The Derivatives Market in Context Flashcards
The 6 elements of the financial system:
Ultimate lenders and borrowers Financial Intermediaries Financial Instruments Creation of money Financial Markets Price discovery
4 Categories of the economy:
Household sector
Corporate sector
Government sector
Foreign sector
Financial Intermediaries
Exist because there is a conflict between lenders and borrowers in terms of the financial requirements (Term, risk, volume, etc.).
They solve this divergence of requirements and perform many other functions such as lessening risk, creating a payment system, monetary policy, etc.
They interpose themselves between the lenders and borrowers.
Spot financial market
Markets for debt and equity instruments which is settled as soon as possible.
Primary markets
Issue of new securities.
Issuers (borrowers) receive money from the lenders (investors).
Secondary Markets
Markets that exist for the trading for already existing marketable securities.
Money flows from buyers to sellers.
2 Types of financial markets
Share Market
Debt Market
The Lenders and borrowers
The non-financial economic units that undertake the lending and borrowing process.
Financial Instruments
They are created to satisfy the financial requirements of the various participants; these instruments may be marketable (e.g. treasury bills) or non-marketable (retirement annuity).
Creation of money
When credit is demanded; banks have the unique ability to create money by extending credit / loans.
Financial Markets
The institutional arrangements and conventions that exist for the issue and trading (dealing) of the financial instruments.
Price Discovery
The price of equity and the price of money / debt (the rate of interest) are “discovered” (made and determined) in the financial markets. Prices have an allocation of funds function.
Debt Market
The market where debt instruments are issued and exchanged.
Interest is paid hence other name: interest-bearing market.
Also called the fixed-interest market.
2 Typed of debt market
Money Market (Short term debt) Bond Market (Marketable long term debt)
The Money Market encompasses the following markets:
- Markets in the short-term debt securities of ultimate borrowers.
- Markets in the short-term deposit securities of banks.
- Markets in the short-term deposit securities of the central bank (bank notes and coins and securities issued for monetary policy purposes).
- Interbank market between private sector banks (the interbank rate is discovered here).
- Interbank market between the central bank and the private sector banks (accommodation/loans to the banks at the repo rate).
- Interbank market between the private sector banks and the central bank (reserves required to be held at no interest).
Equity/Share Market
Market of issuing and trading of shares. The term equity refers to the capital of a company.
3 Parts of the equity market:
- Ordinary shares
- Preference shares
- Retained Profits
Ordinary shares
These shares are permanent capital in the sense that they represent a share in the ownership of a company.
Preference shares
These shares are long-term capital if they have a maturity date (they usually do), or permanent capital if they are perpetual, i.e. have no maturity date.
Short-Selling
The sale of a security spot and buying it back spot when deemed propitious. In order to do this, the seller has to borrow the security from a scrip lender.
The scrip lender charges the scrip borrower a fee for the service.
Scrip
The term used in the past for physical securities when securities registries were not electronic.
Motivation for short-selling
To profit from a decline in price.
Two risks to consider when short-selling:
- If the spot price of the security rises, the short-seller will make a loss.
- If the liquidity of the market (high turnover in a market means good or efficient price discovery) deteriorates after the spot sale, it may be difficult to purchase the security, with price implications.
The Yield curve
Representation of the relationship between interest rates and term to maturity.
Derivatives
Contracts between two parties to buy, sell or exchange (optional or obligatory) a standard or non-standard quantity and quality of an asset or cash flow at a pre-determined price on or before a specified date in the future.
Financial markets consist of four distinct markets: the debt markets, the equity market, the foreign exchange market and the derivatives market.
True or false?
False. Derivatives are found in all the financial markets and it is not a market on its own.
Prices in derivatives markets are not as volatile as prices in spot markets. True or false?
False. Derivatives derive their values from that of the underlying instruments and will therefore reflect the changes in the prices of the latter.
Derivatives are found in both formalised (exchange) markets and informal (OTC) markets. True or false?
True
Define a ‘derivative’?
Derivatives are contracts between two parties to exchange a standard or nonstandard quantity and quality of an asset or cash flow at a pre-determined price at a specified date in the future.
