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58 Cards in this Set
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What is a financial system? |
A set of institutions that allow the exchange of funds between lenders, investors and borrowers. Financial analysts understanding leads to trading decisions |
Things like banks and insurance companies or JSE |
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Main functions of the financial system |
1. Saving money for future use. Create investment vehicles like bank deposits without transaction costs. 2. Borrow money for current use. Via collection, analysis and dissemination of credit info. 3. Raise equity capital. Issue and value securities. 4. Manage risks. By trading contracts that serve as hedges for the risks. 5. Exchange assets for immediate and future deliveries. Arrange and settle trades without transaction costs. 6. Trade on information. Allow active managers to trade without transaction costs. |
Save Borrow Raise Manage Exchange Trade |
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What is an equilibrium interest rate? |
The rate where the supply of funds saved and the aggregate demand for funds through borrowing and equity issuing will be made equal. Expected rate of return for savers= the cost of borrowing or giving up equity ownership. |
Borrowers and savers |
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How are rates of return determined? |
With the equilibrium interest rate. Also, government do borrow as well as issue instruments (BA, CD, issue bonds) so that leads to the return to be known a risk free rate of return. |
Government borrowings |
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Capital allocation efficiency part 1 |
*When an economy's financial system allocate scarce capital to the best projects to productive uses *Raise capital by borrowing funds or issuing equity securities (companies) *Raise capital by borrowing or issuing bonds *Savers determine which projects to invest in (direct/indirectly) |
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Capital allocation efficiency part 2 |
*Direct allocation: choose which security to invest in *Indirect allocation: give funds to financial intermediary who invest as to minimize savers' risk of loss *Make well informed decisions *Allow savers to choose projects in which the value expected > cost of the project |
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How are markets classified (4) |
1. SPOT MARKETS (traded for immediate delivery) in: •forward and futures market • Options markets (delivery is contingent on the option exercised) 2. PRIMARY MARKET (issuers sell securities to investors) and SECONDARY MARKET (investors sell securities to other investors) 3. MONEY MARKET (trade debt instruments maturing in 1 year or less) CAPITAL MARKET (trade instruments of long duration like bonds/equities) 4. TRADITIONAL INVESTMENT MARKETS (all publicly traded debt/equities & shared in pooled investment vehicles) ALTERNATIVE INVESTMENT MARKET (include hedge funds, private equities, commodity, real estate securities/property, securitized debts, operating lease, machinery, collectibles and precious gems) |
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How are assets classified? |
1. SECURITIES: represent ownership (stocks)/a debt agreement (bonds). Include equity, fixed income & pooled investments. Either public or private. 2. CURRENCIES: money issued by national monetary authorities. Currently 175 currencies: • RESERVE CURRENCY: held by many governments. Tends to be a international pricing currency • PRIMARY RESERVE CURRENCIES: $ and € (euro) • SECONDARY RESERVE CURRENCIES: £(pounds), ¥, Swiss franc. 3. CONTRACTS: an agreement. Depends on value of underlying assets. 4. COMMODITIES: includes precious/industrial metals, energy/agricultural products, and carbon credits 5. REAL ASSETS: tangible properties like real estate, airplane, machinery, or lumber stands |
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How are securities classified? |
1. FIXED INCOME: promises to repay borrowed money. Generate income regularly. Value from promised cash flow. Made by people, companies and government to repay loans 2. EQUITIES: residual ownership in companies after all other claims have been satisfied. CC: preferred equities. 3. POOLED INVESTMENTS: ownership of an undivided interest in an investment portfolio. Includes securities, currencies, contracts, commodities or real assets. 4. PUBLIC SECURITIES: registered to trade in public markets on exchanges/through dealers. 5. PRIVATE SECURITIES: all other securities. Like venture capital. |
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Pooled investments vehicles? |
*Are mutual funds (shares), trusts (units), depositories (depository receipts) and hedge funds (limited partnership interests) *Issue securities that represent ownership in the assets. *To benefit from investment management services and diversification opportunities. |
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Open-ended mutual funds? (Definition) |
*Issue new shares and redeem/sell existed shares on demand based on NAV of fund portfolio *Don't trade on exchanges. *Sold/issued to investors directly on a continuous basis *Number of shares varies throughout its existence, depending on shares bought by investors |
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Disadvantage of open-end funds |
*They need cash to redeem their shares for investors who want to move out to either: •have a lot of cash on hand (earns the current prevailing interest rate) •to sell securities to raise cash (possibly generating Capital gains taxes for the remaining investors of the fund) |
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Close-end mutual funds (defined)? |
*Issue funds in primary markets offering (IPO) at premium to the NAV *Only allowed to be sold in secondary market to other investors at a discount to the NAV *Discount reflects the expenses of running the fund *Prices sold in secondary markets are below the NAV hence a discount is given on the stock exchange. |
