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54 Cards in this Set
- Front
- Back
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Types of Financial Markets (6) |
1. Equity (stock) Markets 2. Bond Markets 3. Money Markets 4. Foreign Exchange Markets 5. Derivative Markets 6. Other Markets - (commodity markets, real estate, etc) |
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Equity (or stock) Market |
Markets for shares of corporations / Market in which shares are issued and traded Example: NYSE, LSE, NASDAQ ~gives companies access to capital and investors a slice of ownership in a company with the potential to realize gains based on its future performance~ |
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Bond Markets |
*Has a sequence of coupon payments and a maturity payment at a specified maturity date in the future *Is a financial market in which the participants are provided with the issuance and trading of debt securities *The bond market primarily includes government-issued securities and corporate debt securities *Over the counter markets and stock exchanges *Goal is to provide long term financial aid/funding |
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Money Markets |
*Financial instruments with high liquidity and very short maturities are traded *used by participants as a means for borrowing and lending in the short term, with maturities that usually range from overnight to just under a year. *Examples of MM instruments: U.S Treasury bills |
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Example of Bond Markets |
The general bond market can be classified into corporate bonds, government and agency bonds, municipal bonds, mortgage-backed bonds, asset-backed bonds, and collateralized debt obligations. |
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Foreign Exchange Markets |
*The foreign exchange market is the market in which participants are able to buy, sell, exchange and speculate on currencies *FOREX |
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Derivative Markets |
*financial market for derivatives which are derived from other forms of assets *derivative asset *options, futures, forward contracts, swaps, etc |
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Derivative Asset |
financial asset whose value depends on the value of other underlying assets |
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Other Markets |
commodity markets, real estate, etc |
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The Role of Financial Markets ? (6) |
*Clearing and settling transactions
*Providing financing for investment projects (pooling resources) *transferring income over time *managing (hedging) risk *revealing information *providing incentives |
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Principles of asset price determination - what determines demand? |
preferences, expectations, information, income, prices, and market microstructure *market equilibrium also affects asset price determination |
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Arbitrage |
transaction in asset markets with *Zero cost *positive future payoff *no risk of negative future payoff *Arbitrage is basically buying in one market and simultaneously selling in another, profiting from a temporary difference. This is considered riskless profit for the investor/trader. |
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Examples of arbitrage |
Let's say you are able to buy a toy doll for $15 in Tallahassee, Florida, but in Seattle, Washington, the doll is selling for $25. If you are able to buy the doll in Florida and sell it in the Seattle market, you can profit from the difference without any risk because the higher price of the doll in Seattle is guaranteed. |
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Financial Innovation |
development of new financial products or institutions |
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Short Sales |
*a transaction in which an investor sells borrowed securities in anticipation of a price decline and is required to return an equal number of shares at some point in the future. *A short seller makes money if the stock goes down in price, while a long position makes money when the stock goes up. In real estate, short sale means selling a house for less than the mortgage owed with the lender's approval. |
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Margin Accounts |
A margin account is a brokerage account in which the broker lends the customer cash to purchase securities. The loan in the account is collateralized by the securities and cash. Because the customer is investing with a broker's money rather than his own, the customer is using leverage to magnify both gains and losses. |
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Market Frictions |
*transaction costs *bid and ask prices *etc |
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types of Trading Mechanisms ? why do they matter? |
two basic mechanisms *quote-driven markets *order driven markets ~also over-the-counter MATTERS BECAUSE market microstructure matters for liquidity and transparency of markets |
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liquidity of a market |
Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's price |
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transparency of a market |
*Transparency is the extent to which investors have ready access to required financial information about a company, such as price levels, market depth and audited financial reports. *Transparency helps reduce price volatility, because all the market participants can base decisions of value on the same data. Companies also have a strong motivation to provide disclosure, as transparency is generally rewarded through the stock's performance |
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Quote-Driven Markets |
*A quote driven market is an electronic stock exchange system in which prices are determined from bid and ask quotations made by market makers, dealers or specialists. In a quote driven market, also known as a price driven market, dealers fill orders from their own inventory or by matching them with other orders *Used in LSE, NASDAQ |
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Order-Driven Markets |
