Introduction to Financial Markets PDF

. ma,ttll 1111d 1111t1tUtlOffl cnapter I Filllnclll - ffi SECTION 1.1 TO FINANCIAL MARKETS ~INT~RO~DU~CT~IO~N~ :.. - - - - - - i ---~ 0 THE FINANCIAL SERVICES INDUSTRY.!r,' ,,.111·1cat...

. ma,ttll 1111d 1111t1tUtlOffl cnapter I Filllnclll - ffi SECTION 1.1 TO FINANCIAL MARKETS ~INT~RO~DU~CT~IO~N~ :.. - - - - - - i ---~ 0 THE FINANCIAL SERVICES INDUSTRY.!r,' ,,.111·1cat111[J cilprtal wrthin the glo bal ~·. Onqllly..-.1, 1.c four main functions The finandll ~ lndustrYI".,.._ In an economy: ► flnan(lal mte,medlltloni ► poolln& and rnancln& risk; ► paymenlS and semement se,vlces; and ► portfolio management. finandal intermediation A_....,..._~c..,..___._1.,- han..,.,,,N.... nel s for funds to move from savers to borrowers. Intermediarie s sign1'frcant1 rmuce infonnation and transaction costs by: y ► provldlngservlces and pn,dudsthat allow saver s to become Investors; ► ensuring the adequate provision of Infor matio n; and ► allowing borrowers to access arange ofsavers that can meet a~riety of terms. fl&ure 1.1 mustratessome ofthe main flows that occu r In afinancial system. Savers can supply funds by hol ~the debt and equity securities Issued by borro directly wers (the dotted lines in Figure 1.1) or they can supply fllldsviun inlennedlary,suchasabankorlnvestm entlnstitutlon (the unbroken lines). Direct through capital markets ls sometimes appropriate, financing although most forms of capital-raising and involve Intermediaries. capit al-saving Fipn U CAPITAL FLOWS Equi ty markets..:... r·i.. : i ! Pension fund s..~.). ~. ~ i; rr)}_i_l 4· --~:: \ :f:'' Binksllldother for lndMduats, itlonally been a key source of finance which Individuals save. They also ~- -- -- -- -- -- -- -- -- -  ,nst itut, ons Chapter 1 - Financial markets and raise or uses the securities markets to and, increasingly, the banking sect perform an Intermediation function. capital or to Invest in those markets. or vehicles (such a~ open-ended s and other investment institutions ~ ~ Insurance companies, pension fund diation function. l':e stm e:t u!l!!,trusts) also perfo~m an interme ~E--1 (...J~~ investment coamaoies (AEICs) and ~ t'h-.Jo :Jc. ~ ~. S f.O \.l ~l ' _.+c«st (aw · ~~ ~ ~-' li setsofba nks. ~ c.~ Q -~ purc has ethe secu ritisedas ff. W\~~~ ,- _E ; c, $# ~~... _ ~,J ~ -~ pooling and managing risk '1flechanisms that efficiently man age risk. Pooled investment prod ~cts ~ ~~ The financial services indu stry prov ides rs to invest in a wider variety of inve stments than they would be able to individually, w~1ch allow multiple save sfer a risk ~) individuals and companies to tran reduces each individual's over all risk exposure. Insurance allows ons and futures, derivatives, such as opti y in return for a premium. Finally, exposure to an insurance compan exposures. allow investors to manage their risk vices Payments and set tlem en t ser be managed, transmitted and received. ey and other financial assets can The financial system means mon exch ange d and deb ts to be settled. prov iders of paym ent systems that allow money to be Banks are the main sellers of securities complete a ices are prov ided by clearing houses to ensure that buyers and Settlement serv transaction. Portfolio management by offering access to markets, spe cialist allows investors to manage their wealth 0 ly, the financial system t are the tw Last investment managemen t services. Investment advice and advice and investment managemen of this volume of the Official Training !If' t=-,c.c., stment industry and are the focus main services provided by the inve -,;,j-- (n,C.. Manual. G} fac tor s Sustainability and environm ental, social and governance (ES in iovesting in recent years as investors look rs into investing has grown rapidly The focus of incorporating ESG facto their investments. The factor that has rs to preserve long-term value of to mitigate the risks from the facto t of the major economie s have com mitt ed been given most prominence is the environmental factor. As mos pan ies as r will likely impact com s by 2050, the environmental facto to achieve net-zero carbon emission eve the targ et. Environmental