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Other examples of pooled investments |
EFTs/exchange listed portfolios/exchange index securities/exchange shares/listed index securities: Based on a portfolio of securities representing a category/index and are traded like stocks on organized stock exchanges. |
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Hedge funds? (Definition) |
* Investment funds generally organized as limited partnerships *Investors are limited partners but hedge fund managers are general partners *Involve wealthy and well-informed individuals who are ready to accept substantial losses *Use diverse strategies to minimize market exposures and maximize gains *Use high leverage, long-short strategies to make positive net returns *MAIN PURPOSE: to earn substantial returns |
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Advantages of hedge funds |
*Investment strategies that have the ability to generate positive returns in both rising and falling bond market *Hedge funds in a balanced portfolio can reduce overall portfolio risk and volatility and increase returns *A huge variety of hedge fund investment styles – many uncorrelated with each other – that provide investors the ability to precisely customize an investment strategy *Access to some of the world's most talented investment managers |
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Disadvantages of hedge funds |
*Concentrated investment strategy exposes hedge funds to potentially huge losses. *Hedge funds tend to be much less liquid than mutual funds. They typically require investors to lock up money for a period of years. *Use of leverage, or borrowed money, can turn what would have been a minor loss into a significant loss |
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How are contracts classified? |
1. Types of contracts include foward, futures, swap, option and insurance contracts. Values of most contracts depends on the value of the underlying asset 2. This asset may be a commodity, security, index, currency pair or basket, or other contracts. |
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Forward contracts (Definition) |
*An agreement to trade the underlying asset in the future at a price agreed upon today. *Contract holders face 2 major risks in addition to the risk associated with the underlying asset: • Counterparty risk problem: The risk that the other party will fail to honor the terms • Liquidity problem: Very difficult as it can only be done with consent from other party |
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Hedging with forward contracts |
*SELLER: • risk- price of the product decreases • needs to sell it in the future (long) • hedges the spot market position by selling the product forward. *BUYER: • risk- price of the product increases • needs to buy it in the future (short) • hedges the spot market position by buying the product forward |
A buyer benefits from hedging with forward contract if price increases in the future A seller benefits from hedging with forward contract if price decreases in the future |
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Future contract (Definition) |
*A standardized forward contract for which a clearinghouse guarantees the performance of all buyers and sellers. *The ability to trade futures contracts provides liquidity *vastly improved the efficiency of forward contracting markets. |
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Futures VS Forward contracts |
*FUTURES: • Standardized • Clearinghouse guarantees performance: - reduces the counterparty risk problem. - allows a buyer who has bought a contract from one person and sold the same contract to another person to net out the two obligations so that she is no longer liable for either side of the contract; the positions are closed. - arrange for final settlement of trades. members are the only traders for whom the clearinghouse will settle trades. Not brokers and dealers. • Strong secondary market *FORWARD: • Customized • Counterparty risk • Typically held to maturity |
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Swap contract (Definition) |
*An agreement to exchange payments of periodic cash flows that depend on future asset prices or interest rates. *provide for the exchange of cash payments in the future. *Types of periodic payments: • Interest rate swap: fixed interest payments are exchanged for variable interest payments. • Commodity swap: fixed payments are exchanged for payments dependent on the future price of some commodity. • Currency swap: parties exchange payments denominated in different currencies. Payments may be fixed or variable. • Equity swap: fixed payments are exchanged for payments dependent on the returns to a stock or stock index. |
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Options contract (Definition) |
*Holder of an option contract has the right, but not the obligation, to buy or sell the underlying instrument at some time in the future. *The writer of an option contract must trade the underlying instrument if the holder exercises the option. *European-style contracts: exercise their contracts only when they mature. *American-style contracts: If they can exercise the contracts earlier. *The price that traders pay for an option is the option premium. *Options can be quite expensive because they do not impose any liability on the holder. |
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Put option (Definition) |
*WROTE=SELL *Option to sell * Exercised when exercise price is above market price *A person who sells a put option (short position), is hoping the person he sold it to doesn't exercise the put option because they want to benefit from the premium (long exposure) *A person who buys a put option (long position) and pays a premium, has the right, but not obligation to sell. (short exposure) |
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Call option (Definition) |
