Week 1 - Introduction to Financial Markets Flashcards
What does a financial centre to be considered an international financial centre? ( 7 things)
To be an international financial centre (IFC), it should have some or all of the following:
1) Large number of both domestic and foreign banks, as well as reasonable share of international bank lending;
2) A substantial amount of foreign exchange business should be conducted;
3) A significant offshore market, that is, deposit and lending markets that deal in currencies different from those of the financial centre;
4) The stock market should be well capitalized and offer investors a high degree of liquidity;
5) A major market for corporate bond finance, domestic and foreign;
6) A range of financial institutions and associated services such as insurance companies, securities houses, brokers, commercial law firms etc.
7) A significant presence in the derivative markets.
What is another name for financial instruments?
Financial instruments are generally referred to as securities
What are financial markets?
Financial markets facilitate the exchange of financial instruments such as stocks, bills, bonds, foreign exchange, futures, options and swaps;
Often, financial assets involve delayed receipts or payments, and they also transfer funds across time, for instance, futures, forwards etc.
What is globalisation?
This means that the world of finance has become a globalized industry, in that national financial markets are increasingly integrated into a global network of markets;
“the ability to do anything anywhere”
What are the characteristics of globalisation?
Globalization has many characteristics:
Borrowers seeking to raise funds are no longer limited purely to their national/local markets
Investors can invest in many other countries
Financial institutions seek to have a global presence both as a means of expansion and to retain their existing customers who are ever more reliant on trade and economic interactions with foreign residents
The abolishing of exchange controls has enabled financial capital to seek out investment opportunities in other countries
What does BRIC stand for?
“BRIC” typically stand for:
Brazil, Russia, India, and China.
What could are the seven main problems/risks of emerging markets?
the seven main problems/risks of emerging markets:
1) Poor Accounting Standards
2) Legal Institutions - Investor and creditor protection
3) Governance of Companies
4) (Geo-)Political Risks
5) Foreign Exchange Risk
6) Controls on Foreign Investment
7) Higher Transaction Costs
What is securitisation?
One of the biggest innovations in debt markets during the 1980s (Investopedia)
This turns relatively illiquid assets with cash flows into a liquid asset by combining the cash flows from illiquid assets into a security for investors:
Suppose Bank ABC wishes to raise £1 billion to take over Bank XYZ but it does not have the cash
It could pool some of its illiquid assets, such as mortgage loans, which generate a cash flow to the bank, and package them into asset-backed securities (ABS) to be sold to investors.
What is financial security?
A financial security is simply a legal claim to a future cash flow, and they are often called financial instruments, financial assets, or financial claims.
Stocks, Bonds, derivatives (e.g., options, futures, etc.), Exchange-traded funds (ETFs), etc.
Each financial security has an issuer that agrees to make future cash payments to the legal owner of the asset; the legal owner of the asset is referred to as the investor or asset holder;
Examples are:
A $10,000 loan by the Bank of America to Mr Gilpin. The issuer (of the loan) is Mr Gilpin and the owner (of the loan) is the Bank of America
A $500 million corporate bond issued by Sony Electronics Group. Here, the issuer is Sony which will agree to pay investors the bond interest during the life of the bond and the principal upon maturity
A $200 million 10-year government bond issued by the U.S. Treasury. The issuer is the U.S. Treasury, which will pay investors (bondholders) in periodic interest (coupon) and principal value upon maturity
What are the two main types of financial security?
Two distinct types of financial securities are debt and equity
What are debt claims?
Debt claims
The holder (investor) has a predetermined cash claim via the rate of interest charged (either fixed or variable).
Known as debtholder, creditors (of the firm), etc.
Typically, holding debt securities involves lower risks.
No capital gain but only downside risk.
Receives a fixed income, i.e., interest.
What are equity claims?
Equity claims
The holder (investor) (i.e., she owns shares of a company) is only entitled to a cash payment in the form of dividends, after holders of the debt claims have been paid.
Known as shareholders, stockowners, etc.
Has no guarantee that any cash flow will be paid.
Equity investors face higher risk.
Enjoys upside gain if the stock price appreciates.
The maximum loss is the invested capital.
Dividend is not mandatory.
What are the five main roles of financial intermediaries?
Financial Intermediaries (e.g., banks) are concerned with recycling funds from surplus to deficit agents, i.e. facilitating the transfer of funds from those that wish to save to those that wish to borrow.
The most important function of financial intermediaries is to assist in the transfer of funds, and in assisting this process a financial intermediary undertakes several economic functions:
The provision of a payments system;
Maturity transformation;
They accept investors’ funds on a short-term basis of less than a year, and transform these liabilities into longer-term assets such as loans.
Risk transformation;
The process of transforming low-risk deposits into bundles of risky
loans/assets.
Liquidity provision;
Surplus agents require a high degree of liquidity.
Reduction of contracting, search and information costs.
what are the two main types of financial markets?
the two main types of financial markets are primary and secondary markets.
What is a primary market?
Primary Markets
Deals in issues of new securities (e.g., Initial Public Offering (IPOs)), which include government bonds, local authority bonds, and shares in new public corporations.
Underwriting is the process by which investment banks guarantee that companies and governments will obtain the funds that they are seeking when issuing debt and equity securities.
What is a secondary market?
Secondary Markets
Deals in financial securities that have already been issued.
Most securities are on a secondary market.
