Learning module 1

Function of a financial system

• The financial system includes markets and financial intermediaries that help transfer financial assets, real assets and financial risk between entities from one place to another, and from one point in time to another.

Six purposes (+2) people use the financial system for:

1. [To save money for the future.

2. To borrow money for current use.

3. To raise equity capital.

4. To manage risks.

5. To exchange assets for immediate and future deliveries.

6. To trade on information.]

• All these 6 purposes fall under “Achieve the purposes for which people are in the financial system.”

• Additional 2 purposes

  • Discover rates of return that equate aggregate savings with aggregate borrowings.

  • Allocate capital to the best uses.

Financial Assets

Means by which individuals hold claim on real assets and future income generated by these assets, e.g. securities like stocks and bonds.

Real Assets

Include physical assets like real estate, equipment’s, commodities, etc.

Debt securities (nature of claim)

In these types of security, the nature of claim is through periodic interest payments made on borrowed funds that might be collateralized.

Equity securities (nature of claim)

In these types of security, the nature of the claim is through, representing ownership positions and claims on the future cash flows of the business.

Publicly traded

These are securities that trade in public markets through exchange or dealers and are subject to regulatory oversight.

Privately traded

These securities are not traded in public markets. They are often not subject to regulation.

Spot market

Markets for immediate delivery of assets.

Forward market

Contracts that call for future delivery of assets and include forwards, futures, and options.

Financial derivative contract

These contracts draw their value from financial assets like equities, equity indexes, debt, and other assets.

Physical derivative contract

These contracts draw their value from real assets like commodities.

Primary market

Issuers sell securities directly from investors.

Secondary market

Investors buy and sell securities among themselves.

Money market

Securities with maturities of one year or less.

Capital market

Securities that have more than one year maturity or equites that do not have any maturity.

Traditional investment markets

Include all publicly traded debt and equities.

Alternative investment market

Includes hedge funds, private equity, commodities, real estate, and precious gems that are hard to trade and value.

Securities

Can be classified as:

• Fixed income (T-bills, bonds)

• Equities (Stocks)

• Shares in pooled investment vehicles

Fixed income

• Refers to debt securities where the borrower is obligated to pay interest and principal at a pre-determined schedule.

• They might be collateralized, i.e., investors have claim of certain physical assets in case of a default.

Types of fixed income:

• Bonds: Long-term debts (>10 years).

• Notes: Intermediate-term debts (1 year < note < 10 years).

• Bank borrowings: Long-to-short-term involving revolving credit lines and other debt instruments.

• Convertibles: Debt can be exchanged for a specified number of equity shares within a company.

Equity

• Refers to ownership claims by investors in companies.

• Can be public & privately traded.

Equity types

• Common shareholders: They have a residual claim over any assets and income after all the senior securities have been paid.

• Preferred shareholders: They receive scheduled dividends before common shareholders. This is not contractual, btw, so it holds less precedence than a bondholder.

• Warrants (call option): They give the holder a right to buy the firm’s security at a price, called the exercise price, within a specified time period (similar to options).

  • The reason this type of option is called a warrant is that it’s issued by the company itself and not a third party.

Pooled investments

• Pooled investments include mutual funds, trusts, exchange-traded funds (ETFs) and hedge funds.

• They issue securities to represent the shared ownership in the assets.

• Money from several investors is pooled together to be managed by a professional money manager according to a specific investment strategy.

• The advantage of investing in pooled vehicles is to benefit from the investment management services of managers and from diversification opportunities.

• Pooled vehicles may be open-ended or closed-ended.

Mutual funds

• They can be open-ended (allow for new investments) or closed-ended (not allow for new investments)

• Open ended mutual funds cannot allow for intra-day trading, whilst closed-ended funds can.

• A mutual fund collects money from many investors and invests in stocks, bonds, or other assets according to a set strategy. Investors buy shares directly from the fund company or platform, not from other investors. The price for these shares is set once per day at the net asset value (NAV) after markets close (This is for open-ended funds).

• Mutual funds can be actively managed (a manager chooses the investments) or passively managed (tracking an index). Most require a minimum investment and may charge management fees and/or sales commissions.

Exchange Traded Funds (ETFs)

An ETF (Exchange-Traded Fund) is similar to a mutual fund: it pools investors' money to buy a basket of assets. The main difference is how you buy and sell ETFs. ETFs trade on stock exchanges throughout the day (open-ended), so their prices fluctuate like individual stocks. This means you can buy and sell at any time during trading hours, and potentially place limit orders or use other trading strategies.

ETFs also calculate their NAV daily after the market closes, just like mutual funds, but the trading price may be slightly above or below NAV depending on market demand. Most ETFs are passively managed and track an index, though some are actively managed. ETFs usually have lower fees, and you can buy as little as one share, depending on your broker.

ETFs vs Mutual Funds (open-ended)

Similarities:

• Both pool investor money to diversify across many assets.

