Financial Markets & Instruments || ✨Theory✨

Five core principles of money & banking

1. Time has value

2. Risk requires compensation

3. Information is the basis for decisions

4. Markets determine prices & allocation resources

5. Stability improves welfare

Participants of financial markets

Firms & individuals

Importance of financial markets

Financial markets are essencial to the economy, chanelling resources, minimizing cost of gathering information & making transactions.

Evolution of money

Money has evolved from coins and paper to electronic funds.

Functions of the financial system

1. saving money for the future

2. borrowing money for current use

3. rasing equity capital

4. exchanging assets for immediate & future deliveries

5. trading of information

Types of finance

direct & indirect

Direct finance

Borrowers sell securities directly to lenders

Indirect finance

An institution stands between the lender & borrower

Assets

something of value that you own

Liabilities

something you owe

Financial instruments

A legal obligation of one party to transfer something of value to another party at some future date under certain condiditons.

Uses of financial instruments

means of payment, store of value, transfer of risk

Characteristics of financial instruments

Standarization, communicate of information

Role of financial institutions

reduction of transaction & information costs, issuing of short-term liabilities & purchase of long-term loans

Financial industry structure

Depository institutions, insurance companies, pension funds, security firms, finance companies, goverment sponsored enterprises

Depository institutions

take deposit and make loans

Insurance companies

accept premiums, pay out based on events

Pension funds

invest contributions, provide payments to retirees

Security firms

provide access to financial markets

Finance companies

raise funds in financial markets, make loans

Government sponsored enterprises

raise funds in financial markets, make loans, provide guarantees

Primary capital markets

markets in which companies & governments raise capital

Most actively traded assets

securities, currencies, contracts, commodities

Securities

generally include debt instruments, equities & shares in pooled investment vehicles

Currencies

money issued by national monetary authorities

Contracts

agreements to exchange securities, currencies, commodities or other contracts in the future

Commodities

include precious metals, energy products, industrial metals & agricultural products

Real assets

tangible properties such as real estate, airplanes or machinery

Futures markets

markets that trade contracts that call for delivery in the future

Spot markets

markets that trade for immediate delivery

Options markets

trade contracts that deliver in the future, but delivery takes place only if the holders of the options choose to excercise them

Primary market

when issuers sell securities to investors

Secondary market

when investors sell securities to others

Money makrets

trade debt instruments maturing in one year or less

Capital markets

trade instruments of duration longer than a year

Traditional investments

include all publicly traded debts, equities and sheres in pooled investment vehicles

Alternative investments

include hedge funds, private equities, commodities, real estate securities & properties, securitized debts, operating leases, machinery, collectibles, precious gems

Securities

Organizations, companies & goverments sell them to raise money, include bonds, notes, commercial paper, mortgages, common stocks, preffered stocks

Fixed-income instruments

contractually include predetermined payment schedules

Equities

represent ownership rights in companies, include common and preffered shares

Common shareholders

own residual rights to the assets of the company

Prefered shares

equities that have preffered rights to the cash flows & assets of the company

Warrants

securities issued by a corporation that allow the holders to buy a security issued by that corporation

Pooled investment vehicles

mutual funds, trusts, depositories & hedge funds that issue securities that represent shared ownership in the assets that these entries hold

Mutual funds

Investment vehicles tht pool money from many investors for investment in a portfolio of securities

Open-end pooled investment vehicles

issue new shares & redeem existing shares on demand, usually on a daily basis

Closed-end pooled investment vehicles

issue shares in primary market offerings that the fund or its investment banks arrange, investor cannot sell their shares back to the fund

currencies

money issued by monetary authorities

contract

an agreement among traders to do something in the future

forward contract

an agreement to trade the underlying asset in the future at the price agreed upon today

swap contract

an agreement to exchange payments of periodic cash flows that depend on future asset prices or interest rates

commodity swap

one party typically makes fixed payments in exchange for payments that depend on future prices of a commodity such as oil

currency swap

the parties exchange payments denominated in different currencies

equity swap

the parties exchange fixed cash payments for payments that depend on the returns to a stock or stock index

credit deafult swap

insurance contract that promise payment of principal in the event that a company deafults on its bonds

option contract

allows the holder an option to buy or sell an underlying instrument at a specified price at or before the specified date in the future

call option

gives the buyer the option to buy shares at the strike price

put option

givesr the buyer the option to sell shares at the strike price

contract for difference

allow people to speculate on price changes for an underlying asset, such as a common stock or an index

commodities

include products such as precious metals, energy products, industrial metals, agricultural products, carbon credits

real assets

include tangible products such as real estate, airplanes, machinery, lumber stands

financial intermediaries

services and products that allow their clients to solve financial problems more efficiently that they would by themselves

investment banks

provide advice to their mostly corporate clients and help them arrange transactions such as initial and seasoned securities offerings

note

a legal document that serves as an IOU from a borrower to a creditor or to an investor

treasury note

a debt security backed by the full faith and credit of the United States government with a maturity between one and 10 years

municipal note

a short-term debt security issued by a local or state government, has a maturity from three months to three years

mortgage-backed note

a derivative whose value is derived from unpaid mortgages

structured note

a debt security issued by financial institutions, which return is based on equity indexes, a single equity, a basket of equities, interest rates, commodities or foreign currencies

brokers

agents who fill orders for their clients

exchanges

provide places where traders can meet to arrange their trades

alternative trading systems

also known as electronic communications networks or multilateral trading facilities are trading venues that function like exchanges but that do not excercise regulatory authority over their subscribers

dealers

fill their clients’ orders by trading with them

securitization

the process of buying assets, placing them in a pool, and then selling securities that represent ownership

depository institutions

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

insurance companies

companies that help people and companies offset risks that concern them

insurance contract

transfers risk from those who buy the contract to those who sell them

credit deafult swap

is also an insurance contract, but historically they have not been subject to the same reserve requirements that most governments apply to more traditional insurance contracts

arbitrageurs

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

clearinghouses

arrange or final settelment for trades, guarantee futures contract performance and in other markets may act only as escrow agents

long position

people have that position when they own assets or contracts

short position

people have that position when they have sold assets that they do not own or when they write and sell contracts

levraged position

in many markets traders can buy securities by borrowing some of the purchase price

the leverage ratio

the ratio of the value of the position to the value of the equity investment in it

order

consists of instructions to a broker or brokerage firm to purchase or sell a security on an investor's behalf

well-functioning financial system

a system in which investors xan easily move money from the prestent to the future at a fair rate of return, borrowers can obtain funds that they need, hedgers can trade away or offset the risk that concerns them and traders can easily trade currencies for other currencies or commodities that they need

index

represents a given security market, market segment or asset class, often constructed as portfolios of marketable securities

price return index

reflects only the prices of the constituent securities within the index

total return index

reflects not only the prices of the constituent securities but also the reinvestment of all income received since inception

index weighting

the weighting decision determines how much of each security to include in the index and has a substantial impact on an index’s value

price weighting

the simplest method to weight an index, the weight on each constituent security is determined by dividing its price by the sum of all the prices of the constituent securities

equal weighting

assigns an equal weight to each constituent security at inception

market-capitalization weighting

the weight on each constituent security is determined by dividing its market capitalization by the total market capitalization of all the securities in the index

fundemental weighting

weighting attempts to address the disadvantages of market-capitalization weighting by using measures of a company’s size that are independent of its security price to determine the weight on each constituent security

rebalancing

refers to adjusting the weights of the constituent securities in the index

reconstitution

is the process of changing the constituent securities in an index, it is similar to a portfolio manager deciding to change the securities in his or her portfolio