Financial Markets Overview

• Session 1 provides an overview of financial markets
• The purpose of the session is to familiarize with financial market terminology, characteristics, and mechanisms, also financial institutions

Key Topics Outlined

• Financial mathematics
• Finance, financial institutions/technology/markets
• Financial markets and intermediaries
• Equity/Bond/Derivatives/Currency markets
• Money, price, and value
• Financial system/infrastructure/stability

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

• The FV of receiving €100 today with interest is €102

• The PV of receiving €102 in the future is €100

• To calculate the Future Value

• FV = PV x (1 + i)

• To calculate present value from a future value:

• PV = FV / (1+i)

• If the money was to be paid back in 2 years using the same formula: €102 x 1.02 = €100 x (1.02) x (1.02) = €100 x (1.02)² = €104.04

• The PV formula to apply to a simple loan, repaid in full, with interest, at maturity, and without intermediary payments: PV = CF / (1 + i)n

• For example, the present value of $250 to be paid in two years with a 15% interest rate: $250 / (1 + 0.15)² = $250 / (1.3225) = $189.04

Yield to Maturity

• Yield to maturity (YTM) is the most important way to calculate interest rates
• It represents the constant interest rate that equalizes the present value of future cash flows to the value of a debt instrument
• YTM is the total return for an investor on a bond, if it is held until maturity
• For a simple loan, yield to maturity is the same as the loan interest rate
• In this formula: i = 15% -> $189.04 = $250 / (1 + i)² where (1 + i)² = $250 / $189.04

Present Value of more than 1 cash flow

• A perpetuity is a constant series of cash flows, C, that occur every unit period (for example year) and continue forever
• Formula: PV = C/r
• A growing perpetuity is a series of cash flows, Ct, which occur every unit period, continue forever, and grows at a constant rate, g, every unit period (year) after.
• Formula: PV = C / (r-g)
• An annuity is a series of constant cash flows, C, that occur every period for a fixed number of unit periods
• Formula: PV = C/r * (1 - (1/(1+r)^T)
• A growing annuity is series of cash flows, C₁, which occur every unit period for a fixed number of periods, and grows at a constant rate, g, every period after
• Formula: PV = C/r-g * (1 - ((1+g)/(1+r)^T)

Finance

• Encompasses money, investing, borrowing, lending, budgeting, saving, and forecasting
• Finance is allocating limited resources, motivating productivity, supporting enterprises, and managing risk/uncertainty
• Financial institutions are entities that deals with financial and monetary transactions like deposits, loans, investments, and currency exchange
• Commercial Banks, Investment Banks, Insurance Companies, Brokerage Firms, and Central Banks are all Financial Intitutions
• Financial technology is technology and innovation that aims to compete with traditional methods in the delivery of financial services
• Examples: Artificial Intelligence, Big Data, Software Robotics, New asset classes (e.g blockchain)

Financial Markets

• Any marketplace trading financial instruments (securities)
• A security is negotiable financial instrument that is a claim on the issuer's future income or assets
• Issuers - governments, municipalities, & corporations
• Equity Securities - the amount of investment put into a company in exchange for shares: common or preferred stocks or shares
• Debt Securities include Bonds, Treasury bills/notes, and bank notes
• Derivative Securit include Forwards, futures, options, and swaps
• Currencies are the US Dollar, Euro, etc.
• Equity market is the market that trades equity
• Debt market is the market that trades debt
• Derivatives market is the market that trades derivatives
• Foreign Exchange Market (Forex) is the market that trade currencies

Bonds and stocks

• Bonds are not ownership and have a fixed maturity and a contractual payment while stocks are shares of ownership with no maturity with no contractual payments.
• Bond returns come from interest with highest senority and stock returns are dividends that increase in price with lowest seniority.
• Common stocks and shares (Equity Securities)

Purpose of Financial Markets

• Funds channel from lenders to borrowers, thereby promoting economic efficiency
• Market activities affect personal wealth, business firms, and the entire economy
• Well-functioning markets are key factors in economic growth
• Financial markets channel excess funds from lender-savers to those who have a shortage of funds
• Lender savers: Households, Business firms, Government, Foreigners
• Borrower spenders: Business firms, Government, Households, Foreigners
• There are 2 ways of channeling funds from lender-savers to borrower-spenders: direct and indirect finance
• Direct: borrowers borrow directly from lenders which are claims on the borrower's future income or assets
• Indirect: Borrowers borrow indirectly from lenders via financial intermediaries such as banks
• If you save $1,000, but there are no financial markets, then you can earn no return on this
• Financial markets are critical for efficient capital allocation by moving funds from people who lack investment opportunities to those who have them
• Well-being of consumers is improved because they can better time their purchases

Financial Intermediaries

• Play the role of the middle-men where the intermediary obtains funds from savers and then loans/investments with borrowers
• More important for financing than securities markets
• Needed as it deals with transaction costs.
• Asymmetric information affects risk-sharing by providing liquidity services such as banks
• Banks provide depositors with checking accounts that enable them to pay bills easily
• Depositors can earn interest on checking and savings accounts which convert into goods and services
• Asymmetric information is when a transaction occurs and one party lacks crucial info about the transaction which affects the decision making process with 2 types of problems:
  • Adverse selection - One party has information before the transaction occurs
  • Moral Hazard - One party has information after the transaction occurs

Exchanges vs Over-the-Counter(OTC) markets

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

Equity Securities and Equity Markets

• Equity securities are shares of ownership in a company with a claim to a share in the net income and assets of a business
• Returns from holding stocks come from if the investment increases in value and the stock holders recieve stock dividends depending on the companys earninga and policy.
• Equity is made of common stocks and preferred stocks.
• New stocks are issued by companies and sold to the first buyers
• Stocks are traded in two markets as primary or secondary -Primary Market-When stocks are being sold for the first time (i.e. an IPO) -Secondary market- when investors trade stocks among themselves

Debt Securities

• A financial asset that one party created when one party lends money to another
• The borrower is required to repay the principal (seller of the debt security) borrowed in addition to the cost of borrowing (interest) over time
• allow governments, corporations, and individuals to borrow money to purchase mortgages and houses.
• Common types of (long-term) debt security are:
  • Distinction according to the issuer (Government bonds, Corporate bonds, Municipal bonds, and Zero-coupon bonds)

Derivatives and Derivatives Market

• A financial instrument (contract) whose value is derived from the value of one or several assets or securities, called the underlying asset(s)
• Hedge risks include interest rate risk, and credit risk to speculate
• Has private agreements to buy/sell something at a future date and traded over the counter. The price which will take place is decieded in the present.
• Options: Contracts where the owner has the right but non-obligation to buy or sell a asset or instruments at a specified strike price on or before a specified date depeding on the option style.

Currencies and Foreign Exchange (Forex) Markets

• Global decentralization of currencies/Foreign Exchange Market.

Money, Price, and Value

• Medium of Exchange and money
• A theoretical notion that believes something is worth "Price and Value"

Financial System and Financial Infrastructure

• The financial System is responsible for banking supervision, comprised of central banks, commercial banks, insurance companies, mutual funds, investment banks, etc.
• It must enforce property rights, have a institutional framework, and instill confidence in framework
• Central banks facilitate transfer payments

Financial Stability

• financial stability can be defined as a condition in which the financial system intermediaries, markets, and market infrastructure can withstand shocks without major disruption,
• stable under the following 3 conditions

1. The financial system is able to efficiently Smoothly transfer resources from savers to investors
2. The financial risks are assessed and priced reasonably and accurately and professionally
3. Comfortably to absorb financial and real economical surprises and shocks.