Transcript Document 7273007

FNCE 4070: FINANCIAL MARKETS
AND INSTITUTIONS
Lecture 2: Understanding Financial
Markets and Institutions
Working Definitions;
Characteristics of an
Efficient Financial Market;
Financial Market Signals
Where is this Financial Market?
Financial Markets and Financial
Institutions

How might you define these?

Perhaps in terms of specific functions?
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What are possible functions of financial markets and
financial institutions?
What are the characteristics of an efficient financial
market?
Perhaps in terms of organizations and institutions
that participate in financial markets
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Commercial organizations
Governmental organizations (Central banks, regulatory
organizations --- SEC; FSA)
Private regulatory organizations (S&P, Moody’s, Fitch)
Function of Financial
Markets

Typical text book definition:
“Markets through which entities with
surplus (“excess”) financial funds
transfer those surplus funds to
entities who have a shortage
(“shortfall”) of available funds.”

Stock markets, bond markets,
mortgage markets.
Functions of Financial
Markets

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Mechanism for raising funds!
 Done in primary financial markets (e.g.,
IPOs)
Mechanism for converting financial assets
into cash before maturity.
 Done in secondary financial markets
(e.g., NYSE, OTC bond markets)
Functions of Financial Markets
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Provides the means for entities to protect
their financial/commercial positions.
 Done in derivatives markets (options,
futures, forwards)
Mechanism for generating a return on
surplus funds.
 Through interest, dividends, capital
appreciation
Functions of Financial
Markets

Allocates financial resources among
competing users.
 And, we assume, if done so in the most
efficient manner (i.e., to the most
productive users):

The process will improve economic
efficiency and
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Result in highest possible economic
growth!
Functions of Financial Markets
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Provides financial signals to market participants
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Interest rates, stock prices, exchange rates as
measures of market’s perception of risk and changing
risk:
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Stock prices and interest rates may tell us something about
the market’s assessment of companies, financial institutions,
and even overall financial markets: 2008 credit crisis.

Exchange rates and government interest rate spreads may
tell us something about the market’s assessment of
countries or regions): 2010 – 2012 Crisis in the Euro-zone.
Perhaps we can use financial market signals as a
leading indicator of economic activity.
Classification of Financial Markets
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Primary Financial Market
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Where new securities are sold to initial buyers (e.g., IPOs)
Important for raising new capital (involves public and private
placements and investment bankers)
Secondary Financial Market
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Where securities previously issued (in primary markets) are bought
and sold (traded among investors).
Secondary markets provide liquidity for previously issued securities
– Allows for conversion of financial assets into cash before asset
matures.
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Done through organized exchanges (central locations; e.g., NYSE,
LSE) or through
Over-the-counter arrangements (dealers in different locations; e.g.,
NASDAQ, and U.S. Government bond market) or through
US Government Sponsored Enterprises (GSEs): Federal National
Mortgage Association and Federal Home Loan Mortgage
Corporation.
Money and capital markets
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Short term versus long term maturities of traded instruments.
Financial Institutions
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Commercial entities that facilitate and
manage the movement of funds from
surplus entities to final borrowers.
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Commercial banks, investment banks,
asset managers (pension funds,
insurance companies), hedge funds,
foreign exchange brokers…
Governmental entities that are involved
in and/or regulate financial markets
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Central banks, regulatory agencies
Financial Instruments
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(1) Instruments which represent a claim on
the issuer’s (of the financial instrument) future
income and/or assets. Examples include:
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Bonds: Debt instruments with a contractual
agreement (indenture specifies interest
payment, maturity date, etc.).
Common Stocks: Instruments representing an
ownership position in a corporation.
(2) Instruments which are neither debt nor
equity based and thus belong in their own
category.

