Financial Markets Overview Flashcards
(27 cards)
What is Finance
Finance is broadly defined as the study of funds management. More precisely, it involves the allocation, management, and investment of money and financial instruments.
At its core, the objective of finance is value maximisation. For firms, this entails maximising shareholder value, while for individuals, it involves increasing personal wealth, typically within a risk tolerance and often with consideration for intergenerational wealth transfer.
Why are Financial Markets Important?
Channelling Funds
Enhancing Economic Efficiency
Impact on Wealth and Decision Making
Facilitating Borrowing and Lending
Channelling Funds
They facilitate the movement of funds from savers (with surplus capital) to borrowers or investors (who lack sufficient capital but have productive investment opportunities). This can occur via:
Direct finance, where savers provide funds directly to borrowers in exchange for financial claims.
Indirect finance, where financial intermediaries (e.g., banks, mutual funds) mediate the process by transforming and reallocating financial assets.
Enhancing Economic Efficiency
Financial markets improve capital allocation by directing funds toward their most productive uses.
Efficient capital allocation supports innovation, economic growth, and overall societal welfare.
Research suggests that halting financial trading could reduce economic output significantly—by 3% to 20% of wealth.
Impact on Wealth and Decision-Making
For INDIVIDUALS, financial markets offer investment opportunities that prevent idle capital, allowing for returns through interest or capital gains
For BUSINESSES, the presence of markets imperfections means that decisions regarding capital structure and investment strategies materially affect their value
Facilitating Borrowing and Lending
Financial Markets include
Primary markets, where new financial securities are issued.
Secondary markets, where existing securities are traded. Both are vital for providing liquidity and pricing information.
What is Adam Smith’s Invisible Hand
Adam Smith’s concept of the invisible hand posits that when individuals pursue their own self-interest, they unintentionally contribute to the greater good of society by fostering economic efficiency. In financial markets, this principle operates as follows:
Investors seeking returns naturally allocate capital to firms with strong growth prospects, supporting efficient capital allocation.
Competitive investment behaviour encourages the discovery and use of relevant information, thereby improving market efficiency.
This self-regulating nature of markets suggests that, under certain conditions, markets can lead to optimal outcomes without external intervention. However, this view assumes ideal conditions. In practice, market failures can occur due to:
Public goods
Externalities
Asymmetric information
These imperfections justify the need for financial regulation and oversight, such as central bank interventions or statutory disclosure requirements, to correct market inefficiencies and protect systemic stability.
What is Market Failure
Market failure occurs when free markets, left to their own devices, do not allocate resources efficiently, leading to a loss of economic and social welfare.
Key Insight:
It shows where the invisible hand fails, necessitating regulation or government intervention.
Causes Include:
Public goods
Externalities (positive and negative)
Asymmetric information
Public Goods and Why they Cause Market Failure
Goods that are non-rivalrous (one person’s use doesn’t reduce availability) and non-excludable (can’t prevent others from using it).
Examples:
Clean air
National defence
Financial system stability
Why They Cause Market Failure:
Free rider problem: Firms won’t produce them voluntarily — there’s no profit incentive, because everyone can benefit without paying. This is called the free rider problem.
In Finance:
A stable financial system is like a public good — all benefit from it, but individual banks may still act in ways that undermine it, such as by taking on too much risk. Hence, tight regulation is necessary.
What are Externalities
An externality is a side effect of a market activity that affects people who are not directly involved in the transaction.
If it causes harm, it’s a negative externality.
If it creates benefits, it’s a positive externality.
Why They Matter:
Markets don’t account for these effects, leading to overproduction of harmful things and underproduction of helpful ones.
What are Negative Externalities
These are costs placed on third parties who didn’t agree to the action.
Examples:
Pollution from factories
Financial crashes caused by risky banking behaviour
In Finance:
A bank may chase high profits by taking excessive risks. If it fails, the wider economy suffers (job losses, reduced lending, taxpayer-funded bailouts).
Why This Is Market Failure:
The social cost is higher than the private cost, so too much of the harmful activity happens. Regulation is needed to align private and social costs.
What are Positive Externalities
Benefits from a transaction that spill over to others who didn’t pay for it.
