Why study financial markets Flashcards
What do financial markets do?
Allow surplus funds to be lended out to borrowers, who can then invest in productive uses.
Whats the domestic equilibrium? Foreign equilibrium?
Y = C + I + G + X - IM
Balance of payments
What’s a security?
A security is a financial instrument that is a claim on the issuer’s future income or assets.
What is a bond? How are they used?
A bond is a debt security that promises to make payments periodically for a specified amount of time.
Bonds can be issued in order to raise finance.
How do bonds work?
An company/govt. may issue a bond from an investor (basically borrow money). The investors are paid interest on the money they’ve loaned.
Bonds are often seen as less risky than stocks, and are sometimes used diversify portfolios.
ie:
A bond may have a face value of £1000. (so the govt. loans £1000.)
The maturity rate may be 10 years, so govt. promises to pay it back in 10 years.
The govt. may pay an annual interest rate of 5% (A COUPON RATE).
The investor has bought the bond at face value for £1000, each year, the govt. pays the investor £50.
This continues for 10 years, until the bond reaches maturity.
Govt. pays back £1000.
Bonds come with a default risk - ie: govt. can’t pay the coupon rate/pay bond when reaches maturity.
Typically, bonds with higher default risk have a higher coupon rate.
A bond may be worth less if interest rates increase, and you sell before the maturity date. ie: i increase, investors will increase in higher rate bonds.
What’s an interest rate?
the cost of borrowing money.
What is a stock in the market?
Share of ownership in a corporation.
It is a security that is a claim on earnings and assets of a corporation
What are the types of financial markets? Advantages and disadvantages?
-DEBT
Issue bonds in order to raise finance
-EQUITY
Issue shares/common stock
Advantage of shares: entitled to vote and potential to dividends if there’s net income after tax.
Disadvantage of shares: debt holders get paid first in case of bankruptcy
What is the foreign exchange market?
A market where funds are converted from one currency to another
What is the foreign exchange rate?
Price of one currency in terms of another currency
Basic flow of funds through the financial market?
Flow of funds can happen via direct finance or indirect finance.
Direct:
Borrowers borrow funds directly from lenders (ie: borrowers issue bonds/offer shares)
Indirect:
Flow of funds take place through financial intermediaries ie: Banks that accept deposits and issue loans.
-more so depositary institutions
Primary vs Secondary markets?
Primary:
- stocks are created
ie: company sells shares to investors
Secondary:
- stocks are traded
ie: Investors/traders sell shares between eachother which were originally bought in the primary market.
Exchange market?
OTC market?
Money market?
Capital market?
Exchange: LSE, London metal exchange
Over the counter market: Foreign exchange, US govt. bond market
Money market: short term debt instruments
Capital market: longer term debt and equity instruments.
What are financial institutions?
They borrow funds from those who have saved, and in turn, make loans from these borrowed funds to other people. ie: banks, insurance companies, pension funds, investment companies.
Why use a financial intermediary instead of accessing the financial market directly? (ie: why loan from the bank instead of issuing bonds?)
- Lower transaction costs. ie: Don’t have to pay lawyer fees - a bank pays for this once, and uses this contract on thousands of people so that the cost is small per person)
- Reduce risk
- banks diversify and take part in asset transformation
3 and 4 are both ASSYMETRIC INFO which the public dont have access to.
- They use adverse selection (before transaction - credit checks, avoid lending to risky borrowers)
- Moral Hazard (after transaction - ensure borrower will not engage in activities that would prevent them paying back the loan -> contracts)
