Lecture 1 - Introduction to Financial Markets

Question 1

How has the world of finance changed over the last few decades?

Aim to name a few

Answer 1

1) Globalisation of the world of finance - increasingly integrated and connected markets globally e.g. much easier now to buy stocks and shares in a different country now
2) Unprecedented increase in volume of funds (number and the size of them) and size of financial industry
3) Funds increasingly managed in the behalf of investors by private managers, apps etc
4) Use of new technology like blockchain (one of the first cryptocurrency softwares) and AI (can be used instead of an actual person to give financial advice and investment recommendations)
5) Development of internet
6) Introduction of Euro currency
7) Increased importance of emerging markets (e.g. BRIC countries - Brazil, Russia, India and China - fastest growing emerging markets in the world)
8) Effect of 2008 - 2010 financial crisis
9) 4th Industrial Revolution (technological developments) in 2016 e.g. Fintech (financial technology) Revolution - refers to use of apps and technology to manage, access finance etc - most banks have now adopted apps as a means of online banking
10) COVID-19 crisis
11) Russia-Ukraine War - disrupted supply chains and trade (Russian gas etc)

Question 2

Name some of the biggest financial centres in the world

Answer 2

1) New York
2) London
3) Singapore
4) Hong Kong
5) San Fransisco
6) Shanghai
7) Los Angeles

Dominated by USA, UK, China and Singapore

Question 3

What is the main purpose of major financial centres like New York?

Answer 3

To meet the demand for financial services of the domestic market

Question 4

What are the features of an International Financial Centre (IFC) like New York and London?

Answer 4

1) Large number of both domestic and foreign banks - as well as some international bank lending
2) Substantial amount of foreign exchange (FX) trading/business
3) Significant offshore market - deposit and lending in currencies different to those of the financial centre
4) Stock market should be well capitalised (significant total investment value) and offer high liquidity - I assume this means that easy access to stocks/shares by purchase using cash and easy access to cash by selling stocks/shares
5) Major market for corporate bond finance - both domestic and foreign - where firms give out bonds meaning that they borrow from the public at an agreement that they will pay the money back to the public in a given time period and with a certain amount of interest (considered safer and therefore returns typically lower but I imagine returns higher than government bonds which are naturally safer as less chance of a an Economy collapsing than a firm)
6) Range of Financial institutions - e.g. insurances companies, commercial law firms, brokers etc

Question 5

Define Finanical Market

Answer 5

Financial markets - facilitate the exchange of financial instruments e.g. stocks, bonds, foreign exchange (FX - currency) etc

Question 6

What are futures, forwards etc?

Answer 6

Financial assets which involve delayed receipts or payments - transfer funds across time

Question 7

What are financial instruments generally referred to as?

Answer 7

Securities

Question 8

What does the value of some financial instruments (securities) e.g. stocks and bonds depend on?

Answer 8

It should depend on the past performance of the issuer (e.g. firm) as well as future performance

Question 9

Define Globalisation

Answer 9

World of finance has become globalised industry whereby national financial markets are increasingly integrated and connected into a global network of markets

Ability to do anything anywhere in terms of finance

Question 10

State the characteristics of Globalisation

Answer 10

1) Borrowers seeking to raise funds aren’t limited to only their national/local market but can venture abroad
2) Investors can invest in many other countries
3) Financial institutions, like banks, seek to have global presence both as a means of expansion and to retain their existing customers who are ever more reliant on trade and economic interactions with foreign residents and firms

Question 11

What has enabled financial capital to seek out investment opportunities in other countries?

Answer 11

The abolishing of exchange controls - restrictions much less now (restrictions of foreign exchange or FX which means dealing with different currencies around the world) - previously some countries prevented foreign investors from obtaining the local currency and therefore prevent them from entering the market

Question 12

What can one say about emerging markets in recent years?

