Topic 1 (Pt1) - Intro to Financial Markets

Question 1

List the main functions to financial markets?

Answer 1

1. Facilitate the allocation of resources
2. Price discovery
3. Access liquidity
4. Risk transfer

Question 2

What are the main functions of financial markets (ALLOCATION)?

Answer 2

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

Question 3

What are the main functions of financial markets (PRICE DISCOVERY)?

Answer 3

The price of a financial asset is determined by the demand and supply of the asset

E.g. Newly issued assets

Question 4

What are the main functions of financial markets (LIQUIDITY)?

Answer 4

Investors can liquidate assets to raise cash

E.g. Liquidate stock portfolio

Question 5

What are the main functions of financial markets (RISK TRANSFER)?

Answer 5

Risk cannot be eliminated but transferred

E.g. Insurance

Question 6

Define liquidity

Answer 6

Liquidity refers to the ease at which an asset can be converted into cash without affecting its market price.

Question 7

What is stock/equity?

Answer 7

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

Question 8

What is meant by Over-The-Counter?

Answer 8

Stocks and derivatives are traded directly between the seller and buyer without a broker or exchange

Question 9

What 4 things can be traded OTC or on Exchanges?

Answer 9

1. Debt securities
2. Foreign Exchange
3. Commodities
4. Derivative securities

Question 10

What are debt securities?

Answer 10

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

Question 11

What are foreign exchanges?

Answer 11

When market players trade currencies

Question 12

What are commodities?

Answer 12

Physical goods NOT financial assets.

Usually production inputs e.g. crude oil, coffee and natural gas

Question 13

What are derivative securities?

Answer 13

Options and futures contracts whose payoff is determined by the price of the underlying asset

Question 14

What are the 3 main purposes of finance?

Answer 14

1. Allocate resources
2. Manage risks
3. Security selection

Question 15

What is the purpose of finance (ALLOCATION)?

Answer 15

Allocate resources to maximise products and services (firms), wealth (investor), social benefits (governments)

Question 16

What is the purpose of finance (MANAGE RISKS)?

Answer 16

It helps quantify risk e.g. what the chances/probability are?

Question 17

What is the purpose of finance (SECURITY SELECTION)?

Answer 17

Which securities to hold within each asset class?

Higher returns = higher risk (AKA risk-return trade off)

Question 18

What challenges does finance face?

Answer 18

1. Valuation of assets - How are financial assets valued?

2. Management of assets - What should i buy/sell and when?

Question 19

What 2 other factors make finance more challenging?

Answer 19

1. Time - cashflows will differ from future cash flows
2. Risk - difficult to model the unknown

These can be addressed by using historical data and use maths (probabilities)

Question 20

List the 6 principles of finance

Answer 20

1. Everything has a cost
2. Market players prefer:
   
   • to have more money to less (Non-satiation)
   • to have money now than later (Impatience)
   • to avoid risk (risk aversion)
3. All agents act to maximise their own objectives
4. Financial market prices shift to equalise demand and supply
5. Financial markets are highly adaptive and competitive
6. Risk sharing is central to financial innovation

Question 21

List the 5 characteristics of competitive markets

Answer 21

1. Many similar economic agents
2. Products are very similar/identical
3. No dominant sellers nor buyers
4. Information is widely available
5. Free entry and exit to the market

Question 22

What is the Efficient Market Hypothesis?

Answer 22

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.

Question 23

Define arbitrage

Answer 23

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.