*Option to buy *Usually only exercised if the price of the underlying is trading above stock price. *The person who buys a call option (long position) is buying a right which leads to the ownership of the asset. Benefit when prices go up (long exposure) •if you buy (short-sell transaction) a call with a long position, the counterparty will have an obligation to sell (short) if you decide to exercise your option at maturity. • leads to the right, and not obligation to buy *The person who sells a call option (short position), the writer, sells the 'contract'/ obligation to sell at a given future date at a predetermined price
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Short VS long position |
*Short (short sellers): •writes the option/issuers of the contract •Assets/contract not owned are sold •Benefits from decrease in price *Long: •holds the option •Assets/contract are owned •Benefits from price appreciation |
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Summary of options |
*If you buy the right, the other party owns the obligation. *If you buy a call, you buy the right to buy *If you sell a call, you will have the obligation to buy *Buy call & buy put: holds the right to exercise the option (HOLDS) (Long) *Sell call & sell put: must satisfy the obligation (WRITES) *PUT contract holder has the right to sell the underlying to the writer. Benefit if price falls leading to a rise in the price of the put contract *Holder is long put contract and has an Indirect short position in the underlying instrument/short exposure *Put contract holders have long exposure to their option and short exposure to the underlying instrument. *Buy: the right *Sell: the obligation
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Major types of financial intermediaries |
1. Commercial, mortgage and investment banks 2. Brokers and exchanges 3. Mutual funds and hedge funds 4. Credit unions 5. Dealers and arbitrageurs 6. Insurance companies 7. Credit card companies 8. Clearinghouse and depositories 9. Other finance corporations |
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Main functions of financial intermediaries |
*Connects buyers and sellers (parties) using complex or easy financial structures *Complex system includes the use of specialized computer systems to identify potential trade and help their clients fill their orders. *Aims to stand between 1 or more parties transfer capital and manage risk *Allows both parties to benefit from the trade without the counterparty's knowledge |
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Exchanges (Definition) |
*Marketplace (physical) for trading *Arrange trades submitted via electronic order matching systems *Regulatory authority: government/voluntary agreement *Examples: Tokyo Stock Exchange, Singapore Exchange, Chicago Mercantile Exchange, Deutsche Bourse, NYSE-Euronext |
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Alternate trading systems (Definition) |
*Electronic communication networks (ECNs)/Multilateral trading facilities (MTFs) *Some offer services similar to exchanges, others offer innovative systems that suggest trades *No regulatory authority except with respect to trading *Dark pools: doesn't display orders *Examples: PureTrading, the Order Machine, Chi-X Europe, BATS, POSIT, Liquidner, Baxter-FX, Turquoise. |
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Types of depository institutions |
1. Credit union 2. Savings association 3. Savings and loan association 4. Commercial bank |
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Services provided by depository institutions |
1. Raise funds from depositors/other investors and lend it to borrowers 2. Give their depositors interest and transaction services, like check cashing, in exchange for using their money 3. Raise additional funds by selling bonds/equities |
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Investors influence on bank investment decisions |
*Investors will be sensitive to the risks a bank is taking and will require a higher return as incentive to invest in a risky bank |
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Securitization (Definition) |
*The process of buying assets, placing them in a pool and then selling securities that represent ownership of the pool. *Greatly improves liquidity because it allows investors to buy assets indirectly that they otherwise wouldn’t buy directly. |
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Mortgage banks (Definition) |
*Commonly originate hundred/ thousands of residential mortgages by lending money to homeowners. *Place mortgage-backed securities *Investors who purchase pass-through securities obtain securities that in aggregate have the same net cash flows and associated risks as the pool of mortgages. |
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Mortgage-backed securities |
*Morgage banks then place the mortgages in a pool and sell shares of the pool to investors as mortgage pass-through securities *All payments of principal and interest are passed through to the investors each month, after deducting the costs of servicing the mortgages |
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Asset-backed securities |
Besides mortgages, banks securitize car loans, credit card receivables, bank loans, and airplane leases, to name just a few assets. |
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Insurance companies |
*Intermediation between parties will to bear risk and buyers of insurance contracts. *Insurers are financial intermediaries because they connect the buyers of their insurance contracts with those parties who are willing to bear the insured risks. *Loss rates for well-diversified portfolios of insurance contracts are much more predictable than for single contracts. *Insurance premiums primarily reflect the expected loss rate in the portfolio plus the costs of running and financing the company. |
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Credit Default Swaps (CDS) |
*Used to hedge against the risk of default. (Insurance contract) *They promise payment of principal in the event that a company defaults on its bonds. *Have not been subject to the same reserve requirements that most governments apply to more traditional insurance contracts. *Sold by insurance companies but also by other financial entities, such as investment banks or hedge funds. |
