AG912 W1 Notes PDF

**Week 1: Financial Markets and Financial Intermediaries** ***[General Information]*** Read required reading (compulsory) before lectures -- introduction and conclusions at least Readings: - Financial Markets and Institutions *-- P. Howells & K. Bain (2007)* - Modern Financial Markets and I...

**Week 1: Financial Markets and Financial Intermediaries** ***[General Information]*** Read required reading (compulsory) before lectures -- introduction and conclusions at least Readings: - Financial Markets and Institutions *-- P. Howells & K. Bain (2007)* - Modern Financial Markets and Institution -- *G. Arnold (2011)* Optional self-quiz at the end of every week to recap Class Test: - MCQ based on week1-5 materials and pre-set reading week 7 - Closed-book - On campus via MyPlace - 25 questions: - 15 general questions - 10 questions based on the 2 required reading - 50 mins - Read the required two academic papers from week 1-5 - Additional paper: - The Blue Bond Market: A Catalyst for Ocean and Water Financing -- *Bosmans P. and F. de Mariz (2023) pp. 184-232* - IPO Price Formation and Board Gender Diversity -- *Rau P.R., Sandvik J.T. (2024)* Finals: - 3 hours - MCQ and essay questions based on entire weeks - Each essay question consists of 3-4 A4 pages of answers: - Definition & Explanation - Answers to the questions (*how the definition applies to the question)* - Examples - Own opinions - Conclusion Academic papers: - Safely ignore any equations - Emphasize on what the authors are trying to investigate ***[Notes]*** Market: - A place where goods and services are exchanged - Involves buyers and sellers Financial Market: - A place where financial claims are exchanged - Involve surplus units and deficit units, where savings and financial claims are exchanged for cash and this process is called direct financing Surpluses and Deficits - Surplus Units - Have more money than they need to spend - Deficit units - Need to spend more money than they have - Financial markets and intermediaries exist to channel funds from surplus units to deficit units - In return, surplus units receive financial claims Financial claims - A claim to the payment of sum of money at some future dates, e.g. - bank - deposits - bonds - shares - Various types of financial claims exist in developed financial systems, each with its own particular characteristics Characteristic of Financial Claims - Risk: - Based on potential investors' risk appetite (Hight, Medium, Low) - Risk is related to returns (More risk, more compensation) - Importance of diversifying your portfolio - Liquidity: - Different financial claims have different liquidity rate - Depends on whether the financial claims are easily exchangeable - Tradability - Real return: - Only few retail investors would willingly to compensate for the inflation - Expected Return - Different financial claims have different returns - Different investors have different expected returns from financial claims - Term to Maturity: - When you are getting the money back Issues with Direct Financing: They are time-consuming and expensive as the needs of the borrowers and lenders may not match and the process of finding a transaction that meets both preferences of the borrower and lender are costly, and such cost includes: - Search cost: - Researching for opportunities - Verification cost: - Lenders have to evaluate borrowing proposals - Monitoring costs: - Borrowers must be monitored once the loan is made - Enforcement costs: - If borrowers default and actions need to be taken to recover the loan Markets and Intermediaries - Organized capital markets can solve some of the direct financing problems - Lenders benefit from being able to sell their claims in the capital markets - Financial intermediaries: - Can reduce financial costs via economy of scale, as well as problems associated with asymmetric information - Often transform financial claims in terms of : - Maturity: - Ability to issue multiple loans with different term of maturity - Short-terms - Long-terms - Risk: - With the large pools of deposits collected from multiple investors, FI can propose multiple loans to diversity their portfolio to reduce risks - Size: - Collect small amount of money from individual investor and pool all the amount together to propose loans Asymmetric Information - Borrowers often know more about what they plan to do with the loan and how likely they are to repay it than lenders do, which creates significant problems - Adverse selection: - Borrowers who most actively seek a loan is the one who is least likely to repay it - Moral hazard: - Borrowers may lie about their purpose of the loan or change their mind about the purpose after the loan is made - Banks can : - develop expertise in assessing borrowers, helping to solve the adverse selection problem via: - Credit scoring models - Research analysts - Afford to devote resources to monitoring borrowers, reducing the moral hazard problem ***[Extra Notes]*** Financial claims: - BD = Bank deposits - GB = Government bonds - CS = Common shares **Risk** Both BD and GB have low risks compared to CS as GB have financial insurance and compensation (redemption scheme) for the risk, meanwhile GB's risk vary depending on the country's government bonds rating (e.g. developed country tend to have safer bonds than developing country, government has the possibility to go default, which could increase the risk in GB). CS have the highest risk among the three common financial claims as they are dependent on a certain company's financial performance, which can be volatile. **Liquidity** BD and CS are more liquid than GB because BD are liquid assets as they have flexible maturity dates and payout options depending on the banks, meanwhile CS are highly liquid as they are easily tradeable on the retail market. Some GBs have low liquidity depending on the difficulty in trading on the bond market. GB's liquidity decreases when they get more difficult to trade due to imbalance in number of buyers and sellers and the price volatility. **Real Value of Certainty** BD has no coverage plan or compensation for the inflation rate, meanwhile for GB, there are coverage plans to compensate for the effects of inflation rate. There are no coverage plans for CS as well, but CS buyers can hedge against inflation. **Expected Return** Generally, CS have the highest expected return compared to BD and GB. **Term to Maturity** CS does not have specific maturity dates as they last forever until the company goes bankrupt. Whereas, BD and GB have specific maturity dates depending on the contract agreement, ranging from short- to long-term agreements.