Financial Markets Overview

Study Notes

Financial Markets

Financial markets facilitate the exchange of funds between savers and borrowers. These markets are categorized into money markets and capital markets.
Money markets deal in short-term debt instruments like Treasury bills and commercial paper. These instruments have maturities of one year or less and are considered low-risk.
Capital markets deal in long-term debt and equity instruments (bonds and stocks) with maturities exceeding one year and varying risk levels.
Key functions include price discovery, risk management, and capital allocation.
Price discovery sets asset prices through buyer-seller interaction.
Risk management allows risk transfer, such as diversification across assets.
Capital allocation moves funds from savers to investors, boosting economic efficiency.

Financial Instruments

Financial instruments are contracts representing promises to pay/deliver value.
Common types include stocks, bonds, derivatives (options, futures, swaps).
Stocks represent company ownership.
Bonds represent loans to borrowers (governments, corporations).
Derivatives gain value from underlying assets (commodities, currencies, stocks).
Instruments finance projects, raise capital, and manage risk.
Market efficiency reflects how quickly market prices adjust to new information.
Efficient markets quickly adapt to new information.
Market participants ensure market liquidity and transactions.

Financial Institutions

Financial institutions facilitate fund flows in financial markets, acting as intermediaries.
Examples include commercial and investment banks.
Banks accept deposits and offer loans.
Investment banks underwrite securities and provide advisory services.
Insurance companies pool risks, offering protection against loss.
Mutual funds aggregate investments, providing diversification.
Pension funds manage retirement savings, providing income.
Financial institution regulation maintains stability and confidence. Regulations mitigate systemic risk and set standards for financial activities/fraud prevention.

Key Financial Concepts

Risk and Return Trade-off: Higher potential returns generally accompany higher risks.
Liquidity: Ease of converting an asset to cash without significant value loss (cash/stocks are highly liquid; real estate/collectibles are illiquid).
Diversification: Reduces portfolio risk by spreading investments across assets/asset classes.
Inflation: A general price increase over time, diminishing purchasing power. Inflation impacts long-term investment decisions.
Time Value of Money: Present money is worth more than future money due to earning potential. Discounting calculates present value.

Financial Statement Analysis

Financial statements (balance sheet, income statement, cash flow statement) evaluate company financial health.
The balance sheet shows assets, liabilities, and equity at a point in time.
The income statement summarizes revenues/expenses over a period, yielding net income/loss.
The cash flow statement tracks cash inflows/outflows, categorizing into operating, investing, and financing activities.
Ratio analysis assesses company performance and financial position relative to competitors/benchmarks/historical trends by comparing ratios.

Portfolio Management

Portfolio management selects, acquires, and manages assets to meet investment goals.
It uses diverse strategies and asset allocations.
Risk tolerance, investment time horizon, and goals influence portfolio choices.
Asset allocation (distributing assets among stocks, bonds) is critical. Diversification balances risk and return.
Portfolio performance is evaluated based on return, risk, and performance ratios (Sharpe ratio).

International Finance

International finance involves financial transactions and interactions across national borders.
Key aspects include exchange rates, international trade, and international investment.
Exchange rates are the values of different currencies.
International trade involves the exchange of goods/services.
International investment includes direct investment (foreign operations) and portfolio investment (foreign equities/bonds).
Currency risk is crucial in international finance due to exchange rate fluctuations. International finance is complex, affected by political, economic, and social factors.

Description

This quiz covers the fundamental concepts of financial markets, including the distinction between money markets and capital markets. Learn about short-term and long-term instruments, key functions such as price discovery, risk management, and capital allocation. Test your understanding of how these markets facilitate exchanges between savers and borrowers.