FNCE 4070: FINANCIAL MARKETS AND INSTITUTIONS Lecture 2: Understanding Financial Markets and Institutions

Working Definitions; Characteristics of an Efficient Financial Market; Financial Market Signals

Where is this Financial Market?

Financial Markets and Financial Institutions How might you define these?

Perhaps in terms of specific functions? What are possible functions of financial markets and

financial institutions? What are the characteristics of an efficient financial

market? Perhaps in terms of organizations and institutions

that participate in financial markets Commercial organizations Governmental organizations (Central banks, regulatory

organizations --- SEC; FSA) Private regulatory organizations (S&P, Moody’s, Fitch)

Function of FinancialMarkets Typical text book definition:

“Markets through which entities with surplus (“excess”) financial funds transfer those surplus funds to entities who have a shortage (“shortfall”) of available funds.” Stock markets, bond markets,

mortgage markets.

Functions of Financial Markets

Mechanism for raising funds! Done in primary financial markets (e.g.,

IPOs) Mechanism for converting financial assets

into cash before maturity. Done in secondary financial markets

(e.g., NYSE, OTC bond markets)

Functions of Financial Markets

Provides the means for entities to protect their financial/commercial positions. Done in derivatives markets (options,

futures, forwards) Mechanism for generating a return on

surplus funds. Through interest, dividends, capital

appreciation

Functions of Financial Markets

Allocates financial resources among competing users. And, we assume, if done so in the most

efficient manner (i.e., to the most productive users): The process will improve economic

efficiency and

Result in highest possible economic growth!

Functions of Financial Markets Provides financial signals to market participants

Interest rates, stock prices, exchange rates as measures of market’s perception of risk and changing risk: Stock prices and interest rates may tell us something about

the market’s assessment of companies, financial institutions, and even overall financial markets: 2008 credit crisis.

Exchange rates and government interest rate spreads may tell us something about the market’s assessment of countries or regions): 2010 – 2012 Crisis in the Euro-zone.

Perhaps we can use financial market signals as a leading indicator of economic activity.

Classification of Financial Markets Primary Financial Market

Where new securities are sold to initial buyers (e.g., IPOs) Important for raising new capital (involves public and private

placements and investment bankers) Secondary Financial Market

Where securities previously issued (in primary markets) are bought and sold (traded among investors).

Secondary markets provide liquidity for previously issued securities – Allows for conversion of financial assets into cash before asset matures. Done through organized exchanges (central locations; e.g., NYSE,

LSE) or through Over-the-counter arrangements (dealers in different locations; e.g.,

NASDAQ, and U.S. Government bond market) or through US Government Sponsored Enterprises (GSEs): Federal National

Mortgage Association and Federal Home Loan Mortgage Corporation.

Money and capital markets Short term versus long term maturities of traded instruments.

Financial Institutions Commercial entities that facilitate and

manage the movement of funds from surplus entities to final borrowers. Commercial banks, investment banks,

asset managers (pension funds, insurance companies), hedge funds, foreign exchange brokers…

Governmental entities that are involved in and/or regulate financial markets Central banks, regulatory agencies

Financial Instruments (1) Instruments which represent a claim on

the issuer’s (of the financial instrument) future income and/or assets. Examples include:

Bonds: Debt instruments with a contractual agreement (indenture specifies interest payment, maturity date, etc.).

Common Stocks: Instruments representing an ownership position in a corporation.

(2) Instruments which are neither debt nor equity based and thus belong in their own category.

Foreign Exchange

Classifications of Financial Instruments (1) Financial instruments can be categorized by form

depending on whether they are cash instruments or derivative instruments:

Cash instruments are financial instruments whose value is determined directly by markets. Stock and bonds

Derivative instruments are financial instruments which derive their value from some other (underlying) financial instrument or variable. Futures, forwards, options (puts and calls) Originated in Chicago in the 1850s (CBOT) for

commodities (flour, hay, corn), but now involves financial assets as well.

