L2 - The Nature and Function of the Financial System

Question 1

Are Market Prices Fair?

Answer 1

Fair Market Price –> Amount at which an asset would change hands between two parties, where both have knowledge of the relevant facts –> invisible hands of the market
- it means that prices reflect the underlying fundamental values, and thus any thing factors that make up what somthing costs, is reflect in its prices –> markets are informationally efficient

• How do we know the prices on the market are correct? –> because of Efficient Market Hypothesis?

Question 2

What is Efficient Market hypothesis?

Answer 2

• The Efficient Market Hypothesis, or EMH, is an investment theory whereby share prices reflect all information and consistent alpha generation is impossible.
• Theoretically, neither technical nor fundamental analysis can produce risk-adjusted excess returns, or alpha, consistently and only inside information can result in outsized risk-adjusted returns.
• According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.
• As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can possibly obtain higher returns is by purchasing riskier investments.

Question 3

What is alpha is the financial markets?

Answer 3

Simply defined, alpha is the excess return (also known as the active return), an investment or a portfolio of investments ushers in, above and beyond a market index or benchmark that represent the market’s broader movements.

Question 4

What is beta in the financial markets?

Answer 4

Beta is a measurement of the volatility, or systematic risk of a security or portfolio, compared to the market as a whole. Often referred to as the beta coefficient, beta is a key component in the capital asset pricing mode (CAPM), which calculates the theoretically appropriate required rate of return of an asset, to make it worth incorporating into an investment portfolio.

Question 5

What is the framework required for markets to be efficient?

Answer 5

• are prices published with great frequency
• is active trading occuring (i.e. high volumes of transcactions)–> millions of pounds trading at a push of a button
• is financially important information rapidly avialable to all trades
• Is the act of trading low cost (not the cost of the goods but the cost of making a transaction – we say there is low friction)?
• frictionless environment is where there is no cost to trade –> this may be an assumption for a financial model but not true in the real work

Question 6

What is a market called when it meets the ‘fair price framework’?

Answer 6

semi-strong form efficient –> i Semi-strong form efficiency is an aspect of the Efficient Market Hypothesis (EMH) that assumes that current stock prices adjust rapidly to the release of all new public information, thus eliminating the use of fundamental or technical analysis to achieving a higher return –> means that the prices quoted are very likely to be good or (as fair) as they can be
- this gives confidence to us as investors

Question 7

what is strong form efficient?

Answer 7

Strong form efficiency is the most stringent version of the efficient market hypothesis (EMH) investment theory, stating that all information in a market, whether public or private, is accounted for in a stock’s price.

Practitioners of strong form efficiency believe that even insider information cannot give an investor an advantage. This degree of market efficiency implies that profits exceeding normal returns cannot be realized regardless of the amount of research or information investors have access to.

Question 8

Why are markets not strong form efficient?

Answer 8

• Having correct/fair prices does not mean necessarily imply that all deals will be profitable
• Correct prices are correct based on the information at the time of the transaction
• They do not include foresight
• Price are volatile - they have risk –> random factors e.g. tweets
• Risk is there because of our inabiltiy to predict the future with precision

Question 9

What is the notion of market efficiency?

Answer 9

• Market efficiency is a cornerstone of modern financial theory.
• Fama (1967, 1970) is credited with promulgating the notion of market efficiency but the concept predates his work. –> this was founded over a century before by Samuelson
• Nevertheless, he did extend the concept considerably.
• Fama identified three types of market efficiency: Weak form efficiency, semi-strong form efficiency and strong form efficiency.
• A market is weak form efficient when current asset prices reflect all information contained in past prices of the asset. This means that past price behaviour of an asset cannot be used to predict the future price of the asset.
• A market is strong form efficient when the price of an asset reflects all information in the public domain about the asset.
• A market is strong form efficient when all public and private information about an asset.

Question 10

What is the efficient market paradox?

Answer 10

• The EMH (semi-strong form) claims that developed securities’ markets are informationally efficient.
• “Efficient” in this sense implies that prices quoted on the market are correct and reflect all available public information.
• but to be efficient, the market relies on traders to believe that it is not efficient and trade securities they believe to incorrectly priced in an attempt to make arbitrage gains
• So the market is efficient only because there are people who believe it isnt
• From the prespective of traders, the paradox is that they might believe the market is not efficient, but by acting on those beliefs they actually make the market efficient

Question 11

What markets are usually efficient?

