Market Organization Flashcards
Main Purposes of the Financial System
6 main purposes:
- to save money for the future;
- to borrow money for current use;
- to raise equity capital;
- to manage risks;
- to exchange assets for immediate and future deliveries;
- to trade on information.
Main Functions of the Financial System
3 main functions:
- the achievement of the purposes for which people use the financial system;
- the discovery of the rates of return that equate aggregate savings with aggregate borrowings; and
- the allocation of capital to the best uses.
Information-Motivated Traders
trade to profit from information that they believe allows them to predict future prices. Like all other traders, they hope to buy at low prices and sell at higher prices. Unlike pure investors, however, they expect to earn a return on their information in addition to the normal return expected for bearing risk through time.
ex. Active Investment Managers
Primary Capital Markets (Primary Markets)
are the markets in which companies and governments raise capital (funds). Companies may raise funds by borrowing money or by issuing equity. Governments may raise funds by borrowing money.
Secondary Market
When investors sell those securities to others, they trade in the secondary market. In the primary market, funds flow to the issuer of the security from the purchaser. In the secondary market, funds flow between traders.
Money Markets
Trade debt instruments maturing in one year or less.
The most common such instruments are repurchase agreements (defined in Section 3.2.1), negotiable certificates of deposit, government bills, and commercial paper.
Capital Markets
Trade instruments of longer duration, such as bonds and equities, whose values depend on the credit-worthiness of the issuers and on payments of interest or dividends that will be made in the future and may be uncertain. Corporations generally finance their operations in the capital markets, but some also finance a portion of their operations by issuing short-term securities, such as commercial paper.
Traditional Investment Markets
include all publicly traded debts, equities, and shares in pooled investment vehicles that hold publicly traded debts and/or every
Alternative Investment Markets
Alternative investments include hedge funds, private equities (including venture capital), commodities, real estate securities and real estate properties, securitized debts, operating leases, machinery, collectibles, and precious gems. Because these investments are often hard to trade and hard to value, they may sometimes trade at substantial deviations from their intrinsic values. The discounts compensate investors for the research that they must do to value these assets and for their inability to easily sell the assets if they need to liquidate a portion of their portfolios.
Fixed-Income Instruments
Fixed-income instruments generally are promises to repay borrowed money but may include other instruments with payment schedules, such as settlements of legal cases or prizes from lotteries. The payment amounts may be pre-specified or they may vary according to a fixed formula that depends on the future values of an interest rate or a commodity price. Bonds, notes, bills, certificates of deposit, commercial paper, repurchase agreements, loan agreements, and mortgages are examples of promises to repay money in the future. People, companies, and governments create fixed-income instruments when they borrow money.
Equities Instruments
Equities represent ownership rights in companies. These include common and preferred shares.
Warrants
Warrants are securities issued by a corporation that allow the warrant holders to buy a security issued by that corporation, if they so desire, usually at any time before the warrants expire or, if not, upon expiration. The security that warrant holders can buy usually is the issuer’s common stock, in which case the warrants are considered equities because the warrant holders can obtain equity in the company by exercising their warrants. The warrant exercise price is the price that the warrant holder must pay to buy the security.
Preferred Equities
Preferred shares are equities that have preferred rights (relative to common shares) to the cash flows and assets of the company. Preferred shareholders generally have the right to receive a specific dividend on a regular basis. If the preferred share is a cumulative preferred equity, the company must pay the preferred shareholders any previously omitted dividends before it can pay dividends to the common shareholders. Preferred shareholders also have higher claims to assets relative to common shareholders in the event of corporate liquidation. For valuation purposes, financial analysts generally treat preferred stocks as fixed-income securities when the issuers will clearly be able to pay their promised dividends in the foreseeable future.
Common Equities
Common shareholders own residual rights to the assets of the company. They have the right to receive any dividends declared by the boards of directors, and in the event of liquidation, any assets remaining after all other claims are paid. Acting through the boards of directors that they elect, common shareholders usually can select the managers who run the corporations.
Pooled Investments
Pooled investment vehicles are mutual funds, trusts, depositories, and hedge funds, that issue securities that represent shared ownership in the assets that these entities hold. The securities created by mutual funds, trusts, depositories, and hedge fund are respectively called shares, units, depository receipts, and limited partnership interests but practitioners often use these terms interchangeably. People invest in pooled investment vehicles to benefit from the investment management services of their managers and from diversification opportunities that are not readily available to them on an individual basis.
Contracts
A contract is an agreement among traders to do something in the future. Contracts include forward, futures, swap, option, and insurance contracts. The values of most contracts depend on the value of an underlying asset. The underlying asset may be a commodity, a security, an index representing the values of other instruments, a currency pair or basket, or other contracts.
Forward Contracts
A forward contract is an agreement to trade the underlying asset in the future at a price agreed upon today. For example, a contract for the sale of wheat after the harvest is a forward contract. People often use forward contracts to reduce risk. Before planting wheat, farmers like to know the price at which they will sell their crop. Similarly, before committing to sell flour to bakers in the future, millers like to know the prices that they will pay for wheat. The farmer and the miller both reduce their operating risks by agreeing to trade wheat forward.
Futures Contracts
A futures contract is a standardized forward contract for which a clearinghouse guarantees the performance of all traders. The buyer of a futures contract is the side that will take physical delivery or its cash equivalent. The seller of a futures contract is the side that is liable for the delivery or its cash equivalent. Buyers and sellers, therefore, can trade futures without worrying whether their counterparties are creditworthy. Because futures contracts are standardized, a buyer can eliminate his obligation to buy by selling his contract to anyone. A seller similarly can eliminate her obligation to deliver by buying a contact from anyone. In either case, the clearinghouse will release the trader from all future obligations if his or her long and short positions exactly offset each other.
Clearinghouse
An entity associated with a futures market that acts as middleman between the contracting parties and guarantees to each party the performance of the other.
A clearinghouse is an organization that ensures that no trader is harmed if another trader fails to honor the contract. In effect, the clearinghouse acts as the buyer for every seller and as the seller for every buyer.
Initial Margin
To protect against defaults, futures clearinghouses require that all participants post with the clearinghouse an amount of money known as initial margin when they enter a contract. The clearinghouse then settles the margin accounts on a daily basis. All participants who have lost on their contracts that day will have the amount of their losses deducted from their margin by the clearinghouse. The clearinghouse similarly increases margins for all participants who gained on that day.
Maintenance Margin
Participants whose margins drop below the required maintenance margin must replenish their accounts. If a participant does not provide sufficient additional margin when required, the participant’s broker will immediately trade to offset the participant’s position.
Variation Margin
Additional margin that must be deposited in an amount sufficient to bring the balance up to the initial margin requirement.
Swaps Contract
A swap contract is an agreement to exchange payments of periodic cash flows that depend on future asset prices or interest rates.
Interest Rate Swap
A swap in which the underlying is an interest rate. Can be viewed as a currency swap in which both currencies are the same and can be created as a combination of currency swaps.
Commodity Swap
A swap in which the underlying is a commodity such as oil, gold, or an agricultural product.
Currency Swap
A swap in which each party makes interest payments to the other in different currencies.
Equity Swap
A swap transaction in which at least one cash flow is tied to the return to an equity portfolio position, often an equity index.
Option
A financial instrument that gives one party the right, but not the obligation, to buy or sell an underlying asset from or to another party at a fixed price over a specific period of time. Also referred to as contingent claim or option contract.
Call Option
An option that gives the holder the right to buy an underlying asset from another party at a fixed price over a specific period of time.
Put
An option that gives the holder the right to sell an underlying asset to another party at a fixed price over a specific period of time.
