Financial Markets Chapter 1 - Role of Financial Markets and Institutions

Flashcards covering key concepts, terms, and formulas from the lecture notes on financial markets and institutions.

What is a Financial Market (FM)?

A market where financial assets such as stocks and bonds are bought and sold; funds are transferred when assets are traded, enabling financing and investing by households, firms, and government agencies.

Who are Surplus Units in financial markets?

Investors who receive more money than they spend and provide net savings to the financial markets.

Who are Deficit Units in financial markets?

Borrowers who spend more money than they receive and access funds from financial markets.

What are Debt Securities?

Securities that represent a claim on the issuer; issuers pay interest periodically and repay the principal at maturity.

What are Equity Securities?

Securities that represent ownership in the issuer; no maturity and may pay dividends; used to raise funds.

Money Markets vs Capital Markets

Money markets facilitate short-term funds (1 year or less) with low risk/return; Capital markets facilitate long-term funds (more than 1 year) with higher risk and return.

Primary Markets

Markets that facilitate the issuance of new securities to raise funds for the initial issuer.

Secondary Markets

Markets that facilitate the trading of existing securities among investors.

Liquidity in financial markets

The degree to which securities can be sold quickly without a loss of value.

How do financial markets facilitate corporate finance?

FM act as intermediaries, channeling funds from investors to corporations and maintaining an orderly market.

What are Derivative Securities?

Financial contracts whose values are derived from the values of underlying assets.

Speculation (derivatives)

Using derivatives to make gains from anticipated movements in the price of the underlying assets without owning them.

Risk Management (derivatives)

Using derivatives to hedge or mitigate risk from movements in the value of underlying assets.

Market Efficiency

A theory that asset prices reflect all available information, making it hard to consistently beat the market.

Behavioral Finance

Application of psychology to financial decision-making to explain why markets are not always perfectly efficient.

Disclosures in financial regulation

The process of making relevant financial and operational information public to ensure transparency.

Regulatory Response to Financial Scandals

Creating new laws, regulations, and oversight to prevent abuses and restore investor confidence.

International Corporate Governance

Rules and practices guiding how a global company is run, ensuring fair and responsible leadership across borders.

Global Integration

How connected different countries' financial markets are; high integration means cross-border events affect multiple markets.

Foreign Exchange Market

Global market where currencies are traded to enable international business and payment in different currencies.

Depository Institutions

Accept deposits from surplus units and provide credit to deficit units via loans and securities.

Commercial Banks

Large institutions that accept deposits and provide loans and financial services.

Savings Institutions

Focus on savings deposits and primarily provide home mortgage loans.

Credit Unions

Nonprofit, member-owned institutions offering lower loan rates and higher savings rates.

Nondepository Financial Institutions

Institutions that generate funds from sources other than deposits and intermediate them in other ways.

Finance Companies

Provide loans to individuals and businesses but do not take deposits.

Mutual Funds

Pools money from many investors to buy a diversified portfolio of securities.

Securities Firms

Assist people and firms in buying, selling, and trading securities.

Insurance Companies

Collect premiums and provide financial protection against risks like accidents or death.

Pension Funds

Invest retirement savings to provide income after workers retire.

Money Market Securities

Debt securities with maturities of one year or less, issued in the money market to provide liquidity.

Treasury Bills (T-Bills)

Short-term government debt securities sold at a discount and repaid at par; highly liquid; common maturities include 4, 13, and 26 weeks.

Par Value

The amount paid back at maturity; also known as the face value of a security.

TB Yield Formula

TB yield = ((Selling price − Purchase price) / Purchase price) × (365 / n).

TB Discount Formula

TB Discount = ((Par value − Purchase price) / Par value) × (360 / n).

Present Value (PV) formula

PV = FV / (1 + k)^n (PV is today’s price, FV is maturity value, k is discount rate, n is periods).

Negotiable Certificates of Deposit (NCDs)

Large, short-term savings deposits issued by banks; 2 weeks to 1 year; moderate secondary market activity.

NCD Yields Formula

NCD yield = ((Selling price − Purchase price + Interest) / Purchase price) × (360 / n).

Commercial Paper

Unsecured short-term IOUs issued by large, creditworthy firms to raise quick cash; 1 day to 270 days; low secondary market activity.

CP Yield Formula

CP yield = ((Selling price − Purchase price) / Purchase price) × (360 / n).

Banker’s Acceptances

Bank’s promise to pay a set amount in the future; used in international trade; 30 to 270 days; high secondary market activity.

Repurchase Agreements (Repos)

Short-term borrowing where securities are sold with an agreement to buy them back at a higher price; 1 to 15 days.

Repo Rate Formula

Repo rate = ((Selling price − Purchase price) / Purchase price) × (360 / n).

Federal Funds

Very short-term loans between banks and other depository institutions to meet reserve requirements; 1 to 7 days; no secondary market activity.

What is the primary role of Secondary Markets?

To provide liquidity for existing securities, allowing investors to sell their holdings and convert them into cash, which generally encourages investment in the primary market.

Why is high liquidity crucial in financial markets?

It enables investors to buy or sell securities quickly without significantly affecting their price, thereby reducing investment risk and enhancing market efficiency.

What are the common characteristics of Money Market Securities?

They are typically short-term, low-risk, highly liquid debt instruments used by governments and corporations to meet immediate funding needs.

What is a Financial Market (FM)?

