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147 Cards in this Set
- Front
- Back
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Six main purposes of the financial markets: |
1. to Save money for the future 2. to Borrow money for current use 3. to raise equity capital 4. to manage risks 5. to exchange assets for immediate and future deliveries 6. to trade on information |
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Three main functions of the financial system: |
1. the achievement of the purposes for which people use the financial system 2. the discovery of the rates of return that equate aggregate savings with aggregate borrowings 3. the allocation of capital to its best uses |
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Investors |
when savers commit money to earn a financial return |
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invest |
buying and asset |
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divest |
selling an asset |
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Main risks to be managed through financial markets: |
default risk interest rate risk exchange rate risk raw material prices sale prices Often the 2 traders (buyer and seller) face opposite risks so trading is beneficial for both parties |
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Forward contracts |
set a future trade price in the present. EX. farmer fears prices will be lower, purchaser fears they will be higher. So, they enter into forward contract to provide specified amount of grain at predetermined price |
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Spot market trading (exchanging assets for immediate delivery) |
commodity securities market in which goods are sold for cash and delivered immediately |
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Information motivated traders |
trade to profit on information that they believe allows them to predict future prices they expect to earn a return in addition to the normal rate of return (market rate of return for example annual return of S&P 500) for bearing risk through time |
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difference between investors and information motivated traders |
investors trade to move wealth from present to the future and information motivated traders trade to profit from superior information Investors hope to attain normal rate of return and information motivated traders hope to earn in excess of normal return |
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Rate of Return |
costs of borrowing funds or giving up ownership for borrower return on funds expected in the future for the lender (equities or bonds(fixed income)) |
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Equilibrium interest rate |
rate at which, in theory, aggregate demand and supply for funds is equal the only rate that would exist if all securities were equally risky, had equal terms, and were equally liquid (easy to quickly buy and sell) |
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Primary capital markets |
markets in which companies and governments raise capital (funds) *governments cannot sell equity, only borrow |
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Securities |
generally include debt instruments, equities, and shares in pooled investment vehicles |
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Currencies |
monies issued by national monetary authorities |
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Contracts |
agreements to exchange securities, currencies, commodities, and other contracts in the future value obtained through the price fluctuations of an underlying investment (forwards, futures, options etc) |
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Commodities |
asset class including precious metals, energy products, industrial metals, and agricultural products |
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Real assets |
asset class including tangible properties such as real estate, airplanes, or machinery |
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Financial Assets |
securities, currencies and contracts |
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physical assets |
commodities and real assets |
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private securites |
all securities that are not registered to trade in public markets only specially qualified investors can invest in them often used when an entity finds public reporting standards too burdensome or do not want to conform with the standards e. g. venture capital |
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equity derivatives |
contracts whose value depends on equities or indices of equities |
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fixed income derivatives |
contracts whose value depends on debt securities of indices of debt securities
so, you don't directly buy the security with a derivative, but buy a contract and speculate on whether the price will move up or down on the underlying asset which could be a stock, bond, index, real asset etc.) |
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options markets |
trade contracts that deliver in the future but delivery only takes place if the holders of the options choose to exercise them |
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spot markets |
markets that trade for immediate delivery |
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forward/future markets |
markets that call for delivery in the future |
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Money markets |
trade debt instruments maturing in less than 1 year repurchase agreements, certificates of deposit, government bills, and commercial paper |
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capital markets |
trade instruments of longer duration such as bonds and equities whose value depends on credit worthiness of issuers or payments of interest on dividends that will be paid in the future |
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traditional investment markets |
markets that include all publicly traded debt and equity securities and shared pooled investments |
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Alternative investment markets |
include hedge funds, private equity, commodities, real estate securities and real estate properties, securitized (consolidated) debts, operating leases (borrowing something, think of car lease), machinery, collectibles and precious gems |
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notes |
fixed income securities with shorter maturities usually ten years or shorter |
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bonds |
fixed income securities with longer maturities usually ten years or longer |
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bills |
debt issued by governments usually mature within one year |
