Financial Markets Unit 1: The Financial System

Introduction to Financial Markets

The Actors

• Haves and Have-Nots: individuals/organizations with capital (haves) and those without capital (have-nots) who borrow
• Households, corporations, government, and financial industry are the main actors in the financial system
• Net wealth = assets - liabilities

Balance Sheet of a Household

• Assets: tangible (physical value), intangible (legal claim to future benefit), financial (claim to future cash)
• Liabilities: mortgage loans, consumer loans, tax debt

Wealth Creation

• Assets put money in your pocket, liabilities take money out
• Value changes in assets and liabilities, net income from labor, capital, or transfers create wealth

Wealth Distribution

• Uniformly distributed among households
• Wealth inequality: not everyone has the same amount of wealth

The Financial System

• Facilitates production, employment, and consumption
• Resources are funneled through the system to their most efficient uses

Role of the Government

• Regulation: disclosure, market conduct, financial institution regulation
• Influence markets through monetary policy
• Act as financial intermediary, provide bailouts, and maintain financial stability

Review Questions

• Unit 1 RQs: borrowers, lenders, net wealth, asset categorization, traditional and alternative investments, liabilities, money markets, capital markets, securities, primary and secondary markets, balance sheets, leverage, government role

Financing Sources

• Equity and debt instruments (loans and debt securities)

Financial History

• Debt instruments are the oldest financial instruments
• Early loan concepts and insurance/risk sharing contracts

Interest Rates

• Price of money, reward for postponing consumption
• Depends on credit worthiness and maturity of debt
• Term structure of interest rates: graph of interest rates vs. maturities
• Shapes of the term structure: normal, inverted, flat### Interest Rates and Credit Spreads
• Lenders charge borrowers a credit spread for expected credit losses, which also embeds a liquidity premium
• Credit spreads vary by maturity and borrower quality, resulting in a term structure of nominal rates for risky assets

Fisher Equation

• Relates nominal interest rates to real interest rates and expected inflation
• Equation: (1 + rnominal) = (1 + rreal) (1 + ε) or rnominal ≈ rreal + ε

Time Value of Money

• Preliminary remark: understanding the time value of money is crucial for fixed income instruments
• Both simple and compounded interest rates are used in practice
• Timeline: a linear representation of cash flows, with inflows (positive cash flows) and outflows (negative cash flows)

Single Cash Flow Compounding

• Simple interest rate: Vt = V0 (1 + rT)
• Compounded annually: Vt = V0 (1 + r)^T
• Compounded m times a year: Vt = V0 (1 + r/m)^(mT)

Single Cash Flow Discounting

• Simple interest rate: V0 = Vt / (1 + rT)
• Compounded annually: V0 = Vt / (1 + r)^T
• Compounded m times a year: V0 = Vt / (1 + r/m)^(mT)

Multiple Cash Flows

• Value additivity: cash flows can be summed if their values are expressed at the same moment
• Example: Paul Draper's crossword competition cash flows

Bond Pricing

• A financial instrument can be seen as a portfolio of single cash flow instruments
• Present values are additive
• Each cash flow has to be discounted at its own interest rate

Yield

• The return on a single cash flow received at the end of period T is called a T-year spot rate
• Yield to maturity is the single return on a stream of cash flows

Institutional Aspects

• Fixed income markets
• Ratings and credit worthiness
• Market taxonomy: money markets (maturity at issuance ≤ 1 year) and capital markets (maturity at issuance > 1 year)

Instruments

• Money market instruments: private (call money, commercial paper) and public (T-bills)
• Unsecured interbank funding/lending market
• Secured lending using repurchase agreements (repo)Here are the study notes:

Commercial Paper

• Definition: A short-term unsecured promissory note issued in the open market representing the obligation of the issuing company.
• Used for seasonal financing of working capital and bridge financing.
• Primary market based on best effort arrangements (no guaranteed placement).
• Hardly any secondary trading; short-term (typically 90 days in the US).
• Yields can be quoted on a discount basis or in interest-bearing form.

Certificates of Deposit (CDs)

• Definition: A financial obligation issued by a depository institution indicating a specific sum of money deposited at the issuing institution for a specific time period.
• Deposit insurance applies for small denominations.
• Can be negotiable or non-negotiable (not resellable in the market).
• Large-denomination negotiable CDs have denominations of $10 million and more.

Money Market Instruments

• Household debt instruments
• Corporate debt instruments
• Intercompany loans
• Trade credit
• Straight loans
• Overdrafts
• Factoring and forfaiting

Public Money Market Instruments

• Treasuries
  • Names: T-Bills (US), T-bill (UK), Schatkistcertificaat (BE), Bon du Trésor (FR), Schatzwechsel (GE)
  • Maturities: 3, 6, 12 months
  • Fungibility
• Primary market: Auctions (tenders)
• American tender principle: Bid price auction (not uniform price auction, i.e., Dutch style)
• On-the-run issues: Most recently issued; off-the-run issues: Less liquid, older issues

Capital Market Instruments

• Long-term loans
• Household debt
  • Mortgage loans
  • Credit lines
  • Investment credit
  • Revolving credits
  • Leasing
• Corporate debt
  • Credit lines
  • Investment credit
  • Revolving credits
  • Leasing
• Debt securities
  • Embed the obligation of issuers-borrowers to make a promised stream of cash flows in the future
  • Determine cash flows, their size, and timing (at issuance)
  • Debt markets (fixed-income markets) where debt securities trade

And so on... Let me know if you want me to continue!

Research Strategies and Design

• Evaluating the applicability and effects of a research strategy is a key learning outcome.
• Understanding the difference between correlation and causation is crucial.
• Research topics should be explored from different perspectives.
• It is essential to start designing one's own research project with a clear understanding of the research area.

The Field of Management Research

• Management research is a discipline-based field that draws from various disciplines, including psychology, sociology, anthropology, and economics.
• Subfields within management research include organizational behavior, human resources, information systems, accounting, and finance.
• Industrial relations and strategy are also essential components of management research.

Influences on Research

• Practical considerations, such as time, budget, ethics, law, and finance, influence research.
• Theory and epistemology also play a significant role in shaping research.
• Social research and values are essential considerations in research.
• Ontology is a critical aspect of research, as it examines the nature of social entities.

Designing Research

• A 'What, Why, and How' framework is useful for designing research.
• What: identifying the research question or topic.
• Why: understanding the significance and relevance of the research.
• How: conceptualizing and practically implementing the research.
• The Research Turtle framework is a helpful tool for guiding research.

Epistemology and Ontology

• Epistemology examines how we can know something.
• Positivism and interpretivism are two approaches to epistemology.
• Ontology, on the other hand, examines what can be known.
• Objectivism and constructionism are two approaches to ontology.

Problem Statement and Research Question

• Translating a problem statement into a research question is a critical step in the research process.
• Research questions can be formulated using a positivist or interpretivist approach.
• A conceptual model can be developed to guide research.

Research Approaches

• Positivist approaches involve large sample sizes, statistical tests, and generalizability.
• Interpretivist approaches involve in-depth interviews, focus groups, and a holistic approach.
• Each approach has advantages and disadvantages.

5C Framework

• The 5C framework consists of common ground, complication, concern, course of action, and contribution.
• It is a useful tool for developing research questions and guiding the research process.

Moderator and Mediating Variables

• Moderator variables affect the relationship between variables.
• Mediating variables explain the relationship between variables.
• Path analysis and structural equation modeling are used to analyze moderator and mediating variables.