1
Financial markets
Lesson 1
Classification of financial markets:
By transacting parties:
• Primary market
• Secondary market
By security type:
• Money markets
• Capital markets
• FX markets
• Derivative markets
Primary vs secondary markets
Primary markets
Users of fund raise cash by offering new securities for sale, usually using the services of
underwriters.
Secondary markets
Holders of securities 8investors) trade already issued securities among each other.
Money markets
Def: Money markets are markets that trade debt securities or instrument with maturities of up to
one year.
Instruments of money markets:
• Treasury bills
• Federal funds
• Repurchase agreements
• Commercial papers
• Negotiable certificate of deposit
• Banker’s acceptance
, 2
Capital markets
Def: capital markets are markets that trade equity 8stocks) and debt (bonds) instruments with
maturities of at least one year.
Capital markets instruments:
• Corporate stock
• Mortgages
• Corporate bonds
• Treasury bonds
• State and local government
• US government agencies
• Bank and consumer loan
As we shall see, the longer maturity makes capital market instrument susceptible to wider price
fluctuations than short-term debt.
FX markets:
Def: Foreign exchange markets are markets in which cash flows from the sale of products or
assets denominated in a foreign currency are transacted.
• Mostly OTC markets
• Historically one of the most important markets in which forward contracts are used to hedge
risk (i.e. exchange rate risk)
Derivative markets
Def: Derivative markets are markets in which derivative securities (securities whose payoffs are
linked to other previously issued securities) trade.
Instruments traded on derivative markets:
• Forward contracts
• Futures
• Options
• Swaps
Regulation of financial markets
Securities and exchange commission (SEC)
• Regulates full and fair disclosure of relevant information to potential investors in securities;
example of non regulation-relevant issues.
• selective disclosure
• analyst recommendations of underwriters
• insider trading
• Investigates potential cases of fraudulent behaviour by markets participants.
Commodities future trading commission (CFTC)
Regulates exchange traded derivatives
, 3
Financial intermediaries
Direct vs indirect finance
Reason for intermediation:
• Transaction costs: fixed transaction cost give rise to economies of scale
• Risk sharing: better ability to use portfolio diversification techniques/ risk sharing due to lower
transaction costs
• Asymmetric info: specialised skills to mitigate asymmetric information problems.
• Adverse selection: screening
• Moral hazard: monitoring
• Asset transformation: transform assets into more attractive ones
• Maturity transformation (long maturities)
• Denomination transformation (large minimum investments)
Types of financial institutions
• Commercial banks: depository institutions (take deposits, make loans)
• Thrifts: depository institutions specialized in one loan segment: credit unions, savings banks,
savings associations
• Insurance companies: offer protection against adverse events, e.g. death, illness, injury, fire,
theft
• Investment banks: help firms issue securities and engage in related activities (brokerage,
trading)
• Finance companies: make loans, but (unlike commercial banks) are funded with short-term and
long-term debt
• Mutual funds: pool funds and invest in diversified portfolios
• Hedge funds: pool funds of small number of wealthy investors and invest on their behalf
• Pension funds: invest funds for retirement; taxation deferred
Regulation of financial intermediaries:
Objectives : Reducing asymmetric information problems and ensuring financial stability
Government regulation of FI’s:
• Restrictions on entry
• Disclosure requirements
• Restrictions on assets and activities
• Deposit insurance
• Limits on competition
• Restrictions on interest rates
, 4
Lesson 2
The determinants of interest rates
Usually we do not know future asset prices in advance.
But let’s say that you do know them exactly because you have a time
machine that allows you to travel into the future.
Imagine that from your last journey to the future you know the prices of four assets in a year from
now (in September 2020) precisely. Given what these assets cost today (and assuming that none
of the assets pays further cash flows), which one represents the best investment?
The best investment will the be asset that delivers the highest payoffs per dollar invested.
Payoffs:
• Gain in value ∆P =Pt+1 −Pt
• Intermediate cash flows C that the asset may pay to its holder
So it is natural that you will calculate and compare the rate of return.
Uncertainty and the expected rate of return
How do I calculate rr under uncertainty?
If you know the corresponding probabilities p1 , p2 , . . . , pn of all possible realizations R1,
R2, . . . , Rn of the asset’s rate of return, you can calculate an expected rate of return Re:
Expected returns and risk
The risk dimension
We can now rank assets by their expected rate of return, but the riskiness of the asset is another
important dimension.
It is a matter of preferences which asset you prefer:
• Risk lovers would prefer the risky asset
• Risk averts would prefer the safe asset
Quantifying risk
Generally investors on financial markets are risk avers: if expected return are the same, they prefer
less risky assets over more risky ones.