degradation ns and carbon taxes to achi governments implement regulatio regulations and stranded assets (i.e. et, but for companies in terms of creates risks, not only for the plan ns, societal change, etc.). The soci al and pated fall in value due to regulatio assets that experience an unantici hip with its workforce and the corp orat e a company manages the relations governance factors relate to how panies as well as inve stme nts. e two areas also pose risks for com governance structures in place. Thes S THE MAIN FINANCIAL INSTITUTION nc1al inst,tutions t ,plJ111 tt1e role and impact of the main f1na ncial etary framework within which fina ban k is a fina ncia l institution involved in setting the mon A_ce ntral rt-term interest rates to mee an t ope rate. This typic ally requires the central bank to set sho g organisa tions rt to the banking sector supplyin target. In add ition, the cent ral bank will act as lender of last reso Inflation liquidity during times of crisis. monetary policy and central banks. ➔ See Chapter 9, Section 9.3 for more on and transfer of funds between surplus ncial inte rmediation involves financial institutions facilitating the ow Fina agents are those who need to borr typically households, and deficit deficit agents. Surplus agents are tutions act as intermediaries, including arily firms and gove rnm ents. A wide variety of financial insti - prim nt institutions. deposit institutions and investme - - - ··- --- -·- - --·- www cfJulr org  from economic agents. The deposits become liabilities f 0 th DepoSlt lnstit utionSacceptdepositS d'rect loans or investments. Depos1't m st·tI ut·rons include c0 ese...1.w. lend funds as 1 a mrnerc'1 I~""":''. ,the banking sector con~ins d111ere~t typ~~ ~f banks, such as Univ a1 ban~ and buRdingSO(ietieS. HowMt:well traditional deposit and lendrng fac1ht1es and investm ersa1 ba which offer financial se,viceS as -~"~- , it- banks, savings institutions also accept depos·ts ent banks. lh ~~. nderwrilffllndilU g,;1... ur.1: 1 and ~ act as broker$,~ __.. nder different rules to banks. rna~e laa although the'/ usually "t"-'... u w ~. the funds they raise in tradable securities such as bonds and eq.. 1nstitlltionsmvest.. u1t1es lnvestment. d ranee companies that offer protection agarnst unwanted ev t tnstltutk>ns mclu e,nsu ents lif lnvestmen.11 nd retirement policies, and general insurance involves loss or d e I ranceconcemsdeath,1 nessa 1 arnag nsu The different nature oflife and genera rnsurance 1s reflected in th.. eto.--.tv homeS, vehicles, etc. e1r 111vest ~~~ ~ strategies:. tend to Wif.f tonger periods, so insurers tend to hold long-term assets. ► Life insurance pollcieS ies usualty hold shorter-term assets, reflecting their greater need for imrn d' ► Generaltnsurancecompan e iate cash. Pension funds are now significant institutional investors in many countries, especially with falling State Pension payments and ageing populations. Many of these institutions operate in the global financial system. Acompany in one country may choose to list ~ the stock market in another country in order to raise capital in a market with different characteristi~ Companies can also raise capital across borders by issuing bonds in another country (see Section 1. 7). This means that investment by savers and capital-raising by firms has aglobal dimension. The gradual removal of capital controls by indMdual nation states and the globalisation of the world economy have contributed to the phenomena ofglobal capital flows. THE ROLE OF GOVERNMENT , ~:r ~. po, 1cy regulation. taxation. Broadly speaking. governments perform four functions: L Providing services that private firms are either unwilling or not allowed to provide. This is often referred to as 'market failure' and ecamp1es include defence, law and order, and maintenance of certain infrastructure. Government poky may irMllve grants and subsidies 1D promote certain issues for which the market may not be satisfactDrly addressing (e.g. 'pen'activities),P.rforwhich the market does not punish externalities (e.g. carbontaxes). 