Financial Market Basics Flashcards
What’s a security?
Also called a financial instrument - is a claim on the issuer’s future income or assets.
What’s a bond?
A bond is a debt security that promises to make payments periodically for a specific period of time.
What’s an interest rate?
An interest rate is the cost of borrowing or the price paid for rental of funds.
How do interest rates impact the overall health of the economy with reference to consumers and businesses?
Affect consumers’ willingness to spend or save
Affect businesses’ investment decisions
What’s type of consumption is in the financial markets and the goods market?
In the financial market you have future consumption
In the goods market you have current consumption
What’s a derivative?
A type of financial contract whose value is dependent on an underlying asset, group of assets or benchmark
What’s a hedge fund?
Actively managed investment pools whose managers use a wide range of strategies often including buying with borrowed money and trading esoteric assets, in an effort to beat average investment returns for their clients
Who are the two lenders?
individuals and companies
What are the four intermediaries?
Banks
Insurance
Pension funds
Mutual funds
What are the five borrowers?
Individuals
companies
central government
municipalities
public corporations
What are the 4 parts of the basic flows in a financial system
Lenders, financial intermediary, borrowers and financial markets
What are financial assets ultimately about?
and what coincides with it?
Supply and demand
time and risk
What are the five fundamental core parts in the financial system?
- Financial assets/instruments
- Financial markets
- Financial institutions
- Money
- Central bank
What are the 6 core functions in the financial system?
- clearing and settling payments
- pooling resources and subdividing shares
- transferring resources across time and space
- managing risk
- providing information
- dealing with incentive problems
What clearing payments?
The first part is the clearing process in which payment information is conveyed from the payor to the payee, probably through intermediary banks.
What’s settling payments?
The second part is settlement in which the actual transfer of value associated with the payment order is made, generally not with cash but with a claim on a bank.
What are pooled funds?
Pooled funds are funds in a portfolio from many individual investors that are aggregated for the purposes of investment.
Whats subdividing shares?
A share split or share subdivision is where the shares in an existing share class are each subdivided into two or more new shares.
Why do banks want effective risk management?
Effective risk management practices can provide banks with a competitive advantage by demonstrating their ability to manage risks and maintain financial stability. This can help attract and retain customers, investors, and business partners.
How do financial systems help spread information?
The financial system is vital in disseminating (spread widely) information about borrowers and investment opportunities. Financial institutions assess the creditworthiness of borrowers and provide information on their financial health, helping investors make informed decisions
What are the 5 core principles of the financial system?
- Time has value
- Risk requires compensation
- Information is the basis for decisions
- Markets set prices and allocate resources (not central banks)
- Stability improves welfare
What’s a financial instrument?
A financial instrument (asset) is the written legal obligation of one party to transfer something of value to another party at some future date, under certain conditions
What are the 3 functions of financial instruments?
Means of payment
Store of value
Trading of Risk
What’s a derivative instrument?
and use…
These assets derive their value/payoff from the behaviour of the underlying instrument
Primary use is to shift risk
What’s a primitive security?
Used by savers/lenders to directly transfer resources to investors/borrowers
What is the definition of money?
Money is anything generally accepted in payment for goods and services or repayment of debts
What are the 4 functions of money?
Means of payment
Store of value
Unit of account
Standard of deferred payment
What’s a financial intermediary?
Is a firm that provides access to financial markets, both to savers (individuals and firms) who wish to purchase financial assets and borrowers who wish to issue them AND to individuals wishing to trade risk
What are the 5 functions of financial intermediaries?
- Provisions of payment mechanism
- Liquidity provision
- Maturity transformation
- Risk transformation
- Reduction of transaction, information, search costs
What’s a central bank?
is the government agency that oversees the banking system and is responsible for the amount of money and credit supplied to an economy
What are the three main functions of the central bank?
Credit creation
Supervision and Regulation
Monetary policy
What is credit creation?
the process by which the money supply of a country or of an economic or monetary region is increased
What’s monetary policy?
is action that a country’s central bank or government can take to influence how much money is in the economy and how much it costs to borrow
includes QE
What’s fiscal policy?
is the use of government spending and taxation to influence the economy.
What’s quantitative easing and its use?
Quantitative easing is a type of monetary policy by which a nation’s central bank tries to increase the liquidity in its financial system, typically by purchasing long-term government bonds from that nation’s largest banks and stimulating economic growth by encouraging banks to lend or invest more freely.
What’s a financial market?
Is a place where financial instrument (assets) are bought and sold.
What are the key characteristics of financial markets?
- Price discovery
- Providing a trading mechanism (auction, lottery)
- Execution of agreements (settlement function)
What are the agents in the financial markets?
Public investors (private individuals, trusts, pension and insurance funds)
Brokers
Dealers
What are the functions of financial markets?
3
Liquidity
Information
Risk sharing
What’s liquidity?
Liquidity means how quickly you can get your hands on your cash. In simpler terms, liquidity is to get your money whenever you need it
What determines price?
Supply and demand
What’s the quantity demanded function?
Qd = F(p,w,er,l,r)
What influences demand?
Price
Wealth
Expected return (RTOA - relative to other assets) - inflation
Liquidity (RTOA)
Risk (RTOA)
What influences supply?
Price
Return on investment
Inflation
Government
What the quantity supplied function?
Qs = F(p,roi,inflation,gov)
What’s Arbitrage?
Arbitrage is the ability to make profits from discrepancies between prices of
different assets but without bearing any price risk.
What is the arbitrage assumption and what market is associated with it?
Look only at markets with absence of arbitrage opportunities(hold all assets)
- Usually associated with frictionless markets (i.e., no costs or restrictions)
What are the market frictions?
Transaction Costs: commissions taxes, fees, time
Institutional Restrictions: Laws
Assume no market frictions
Nominal interest rate?
Is the premium paid by a borrower to have the use of lender’s funds for some period of time
What is the nominal interest rate formula?
i= (nominal repayment - nominal loan)/Nominal loan
What is the real interest interest rate?
Is the premium paid by a borrower to have the use of lender’s funds for some period of time, in terms of goods and services
Formula for real interest?
r = (real repayment - real loan) / real loan
What is the fisher equation?
The Fisher equation is a concept in economics that describes the relationship between nominal and real interest rates under the effect of inflation.
𝑟 = 𝑖 – π^e
