Introduction to the Financial Markets Flashcards
What is a financial market?
Mechanism that allows buying and selling of financial securities at prices that reflect supply and demand.
What are the functions of financial markets in modern economy?
Facilitate:
- raising of capital;
- transfer of risk;
- transfer of liquidity;
- international trade.
Distributing the economy’s resources for the best available alternatives at each moment in time.
Channeling funds from households, firms and governments that have saved surplus funds to those that have a shortage.
How is the relationship between financial markets and corporations?
They are different things but interact and influenciate each other
What is the turnover rate?
number of shares traded over a period of time/number of shares outstanding
What dos it mean if the turnover rate increases?
Means that shares are being traded more agressively
What have companies been doing regarding investments and financings?
They have been increasing their investments in financial assets and getting more financing, which means that they also pay higher amounts to financial markets.
Why is it important to understand financial markets?
- They involve capital flows affecting businesses, production and wellfare of countries;
- To take regulation measures;
- They impact the economy, like GDP growth.
Why are financial markets important?
Because savers aren’t always the ones who have profitable investment opportunities available;
Allow consumers to time their purchases better - distinguish good ideas that should be financed, from bad ideas.
What do firms do during periods of stress in the financial system?
They tend to substitute bank debt with funding from capital sources.
Why are intermediaries and indirect finance also important?
They complement the financial market regarding transaction costs, risk sharing and asymmetric information.
Why do financial intermediaries and indirect finance complement financial markets regarding transaction costs?
Because
-their large size allows them to take advantage of economies of scale
-small savers and potential borrowers might be frozen out of financial markets.
Why do financial intermediaries and indirect finance complement financial markets regarding risk sharing?
- through asset transformation, since they create and sell assets with risk characteristics that people are more comfortable with, and then buy other assets that have more risk
- diversification
Regarding asymmetric information in the financial markets, what is the problem that might occur before the transaction?
Adverse selection - when potential borrowers with bad cerdit risk are the ones more actively seeking out a loan, thus more likely to be selected; also, people tend to doubt higher returns, but good companies tend to have higher returns.
Regarding asymmetric information in the financial markets, what is the problem that might occur after the transaction?
Moral hazard - risk that borrowers might engage in activities that are undesirable from the lender’s point of view - these can’t monitor borrowers and may not make a loan
How can banks alleviate the problems of adverse selection and moral hazard (due to asymmetric information)?
- banks are better equipped to separate bad credit risk from good
- banks can develop expertise in monitoring the parties they lend to
What is one of the reasons why problems like adverse selection and moral hazard can affect financial intermediaries?
Banks tend to create a higher level of risk because if everything goes right they profit a lot, but if things go wrong they will be helped
In what can capital markets be classified as?
- Primary markets - where private firms issue bonds/stocks for the first time;
- Secondary market - where stocks are traded between investors.
What are the functions of investment banks?
1) Origination - advise on type of securities to issue, time of issuance and issue price
2) Distribution - sale of securities
3) Assumption of risk - underwriter can purchase the entire issue at a negotiated price, and assumes the risk of loss if the issue is unmarketable
4) Certification - underwrite certifies the quality of the issue
When does the seasoned issue happens?
Happens when a corporation sells additional stock, after going public, to raise further capital
What is defined on the underwriter agreement?
The securities to be sold; the quantity and the selling price.
Which kinds of underwriting agreements are there?
- Firm commitment agreement - underwriters agree to pay a fixed amount for the issue before selling to the public, therefore, the compny is sfe from changes in the market price and unability to sell the shares to the public.
- Best effort agreement - the money the company receives is according to the shares sold. If the sales don’t reach a minimum, the offer is canceled.
What happens in a firm commitment IPO if the entire issue doesn’t sell out?
The remaining shares must be sell at a lower price and the underwriter must take the loss.
What do we call several financial intermediaries preparing public offerings?
Syndicate of underwriting firms
When does a private placement happens?
Happens when a firm seels its shares directly to a small group of institutional /wealthy investors.
What are the main differences between IPOs and private placements?
- the disclosure of information
- mandatory registration at CMVM
- costs - private placement can be cheaper than public offerings because of less registration costs.
What are the documents containing the required information about the public offer?
Offer announcement and prospectus
What is a preliminary announcement about?
Is the preliminary announcement the company must publish when it decides to go public with things like the name, securities that intends to buy and so on. This announcement might also mitigate the level of uncertainty, lowering price’s volatility
What is the way of distributing securities when they are not sufficient to meet all orders given by the investors in public offerings?