Financial markets
Lesson 1
Classification of financial markets:
By transacting parties:
• Primary market
• Secondary market
By security type:
• Money markets
• Capital markets
• FX markets
• Derivative markets
Primary vs secondary markets
Primary markets
Users of fund raise cash by offering new securities for sale, usually using the services of
underwriters.
Secondary markets
Holders of securities 8investors) trade already issued securities among each other.
Money markets
Def: Money markets are markets that trade debt securities or instrument with maturities of up to
one year.
Instruments of money markets:
• Treasury bills
• Federal funds
• Repurchase agreements
• Commercial papers
• Negotiable certificate of deposit
• Banker’s acceptance
, 2
Capital markets
Def: capital markets are markets that trade equity 8stocks) and debt (bonds) instruments with
maturities of at least one year.
Capital markets instruments:
• Corporate stock
• Mortgages
• Corporate bonds
• Treasury bonds
• State and local government
• US government agencies
• Bank and consumer loan
As we shall see, the longer maturity makes capital market instrument susceptible to wider price
fluctuations than short-term debt.
FX markets:
Def: Foreign exchange markets are markets in which cash flows from the sale of products or
assets denominated in a foreign currency are transacted.
• Mostly OTC markets
• Historically one of the most important markets in which forward contracts are used to hedge
risk (i.e. exchange rate risk)
Derivative markets
Def: Derivative markets are markets in which derivative securities (securities whose payoffs are
linked to other previously issued securities) trade.
Instruments traded on derivative markets:
• Forward contracts
• Futures
• Options
• Swaps
Regulation of financial markets
Securities and exchange commission (SEC)
• Regulates full and fair disclosure of relevant information to potential investors in securities;
example of non regulation-relevant issues.
• selective disclosure
• analyst recommendations of underwriters
• insider trading
• Investigates potential cases of fraudulent behaviour by markets participants.
Commodities future trading commission (CFTC)
Regulates exchange traded derivatives
, 3
Financial intermediaries
Direct vs indirect finance
Reason for intermediation:
• Transaction costs: fixed transaction cost give rise to economies of scale
• Risk sharing: better ability to use portfolio diversification techniques/ risk sharing due to lower
transaction costs
• Asymmetric info: specialised skills to mitigate asymmetric information problems.
• Adverse selection: screening
• Moral hazard: monitoring
• Asset transformation: transform assets into more attractive ones
• Maturity transformation (long maturities)
• Denomination transformation (large minimum investments)
Types of financial institutions
• Commercial banks: depository institutions (take deposits, make loans)
• Thrifts: depository institutions specialized in one loan segment: credit unions, savings banks,
savings associations
• Insurance companies: offer protection against adverse events, e.g. death, illness, injury, fire,
theft
• Investment banks: help firms issue securities and engage in related activities (brokerage,
trading)
• Finance companies: make loans, but (unlike commercial banks) are funded with short-term and
long-term debt
• Mutual funds: pool funds and invest in diversified portfolios
• Hedge funds: pool funds of small number of wealthy investors and invest on their behalf
• Pension funds: invest funds for retirement; taxation deferred
Regulation of financial intermediaries:
Objectives : Reducing asymmetric information problems and ensuring financial stability
Government regulation of FI’s:
• Restrictions on entry
• Disclosure requirements
• Restrictions on assets and activities
• Deposit insurance
• Limits on competition
• Restrictions on interest rates
, 4
Lesson 2
The determinants of interest rates
Usually we do not know future asset prices in advance.
But let’s say that you do know them exactly because you have a time
machine that allows you to travel into the future.
Imagine that from your last journey to the future you know the prices of four assets in a year from
now (in September 2020) precisely. Given what these assets cost today (and assuming that none
of the assets pays further cash flows), which one represents the best investment?
The best investment will the be asset that delivers the highest payoffs per dollar invested.
Payoffs:
• Gain in value ∆P =Pt+1 −Pt
• Intermediate cash flows C that the asset may pay to its holder
So it is natural that you will calculate and compare the rate of return.
Uncertainty and the expected rate of return
How do I calculate rr under uncertainty?
If you know the corresponding probabilities p1 , p2 , . . . , pn of all possible realizations R1,
R2, . . . , Rn of the asset’s rate of return, you can calculate an expected rate of return Re:
Expected returns and risk
The risk dimension
We can now rank assets by their expected rate of return, but the riskiness of the asset is another
important dimension.
It is a matter of preferences which asset you prefer:
• Risk lovers would prefer the risky asset
• Risk averts would prefer the safe asset
Quantifying risk
Generally investors on financial markets are risk avers: if expected return are the same, they prefer
less risky assets over more risky ones.
