Chapter 1 Flashcards
WHAT IS THE ROLE AND OBJECTIVES OF THE FINANCIAL MARKET?
A productive economy requires firms to produce goods and services for consumption, and these firms need resources.
It is the financial market that links the resource needs of these firms with the people willing to provide the necessary resources: in the form of investments.
THE ROLE AND OBJECTIVES OF THE FINANCIAL MARKET
The financial system exists to facilitate the design, sale and exchange of funds and financial investments. This exchange system takes one of two forms: direct and indirect.
What is direct exchange?
In direct exchange (financing) system, borrowers (issuers) sell securities directly to lenders (buyers).
Borrowers: central governments, local governments, and corporations.
Lenders: individuals, financial and non-financial institutions and other governments
THE ROLE AND OBJECTIVES OF THE FINANCIAL MARKET
The financial system exists to facilitate the design, sale and exchange of funds and financial investments. This exchange system takes one of two forms: direct and indirect.
What is indirect exchange?
In indirect exchange (financing) systems, financial institutions such as banks facilitate the transfer of funds between borrowers and lenders, by borrowing from the lenders and then providing the funds to the ultimate borrowers.
Such financial institutions are called intermediaries and they include banks, insurance companies and mutual funds.
The role of the financial system in this respect is to…
Facilitate:
- Production,
- Employment, and
- Consumption.
The definition of an investment…
Current commitment of money or other resources in the expectation of future benefits.
An investment could be a financial asset or a real asset.
What are financial assets and what role do they play?
Shares and bonds…
Play the vital role of linking investors with firms needing resources to enable the proper functioning of the economy.
An investment could be a financial asset or a real asset.
What are real assets and what role do they play?
Are the assets (eg, property, plant & equipment) that are purchased by firms to actually produce goods and services for consumers.
The spot market is…
The market in which commodities or currencies are sold for cash and delivered immediately.
It is also called actual market or cash market.
The futures market is…
The exchange where futures contracts and options on futures contracts are traded.
Exchanges may trade commodities, financial derivatives, or a combination of the two.
Examples of future exchanges include, Chicago Board of Trade (CBOT) and Chicago Mercantile exchange (CME).
What is the money market?
The money market is that segment of the financial market in which short term financial assets are traded.
(Securities with less than one year to maturity such as government treasury bills, bank certificates of deposits, etc.)
Most trades in this market is in large sizes, generally of one million dollars (in the US) or more, and therefore outside the scope of small to medium investors.
How can individuals participate in the money market?
Individuals, however, can participate in this market through money market mutual funds.
In the money market, who are the key players that facilitate trade?
Market makers such as:
- large commercial banks,
- brokerage firms, and
- money market dealers
facilitate trading of securities in the money market.
Define brokers in the money market:
Brokers primarily act as intermediaries by bringing together potential buyers and sellers and charge a commission for their services.
Define dealers in the money market:
Dealers have an active positions in the securities that they deal in, by standing ready to buy (at the bid price) and to sell (at the ask price) depending on the needs of the client.
Some of the more important money market securities are:
- Treasury Bills (TBS).
- Certificates of Deposits (CDs).
- Commercial Paper.
- Bankers’ Acceptances.
- Repurchase Agreements (Repos).
What is the Capital Market?
The capital market is that segment of the market in which long term financial assets (securities with more than one year to maturity such as government and corporate bonds, stocks, etc.) are traded.
What is the primary market and its purpose?
The primary market is that part of the market in which issue of new securities is carried out, often referred to as the new issues market.
In the primary market, firms and other organizations raise the funds they need by issuing (selling) long-term securities such as stocks and bonds to potential investors.
In the primary market, what is the role of investment banks?
The investment bank is simply an intermediary between prospective investors in a security, and the issuing unit.
The issue of new securities by the investment bank can either be:
‘firm commitment’ basis in which case the bank guarantees the sale of the securities, or
‘best efforts’ basis, where unsold securities are returned to the issuing company.
In order for the investment bank to carry out its role properly, it has to address four functions:
A AUD
(1) The first function is an advisory function, which entails providing advice to its clients regarding the size and pricing of the issue, its proper timing, and availability of other financing alternatives.
(2) The administrative function is the actual process of issuing the security and its registration. This involves satisfying various legal and regulatory requirements set down by the stock market administrator, and Securities and Exchange Commission (SEC) in the US, or Capital Market Authority (CMA) in Saudi Arabia.
(3) The underwriting function, where the investment bank purchases the securities from the issuing firm and then re-sells them to the public.
In a firm commitment arrangement, the investment bank pays in advance the total value of the quantity it underwrites to the security issuer.
In the case of the best-efforts alternative, the investment banker agrees to help the issuer sells the issue to the public for an agreed upon commission, and the unsold securities are returned to the issuing firm.
(4) The distribution function, which is the investment bank’s effort in the actual marketing and distribution of the issue to the public.
What is the secondary market and its purpose?
The secondary market is where the purchase and sale of already-issued securities takes place among investors.
These transactions do not change the total amount of securities outstanding; it simply transfers ownership from one investor to another.
Within the secondary market in the Saudi Market is done through?
An electronic network that links Authorized persons (security brokers) to a central trading computer unit (CTU).
The electronic network and the supporting infrastructure is referred to as the TADAWUL System.
What are round lot orders?
The number of shares in an order is generally 100 shares or multiples of 100 and is called a round lot order.
What are odd lot orders and why do they incur high costs?
Orders to buy or sell less than 100 shares are called odd lot orders.
Odd lot orders incur a higher transaction cost for two reasons:
First, the commission per security in odd lot orders exceeds that for round lot orders.
Second, an odd lot differential is usually added (or subtracted) in the case of buying (or selling) odd lot shares.
Types of Orders: Market Order
Market order is the easiest type of order a customer can place.
Under a market order, an investor asks the broker to execute the required transaction as quickly as possible, and at the best price available in the market,
lowest price in the case of a buy (i.e. at the lowest ask price) and
highest price in the case of a sell (i.e at the highest bid price).
Because the order specifies only the quantity and not the price, the deal is usually executed within a few minutes.
Types of Orders: Limit Order
In case of limit orders the investor specifies both the quantity and the price at which he is willing to buy or sell a security.
Thus, the broker does nothing but waits to seize the opportunity when the market price of the stock reaches or falls below the specified price in the case of a limit buy order.
Usually the investor will specify the period of time for which the limit order is to be kept alive. A day limit order is kept active through the trading day, but will be cancelled if not executed by the end of the trading day.
Types of Orders: Fill or Kill Order
A ‘fill or kill’ order is a type of limit order.
In a ‘fill or kill’ limit order the investor is requesting a limit order to be withdrawn if it cannot be executed immediately.
Types of Orders: Stop Loss Order
Stop loss orders are similar to the limit order, except that the trade is not to be executed unless the stock hits a particular price.
Unlike the limit order however…
Stop loss sell is executed when the stock price hits or declines below the particular price,
Stop loss buy is executed when the stock price hits or exceeds the particular price.
As the name suggests these orders are intended to limit the loss to the investor.
A stop order becomes a market order once the stop price is reached.
Types of Orders: Stop Loss Order
The stop-limit order tackles the uncertainty about the price at which the trade will be executed in a stop order by combining the features of a stop order with a limit orders.
What is a margin transaction?
When an investor’s own money is not enough to buy a security and the investor wants to add to his/her portfolios the market helps by enabling him buying the security on margin.
Similarly when an investor desires to sell a security he does not have, he can borrow the security from the broker/dealer and sell it short.