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Arbitrageurs (Definition) |
*Financial intermediaries because they connect buyers in one market to sellers in another market. *Often trade securities or contracts whose values depend on the same underlying factors, e.g., sell calls and buy shares on the stock underlying the calls. *Buying a risk in one form and selling it another form involves a process called replication. *Provide liquidity to buyers and sellers who arrive at different markets at the same time. *They move liquidity across markets |
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Dealers (Definition) |
*Provide liquidity to buyers and sellers who arrive at the same market at different times. *They move liquidity through time. . |
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Levered position (Terminology) |
1. Buying on margin: margin loan must be bought on margin 2. Margin loan: borrowing of some of the purchase price 3. Call money rate: The interest rate that the buyers pay for their margin loan 4. Initial margin requirement: the minimum fraction of the purchase price that must be trader’s equity. 5. Maintenance margin requirement: protects the broker from the investor’s stock position being worth less than the loan owed to the broker. 6. Margin call: If the value of equity falls below the maintenance margin requirement. If the investor does not deposit additional equity with the broker in a timely manner, the broker will close the position to prevent further losses and thereby secure repayment of the margin loan. 7. Leverage ratio: the ratio of the value of the position to the value of the equity investment in it. The maximum leverage ratio is one divided by the minimum margin requirement. If the requirement is 40 percent, then the maximum leverage ratio is 1 ÷ 0.40 = 2.5. |
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Orders (Definition) |
*specify what instrument to trade, how much to trade, and whether to buy or sell. *Additional instructions: •Execution instructions indicate how to fill the order. •Validity instructions indicate when the order may be filled. •Clearing instructions indicate how to arrange the final settlement of the trade. Know as standing instructions. Indicate what entity is responsible for clearing and settling the trade. For retail trades (customer’s broker). For institutional trades (custodian or another broker). |
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Market VS Limit order |
*Market order: •Executed immediately if trader takes other side of the trade •Receives best available price •Expensive if Market for thinly traded security *Limit order: •Executes at Limit Price or better (may not execute) •Receives best available price •Mitigates concerns over price concessions (adjustments on price) |
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Reasons for no execution of Limit order |
*Marketable limit order: limit price is such that at least part of the order can trade immediately.*Outstanding or standing limit orders: limit orders that are waiting to trade. E.g trade will not occur unless price drop to a certain limit*Behind the market or away from the market: refers to a buy order where the limit price is below the best bid or a sell order where the limit price is above the best ask. |
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Purchase price concession |
*An adjustment to the purchase price agreed to in the executive instruction. *Occurs during or after due diligence, but before closing of the transaction. *Typically, these adjustments are reductions of the purchase price, but they may also be increases. |
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Bids VS offers |
*Bid: maximum price buyer is willing to pay for stock/security. *Offer/ask: minimum price seller is willing to take for that same security. * highest bid = best bid * lowest offer = best offer * BEST bid and BEST offer make the market order *Make a market: traders who offer to trade *Take a market: those who trade with them *Make a NEW market: the space between the current best bid and offer (inside the market) if the limit order arrives here. Best bid below the best offer |
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Validity instructions |
1. Day order: good on the day it is submitted. 2. Good-till-cancelled order (GTC): good until cancelled but most brokers limit how long they will manage an order to ensure that they do not fill orders that their clients have forgotten. 3. Immediate-or-cancel order (IOC): cancel immediately if they can’t be filled. 4. Good-on-close order: can only be filled at the close of trading day. 5. Market-on-close order: good-on-close orders that are market orders 6. Good-on-open order: used by many traders |
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Stop order (stop-loss orders) |
*For a sell (sell stop) order, the stop price condition suspends execution of the order until a trade occurs at or below the stop price. Can only be filled once the market has traded at a price at or below the stop price. *For a buy order (buy stop) with a stop condition becomes valid only after a price rises above the specified stop price. Can only be filled once the market has traded at a price at or above the stop price. *The role that these prices play in the arrangement of a trade are completely different. *A limit price places a limit on what trade prices will be acceptable to the trader. A buyer will accept prices only at or lower than the limit price whereas a seller will accept prices only at or above the limit price.*Indicates when an order can be filled. *Both order instructions may delay or prevent the execution of an order. *Stop-buy order will not execute if the market price never rises to the stop price. *Stop-sell order will not execute if the market price never falls to the stop price. |
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Primary market |
