Financial Markets Flashcards
What are financial markets?
A structure where financial assets are exchanged or traded.
Provision of Liquidity (Role of Financial Markets)
- Provide a place of gathering of WILLING buyers & sellers.
- Enforces regulation to protect buyer & seller. (Standardised the contract per trade)
- Matches buyers and sellers –> Efficient allocation of resources.
Price discovery process (Role of Financial Markets)
(2)
- Determining the price of financial assets. (A point where everyone agrees)
- Determining the amount of return for each financial asset.
How is the price discovery process influenced?
4
- Liquidity
- Risk
- Information
- Transaction
*Ultimately, the demand and supply forces
Reduction of transaction costs (Role of Financial Markets)
- Reduce search time and cost
2. Reduce contracting cost and risk (no need for a lawyer to draw up the contract)
How does the risk decrease by trading in the Financial Markets?
CENTRAL COUNTER PARTY
- Clearing members contribute security funds to cover default costs.
- They mainly come from financial institutions.
- Allow their clients to trade.
- Acts as a guarantor for transactions
- Prevents the risk of default by one of the trading parties
- Even if someone goes bankrupt we will still get our revenue
THEREFORE, counterparty risk is minimised since buyer is dealing with the clearing house/dealer and not directly with the seller, vice versa.
What is “Too big to bail”?
Too big to save
What is “Too big to fail”?
Government/regulator will protect these institutions to prevent failure and wastage of national resources. (i.e. taxpayers money)
What are the 9 types of financial markets?
- Primary
- Secondary
- Asset class
- Money
- Capital
- Exchange
- Over-the-counter (OTC)
- Spot
- Future/Foward
What financial assets are in the primary market?
- IPO - Initial Public Offering: Company sell shares for the first time
- SEO - Season Equity Offering: Company have already went through IPO, but want to sell more new shares.
- Private Placement: New shares for institutional investors (Large banks, mutual funds, insurance companies, pension funds)
What financial assets are in the secondary market?
- Trading of issued assets
- Exchanging existing assets between owners
What is a counterparty risk?
Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation.
How does a broker represent his/her client?
Be a clearing member.
What does a clearing member needs to pledge?
- Collateral
- Safety Fund
What happens if the clearing member fails?
- Collateral from the clearing member
- Safety fund from the clearing member
- Exchange capital
- Other clearing member
What financial assets are in the asset class market?
4
1) Debt/Bonds
2) Equity/Stocks
3) Foreign Exchange
4) Derivatives (Options & Instruments)
What financial assets are in the Money market?
6
Short-term ones (1 year or less)
1) Discount Windows
2) Federal funds
3) Certificates of deposits (negotiable & non-negotiable: Cannot trade/contract cannot be adjusted)
4) T-bills
5) Repurchase Agreement
6) Commercial papers
Example of short-term financial assets in the money market?
12-mth T-bills
What are discount windows?
An instrument of monetary policy that allows eligible institutions to borrow money from the central bank.
“CENTRAL BANK DISCOUNT RATE”
- Usually on a short-term basis
- Allow these institutions to meet temporary shortages of liquidity caused by internal or external disruptions
*Central bank is the lender of last resort (when company is really desperate and credit is not very high)
Function of fed funds?
Inter-bank borrowing.
- Rates that banks charge each other for loans that are used to hit the reserve requirements
- Lend their excess reserves to other banks who are in deficit overnight
What is the rate that the fed funds use?
Central Bank: F.O.M.C. –> They control the fed funds rate
CURRENT: 0%-0.25%
How does the F.O.M.C. control the fed funds rate?
They set up a target band (discount windows) that they want to see the interest rate in.
- But they are not obliged to transact at that rate.
- If i/r is transacted outside of the target band, the central bank will OMO and let market forces decide.
What is a repurchase (REPO) agreement?
Selling securities and simultaneously agreeing to repurchase the same after a specified time at a given price/set time.
How does the selling securities take place in a REPO agreement?
(2)
Financial institutions can borrow from each other very quickly at a low cost for a short period of time.
Underlying securities serve as a collateral.
What is the process in a REPO agreement?
1) Borrower sells T-bills to the lender. (coupon still goes to the borrower)
2) Lender pays borrower in cash which the borrower needs.
3) then the lender buys back the T-bills (can be at a higher price, and thus, earn profit)
4) Borrower pays the lender in cash
What are commerical papers?
- Short-term unsecured promissory notes issued by corporations and foreign governments
- Less than 1 yr
- No collateral is pledged
- Therefore, its a RISKY loan as there is nothing to fall back on.
Comparing different interest rates for different durations
3-yr: 8%
3-mth: 6%
- Liquidity risk
- Since funds are tied up for a longer period of time, liquidity risk increase, thus, higher interest rates
- After allocated period of time, the loan will roll over, not good to keep on delaying
What are the assets in a capital market?
2
- More than 1 yr
1) Stocks
2) Bonds
How does the Exchange Market function?
- Formal Financial market
- Trade, clear, and settle in and by an exchange (or its clearing house)
What are the advantages of an exchange?
4
- Facilitates liquidity
- Provides transparency (Ensure fair and orderly trading + efficient dissemination of price information for any securities trading on that exchange)
- Maintains current market price
- Matches buyers and sellers together
How does OTC (Over-the counter) market function?
- Off-Exchange trading
- Two parties directly trade
- Trade is faciliated like broker-dealer
- Therefore, there is counterparty risk, buyers and sellers bear their own risks.
How does the Spot market function?
- Cash/Physical market
- Immediately delivery (ASAP): Commodities or financial instruments are bought and sold for immediate delivery/within a couple of days
- Spot price
- Public financial market
How does the future/forward market function?
- Contrast with spot market
- Future delivery
- Traders purchase & sell futures contract
- Payment and Delivery on a future date