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certificates of deposit |
debt issued by banks usually mature within one year |
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commercial paper |
debt issued by corporations usually mature within one year but can be longer |
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repurchase agreements |
short term lending instruments term can be as short as overnight borrower seeking funds will sell an instrument typically a high quality bond to a lender with an agreement to repurchase it later at a higher price based upon agreed upon int rate |
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preferred shares |
generally have the right to receive a specific dividend on a regular basis generally treated as fixed income securities when it is probable that promised dividends will be received in foreseeable future |
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warrants |
securities issued by a corporation that allow the warrant holders to buy a security issued by that corporation, if they so desire, usually at anytime before the warrants expire or if not upon expiration usually can buy issuer's common stock exercise price is the price that the warrant holder must pay to buy the security |
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pooled investment vehicles |
mutual funds, trusts, depositories, and hedge funds that issue securities that represent shared ownership in the assets that these equities hold |
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securities created by mutual funds are called |
shares |
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securities created by trusts are called |
units |
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securities created by depositories are called |
depository receipts |
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securities created by hedge funds are called |
limited partnership interests |
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open ended mutual funds |
issue new shares and redeem existing shares on demand, usually on a daily basis sold at net asset value which is the difference between the funds assets and liabilities on a per share basis |
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closed end mutual funds |
issue shares in primary offerings and then are traded in secondary markets by investors (just like stocks) usually sell at a discount to net asset value because of expenses of running the fund or in more concerning cases when investors have concerns about management of the fund |
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ETF |
open ended funds that investors can trade among themselves in the secondary market |
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in kind deposits and redemtions |
paying for and receiving from with portfolios of securities rather than cash common in ETFs |
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asset backed securities |
securities whose value is derived from a pool of assets such as mortgage bonds, credit card debt, or car loans typically pass interest and principal payments received from the pool back to holders on a monthly basis |
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hedge funds |
investment funds that generally organize as limited partnerships fund managers are general partners qualified investors can become limited partners, but must be wealthy enough and well informed enough to tolerate and accept substantial losses should they occur usually the managers invest in higher risk investments in order to create substantial returns, but with more risk more loss of principal results when prices decline |
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forward contracts |
agreement to trade the underlying asset in the future at a price agreed upon today |
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counterparty risk of forward contracts |
the risk that the other party to a contract will fail to honor the terms of the contract this risk ensures that only parties that have long standing relationships execute forward contracts |
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liquidity problem with forward contracts |
trading out a forward contract is very difficult because it can only be done with the consent of the other party |
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futures contract |
standardized forward contract for which a clearinghouse guarantees the performance of all traders buyer is the side that will take physical delivery or cash equivalent seller is the side that is liable for physical delivery or cash equivalent |
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initial margin |
amount required by participants in a future market by the clearinghouse to protect against defaults accounts are settled on a daily basis and participants who lost will have money deducted from this margin those who gain will have money added |
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maintenance margin (futures) |
amount of money that must be in the margin account for a future set by the clearinghouse if insufficient when required, the broker will immediately trade to offset the participants position |
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variation margins (include maintenance margin) |
these margin payments ensure that liabilities associated with futures contracts do not grow too large |
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swap contract |
agreement to exchange periodic cash flows that depend on future asset prices or interest rates differs from forward contract because there are many periodic payments as opposed to one at the end of the forward contract |
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interest rate swaps |
exchanges fixed interest payments for variable interest payments usually used by investment managers that have a fixed long term income stream that they want to convert to cash flows that vary with current short term interest rates or vice versa |
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commodity swap |
one party typically makes fixed payments in exchange for payments that depend on the future prices of a commodity such as oil |
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currency swap |
parties exchange payments denominated in different currencies may be fixed or variable depending on the future interest rates of the 2 countries |
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equity swap |
the parties exchange fixed cash payments for payments that depend on the returns to a stock or a stock index |
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option contract |
allows the holder (purchaser) of the option to buy or sell, depending on the type of option, an underlying instrument at a specified date in the future. fees are high because of the risks the underwriters undertake |
