Financial Markets and Institutions

Case study: Financial Crisis - 2008

Attendanceandselfstudy
Itis foryourbenefittoattendalltheclasses.Minimum80%attendanceis
expected.Lecturemaynotberepeatedifithasbeenvoluntarilymissedbya
candidatewithoutanyunavoidablereason.
Minimum 3hoursofselfstudyisencouragedforeverylecture.Yourmotivation
andselfstudyisthekeytoyourlearningexperience.
Suggestions
Everyone attending the lecture has to do it:
a) Watch the video: http://vimeo.com/3261363
b) Read all the topics under "USA financial crisis" from:
http://2008financialcrisis.umwblogs.org/analysis/.
Videos to watch:
Relationship between bond prices and interest rates
Trading Basics
How the Markets Work

Please read the web chapter on Financial markets and institutions.
.

Please study continuous compounding and materials regarding the present
value of money.
http://wps.aw.com/wps/media/objects/5448/5579249/FinancialMarketsandInstitutions.pdf
What is a Market
Definition: Congregation of buyers and sellers
Physical - Bazaar
Electronic trading
Real assets vs. financial assets. Main street vs. wall street
Financial Markets: Markets in which funds are transferred from people
who have an excess of available funds to people who have a shortage of
funds
Financial markets promote efficiency in economic system
Taking funds from those who do not have productive use of funds and
Giving to those who can best utilize the funds
Affect wealth and behavior of business firms and individuals
Financial markets
Savers
Borrowers
Savers
Borrowers
Funds
Claims
Interest rates: An interest rate is the cost of borrowing or the price paid for
the rental of funds (usually expressed as a percentage of the rental of 100
per year)
Interest rates affect both individuals and corporations decisions to
spend or save
A stock: A share of ownership in a corporation. It is a security, that is a claim
on the earnings and assets of the corporation. The stock market is where
stocks are traded.
A stock index is a measure of performance of well-defined collection of
stocks.
Commodity markets are markets where raw or primary products are
exchanged. E.g., crude oil, gold markets
Important definitions
Below are some of the good proxies for risk free interest rate(it's subjective)
a) Return on federal government securities
b) Interbank exchange loan rates
c) Interest rates charged by banks.
How would you study relationships between commodity markets and equity
markets?
Or relationship between risk free interest rates and equity markets.
Introduce Time Series modeling here.
Bond: A debt security that promises to make payments periodically for a
specified period of time. The bond market is where bonds are traded.
It enables corporations or governments to borrow to finance activities
It is where interest rates are determined
Important definitions
Derivatives: A financial asset whose value is derived from the value of an
underlying asset.
E.g. Option to buy a stock or a security.
Used to hedge risks and speculate.
A foreign exchange market is a market where funds are converted from
one currency to another
To transfer funds from one country to another for trade

Classification of financial assets
Money market
Capital market
Risk vs. return.
Interest rates depend on a) risk taken, b) time to payoff
Orders: 1) Long (Buy)
2) Short (Sell)
3) Sell short
4) Buy-to-cover
Types of Buy/Sell Orders
Brokers can typically perform the following buy/sell orders
for exchange traded assets:
Market orders request the trade happen immediately at the
best current price.
Limit orders demand a given or better price at which to
buy or sell the asset. Nothing happens unless a matching
buyer or seller is found.
Stop or stop-loss order becomes a market order when a
given price is reached by the market on the downside.
This enables an investor to minimize their losses in a
market reversal, but does not guarantee them the given
price.
Market-if-Touched order (MIT) becomes a market order
when a given price is reached by the market on the upside.
This enables an investor to take prots when they are
available, but does not guarantee them the given price.
The volume and distribution of stop and limit orders in
principle contains information about future price movements.
Theory argues against making such orders as giving away
an option for no payoff, however, such orders are useful
particularly for modest-sized investments.
Types of BUY/SELL orders
Tradestation
BUY/SELL orders
Stop-loss
Trailing stop
Profit target
Strategy optimisation tool in TradeStation.
Capital Allocation
Financial Institutions/intermediaries
Firms/Govt
Money market;
Bonds; Stocks
Kinds of financial markets
Private vs. Public:
Private: Worked between two parties. Bank loan
Public: Standardized contracts are traded on organized exchanges NYSE
Money v. Capital market
Money: Short-term highly liquid securities
Capital: Intemediate or long-term securities. NYSE
Primary v. Secondary
Primary: Trading newly created securities. Initial Public Offering
Secondary: Trading securities after they have been issued by
corporation. NYSE
Debt v. Equity: Trading debt vs. equity. Mortgages, NYSE
Exchanges v. Over-the-counter markets:
Exchanges: Institutional and more organized
OTC: Dealers and contacts. Informal.
Spot v. Futures


Different types of securities
Bonds and interest rates
Bond
Par value (face value)
Coupon rate
Coupon payment
Zero coupon
Maturity date
PV $100 $100 $100
Bonds and interest rates
Bond
Par value (face value)
Coupon rate
Coupon payment
Zero coupon
Maturity date
PV $100 $100 $100 $100
Discrete compounding
Recall that the effective interest rate depends on the number of compounding
periods.
Interest rates are often quoted in APR form.
Examples:
r = 6%, annual compounding
$100 invested for 1 year yields $106
the effective interest rate is just r
eff
= 6%
r = 6%, monthly compounding
this means that the monthly interest rate is 6%/12 = 0.5%
So $100 invested for 1 year yields $100 (1.005)
12
= $106.17
the effective interest rate is r
eff
= 6.17%
Bond FNCE 206/717 p. 2/9
Examples continued
r = 6%, daily compounding
this means that the daily interest rate is 6%/365 = 0.016438%
So $100 invested for 1 year yields
$100 (1 + 0.016438%)
365
= $106.18
So r
eff
= 6.18%
In general, the effective interest rate is given by
1 + r
eff
=

1 +
r
k

k
where k is the number of compounding periods and r is the APR
Bond FNCE 206/717 p. 3/9
Continuous compounding
Continuous compounding is when k is innite:
write k
mathematical fact:

1 +
r
k

k
e
r
as k
e is the Euler number, and is equal to 2.71828 . . .
it can be found on your calculator
it is common to write exp(x) in place of e
x
in Excel, use the exp function
So with continuous compounding,
1 + r
eff
= e
r
= exp(r)
Example: interest rate 6%, continuous compounding
effective rate is e
0.06
1 = 6.18%
Bond FNCE 206/717 p. 4/9
Bonds and interest rate calculations
Evaluating investments