Financial Markets (definition)
The coming together of buyers and sellers to trade assets such as equities, debt, currencies, and derivatives
What are three essential economic factors that financial markets facilitate?
The raising of capital; the transfer of risk; international trade
What are five critical factors for the performance of financial markets?
efficiency; liquidity; continuity; marketability; timely and accurate information
Efficiency as a factor of the financial market
Markets must foster internal and external efficiency by quickly disseminating and reacting to the latest news, and ensuring that existing prices reflect all available information
Liquidity as a factor of the financial market
Markets must include enough buyers and sellers so that assets can be bought and sold quickly
Continuity as a factor of the financial market
In absence of new information, market prices must not change drastically from one transaction to the next
Marketability as a factor of the financial market
Markets must facilitate rapid conversion of assets into cash at a price that is determined by the market for that asset
Timely and accurate information as a factor of the financial market
New information must flow to the market with speed and precision
What happens in capital markets?
Offer companies and governments the opportunity to raise long-term funds, by matching those that want capital with those that have it
What is long term in a capital-market?
One year
What do capital markets consist of?
Stock markets and bond markets
What occurs in the stock market?
Provide equity financing through the issuance of shares of common stock and their subsequent trading
What occurs in the bond market?
Provide debt financing through the issuance of corporate, municipal or government bonds and their subsequent trading
What are the two possible classifications of capital markets?
Primary markets and secondary markets
What are primary markets?
Place in capital markets where new stock or bond is issued
How do primary markets relate to investment banking?
Investment bankers, acting in an underwriting capacity, help customers raise capital by originating securities and selling them to investors. This includes IPOs or additional issues whereby an existing public company sells new shares into the market
What are secondary markets?
Place where existing securities are bought and sold directly among investors or traders
Where do secondary market transactions take place?
On a securities exchange, over-the-counter, elsewhere
What occurs in the commodities market
Raw materials and agricultural products are exchanged. Transactions take place on regulated commodities exchanges, where these goods are bought and sold in standardized contracts. These contracts can include spot prices, forwards, futures, and options on
What occurs in the money markets?
Short term debt financing and investments take place in the money markets, where financial instruments with high liquidity and very short maturities are traded
What do money market participants use that market for?
Borrowing and lending for periods ranging from several days to just under a year
What are money market securities?
Debt instruments such as negotiable certificates of deposit (CDs), banker's acceptances, U.S. treasury bills, commercial paper, municipal notes, federal funds, and repurchase agreements (repos)
Why are money market securities considered to be relatively safe investments?
Because of their relatively short maturities and high liquidity
What occurs in the derivatives markets?
Buying and selling of financial instruments that derive their value, or part of it, from the value of another security
What forms do derivatives come in?
All kinds of forms but they primarily include commodities, mortgages, stocks, bonds, or currencies
What are some characteristics of derivatives?
They are highly leveraged and a small movement in the value of the underlying asset can cause a large fluctuation in the value of the derivative
What is an appeal aspect of the derivatives market?
Potential for a larger return than is usually the case with other forms of investment
Why would an investor use derivatives?
To speculate and make a profit if the value of the underlying asset moves the way they expect; traders can also use derivatives to hedge or mitigate risk in the underlying asset by entering into a derivative contract whose value moves in the opposite dire
What occurs in the insurance market?
Instruments that transfer the risk of loss from one entity to another are bought and sold in the insurance market. In exchange for a premium payment, an insurance company guarantees against various types of loss
What occurs in foreign currency markets?
Trading of foreign currency (duh)
How much of the volume of financial market transactions occurs in foreign currency markets?
A high amount
What are the characteristics of the foreign currency market?
Worldwide, decentralized over-the-counter marketplace, majority of transactions are electronic, governments are the biggest buyers and sellers, trading occurs 24 hours a day except on weekends
What are two other names for the foreign currencies market?
Forex or FX market
What is the purpose of the foreign exchange (currency) market?