Answer 11

• those in development market economies
• in economies that are developing from a planned (communist economy) with by informationally inefficient
• the aim here is to see if those economies are moving to efficiency

Question 12

What is an interesting implication of the market efficiency paradox?

Answer 12

• One interesting implication of the efficient market hypothesis as explained here is that whilst most (all) analysts believe the asset traded on the market is either under-priced or over-priced, the market price is actually ‘correct’.
• by their action (buying low and hoping to sell high and vice versa) traders actually propel the market to its fundamental (fair) equilibrium vlaue. The market is efficient only because traders believe it isnt

Question 13

What is the Grossman-Stiglitz Paradox?

Answer 13

Having discussed the Efficient Market Paradox, we seem now to be agreed that market prices are sufficiently accurate to be trusted.

But…..
If everyone thinks that the market prices are correct then why would anyone bother to analyse securities, financial analysis, technical analysis chartism)

• Yet these types of analyses are performed on an industrial scale

A well known joke that illustrates this is:
An economist and his friend are walking down the street and the economist sees, but walks over, a $100 bill on the pavement. The friend asks why; and the economist replies: “If it were real, someone would have already picked it up”.

Question 14

Why in an efficient market can people make money and seem to predict the direction with an acceptable probabiltity?

Answer 14

• priced at a discount
• long-term trends (economy is growing so the value of the stock market will be too)
• human still make mistakes (fat fingers - HBSC who put in the price of the order into the volume of the order causing their stock to drop 4%)
• data anomalies (at the smallest of time frames with UHFT)
• diversification can reduce the risk of investing making it easier to calculate future return and make it sustainable in the long term

Question 15

When experimenting whether a group of people can predict the direction of the stock market what was found?

Answer 15

• even if an individual got it right everytime or wrong everytime
• on average everyone would be right - that is an efficient market

Question 16

What are the 3 broad function of a Financial System?

Answer 16

• A monetary system which is concerned with creating and transferring money.
• Financial institutions which are concerned with saving and lending/investing
• Financial markets which are concerned with raising of funds and transferring these between borrowers/investors and lenders.

Question 17

What are the overall Functions of a Financial System? (1)

Answer 17

• Manage the payments and settlements system
• Provide mechanisms for borrowing and lending
• Creation of financial assets and liabilities
• Create financial instruments and contracts
• Mechanism for pooling of funds and financial large-scale projects –> also risk
• Bridge different portfolio preferences
• Mechanisms for transferring resources: time, agents, geography
• Allocation of funds to most efficient use

Question 18

What are the overall Functions of a Financial System? (2)

Answer 18

• Manage uncertainty
• Risk transformation –> pooling assets makes short term rise into long term risk
• Risk transfer: ability / willingness
• Price risk –> what if i want my money out now instead of water for a bond to mature.
• Facilities and markets to enable wealth-holders to change the structure of their portfolio of assets and liabilities
• Deal with asymmetric information problems: resolution of moral hazard e.g. taking out insurance on your car does it make you a less capable driving? if taking out insurance encourages you to drive less carefully its a moral hazard
• Specialist services

Question 19

What is the Monetary Systems primary function?

Answer 19

• A monetary system which is concerned with creating and transferring money from the source to the other components of the system.
• Historically, at least in recent centuries, the central bank, as the government’s bank, has been the sole source of money in an economy –> endowed with certain privledges which is mainly trust –> all pound notes have a promise on it to prove its a money –> we trust it
• what about kyrpto and credit cards –> are they money in the conventional sense

Question 20

What are the function of Financial Institutions?

Answer 20

• Financial institutions which are concerned with saving and lending/investing. We distinguish between banks and non-bank financial intermediaries.
• Banks are easy to udnerstnad since we all maintain bank accounts –> allow money transmission mechanisms
• Non-bank financial intermediaries provide financial services such as investment and brokeage facilities
• These institutions do not normally have full banking licenses
• An exmaple of non-bnak financial intermediaries include finance and insurance companies

Question 21

What are some different types of financial market?