Allotment
What are open capital corporations?
The ones with their capital dispersed by the public - like stocks traded in a stock exchange
What are the four IPO puzzles?
1) IPOs appear to be underpriced, on average;
2) The number of issues is highly cyclical (not so much about them being cyclical, but about the magnitude of the cyclitude)
3) The costs of an IPO are very high
4) The long-run performance of a newly public company is poor.
What were the theories presented to explain underpricement of IPOs?
1) Asymmetric information theory -> underpricing as a compensation for the asymmetry of information
2) Litigation theory -> underpricing as a strategy to lower the probability that investors will sue underwriters
3) Impresario hypothesis -> underprice to maximize profits - underpricing creates a high initial return, which will produce greater demand.
Regarding the cyclicality, what is the window of opportunity hypothesis about?
issuers timing their decision to go public when they can obtain a high valuation for their shares
What does the year-by-year underperformance of the IPOs suggests?
Suggests that investing public may be too optimistic about the prospects, and explains the high first day returns and hot issue markets
What are the main differences between a season equity offering (issuance of more stocks) from an IPO?
- A market price already exists, and trading market prices can be used as a reference to the seasoned issue’s offering price
- Season issues are less common
What types of shares can a firm issue in a season equity offer?
- Primary shares: new shares issued by the company
- Secondary shares: shares sold by existing shareholders (shares that already existed but were not publicly traded).
Since the costs for issuing shares are high, what seems to be the main objectives of the issuance?
Status and prestige of being listed
Higher ability to acquire other businesses for shares instead of cash
What are the 3 market structures for trading stocks?
- Order-driven - buy and sell orders of public participants who estabish the prices for trading (like an auction) - investors supply the liquidity
- Quote-driven - intermediaries quote the prices at which the public participants trade - they firsts provide the liquidity
- Hybrid markets - combines the advantages of the two systems
What are the two ways order-driven markets can be structured?
Continuous market - orders for trade are executed as soon as the appropriate price becomes available
Call auction - orders accumulate and at a specific point in time they are executed all at once
What are the vantages and advantages of continuous market?
Vantages: speed, therefore better for costumers who need immediacy
Advantages: higher costs due to placing many small individual orders
What are the two categories in which secondary markets can be classified as?
-Exchanges - buyers and sellers gather at a central location to trade
-Over-the-counter (OTC) - multiple dealers provide quotes and make trades - descentralized market
which category of secondary markets offers more competitive prices?
Over-the-counter, since the entities are in contact
Which category of the secondary markets is better at providing liquidity?
Exchanges, because in the OTC we have to compare prices
how can financial markets be classified according to the adopted trading system?
-Electronic trading - securities traded electronically
-Floor trading - traders and brokers meet at a specific location - trading floor - use the open outcry method to communicate
What is the open outcry method of communication?
Involves shouting and hand signals to transfer information about buy and sell orders.
What are the types of orders in trading in the stock exchanges?
- Market order: buy/sell order to be executed immediatly at current market prices
- Limit order: order to buy a security at no more than a specific price / sell at no less
- Stop order: buy/sell once the price of the stock reaches a specified price - stop price
What is a limit order book?
Is a collection of limit orders waiting to be executed
How can buy/sell orders be constrained?
Fill or Kill - the orders has to be completely filled on the first attempt or is canceled
All or None - order must be filled with the entire number of shares. If not, is hell in the order book for later
How does a stop order work?
- a buy order enters at a stop price above market price
- sell-order enters at a stop price below the market price
Used to limit loss/protect profits
What are the differences between inside quotes and bid-ask spread?
- Inside quotes: buy and sell orders at the top of the list - used to colect bid-spread
- Bid-ask spread: the difference between the prices quoted for an immediate sale and an immediate purchase - the lower the bid-ask spread, the higher the liquidity in the market
What is short selling?
Consists in selling a security the seller doesn’t own, has to be borrowed to sell and at a later date returned to that third party. Short-seller will profit if the stock goes down in price between sale and repurchase. They may have to pay a fee for borrowing and dividends.
What are the differences between short selling and naked short selling?
The shres aren’t borrowed. If the seller doesn’t obtain the shares in the required period, the result is a “fail to deliver”.
What is the counterpart risk?
The risk that a counterparty in a futures transaction will default before the expiration of the trade
