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

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


1
FNCE 4070 FINANCIAL MARKETS AND INSTITUTIONS
Lecture 2 Understanding Financial Markets and
Institutions
Working Definitions Characteristics of an
Efficient Financial Market Financial Market
Signals
2
Where is this Financial Market?
3
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)

4
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.

5
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)

6
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

7
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!

8
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.

9
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.

10
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

11
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

12
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.

13
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

14
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

15
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.

16
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.

17
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.

18
Interest Rates
19
Annual Data YoY
20
Corporate AAA Total Return
21
Changes in Stock Prices
22
Annual Data YoY
23
Changes in Exchange Rates
24
Annual Data (YoY)
25
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).

26
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?

27
Stock Market as a Leading Indicator 1968-1983
28
Stock Market as a Leading Indicator 1989-1992
29
Stock Market as a Leading Indicator 1997-2011
30
Appendix 1
  • Useful Websites for Stock Prices and Exchange
    Rates

31
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

32
Exchange Rates
  • Go to
  • http//fx.sauder.ubc.ca/
  • http//www.fxstreet.com/
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