of face value and not of the amount raised.
• Forgetting to annualise a short-term rate.
• Saying a bond’s price rises when yields rise.
• Confusing a repo (secured) with an inter-bank loan (unsecured).
• Quoting LIBOR as a live rate without noting it has ended.
• Treating a bankers’ acceptance as unsecured paper.

Quick revision

• Capital market: shares and bonds. Primary and secondary.
• Bond price falls as yield rises.
  R = [I + (P1 − P0)] ÷ P0.
• Money market: wholesale, one year or less. Inter-bank and repo.
• Discount instruments: Treasury bills, bills of exchange, commercial paper.
• Derivative: value follows an underlying, little outlay, future settlement.
• CAMA 2020: ss. 377(1), 378, 385, 308, 404(7).

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

The real ICAN paper has no multiple-choice section. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

Spotted a mistake? Tell us and we will check it.