1. Introduction to Financial Markets

Question 1

1.1. What is a financial market?

Answer 1

A mechanism that allows people and entities to buy and sell financial securities at prices that reflect supply and demand.

Question 2

1.1. What do financial markets facilitate?

Answer 2

• The raising of capital,
• The transfer of risk,
• The transfer of liquidity,
• International trade

Question 3

1.1. What do financial markets include?

Answer 3

• the stock markets
• the bond markets
• the derivatives markets
• the money markets
• the foreign exchange markets

Question 4

1.1. What are the main reasons to study financial markets?

Answer 4

1. Interaction of people with financial markets throughout their lives
2. 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)
3. Understanding the financial markets is important to take regulation measures (especially during crisis)
4. Financial markets can impact the real economy (GDP growth, employment, wealth)

Question 5

1.1. What is Financialization?

Answer 5

The growing role of the financial industry in the economy, economies are very dependent on financial operations.

Question 6

1.1. Name the main function of financial markets.

Answer 6

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.

Question 7

1.1. What is the problem regarding its main function?

Answer 7

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.

Question 8

1.1. Identify and describe the 2 main agents in Financial markets.

Answer 8

1. Lender-savers- those who have excessive liquidity.
2. Borrower-savers- those who have need for liquidity.
   The agents can both be Households, Business firms, Government, Foreigners.

Question 9

1.1. There are two-types of finance. Which ones?

Answer 9

1. Direct Finance- the interaction between the 2 agents (lends and borrowers).
2. Indirect Finance- The interaction between the 2 agents with the “help” of intermediaries (like banks).

Question 10

1.1. What is the importance of the role played by financial markets?

Answer 10

The people who save are frequently not the same people who have profitable investment opportunities available to them, the entrepreneurs.

Question 11

1.1. Describe what happens in periods of stress in the financial system.

Answer 11

During that period, firms tens to substitute bank debt with funding from capital market sources.

Question 12

1.2. Why do financial intermediaries complement financial markets? (3 reasons)

Answer 12

1. Transaction Costs
2. Risk Sharing
3. Asymmetric information

Question 13

1.2. Explain Transaction Costs in depth.

Answer 13

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.

Question 14

1.2. What about risk sharing?

Answer 14

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

Question 15

1.2. Name 2 reasons why financial institutions may reduce the exposure of investors to risk?

Answer 15

1. 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.
2. 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.

Question 16

1.2. Explain Asymmetric information in depth.

Answer 16

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)

Question 17

1.2. Define adverse selection.

Answer 17

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.

Question 18

1.2. Define Moral hazard.

Answer 18

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.

Question 19

1.2. Name some cautions that should be taken into account regarding Financial Intermediaries.

Answer 19

The “too big to fail” thinking associated with banks brings a problem: Knowing they have the Government’s support, Big Banks tend to make investments with higher risk that offer more leverage, thus, creating instability.

Question 20

1.3. Capital markets can be classified as …

Answer 20

Primary markets
Secondary markets

Question 21

1.3. Define primary markets.

Answer 21

In terms of
- Information: not much info.
- When a private firm goes public, issue stocks for the 1st time.
- Higher importance than in secondary markets.
- The new securities are sold in primary markets by investment banks.

Question 22

1.3. Define secondary markets.

Answer 22

In terms of
- Information: abundant
- When the stocks are already owned by investors that want to sell stocks to other investors

Question 23

1.3. What happens in primary vs. secondary markets?

Answer 23

In the primary markets- The new securities are sold by the investment banks.
In the secondary markets- where the transactions between investors of securities that have been issued occur.

Question 24

1.3. Name the functions of an investment bank.

Answer 24

Main functions:
Origination (advice about the types, time and issue price of the issuance)
Distribution (sale of securities)
Assumption of risk (the underwriter takes risks by purchasing the entire issue)
Certification (certifies the quality of the issue)

Question 25

1.3. Difference between IPO and seasoned issue.

Answer 25

IPO- occurs when a privately held corporation decides for the first time to sell common stock to the public.
Seasoned issue- happens when a corporation, after going public, sells additional stock to raise further capital.

Question 26

1.3. The underwriter agreement between the corporation and the investment bank defines…

Answer 26

• the securities to be sold
  -the quantity
  -the selling price

Question 27

1.3. What are the 2 types of underwriting agreements?

Answer 27

1. Firm commitment agreement: underwriters agree to pay a fixed amount for the issue before selling it to the public (underwriters agree to pay a fixed amount for the issue before selling it to the public)
2. Best effort agreement: the amount of money to be received by the corporation will be determined by the percentage of shares sold, if the sale does not reach the minimum number of shares agreed upon between the corporation and the underwriters, the offer is canceled (all-or- none clause).

Question 28

1.3. Primary offerings can be sold in a private placement (not public offering). What is a private placement?

Answer 28

When the firm (using an investment banker) sells shares directly to a small group of institutional or wealthy investors.

Question 29

1.3. what are the differences between an IPO and private placemnt?

Answer 29

-the disclosure of information in a standard format
-mandatory registration at the Comissão de Mercado de Valores Mobiliários (CMVM)
-private placements can be far cheaper than public offerings because the registration is less costly.

Question 30

1.3. what are preliminary announcements? What does it include?

Answer 30

When a corporation decides to launch a public offering, it must publish a preliminary announcement with the following:
- the name of the corporation which proposes the bid
- the name of the target corporation
- the securities that intends to buy
- the price of the offer, etc.

Question 31

1.3. Name the 4 IPO puzzles.

Answer 31

1. IPO’s are usually underpriced.
2. The number of issues is higly cyclical. (in some periods there are more IPO’s than in others)
3. The costs of an IPO are very high (this fee is large, especially considering the additional cost associated with underpricing)
   4.The long-run performance of a newly public company is poor (the year-by-year underperformance of the IPOs suggests that, on average, the investing public may be too optimistic about the prospects of these firms).