Facilitate international trade and investment
Who participates in the foreign exchange market?
Banks and financial institutions, speculators, governments, importers and exporters, tourists
What is the spot exchange rate?
The current exchange rate
What is the forward exchange rate?
Exchange rate that is quoted and traded today but for delivery and payment on a specific future date
What is the main function of a stock exchange?
Facilitate the buying and selling of securities: companies listed on a particular stock exchange can make shares available for public trading, and can raise additional capital by selling more shares
What is the purpose of stock markets?
Offer investors liquidity or the ability to quickly and easily sell securities
What is meant by the expression that exchanges act as clearinghouses for each transaction?
They collect and deliver the shares, and guarantee payment to the seller of a security, eliminating risk to an individual buyer or seller that the counter-party could default on the transaction
What were the two basic objectives of the Securities Act of 1933?
To require that investors receive significant and material information concerning securities being offered for public sale; and to prohibit deceit, misrepresentation, and other fraud in the sale of securities to the public
Prospectus
Disclosure documents one must file with SEC to show sufficient information is available for investors to make informed decisions
What does the Securities Act of 1934 do?
Governs the secondary market; regulates US financial markets and their participants and requires they be registered; all US exchanges and over-the-counter markets are subject to the SEC's oversight, as are broker dealers and their representatives who tran
What is a principle difference between the Securities Act of 1933 and the Securities Act of 1934?
The Securities Act of 1933 prohibits fraud in the initial sale of securities, while the Securities Act of 1934 prohibits fraud in secondary market transactions
What is the process and manner in which the NYSE trades stocks?
Some transactions are completed on the trading floor as trades are directed to the floor by telephone or electronically as a broker matches interested buyers and sellers; to compete with new exchanges, the NYSE executes transactions through its hybrid mar
What is the name of the process in which stocks are traded on the NYSE?
Auction marketplace
What types of stocks are traded on the New York Stock Exchange?
Well-established companies and industrial firms that have long been the backbone of the U.S. economy; these are often called blue chip stocks
What is the process and manner in which the Nasdaq trades stocks?
Dealers hold inventories or make markets in certain securities. They stand ready to buy or sell securities from other market participants, and profit from the spread between the price at which securities are purchased are sold; participants in the market
What is the name of the process in which stocks are traded on the Nasdaq?
Deal or negotiated marketplace
What types of stocks are traded on the Nasdaq?
Since the Nasdaq is a high-tech marketplace, it attracts many firms that deal with the internet or electronics; firms are more volatile and growth oriented than the blue chip companies
What does the term over-the-counter refer to?
Stocks not traded on a national exchange; markets generally have fewer regulates and requirements than national exchanges
What are some characteristics of OTC markets?
Rely on market makers who stand ready to buy or sell shares; stocks traded are often issued by small companies or companies that do not meet the stringent listing requirements of NYSE or Nasdaq
What are the two primary OTC markets?
OTC bulletin and OTC Pink
What are the two additional secondary trading markets besides the exchanges and over-the-counter markets?
Third market and fourth market
What does third market refer to?
Over-the-counter, negotiated-price trading of exchange-traded securities; for example, if a market maker provides liquidity in a stock that is NYSE listed, it is said to be a third market maker
What does fourth market refer to?
Involves the direct trading of large blocks of securities between institutions and/or retail investors; trades are transacted through electronic networks off the exchange floor, referred to as Electronic Communication Networks
What are two primary classifications of indices (REVIEW on page 17)?
Price-weighted; capitalization-weighted
What is a price-weighted index?
Price of each included stock is the basis for determining the index value; DJIA is an example of a price-weighted index; price fluctuation of a single stock in the index can have a large influence on the index value
What is a capitalization-weighted index?
Reflects the size of the company; each company's value is computed by multiplying share price by the number of shares outstanding of a public company; price movement in a large company will significantly influence the value of this index; examples are S&P
What does it mean when a capitalization-weighted index is calculated on a free float basis?
