1. Introduction to Financial Markets Flashcards
1.1 Importance of financial markets 1.2. The financial System 1.3. Functioning of financial markets
1.1. What is a financial market?
A mechanism that allows people and entities to buy and sell financial securities at prices that reflect supply and demand.
1.1. What do financial markets facilitate?
- The raising of capital,
- The transfer of risk,
- The transfer of liquidity,
- International trade
1.1. What do financial markets include?
- the stock markets
- the bond markets
- the derivatives markets
- the money markets
- the foreign exchange markets
1.1. What are the main reasons to study financial markets?
- Interaction of people with financial markets throughout their lives
- During the last decades, the financial markets have grown very rapidly (increase in volume and sophistication, and increase in the interaction between financial markets and corporations)
- Understanding the financial markets is important to take regulation measures (especially during crisis)
- Financial markets can impact the real economy (GDP growth, employment, wealth)
1.1. What is Financialization?
The growing role of the financial industry in the economy, economies are very dependent on financial operations.
1.1. Name the main function of financial markets.
Financial markets in theory perform the function of channeling funds from households, firms and governments that have saved surplus funds to those that have a shortage of funds.
1.1. What is the problem regarding its main function?
Bank credit is not limited by any previous stock of savings: Commercial banks can obtain financing from central banks, so banks lend more money than what they have in deposit.
1.1. Identify and describe the 2 main agents in Financial markets.
- Lender-savers- those who have excessive liquidity.
- Borrower-savers- those who have need for liquidity.
The agents can both be Households, Business firms, Government, Foreigners.
1.1. There are two-types of finance. Which ones?
- Direct Finance- the interaction between the 2 agents (lends and borrowers).
- Indirect Finance- The interaction between the 2 agents with the “help” of intermediaries (like banks).
1.1. What is the importance of the role played by financial markets?
The people who save are frequently not the same people who have profitable investment opportunities available to them, the entrepreneurs.
1.1. Describe what happens in periods of stress in the financial system.
During that period, firms tens to substitute bank debt with funding from capital market sources.
1.2. Why do financial intermediaries complement financial markets? (3 reasons)
- Transaction Costs
- Risk Sharing
- Asymmetric information
1.2. Explain Transaction Costs in depth.
The large size of the financial intermediaries allows them to take advantage of economies of scale
The minimum investment value in financial markets may be too high for some small investors, so they might be frozen out of financial markets, and be unable to benefit from them.
1.2. What about risk sharing?
Financial institutions, at least in theory, may help reduce the exposure of investors to risk.
Additionally there is a positive relationship between Risk and Return.
> Risk (means) > Returns
1.2. Name 2 reasons why financial institutions may reduce the exposure of investors to risk?
- Asset transformation: banks create and sell assets with risk characteristics that people are comfortable with and then use the funds they acquire to purchase other assets that have far more risk.
- Diversification: banks create and sell assets with risk characteristics that people are comfortable with and then use the funds they acquire to purchase other assets that have far more risk.
1.2. Explain Asymmetric information in depth.
Asymmetric information relates to the idea that in financial markets, one party does not know enough about the other party to make accurate decisions (e.g., borrower and lender). Asymmetric information may create 2 problems: adverse selection and moral hazard. (Financial Intermediaries, at least in theory, alleviate these problems)
1.2. Define adverse selection.
Adverse selection happens before the transaction, and occurs when the potential borrowers who are the most likely to produce an undesirable (ar/yerse) outcome - the bad credit risk - are the ones who most actively seek out a loan and are thus most likely to be selected. Because of this, lenders may decide not to make any loans.
1.2. Define Moral hazard.
It happens after the transaction occurs. It’s related to the risk that the borrower might engage in activities that are undesirable/immoral or use the loans for riskier purposes, from the lender’s point of view, because they make it less likely that the loan will be paid back (e.g., conflict among bondholders). As such lenders may decide that they would rather not make the loan.