QUIZZ SESSION 1

Session 1: Overview of the Financial Markets

• The session aims to familiarize participants with the terminology, characteristics, and mechanisms of financial markets and institutions.

Outline of Introductory Lecture:

• Reminder of financial mathematics
• Key market concepts of finance, financial institutions, technology, and respective markets
• Overview of financial markets and intermediaries
• Insight into equity/bond/derivatives/currency markets
• Key valuation concepts, including money, price, and value
• Financial systems, infrastructure, and stability

Discounting: Present Value (PV) vs. Future Value (FV)

• Future Value (FV) = Present Value (PV) × (1 + interest rate)
• Present Value (PV) = Future Value (FV) / (1 + interest rate)
• If €100 is placed in a savings account with a 2% interest rate, after one year, it becomes €102.
• Prefer to receive €100 today because the opportunity cost (2%) is positive.

Compounding Over Multiple Periods

• Formula for money paid back over multiple years: FV = PV × (1 + i)^n
• PV is the present value and n is the number of years.
• With an initial investment of €100 and an interest rate of 2% over two years, the balance becomes €104.04, calculated as €100 × (1.02)^2.

General FV Formula

• Cash Flow PV = Cash Flow / (1 + Interest Rate)^n
• This applies to a simple loan repaid in full at maturity, including interest, without intermediary payments.
• For a $250 payment in two years with a 15% interest rate, the present value is $189.04.

Yield to Maturity (YTM)

• YTM is a significant method of determining interest rates.
• This rate equates present value to future cash flows relative asset value, if it is kept until its maturity.
• Equals the loan interest rate, for a simple loan.

Present Value (PV) of Multiple Cash Flows

• Perpetuity: A constant series of cash flows (C) occurring every unit period and continuing indefinitely
• PV = C/r
• Growing Perpetuity: growing series of cash flows at a constant rate (g) every unit period forever as of the first year (C)
• PV = C / (r - g)
• Annuity: fixed number of unit periods
• PV = (C / r) * (1 - (1 / (1 + r)T))
• Growing Annuity: fixed number of periods that grows at a constant rate, g
• PV = (C / r-g) * (1 - ((1 + g) / (1 + r))^T)

Finance Overview

• Finance includes money, investments, borrowing, lending, budgeting, saving, and forecasting.
• It is a pillar of human society, allocating resources through space and time while motivating productivity.
• It supports enterprises.
• It manages risk and uncertainty.

Financial Institutions

• Financial Institutions deal with financial and monetary transactions like deposits, loans, investments, and currency exchange.
• Examples include Commercial Banks (BNP Paribas, Société Générale), Investment Banks (J.P. Morgan, Goldman Sachs), Insurance Companies (AXA, Allianz Life), Brokerage Firms (Fidelity, Vanguard), and Central Banks (ECB, Fed).

Financial Technology

• Financial technology competes with traditional methods in delivering financial services.
• Artificial Intelligence, Big Data, Software Robotics, and new asset classes like blockchain are used.

Financial Markets

• Financial markets are marketplaces where financial instruments or securities are traded
• A security is an instrument that holds monetary value, which can be traded between parties
• Entitles the owner to some cash flow, or asset.

Trading Securities

• People trade to solve individual needs, such as saving for retirement via pension funds.
• Securities are categorized into Equity Securities, Debt Securities, Derivative Securities, and Currencies.
• The market is named based on the traded securities (e.g., equity market, debt market, forex).

Bonds vs. Stocks (Summary)

• Bonds:
  • Not a share of ownership.
  • Fixed maturity.
  • Contractual payments.
  • Return is interest.
  • Highest seniority.
• Stocks:
  • Share of ownership.
  • No maturity.
  • No contractual payments.
  • Return is dividend + price increase.
  • Lowest seniority.
• Stocks are riskier than bonds but offer higher returns.

Importance of Financial Markets

• Financial markets channel funds from lenders to borrowers, promoting economic efficiency.
• They affect individuals, business firms, the entire economy and can grow economies.

Channeling Funds in Financial Markets

• Financial markets channel excess funds from lender-savers to those needing funds.
• Lender-Savers: Households, Business firms, Government, Foreigners
• Borrower-Spenders: Business firms, Government, Households, Foreigners

Functioning of Financial Markets: Direct and Indirect Finance

• Funds channel from lender-saves to borrower-spenders in 2 ways.
• Direct finance allows borrowers to sell financial instruments to lenders.
• Indirect finance uses financial intermediaries like banks for loans.