Examples:
Education (society benefits from more informed citizens)
Vaccinations
Financial education and CSR in banks
Why This Is Market Failure:
People or firms may under-invest in these activities, since they don’t get all the benefits. Government may step in via subsidies or incentives.
In Finance:
Banks might not voluntarily invest in financial literacy campaigns, even though society benefits.
What is Asymmetric Information
This happens when one party in a transaction knows more than the other, creating an imbalance that can distort decision-making.
Why It Matters:
In finance, trust and transparency are essential. Without equal information, markets can’t function properly.
Main Problems:
Adverse Selection (hidden information, before deal)
Moral Hazard (hidden actions, after deal)
Adverse Selection (Hidden Information)
Occurs before a deal is made. The seller or borrower knows more than the buyer or lender and uses that to their advantage.
Examples:
Risky borrowers applying for loans without disclosing risks
Subprime mortgages bundled and sold as “safe” before the 2008 crisis
Why It’s Market Failure:
Buyers can’t tell good from bad, so they may avoid the market altogether or only accept lower prices. High-quality players leave the market, worsening the problem.
In Finance:
It leads to mispriced assets, credit crunches, and a loss of trust in financial institutions.
What are financial markets and why are they important
Financial markets are platforms where financial assets (like stocks and bonds) are traded. They connect savers (who have money) with investors (who need money), helping to fund new businesses and economic growth.
Importance:
Enable investment and wealth creation.
Improve economic efficiency — shutting down financial trade could reduce total wealth by 3% to 20%.
Act as vital infrastructure and lubrication for the economy.
Help individuals and companies manage risk and raise capital.
Historical and Current Importance of Financial Services
Before 2010:
Financial services made up nearly 48% of GDP in some cities (e.g., New York City).
Accounted for around 17% of employment in those regions.
NYC’s financial sector GDP was comparable to countries like Malaysia or Chile.
Now (2023):
Emerging financial centers like Beijing, Shanghai, and Dubai are nearly as important as traditional centers like New York and London.
London and New York trade places as top global financial hubs.
Global debt has soared to $315 trillion (3x world GDP), with corporate debt at $164.5 trillion.
Total market capitalization stands around $111 trillion.
What are Financial Instruments and What are the Major Types
Financial instruments are assets that can be traded in financial markets. They come in several major types:
Debt Instruments: Promise fixed returns and repayment.
Common Stock: Represents ownership with variable returns.
Preferred Stock: Equity with fixed dividends and payment priority.
Derivative Securities: Value depends on other assets (used for hedging/speculation).
What are Debt Instruments
Instruments that promise a constant state of return:
Money Market Instruments: Short-term (under 1 year) debt like Treasury bills and commercial paper. Usually very low risk.
Bonds: Long-term debt (10+ years) with regular interest (coupons) and principal repayment. Examples: US Treasury bonds, municipal bonds, corporate bonds.
What is Common Stock
Represents ownership in a company (equity).
Provides a residual claim: shareholders get what’s left after debts are paid.
Offers dividends and potential capital gains, both uncertain.
No maturity date — companies are assumed to operate indefinitely.
Shareholders have limited liability — they can’t lose more than their investment.
What is Preferred Stock
Hybrid between debt and equity.
Offers fixed dividend payments.
Has priority over common stock in dividends and liquidation.
Often does not have voting rights like common stock.
What are Derivative Securities
Financial contracts whose value depends on underlying assets (stocks, bonds, commodities).
Used mainly to hedge risk or speculate on price changes.
Examples include futures, forwards, swaps, and options.
What is a Financial Market and Examples of Them
A venue for trading financial assets (stocks, bonds, derivatives).
Includes both primary markets (new issues sold by issuers) and secondary markets (trading of existing securities).
Examples: London Stock Exchange (LSE), New York Stock Exchange (NYSE), NASDAQ, US government bond market.
What are Primary and Secondary Markets
Primary Market: Issuer sells new securities directly to investors (e.g., IPOs).
Secondary Market: Investors trade existing securities among themselves; issuer doesn’t receive funds (e.g., LSE, NYSE).
What are Exchanges and Over The Counter Markets
Exchanges: Centralized venues with regulated trading (e.g., NYSE, LSE).
OTC Markets: Decentralized, dealer-driven markets, where trades happen bilaterally at various locations.W
