Fiche overview of financial market

FINANCIAL MARKETS

An overview of the financial system

        A market is the institutional that organizes a meeting b/w the buyer and the seller, a shop for example. It allows buyers and sellers to trade goods or financial securities.

        A good is devoted to the response of one desire/need.

Now, markets can be online and not only physical, i.e Ebay, Amazon.

Historically, markets for goods were physical meeting places where buyers and sellers could trade.  

important ingredients for a market to behave efficiently:

• Property rights are correctly enforced,

• Transparency of the institutional framework

• Confidence in the institutional framework, need a good atmosphere etc..

An important source of market disruption: lack of trust.

A financial security is a piece of paper which is a claim on an issuer’s future income or assets.

It could be a sheet, an agreement, etc…

Basic securities: bonds, stocks

Bond : debt security that promises to make payments periodically for a specified period of time. Bondholders receive coupons. At the end of the period, you know how much you will get.

Stocks :  different from the bond cause you don’t know the price you will get at the end. They are much more volatile. It is a security that is a claim on the earning and the assets of the corporation. Stockholders receive, if any, dividends.

Bonds represent borrowings, stocks represent ownership

Bond/ Debt[pic 1]

● Not a share of ownership;

● Fixed maturity
● Contractual payment

Stocks : common stocks, preferred stocks

Bonds : floating rate notes (non constant interest rate), fixed rate note (constant interest rate)

Consider an investor with a buy and hold strategy.

• A stockholder (of a firm that pays dividends on a regular base) expects to receive a flow of dividends over time.

• A bondholder expects to receive the flow of coupons over time.

A Financial market is an institution in which investors can buy and sell financial securities at the (current) market price.

Firms may finance their investment by issuing debt or stocks. Governments or municipalities may finance their expenditures by issuing debt

primary versus secondary markets:

A primary market is a financial market in which new issues of a security are sold to initial buyers.

A secondary market is a financial market in which securities that have been previously issued can be resold.

They can be organized in two ways:

- An exchange-traded market: buyers and sellers if securities meet in one central location to conduct trades

        - Over-the-counter market (OTC): it is an intangible organization which is a telephone and computer-linked network of traders who work for a financial institution.

Secondary market serves two important functions:

        - Establish a price for the securities

        - Provide liquidity, that is, making it easy to buy and sell the financial securities at the current market price.

As a shareholder, without secondary market, it would be very difficult to sell your shares.

Brokers-dealers are the most important acts of OTC trading, they provide liquidity.

A broker-dealer is a financial institution that engages in the business of trading securities for its own account (proprietary trading) or on behalf of its customers.

When executing trade orders on behalf of a client, the institution is said to be acting as a broker.

When executing trades for its own account, the institution is said to be acting as a dealer.

OTC trading is generally facilitated with market makers (MM). It is an individual (who typically works in an investment bank) who is always prepared to quote:

        - a bid price (price at which MM buys)

        - an offer price (price at which MM sells)

MM must buy and sell at their quoted prices.

The spread bid ask is the source of profit.

money and capital markets

It is usual to distinguish markets on the basis of the maturity of the securities traded.

The money market is a financial market in which only short-term debt instruments (with maturity of less than 1Y) are traded.

The capital market is the market in which longer- term debt and equity instruments are traded.

Exemples :

• US Treasury bills, which are short-term debt of the US government to finance the federal government. See the AFT (Agence France Trésor website) for the case of France.

• Corporate bonds, which are long-term debt issued by corporation.These bonds may be rated by rating agencies.

derivatives

A derivative is a financial instrument (contract) whose value are derived from the value(s) of underlying asset(s) (e.g., a stock).

Financial derivatives are useful instruments that can be used to reduce or eliminate a risk (interest rate risk, a default risk...).This is generally called risk management.

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