Lecture 1 - Introduction to Financial Markets and Institutions

Question 1

In recent years, a number of events have made finance a particularly interesting discipline to study. What are these?

Answer 1

• Globalisation of markets.
• New technology.
• New securities.
• Market crashes.

Question 2

Financial decisions are characterised by what?

Answer 2

• Money.
• Time.
• Risk.

Question 3

Businesses have to go to financial markets and institutions for…

Answer 3

The financing they need to grow.

Question 4

When they have a surplus of cash, and no need for immediate financing…

Answer 4

They have to invest the cash, for example, in bank accounts or in securities.

Question 5

Financial markets include…

Answer 5

• Stock markets.
• Fixed-income markets.
• Money markets.
• Other markets.

Question 6

Financial institutions include…

Answer 6

Banks and insurance companies.

Question 7

Financial intermediaries include…

Answer 7

Mutual funds and pension funds.

Question 8

What is the primary market?

Answer 8

Market for the sale of new securities by corporations.

Question 9

What is the secondary market?

Answer 9

Market in which previously issued securities are traded among investors.

Question 10

What are the different types of secondary markets?

Answer 10

• Direct search markets.
• Broker (agents) markets.
• Dealer markets (principals).
• Auction markets.

Question 11

What is the role of secondary markets?

Answer 11

Diversification - invest in a wide range of enterprises to spread risk.
Risk shifting - various types of security; give investors a choice of the degree of risk they take.
Hedging - taking out counterbalancing contracts to offset existing risks.
Arbitrage - buying a security at a low price in one market and simultaneously selling it in another market at a higher price to make a profit.

Question 12

What is the stock market?

Answer 12

Market where stocks are issued and traded.

Question 13

What is the fixed income market?

Answer 13

Market for debt securities.

Question 14

What is the capital market?

Answer 14

Market for long term financing.

Question 15

What is the money market?

Answer 15

Market for short term financing.

Question 16

Other financial markets include…

Answer 16

• Foreign-exchange markets.
• Commodities markets.
• Market for options and other derivatives.

Question 17

What is operational efficiency?

Answer 17

Low transaction cost, most volume, trading can be quickly achieved.

Question 18

What is informational efficiency?

Answer 18

Price full and fairly reflects all information.

Question 19

What is allocational efficiency?

Answer 19

Efficiently allocate savings into investments.

Question 20

What is price volatility?

Answer 20

Holding inventories of securities incurs price volatility.

Question 21

What is adverse selection?

Answer 21

Those making markets may not know whether they are trading with an informed or uninformed participant.

Question 22

What is moral hazard?

Answer 22

Insurance brings forth bad risks.

Question 23

What is securitisation?

Answer 23

Making an otherwise untradeable financial transaction in tradable (e.g., mortgage backed securities, exchange credit card debt).

Question 24

What is globalisation?

Answer 24

Redenomination of European assets into Euros. Mergers and agreement among exchanges: LIFFE, CME, Eurex.

Question 25

What is financial engineering?

Answer 25

Bundling or unbundling securities, or creating securities that provide exactly tailored cash flows.

Question 26

What is a financial organisation?

Answer 26

An organisation that raises money from investors and provides financing for individuals, companies, and other organisations.

Question 27

Why is a financial intermediary different from a manufacturing corporation?

Answer 27

• It raises money in different ways (taking deposits or selling insurance policies).
• It invests in financial assets.

Question 28

What is a mutual fund?

Answer 28

An investment company that pools the savings of many investors and invests in a portfolio of securities.

Question 29

What is a hedge fund?

Answer 29

A private investment pool, open to wealthy or institutional investors, that is only lightly regulated and therefore can pursue more speculative policies than mutual funds.

Question 30

What is a pension fund?

Answer 30

Fund set up by an employer to provide for employees’ retirement.

Question 31

What is a financial institution?

Answer 31

A financial institution is an intermediary that does more than just pool and invest savings. Institutions raise financing in special ways, for example, by accepting deposits or selling insurance policies, and they provide additional financial services.

Question 32

What do commercial and investment banks do?

Answer 32

They advise and assist companies in obtaining finance (e.g. underwrite stock offerings, advise on takeovers, mergers, and acquisitions).

Question 33

What are insurance companies?

Answer 33

They are massive investors in corporate stocks and bonds, and they often make long-term loans directly to corporations.

Question 34

What are the functions of financial markets and intermediaries?

Answer 34

• Transport cash across time.
• Risk transfer and diversification.
• Liquidity.
• Payment mechanism.
• Provide information.

Question 35

What information is provided by financial markets?

Answer 35

• Commodity prices.
• Interest rates.
• Company value.
• Cost of capital.

Question 36

Summarise the differences between a commercial bank and an investment bank.

Answer 36

Commercial banks accept deposits and provide financing primarily for businesses. Investment banks do not accept deposits and do not loan money to businesses and individuals. Investment banks may make bridge loans as temporary financing for a takeover or acquisition. In addition, investment banks trade many different financial contracts, such as bonds and options, while providing investment advice and portfolio management for institutional and individual investors.