Topic 1 (Pt1) - Intro to Financial Markets Flashcards
List the main functions to financial markets?
- Facilitate the allocation of resources
- Price discovery
- Access liquidity
- Risk transfer
What are the main functions of financial markets (ALLOCATION)?
Those with surplus funds can invest/lend to those in need.
E.g. Firms can raise capital by issuing bonds. The return for the investor is cost of capital
What are the main functions of financial markets (PRICE DISCOVERY)?
The price of a financial asset is determined by the demand and supply of the asset
E.g. Newly issued assets
What are the main functions of financial markets (LIQUIDITY)?
Investors can liquidate assets to raise cash
E.g. Liquidate stock portfolio
What are the main functions of financial markets (RISK TRANSFER)?
Risk cannot be eliminated but transferred
E.g. Insurance
Define liquidity
Liquidity refers to the ease at which an asset can be converted into cash without affecting its market price.
What is stock/equity?
A stock is part-ownership of a company
- Companies can raise cash by issuing stocks
- Stocks can be traded on EXCHANGES and OVER-THE-COUNTER e.g. LSE
What is meant by Over-The-Counter?
Stocks and derivatives are traded directly between the seller and buyer without a broker or exchange
What 4 things can be traded OTC or on Exchanges?
- Debt securities
- Foreign Exchange
- Commodities
- Derivative securities
What are debt securities?
They pay a regular income unless coupon.
Money market instruments = short term financing e.g. treasury bills
Capital market instruments = medium to long term financing e.g. government bonds
What are foreign exchanges?
When market players trade currencies
What are commodities?
Physical goods NOT financial assets.
Usually production inputs e.g. crude oil, coffee and natural gas
What are derivative securities?
Options and futures contracts whose payoff is determined by the price of the underlying asset
What are the 3 main purposes of finance?
- Allocate resources
- Manage risks
- Security selection
What is the purpose of finance (ALLOCATION)?
Allocate resources to maximise products and services (firms), wealth (investor), social benefits (governments)
What is the purpose of finance (MANAGE RISKS)?
It helps quantify risk e.g. what the chances/probability are?
What is the purpose of finance (SECURITY SELECTION)?
Which securities to hold within each asset class?
Higher returns = higher risk (AKA risk-return trade off)
What challenges does finance face?
- Valuation of assets - How are financial assets valued?
2. Management of assets - What should i buy/sell and when?
What 2 other factors make finance more challenging?
- Time - cashflows will differ from future cash flows
- Risk - difficult to model the unknown
These can be addressed by using historical data and use maths (probabilities)
List the 6 principles of finance
- Everything has a cost
- Market players prefer:
- to have more money to less (Non-satiation)
- to have money now than later (Impatience)
- to avoid risk (risk aversion)
- All agents act to maximise their own objectives
- Financial market prices shift to equalise demand and supply
- Financial markets are highly adaptive and competitive
- Risk sharing is central to financial innovation
List the 5 characteristics of competitive markets
- Many similar economic agents
- Products are very similar/identical
- No dominant sellers nor buyers
- Information is widely available
- Free entry and exit to the market
What is the Efficient Market Hypothesis?
It states that market prices fully reflect all available information and the market responds immediately to new information.
Links to arbitrage as the only way to earn more than a risk-free return in the market is to accept the economic risk.
Define arbitrage
Arbitrage is the simultaneous buying and selling of an asset in different markets in order to profit from tiny differences in the asset’s listed price.
