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Prep Exams > Financial markets > Flashcards

Financial markets Flashcards

1
Q

Definition of Financial Systems

A

Financial Systems produce and exchange financial instruments; provide transfer and allocation of funds from resources to uses; provide regulation and control over these activities.

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2
Q

What are 4 fundamental functions of financial systems?

A
  1. Borrowing and lending
  2. Ownership and control allocation
  3. Diversification of wealth
  4. Saving and investment coordination
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3
Q

Definition of financial instruments

A

Financial instruments are contracts whereby one party receives an amount of money from the other against the promise to repay the same or a greater amount at a future date.

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4
Q

How can financial instruments be classified?

A

4 possible criteria:

  1. Bank vs Market
  2. Direct vs Indirect
  3. Liquidity:property of being tradable with low transactions costs (cash=0)
  4. Risk:uncertainty over the future payment of instrument (cash=0)
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5
Q

What are types of financial systems?

A
  1. Market system or Anglo-Saxon model (smaller role of banks and larger share of market instruments)
  2. Bank system or Continental model
    However both types moved towards market instruments - “Transnational model”, which is common pattern for all developed countries, the difference is intensity.
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6
Q

What are the main characteristics of bank and market systems?

A

Financial intermediaries: BS-mainly banks, MS-mainly market intermediaries

Security markets: BS-thin (less liquidity), MS-thick (more liquid)

Credit market: BS-wide(concentrated), MS-limited (dispersed)

Firms in the stock market: BS-few, MS-many

Savers’ attitude: BS-liquidity and control, MS-risk and diversification

Legal system: BS-Civil Law, MS-Common Law

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7
Q

3 fundamental goals of EMH (Efficient Market Hypothesis)

A
  1. Market Equilibrium: demand of funds=supply; at the prevailing market conditions, everyone can freely lend and borrow as much as wanted
  2. Allocation efficiency: allocation of funds is the best possible one (minimal cost, maximum benefit, for each agent and society as a whole)
  3. Information efficiency: the market transmits all the necessary information to achieve efficient allocations
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8
Q

What are 3 conditions for efficiency in the market to occur?

A
  1. Perfect competition (free entry/exit, no dominant position)
  2. No transaction costs
  3. Perfect information (all operators are freely and equally are provided with “all relevant information”
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9
Q

What are securities?*

A

Securities - financial instruments that are traded at a price in organized markets (stocks, bonds, notes, funds and etc.)

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10
Q

What is the relationship between RR (the rate of return) and the future value? Formula

A

The RR of a security is inversely proportional to its price for its given future value.
Rkt +1=Vkt+1/Pkt - 1
Vkt=future value
Pkt=purchase price/opening price (at a time T)
Simple meaning of the formula: you invest Pkt to get Vkt+1 in one year

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11
Q

Demand and supply of funds with regard to price of supply/demand of securities

A

Those who demand funds => security supply is increasing in its price
Those who supply funds => security demand is decreasing in its price

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12
Q

What is arbitrage?

A

Under conditions of an efficient market, fund suppliers compare the RRs across securities and seek higher RR. They sell low RR (high price) and buy big RR (low price) assets.
Low RR -> demand increases -> price increases -> RR falls
High RR -> demand decreases -> price falls -> RR rises

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13
Q

What is market return rate (r)?

A

The Market return rate (r) is a unique RR. In force of efficient arbitrage security trading goes on until all securities pay r.
Formula: Rkt=Vkt+1/Pkt-1 => r

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14
Q

What is equilibrium price (“right price”) of a security?

A

Equilibrium price of a security is its future value discounted at the market rate.
Formula: Pkt=Vkt+1/1+r

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15
Q

Why are security prices are so variable (“volatile”)?

A

They react quickly to changes in r (market return rate) and V (future, unobservable variable, assessed by investors). “News” about changing in V are the most important factor.

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16
Q

Define uncertainty and risk

A

Uncertainty defines a general characteristic of human reasoning arising from limitations concerning our knowledge and information. Broadly speaking, we are uncertain because we do not know with certainty the future value of the relevant economic variable of the factors that may determine it.
Risk is a specific treatment of uncertainty in probabilistic terms.
All risks are uncertain, but not all uncertainties are risks.
Risk is the effect of uncertainty on objective

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17
Q

Where do probabilities come from? 2 main views of probability

A

1) Probability should have an objective foundation, which is provided by past experience. By observing large number of repeated occurrence of the random variable we can compute FREQUENCY of each possible outcome, which gives a fair approximation of the probability of each outcome.
2) probability may also have subjective foundation - “the degree of confidence in our beliefs”. The “beliefs” may come from experiences as well as from other “rational judgement.