Question 32

1.3. Explain the puzzle number 1. IPO’s are usually underpriced.

Answer 32

• The market price at the end of trading on the first day is often substantially higher than the IPO price
• The error is not random: underwriters often underprice the shares because their main concern/goal is to sell all the shares

Question 33

1.3. Why does IPO get underpriced?

Answer 33

3 explanatory theories:
(1). Asymmetric information- underpricing serves as compensation for the winner’s curse for those who get allocations, investors know that there is asymmetric info, but choose to invest anyway, and that is the compensation they are offered.
(2) Litigation theory- if the IPO is undervalued investors can sue the underwriters, to please investors they low the prices, in other words, underpricing reduces the probability that investors will sue underwriters.
(3) Impresario hypothesis- investment banks are like agents for the investors, they have to keep a good reputation among them, in order to get more deals, and then maximize the value they get. More good IPO’s will lead to more events, and agreements, thus, more demand in subsequent events.

Question 34

1.3. What can explain the IPO puzzle number 2. (nº of issues is highly cyclical)?

Answer 34

2 Reasons
1. Window of opportunity hypothesis- issuers time their decision to go public when they can obtain a high valuation for their shares.
2. Financing waves hypothesis.

Question 35

1.3. Definition of seasoned equity offering.

Answer 35

When firms return to the equity markets and offer new shares for sale (already ecxisting public company decides to issue more shares).

Question 36

1.3. The main difference between a seasoned equity offering and an IPO is …

Answer 36

That a market price for the stock already exists- trading market prices can be used as a reference to the seasoned issue’s offering price.
In a seasoned equity offer, the firm may issue the following:
- primary shares (new shares issued by the company) or secondary shares (shares sold by existing shareholders)

Question 37

1.3. Name the 3 market structures for trading stocks.

Answer 37

1. Over-driven
   - Buy and sell orders of public participants, the investors supply the liquidity, and the securities’s prices are established by the holders.
   2.Quote-driven
   - Intermediaries determine the prices at which the public participants trade, intermediaries provide liquidity.
2. Hybrid-markets
   - Combines the 2 systems (ex.The NYSE)

Question 38

1.3. Over-driven markets can be structured in 2 different ways. What are those?

Answer 38

1. Continuous market: orders for trade are executed immediately as soon as the appropriate price becomes available.
   - Benefits: increased speed, better for customers who need immediacy
   - Downside: increased cost of placing many small individual orders
   -Undetermined number of prices:
   first, there is a price priority; among orders given with the same price, there is a time priority.
2. Call auction: orders accumulate, and then, at a specific point in time, they are executed all at once.
   - Limit orders are collected over a fixed period, at the end of this period, the orders are processed in the auction
   - The price that enables the largest number of assets to be traded is chosen.

Question 39

1.3. Name the 2 categories of secondary markets.

Answer 39

1. Exchanges: buyers and sellers gather at a “central location” to trade.
2. Over-the-counter (OTC): ): where multiple dealers (mainly banks) provide quotes and make trades, investors should compare different dealers offerings.

Question 40

1.3. Classification of financial markets according to the trading system.

Answer 40

1. Eletronic trading: (method of trading securities electronically, in virtual marketplaces).
2. Floor trading: where traders and brokers meet at a specific venue referred to as a trading floor or pit to buy and sell financial instruments using the open outcry method (este método é como no pursuit of happiness, toda a gente a gritar e a falar alto para ganhar o melhor deal) to communicate with each other (tipo lobo de wall street).

Question 41

1.3. Trading in the stock exchanges: types of orders. Describe these types.

Answer 41

1. Market order: buy/sell order to be executed immediately at current market prices (investor doesn’t specify the price).
2. Limit order: order to buy a security at no more than a specific price or to sell a security at no less than a specific price. (limit order book is a collection of orders waiting to be executed).
3. Stop order: order to buy or sell a stock once the price of the stock reaches a specified price, known as the stop price- when the stop order is reached, a stop order becomes a market order.

Question 42

1.3. What are the constraints of buy and sell orders?

Answer 42

1. Fill or Kill (FOK)- the order is either filled completely on the first attempt or canceled outright.
2. All or None (AON): the order must be filled with the entire number of shares specified or not filled at all.

Question 43

1.3.How are market quotes formed?

Answer 43

Through a double auction process:
Inside quotes- buy and sell orders at the top of the list, used to calculate the bid-ask-spread.
Bid-ask-spread- difference between the prices quoted for an immediate sale (ask) and an immediate purchase (bid).
The lower the bid-ask-spread, more liquidity there is in a market.

Question 44

1.3. What is short-selling?

Answer 44

1. Short-selling: sell of a security the seller does not own.
   The security is borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party. They assume they will be able to buy the stock at a lower amount than the price they sold short. (they profit if the stock goes down between the sale and the repurchase). There is no limit of losses that can occur.

Question 45

1.3. What is naked short-selling?

Answer 45

Naked short selling: practice of short-selling without first borrowing the security.
- When the seller does not obtain the shares within the required time frame, the result is known as a “fail to deliver”.
- Abusive naked short selling is illegal in most of the developed financial markets.

Question 46

1.3. What are the main characteristics of trading over-the-counter markets.

Answer 46

• Banks offer contracts similar to those traded in the exchanges (such as forwards, swaps, caps, floors, collars, options)
  -The contracts are offered to the bank’s client directly
• These markets are decentralized, so it is necessary to contact several banks to find the best price (e.g., of an option).
• counterparty risk is an important issue.
• counterpart risk: the risk that a counterparty in a future transaction will default before the expiration of the trade.