Answer 12

Countries in Southeast Asia (e.g. Singapore, Malaysia etc) and Latin America (Brazil etc) have attracted the interest of investors from developed economies due to the rapid rates of economic growth of these countries

Question 13

Are there issues with investing in emerging markets?

Answer 13

Yes, whilst offer appealing returns they also lead to equally large losses e.g. Mexican crisis (1994/1995)

Question 14

What have investors learnt from the losses in emerging markets?

Answer 14

That overexposure to a single emerging market is a risky business

Question 15

What is BRIC and what does it stand for and represent?

Answer 15

BRIC - Brazil, Russia, India, China

These 4 countries are the fastest growing emerging markets

Question 16

State the problems/risks of emerging markets

Answer 16

1) Poor accounting standards - minimal or weak regulation of the accounting reports of firms in an emerging economy may mean that profits and gains are shown to be higher than what they are - managers are incentivised to do in order to gain capital - therefore you buy stocks/shares in an emerging country because of the fact that you think a country and its firms are performing better than reality … the financial information about a country and its firms is not reliable - you have no indicator of true performance
2) Weaker legal institutions - especially relating to the protection of minority investors (shareholders) and creditors - in developed economies there are typically rules/regulations and provisions in place to ensure that the insider of the firm (a majority shareholder) is not abusing their power - for example typically to pass a major restructuring decision a 50% agreement vote is required but this may not occur in emerging market firms where someone with say a 30% share in the firm may be able to do what they want with little to no resistance -> this leads to governance issues in firms in emerging markets
3) Geo-Political risks - warfare, instability of governments, coups - uncertainty of political systems, fiscal policy etc
4) Foreign exchange risks - currency may depreciate if the emerging market has high inflation (high inflation caused by poor policy)
5) Controls on foreign investment - some emerging markets/economies may prevent foreign investors to invest - also foreign investors exposed to a lot of risk as the state/government may expropriate (take/seize) the assets/investment of the foreign investors
6) Higher transaction costs - information is not reliable - payment system may not be as sophisticated - if the market is not that liquid then this would also, alongside the factors mentioned previously, contribute to higher transaction costs

Question 17

How has technology changed the world of financial markets?

Answer 17

Positives:
- large increase in the use of technology in the 1980s (especially computers) -> led to switch from paper trading to screen based trading -> led to less shouting on trading floor
- computers allow new complex products to be devised and priced in real time
- trading occurs at a very high frequency (nano seconds) - done by machines using algorithms
- financial services industry now much more efficient due to technology and clients now offered better range of products and quality of service
- mobility of clients - to obtain banking/financial services you no longer require going to a bank - can be obtained through technology (online banking) - via your phone (on the go banking services) - virtual meetings can be set up as a result of technology - clients can there access banking services on the go whilst mobile - change in the way banking/financial services provided as a result of technology - self help machines in bank branches reduce the number of staff required saving on salary/wage costs

Negatives:
- use of technology can be expensive - equipment expense and the maintenance of the machines - I.T staff required to do so
- security and reliability problems due to greater use of technology - data breaches - hackers may hack into companies and banks and distribute the information relating to the clients of the companies/banks - very problematic, tech glitches - could be very costly e.g. in 2023 the Bank of Ireland allowed customers to withdraw money they did not have in their accounts

Question 18

What else has in financial markets leading to further innovation?