The price on the secondary helps value a firm.
It is also vital for investors as it provides liquidity that enables them to sell their shares.
If it lacks liquidity, then the issuer of the shares will have to pay a liquidity premium to compensate investors for the lack of liquidity.
what is a market maker?
A market maker is a company or an individual (usually large banks or financial institutions) who actively quotes bid-offer prices on securities. “Makes” a market by providing liquidity and depth; they earn the “bid-ask spreads”.
what are the seven Types of Participants in Financial Markets?
the seven Types of Participants in Financial Markets are:
Individuals - e.g., retail investors, households, etc.
Institutional investors
Commercial and Investment Banks, etc.
Insurance and Pension Funds, etc.
Mutual funds, Hedge funds, etc.
Governments (e.g., Sovereign wealth funds)
Brokers – intermediary on behalf of investors wishing to conduct a trade
Arbitrageurs – economic agents that buy and sell financial securities to make riskless profits
Hedgers – economic agents who seek to reduce or limit some risk by engaging in the purchase or sale of a financial security, e.g., Gold
Speculators – economic agents who utilise strategies based on their expectations in the hope of making a profit
what is the expected real interest rate?
Expected real interest rate (R):
Rate of interest that equates the supply of funds from those willing to lend between two periods with the demand for funds from those willing to borrow between two periods it is adjusted to remove the effects of inflation;
An individual’s time preference measures the willingness to forgo consumption now (period one) for additional consumption later (period two);
High time preference = prefer current consumption (vice-versa);
Example:
Luke wants to borrow £100 of you, but you want to go out on Friday night with that money, so your real interest may be high. However, if you have no plans for that £100, your real interest rate may be lower
why is the expected inlfation rate important?
Lenders will be expected to be compensated for expected inflation
What the increase in prices is going to be, from a basket of goods
If they aren’t, loans will be repaying in a depreciated currency
Example:
Expected inflation is 6% but the real interest rate is only 4%.
Loan repayment = £100 * (1 + real interest rate) * (1 + expected inflation rate)
Loan repayment = (100 * 1.04 * 1.06) = £110.24
Nominal rate of interest = 10.24%
Thus, inflation is very important. Current inflation rates are quite High
what is a yeild curve?
Yield curve
Depicts the relationship between the maturity and interest rates of loans.
Normally upward-sloping, i.e., nominal rates increase with maturity.
what is the expected liquidity premium?
Expected Liquidity Premium: We must take into account the maturity of the loan on the interest rate
Lenders prefer to lend for a short period (i.e., they prefer to consume earlier);
Borrowers prefer to borrow for long periods;
Lenders must be compensated for lending for longer periods.
what is Systematic Risk ? whata re its four parts?
Due to market conditions and business cycles – everyone faces them.
That is, it cannot be diversified away.
Example
Firms’ earnings are positively correlated with business cycles, so if there is a recession, all firms’ earnings are negatively affected at the same time.
Also known as:
Covariance risk
Market risk
Non-Diversifiable risk
Management risk – the risk that the managers running the firm are incompetent
and lead the firm into insolvency. It is quite high in new firms with untried and
untested managers.
- Business risk – the risk from the asset side of the firm’s balance sheet. It is the
risk that the firm will not generate sufficient sales of revenue to finance the fixed
costs of its operations.
* Financial risk – the risk from the liability side of the firm’s balance sheet. It is
the risk that the firm will not generate enough sales revenue to finance the fixedcharge liabilities on the balance sheet.
* Collateral Risk – the risk that investors face if they have poor collateral and
claims to the assets of the firm and behind other investors.
Non-systematic risks can be diversified and reduced (if not eliminated) if they
are independent of other things happening in the economy.
what is expected risk premium?
Due to market conditions and business cycles – everyone faces them.
That is, it cannot be diversified away.
Example
Firms’ earnings are positively correlated with business cycles, so if there is a recession, all firms’ earnings are negatively affected at the same time.
Also known as:
Covariance risk
Market risk
Non-Diversifiable risk
What is non-systemic risk?
Due to the industry, sector the security is in; or even at firm-specific level
Can be diversified away!
Example: British Airways (BA) shares are negatively correlated with the oil price, while British Petroleum (BP) are positively correlated
what are the four components of non-systematic risk?
Management risk – incompetent managers, management style.
Business risk – balance sheet on costs
Financial risk – balance sheet on debt
Collateral risk – secured debt – general creditors – preferred stockholders – common stockholders
What is non-systematic risk also called?
non-systematic risk is also called idiosyncratic risk, (firm-)specific risk, and diversifiable risk.
What is the yield curve made out of?
the risk premium,, the liquidity premium the expected inflation rate and the real interest rate
What are the main components of the nominal rate of interest and briefly explain each one?
The nominal rate if interest is equal to the expected real interest rate, expected inflation rate, expected liquidity premium and expected risk premium. The first three are time components while the latter is the risk component.
Expected real interest rate is the supply of funds from those willing to lend between two periods with the demand for funds from those willing to borrow between two periods, i.e. opportunity cost.
Expected inflation rate is the rate at which lenders want to be compensated for in case
of future inflation.
Expected liquidity premium is the premium the lender requires from lending to the borrower due to fact that the lender cannot quickly and easily turn their investment into
cash.
Expected risk premium is the premium the lender requires due to the risk of the
borrower. Talk about the two different types.
