Financial Markets PDF

GROUP 1 [FINANCIAL MARKETS] Capital Formation OVERVIEW OF FINANCIAL MARKETS AND -Capital formation is the process of accumulating and INVESTMENT PRODUCTS investing financial resources to create or e...

GROUP 1 [FINANCIAL MARKETS] Capital Formation OVERVIEW OF FINANCIAL MARKETS AND -Capital formation is the process of accumulating and INVESTMENT PRODUCTS investing financial resources to create or expand physical assets like buildings, machinery, and technology, as well as human capital and Topic 1: Functions and Participants of the infrastructure. It involves the mobilization of savings Financial Markets and investment into productive uses. Financial market Participants -a marketplace where buyers and sellers Individual Investors trade financial instruments, such as stocks, bonds, currencies, and derivatives. · Individual investors are private persons who buy and sell financial assets, such as stocks, Functions bonds, mutual funds, and real estate, often through brokerage accounts. Capital Allocation Institutional Investors -it involves directing funds from those who have surplus capital (savers or investors) to those who need capital for productive purposes (businesses or · Institutional investors are organizations that governments. invest large sums of money on behalf of their members or clients. These include pension Liquidity funds, insurance companies, mutual funds, hedge funds, and endowments. -Liquidity describes how easily an asset can be converted into cash or its equivalent without affecting Brokers and Dealers its market price. · Brokers act as intermediaries who facilitate Price Discovery transactions between buyers and sellers of securities, typically earning a commission for -Price discovery is the process through which the their services. Dealers, on the other hand, market sets the price of an asset based on supply and buy and sell securities for their own accounts demand dynamics, investor perceptions, and available and profit from the spread between buying information. and selling prices. Risk Management Investment Banks -Risk management involves identifying, analyzing, and · Investment banks are financial institutions mitigating risks associated with financial activities. that assist companies, governments, and Financial markets provide tools and mechanisms to other entities in raising capital by manage and transfer these risks. underwriting and issuing securities. They also provide advisory services for mergers, Information Dissemination acquisitions, and other financial transactions. -ensuring that market participants have access to Commercial Banks relevant and timely information, which helps them make informed decisions. · Commercial banks are financial institutions that accept deposits, provide loans, and offer Facilitation of Payment Systems a range of financial services to individuals and businesses. They also participate in -enabling transactions and transferring funds efficiently. financial markets by investing in securities and managing liquidity. This function ensures that payments for goods, services, and financial assets are processed quickly and securely. Regulators and Supervisory Authorities · Regulators and supervisory authorities are governmental or independent bodies responsible for overseeing and regulating  financial markets to ensure they operate Financial institutions fairly, transparently, and efficiently. Institutions that perform the essential function Central Banks of channelling funds from those with surplus funds to those with shortages of funds · Central banks are national institutions responsible for managing a country’s How Financial Intermediaries helps in Transaction monetary policy, including controlling interest Costs, Risk Sharing, and Asymmetric Information rates, regulating money supply, and overseeing the banking system. Transaction Costs Financial intermediaries can substantially Rating Agencies reduce transaction costs because they have developed expertise in lowering them. · Rating agencies are firms that assess and Their large size allows them to take assign credit ratings to various financial advantage of economies of scale instruments, including bonds and other debt securities. Allow Risk Sharing Custodians They create and sell assets with risk characteristics that people are comfortable · Custodians are financial institutions that with, and the intermediaries then use the hold and safeguard financial assets on behalf funds they acquire by selling these assets to of investors, providing services such as purchase other assets that may have far recordkeeping, settlement, and reporting. more risk. Financial Advisors Asymmetric Information: Adverse Selection and Moral Hazard · Financial advisors are professionals who Asymmetric information refers to when one provide personalized advice and party in a transaction possesses more recommendations to individuals and information than the other. businesses regarding investment strategies, ○ Adverse selection is the problem financial planning, and wealth management. created by asymmetric information before the Transaction occurs. Topic 2: Overview of Financial Intermediaries and ○ Moral hazard is the problem Financial Institutions created by asymmetric information after the transaction occurs. With financial intermediaries in the economy, small savers can provide their funds to the financial markets by lending these funds to a trustworthy intermediary TYPES OF FINANCIAL INTERMEDIARIES Depository Institutions Contractual Savings Institutions Investment Intermediaries Services performed by Financial Institutions Direct transfer Services Provided by Financial Institutions A direct transfer involves moving funds directly from the lender-savers to the Services Benefiting Suppliers of Funds: borrowers-spender without intermediaries. Monitoring costs - aggregation of funds in Indirect transfer an Fl provides greater incentive to collect a firm's information and monitor actions. The A transfer of funds between users and relatively large size of the Financial suppliers of funds through a Financial Institutions allows this collection of Intermediary information to be accomplished at a lower average cost (economies of scale).  