Topic 1: Overview of the Financial System

Barter Economy

• a system where goods and services are exchanged directly for other goods and services without using money

• Challenge: double coincidence of wants (inefficency)

Machine learning

• A subfield of AI that teaches computers to learn from data rather than follow fixed rules

• Algorithms detect patterns in data and improve with experience

Purpose of financial markets

Channel funds from those who do not have a productive use for them to those that do

How does machine learning predict markets?

• Forecasting bond yields and stock volatility

• natural language processing for news and sentiment analysis

• Anomaly detection for fraud and systemic risk

• Algorithms learn patterns from vast, complex datasets

Security

claim on the issuer’s future income or assets

Bond

Debt security that promises to make payments periodically for a specified period of time

Interest rate

The cost of borrowing, or price paid for the rental of funds

T-bills

Federal government bonds that provide no interest, but sold at a discount

Stock

• a share of ownership in a corporation

• value reflects the current value of a company, and expectations of future earnings growth

• doesn’t have maturity dates

• equity holders are residual claimants

Rate of return on a bond

rate of return = (FV - P) / P

Short selling

implies establishing a market position by selling a security one does not own

Primary market

• new security issues sold to initial buyers

• private

• investment banks guarantee prices (underwriting)

Secondary market

• Previously issued securities can be bought and sold

• Brokers match buyers and sellers with each other

• Dealers offer to buy and sell securities at stated prices

Over the counter market

• Type of secondary market

• dealers have inventory, and are ready to buy/sell at stated prices

• ex. canadian government bond

Money markets

• only short-term debt instruments are traded (<1yr)

• Corporations and banks actively use money markets to earn interest on temporary surplus funds

• more liquid than capital markets

Capital markets

• markers for longer-term debt (>1yr)

• less liquid than money markets

Money market instruments

• T bills

• Certificates of deposit

• commercial paper

• repurchase agreements

• overnight funds

capital market instruments

• stocks

• mortgages and mortgage-backed securities

• corporate bonds

• gov of canada bonds

• canada savings bonds

• provincial and municipal gov bonds

• gov agency securities

• consumer and bank commercial loans

Roles of financial intermediaries

1. Lowers transaction costs

2. Improves risk sharing

3. helps solve asymmetric information problems

• adverse selection: potential borrowers who are more likely to default are the ones who most actively seek out loans

• moral hazard: borrowers might engage in activities that are undesirable from a lender’s point of view

Depository institutions

• Chartered banks

• Trusts and mortgage loan companies

• credit unions

• caisses populaires

Contractual savings institutions

• life insurance companies

• property and casual life insurance companies

• pension funds and retirement funds

Investment intermediaries

• finance companies

• mutual funds

• money market mutual funds

• investment banks

Fintech

• digital payments

• lending platforms

• cryptocurrencies

• robo-advisors

• digital banks

Triple-barrier method: 3 exit rules

• profit target (upper barrier)

• stop-loss (lower barrier)

• time limit (vertical barrier)

Meta-labeling

• Base-model: predicts direction

• Meta-model: decides whether to trust the signal