Lecture 2: Financial Markets Flashcards
Financial Markets definition
a marketplace for the buying and selling of financial securities/assets such as equities, bonds, foreign exchange and derivative instruments.
Types of finance
Direct Finance: The transfer of funds from surplus units (lenders/savers) to deficit units (borrowers) occurs via financial markets. Direct finance is a method of financing where borrowers borrow funds directly from the financial market without using a third-party service, such as a financial intermediary.
Indirect Finance: The transfer of funds does not occur directly from lenders to borrowers- financial intermediaries interpose between lenders and borrowers. Indirect finance is where borrowers borrow funds from the financial market through indirect means, such as through financial intermediary.
Why do financial markets and financial intermediaries exist?
Pricing function: Determining the fair prices and allocating resources. Financial markets provide both buyers and sellers with “fair” evaluation of the asset they are buying/ selling- if the number of buyers exceeds the number of sellers of an asset, this will push it up in price, whereas if the number of sellers exceeds the numbers of buyers, the price will be driven down.
Discipline function: Ensuring the prudent discipline on trading parties. Financial markets are regulated- regulation encourages issuers of securities (borrowers) not to engage in activities that the market deems detrimental to the value of their assets.
Needs of lenders and borrowers
Lenders Requirements:
o Minimisation of risk
o Minimisation of costs
o Maximisation of returns
o Liquidity (ease of converting a financial claim into cash without loss of capital value.
Borrowers Requirements:
o Funds at a particular specified date, for a specific period of time (preferably long term) and at the lowest possible cost.
Financial claims meaning
o Debt and equity are the most commonly known financial claims in financial markets
o Debt claim holder has a predetermined cash claim via the rated of interest. (can be fixed or variable)
o Equity claim holder entitle to a cash payment in the form of dividends (if profitable) once debt claim holders have been paid.
o Debt claim holders facing less risk than equity claim holders.
Financial claim type of liabilities
Type 1: The amount the liability is known, and the timing of the liability is known
Type 2: The amount of liability is known, and the timing of liability is uncertain
Type 3: The amount of liability is uncertain, and the timing of the liability is known
Type 4: The amount of liability is uncertain, and the timing of the liability is uncertain
Financial markets: Different taxonomies
- Whether the assets traded are newly issued or already issued (primary market and secondary market)
- Type of asset traded (bond and equity markets)
- Maturity of the asset traded (money market and capital market)
- The means of settlement (cash and futures markets)
- The obligation to exchange (forward and options markets)
- The organisational structure of the market (regulated and over the counter OTC markets)
- The method of sale/pricing
Primary markets
- Deal with the issue of new securities – securities must be UNDERWRITTEN and DISTRIBUTED (usually to institutional investors) – issuer receives funds from sale
- Corporations, government, local authorities might decide to issue securities (either debt or equity) to raise funds
- The new securities are underwritten by financial institutions (investment and commercial banks), who distribute them to the public and other institutions
- Underwriting process ca occur via: Bought deals, auctions, pre-emptive rights offerings, private placements
Secondary markets
- Deal with financial securities that have already been issued – issuer does not receive funds from sale (securities bought and sold in the market.
- Once a security has been allocated to the investors for the first time, it can be bought and sold on the stock market
- Despite the fact that the issuer does not get any proceeds from the issuance on the secondary market, this market is very important for the issuer, for two reasons:
- 1.) Prices on secondary market are an estimate of a company’s value
- 2.) The liquidity provided by secondary markets decreases the cost of capital of the issuers
- Role of market makers: Provide liquidity to the market by quoting bid (market makers buys) and ask (market maker sells) prices continuously – if market makers did not exist, trading would slow down and for certain securities stop altogether.
Bond and equity markets
Financial markets mainly deal in two types of financial securities:
1.) Bonds: issued by corporations, banks or governments
2.) Equity (shares): issued by any kind of public company (financial or non-financial)- but NOT by the government (although the government can hold a large stake of the ownership)
Markets exist also for financial securities other than bonds and equities- e.g. hybrid instruments (e.g. convertible bonds) or future markets (financial derivatives).
Money markets and capital markets
Money markets: where short term debt securities are traded (typically, maturity <1 year)- e.g. Treasury Bills
Capital markets: where medium- or long-term securities are traded (maturity > 1 year) e.g. treasury or corporate bonds.
Cash and future markets
Cash market: settlement occurs immediately – the price is agreed on today and the settlement also takes place today
Futures market: settlement occurs at a future date with respect to when the transaction takes place – the price is agreed on today, but the settlement takes place some time in the future.
Forward and options market
Spot/ Forward market: The buyer is obliged to buy the asset on the date and at the price agreed some time in the past. (Forward contracts are similar to futures contract, while forward contracts are not standardized.)
Options market: The buyer has the right but not obligation to buy the asset on the date ad at the price agreed some time in the past.
Regulated and over the counter OTC markets
Regulated market:
• The trading is organised by the exchange
• Clearing house: for each transaction, the buyer/seller enters a contract with the exchange itself (represented by the clearing house) – the risk that the counterparty does not fulfil does not fulfil the contract is covered
Over the counter (OTC) market:
• Dealers simply trade between themselves
• No clearing house- the parties are not protected from the risk that either of them does not fulfil the contract
Market makers and dealers market; screen based and pit trading
- In regulated markets, market makers provide liquidity to the market by quoting bid-ask prices
- In OTC markets, dealers negotiate prices between themselves
- Screen based trading occurs via computers – no need for traders to be located in the same space
- Pit trading occurs INSIDE the exchange (open outcry)
