2nd part of HOLY BFI

are the places where financial instruments are bought and sold.

Financial markets

The Role of Financial Markets Market

LIQUIDITY
INFORMATION
RISK SHARING

Ensure that owners of financial instruments can buy and sell them cheaply and easily.

LIQUIDITY

Pool and communicate information about the issuer of a financial instrument.

INFORMATION

Provide individuals with a place to buy and sell risks, sharing them with others.

RISK SHARING

3 WAYS TO CATEGORIZE FINANCIAL MARKETS

PRIMARY VERSUS SECONDARY MARKETS
CENTRALIZED EXCHANGES vs. OVER-THE- COUNTER MARKETS
DEBT AND EQUITY VS. DERIVATIVES MARKETS

where newly issued securities are sold.

Primary markets

where existing securities are traded.

Secondary markets

Secondary markets where dealers meet in a central, physical location.

Centralized exchanges

Decentralized secondary markets where dealers stand ready to buy and sell securities electronically

Over-the-counter markets

An electronic system that brings buyers and sellers together for electronic execution of trades without the use of a broker or dealer.

Electronic communication networks (ECNS)

where financial claims are bought and sold for immediate cash payment.

Debt and equity markets

where claims based on an underlying asset are traded for payment at a later date

Derivatives markets

is a key process performed by investment banks during the issuance of new securities.

UNDERWRITING

is a financial institution that assists companies in raising capital by issuing securities.

INVESTMENT BANK

A market where derivatives, financial instruments whose value is derived from an underlying asset, are traded.

DERIVATIVE MARKET

CHARACTERISTICS OF A WELL-RUN FIN. MARKET Well-Run Financial Market A well-run financial market should be:

• Must be designed to keep transaction costs low.

• The information the market pools and communicates must be both accurate and widely available.

• Investors need protection.

it is the expenses incurred when buying or selling goods and services.

Transaction cost

is a PSE regulation which ensures that stockbrokers have enough capital to cover its exposure to risks decline.

Risk Based Capital Adequacy

acts as the independent audit, surveillance, and compliance arm of the Exchange.

Capital Market Integrity Corporation CMIC

USES OF FINANCIAL INSTRUMENTS

• Acts as a means of payment

• Stores of value

• Transfer Risk

sometimes called Primitive Securities, are used by savers/lenders to transfer resources directly to investors/borrowers.

UNDERLYING INSTRUMENT

Their value and payoffs are “derived” from the behavior of the underlying instruments. Primarily used to shift risk among investors.

DERIVATIVE INSTRUMENT

What Makes a Financial Instrument Valuable?

Size
Timing
Likelihood
Circumstances

Payments that are larger are more valuable.

Size

Payments that are made sooner are more valuable.

Timing

Payments that are more likely to be made are more valuable.

Likelihood

Payments that are made when we need them most are more valuable.

Circumstances

A borrower obtains resources from a lender immediately in ex-change for a promised set of payments in the future. The borrower, who can be either an individual or a firm, needs funds to make an investment or purchase, while the lender is looking for a way to store value into the future.

BANK LOANS

are a form of loan. In exchange for obtaining funds today, a corporation or government promises to make payments in the future.

BONDS

are shares in the returns or payments arising from specific assets, such as home mortgages, student loans, credit card debt, or even movie box-office receipts.

Asset-backed securities

Financial instruments used to transfer risk

Insurance contracts
Future contracts
Option
swap

is a measure of uncertainty about the future payoff to an investment, assessed over sometime horizon and relative to a benchmark.

Risk

is defined as the average of the squared deviations of the possible outcomes from their expected value, weighted by their probabilities.

Variance

is the (positive) square root of the variance,

Standard deviation

is the worst possible loss over a specific time horizon, at a given probability.

Value at Risk

A risky investment, then, must have an expected return that is higher than the return on a _______.

risk-free asset.

In general, the riskier an investment, the higher the __________ (the higher the compensation investors require for holding it)

risk premium

those affecting a small number of people but no one else.

Idiosyncratic risks or unique risks

those affecting everyone.

Systematic risks or economy wide risks

Types of diversification

Hedging
Spreading risk
Geographic and time horizon diversification

is the strategy of reducing idiosyncratic risk by making two investments with opposing risks. When one does poorly, the other does well, and vice versa. So while the payoff from each investment is volatile, together their payoffs are stable.

Hedging

all you need to do is find investments whose payoffs are unrelated.

Spreading the risk