2. ReplatinafiffllS and ma,1-, pdncipallytD protectthe consumer. This includes regulation to promote mnpetitbt.p!Mlltfraud~~llscan also regulate markets by restricting entry to them and enbdngrulestopem partidpianls'~. In the UK, the Financial Conduct Authority (FCA), the. Prudential lleglatlon '1illhority {PRA) iiid the Financial Policy Committee (FPC) are the main regulatory bodies larflnandalsri:es. 1 'ntetvenlnc the~pne,ated byprivaw market transactions in order to conform to tomealtedonofeqwtJ,fa(~a mldnlun WIii guarantee. Redistribution of income and weal th is I also policy ofmost~1hls ls often achieved through transfer payments to households - for ::..statebenellt,a,mems.Tllilllon Is also used to achieve abetter distribution of income among the 4 Stabllisinctheeconom,by1111mp11n:.:::.:L_ I mowmentslattheeenerat~':;fluctuaUonsln Income and employment, and to contr~ b mln&lntnst--.1nt11ew. lalnomlestocfay, emphasis is placed on controlling inflation y thlslraiild~the Banlc ofEngland's Monetary Policy Committee (MPC)... 1'wmain~Wit,for/ulandal.,_CllllltW-Nlllit,cna,l'tl'fdin Chapter 3. -------------- ---- CFA Soci~ty dof11 United Krn9  Chapter I - Frnanc1al markets and institutions SECTION 1.2 THE ROLE OF SECURITIES MARKETS IN PROVIDING LIQUIDITY AND PRICE TRANSPARENCY TYPES OF INVESTMENTS 1? 1 n1ffprent1ate between a financial security and a real asset One of the main functions of the financial services industry is to provide a link between savers with funds to invest (also referred to as lenders or investors) and borr9wers that need funds. The main lenders in an economy are households - generally, households have a surplus of income after spending. The main borrowers in an economy are typically companies and governments. Direct lending~ between lenders and_ borrowers is uncommon, although the growth of peer-to-peer lending has provided some impetus to this type of lending. More commonly, households lend or invest their savings indirectly in a range of assets through intermediaries. Real assets and financial securities _ '\... Jl,r\J ~ Assets have value and include r.:.e.::.al:.:a:.::s;;:.;se~t;:.s;.a~nd:..:,;.fin:.;,;a;,;n~·!::!11~.:.:;..==-.;;:;..:a:.::=.~h:.:.i..:s~ical assets such as land, - - ~ '-! buildings and gold. F (such as a bank deposit or ~~ a bond) or tg owoecsbip of ph~sical ~ts. For example, a share represents ownership in a company and gives ~)~co'"' the shareholder rights to some of that company's assets and earnings. We can categorise these two different types of financial assets as debt claims and equity securities: ~Gf; :. ~ ~ ~ ' " " ' 1. Debt claims are loans made by lenders to borrowers. Lenders expect borrowers to repay the loan and to make ~ interest payments until it is repaid. A simple example is a bank deposit, which may pay a fixed or variable rate of interest over a term. A bank deposit represents a claim the lender has on the bank and is not tradable. Most debt claims are tradable, and one example of a tradable debt is a bond. A tradable dajm is also cetecced to as a security. Bonds are issued by governments and companies and generally pay a fixed rate of interest. As such they are often referred to as fixed-income securities. 2. Equity securities are also called shares. Like bonds, they are tradable securities. Shareholders have an ~ ~a~ ownership stake in the company they have invested in. The company~ obligation either to repay the. money invested by the shareholders, or to make regular payments known as dividends. However, investors who buy shares expect to make a return by selling their shares at a higher price than they bought them and, possibly, by receiving dividends. Indirect investment through intermediaries Savers generally invest in shares and bonds indirectly through intermediaries, such as insurance companies, pension funds and pooled investment vehicles. Savers therefore invest in the products created by intermediaries. The advantage of indirect investment is a reduction in risk due to: ► greater diversification; ► reduced transaction costs as the intermediary can trade at lower cost than the individual saver; ► access to specialist expertise in the financial assets being invested in; and ► the ability to invest in assets that would not be available to an individual investor, such as commercial property. www.cfJuk org  ' iqUldeS IS an example ofa pooled investment vehicle. ih Aunltrust# ttolnvest. the fund issues new units in excha ese vehicles ~ l'IW, tMtund redeems (repurchases) thn~e for cash a,, the ~ ot.. erru Pa; rdlng~_demandforitsumts. The fund n,tsand db: out~Tfieflindtlll~,11t J1t.iri,t,e4 and the value of UK equities increas manager in Pah thl!cash DtUKShirlS..,,111 , es, the va1 ~ests............ &rt.~~~l Ueorlk UIJIY IIU.u.... ,I.II -~...·..:...:.:......IIWmlawered in Qiaptu 16. ➔ Unit -r.«.,,"' '""'~a.z f~~~~:q ;;,,·-- manage risk. Aderivative is a fina. ncraf c0 rice movements of the derivative and ntract can be used: th eunderty; ~ ► ·CNll':dlall nthe price of an index or asset; and. Ifthe,,.........,_.:-. associa ►.,._,,..,. -. ted· with investing in it. For example b.directly fs n -~ tract IS I~ costly. ' IIY1ng 01) ➔ Fo A'-"" '........L.----~ for example, aUK-based fund manager IVl~ ~ ~ r- ~. purtha USseaJ managerwfll need to convert pounds sterling into us wants doll to.. transactlonwlll be ~.. '-""'..i.....;1 15o..s ed ars. This _,.,...,"'-.,,., ~_ndl)5 ~mlrM: "~ ,a n:,err _to as th~ currency markets ). For ta,gevaluetra. '"'··"-'"~"~'""""" ffltik e place directly. with a deale~ The d ~ ~~~ ealer ~ ~~~~~m~~~~~~ IJlll'111Mi....1.,........ broker who will arrange for the dollars m liiillllllW nanclal securities together. A have maturity shorter than a year,.L (mi ~uities (ordinary shares) or bonds flnn or other resources that enable the liq , s the mobilisation of savings. The ed by borrowers. This leads to a 2. Tranlfln:ii!ulafliii value derivatives to hedge the risk that the protectl The fund manager has obtained n transferred to the counterparty of the would the equity fndex to rise in the future and 3. the emergence of a price at wh.,ch Liff¼' markets, this process takes iequllibrium price will change only CFASociety United Kingdoff1 - Chapter 1- Financial markets and Institutions liquidity. Securities markets enable investors who hold investments to sell (liquidate) them. The 4. creating ability to sell investments quickly makes them more attractive to hold and encourages investors to buy them in the first place. Liquidity in a financial market is typically defined as the ability to sell a security without causing a significant movement in its price and with minimum loss of value. A liquid market is therefore one in which there are many buyers and sellers. A seller is more likely to sell at a price they wish to sell at if there are many buyers willing to trade at the same time. ➔ See Chapter 15, Section 15.4 for more on efficient markets. Primary and secondary markets one important distinction is between primary and secondary markets: are those where securities are initially sold to investors. For example, a company may raise 1. Primary markets capital by issuing new ordinary shares in order to raise capital. Where this is the first issue into the markets, the company is said to be making an initial public offering (IPO). 2 , secondary markets are where any subsequent trading of shares take place. The secondary market plays an important role in providing liquidity to investors. This liquidity provision makes it more likely that issuers of securities can make the first issue to raise capital and may even increase the price by which the securities are initially sold. Another feature is whether a trader is on the sell-side or the buy-side. Sell-side firms - such as investment banks, brokers and dealers - primarily provide transaction services and investment products. Buy-side firms - investment managers - purchase these services and products. This classification scheme is not easily applied to many large, integrated firms, because many investment banks have divisions or wholly owned subsidiaries that provide asset management services. These functions t" are on the buy-side, even though investment banks are sell-side. ➔ A further distinction exists between quote-driven and order-driven markets, and chis is discussed in Section 1.3. PRICE TRANSPARENCY AND LIQUIDITY Identify the reasons why liquidity and price transparency are thought to be important for the efficient allocation of capital when trading in securities markets 1.2.5 Identify the types of securities and the market conditions where price transparency, liquidity and depth are likely to be high/low I26 Define liqu1d1ty risk and 1dent1fy why it 1s important Price transparency As well as determining the equilibrium price, markets also disseminate that price to the public. There are two types of price dissemination: 1. A market is pre-trade transparent if it publishes real-time data about quotes and orders. 