Liquidity and price risk - Financial Overseeing the inter-bank market – they Institutions provide financial claims to ensure that the relevant financial laws are household savers with superior liquidity respected and they monitor national payment attributes and with lower price risk. systems to make sure that they are working Transaction cost - services similar to properly. economies of scale in information production costs, a Financial Institutions size can result The Functions of a Central Bank can be discussed in economies of scale in transaction cost. as follows: Maturity intermediation - Financial Institutions can better bear the risk of 1. Currency regulator or bank of issue mismatching the maturities of their assets 2. Bank to the government and liabilities. 3. Custodian of Cash reserves Denomination intermediation - Financial 4. Custodian of International currency Institutions such as mutual funds allow small 5. Lender of last resort investors to overcome constraints to buying 6. Clearing house for transfer and settlement ansets imposed by large minimum 7. Controller of credit denomination size, 8. Protecting depositors interests Services Benefiting the Overall Economy: Money supply transmission - depository Topic 4: Types of Banks and Other Financial institutions are the conduit through which Intermediaries monetary policy actions impact the rest of the financial system and the economy in general. Financial Intermediary – a financial firm, such as a Credit allocation - Financial Institutions are bank, that borrows funds from savers and lends them often viewed as the major, and sometimes to borrowers. only, source of financing for a particular sector of the economy, such as farming and Basic Structure of Financial Institutions/ residential real estate. Intermediaries Intergenerational wealth transfers - Financial Institutions, especially life insurance companies and pension funds, provide savers with the ability to transfer wealth from one generation to the next. Payment services - the efficiency with which depository institutions provide payment services directly benefits the economy. Topic 3: Role and Function of the Central Bank Central Bank is a financial institution that has the privilege A. Depository Institutions of producing and distributing money (and 1. Commercial Banks/Universal Banks credit) for a country or a group of countries. It Commercial Banks – most important is a public institution that is responsible for intermediaries. They play a key role in implementing monetary policy, managing the the financial system by taking in currency of a country, or group of countries, deposits from households and firms and and controlling the money supply. investing most of those deposits, either: ○ by making loans to households and Some of the main responsibilities central banks firms; or have are: ○ by buying securities, such as government bonds, or securitized Defining monetary policy – central banks loans. set macroeconomic objectives such as to ensure price stability and economic growth. Universal Bank – also referred to as a Regulating money in circulation – they are full-service financial institution, a the authority for issuing coins and notes, the universal bank provides a large array of money supply, and for regulating how much services including those of commercial money is in circulation. banks and investment banks.  2. Savings and Loans Associations - also money market securities. They offer savers known as savings bank, thrifts, and thrift the advantage of reducing transaction costs. institutions, are lending and banking a. Closed-end mutual fund - issues a institutions specialized in offering residential fixed number of non-redeemable shares, mortgage loans and accepting savings which investors may then ride in deposits. They may also offer other services over-the-counter markets just as stocks that commercial banks provide to their are traded. customers, such as checks and other types b. Open-end mutual fund - issues share of loans. that investors can redeem each day after the markets close for a price tied to 3. Mutual Savings Bank - is a type of thrift the market value of the assets/net asset institution originally designed to serve value (NAV). low-income individuals. 