Functioning of Financial Markets (Examples)

• General Motors can get a bank loan or sell bonds or stock if they need to borrow funds to pay for a new factory
• Although getting a bank loan may not always be possible because of certain limitations.
• A Government deficits can issue bonds for the reason of reimbursing previous debts or bonds.
• Financial markets help move funds from those lacking a productive use to those with opportunities.

Efficient Allocation of Capital

• Financial markets produce this which allows funds to move from those with productive investment companies.
• Improve consumers well-being as their purchases are timed better.

Role of Financial Intermediaries

• They are primary in moving funds from leaders to borrowers in financial markets.
• For example, banks play the role of middleman.
• Intermediaries reduce transaction costs, provide liquidity services, reducing costs.

Asymmetric Information

• Occurs as a transaction when one party lacks vital detail to inform their decision-making.
• Discussed along two fronts: adverse selection & moral hazard. -Occurs after the transaction
• Borrower engages activities that make borrower unlikely to pay borrower back, when borrower borrows money/is insured

Risk Sharing

• Financial intermediaries reduce costs, addresses asymmetric transaction, and reduces the exposure of investors.
• This occurs as financial intermediaries can create and sell assets with lower risk, in order to acquire assets, with greater ones.

Exchanges vs. Over-the-Counter (OTC) Markets

• Security market is a component of the wider financial market where financial securities can be bought and sold between different parties, based on demand and supply.
• Centralized exchanges
• Broker-dealer networks, also known as Over-the-Counter (OTC)

Equity Securities and Equity Markets

• Equity securities are shares of ownership in a company.
• Returns of stock are: -Stock prices growing Receive dividends, which depend on their share of the profits that the company makes
• Common and preferred stocks are the two main types of equities.

Primary vs. Secondary Markets

• New stocks are issued (IPO).
• Issuers can then then trade those stocks in the secondary market based on supply and demand.
• Security sold for the first time are primary markets.

Importance of Secondary Stock Markets

• It does not provide financing for transaction.
• Give and idea of their stock if they have new financing issues/needs.
• Companies tend to monitor the price of market.
• Stock markets receive a of coverage in media.

Debt Securities vs. Debt Markets

• Debt securities come from loans.
• Debt markets exist so govs, corporations, and individuals to borrow.
• Distinction comes according to the issuer.
  • Govt/Corporate/Municipal Bonds -Zero-Coupon Bonds

Geographical Comparison between Bonds/Stocks

• In the USA, Bonds are 44%, Stocks are 38%, and Bank debt are 18%
• In Euro Zone, Bank debt are 51%, Bonds area 25% and Shares are 24%

Reasons for Geographical Differences

• Historical reasons,culture, religion, protection of of investors, and corporate governance.

Derivatives and Derivatives Market

• Derivatives is an instrument whose value is derived from the value of one or several assets or securities, called the udnerlying asset(s).
• Derivatives reduce/eliminate different types of risk/speculate.
• This could include forwards which are traded over the counter AND:
• Options which include owners who have the right contract that allows them to buy or sell.

Currencies and Foreign Exchange (Forex) Markets

• This is where exchange rates and where currencies trade on the inter nation market.
• Currency trading is all OTC and there isn't central market place as it is conduct electronically.
• Changes in exchange rates affect the prices of imported goods and domestic products that rely on imported parts and raw materials.

Money and Value (Distinction)

• Money is a medium of exchange that acts a measure of value.
  • Price is market worth something is
  • Value is theoretical notation refers to what one believes something is worth intrinsically
• For money to be used, it must be a high degree of confidence of financial system
• Legal tender made by decree = fiat money

Determination of Money Amount

• The amount of money is administered by the monetary policy from central banks.
• Central banks important in the financial system.

Financial Infrastructure

• Financial is composed by a type of insitutions like commercial banks, insurance companies, investment banks etc.
• Helps financial markets operate, but needs to be stable to occur.
• Infrastructure and stability are needed as well as property rights/transparency by participants.

Europe and the ECB

• At European Level, the ECB establishes the SSM responsible for for banking supervision for countries in Europe.
  • Main aim is for for financial stability

Financial Stability

• The financial system is stable if it can efficiently transfer resources and avoid being prone to market disturbances or having drops in asset prices and the failure of many financial institutions.