Answer 21

• Financial markets basically trade assets/instruments and, like all markets, participants are market makers, that is, they stand ready to deal and set the prices at which they are prepared to do business.
• Only dealers participate in the money market - we can too but only through a broker
  We can distinguish between four types of financial markets:
• Debt markets
• Stock markets
• Derivative market
• Foreign Currency (Forex) market

Question 22

What is the Debt Market?

Answer 22

Debt markets are where bonds and bills are traded. One branch of the debt market which we will be particularly concerned with is the money market. (sometimes referred to as the cash market)
- This is the market in short term instruments issued by companies (inclluding financial intermediairies) and governments (central and local)

Question 23

What is the Stock market?

Answer 23

Stock markets are where common stock is originated (the primary market - though not all equity is raised though the primary market) and subsequently traded (the secondary market).
- stock can be see as a perpentuity

Question 24

What are Derivative markets?

Answer 24

Derivative markets are where instruments that derive their value from some underlying instrument or commodity are traded.There are four types of derivative instrument:

1 - Forwards – These are agreements to buy or sell an asset of a carefully defined type and quantity at a specified future point in time.
2 - Futures – These are agreements to buy or sell an asset of a carefully defined type and quantity at a specified future point in time.
3 - Options
4 - Swaps

Question 25

What are some properities of Futures?

Answer 25

• Standardised exchange traded contracts –> arranged for a specific time and date on the spot and their value based on the interest rate at that time
• Daily settlement or mark-to-market –> if the future contract moves into the money the value in the contract at the close of play (4:32) money is taken out and margin is paid to the exchange and then the buyer –> reduces the default risk
• Rarely go to delivery
• Issued by futures exchanges Clearinghouse
• Used for hedging and speculation

Question 26

What are some properties of Forwards?

Answer 26

• OTC tailor made contracts
• No daily cash flows
• Almost always go to delivery –> only dont go to delivery if someone has defaulted
• Created by banks
• Used for hedging

Question 27

What is LIFFE?

Answer 27

The London International Financial Futures and Options Exchange (LIFFE) is the former name of the largest futures and options exchange in London, England. It has been renamed as the ICE Futures Europe after a series of mergers and acquisitions left it under the ownership of Intercontinental Exchange (ICE)

Question 28

What are Options?

Answer 28

• Options are another derivative instrument. Their distinctive characteristic is that they give the holder the right but not the obligation to buy (call option or simply a call) or sell (a put option or simply a put) a carefully defined quantity of a particular asset at a predetermined price on a specified future (expiry) date (European option) or at any time up to the expiry date (American option) or within certain specified windows during which trading is allowed up to and including the date of expiry.

Question 29

What are Swaps?

Answer 29

• The final type of derivative instrument is a swap contract. Swaps are OTC contracts between two parties that have a finite life. In order of quantitative importance we have interest rate swaps, currency swaps, credit default swaps commodity swaps and equity swaps.
• For detail, we focus on interest rate swap contracts. These basically involve two counterparties agreeing to pay or receive each other’s interest. The basic swap contract is a plain vanilla swap, but there are many variations of this.
• Interest rate swaps have proved to be very popular because they can provide a way of reducing interest costs, increasing asset returns and reducing risk. (Clearly these cannot all be achieved simultaneously!)

Question 30

What is a interest rate swap?

Answer 30

• An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than would have been possible without the swap.
• A swap can also involve the exchange of one type of floating rate for another, which is called a basis swap.

Question 31

What is the foreign currency market?

Answer 31

Foreign currency markets are where currency is bought and sold spot and forward. Foreign currency derivatives are also traded and if we single these out from ‘domestically’ traded derivatives, the foreign exchange market is easily the biggest of all the other financial markets and is actually bigger in terms of value traded that the other three markets put together.

Question 32

What is the role of Financial Intermediaries?

Answer 32

• direct and indirect investment

In performing their basic function of attracting funds from borrowers and transferring them to lenders, financial intermediaries perform at least one of four economic functions:

• maturity transformation
• reducing risk via diversification
• reducing the cost of contracting and information processing
• provision of a payments mechanism

Question 33

What is direct and indirect investment?