2. A market is post-trade transparent if it publishes trade prices and sizes shortly after trades occur. Buy-side traders value transparency because it allows them to better manage their trading, understand market values and estimate potential transaction costs. Sell-side traders, however, prefer to trade in opaque markets because, as frequent traders, they have an informational advantage over counterparties. Organised markets, such as the London Stock Exchange, tend to be more transparent than an over-the-counter (OTC) market, such as the market for credit default swaps. In Europe, pre- and post-trade transparency for many securities (especially equities) is required under the Markets in Financial Instruments Directive (MiFID) II. ------··-·--- ----·--·---- ------------ ----- ------ ------- www cfau~ org  a,apt8rl-BIM dlf-- ____..,.,.....,...,,... l I Uqulcllt)' Ir,~~~~ loolont at bid-ask spreads. Bid-ask spreads tend I u.-fn\lllSIDrSassesU~~}~_!tli~.:. able price Is harder for traders. Transpa to be w· a: - 1. _,2d;;;;,Hcfn,~,1 !~':t~ rency, 'dtr w In opaquemartcets r,ecauao: - ~~ martcets. llquldity can be Judged by the diffi educes 1~ Ii: prNds. wfltch l,enefftS'f~ ,n ererice b ~ < :c (.J :iebest buy and self pibs (;,'Y eiw,eri llqUld If tfl«e ,rea lot of ready-and-willing buyers and sellers. Amartcet may also be conskfeted..ta1t..: slit oforder that Is needed to move the market (h This is rei..,....... whk:hlsameasutturu,.. dh.. a11eao·1 a~. tomartcet-.,.,, ~/r~stoc k market woul ave a suff1c1ent volume f 1"1lpact ' pnceJbyace,talnamount. !,~a orderfro mslgnlfican tly moving the price A~ Peodi0&orde0fl on both the bid nd ,skslde, T ~ , u t the large volume of transactions, low bi~ :xan,Ple of a rs deeplyllquld market Is thei~7"'~J make transaction costs very low. -as spreads allC JOO), or 0.50%, lnn11 Ahu)'t'r who 11cq11il't'1 thl' ,tufk Rt £1011ml lmmrdillrrlyl('II fl 111 rhe hid prlrr of t:9.'J!i woulil I "~ of 0.50% of rtw trnn111wtlon value due 101hr ►p1rnd. n,e purdin11t' nnd lm1111 dl111r uult of JOO hun-s woulJ rntull n £5 los~, while if J0,0001ih11rt'a wc rt' 1old, 1h111().. would lw £500. Till' prrrrnr,.-Jo.s rt'~uhlng from 1hr 1prt'11d 11 tht' snmr In borh c11r.r1, lra de n cho oM the ir Ofd M Wb ml llon ltr a~ ft \ cos ts. Marlwt par tlcl pan u. I I un uw v r lou , \9o\h th I, \ran uc.\ lon a\1orlthm, to m n g : " ) I \!'I I'() SD Rt \ '.,' \\1 \11 M \1Ny IC\t \wo \mi le!. Ne;,\ ttl ,t lnb -.o luk \ Nt, \ ( ()',\ lpt- lt t-1,\1,\\l \ KETS ofMIFID In 2007, which created h le Arel (EEA) states, Three types ofarrnon·1sed Order execulj~ Introduced with MiFID 11. All fou f r o these. of trading. with the London Ste late 2015. ck w... ed FTSE 100, FTSE 250 and FTSE Small Cap In addition, exchange-traded funds provision of market maker electronically ange market size (EMS). The EMS is set ers, and a market maker is obliged to quote ETS are conducted at the opening and dosing price. These auctions allow traders In a limited timeframe (ten minutes at the speed an investor can trade. ~iiie lthe percentage threshold since on the bid and sellers on the ask match auctions can be triggered when London Stock Exchange), and thepnc e by SETS. It combines a peno die I ce Several un-crossings take Pa each LJ  and at dosins, 1nvestoB rd boOk execution through auctions at 8am, 9am, 11am, 2~. Note that many d,Y, which '''°:~';,of trading In either the quote-driven or order boOk auctwn ~rv::ide bid-ask spread. therefore ti,ve have very low liquidity 50 a market maker will cover their risk by setting SE,sq,c stoeks. n betWten mat1