Answer 18

The underlying asset has evolved - no longer individual stocks - rise in popularity in:
- index funds
- ETF’s (exchange traded funds) - fund that may follow an index such as the FTSE 100 or the S&P 500 or US equity as a whole (all American firms trading on the stock market - all American plc’s) - like index funds, involve buying a share in all the firms in an index - very diverse portfolio - ETF’s grown in popularity in the last couple of decades - very similar to index funds but only difference is that index funds only value and trade once a day (usually at midday) which is why if trading for a day has closed, a trader won’t know exactly what price they’re buying or selling at (which is what I experience because mine is an index fund)
- junk bonds (high risk and high return)
- cryptocurrency e.g. bitcoin (prices fluctuate considerably - very volatile - extremely risky)
- NFT’s (non-fungible tokens) - digital assets
- rise of retail/social trading platforms e.g. Robinhood, StockTwit etc - these platforms allow average small size retail investors to invest and communicate with each other stating their opinions and beliefs about certain stocks and funds - gained popularity after the GameStop incident where big hedge funds believed (using past trends and other information) that the GameStop stock price would fall as they thought its business model as an in person gaming console and game supplier was obsolete and that the future was online - the hedge funds shorted the stock expecting it to fall where they would cash out and make a fortune - however as GameStop has been around for several years and holds an important part in the life in many consumers, small time investors on platforms like Robinhood began buying the GameStop stock excessively and managed to push the stock the price upwards causing extreme losses for the hedge funds which had shorted the stock expecting it to fall - this is an example of how small time investors on platforms like Robinhood were able to win against big time Wall Street investors and hedge funds

Question 19

How did the trading floor differ a few decades ago to today?

Answer 19

It was a lot more chaotic and crowded than it is today - the outcry method was something where traders would shout and project hand signals on the floor to complete trades in the pre technology era - since the introduction of technology trading has become more efficient, calmer and quiet through apps and platforms like Robinhood, Stocktwits, Vanguard, Etoro etc

Question 20

What is high frequency trading and what is being done to improve it?

Answer 20

High frequency is different to the long term horizon trading which is also done - high frequency trading is done by large institutions constantly (closely watch news/earnings announcements and the trade accordingly within milliseconds)

Large amounts of trading occurs between London (London Stock Exchange - LSE) and Frankfurt (Frankfurt Stock Exchange) - existing networks can send signals between the two areas where stock exchanges are located in 6 milliseconds - this seems minimal but due to the amount of trading taking place even 6 milliseconds can seem too long - mainly due to the ability of investors to arbitrage (which is where an asset/stock, which cross listed in multiple stock exchanges e.g. London and Frankfurt, is purchased and sold almost simultaneously in different markets in order to profit from tiny differences in the asset’s listed price)

Therefore new communication masts (tall towers with antennas) are being set up in Kent to further reduce the signal transfer time by a few milliseconds

Question 21

What is securitisation?

Answer 21

One of the biggest innovations in debt markets during the 1980s - therefore not a new concept - arguably one of the major/main reasons which led to the global financial crisis (subprime crisis) in about 2006-2009

Securitisation turns relatively illiquid assets with cash flows into a liquid asset by combing/pooling the cash flows from illiquid assets into a security for investors (sold to investors)

For example say a bank wishes to take over another bank but does not have the required cash - the bank main income comes from giving out mortgage loans and earning an interest on them - the bank could pool some if it’s illiquid assets (mortgage loans) together which generate a cash flow to the bank and package them into something called asset-backed securities (ABS) to be sold to investors

Investor buys security from bank and therefore the bank receives the cash/money immediately for the combined illiquid mortgage loans (so that they can take over another bank as planned) - the interest the bank receives from the borrowers is PASSED to the investor so that the investor earns a fixed income (their gain from buying the combined security) - so the bank sacrifices it’s long term interest earning for immediate cash/capital to fulfil any monetary tasks like mergers and acquisitions

The asset backed securities (ABS) are sometimes called mortgage backed securities (MBS) or collateralised debt obligations (CDO’s) - CDO is a more general term as the they may include a more broader type of assets like mortgages, debt obligations and may even include MBS within them

CDO’s when they are sold are put into different tranches (different class) according to the risk level of each product - e.g. the product from which the interest income is earned first from the borrower by the investor would be the safest CDO with the lowest risk level as payment/earning is earned first

Question 22

Why is securitisation done? CONFIRM ANSWER USING TUTORIAL Q IN WEEK 2

Answer 22

For liquid assets (cash etc) otherwise banks have many illiquid assets (interest which is earned from borrowers over several years - sometimes 25-30 years for certain mortgage loans) - therefore to gain access to capital, securitisation is done - allowing for mergers and acquisitions and other tasks which require liquid assets/capital like cash

Question 23

What is a financial security?

