Lecture 2 - Financial Markets Flashcards
(23 cards)
Direct finance
The transfer of funds from surplus units (lenders/savers) to deficit units (borrowers) occurs via financial markets
Indirect finance
The transfer of funds does not occur directly from lenders to borrowers - financial intermediaries interpose between lenders and borrowers
Direct finance diagram
Savers/lenders<->financial markets<->borrowers
Indirect finance diagram
Savers/lenders<->financial intermediaries<->borrowers
Why do financial markers and financial intermediaries exist?
Pricing function:
Determining the fair prices and allocating resources
- financial markets provide both buyers and sellers with “fair” evaluation of the asset they are buying/selling
Discipline function
Ensuring the prudent discipline on trading parties.
Financial markets are regulated - regulation encourages issuers of securities (borrowers) not to engage in activities that the market deems detrimental to the value of their assets
If financial markets can ensure the transfer of funds from savers to borrowers, why do financial intermediaries exist?
- difficulty and expense of matching the complex needs of individual borrowers and lenders (look for counterparty with exactly opposite needs) - COST REDUCTION
- absolutely incompatibility of the financial needs of borrowers and lenders
Needs of lenders and borrowers
Lender requirements:
- minimisation of risk
- minimisation of costs
- maximisation of returns
- liquidity (ease of converting a financial claim into cash without loss of capital value)
Borrower requirements
- funds at a particular specified date, for a specific period of time (preferably long term) and at the lowest possible cost
Direct or indirect finance, which one is better?
Financial intermediaries has advantages over direct finance, but also additional costs for borrowers and lenders (fees or interest rate spreads)
To state that intermediates finance is more advantageous than direct finance it is necessary that the benefits of such activity outweigh the costs associated with intermediation
Financial claims and financial liabilities
- debt and equity are the most common financial claims in markets
- debt claim holder has predetermined cash claim via the rate of interest (variable or fixed)
- equity claim holder entitled to a cash payment in the form of dividends (if profitable) once debt claim holders have been paid
- debt claim holders facing less risk than equity claim holders
Each financial claim undertakes one of the following financial liabilities
- The amount of liability is known and the timing of the liability is known
- The amount of liability is known and the timing of liability is uncertain
- The amount of liability is uncertain and the timing of ability is known
- The amount of liability is uncertain and the timing of the liability is uncertain
Different taxonomies
Financial markets can be classified according to several features they present:
- Whether the assets traded are newly issued or already issued
- Type of asset traded
- The means of a settlement
- Maturity of the asset traded
- The obligation to exchange
- The organisational structure of the market
- The method of sale/pricing
- Primary and secondary markets
Primary markets deal with the issues of new securities-> securities must be UNDERWRITTEN or DISTRIBUTED (usually to institutional invenstors)
-> issuer receives funds from sale
Secondary markets deal with financial securities that have already been issued
-> issuer does not receive funds from sale (securities bought and sold in the market)
The primary market
- corporations, government, local authorities might decide to issue securities (either debt or equity) to raise funds
- the new securities are underwritten by financial institutions (investment and commercial banks), who distribute them to the public and other institutions
- underwriting process can occur via: bought deals, auctions, pre-emptive right offerings, private placements
The secondary market
- once a security had been allocated to the investors for the first time, it can be bought and sold on the stock market
- despite the fact that the issuer does not get any proceeds from the issuance on the secondary market is very important for the issuer for two reasons:
- prices on secondary market are an estimate of a company’s value
- the liquidity provided by secondary markets decreases the cost of capital of the issuers
Continued
- the role of the market makers: market makers provide liquidity to the market by quoting bid (market makers buys) and ask (market maker sells) prices continuously - if market makers did not exist trading would slow down and for certain securities stop altogether
- Bond and equity markets
Markets mainly deal in two types of financial securities:
1. Bonds - issued by corporations, banks or governments
2. Equity (shares) - issued any kind of public company (financial or non financial) but not by the government (although the government day told a large stake of the ownership)
- Money markets and capital markets
Money markets are those where short term debt securities are traded (typically, maturity <1 year) - e.g treasury bills
Capital markets are those where medium or long term securities are traded (maturity > 1 year) e.g treasury or corporate bonds
- Cash and future markets
In a cash market, the settlement occurs immediately after - the price is agreed on today, and the settlement also takes place today
In a futures market, the settlement occurs at a future date with respect to the when the transaction takes place.
- Forward and Options market
In the forward market, the buyer/seller is obliged to buy/sell the asset on the date and at the price agreed some time in the past. (Forward contracts are similar to futures contract, while forward contracts are not standardized)
In the options market, the buyer/seller has the RIGHT, but not the obligation, to buy/sell the asset on the date and at the price agreed some time in the past
- Regulated and OTC markets
In a regulated market, the trading is organised by the exchange
Clearing house: for each transaction, the buyer/seller enters a contract with the exchange itself (represented by the clearing house) - the risk that the counterparty does not fulfill the contract is covered.
In an OTC market, dealers simply trade between themselves
There is no clearinghouse house - the parties are not protected from the risk that either of them does not fulfill a contract
- Market makers and dealers market; screen based and pit trading
- in regulated markets, market makers provide liquidity to the market by quoting bid-ask prices
- in OTC markets, dealers negotiate prices between themselves
- screen based trading occurs via computers - no need for traders to be located in the same space
- pit trading occurs inside the exchange