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call option |
option to buy underlying security |
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put option |
option to sell underlying security |
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when to exercise call options |
if strike price is below the market price of underlying instrument allowing them to buy at a lower price than the market price |
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when to exercise put options |
if stroke price is above the underlying instrument price so that they sell at a higher price than market price |
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american style contracts |
if contracts can be exercised before maturity they are called |
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european style contracts |
if contracts cannot be exercised until maturity they are called |
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credit default swaps |
insurance contracts that promise payment of principal in the event that a company defaults on its bonds used to convert risky bonds into more secure investments other creditors may use them to hedge the risk that they will to be paid of the company goes bankrupt |
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brokers |
agents who fill orders for their clients do not trade with clients rather they search for traders who are willing to take the other side of the clients orders |
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investment banks |
provide advice to their mostly corporate clients and help them arrange transactions such as initial and seasoned securities offerings help issue securities, and identify acquisition targets |
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exchanges |
provide places where traders can meet to arrange their trades
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alternative trading systems (ATS's), also known and electronic communications networks (ECN's) or multilateral trading facilities (MTF's) otherwise known as DARK POOLS |
trading venues that function like exchanges but that do not exercise regulatory authority over their subscribers except with respect to the conduct of their trading within the trading system |
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dark pools |
same as alternative trading systems. were given this name because these exchanges do not display orders that their clients end to them used by large investment managers because market prices often move to their disadvantage when other player in the market see their large orders |
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dealers |
fill their clients order by trading with them after completing a transaction they hope to reverse the transaction by trading with an investor on the other side of the market (effectively connecting buyers and sellers) provide liquidity |
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liquidity in trading |
ability to buy and sell with low transaction costs |
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broker-dealer |
dealers and brokers at same time cause conflict of interest because as a broker you are looking for the best price for your cleint and as a dealer you are looking to sell at high prices and buy at ow ones |
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securitization |
process of buying assets, placing them in a pool, and then selling the securities that represent ownership of the pool |
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mortgage backed securities |
mortgage banks commonly originate hundreds or thousands of residential mortgages by lending money to homeowners then they place them in a pool of securities and sell shares of the pool to investors all pmts of principal and interest are passed through to investors each month after deducting the costs of servicing the mortgages |
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special purpose vehicle (SPV) or special purpose entity (SPE) |
in many securitizations the financial intermediary avoids placing the assets and liabilities on its balance sheet by creating a special corporation or trust that buys the assets and issues the securities advantageous to investors because it protects them of the possibility of the parent firm going bankrupt |
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tranches |
different classes of securities created during securitization which give different rights to cash flows senior have first right to cash flows junior tranches after and effectively share a larger proportion of the risk |
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depository institutions |
include commercial banks, savings and loans banks, credit unions, and similar institutions that raise funds from depositors and other investors and lend it to borrowers |
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arbitrageurs vs. dealers |
both provide liquidity in the market but dealers connect buyers and sellers who arrive in the same market at different times while, arbitrageurs connect buyers and seller who arrive at the same time in different markets |
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position (in an asset) |
the quantity of an instrument that an entity owns or owes
a portfolio consists of a set of positions |
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long positions |
when an asset or contract is owned in anticipation of it gaining value e.g. stocks, bonds, currencies, contracts, commodities, and real assets benefit from an appreciation of the assets or contracts owned and receive dividends |
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short position |
borrow stock from broker sell stock immediately and hope price goes down when price goes down buy the share back and the difference is your profit if price goes up you must pay the broker the difference *broker receives any dividend payments over the time period |
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long side (short side) of forward/futures contracts |
side that will take physical delivery or cash equivalent (side that is liable for delivery of cash or equivalent) |
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long side of options contract |
side that holds the right to exercise the option in a put (right to sell underlying asset) the holder will benefit if the underlying value falls in which case the value of the put will rise so, the holder is long on the put contract (expecting price to fall so that put become more valuable) and INDIRECTLY short on the underlying asset because they are hoping the underlying asset falls in value |
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short side of options contract |
side that must satisfy the obligation |
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put side of options contract |