*An order driven market is a financial market where all buyers and sellers display the prices at which they wish to buy or sell a particular security, as well as the amounts of the security desired to be bought or sold *NYSE, Gold fixing *"Auctioneer" can be a specialist, open outcry, etc *Typical orders: limit orders and market orders |
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limit orders |
A limit order is a take-profit order placed with a bank or brokerage to buy or sell a set amount of a financial instrument at a specified price or better; because a limit order is not a market order, it may not be executed if the price set by the investor cannot be met during the period of time in which the order is left open. *Limit orders also allow an investor to limit the length of time an order can be outstanding before being canceled. |
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market orders |
An investor makes a market order through a broker or brokerage service to buy or sell an investment immediately at the best available current price. *A market order is the default option and is likely to be executed because it does not contain restrictions on the price or the time frame in which the order can be executed. A market order is also sometimes referred to as an unrestricted order |
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Predictability of Asset Prices |
*extent to which asset prices in the future can be predicted on the basis of current information |
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What is the model of Unpredictable Prices? |
Martingale Model |
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Martingale model? |
????? E[pt+1|Ft] = pt * where pt is price at date t and Ft is information at t. Here pt is a random process. *fair game - no gain or loss in expectation |
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Random walk model |
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better model of unpredictable prices |
E[pt+1|Ft] = (1 + μ)pt * This is, using returns, E[rt+1|Ft] = μ (1)One can write rt+1 = μ + ǫt+1 where E[ǫt+1|Ft] = 0. In (1) information in Ft - which includes rt - gives noindication on whether rt+1 will exceed μ or not. |
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Informational Efficiency |
“Market is efficient if it fully and correctly reflects allrelevant information in determining security prices.” |
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forms of informational efficiency ? (3) and describe |
**weak form - current prices fully reflect all past pricesand returns ***semi-strong form - current prices fully reflect allpublicly available information **strong form - current prices fully reflect all (privateand public) information |
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What does “prices reflect information” mean? |
Knowing current prices is the same as knowingthe relevant information. In particular, conditioning onprices and on information is the same |
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strong efficiency leads to..? |
paradox of information acquisition ** If prices reflect all information including privateinformation, there would be no incentives for traders togather information |
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Grossman-Stiglitz paradox |
*idea that because information is costly, prices cannot perfectly reflect the information which is available, since if it did, those who spent resources to obtain it would receive no compensation, leading to the conclusion that an informationally efficient market is impossible. *strong efficiency makes little sense |
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Risk |
probabilities of events can be objectively assigned |
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Uncertainty |
probabilities cannot be objectively assigned |
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NOT ALWAYS - but - probabilities can be ? assigned for uncertainty |
Subjectively *so the agent acts as if probabilities were known |
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Investor's portfolio choice problem |
?? max U(W1,...,Wl) *subject to budget constraint |
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Expected Utility Hypothesis |
states that if specific axioms are satisfied, the subjective value associated with an individual's gamble is the statistical expectation of that individual's valuations of the outcomes of that gamble |
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Risk Aversion |
*weakly prefers risk-free wealth to risky wealth for all W * E[u(W )] ≤ u(E[W ]) |
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Risk Neutrality |
* E[u(W )] = u(E[W ]) *indifferent between risk free E[W] and risky W for all W |
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Risk averse iff u'' ? |
u is concave * ≤ 0 |
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Risk Neutral IFF u'' ? |
*=0 *linear |
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Expected utility and portfolio choice |
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Fundamental Valuation Relationship |
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If an investor is strictly risk averse, then hisoptimal investment in risky asset is ? |
(i) strictly positive if E(r) > r0, and (ii) zero if E(r) = r0. * More generally, with n assets, if an agent is strictly riskaverse and E(rj) = r0 for every j = 1,...,n, then a∗j = 0 forallj anda∗0 =A *strictly risk averse meaning u'' < 0 |
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Assumptions of the EUH |
Irrelevance of Common Consequences (ICC) |
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Theorem: If utility U satisfies ICC axiom and is risk averse withrespect to probabilities π....? |
then it has expected utility representation E[u(W )] with utility-of-money function u |
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Ellsberg Paradox |
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Prospect Theory |
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Multiple Prior Expected Utility |
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Irrelevance of Common Consequences |
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if we want to invest in risky asset - expected return on risky should exceed that of risk free - T/F? |
T |
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1 |
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