Foreign Exchange
Classifications of Financial Instruments
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(1) Financial instruments can be categorized by form
depending on whether they are cash instruments or
derivative instruments:
 Cash instruments are financial instruments whose
value is determined directly by markets.
 Stock and bonds
 Derivative instruments are financial instruments
which derive their value from some other
(underlying) financial instrument or variable.
 Futures, forwards, options (puts and calls)
 Originated in Chicago in the 1850s (CBOT) for
commodities (flour, hay, corn), but now involves
financial assets as well.
Classifications of Financial Instruments
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(2) As noted, financial instruments can also be
categorized depending on whether they are
equity based (reflecting ownership of the issuing
entity) or debt based (reflecting a loan the
investor has made to the issuing entity).
If debt, financial assets can be further
categorized into short term (one year or less) or
long term.
 Short term: money market instruments
 Long term: capital market instruments
Characteristics of an Efficient
Financial Market
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(1) Transparency:
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All participants will have access to reliable and
important information at the same time.
 Importance of trading platforms to transparency.
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Importance of financial services providers to
transparency in disseminating financial information.
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How quickly is trading information made available?
Do all potential traders have access to same trading
information (bid and ask prices publicly displayed).
Dow Jones, Bloomberg, Reuters.
Central banks and central bankers also play in role
in this process by pursuing transparency in terms of
their monetary policy processes.
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Web sites: http://www.bis.org/cbanks.htm
Efficient Financial Market
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(2) Adequate, but Not Excessive, Regulation:
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Financial markets need to have regulation which
ensures a level and fair playing field and appropriate
behavior.
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Regulation needs:
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To discourage insider trading, price manipulations, unethical
behavior
Provide appropriate reporting of financial information to markets.
Securities and Exchange Act of 1934 makes it unlawful for any
person "to use or employ, in connection with the purchase or sale
of any security… any manipulative or deceptive device…”
Issue for regulators: A what point does regulation
become a burden (excessive) and/or drive financial
service providers to other markets?
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Cost – Benefit Analysis done by regulators.
U.S. Sarbanes Oxley Act (2002)
Regulation of hedge funds.
Efficient Financial Market
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(3) Competition:
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Markets need to be structured and regulated so as to
offer easy access and exit.
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Not segmenting financial service providers.
Not overly protecting (or rescuing) poorly run firms.
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Moral hazard issue
Applies to both domestic and foreign entities.
Will ensure best prices and services for end users.
(4) Market Structure which Allows for Innovation:
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To provide needed new services and new product
development.
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Allow financial service providers to respond to needs of end
users.
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Development of derivative products in the 1970s through today.
Major Issue Facing Participants in
Financial Markets
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Are the prices of financial instruments
potentially unstable? How volatile are they?
Are they subject to?
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Quick and large short term moves.
Substantial longer term trend changes
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Quick answer: YES!!!
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Volatility is one major issue facing
participants in financial markets.
Interest Rates
Annual Data YoY
Corporate AAA Total Return
Changes in Stock Prices
Annual Data YoY
Changes in Exchange Rates
Annual Data (YoY)
Impact of Changes in Financial Variables
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Changes in interest rates:
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Affect the cost of borrowing (end users and intermediaries)
Influence the returns (and profit margins) to interest sensitive
financial institutions (e.g., banks) and the borrowings/investments
of non-financial sectors (household and companies).
Affect asset prices (bonds, stocks, foreign exchange).
Impact on the M&A market (leveraging activities)
Impact on mortgage markets.
Changes in stock prices:
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Affect the economy’s perception of wealth:
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Influence spending decisions (through the “wealth effect”).
Affect the IPO market and M&A market (P/E multiples)
Changes in exchange rates:
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Affect the competitive position of global firms, exporters and
importers.
Affect the returns to global investment funds (mutual funds, pension
funds).
Signals from the Stock Market
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Forecasters have
noted that for the U.S.
investors start
discounting the end
of an expansion and
the beginning of a
recovery in advance
of the business cycle
turning point.
How can you explain
this leading
relationship?
Stock Market as a Leading Indicator:
1968-1983
Stock Market as a Leading Indicator:
1989-1992
Stock Market as a Leading Indicator:
1997-2011
Appendix 1
Useful Websites for Stock Prices
and Exchange Rates
Stock Prices
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For long term historical views go to:
http://moneycentral.msn.com/investor/charts/
chartdl.aspx?Symbol=%24INDU&CP=0&PT=
5
For a view of what’s happening now go to:
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http://bloomberg.com/
Or:
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http://finance.yahoo.com/marketupdate?u
Exchange Rates
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Go to:
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http://fx.sauder.ubc.ca/
http://www.fxstreet.com/