• Both are managed professionally and can be passive or active.

• Both use NAV to value shares at the end of each day.

Differences:

• Trading: Mutual funds transact once daily at NAV; ETFs trade all day at market prices (which may differ from NAV).​

• How you buy: Mutual funds are bought directly from the fund company; ETFs are bought/sold on stock exchanges.

• Fees/Minimums: ETFs commonly have lower fees and no minimums; mutual funds may have higher fees and often require a minimum investment.​

• Tax efficiency: ETFs can be more tax-efficient due to their creation/redemption process (less likely to distribute capital gains).

Currencies

• These are monies issued by national monetary authorities.

• Reserve currencies such as dollar and euro are currencies that national central banks around the world hold in large quantities.

• Currencies trade in foreign exchange markets, spot markets, forward markets, or future markets.

Commodities

• These include metals, energy products, industrial metals, agricultural products and carbon credits.

• Traded on the spot, forward and future markets.

Real assets

• Real assets are tangible assets such as real estate, machinery and airplanes which are normally held by operating companies.

• Real assets are unique, illiquid (hard to sell) and costly to manage.

• They are attractive to investors for two reasons:

  • Low correlation with other investments.

  • Income and tax benefits to investors.

Real estate investment trusts (REITs) or Master limited partnerships (MLPs)

• Similar to pooled investments.

• You securitize real assets and facilitate indirect investment in real assets.

• Since these securities are more homogenous and divisible than the real assets they represent, they are often more liquid and more suitable as investments.

Contracts

• A contract is an agreement between traders to perform some action in the future that can either be settled physically or in cash.

  • Physically means, I get sold the actual commodity, which I can then sell for cash, or I can get cash directly.

• These contracts draw their value from the underlying assets.

  • E.g. Let's say one person is going long (buying) while another person is going short (selling) on the price of oil. We lock in the price at $80. This means that if I want to buy oil later and the prices increase, I can still purchase it at this lower price.

Types of Contracts:

Physical contract: If contracts are based on physical assets like crude oil, wheat, gold, or any other commodity, then it is a physical contract.

Financial contract: If contracts are based on financial assets, such as indexes, interest rates, and currencies, then they are called financial contracts.

Contracts for Difference (CFD)

• CFD allows for people to speculate the price of an underlying asset, the buy benefits if the price of the underlying asset increases.

• These are derivative contracts because their value is derived from the underlying asset.

• They are generally settled in cash,

Forward contracts

• A forward contract is an agreement to trade the underlying asset at a future date at a pre-specified price.

• It is not standardized and is not traded on exchanged or in dealer markets. Its also known as over the counter contract, suggesting the deal is done between traders over the counter, no third-part involved.

Future contracts

• A future contract, on the other hand, is a standardized forward contract for which amount, asset characteristics and delivery date are the same.

• Standardization ensures higher liquidity.

• You don’t directly trade with the other party, rather you deal with the exchange, so the long party does not know the short party and vice versa.

• You can easily exit this contract, in comparison to a forward contract, which will be less liquid and harder to get out of.

Swap contract

• A swap contract is an agreement to swap payments of one assets for the other.

• The different types are:

  • Interest rate swap: Floating rate payments are swapped for fixed-rate payments for a specified period.

  • Currency swap: Currency amount swapped for another currency for a specified period.

  • Equity swap: Returns earned on one investment are swapped for the other.

Option contracts

• Contracts that give the holder, a right, but not the obligation, to buy (call) / sell (put) an underlying security at a specified price at or before a specific date.

Call options

• Buyer gets the right, but not the obligation, to buy the underlying security.

• The seller of the call option gets the premium upfront, but has to sell the security if the buyer exercises his option to buy.

Put options

• Buyer gets the right, but not the obligation, to sell the underlying security.

• The seller of the put option gets the premium upfront but has to buy the security if the buyer exercises his option to sell.

Credit default swaps

• Contracts the offer insurance to bondholders.

• They make payments to a bondholder if a borrower defaults on its bonds.

• Example, you buy Bonds issued by Apple, you than go to AIG (insurance company) and say if you can buy insurance on those bonds, if Apple defaults, than it will become AIG’s obligation to pay out those bond payments.

Financial intermediaries

• Financial intermediaries help entities achieve their financial goals (e.g. banks)

• They provide products and services which help connect buyers to sellers.

Brokers (Financial intermediaries)

• They find counterparties for transactions )other entities willing to take the opposing side in a transaction) and do not indulge in trade with their clients directly.

Block brokers (Financial intermediaries)

• Provides similar services as a broker, except that their clients have large trade orders that might potentially impact the security prices if the trade is executed without proper care.

Investment banks (NOT COMMERCIAL BANK) (Financial intermediaries)

• They provide advice for corporate actions like mergers and acquisition and help firms raise capital by issuing securities such as common stock, bonds, preferred shares, etc.

