Financial Markets Overview

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.