Chapter 16 > Financial Markets: Equities & Bonds Flashcards
What is the financial system?
The Financial System of each country is the collection of rules and institutions that facilitate credit and payments.
The Financial system is made up of:
- The central Bank
- Commercial Banks
- Non-Bank Financial Institutions
- Financial Markets
- Equity Markets
- Security Markets
What is the key role of the financial sector?
Its key roles is to ensure that savings are allocated efficiently; that is, channelled to the most productive investment projects. It channels funds from savers to borrowers.
What two markets does the financial sector deal with?
Debt (Bonds) & equity (shares)
What are the features of debt?
Not an ownership interest. No voting rights. Interest payments tax exempt. Creditors have legal recourse if payments are not made. Excess debt can lead to bankruptcy.
What are the features of equity?
Ownership.
Voting rights.
Dividends paid after corporation tax.
Shareholders have no legal recourse if dividends aren’t paid.
An all-equity financed firm can’t go bankrupt.
What are stock markets?
Stock markets are the place were shares are traded and share prices fluctuate widely (both individual company and price indices).
Stock market trends are often used to assess economic trends and stock market prices react to economic news.
What is a bubble?
A bubble occurs when an asset price deviates substantially from its fundamentals, and this difference does not disappear even if investors know that the price is above its fundamental value.
What is a bond?
A bond is a promise of a stream of payments at specific dates in the future. Bonds are traded in secondary markets, which makes them highly liquid assets. An “I owe you” (IOU).
Bonds are traded in securities markets (the bond market). This distinguished bonds from bank debt: claims held by banks cannot, in general, be sold to a third party.
How are bond prices set?
Bond prices are set, on a minute-by-minute basis, by market makers who typically work for large financial institutions like Morgan Stanley, UBS, etc… They quote prices at which they buy and sell bonds.
Bond prices reflect the balance of supply (borrowers) and demand (savers/investors) for debt. The flow of new bonds coming onto the market depends on the level of investments that companies wish to undertake and the needs of government to borrow.
What is the yield of a bond?
The yield of a bond is the average rate of return if it is held to maturity (it is the rate at which discounted payments equal current market price).
What happens if the yield of a bond is higher than the average expected return of a bank deposit?
People would move money from bank deposits to bonds (price of bonds up and return on deposits up)
What happens if the yield of a bond is lower than the average expected return of a bank deposit?
People will not buy bonds (prices will have to fall and yields will increase)
What does the yield curve show?
The yield curve (drawn at a point in time) is a line showing interest rates of bonds with similar risk (usually public debt) and different maturity lengths.
The shape of the yield curve changes with time reflecting changes in the expected path of short-term interest rates.
