Main Functions of the Financial Market (Totally three functions)
Fulfill different entities’ requirements: Save and borrow money, raise equity capital, manage risks, trade assets currently or in the future, and trade based on their estimates of asset values.
Determine interest rates :Determine the returns (i.e., interest rates) that equate the total supply of savings with the total demand for borrowing.
Allocation of capital to the best uses: Economies are said to be allocationally efficient when their financial systems allocate capital (funds) to those uses that are most productive.
First function: fulfill different entities’ requirements
Second function: Determining Rates of Return
Third function: Allocate capital to its most efficient uses
Intermediaries of Financial Market (Summary)
Brokers, Dealers and Exchange
Securitizers
Depository Institutions
Insurance Companies
Arbitrageurs
Clearinghouses and Custodians
Hedgers
Brokers, Dealers and Exchange
Securitizers
Securitizers purchase and repackage assets or mortgages and put them into a pool in order to sell them in shares.
Depository Institutions
Raise funds from depositors and other investors and lend it to borrowers
Provide transaction services on one hand, and then make loans with the deposits on the other hand.
Insurance Companies
Arbitrageurs
Arbitrageurs are intermediaries who seek to gain certain return without bearing any risk.
If information about prices is readily available to market participants, pure arbitrages involving the same instrument will be quite rare.
Clearinghouses and Custodians
Clearinghouses: act as buyers when customers want to sell assets and as sellers when customers want to buy assets, and thus limit counterparty risk.
Custodians: help prevent the loss of securities through fraud, oversight, or natural disaster by holding securities on behalf of their clients.
A well functioned financial market: allows entities to achieve their purposes.
Characteristics of a well functioned financial Market
Complete markets: Savers receive a return, borrowers can obtain capital. hedgers can manage risks, and traders can acquire needed assets.
Operational efficiency: Trading costs are low.
Informational efficiency: Prices reflect fundamental information quickly.
Allocational efficiency: Capital is allocated to its most productive use.
Market Regulation
Classification of assets (Summary)
Security (Fixed income vs. Equity Securities)
Security (Public vs. private)
Public securities: trade in liquid markets in which sellers can easily find buyers for their securities.
Private securities: are not traded in public markets which are often illiquid and not subject to regulation.
Currency:
issued by national monetary authorities.
Some of these currencies are regarded as reserve currencies. Reserve currencies are currencies that national central banks and other monetary authorities hold in significant quantities.
Contract:
are agreements between two parties that require some action in the future, such as exchanging an asset for cash.
Commodity:
Commodities are goods like precious metals, industrial metals, agricultural products, energy products, and credits for carbon reduction that are traded in spot, forward, and futures markets.
Note: Spot markets are for immediate delivery while forwards, futures, and options markets are for the future delivery of physical and financial assets.
Real Assets:
Real assets include such tangible properties as real estate, airplanes, machinery, or lumber stands.
Characteristics:
Provide income, tax advantage, diversification benefits
Entail substantial management costs
Require substantial due diligence before investing
Classification of markets
Primary vs. Secondary markets
Primary market: the place for firms to publicly rise capital:
IPO (initial public offerings): The first time a company offer its securities to market.
Seasoned offerings (secondary issues): A listed company issues new shares to the market.
Money vs. Capital markets
Money markets: The market for short-term debt instruments (oneyear maturity or less).
Capital markets: Financial markets that trade securities of longer duration, such as bonds and equities.
Traditional vs. Alternative markets
Traditional investment markets: Markets for traditional investments, include all publicly traded debts and equities.
Alternative markets: Market for investments other than traditional securities investments (i.e. traditional common and preferred shares and traditional fixed income instruments).