3. Hedge Funds - financial firms organized as a It is a bank organized without stock partnership of wealthy investors that make which receives savings deposits and relatively high risk, speculative investments. whose earnings accrue entirely to the 4. Finance Companies - non-bank financial benefit of its depositors. intermediaries that raise funds through sales of commercial paper and other securities and 4. Credit Unions - are cooperative associations use the funds to make small loans to whose members have a common bond, such households and firms. as being employees of the same firm. 5. Money Market Mutual Funds - These are Members’ savings are loaned only to relatively new financial institutions that have other members, generally for auto the attributed of a mutual fund but also purchases, home improvement loans, function to some extent as a depositing and even home mortgages. institution because they offer deposit-type These are often the cheapest source of accounts. funds available to individual borrowers. Topic 5: Types of Investment Products and Their B. Contractual Savings Institutions - these are Characteristics financial intermediaries that receive payments from individual as a result of a contract and uses the funds to make investments. 1. Insurance Companies - specialize in writing contracts to protect their policyholders from Types of Description Characteristic the risk of financial losses associated with Investment s particular events. They collect premiums from Product policyholders, which the companies then 1. Stock Buying a piece Risk: High invest then obtain the funds necessary to pay s of a company. potential for claims to policyholders and to cover their You make loss; stock other costs. money if the prices can be a. Life Insurance Companies company does volatile. b. Property and Casualty Companies well, but you 2. Pension Fund - is a financial intermediary might lose money if it that invests contributions of workers and doesn't. firms in stocks, bonds, and mortgages to provide pension benefit payments during 2. Bond Loans to Risk: workers’ retirements. s companies or Generally a. Defined Contribution Plan governments. lower risk b. Defined Benefit Plan You earn compared to regular interest stocks, but still C. Investment Intermediaries - are financial firms and get your subject to that raise funds to invest in loans and securities. money back interest rate later. Generally and credit risk. 1. Investment Banks - concentrate on safer than providing advice to firms issuing stocks and stocks. bonds or considering mergers with other firms. They also engage in underwriting, in 3. Mutu Pools of Risk: which they guarantee a price to a firm issuing al money from Moderate risk, stocks or bonds and then make a profit by Fund many investors depending on selling the stocks or bonds at a higher price. s to buy a mix of the underlying stocks and assets. 2. Mutual Funds - allow savers to purchase bonds. shares in portfolio of financial assets, Managed by including stocks, bonds, mortgages, and  professionals set price in the leverage, and help future. Very increasing spread out risk. risky and used potential gains for speculation and losses. 4. Exch Like mutual Risk: Varies or to protect ange- funds, but they based on the against price Risk: Very Trade trade on stock assets in the changes. risky; used for d exchanges and ETF; can be speculation or Fund can be bought bought or sold to hedge s or sold anytime throughout the against price (ETF during market trading day. changes. s) hours. 10. Annui Insurance Types: Can be 5. Real Companies Income: ties products that fixed, variable, Estat that own real Provides give you immediate, or es estate. You income regular deferred with Inves earn income through payments over different tment from the dividends from time, often features and Trust property and rental income used for benefits. s benefit if or property retirement (REIT property values sales. planning. They Purpose: s) go up. come in Often used for Risk: Subject different types retirement to real estate with various income; terms market features. and fees can fluctuations. vary widely. 6. Certifi Bank savings Interest Rate: cate accounts with Fixed interest of a fixed interest rate for a set Depo rate for a set term. sits time. Very (CDs) safe, but lower Safety: Very Topic 6: The Stock Markets returns. low risk; typically insured by the Stock Market government. The stock market is a platform where shares Liquidity: Low of publicly traded companies are bought and liquidity; early sold. withdrawal may incur penalties. Key Participants 7. Com Investing in Volatility: Investors: Include individuals, and modit physical goods Prices can be institutional investors, who buy and sell ies like gold or oil. highly volatile. stocks in search of financial returns. Prices can be Brokers/Dealers: Act as intermediaries unstable, but Inflation between buyers and sellers, executing trades they can help Hedge: Can protect against act as a hedge on behalf of investors. inflation. against Regulatory Bodies: Organizations that inflation. regulate the market to ensure fairness and transparency. 