right to sell the underlying to the writer will benefit if the underlying price falls resulting in the put options value increasing short side holds the options and long side writes the option |
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option positions and their underlying risk exposures |
pg. 39 table |
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long and short positions on currencies |
when one person trades a currency they are long on the one they are buying and consequently short on the one they are selling so if you buy dollar and sell yen you are said to be long on the dollar and short on the yen |
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shorts vs. long risk |
shorts are more risky because losses are unbounded because underlying asset could appreciate infinitely whereas it can only fall 100% of the value sold for longs are less risky because they can only fall 100% and rise infinitely |
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margin loan |
investors borrow some of the purchase price of securities from broker to purchase securities the traders equity is the portion of the investment that they have paid for these traders are subject to minimum margin requirements like those of futures can significantly increase returns and losses because the investor can purchase more of the security than she could on her own |
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call money rate |
interest paid on margin loans above government bill rate and is negotiable |
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initial margin requirement (margin trading) |
minimum amount of initial investment that must be trader's equity |
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financial leverage (for an investor) |
relation between risk and borrowing positions are leveraged when securities are bought on margin to buy more securities a highly leveraged position is large relative to the equity that supports it |
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leverage ratio formula |
value of the position (100%)/value of equity invested e.g. 100%/40%=2.5 or the margin position is 2.5 times larger than the equity position |
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margin call price formula |
when an investor will have to replenish margin if security price falls equity per share/price per share e.g buys on margin posting 40% as equity, initial price of 20, maintenance margin require 25% at what price will it need to be replenished? 8+(P-20)/P=25% @$16 |
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orders |
specify what instrument to trade, quantity, and whether to buy or sell |
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bid prices |
price at which someone is willing to buy always lower than ask prices highest bid is the "best bid" in the market |
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ask prices |
prices at which someone is willing to sell always higher than bid prices lowest ask is the "best offer" in the market |
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making/ taking a market |
traders who offer to trade (ask selling price) make a market and those who are willing to trade with them (bid buying price) take the market |
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bid-ask spread |
difference between the best bid and best ask in the market |
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market order |
instructs the broker or exchange to obtain the best price immediately available when filling the order |
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limit order |
obtain the best price available, but in no event accept a price higher than a specified limit price when buying or accept a price lower then a specified limit price when selling |
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marketable limit orders |
at least part of the order can trade immediately for buy orders price be higher relative to less aggressively placed limit orders enticing sellers for sell orders price will be lower relative to less aggressively price sell limit orders enticing buyers |
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behind the market |
buy order placed below the best bid |
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standing limit orders |
limit orders that are waiting to trade |
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making a market |
when a trader offers to trade regardless if it a bid or ask(offer) standing limit orders (limit orders that have not yet traded) make markets market orders and limit orders that trade take markets |
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taking a market |
when a trader accepts a trade or offer to trade |
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all or nothing orders |
will only be executed if the entire size of the order can be bought or sold at once |
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hidden orders |
exposed only to the brokers and exchanges that receive them usually large orders that would influence traders in the market so that the large order would be negatively affected |
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display size |
size of an order that an investor chooses to be seen by the rest of the market when placing a hidden order it is often referred to as an iceberg order because only a small portion of it can be seen used to show other investors that they want to trade a specific price but do not want to disclose how large their position is |
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validity instructions |
indicate when an order may be filled |
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day order |
good for the day on which it is submitted if it is not filled in a day it expires
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good till canceled orders |
used to limit how long an order will be on the market to make sure investors do not forget about outstanding orders |
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immediate or cancel orders |
are good only upon receipt by the broker or exchange if they cannot be filled in part or in whole they are cancelled immediately also known as fill or kill orders *used in high frequency trading to see pending bid and ask's standing |
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good on close orders |
can only be filled at the close of the trading day usually market orders so they are usually called market on close orders opposite is good on open orders |
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stop order |
order on which a trader has a specified stop price condition cannot be filled until the stop price condition has been satisfied for sell order stop price the execution of the trade is suspended until a trade occurs at or below the stop price for buy order stop price execution of trade is suspended until a trade occurs at or above the stop price |