A market where financial assets such as stocks and bonds are bought and sold; funds are transferred when assets are traded, enabling financing and investing by households, firms, and government agencies.

Who are Surplus Units in financial markets?

Investors who receive more money than they spend and provide net savings to the financial markets.

Who are Deficit Units in financial markets?

Borrowers who spend more money than they receive and access funds from financial markets.

What are Debt Securities?

Securities that represent a claim on the issuer; issuers pay interest periodically and repay the principal at maturity.

What are Equity Securities?

Securities that represent ownership in the issuer; no maturity and may pay dividends; used to raise funds.

Money Markets vs Capital Markets

Money markets facilitate short-term funds (1 year or less) with low risk/return; Capital markets facilitate long-term funds (more than 1 year) with higher risk and return.

Primary Markets

Markets that facilitate the issuance of new securities to raise funds for the initial issuer.

Secondary Markets

Markets that facilitate the trading of existing securities among investors.

Liquidity in financial markets

The degree to which securities can be sold quickly without a loss of value.

How do financial markets facilitate corporate finance?

FM act as intermediaries, channeling funds from investors to corporations and maintaining an orderly market.

What are Derivative Securities?

Financial contracts whose values are derived from the values of underlying assets.

Speculation (derivatives)

Using derivatives to make gains from anticipated movements in the price of the underlying assets without owning them.

Risk Management (derivatives)

Using derivatives to hedge or mitigate risk from movements in the value of underlying assets.

Market Efficiency

A theory that asset prices reflect all available information, making it hard to consistently beat the market.

Behavioral Finance

Application of psychology to financial decision-making to explain why markets are not always perfectly efficient.

Disclosures in financial regulation

The process of making relevant financial and operational information public to ensure transparency.

Regulatory Response to Financial Scandals

Creating new laws, regulations, and oversight to prevent abuses and restore investor confidence.

International Corporate Governance

Rules and practices guiding how a global company is run, ensuring fair and responsible leadership across borders.

Global Integration

How connected different countries' financial markets are; high integration means cross-border events affect multiple markets.

Foreign Exchange Market

Global market where currencies are traded to enable international business and payment in different currencies.

Depository Institutions

Accept deposits from surplus units and provide credit to deficit units via loans and securities.

Commercial Banks

Large institutions that accept deposits and provide loans and financial services.

Savings Institutions

Focus on savings deposits and primarily provide home mortgage loans.

Credit Unions

Nonprofit, member-owned institutions offering lower loan rates and higher savings rates.

Nondepository Financial Institutions

Institutions that generate funds from sources other than deposits and intermediate them in other ways.

Finance Companies

Provide loans to individuals and businesses but do not take deposits.

Mutual Funds

Pools money from many investors to buy a diversified portfolio of securities.

Securities Firms

Assist people and firms in buying, selling, and trading securities.

Insurance Companies

Collect premiums and provide financial protection against risks like accidents or death.

Pension Funds

Invest retirement savings to provide income after workers retire.

Money Market Securities

Debt securities with maturities of one year or less, issued in the money market to provide liquidity.

Treasury Bills (T-Bills)

Short-term government debt securities sold at a discount and repaid at par; highly liquid; common maturities include 4, 13, and 26 weeks.

Par Value

The amount paid back at maturity; also known as the face value of a security.

TB Yield Formula

TB yield = ((Selling price − Purchase price) / Purchase price) × (365 / n).

TB Discount Formula

TB Discount = ((Par value − Purchase price) / Par value) × (360 / n).

Present Value (PV) formula

PV = FV / (1 + k)^n (PV is today’s price, FV is maturity value, k is discount rate, n is periods).

Negotiable Certificates of Deposit (NCDs)

Large, short-term savings deposits issued by banks; 2 weeks to 1 year; moderate secondary market activity.

NCD Yields Formula

NCD yield = ((Selling price − Purchase price + Interest) / Purchase price) × (360 / n).

Commercial Paper

Unsecured short-term IOUs issued by large, creditworthy firms to raise quick cash; 1 day to 270 days; low secondary market activity.

CP Yield Formula

CP yield = ((Selling price − Purchase price) / Purchase price) × (360 / n).

Banker’s Acceptances

Bank’s promise to pay a set amount in the future; used in international trade; 30 to 270 days; high secondary market activity.

Repurchase Agreements (Repos)

Short-term borrowing where securities are sold with an agreement to buy them back at a higher price; 1 to 15 days.

Repo Rate Formula

Repo rate = ((Selling price − Purchase price) / Purchase price) × (360 / n).

Federal Funds

Very short-term loans between banks and other depository institutions to meet reserve requirements; 1 to 7 days; no secondary market activity.

What is the primary role of Secondary Markets?

To provide liquidity for existing securities, allowing investors to sell their holdings and convert them into cash, which generally encourages investment in the primary market.

Why is high liquidity crucial in financial markets?

It enables investors to buy or sell securities quickly without significantly affecting their price, thereby reducing investment risk and enhancing market efficiency.

What are the common characteristics of Money Market Securities?

They are typically short-term, low-risk, highly liquid debt instruments used by governments and corporations to meet immediate funding needs.

What is the primary method for Surplus Units to provide funds to financial markets?

They provide net savings to the financial markets.

How do Deficit Units access funds from financial markets?

They access funds from financial markets as borrowers.

What is the typical maturity of funds facilitated by Capital Markets, and what are their associated

Capital markets facilitate long-term funds (more than 1 year) with higher risk and return.