FINANCIAL MARKET

LESSON 1: FINANCIAL MARKETS

WHAT DO MARKETS DO?
Price setting

- The value of an ounce of gold or a share of stock is no more, and no less, than what someone is willing
to pay to own it. Markets provide price discovery, a way to determine the relative values of different
items, based upon the prices at which individuals are willing to buy and sell them.

Asset valuation

- Market prices offer the best way to determine the value of a firm or of the firm’s assets, or property.
This is important not only to those buying and selling businesses, but also to regulators.

Arbitrage

- In countries with poorly developed financial markets, commodities and currencies may trade at very
different prices in different locations. As traders in financial markets attempt to profit from these
divergences, prices move towards a uniform level, making the entire economy more efficient.

Investing

- The stock, bond and money markets provide an opportunity to earn a return on funds that are not
needed immediately, and to accumulate assets that will provide an income in future.

Risk management

- Futures, options and other derivatives contracts can provide protection against many types of risk,
such as the possibility that a foreign currency will lose value against the domestic currency before an
export payment is received. They also enable the markets to attach a price to risk, allowing firms and
individuals to trade risks so they can reduce their exposure to some while retaining exposure to others.

Raising capital

- Firms often require funds to build new facilities, replace machinery or expand their business in other
ways. Shares, bonds and other types of financial instruments make this possible. The financial markets
are also an important source of capital for individuals who wish to buy homes or cars, or even to make
credit-card purchases

Commercial transactions

- As well as long-term capital, the financial markets provide the grease that makes many commercial
transactions possible.

The size of the markets

Financial markets - statistics & facts | Statista

CROSS-BORDER FINANCING
Cross-border financing

- process of sourcing funds from outside the home country’s border. It is useful for multinational
businesses to conduct international trade without needing to hold a large reserve of working capital.

TYPES OF CROSS-BORDER FINANCING

1. Cross-Border Loans
o Cross-border loans work similarly to regular loans – the difference is exposure to two
currencies instead of one.
2. Letter of Credit
o Letters of credit are a guarantee between the buyer, seller, and bank. When the
previously agreed-upon conditions are met (such as the seller shipping the
merchandise), the seller is guaranteed to be paid. If the borrower defaults on payments,
the bank steps in to pay the outstanding amount owed. LOCs are useful to mitigate the
default risk of counterparties, especially in the international business context, where it is
harder to personally gauge the creditworthiness of the parties to the contract.
3. Cross-Border Factoring
o In cross-border factoring, a factoring company buys the business’ accounts receivable in
the foreign currency at a discount. The risk of bad debt expense (customers not fulfilling
their accounts receivable) is shifted to the factoring company, which makes a profit
between the discounted value they pay to the business, minus any bad debt expenses.
Cross-border factoring is useful for businesses that wish to receive immediate cash flows
to pay outstanding debt obligations, operating expenses, and investments for growth.

RISK TO BORROWERS

1. Legal Risk
o Due to the foreign jurisdiction, borrowers are faced with different laws and tax
consequences.

2. Currency Risk

o Borrowers are subject to foreign currency exposure due to the fluctuating nature of the
exchange rate.
RISK TO LENDERS

1. Country/Political Risk
o For businesses in foreign countries that are politically unstable, there is uncertainty
regarding disruptions in business operations due to events such as riots & coups,
regulatory changes, government intervention, and more.
2. Default Risk
o For any debt or loan, default risk is an important factor to consider. The
creditworthiness of the business (and end customers in factoring) are crucial in
determining whether to lend and at what rate.

MANAGING RISKS

1. Increase Returns
o Lenders can price in the risks by increasing their interest rates. As a general rule, a
higher risk is compensated by higher returns. In the case of factoring, lenders can
discount the value paid for the accounts receivable.
2. Decrease Risk
o Lenders can decrease risks by requiring collateral or recourse. With collateral, the lender
can legally take the collateralized asset if the lender fails to make their payments. With
recourse, the lender can go after other assets of the lender that were not collateralized.
Alternatively, lenders can buy insurance in case the borrower defaults.

CROSS-BORDER FINANCING MARKET

The cross-border financing market has grown remarkably over the years, with $7 trillion outstanding loans
worldwide. The increase can be attributed to multiple intertwined factors. The improvement of IT and
globalization of business has greatly driven demand.