Answer 33

• Financial intermediaries obtain funds by issuing financial claims against themselves to market participants. These financial claims are referred to as direct investments. Market participants who hold the hold the financial claims issued by financial intermediaries are said to make indirect investments.
• for example a bank accepts deposits and uses these to makes loans. thre deposits represent an I-O-U of the bank. This is an example of direct investment
• The loan is an I-O-U of the borrowing entity and a financial asset of the bank. the bank has made a firect investment in the borrowing entity and the depositor has made an indirect investment in that borrowing entity

Question 34

What is maturity transformation?

Answer 34

Typically banks accept funds on a short term basis. Some funds are even withdrawal on demand (sight). Other deposits have a fixed maturity date but the majority of deposits with banks have less than two years to maturity –> (time deposits)

• On the other hand, many loans made by banks run for longer than two years
• In the absence of bank borrowers, might only be able to borrow for periods shorter than they would ideally like to. they might also restrict the facilities they offer to restrict deposits to those made for longer periods than depositors would ideally like
• Banks, by issuing their own financial claims effectively offer maturity transformation. They transform short term deposits into longer term loans. They do this by tuning over short term deposits. To make this possible they must offer deposit facilities attractive enough to encourage a continuous flow of deposits.

Question 35

What are the implication of maturity transformation for financial markets?

Answer 35

• it provides depositors with more choice. in the anvsence of a bank, borrows might only be able to borrow for periods short than they would ideally like to, They might also restrict the facilities they offer to restrict deposits to those made for longer periods than depositors would really like
• Because savers (prefer short-term maturities) are naturally reluctant to commit funds for longer periods, longer term borrowers pay a premium. However, by turning over deposits, banks are able to offer a lower rate of interest to longer term borrowers than would otherwise be possible.

Question 36

How do Financial Intermediaries reduce risk via diversification?

Answer 36

• Suppose a saver places funds in an investment company and that these funds are subsequently invested in several companies in different sectors. The investment company has effectively diversified its risk.
• Private savers, even with access to only relatively small sums, can still achieve such diversification, for exmaple by buying trackers which tracks the FTSE. However they might find such diversification less cost effective than with the financial intermediary, more difficult to achieve

Question 37

How do Financial Intermediaries reduce the cost of contracting and information processing?

Answer 37

• If savers want to make a private loan, it is their responsibility to draw up a financial contract. To do this effectively and minimise risk, it would be necessary to evaluate the borrower as well as the purpose to which loans would be put once loaned. There might also be costs involved in enforcing the contract once it is drawn up. These are referred to as contracting costs. –>
• once a contract is drawn up for a certain bond for example it can be used multiple times reducing the cost of creating a new one –> average cost of contracting decline so banks experience economies of scale
• As well as time there are costs involved in gathering and processing information
• Good information is everything! Financial intermediaries know how to process, gain and value information extremely well
• Financial intermediarieis have both experience and expertise in both of these areas and therefore can provide a more cost effective service

Question 38

What is Provision of Payments Mechanisms?

Answer 38

• Most transactions payments are no longer made with cash. Instead, payments are made using the internet which facilitates the electronic transfer of funds, mobile phones, debit cards credit cards and to a declining extent, cheques.
• These methods of making payments are called payments mechanisms.
• The ability to make payments without cash is critical for the functioning of a financial market. In short, financial intermediaries transform assets that cannot be used to make payments into other assets that offer that property.

Question 39

What are Financial Assets?

Answer 39

Anassetis anything of durable value, that is, anything that acts as a means to store value over time. Financial assetsare claims against real assets, either directly (e.g., stock share equity claims) or indirectly (e.g., money holdings, or claims to future income streams that originate ultimately from real assets).

Question 40

What are Financial Liabilities?

Answer 40

A liability is an obligation to, or something that is owed to, somebody else. In the financial system, liabilities are debts denominated as debt instruments and often collectively referred to as ‘securities’. Liabilities are either short term (less than a year so that liabilities are bought and sold in the money market) or long term (More than a year so that liabilities are bought and sold in the capital market).

Question 41

What is the asset/liability problem that financial intermediaries face?

