Summary
Summary Lectures FMI year 3 FMI EBE
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Financial markets perform the essential economic function of channeling funds from households,firms, and governments that have saved surplus funds by spending less than their income to those
that have a shortage of funds because they wish to spend more than their income. Those who have
saved and are lending funds, the lender-savers, and those who must borrow funds to finance their
spending, the borrower-spenders. Funds flow from lender-severs to borrower-spenders via two
routes:
1. Direct finance, in which borrowers funds directly from financial markets by selling securities
2. Indirect finance, in which a financial intermediary borrows funds from lender-savers and then
uses these funds to make loans to borrower-spenders.
As shown in the photo, households are the most important lender-savers, business firms the most
important borrower-spenders.
Classifications of financial markets
- A security is a claim on the issuer’s future income or assets.
Money market Capital markets
Maturity < 1y >1y
Lenders Park money until they find Invest
better use
Borrowers Borrow short-term Borrow long-term
Common trading venue OTC IPO, SEO, organized secondary
market exchanges
Money market instruments
- US Treasury bills
- Negiotiable bank certificates of deposit
- Commercial papers
- Repurchase agreements
- Federal funds
,Capital market instruments:
- Stocks
- Mortgages and mortgage-backed securities
- Corporate bonds
- Government, municipal, and government agency securities
Classifications of markets according to different parameters:
1. Type of security: debt markets, equity markets.
Firm or individual can obtain funds in a financial market in two ways. The most common way
is through the issuance of a debt instrument, such as a bond or mortgage, which is a
contruactual agreement by the borrower to pay the holder of the instrument fixed dollar
amounts at regular intervals. The maturity of a debt instrument is the number of years until
that instrument’s expiration date. Short term if it is less than a year, long term if it is ten
years or longer. Elseway, intermediary.
The second method of raising funds is through the issuance of equitys, such as common
stock, which are claims to share in the net income and the assets of a business. The main
disadvantage of owning a corporation’s equities rather than it’s debt is that an equity holder
is a residual claimant; the corporation must pay all its debt holders before it pays its equity
holders.
2. Nature of securities traded: primary / secondary markets
Primary market is a financial market in which new issues of a security, such as a bond or
stock, are sold to initial buyers by the corporation or government agency borrowing the
funds.
A secondary market is a financial market in which securities that have been previously issued
can be resold. Security brokers and dealers are crucial to a well-functioning secondary
market. Brokers are the agent of investors who match buyers with sellers of securities;
dealers link buyers and sellers by buying and selling securities at stated prices. Two
important functions of secondary markets:
- they make it easier and quicker to sell these financial instruments to raise cash, more liquid
- determine the price of the security that the issuing firm sells in the primary market.
3. Form of organization: exchanges / OTC
Secondary markets can be organized in two ways. (1) Through exchanges where buyers and
sellers of securities meet in one central location. (2) OTC in which dealers at different
locations who have an inventory of securities stand ready to buy and sell securities over the
counter to anyone who comes at them and is willing to accept the prices.
4. Maturity of instruments: money market (<1y debt), capital markets (>1y)
Money market is a financial market in which only short-term debt instruments are traded.
The capital market is the market in which longer-term debt instruments and equity are
traded.
5. Place where instruments issued: domestic / international markets
Benefits of financial intermediaries
- Lower transaction costs
- Economies of scale
- Liquidity services
- Customization of specific needs
, - Risk sharing
- Diversification
- Better equipped and develop expertise to deal with asymmetric information problems
1. Adverse selection screening before the transaction
2. Moral hazard monitoring after the transaction
Asymmetric information: one party has more or better information than the other
Information asymmetry: adverse selection + moral hazard
- Adverse selection: problem created by asymmetric information before the transaction
occurs. Occurs when potential borrowers who are the most likely to produce an undesirable
outcome are the ones who actively seek out a loan and thus are most likely to be selected.
- Moral hazard: the problem created by asymmetric information after the transaction occurs.
The risk that the borrower might engage in activities that are undesirable from the lender’s
point of view, because they will be less likely to pay it back.
Regulation in financial system, aims:
1. To increase information available to investors
2. To ensure the reliability of the financial system
PV = CF / (1+i)^n
Loan principal: the amount of funds the lender provides to the borrower
Maturity date: the date the loan must be repaid. The loan term is the time elapsed from initiation to
maturity date
Interest rate: the percentage of principal that must be paid as interest to the lender, expressed on
annual base
Yield to maturity: the interest rate that equates the PV of CF payments received from a debt
instrument with its value today
Interest rates vs returns
- Investors may buy and hold bonds for a shorter period than their maturity
- Bond prices can change over time returns too
- Rate of return for holding a bond
Interest-rate risk
- Prices of bonds change when the interest rate changes
1. Prices and returns for long-term bonds change more than those for shorter-term
bonds
2. There is no interest-rate risk for any bond whose time to maturity matches the
holding period
Nominal interest rate makes no allowance for inflation
Real interest rate is adjusted for changes in price level so it more accurately reflects the cost of
borrowing.
Which factors affect nominal interest rates, plan:
1. Bond prices are negatively related to interest rates
2. We evaluate which factors affect bond prices
3. The same factors affect nominal interest rates
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