Introduction to Financial Markets Part 1 Flashcards
(37 cards)
Key functions of financial markets
- Facilitate the efficient allocation of resources
- Price discovery/valuing assets
- Access liquidity
- Risk transfer/sharing
Facilitate the efficient allocation of resources
allowing those with surplus funds to invest/buy/lend to those in need of funds (selling/borrowing) e.g. firms raise capital through the issuing of bonds or selling equity, the return for the investor is the cost for the firm (cost of capital).
Price discovery/valuing assets
the price of a financial asset (like all assets) is determined by the demand for and supply of this asset. For financial assets these could be newly issued assets or those traded on the secondary markets.
Access liquidity
investors can liquidate assets to raise cash, e.g. liquidate stock portfolio.
Risk transfer/sharing
key we cannot eliminate risk but only transfer it, e.g. insurance
The role of finance
moving, allocating and pricing.
Financial intermediary
middleman in a transaction between buyer and seller, e.g. bank, building society, stock exchange
Nature of investment
commitment of current resources in expectation of future benefit
Allocation of risk
financial markets facilitate the transferal of risk; insurance
Consumption timing
transfer wealth from high earning periods to low; pensions
Information role
Stock prices reflect market’s assessment of firm’s current and future performance, as well as optimism about the global environment. Google effect.
Real assets
assets used to produce goods and services, include land, buildings, machines and knowledge.
Financial assets
Claims on real assets: derive their value from a contractual claim on an underlying asset; stock, bonds, derivatives.
Types of financial assets and markets
Stock/Equity
Fixed income or debt securities
Stock/Equity
part ownership of a company. Income is not guaranteed. Most well known of markets, firms can raise capital issuing shares, once this initial public offering (IPO) is made these shares can be sold and bought on the secondary market. Stock can be traded on exchanges.
Over the counter (OTC) - here market players can trade stocks, derivatives and other assets directly with each other, without the need for a broker or exchange.
Fixed income or debt securities
Pays a regular income, unless zero coupon.
Money market instruments-short term financing, e.g. treasury bills.
Capital market instruments-medium to long term financing, e.g. government bonds, ‘sleeping beauty’ bonds.
Bond markets issue new debt, or allow for existing debt to be bought and sold.
Commodities
physical goods not financial assets, usually production inputs, including crude oil, coffee, natural gas, gold, wheat…
Foreign Exchange/Currencies
trade currencies, in terms of volume this is the largest market, with key participants being large financial institutions.
Derivative securities
options and futures contracts whose payoffs is determined by the price of an underlying asset.
Underlying assets could be stocks, interest rates, commodities…
Derivatives markets allow for speculation on the price of commodities without actually taking delivery of them
Market participants/players
Individuals and organisations who buy and sell financial assets, i.e. engage in financial markets, e.g. governments, banks, firms, private investors…
In the derivatives market these are hedgers, speculators, arbitrageurs, more later!
Purpose of finance
Allocate resources
Manage risks
Security selection
Allocate resources
maximize products and services (firms), wealth (investor),
social benefit (governments)
How should wealth be allocated? What assets should be held?
assess characteristics of assets-return and risk
the optimal allocation may change over time
Manage risks
diversification, various financial instruments
Important to be able to quantify risk and manage it such that are exposed to the “right” level of risks.
Security selection
which particular securities to hold within each asset class?
security analysis
Typically higher return comes with higher risk, risk-return trade-off.