Answer 23

A financial security is a legal claim to a future cash flow - called financial instruments, financial assets or financial claims - e.g. stocks, bonds etc

Each financial security has an issuer that receives the lump sum money and agrees it make future cash payments (in the form of interest) to the legal owner of the asset (who supplies the lump sum money) often referred to as the investor or asset holder

Remember that the issuer receives the lump sum and agrees to make interest payments

For example if Sony was to issue a corporate bond of £500 million - they would be the issuer and receive the lump sum of £500 million and agree to make interest payments to the investors - Sony would pay bond interest to the investors during the life of the bond and the principal amount (original amount borrowed) back to the investors upon maturity of the bond (after the term of the bond has ended)

Question 24

How many types of financial securities are there?

Answer 24

2 distinct types

Question 25

What are the types of financial securities?

Answer 25

1) Debt claims - those who provide debt to a firm in the firm of loans etc - I.e the creditors (banks) etc - have a predetermined cash claim via the rate of interest charged - holding debt securities I.e being a creditor or investing in bonds generally involves lower risks as a fixed income in the form of interest is earned (but if the issuer fails to pay you, you receive nothing - but if the firm or issuer is in financial difficulty they have an obligation to repay you first and then the remainder amount will go to those holding equity hence the lower risk associated with holding a debt security compared to an equity security like a stock) but a creditor/debt security holder does not benefit from a gain if the underlying asset increases (e.g. stock price goes up) in value unlike equity security holders (shareholders) - debt security holders only entitled to interest payment
2) Equity claims - those who own shares in a company e.g. shareholders, stock owners, stockholder etc - only entitled to the cash payment in the form of a dividend which isn’t guaranteed (manager choice/discretion not obligatory and only paid after debt holders paid and if profit made) - these investors face higher risk as there is no guaranteed fixed income like debt security holders but benefit from capital gain if the price of the asset rises

Equity investment is riskier than investing in debt or bonds

Question 26

Give examples of each type of security

Answer 26

1) Debt claims - bonds, loans (being a creditor like a bank etc) - tend to be safer as fixed income guaranteed etc but investor does not benefit from any capital gains in the asset
2) Equity claims - shares, stocks in a company etc - involve greater risks as no guaranteed or fixed income but investor benefits from capital gains in the asset

Question 27

What are financial intermediaries - give examples and state their economic functions

Answer 27

Financial intermediaries, e.g. banks, assist in the transfer of funds from surplus (those who have money) to deficit agents (those that need money) - they recycle funds from those that want to save to those that want to borrow

Economic functions:
1) provide a payment system
2) they accept investor funds (in the form of a deposit when buying a house 10-20%) and transform those liabilities into longer term assets such as loans
3) they transform low risk deposits into bundles of riskier loans/assets (riskier because there is a chance that borrowers may not be able to the entirety of the loan back)
4) banks provide liquidity - especially for surplus agents with a large amount of money/funds - they could take this money out at any time and the bank needs to have this cash available for them to do so

Question 28

How many types of financial markets are there?

Answer 28

2 types

Question 29

What are the types of financial markets and describe them

Answer 29

1) Primary Markets - when you issue equity for the first time e.g. in an IPO (initial public offering) where shares are issued for the first time - also when you issue bonds for the first time
2) Secondary Markets - deals in financial securities (shares, bonds etc) that have already been issued (where shares are traded - bought and sold) - most securities are on a secondary market - price of the securities on the secondary market helps value a firm (the number of shares issued multiplied by their value gives you an estimate of the value of the firm - the greater the demand for the shares or bonds the greater their value) - a liquid secondary market is vital for investors as it allows them to sell their shares with ease - if there is a lack of liquidity then the issuer of the shares (I.e the firm) will have to pay a liquidity premium to compensate investors for the lack of liquidity

Question 30

What is underwriting?