Index only incorporates value of publicly tradable portion of the company
NYSE Composite Index
Tracks movement of all common stocks listed on the NYSE, currently more than 2000 issues and it is capitalization-weighted
S&P 500 Composite Stock Price Index
The standard for measuring large-cap U.S. stock market performance; includes a representative sample of leading companies in leading industries
Wilshire 5000 Total Market Index
Capitalization-weighted index intended to measure the entire U.S. stock market; includes more than 4000 companies and incorporates all S&P 500 stocks
Russell 2000 Total Market Index
Measures the performance of the 2,000 smallest publicly traded U.S. companies in terms of market capitalization
Nasdaq-100 Index
Modified capitalization-weighted index designed to track the performance of a market consisting of the largest and most actively traded non-financial domestic and international securities listed on the Nasdaq
If a stock has been delisted from the Nasdaq, an investor can conclude that...
A company has fallen out of compliance with that exchange's requirements. These requirements typically involve the company's market capitalization, share price, and/or number of outstanding shares; although a company is not necessarily bankrupt when it is
What is an unlisted security?
One that trades over-the-counter instead of on a centralized exchange such as the NYSE or Nasdaq
Where are derivatives and bonds most typically traded?
Over-the-counter, also known as off-exchange
Gross Domestic Product (GDP)
The total market value of goods and services produced within the borders of a country, regardless of who produces them
Gross National Product (GNP)
Total market value of goods and services produced by residents of a country, even if they are living abroad
Real Economic Growth
Rate of growth of GDP adjusted for inflation or deflation
Exchange Rate
Specifies how much one currency is worth in terms of another currency
What happens to imports with a weak US dollar?
Imports decline as they will become more expensive to US businesses and consumers
What do high interest rates mean?
Higher cost of credit and a deterrence to capital investment but they are attractive to savers
What do low interest rates mean?
Stimulate capital investment but they are unattractive to savers
Inflation
Rise in the general level of prices of goods and services in an economy over period of time; currency buys fewer goods and services and erodes the purchasing power of money
What are the general negative effects of inflation?
Decrease in the value of money; uncertainty about future inflation may discourage investment and saving; and high inflation may lead to shortages of goods if consumers begin hoarding out of concern for future price increases
What is the effect of inflation on cash?
Inflation causes rising interest rates, therefore savers tend to earn a better return when inflation is higher
What is the effect of inflation on bonds?
Inflation erodes the fixed interest payment of bonds. As interest rates rise bond prices fall, so bonds perform worse when inflation is higher
What is the effect of inflation on stocks?
Inflation can increase asset values but erode cash flows. Stocks tend to do best when inflation is low or moderate, and to fall in the case of either high inflation or deflation
What is the effect of inflation on real estate?
Higher cash flows and asset values tend to result in a positive correlation between real estate and inflation
Unemployment rate
The percentage of those in the labor force who are without work
Balance of trade
Difference between a country's exports and imports
What are debit items in the balance of trade and what is the result of debit items in the balance of trade?
Debit items include imports, foreign aid, and domestic spending abroad or domestic investments abroad and can lead to a deficit
What are credit items in the balance of trade and what is a result of credit items in the balance of trade?
Credit items include exports, foreign spending in the domestic economy and foreign investments in the domestic economy and can create a surplus or reduce a deficit
Why is a deficit balance of trade not always a bad thing?
In a recession countries try to increase exports with the intent of creating new jobs and increasing demand. In a strong expansion, countries prefer to increase imports, providing price competition. This helps limit inflation and, without increasing price
What are the four stages of the business cycle?
Contraction, trough, expansion, and peak
What is the contraction phase of the business cycle?
Slowdown in the pace of economy activity
What is a recession?
Prolonged period of contractions, typically a decline in GDP for two or more consecutive quarters; however economists prefer a definition whereby a recession is a time when business activity has peaked and starts to fall until the time when business activ
What is a depression?