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Book building (for IPO's) |
investment bank lining up subscribers who will buy the newly issued security basically trying to presell as many shares as possible the bank usually provides information about the issuer in order to entice potential investors |
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accelerated book build |
in Europe issuers may want to issue securities quickly and using this method the bank creates a book of buyers in 2 to 3 days usually at discounted prices |
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IPO |
consists of newly issued shares and may also include shares of early investors who are looking to liquidate (turn to cash) their investment |
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underwritten offering |
most common offering, the investment bank guarantees the sale of the issue at a price which is negotiated with the issuer If undersubscribed the bank will buy whatever shares it cannot sell from its book issuer usually pays a fee of about 7% |
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best effort offering |
investment bank acts only as a broker and if it is undersubscribed the issuer will not sell as much equity as it had hoped |
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shelf registration |
corporation makes all public disclosures that it would for a regular offering, but does not sell the shares in a single transaction. instead sells directly to the secondary market over time, generally when additional capital is needed within the business |
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dividend reinvestment plans |
type of offering where stockholder can reinvest their dividends in NEWLY issued shares of the company's stock allow current shareholders to buy shares at a slight discount to market value |
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rights offering |
distributes rights to buy stock at a fixed price to existing shareholder's proportionate to the size of their holding in the company because these "rights" need to be exercised they are considered options exercise price is set below current market price to provide discount and incentive because it will be immediately profitable for the investor *valued as short term stock warrants by analysts |
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2 different type of secondary markets |
call markets and continuous trading markets |
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call market |
trades can only be arranged when the market is called at a particular time and place (when the market is open) very liquid when open because all traders are present at the same time and place but completely illiquid between trading sessions (when market is closed) usually organized only once a day |
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continuous trading market |
trades can be arranged and executed anytime the market is open arranging orders can be more difficult because buyers and sellers are not always present at the same time |
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single price auctions |
usually used by call markets markets construct order books representing all buy and sell orders market then chooses a single trade price that will maximize volume of trade (basically supply and demand schedules) |
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quote driven markets |
customers trade with dealers most trading other than stocks take place in these markets trade at prices quoted by dealers |
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order driven markets |
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 used by most ECN's (electronic communication networks) and exchanges |
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brokered markets |
brokers arrange trades between their customers common for unique investments such as real assets, intellectual properties (trademarks, patents, copyrights etc.) or large blocks of securities |
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order precedence hierarchy |
determines which orders go first in an order driven market
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2 rules of order precedence hierarchy: |
1. price priority- highest price buy orders and lowest riced sell orders trade first 2. secondary precedence rules- determine how to rank orders at the same price *first to arrive, or unhidden orders go first (remember ice berg orders) |
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order matching rules |
match buyers to sellers using rules that rank the buy orders and sell orders based on price |
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trade pricing rules |
after orders are matched these rules are used to determine the trade price |
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uniform pricing rule |
all trades execute at the same price market finds price where most securities will trade |
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discriminatory pricing rule |
standing order determines the trade price *quote that first arrived provides large traders the opportunity to get the best deals without price discriminating on their own |
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crossing networks |
trading systems that match buyers and sellers who are willing to trade at prices obtained from other markets most systems price these trades at the midpoint of the best bid and ask quote published by the exchange * this rule is called the derivative pricing rule because the price is derived from another market |
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brokered market |
brokers arrange trades among their clients in this type of market unique investments where finding buyers and sellers is difficult |
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primary advantage of quote drive, order driven, and brokered markets: |
In a quote driven market dealers are generally available to supply liquidity. in order driven markets traders can supply liquidity to each other. in a brokered market brokers help find traders who are willing to trade when dealers would not be willing to make markets and when traders would not be willing to post orders. |
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*** READ SECTION 9 ON WELL FUNCTIONING FINANCIAL MARKETS *** |
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allocationally efficient economies |
economies that use resources where they are most valuable |
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responsibilities of market regulators (SEC in the U.S.) |
1. control fraud 2. control agency problems 3. promote fairness 4. set mutually beneficial standards 5. prevent undercapitalized financial firms from exploiting their investors by making excessively risky investments 6. ensure that long term liabilities are funded |
