FNCE 4070: FINANCIAL MARKETS AND INSTITUTIONS Lecture 2: Understanding Financial Markets and Institutions

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FNCE 4070 FINANCIAL MARKETS AND INSTITUTIONS
Lecture 2 Understanding Financial Markets and
Institutions
Working Definitions Characteristics of an
Efficient Financial Market Financial Market
Signals
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Where is this Financial Market?
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Financial Markets and Financial Institutions

• How might you define these?
• Perhaps in terms of specific functions?
• 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
• Commercial organizations
• Governmental organizations (Central banks,
  regulatory organizations --- SEC FSA)
• Private regulatory organizations (SP, Moodys,
  Fitch)

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Function of FinancialMarkets

• 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.

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Functions of Financial Markets

• 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)

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Functions of Financial Markets

• 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

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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
• Result in highest possible economic growth!

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Functions of Financial Markets

• Provides financial signals to market participants
• Interest rates, stock prices, exchange rates as
  measures of markets perception of risk and
  changing risk
• Stock prices and interest rates may tell us
  something about the markets 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 markets
  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.

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Classification of Financial Markets

• Primary Financial Market
• 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
• 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.
• 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
• Short term versus long term maturities of traded
  instruments.

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Financial Institutions

• Commercial entities that facilitate and manage
  the movement of funds from surplus entities to
  final borrowers.
• 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
• Central banks, regulatory agencies

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Financial Instruments

• (1) Instruments which represent a claim on the
  issuers (of the financial instrument) future
  income and/or assets. Examples include
• 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

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Classifications of Financial Instruments

• (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.

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Classifications of Financial Instruments

• (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

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Characteristics of an Efficient Financial Market

• (1) Transparency
• All participants will have access to reliable and
  important information at the same time.
• Importance of trading platforms to transparency.
• How quickly is trading information made
  available?
• Do all potential traders have access to same
  trading information (bid and ask prices publicly
  displayed).
• Importance of financial services providers to
  transparency in disseminating financial
  information.
• 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.
• Web sites http//www.bis.org/cbanks.htm

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Efficient Financial Market

• (2) Adequate, but Not Excessive, Regulation
• Financial markets need to have regulation which
  ensures a level and fair playing field and
  appropriate behavior.
• Regulation needs
• 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?
• Cost Benefit Analysis done by regulators.
• U.S. Sarbanes Oxley Act (2002)
• Regulation of hedge funds.

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Efficient Financial Market

• (3) Competition
• Markets need to be structured and regulated so as
  to offer easy access and exit.
• Not segmenting financial service providers.
• Not overly protecting (or rescuing) poorly run
  firms.
• 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
• To provide needed new services and new product
  development.
• Allow financial service providers to respond to
  needs of end users.
• Development of derivative products in the 1970s
  through today.

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Major Issue Facing Participants in Financial
Markets

• Are the prices of financial instruments
  potentially unstable? How volatile are they? Are
  they subject to?
• Quick and large short term moves.
• Substantial longer term trend changes
• Quick answer YES!!!
• Volatility is one major issue facing
• participants in financial markets.

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Interest Rates
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Annual Data YoY
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Corporate AAA Total Return
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Changes in Stock Prices
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Annual Data YoY
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Changes in Exchange Rates
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Annual Data (YoY)
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Impact of Changes in Financial Variables

• Changes in interest rates
• 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 MA market (leveraging activities)
• Impact on mortgage markets.
• Changes in stock prices
• Affect the economys perception of wealth
• Influence spending decisions (through the wealth
  effect).
• Affect the IPO market and MA market (P/E
  multiples)
• Changes in exchange rates
• Affect the competitive position of global firms,
  exporters and importers.
• Affect the returns to global investment funds
  (mutual funds, pension funds).

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Signals from the Stock Market

• 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?

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Stock Market as a Leading Indicator 1968-1983
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Stock Market as a Leading Indicator 1989-1992
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Stock Market as a Leading Indicator 1997-2011
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Appendix 1

• Useful Websites for Stock Prices and Exchange
  Rates

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Stock Prices

• For long term historical views go to
• http//moneycentral.msn.com/investor/charts/chartd
  l.aspx?Symbol24INDUCP0PT5
• For a view of whats happening now go to
• http//bloomberg.com/
• Or
• http//finance.yahoo.com/marketupdate?u

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Exchange Rates

• Go to
• http//fx.sauder.ubc.ca/
• http//www.fxstreet.com/