• The functions of financial markets:
o 3 type financial markets: stock market (shares), corporate bond market
(debt), money market (short term debt instrument, very liquid)
o Financial intermediation through institutional investors: pension funds,
investment funds, venture capital, private equity
• Financial markets play a crucial role in the economy:
o Financial markets determine how much money different companies are going
to get (allocation of capital)
o Financial markets allow to smooth consumption over time (when we are
going to consume) à this is called consumption smoothing (for example
putting money in a bank, getting a loan, etc.)
o Separation of ownership and management à shareholders do not need to be
that active anymore
o Provision of liquidity à easily converting into cash à financial markets allow
this (converting stocks and bonds)
o You can invest in riskier security if you want to
o Financial markets gather information à stock price is a proxy of information
• Margin trading
o à purchasing securities in part by borrowing money
o Margin = capital put up by investors to secure credit from a broker to buy
securities
o The broker requires investors to put up a certain minimum margin (50%
initial margin requirement of 50%)
o If margin falls below threshold (maintenance margin), the investor gets a
margin call and has to put up extra capital in the brokerage account
, CASH FLOWS OF BUY/SHORT SIDE
• Long position margin (you buy a stock)
o The balance sheet at your brokerage account would look like this:
• Short position margin
o Short sales allow investors to profit from a decline in security’s price by
selling a security that is borrowed from another investor (you do not own it,
you buy it back when the price goes down)
o Mechanisms: borrow stock through a broker, sell it and deposit proceeds and
margin in an account, closing out the position and buy it back and return to
the party which it was borrowed from
o You still need to put a margin in the account since the broker is going to do
the operation for you and the loss is unlimited
, EXAMPLE 1:
• Asset side is nondependent on the price of the stock: both numbers are CASH
positions
• Stock owed changes when the price of the stock changes
• Equity = assets – stock owed
• Margin = equity / market value of position (for now is exactly 50%)
EXAMPLE 2:
• What happens when the stock price moves?
• If the stock price goes up to 110:
• At what stock price are you getting a margin call? Above the price P found
with the equation:
, EXAMPLE 3:
Lecture 1:
• How are financial markets organized?
o Dealer markets (fixed income, FX, some derivative markets)
o Agency markets / limit order book (most stock, some derivative markets)
• Why do we care?
o Type of market determines way of trading, trading is important consideration
in portfolio management and asset pricing, neglected in many courses on
asset management
• Since trading is costly, investors are concerned about market liquidity:
o The ability to trade large quantitates of financial asset quickly, at low cost,
and with little impact on the price
o Three elements of market liquidity:
§ Transaction costs
§ Depth (how much demand and supply are available in the market)
§ Price impact
• Illiquidity can be a source of risk!! à bid ask spread
Dealer markets:
• In dealer markets, buyers and sellers do not trade with each other, but with
“dealers”9usually banks) who act as intermediary and stabilize the market by
supplying immediacy
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