Chapter 1: Introduction to Financial Markets Flashcards
The equity markets and bond markets together are known as the capital markets and are for longer term financing than the money markets.
Money markets is for cash and are usually for short term financing
The financial markets help bring together the buyers and sellers of the different financial instruments or securities
The main financial markets are:
Money markets
Equity markets
Bond markets
Currency markets
Derivatives markets
For undertstanding:
The main financial markets:
1.2.1: Money markets
The money markets deal with short-term financing and investing, which includes cash deposits, money market instruments such as treasury bills, and commercial paper (which we’ll look at later). These are generally safe and very liquid, so savers / investors can easily get their hands on the cash if needed.
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1.2.2: Equity markets
The equity markets are where individuals and fund managers can buy and sell the shares of listed companies. In the UK, the main stock exchange is the London Stock Exchange, but we will see later in the guide that there are many other trading venues where we can trade UK equities.
Each country will have its own exchange where companies from that country (and maybe from other countries too) may want to list their shares. For example, the New York Stock Exchange in the US and the Tokyo Stock Exchange in Japan.
The global equity markets are pretty huge. As at the end of 2021, the global market capitalisation (the combined value of all the shares across the globe) stood at more than $122 trillion; a number that’s hard to even imagine!
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1.2.3: Bond markets
The bond markets are generally less well known.
Most people have heard of the stock markets but not as many have heard of the bond markets. This is where we can buy and sell bonds issued by both Governments and companies. It is even larger than the equity markets. The current amount of current global bonds exceeds $128 trillion.
Unlike the equity markets however, there is no physical marketplace for trading bonds and trading is done ‘over-the-counter’. We’ll explain more about what that means in chapter 3.
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1.2.4: Currency markets
The currency markets are the largest of them all with an average daily turnover of more than $6 trillion.
All currencies are traded in pairs, so one currency compared to another, and each currency is assigned a 3-letter code. For example, GBP-USD represents how many US dollars we can buy with 1 Great British pound. Most currencies are traded against the US dollar.
Like the bond markets, there is no central currency marketplace, and currency trades over-the-counter virtually 24 hours a day.
1.2.5: Derivatives markets
Derivatives are not assets in and of themselves. Instead, they are financial contracts to buy or sell assets.
These contracts derive their value from another underlying asset, hence the term ‘derivative’. They can be used to speculate against rising or falling prices, to hedge against risks, or to gain exposure to the underlying asset without having to buy it.
The derivatives markets can be split into 2 categories:
Exchanged traded Derivatives (tradable on exchanges such as the Chicago Mercantile Exchange)
OTC derivatives
As well as individual investors, known as retail investors, there are also a group of other investors known as institutional or wholesale investors. These are large investors and organisations who hold portfolios of investments, either for themselves or on behalf of other investors.
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So, investors include:
Private investors
Pension funds
Insurance companies
Collective investment schemes (mutual funds)
Banks
Charities
1.3.2: Borrowers
The main borrowers in the markets are:
Governments
Companies
Municipals or local authorities
Banks; both ‘local’ and ‘supranational’ banks
1.3.3: Intermediaries
Intermediaries act as the go-between for the borrowers and investors. They include banks, brokers, wealth managers and financial advisers.
1.4.2: Fixed interest securities
The riskiest bonds are sometimes known as high-yield bonds.
1.4.3: Equities
Private equity shares will generally have greater risk and potentially greater returns than public shares. One of the reasons, is the fact that listing shares on an exchange makes them easy to trade, so increases their liquidity.
Private equity shares, which are not listed on an exchange, will have additional liquidity risk due to the potential difficulty in being able to sell them.
A decentralised marketplace is one where:
trading occurs in a physical marketplace such as the London Stock Exchange.
trading occurs on an ‘over-the-counter’ basis.
there is a one exchange where all trades are executed in each national jurisdiction.
brokers do not charge any commission if the transaction occurs away from a central exchange.
trading occurs on an ‘over-the-counter’ basis.
A decentralised marketplace has no central or physical trading venue, which means that parties trade directly with each other ‘over-the-counter’. Brokers charge commission in any marketplace.
The following markets can all be traded OTC EXCEPT:
Currency markets
Bond markets
Equity markets
Derivative markets
Equity markets
There is no central exchange for the bond or currency markets, so they will always trade OTC. The derivative markets can be exchange-traded or OTC depending on the contract. Equity markets trade via a central exchange in each nation, and so are not considered to be OTC.
Over-the-Counter (OTC) refers to a method of trading financial instruments directly between two parties, rather than through a centralized exchange (like the New York Stock Exchange or NASDAQ).
OTC markets are decentralized, meaning transactions are conducted via networks of dealers, rather than being listed or traded on formal exchanges.
The main difference between money markets and capital markets is:
Money markets are where you trade currencies; everything else is traded in the capital markets.
Money markets are where you trade bonds, only equities are traded in the capital markets.
Money markets are for short term finance such as cash deposits, T-bills and commercial paper, capital markets are for long term finance such as bonds and equities.
Investors trade in the money markets, borrowers trade in the capital markets.
Money markets are for short term finance such as cash deposits, T-bills and commercial paper, capital markets are for long term finance such as bonds and equities.
Money markets are for short-term finance such as cash, T-bills and commercial paper – usually with a maturity of under 1 year. The capital markets are for long term financing such as equities and bonds.
Which ONE of the following is true regarding the risk and return of asset classes?
High-yield bonds usually have the highest risk compared to cash and equities.
Government bonds usually have the lowest amount of risk compared to cash and equities.
Private equity generally provides higher returns than listed equity.
Corporate bonds are generally riskier than shares issued by the same company.
Private equity generally provides higher returns than listed equity.
Cash is the least risky asset class, then government bonds, corporate bonds, high-yield bonds, equity, and then private equity. Shares issued by a company will be subject to higher risk than the bonds.
Which of the following is FALSE regarding diversification?
Diversification helps to reduce risk.
Diversification means holding different highly positively correlated asserts.
A well-diversified portfolio is one which diversifies within each asset class as well as across the different asset classes.
The greater the number of assets held, the greater the potential diversification.
Diversification means holding different highly positively correlated asserts.
Diversification reduces risk by holding a large number of assets from different asset classes, and spreading the risk within each asset class, by holding securities with low correlations to each other. If two assets are highly positively correlated, they will move in line with each other which will not help to reduce the risk of the portfolio.