Exchanges (Financial intermediaries)

• They provide places where traders can meet.

• They regulate traders’ actions to ensure the smooth execution of the trades.

Alternative trading systems (ATS) (Financial intermediaries)

• They serve the same trading function as exchanges but have no regulatory oversight.

• ATS where client orders are not revealed are also known as dark pools.

Dealers (Financial intermediaries)

• They trade directly with their clients by taking the opposite side of their trades.

• They provide liquidity by buying or selling from their own inventory and earning profits on the spread between the transactions.

Arbitrageurs

• Arbitrageurs trade when they can identify opportunities to buy and sell identical or essentially similar instruments at different prices in different markets.

Securitizer

• Securitization is the process of buying assets, placing them in a pool, and then selling assets that represent ownership of the pool.

• One common example is that of mortgage-backed securities or mortgage-passthrough securities

• E.g. A bank gives out a mortgage loan to people for their houses, now as these loans tend to be long-term (25+ years), the bank does not want to wait around and receive its money, because it wants to give other loans as well. So, instead, it make an SPE (special purpose entity), under which it offers these mortgages as the securitize, which people can than purchase ownership in these assets (the mortgage). So, once this process is done, the people paying the mortgages are no longer paying it to the bank, but rather the SPE, which than distributors that as coupon payments (interest payments) to the different asset owners.

Depository Institutions

These include commercial banks, savings and loan banks, credit unions, and similar institutions that raise funds from depositors and other investors and lend them to borrowers.

• The depositors, in return, get interest paid to them. Of course, the interest a bank receives from the borrower is more than the amount they give to depositors; this is one way they can make money.

Insurance companies

• Insurance companies help people and companies offset risks by issuing insurance contract.

• The contracts make me a payment to the party that buys the contracts in case an event occurs.

• Examples of insurance contracts include life, auto, home, fire, medical, theft and disaster.

Clearinghouse

• A clearinghouse helps client settle their trades. So, in a futures market, they guarantee contract performance (that party’s obligation and don’t run away) and, hence, eliminate counterparty risk.

• They do this by requiring participants to post an initial margin and maintain the margin (margin meaning a deposit), and the clearinghouse ensures there are no defaults.

  • Initial margin is the initial deposit, let’s say $10 from each party (short and long). Let’s say the price of the commodity at the beginning was $45 and now it $50, meaning the margin for the short position went from $10 - $5 = $5, while the long position went up $5. If this margin falls below the maintenance margin, the clearinghouse will give a margin call to the short party to deposit more funds, or else they will close the contract.

• This amount is then stored with an escrow agent (a third party), and they will then transfer the money to whichever side (long or short).

Depositories/Custodians

These entities hold securities for their clients so that investors are insulated from loss of securities through fraud or natural disasters.

What is short selling?

• We know what’s going long, which is when you agree upon a contract to buy an asset at a specific price and when the actual price goes up, you can buy a the lower, agreed upon price and sell at higher price.

• Short selling is, for example, I own an asset worth $50, and I let someone borrow it, and that person decides to sell the asset for $50, but than hopes the value drops, so that they can rebuy at a lower price, lets say $25 and than give it back to me, pocketing the $25 as profit.

Long positions

These are created when a trader owns an asset or has a right or obligation under a contract to purchase an asset.

• Investors who are long benefit from an increase in the price of the security.

• A long position can be levered or unlevered.

Short positions

• These are created when traders borrow an asset and sell it, with the obligation to replace the asset in the future.

  • They don’t just borrow for free, but rather have to pay a certain amount to borrow, and also, when you sell the asset, that total amount will go to the owner as collateral, just in case the price of the asset goes up instead.

• Investors who are short benefit from a decrease in the price of the security.

Short call Bounded vs Unbounded

• Example, lets say you borrow an asset worth $50 and decide to short it, because you think the price of the asset will drop. Lets say it dropped to $40, and now you have made $10.

• However, the stock could have dropped to $0, where you could have made $50 profit, the potential gain is bounded.

• But, imagine the stock went up to $1000, or even more, the potential loss is unbounded.

Leverage ratio

• In some markets, traders are allowed to buy securities by borrowing some percentage of the purchase price.

• The leverage ratio is a measure of the amount borrowed relative to the total value of the asset.

• It shows how many times larger a position is than the equity that supports its.

Leverage ratio = Value of position / Value of equity investments in it

Margin Call price (long position)

• As discussed before, the minimum amount of equity to be maintained in the positions is called the maintenance margin requirement.

• Traders receive a margin call when equity falls below the maintenance margin requirement.

Margin Call price = P x ((1 - Initial Margin) / (1 - Maintenance Margin))

• This is from the long position perspective, not short.

• For short position, flip what’s in the (), so on numerator becomes (1 - MM) and the denominator becomes (1 - IM)

Margin Call Price (Short position)

Margin Call price = P x ((1 - Maintenance Margin) / (1 - Initial Margin))