Answer 30

The process by which investment banks guarantee that companies and governments will obtain the funds that they are seeking when issuing debt and equity securities

Question 31

What is a market maker?

Answer 31

A company or individual (usually large banks or financial institutions) who actively quote bid offer prices on securities to stimulate demand for them and therefore aim to make the market more liquid

Question 32

Who participates in financial markets?

Answer 32

1) Individuals - e.g. retail investors (basically us who are non professional individuals who invest money in their own accounts through brokerage firms like Vanguard or a savings account), households etc
2) Institutional investors - commercial banks (provide services to individual consumers as well as small and medium sized businesses), investments banks (provide services to large corporations and institutional investors), insurance funds (safety nets that protect bankrupt traders from adverse losses and ensure that the profits of winning traders are paid in full), pension funds (fund that accumulates capital by being invested in shares and bonds to be paid out as a pension for employees when they retire at the end of their careers), mutual funds (group investment from multiple shareholders - funds invested in stocks, bonds and other assets - available to the public including the average investor - a way to build a diversified portfolio by contributing to a mutual fund so that you also own shares in whatever the mutual fund has invested in) and hedge funds (different from mutual funds in that they only accept money from accredited investors which have a certain net worth and are considered wealthy to ensure that they can handle the potential risks that hedge funds are permitted to take)
3) Governments (may issue governments bonds, may invest in stocks through sovereign wealth funds (state owned investment funds comprised of surplus money generated by the government - surplus reserves)
4) Brokers - intermediaries who act on behalf of investors wishing to conduct a trade
5) Arbitrageurs - economic agents that buy and sell financial securities to make risk less profits by exploiting/taking advantage of market inefficiencies (think back to the new communication masts/towers with antennas being built in Kent to reduce the signal transfer time from the London Stock Exchange to the Frankfurt Stock Exchange from 6 milliseconds to even less to reduce arbitrage) by simultaneously buying a cross listed asset (e.g. a share listed on multiple stock exchanges) at a lower price and selling it at a higher price to make a profit - they essentially take advantage of the delay in the synchronisation of changes in a share or stock price across exchanges in different parts of the world e.g. London and Frankfurt
6) Hedgers - economic agents who seek to reduce or limit some risk by engaging in the purchase or sale of a financial security e.g. Gold - individual or firm who buys or sells the actual physical commodity and include producers, wholesalers, retailers, manufacturers etc
7) Speculators - economic agents who try to make a profit by predicting the market - by either buying an asset early and selling later at a higher price due to expectations that the asset is likely to be in demand and therefore increase in price - speculators want to increase their risk to increase their return

Question 33

How have interest differed in the last 15 years in the UK?

Answer 33

From about 2010, after the 2008 financial crisis, interest rates were very low (just over 0% called the zero lower bound) and they remained at this rate for about 10 years until 2020

After COVID and the Ukraine war and due to high inflation caused by several setbacks, the current interest rate is high around 5% in order to control inflation (which makes us all poorer)

Question 34

What does the current interest mean for consumers including individuals, businesses etc?

Answer 34

An interest rate of about 5% means that it is costly to borrow which means that it is more expensive to take out a loan to buy a house and it is more costly for firms to take out loans to finance their operations

However saving enables a greater interest/yield so now is the time to save - makes sense why banks like metro can introduce their 5.2% rate which they now have dropped to just under 5% - they are following the governments announcements of interest rates

Question 35

Stopped making flashcards slide 38 of L1 because would not have enough time to do all lectures before online MCT - also I think better tactic for all modules is to do the lecture and then the tutorial for revision and knowledge check and then past papers - doing lectures and making flashcards, revising flashcards, doing tutorials and then past papers is too time consuming - I think best to take out the flashcards element and just do lectures and then tutorials and then past papers

Answer 35

A