Financial Markets and Instruments Overview

Financial Markets and Instruments

• Financial markets encompass various platforms enabling buyers and sellers to trade financial instruments.
• Financial instruments represent legal agreements between parties outlining conditions for receiving benefits (financial asset) or incurring costs (financial liability/equity).
• Portfolios, broker/trader books, and trading books categorize collections of financial instruments.
• Financial institutions facilitate transactions like deposits, loans, investments, and currency exchange.
• Financial institutions include banks, insurance firms, and brokerage businesses.
• Money functions as a medium of exchange, a unit of account, and a store of value.

Players in Financial Markets

• Four key players exist: retail investors, firms, governments, and financial intermediaries.
• Financial intermediaries include banks, central banks, pension funds, hedge funds, and family offices.
• Intermediaries assist individuals and businesses in financial markets.
• Non-bank intermediaries operate outside regular banking regulations.
• The first three players (retail investors, firms, and governments) are part of the real economy

Types of Funds

• Regulated Funds:
  • Exchange-traded funds (ETFs) replicate stock indices, trading on exchanges.
  • Pension funds invest in pooled funds offering retirement income.
  • Collective Investment Schemes (CIS) or OPCVMs are financial intermediaries who provide investment access to markets otherwise unavailable.
• Unregulated Funds:
  • Private equity involves investments in privately held companies.
    • Venture capital is a type of financing provided to startup companies and small businesses with growth potential.
  • Hedge funds utilize sophisticated investment strategies for qualified investors.
  • Family offices manage investments and wealth for wealthy families.

Buy-Side vs. Sell-Side

• The buy-side invests in securities, while the sell-side promotes and sells securities.
• Fund managers are key players on the buy-side.
• Sales personnel, brokers, and traders are players on the sell-side

Players in Financial Institutions

• Market makers, traders, brokers, dealers, hedgers, arbitrageurs, speculators, structurers, fund managers, and others (analysts, risk managers, regulators, treasurers) are involved.
• Arbitrageurs profit from exploiting market inefficiencies.
• Brokers act as intermediaries between investors and exchanges.

Purposes of Financial System

• Clearing and Settlement: Facilitating payments
• Pooling and Subdividing: Bringing together resources
• Transferring Resources: Across time and space
• Managing Risks: Mitigating potential losses
• Providing Information: Guiding decisions
• Addressing Incentive Problems: Fighting fraud and market manipulation

Types of Financial Instruments

• Cash Instruments: Assets with immediate settlement (real assets, securities, cash).
• Derivative Instruments: Instruments deriving their value from other assets (futures, options, forwards).
• Equity-based: Represents ownership stake
  • Stock
• Debt-based: Represented by loans
  • Bonds
• Foreign Exchange: Involve multiple currencies

Financial Markets

• Primary Market: for new securities issues (IPO, follow-on).
• Secondary Market: for existing securities trading.
• Over-the-Counter (OTC) Markets: for customized transactions (e.g., foreign exchange).
• Organized Markets: for standardized transactions on exchanges (e.g., stock).

Securitization

• Pooling debt assets into securities and selling them to investors.
• Common types include mortgage-backed securities (MBS), asset-backed securities (ABS), collateralized debt obligations (CDOs).

Securities

• Fixed-income Securities: Debt instruments with defined maturity, periodic payments. (e.g. CDs, Commercial paper, Treasury Bills, Repurchase agreements, bonds)
• Equity Securities: Represents ownership in a company (common stock, preferred stock)

Derivatives

• Options: Provide the right, but not the obligation, to buy or sell an underlying asset at a set price.
• Forwards: Agreements to buy or sell an asset at a future date at a predetermined price.
• Futures: Standardized forward contracts traded on exchanges.
• Swaps: Agreements to exchange cash flows at future dates.
• Credit Derivatives: Provide protection against credit risk.

Bank Balance Sheet

• Includes assets (cash, loans, securities) and liabilities (deposits, debt, equity).

Financial Instruments Purposes

• Capital Raising, funds for firms and governments

• Consumption Smoothing: Facilitating spending across time

• Risk Management: Transfer risk via derivatives and portfolio construction

• Speculation: Profiting from price changes