Furthermore, emerging markets seeking to penetrate the global market need capital to grow. Due to the
political instability and currency risk of emerging markets, lenders get higher returns, which is attractive to
those who prefer higher risk and returns.

THE INVESTORS

The driving force behind financial markets is the desire of investors to earn a return on their assets

This return has two distinct components:

1. Yield - is the income the investor receives while owning an investment.

2. Capital Gains - are increases in the value of the investment itself, and are often not available to the
owner until the investment is sold.

Investors can be divided broadly into two categories:

Individual
 - Collectively, individuals own a small proportion of financial assets. Most households in the wealthier
countries own some financial assets, often in the form of retirement savings or of shares in the
employer of a household member

Institutional Investors

- Insurance companies and other institutional investors, including high-frequency traders, are
responsible

MUTUAL FUNDS

- combine the investments of a number of individuals with the aim of achieving particular financial goals
in an efficient way
- Mutual funds and unit trusts are investment companies that typically accept an unlimited number of
individual investments.

HEDGE FUNDS

- accept investments from only a small number of wealthy individuals or big institutions.
- able to employ aggressive investment strategies, such as using borrowed money to increase the
amount invested and focusing investment on one or another type of asset rather than diversifying. If
successful, such strategies can lead to very large returns; if unsuccessful, they can result in sizeable
losses and the closure of the fund

INSURANCE FUNDS

- Insurance companies are the most important type of institutional investor, owning one-third of all the
financial assets owned by institutions.
- consisted of annuities, which guarantee policy holders a sum of money each year as long as they live,
rather than merely paying their heirs upon death. The growth of pre-funded individual pensions has
benefited insurance companies, because on retirement many workers use the money in their accounts
to purchase annuities

PENSION FUNDS

- aggregate the retirement savings of a large number of workers.

- Typically, pension funds are sponsored by an employer, a group of employers or a labour union. Unlike
individual pension accounts, pension funds do not give individuals control over how their savings are
invested, but they do typically offer a guaranteed benefit once the individual reaches retirement age.

ALGORITHMIC TRADERS

- also known as high-frequency trading, has expanded dramatically in recent years as a result of
increased computing power and the availability of low-cost, high-speed communications.
- Investors specializing in this type of trading program computers to enter buy and sell orders
automatically in an effort to exploit tiny price differences in securities and currency markets.

OTHER INSTITUTIONS

- Other types of institutions, such as banks, foundations and university endowment funds, are also
substantial players in the markets.
FORMAL MARKETS
1. Liquidity
o easy to find another party ready to make the desired trade and the difference or
“spread” between price at which a security can be bought and the price for which it can
be sold, maybe high.
2. Transparency
o the availability of prompt and complete information about trades and prices.
3. Reliability
o Ensuring that the trades are completed quickly according to the terms agreed.
4. Legal Procedures
o adequate to settle disputes and enforce contracts.
5. Suitable Investors Protection and Regulation
o gives the investors a confidence in the available information about the securities they
may wish to trade, the procedures for trading, the ability of trading partners and
intermediaries to their commitments, and the treatment they will receive as owners of a
security or commodity once a trade has been completed.

THE FORCES OF CHANGES

1. Technology
o Abundant computing power and cheap telecommunications have encouraged the
growth of entirely new types of financial instruments and have dramatically changed the
cost structure of every part of the financial industry.

2. Deregulation
o The trend towards deregulation has been worldwide. It is not long since authorities
everywhere kept tight controls on financial markets in the name of protecting
consumers and preserving financial stability.
3. Liberalization
o Deregulation has been accompanied by a general liberalization of rules governing
participation in the markets. Many of the barriers that once separated banks,
investment banks, insurers, investment companies and other financial institutions have
been lowered, allowing such firms to enter each others’ businesses
4. Consolidation
o Liberalisation has led to consolidation, as firms merge to take advantage of economies
of scale or to enter other areas of finance. Almost all the UK’s leading investment banks
and brokerage houses.
5. Globalisation
o Consolidation has gone hand in hand with globalisation. Most of the important financial
firms are now highly international, with operations in all the major financial centers.
Many companies and governments take advantage of these global networks to issue
shares and bonds outside their home countries. Investors increasingly take a global
approach as well, putting their money wherever they expect the greatest return for the
risk involved, without worrying about geography.
LESSON 2: WHY STUDY FINANCIAL MARKETS?
 markets in which funds are transferred from people who have an excess of available funds to people
who have a shortage
 Financial markets, such as bond and stock markets, are crucial to promoting greater economic
efficiency by channeling funds from people who do not have a productive use for them to those who
do
 well-functioning financial markets are a key factor in producing high economic growth, and poorly-
performing financial markets are one reason that many countries in the world remain desperately poor
 Activities in financial markets also have a direct effect on personal wealth, the behavior of businesses
and consumers, and the cyclical performance of the economy

FUNCTION OF FINANCIAL MARKETS

Why Study Financial Institutions and Banking?