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18
Q

What is the expected value of a random variable?

A

The expected value of a random variable is the weighted sum of its possible values with their respective probabilities.
Formula if u use relative frequencies:
R1alpha1 + R2alpha2….
R-RR
Alpha=uniform distribution=1/N (of outcomes)

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19
Q

What EV (Expected Value) tells you and what it doesn’t

A

The EV gives you the best statistical forecast of the outcome of a random variable.

Doesn’t:

1) EV is not necessarily the most probable outcome
2) EV may be none of the possible outcomes (knowing the EV of a random variable does not prevent you from making forecast errors)

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20
Q

What is the variance of a random variable?

A

The variance is an aggregate measure of risk, because it encompasses all possible forecast errors and not single ones. It is also ABSOLUTE measure, because it yields a pure number that encompasses both negative and positive forecast errors.

The variance of random variable is the expected value of the square forecast errors of possible values. (By how much the Expected Value will be wrong since we cannot predict that our possible outcome will be equal to EV)

Formula: Variance=(Ri-EV)^2 * Alphai
Forecast error: Ri-EV
Alpha-probabilities

21
Q

Define Return-Risk analysis

A

Return-Risk analysis is based on the idea that any security is identified by its expected RR (ERR-expected rate of return) and risk (SE- Standard Error).
The analysis can be done by means of a “map” of securities.

22
Q

The fundamental law of finance

A

More return goes with more risk

23
Q

Define portfolio

A

Portfolio is a combination of securities in given proportions (“portfolio shares”). It is still identified by its own ERR-SE and can be plotted in the security map.

24
Q

What is ERR(expected rate of return) of portfolio?

A

The ERR of a portfolio (P) is the weighted average of the ERRs of the underlying securities (k) with the respective shares (Qk)
Q is probability
Formula: P=k1Qk+k2(1-Q2)

25
Q

What is SE (Standard Error) of a portfolio?

A

SE of a portfolio is the square root of its variance.
Variance of portfolio is the covariance of the ERRs of the underlying securities.
Positive covariance => the ERRs of different securities move in the same direction
Negative => opposite direction
Covariance is a key factor for portfolio management! COMBINE SECURITIES WITH NEGATIVE COVARIANCE.
As long as covariance is negative the SE (risk) of a portfolio is less than the sum of the SEs of the underlying securities.

26
Q

What is correlation coefficient?

A

C.c. Is a simpler indicator for the risk management of securities in portfolio. Covariance is often translated to correlation coefficient of the RR:
C=cov(1,2) / (SE(1)*SE(2))
The index has the same sign of the covariance, but the advantage that
C=0 no correlation
C=1 perfect positive correlation
C=-1 perfect negative correlation

27
Q

What is Capital Market Line?

A

Capital Market Line is a straight line of the combinations of a safe security and an efficient risky portfolio.

28
Q

What should the ideal portfolio consist of?

A

Should contain a share of the safe securities and of an efficient portfolio of all the risky securities available in the market (it should lay on CML-Capital Market Line)

29
Q

What is the return-risk trade-off?

A 
How much more risk is necessary to hear in order to have 1% more ERR. Is measured by the slope CML (capital marker line) = ERR(K)-RFR / SE(K)
High slope ( high ERR, low SE) indicators a more favorable trade off => choose K that make slope the highest
30
Q

Is risk a source of malfunctioning financial markets? Or does risk disrupt financial efficiency?

A

No.

1) following the conditions for financial efficiency in the market, the mere existence of risk doesn’t violate those 3 conditions, provided that the relevant risk parameters of all securities are included in the information set of all investors.
2) return-risk analysis doesn’t violate the basic mechanisms of financial efficiency, arbitrage and fundamental valuation, provided that:
a) fundamental valuation is corrected for risk ( the future stream of payments if a security is reformulated in terms of its EV and SE)
b) securities are classified, and compared, in homogeneous risk classes (both dimensions of ERR and SE)

31
Q

Define households

A

Households stands for units that own production factors and assets, earn related incomes and have consumption as an aim.

32
Q

What is the optimal portfolio?

A

The optimal portfolio chosen by the saver is the one such that the market return-risk satisfies his/her preferred one.
Savers with different risk aversion choose different portfolios

33
Q

Investment valuation.
What is the net present value?
What is the condition of NPV for investment to be profitable?
What is marginal (or break even) investment?