*When issuers first sell their securities *Public offering- Initial Public offering (IPO): a placing of a security issue when it sells the security to the public for the first time. *Public offering- Seasoned offering: a security that an issuer has already issued (previously issued security) *Private placement: corporations sell securities directly to a small group of qualified investors, usually with the assistance of an investment bank. *Shelf registration: the corporation makes all public disclosures that it would for a regular offering, but it does not sell the shares in a single transaction. It sells the shares directly into the secondary market over time, generally when it needs additional capital. *DRPS or DRIPS: issued shares via dividend reinvestment plans that allow their shareholders to reinvest their dividends in newly issued shares of the corporation . * Rights offering: the corporation distributes rights to buy stock at a fixed price to existing shareholders in proportion to their holdings. Because the rights need not be exercised, they are options. |
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Secondary market |
*a market where investors purchase securities or assets from other investors, rather than from issuing companies themselves. The New York Stock Exchange and the NASDAQ are secondary markets. *Call markets: •trades can be arranged only when the market is called at a particular time and place. •Gathers all traders to make it easier for buyers to find sellers and vice versa. •trading can take place only when the market is called. *Continuous markets: •trades can be arranged and executed anytime the market is open. •if buyers and sellers are not present at the same time in, they cannot trade. •A willing buyer and seller can trade at anytime the market is open. |
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How secondary markets support primary markets |
*Corporations and governments can raise money in the primary markets at lower cost when their securities will trade in liquid secondary markets. *In a liquid market, traders can buy or sell with low transaction costs and small price concessions hence reduce the cost of raising capital (cost of capital) |
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Execution mechanisms |
*Order-driven market: an order matching system run by an exchange, a broker, or an alternative trading system uses rules to arrange trades based on the orders that traders submit. Exchanges and every trading system, for example, stock *Quote-driven market: customers trade with dealers. Worldwide trading like bonds, currencies and spot commodities *Brokered markets: brokers arrange trades between their customers. Common for transactions of unique instruments like real estate properties, intellectual property, liquor license, etc. |
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Order-driven markets |
[Order matching rules] *ORDER PRECEDENCE HEIRARCHY (determines which orders go first): •Price priority: The highest priced buy orders and the lowest prices sell orders go first. They are the most aggressively priced orders. •Secondary precedence rules: determine how to rank orders at the same price. Most trading systems use time precedence to rank orders at the same price. [Trade pricing rules] *UNIFORM PRICING RULE: Call markets commonly use it. All trades execute at the same price. The market chooses the price that maximizes the total quantity traded. *DISCRIMINATORY PRICING RULE: Continuous trading markets use this. The limit price of the order or quote that first arrived—the standing order—determines the trade price. *DERIVATIVE PRICING RULE: Crossing networks use this. Crossing networks are trading systems that match buyers and sellers who are willing to trade at prices obtained from other markets. It's called this because the price is derived from another market. |
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Characteristics of well-functioning financial system |
*Complete markets: The existence of well-developed markets that trade instruments that help people solve their financial problems. *Operationally efficient markets: Liquid markets in which the costs of trading—commissions, bid–ask spreads, and order price impacts—are low.*Support Informationally efficient markets: Timely financial disclosures by corporations and governments that allow market participants to estimate the fundamental values of securities. *Informationally efficient markets: Prices that reflect fundamental values so that prices vary primarily in response to changes in fundamental values and not to demands for liquidity made by uninformed traders. |
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Objectives of market regulation |
*Regulation is necessary because regulating certain behaviors through market-based mechanisms is too costly for people who are unsophisticated and uninformed. *Effectively regulated markets allow people to better achieve their financial goals. *Control fraud: Financial markets are complex, and customers are less sophisticated than professionals, the potential for losses through various frauds can be unacceptably high in unregulated markets. *Control agency (conflict of interest). Customers generally do not have much information about market conditions, so find it extremely difficult to measure the added value they obtain from their agents. *Promote fairness (no exploitation on participants). To level the playing field for market participants. *Set beneficial standards (benefit to both parties involved in trade). Having all companies report financial results on a common basis allows financial analysts to easily compare companies. *Prevent exploitation: To ensure that the companies will be able to honor their contractual commitments when unexpected market movements or poor decisions cause them to lose money and they ensure that the owners of financial firms have substantial interest in the decisions that they make *Insure liabilities are funded (ability to pay obligations). To maintain adequate reserves to ensure that they can fund their liabilities. |
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