Banks and other financial institutions are what make financial markets work. Without them, financial markets
would not be able to move funds from people who save to people who have productive investment
opportunities. Thus financial institutions play a crucial role in the economy

Structure of the Financial System

The financial system is complex, comprising many different types of private sector financial institutions,
including banks, insurance companies, mutual funds, finance companies, and investment banks, all of which
are heavily regulated by the government
The financial intermediaries, which are institutions that borrow funds from people who have saved and in
turn make loans to people who need funds

Banks and Other Financial Institution

 Banks are financial institutions that accept deposits and make loans.
 The term banks includes firms such as commercial banks, savings and loan associations, mutual savings
banks, and credit unions
 Banks are the financial intermediaries that the average person interacts with most frequently
 Banks are not the only important financial institutions. Indeed, in recent years, other financial
institutions, such as insurance companies, finance companies, pension funds, mutual funds, and
investment banks

WHY STUDY MONEY AND MONETARY POLICY?

Money

 also referred to as the money supply, is defined as anything that is generally accepted as payment for
goods or services or in the repayment of debts.
 is linked to changes in economic variables that affect all of us and are important to the health of the
economy.

Money and Business Cycles

 During 1981–1982, the total production of goods and services (called aggregate output) in the U.S.
economy fell and the unemployment rate (the percentage of the available labor force unemployed)
rose to over 10%.
 After 1982, the economy began to expand rapidly, and by 1989, the unemployment rate had declined
to 5%
 In 1990, the eight-year expansion came to an end, with the unemployment rate rising to above 7%
 The economy bottomed out in 1991, and the subsequent recovery was the longest in U.S. history, with
the unemployment rate falling to around 4%.
 A mild economic downturn began in March 2001, with unemployment rising to 6%; the economy
began to recover in November 2001, with unemployment eventually declining to a low of 4.4%
 Starting in December 2007, the economy went into a steep economic downturn and unemployment
rose to over 10% before the economy slowly began to recover in June 2009

Why did economy undergo such pronounced fluctuations?

 Evidence suggests that money plays an important role in generating business cycles, the upward
and downward movement of aggregate output produced in the economy
 Business cycles affect all of us in immediate and important ways.

Money and Inflation

Aggregate Price Level

- The average price of goods and services in an economy

Inflation

- continual increase in the price level, affects individuals, businesses, and the government

Inflation rate

- (the rate of change of the price level, usually measured as a percentage change per year)

Money and Interest Rates

- Money plays an important role in interest-rate fluctuations, which are of great concern to businesses
and consumers

Conduct and Money Policy

- Because money affects many economic variables that are important to the well-being of our economy,
politicians and policymakers throughout the world care about the conduct of monetary policy,
monetary policy, the management of money and interest rates
- The organization responsible for the conduct of a nation’s monetary policy is the central bank

Fiscal Policy and Monetary Policy

- Fiscal policy involves decisions about government spending and taxation

- A budget deficit is an excess of government expenditures with respect to tax revenues for a particular
time period budget surplus arises when tax revenues exceed government expenditures.
- The government must finance any budget deficit by borrowing, whereas a budget surplus leads to a
lower government debt burden

LESSON 3: WHY STUDY INTERNATIONAL FINANCE?

FOREIGN EXCHANGE MARKETS

 directly influence each country’s foreign-trade patterns, guide the flow of international investment and
affect domestic interest and inflation rates.
 form the largest financial market by far
 Hundreds of thousands of foreign-exchange transactions occur every day, with an average turnover
totaling $5.3 trillion a day in 2013.
 By the late 14th century bankers in Italy were dealing in paper debits or credits issued in assorted
currencies, discounted according to the bankers’ judgment of the currencies’ relative values.

 This allowed international trade to expand
 far more than would have been possible if
 trading partners had to barter one
 shipload of goods for another or to
 physically exchange each shipment of
 goods for trunks of precious metal