A

The NPV of an investment is the difference between the present value of future (gross) profits and its initial value. For an investment to be profitable, NPV should be non negative (>=0)
If NPV=0, it’s called “marginal or break-even investment”
Formula: NPV=P1/1+r - I0>=0
P1-future profit streams
I0-initial value (investment cost?)

34
Q

Lessons from intertemporal budget*

A
  1. Saving/borrowing cannot change the PV of the consumption plan
  2. Financial wealth only matters if it exists initially and if our household has planned a final value greater or lower than initial value
    Saving exchanges less present consumption for more future consumption
    Borrowing exchangers more present consumption for less future consumption
35
Q

What is NPV?

A

The NPV is the difference between the present value of future profits and its initial value
NPV used for evaluation of investment in terms of cash inflows and outflows

36
Q

What is IRR?

A

IRR is the highest interest rate (cost of capital) that the investment can sustain)
IRR is the rate p such that NPV=0

37
Q

What is the cost of capital of a new investment in terms of new equities r(e)?

A

It is the ration i the year profit to the equity value of the investment:
R(e)=п/V

38
Q

What is the equity(or market) value of the investment?

A

It is the amount of funds that the firm can collect from the stock market by selling new shares:
V=A*p
p-the price of a single share
A-the number of shares

39
Q

On what condition equity finance (investment) is feasible (probable)?

A

If p>r(e)

If the market price of new shares is bigger than the cost of capital of a new investment in terms of new shares

40
Q

What is the general principle for the investment to be profitable?

A

For any financial instrument or combination of financial instruments the general rule is that the investment is profitable only if the cost of capital doesn’t exceed IRR of the investment. (<=p)
p=IRR

41
Q

What is composite cost of capital?

A

If a firm pools different financial instruments, the cost of capital is the weighted average of the costs of the different instruments:
rt=qfrm +qdrd+qere
qf,qd,qe - the proportions of investment I financed by internal fund, debt and equity (qf+qd+qe=1)

42
Q

What are the three types of empirical notions and tests on efficiency?

A
  1. Good evidence of weak efficiency: prices adjust quickly to new info and are unpredictable (follow random walk), impossible to gain systematically higher returns than market rate.
  2. Some evidence of semi-strong efficiency: prices adjust quickly to the arrival of new publicly available information that is relevant for the future value according to the market beliefs.
  3. Poor evidence of strong efficiency: prices poorly satisfy fundamental valuation in a strict sense o
43
Q

3 puzzles of financial market

A
  1. Wrong fundamental valuation - stock prices present prolonged period of over/under - valuation w.r.t. fundamental valuation.
  2. Excess volatility - stock prices are more volatile than the underlying fundamental variable (Ykt+1)
  3. Bubbles - are self-sustained, persistent, but temporary unidirectional movements of the price of a security or of an index of insecurities
44
Q

Why financial market fail?

A
  1. Allocation problem

For households:
Too much savings or too little? - both young and retire households show higher saving and wealth (low consumption), saving rate in advances economies is declining.

Excess volatility of consumption - consumption is less stable and more dependent on current incomes than it should be in efficient market.

For firms:
Financial hierarchy and constraints-firms pursue diversification of investment financial instruments, the stock market is less used, financial constraints for smaller firms.

Inelasticity-investments seem poorly elated to interest rates and strongly dependent on internal funds.

Procyclicality- there is a strong positive correlation between investment and consumption which indicates that the market tends to amplify shocks instead of damping them

  1. Security markets and informational problems
    The “no trade paradox”
45
Q

What is rationing?

A

Rationing is the case of market inefficiency, when someone (borrower or lender) has no access to the market (unable to borrow or land at the given market conditions)

46
Q

Portfolio’s frontier

A

By combining 2 or more risky securities in different proportions (summing up to 1), it is possible to obtain the set of all possible portfolios, each identified by its own ERR-SE

47
Q

What is a consumption plan?

A

A consumption plan is a sequence of consumption expenditures to be realized over a given period of time.
Has 2 dimensions:
1.time profile of consumption preferred by the household
2. The resources in each period

48
Q

Modigliani-Miller Theorem

A

Investment finanaving structure is irrelevant:

  1. If financial markets are efficient, all financial instruments have the same cost for all firms, and investments do not depend on the choice of financial instruments.
  2. The value of the investment doesn’t depend on the particular financial structure adopted

Prep Exams (4 decks)

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