Answer 41

• In an nutshell, banks buy and sell money. They generate income from the difference between their costs (mainly the cost of sourcing money) and their revenue (income from lending money).
• In finance, an asset–liability mismatch occurs when the financial terms of an institution’s assets and liabilities do not correspond. Several types of mismatches are possible. … A bank could also have substantial long-term assets (such as fixed-rate mortgages) funded by short-term liabilities, such as deposits.
• They are in profit from any particular deal when the spread is positive. –> difference between the rate they pay on deposits and the rates they charge on deposits
• Other non-bank financial intermediaries, insurance companies for example, are also in the ‘spread business’. Pension funds are not.
• These institutions simply take regular contributions which fund their payments to those in receipt of a pension provided by them.

Question 42

What are Type I Liabilities?

Answer 42

• Amount of Cash Outlay –> Known
• Timing of Cash Outlay –> Known
• e.g. a bond with an exact amount and time it matures
• A type I liability is when a known financial outlay is scheduled to occur
• The timing and the amount are both knwon in advance with certainty
• For example when a bank accepts a fixed rate time deposit, the maturity and the outlay are known eith certainty at the time of issue
• Another example would be endowment policy with a fixed guarenteed amount at maturity
• By way of illustration an insurance company offers 10% return compounded annually on a £10m five year deposit it knows with certainty that in five years after the date of issue, it will be liable to pay £16.11 million

Question 43

What are Type II Liabilities?

Answer 43

• Amount of Cash Outlay –> Known
• Timing of Cash Outlay –> Uncertain
• In this case the outlay is known but the timing of the outlay is uncertain
• The most obvious exmaple of this is a life insurance policy
• Whilst there are many types of life insurance policies, a basic whle life policy guarentees a fixed payout to the beneficiaries on death of the policy holder

Question 44

What are Type III Liabilities?

Answer 44

• Amount of Cash Outlay –> Uncertain
• Timing of Cash Outlay –> Known
• e.g. an investment on a variable rate of interest
• In this case the timing cash outlay is known but the amount of the outlay is uncertain.
• One example would be when bank issues a certificate of deposit at a floiating (variable) interest rate
• Such rates are often linked to some benchmark rate such as Libor and the rate payable might be Libor plus 100bps (basis point) ( means 1%)

Question 45

What are Type IV Liabilities?

Answer 45

• Amount of Cash Outlay –> Uncertain
• Timing of Cash Outlay –> Uncertain
• In this case the time and the amount of the cash flow are both uncetain.
• There are many insurance policies that imply a type IV liability, where the timing of the outflow and the cash amount of the outflow are uncertain
• The most obvious example are motor insurance and house insurance which covers damage in certina eventualities
• For exmaple if a house suffers storm damaage the amount of the cash outlays depends on the extent and type of damage sustained
• The timing of the payout is random - cant predict the weather!

Question 46

How does a swap work?

Answer 46

• Even though the company with a higher credit rating could get lower terms in both fixed and floating rate markets, it only has a comparative advantage in one of them.
• Suppose Company AA can borrow in the fixed-rate markets at 10 percent or the six-month LIBOR at LIBOR + 0.35 percent. Company BBB can borrow fixed at 11.25 percent or the six-month LIBOR + one percent.
• Both companies would like to borrow $10 million over 10 years. A mutually profitable swap can be negotiated as follows:
• Company AA borrows at a 10 percent fixed-rate and BBB borrows at LIBOR + one percent. Company AA agrees to pay BBB interest at the flat six-month LIBOR (not + one percent) and receives a fixed rate of 9.9 percent in exchange.
• The net effect is that Company AA is actually borrowing at LIBOR + 0.1 percent, or 0.25 percent less than if it went directly to floating-rate lenders. Company BBB is actually borrowing, on net, a fixed rate of 10.9 percent (the one percent on LIBOR and 9.9 percent to AA), which is 0.35 percent less than a direct fixed loan.
• In this example, the two companies have arbitraged their relative opportunity cost differences.

Question 47

What did Fama say about his theory in an interview with Chicago Booth?

Answer 47

while it works in theory, to actually prove it is another thing

• implies that the market may not even be semi-form efficient
  https: //www.youtube.com/watch?v=xG8FY1TAj8s madelbrot