8. Optio Contracts that Risk: Can be ns let you buy or very risky and Global/World Stock Markets sell something complex; at a specific potential for price. Can be significant loss. The stock market operates on a global scale, with risky and are major exchanges in the U.S., Europe, and Asia. Some often used for Speculation: of the global markets include betting on price Often used for changes. speculative New York Stock Exchange (NYSE) trading or hedging. National Association of Security Dealers Automated Quotations (NASDAQ) 9. Futur Contracts to Leverage: Can London Stock Exchange (LSE) es buy or sell involve Tokyo Stock Exchange (TSE) something at a significant Philippine Stock Exchange (PSE) Two broad segments of Stock Market Company Performance - company’s financial health, earning reports, and growth prospects 1. The organized Stock Exchange – The stock directly impact its stock price exchanges will have a physical location where stocks Economic Indicators - Macroeconomic buying and selling transactions take place in the stock factors such as interest rates, inflation, and exchange floor. unemployment rates influence investor sentiment and stock prices 2. The Over-the-Counter (OTC) Exchange – Where Market Sentiment - Investor perceptions and shares, bonds, and money market instruments are emotions, often influenced by news, events, traded using a system of computer screens and and broader market trends, can cause stock telephones. prices to fluctuate Global Events - Geopolitical developments, Types of Stocks trade policies, and global economic conditions also play a role in determining 1. Common Stocks: Provide ownership in a company stock prices and a claim on a portion of its profits. Shareholders also often have voting rights. Common Stock as an Investment Product 2. Preferred Stocks: Offer no voting rights but provide Diversification - investors use common a higher claim on assets and earnings, often with fixed stocks as part of diversified investment dividends. portfolio to manage risk and potential return Growth Potential - common stocks offer the Topic 7: The Market for Common Stocks potential for significant capital appreciation, Income Generation - Dividends from common Common Stocks stocks can provide a steady income stream for investors, particularly those focusing on dividend-paying stocks A security that represents ownership of Liquidity - common stocks are highly liquid, equity in a corporation allowing investors to buy and sell shares easily on the stock exchange, making them a Characteristics of Common Stocks flexible investment option Ownership and voting rights - have the right Risks Associated with Common Stocks to vote on corporate matters, including the election of the BOD and major corporate Market Risk - Stock prices can be volatile, policies and investors may experience significant Dividends - not guaranteed and are paid out losses during market downturns. at the discretion of the board of directors Business Risk - Company-specific risks, such Capital Gains - investors can benefit from as poor management decisions or financial capital appreciation when the stock price difficulties, can lead to a decline in stock increases over time value. Risk and Return - generally considered Economic Risk - Economic downturns, riskier than bonds and preferred stocks but recessions, or adverse changes in the they offer the potential for higher returns industry can negatively impact stock performance. Market Structure for Common Stocks Dividends Risk - Unlike bonds, where interest payments are often fixed, dividends from Primary Market - where new issues of common stocks are not guaranteed and can common stocks are sold directly to investors, be reduced or eliminated. typically through an Initial Public Offering (IPO) Topic 8: Stock Market Returns and Stock Market Secondary Market - after the initial issuance, Efficiency common stocks are traded in the secondary market where existing shares are bought and Stock Market Returns sold among investors Over-the-Counter (OTC) Market - some - Stock markets generate returns through the buying common stocks are traded in the OTC and selling of stocks, which represent ownership in market which is decentralised and involves companies. direct trades between parties, often facilitated by a dealer network Capital Gains Factors Influencing Common Stock Prices - a price appreciation occurs when the price of a stock increases from the purchase price, allowing the investor to sell the stock at a higher price. - These gains are driven by various factors including company performance, investor sentiment, and broader economic indicators. Dividends - these are payments made by a corporation to its shareholders, usually derived from the company's profits, and paid out quarterly. - provides a steady income stream for investors, supplementing the capital gains from stock price appreciation. Interest Income (for certain securities) - securities, such as preferred stocks or bonds, that offer fixed interest payments. Stock Market Efficiency - a market is considered efficient if stock prices at any given time fully incorporate all relevant information, meaning that prices adjust quickly to new information. Efficient Market Hypothesis (EMH) - is the central theory, states that share prices reflect all available information. Three forms: 1. Weak Form Efficiency: Stock prices reflect all past trading information, such as historical prices and volumes. Technical analysis (predicting future price movements based on past price patterns) is ineffective in this form. 2. Semi-Strong Form Efficiency: Stock prices reflect all publicly available information, including financial statements, news, and economic indicators. Stock prices adjust rapidly to new public information. Fundamental analysis (analyzing financial statements to assess a stock’s value) is ineffective. 3. Strong Form Efficiency: Stock prices reflect all information, both public and private. Even insiders with access to non-public information cannot achieve excess returns because the market price already incorporates this information.