Sustained, long-term downturn in economic activity in one or more economic sectors
What are the characteristics of a depression?
Its length, abnormal increases in unemployment, decline in the availability of credit, shrinking output and investment, numerous bankruptcies, reduced amounts of trade and commerce, volatile currency value fluctuations (mostly devaluations)... (price defl
What is the quantitative definition of a depression?
A decline in real GDP exceeding 10% or at least six consecutive quarters of negative GDP growth
What is the trough portion of a business cycle?
When a contraction reaches its lowest point and begins to turn: it is the point at which the contraction turns into an expansion
What is the expansion portion of the business cycle?
Increased economic activity, decline in unemployment, rise in GDP, increased availability of goods and services in the marketplace
What is the peak portion of the business cycle?
Expansion reaches its highest point and begins to turn; it is the point where expansion turns into a contraction
What are the two types of economic policy?
Fiscal policy and monetary policy?
What is fiscal policy?
Use of government spending and taxation to influence the economy
What are the three types of fiscal policy?
Neutral fiscal policy; expansionary fiscal policy; contractionary fiscal policy
What is neutral fiscal policy?
Implies a balanced budget where government spending equals tax revenue. In other words, government spending is fully funded by tax collection
What is expansionary fiscal policy?
Involves an increase in government spending over taxation; designed to stimulate economic growth, but will typically increase budget deficit
What is contractionary fiscal policy?
Government spending is reduced on its own, or in combination with higher taxation; intended to slow down economic growth and can reduce a budget deficit
What is monetary policy?
Concerned with the amount of money in circulation as well as interest rates and inflation; objective is to raise and lower the supply of money to control inflation and economic growth
What are the tools the federal reserve has to control the US monetary supply?
Open market operations; reserve requirements; discount window lending; moral suasion
What are open market operations?
Controls the quantity of money in circulation where the Fed buys and sells treasury securities with primary dealers
What does tightening the money supply refer to?
The Feds efforts to curb inflation or prevent overheating by selling securities to primary dealers and draining cash from the banking system. When less available cash causes interest rates to rise
What is referred to by easing the money supply?
When securities are purchased by the Fed, the money supply increases and interest rates will fall. The goal is to increase lending, spurring the economy, and/or bringing the economy out of a recession
Federal funds rate
The interest rate charged between banks when they lend funds to each other
Discount window
Where the Fed lends funds to depository institutions
Discount rate
Applies to the interest rate on credit available from the Federal Reserve's Discount Window; institutions usually exhaust other financing sources first because the discount rate is typically higher than the federal funds rate and may create the perception
What are reserve requirements
Portion of deposits that banks are not permitted to lend and must keep either on hand or on deposit at a Federal Reserve Bank; changes to reserve requirements are made infrequently and play a limited role in the US money creation
What occurs with higher reserve requirements?
Reduced money creation and reduced economic activity; an increase in reserve requirement tightens the money supply
What occurs with lower reserve requirements?
Economic expansionary activity
What is moral suasion?
Tactic used to influence and pressure, but not force, banks into adhering to policy
What are some categories of economic indicators?
Total output, income, spending; employment, unemployment, and wages; production and business activity; prices; money, credit, and security markets; federal finance; international statistics
What are leading indicators?
Change before the economy starts to follow a patter or trend and they include bond yields, building permits, stock market indices and averages, average of weekly unemployment insurance claims, and changes in business activities
What are lagging indicators?
Change after the economy has already begun to follow a particular pattern or trend and they include interest rates, unemployment rate, corporate profits, labor cost per unit of output, and commercial and industrial loans outstanding
What is the prime rate?
Key bank lending rate that is often used as a reference rate for credit cards and other loans
What are coincident indicators?