Classifications of Financial Instruments (2) As noted, financial instruments can also be

categorized depending on whether they are

equity based (reflecting ownership of the issuing

entity) or debt based (reflecting a loan the

investor has made to the issuing entity). If debt, financial assets can be further

categorized into short term (one year or less) or

long term. Short term: money market instruments Long term: capital market instruments

Characteristics of an Efficient Financial Market (1) Transparency:

All participants will have access to reliable and important information at the same time. Importance of trading platforms to transparency.

How quickly is trading information made available? Do all potential traders have access to same trading

information (bid and ask prices publicly displayed). Importance of financial services providers to

transparency in disseminating financial information. Dow Jones, Bloomberg, Reuters.

Central banks and central bankers also play in role in this process by pursuing transparency in terms of their monetary policy processes. Web sites: http://www.bis.org/cbanks.htm

Efficient Financial Market (2) Adequate, but Not Excessive, Regulation:

Financial markets need to have regulation which ensures a level and fair playing field and appropriate behavior. Regulation needs:

To discourage insider trading, price manipulations, unethical behavior

Provide appropriate reporting of financial information to markets. Securities and Exchange Act of 1934 makes it unlawful for any

person "to use or employ, in connection with the purchase or sale of any security… any manipulative or deceptive device…”

Issue for regulators: A what point does regulation become a burden (excessive) and/or drive financial service providers to other markets? Cost – Benefit Analysis done by regulators. U.S. Sarbanes Oxley Act (2002) Regulation of hedge funds.

Efficient Financial Market (3) Competition:

Markets need to be structured and regulated so as to offer easy access and exit. Not segmenting financial service providers. Not overly protecting (or rescuing) poorly run firms.

Moral hazard issue Applies to both domestic and foreign entities. Will ensure best prices and services for end users.

(4) Market Structure which Allows for Innovation: To provide needed new services and new product

development. Allow financial service providers to respond to needs of end

users. Development of derivative products in the 1970s through today.

Major Issue Facing Participants in Financial Markets Are the prices of financial instruments

potentially unstable? How volatile are they? Are they subject to? Quick and large short term moves. Substantial longer term trend changes

Quick answer: YES!!! Volatility is one major issue facing

participants in financial markets.

Interest Rates

Annual Data YoY

Corporate AAA Total Return

Changes in Stock Prices

Annual Data YoY

Changes in Exchange Rates

Annual Data (YoY)

Impact of Changes in Financial Variables Changes in interest rates:

Affect the cost of borrowing (end users and intermediaries) Influence the returns (and profit margins) to interest sensitive

financial institutions (e.g., banks) and the borrowings/investments of non-financial sectors (household and companies).

Affect asset prices (bonds, stocks, foreign exchange). Impact on the M&A market (leveraging activities) Impact on mortgage markets.

Changes in stock prices: Affect the economy’s perception of wealth:

Influence spending decisions (through the “wealth effect”). Affect the IPO market and M&A market (P/E multiples)

Changes in exchange rates: Affect the competitive position of global firms, exporters and

importers. Affect the returns to global investment funds (mutual funds, pension

funds).

Signals from the Stock Market

Forecasters have noted that for the U.S. investors start discounting the end of an expansion and the beginning of a recovery in advance of the business cycle turning point.

How can you explain this leading relationship?

Stock Market as a Leading Indicator: 1968-1983

Stock Market as a Leading Indicator: 1989-1992

Stock Market as a Leading Indicator: 1997-2011

Appendix 1

Useful Websites for Stock Prices and Exchange Rates

Stock Prices

For long term historical views go to: http://moneycentral.msn.com/investor/charts/

chartdl.aspx?Symbol=%24INDU&CP=0&PT=5

For a view of what’s happening now go to: http://bloomberg.com/

Or: http://finance.yahoo.com/marketupdate?u

Exchange Rates

Go to: http://fx.sauder.ubc.ca/ http://www.fxstreet.com/