EFB201 W1 NOTES

Financial Markets Study Notes

Introduction

  • Overview of financial markets including key concepts and structures.

Outline

  • Discussion on financial market organization and structure from a demand-supply perspective.

  • Main purposes of participation in financial markets.

  • Classification of financial markets.

  • Basic properties of trades in financial markets.

  • Efficiency of financial markets.

  • Reference: Chapters 1-2, Financial Markets, Institutions and Money (4th Ed) by Kidwell et al., Wiley, 2019; CFA Curriculum, 2020 Level I, Reading 36.

Main Purposes in Participating in Financial Markets

  1. Raise (Save) Money for Current Use (Future Needs)

    • Individuals and institutions seek to acquire funds to meet immediate and long-term financial needs.

    • Deficit Spending Units (DSU) include:

      • Households

      • Businesses

      • Governments

    • Surplus Spending Units (SSU) also include:

      • Households

      • Businesses

      • Governments

  2. Make a Profit by Trading on Information

    • Profit opportunities arise when traders exploit information about future price movements of assets.

    • Example:

      • Short selling an asset (selling borrowed securities) expecting its value to fall and repurchasing it at a lower price for profit.

      • Buying shares when expecting their value to rise and selling them later.

    • Short Selling Definition: The process wherein an investor borrows a security to sell it, anticipating a price drop, allowing the investor to repurchase it at a lower price and return the borrowed security.

  3. Manage Risks

    • Involves balancing risk and acceptance of potential losses.

    • Example: Reducing exposure to asset price changes or financial risks by using hedging strategies.

  4. Exchange Assets for Immediate and Future Deliveries

    • Financial markets facilitate the exchange of currencies or other assets, enabling transactions across different time frames.

    • Example: Currency exchange transactions (e.g., US dollar for Euro).

  5. Facilitation of Purposes via Financial Intermediaries

    • Entities that help facilitate the above functions:

      • Brokers, dealers, banks, rating agencies, analysts.

Real-World Example: GameStop Short Squeeze

Context

  • GameStop Corp., a chain of video game stores, struggled due to increased competition and the COVID-19 pandemic, resulting in a high number of shorted stocks by institutional investors.

  • In January 2021, retail investors banded together to counter institutional short sellers, leading to a significant price surge (termed a short squeeze).

Short-Squeeze Dynamics

  • Price Movement Over Time: Illustrates the timing of the price movement for GameStop's stock during the short squeeze (denoted by graphs showing stock price fluctuations).

  • Motivation Analysis: In the scenario of the GameStop short squeeze, participants may have:

    1. Raised/saved money for future use.

    2. Managed risks involved in stock investments.

    3. Engaged in asset exchange for present and future transactions.

    4. Tactically manipulated market information to profit from trades.

    5. Utilized financial intermediaries to expedite transactions.

Classification of Financial Markets

  1. By Financial Instrument (Product/Claim):

    • Fixed Income Market: Includes retail private debt (credit cards, car loans, mortgages), corporate bonds, government bonds, etc.

    • Equity Market: Encompasses private equity shares, common/preferred shares, and structured finance products.

    • Foreign Exchange Market: Involves trading of currency pairs.

    • Derivatives Market: Includes options, swaps, forwards, and futures contracts.

  2. By Time of Entry:

    • Primary Market: For initial issuance of instruments. Example: issuance of stocks or bonds.

    • Secondary Market: For trading previously issued instruments, enabling liquidity and the ability to buy/sell financial claims (e.g. stocks listed on the exchanges).

  3. By Instrument Maturity:

    • Money Market: Instruments that mature in less than a year (e.g., treasury bills, commercial paper).

    • Capital Market: Generally involves instruments with a maturity of more than one year (e.g., stocks, long-term bonds).

  4. By Organization of Trade:

    • Order-Driven Markets: Where trades are arranged through exchanges based on a ranking of orders (price/time)

    • Quote-Driven Markets (Dealer Market): Where transactions occur at prices quoted by traders/dealers, including both listed and unlisted instruments.

Basic Properties of Trades in Financial Markets

  1. Position:

    • Long Position: Buying an asset with the intention of selling at a higher price later.

    • Short Position: Selling an asset with the intention of repurchasing it later at a lower price.

    • Leveraged Position: Involves borrowing money to amplify potential returns; margin indicates the portion of equity used in a trade.

  2. Execution Mechanism:

    • Order Types: Defined instructions for trades indicating what, how much, and when to trade.

    • Includes: bid price, offer price (ask), and the bid-ask spread.

    • Orders can specify fill conditions (e.g., all or nothing; good till canceled).

Trading Examples

  1. Long Position Scenarios:

    • Scenario A: Investor Sam buys GameStop shares with projected high returns.

    • Scenario B: Sam experiences major stock price fluctuations and adjusts his positions accordingly.

  2. Leveraged Long Position Scenarios:

    • Sam utilizes margin to amplify potential earnings during a price surge, calculating gross gains and losses based on stock performance.

    • Metric calculations involve equity, total asset market value, and management of margin calls based on market conditions.

Efficiency of Financial Markets

  • A well-functioning market enables easy transactions for surplus units, providing a fair return on investments while allowing deficit units to access necessary funds, enabling hedgers to manage risks efficiently.

  • Discussion on the efficiency of financial markets post-GameStop short squeeze raises ethical and operational considerations surrounding market operations and the role of institutional vs. retail investors.

Conclusion

Overall, understanding the intricacies of financial markets requires an in-depth look into sources of capital, trading strategies, market classifications, and their practical implications informed by real-world case studies like GameStop. This foundational knowledge is crucial for both aspiring finance professionals and informed investors.