Economic factors that vary simultaneously with the business cycle and they include GDP, employees on non-agricultural payrolls, personal income, consumer spending, inventory/sales ratio, retail sales, and manufacturing sales
Systemic risk
Often referred to as overall market risk; reflects the fact that performance of an individual security will be impacted by the performance of the overall market; sources of system risk are recession, significant political events, and interest rates; canno
How do derivatives avoid systemic risk?
Offset positions to protect the portfolio by limiting loss or locking in a certain amount of gain
Beta
Measure of volatility, or system risk, of a security or of a portfolio in comparison to the market as a whole
What does a Beta of 1 signify?
Security's price will move with the market
What does a Beta between 0 and 1 signify?
Security will be less volatile than the market; utilities are an example of a beta less than 1
What does a Beta over 1 signify?
Security's price will be more volatile than the market; typically tech stocks are an example of this
What does a Beta over 1.3 signify?
Stock price theoretically changes 30% more than the market overall
Non-systemic risk
Often called specific risk and this risk will not impact an investor's entire portfolio so diversification protects the portfolio against this; in other words, it represents the possibility of a company making poor decisions that negatively impact the per
What are examples of non-systemic risk?
Changes in corporate management or product recalls as these risks only impact a single stock
Capital risk
Risk that an investor could lose all of the money that was invested
Country risk
Risk that a country could default on its financial obligations and harm the performance of all other financial obligations; applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country
Foreign Exchange Risk
Applies to the risk that currency exchange rates can change the price of an asset
Inflationary Risk (Purchasing Power Risk)
Impacts the amount of goods or services that money can buy; today's dollars are worth less in the future because of inflation; risk that is detrimental for retirement planning, or future income needs, where it is critical to keep up with cost of living in
Consumer Price Index
Estimates the average price of consumer goods and services purchased by households; measures a price change for these goods and services from one period to the next within a given area
Liquidity Risk
Many investments are not readily able to sale or convert into cash in the open market; shares in direct participation programs and real estate can have a high degree of liquidity risk
Political risk
New legislation or changes in political control; one of major reasons why developing countries may lack foreign investment
Interest Rate Risk
Risk that an investment's value will change as a result of a change in interest rates; risk affects value of bonds more directly than stocks
What happens to bond prices when interest rates rise?
Bond prices fall
What happens to bond prices when interest rates fall?
Bond prices rise
What is the relationship between price and yield?
It is inverse
What type of interest rates does the stock market prefer?
Low interest rates
What happens in the stock market when interest rates are low?
Consumer spending increases and businesses can borrow money for expansion and other needs at more affordable rates. Cheaper money encourages spending which is good unless the economy is growing too fast, which would lead to inflation
What occurs in the stock market with higher interest rates?
More expensive for consumers and businesses to borrow; this slows economic growth but it reduces the threat of inflation
Credit Risk
Stems from the possibility that a bond issuer will default on a payment or that is credit rating will be downgraded, leading to capital risk or loss of principal, or a missed interest payment. The issuer would have to issue new bonds at a very high rate i
Call risk
Risk that a bond may be called by an issuer when interest rates are falling; certain bonds are issued with a call feature that allows the issuer to buy back its bonds in order to reissue bonds at a lower interest rate. This reduces the issuer's interest e
What does call risk lead to?
Reinvestment risk, which is the risk that there are no available investments that can provide a similar return to a bond that has been called
What is call risk limited too?
Bonds and other callable instruments, such as callable prefered stock
Electronic Communications Network
An alternative type of trading system that facilitates computerized trading of financial products away from an exchange; place where many after-hours trades are completed; intended to improve transparency and increase competition among trading firms, ther
What is an example of a third market transaction?
The direct trading of exchange listed securities that takes place away from an exchange
Why would an increase in the value of the U.S. dollar fail to drive economic growth?
Although an increase in the value of the US dollar is good news for Americans traveling abroad, it results in reduced U.S. exports as it will take more foreign currency to buy the same U.S. goods. Fewer exports can slow economic growth
What is the OTC Bulletin Board?
Quotation facility for non-exchange listed securities only