💰Intro to Finance Unit 2 – Financial Markets and Institutions

Key Concepts and Definitions

• Financial markets facilitate the exchange of financial assets and securities between buyers and sellers
• Financial institutions act as intermediaries in financial markets, providing services such as lending, investing, and risk management
• Market efficiency refers to the degree to which market prices reflect all available information and how quickly new information is incorporated into prices
• Liquidity measures the ease with which an asset can be bought or sold without affecting its price
• Volatility represents the degree of price fluctuation in a financial market over a given period
• Systematic risk affects the entire market or economy and cannot be diversified away (market risk, interest rate risk)
  • Unsystematic risk is specific to individual securities and can be reduced through diversification (company-specific risk)
• Regulation aims to ensure fair and transparent market practices, protect investors, and maintain financial stability

Types of Financial Markets

• Capital markets enable long-term financing through the issuance and trading of stocks and bonds
  • Primary markets involve the initial sale of securities by issuers to investors (initial public offerings - IPOs)
  • Secondary markets facilitate the trading of previously issued securities among investors (stock exchanges)
• Money markets provide short-term financing and liquidity management through instruments with maturities of less than one year (Treasury bills, commercial paper)
• Derivatives markets trade financial instruments whose value is derived from an underlying asset (futures, options, swaps)
• Foreign exchange markets enable the trading of currencies and determine exchange rates
• Commodities markets facilitate the trading of physical goods such as agricultural products (corn, wheat), energy (oil, natural gas), and metals (gold, silver)
• Interbank markets allow banks to lend and borrow funds from each other to manage liquidity and meet reserve requirements

Major Financial Institutions

• Commercial banks accept deposits, provide loans, and offer various financial services to individuals and businesses
• Investment banks assist companies in raising capital through underwriting securities, facilitating mergers and acquisitions, and providing advisory services
• Insurance companies pool risks and provide financial protection against losses in exchange for premium payments
  • Life insurance provides financial support to beneficiaries upon the policyholder's death
  • Property and casualty insurance covers losses related to assets (homes, vehicles) and liabilities
• Pension funds manage retirement savings and invest in various assets to generate returns for beneficiaries
• Mutual funds pool money from multiple investors to invest in diversified portfolios of securities
• Hedge funds employ sophisticated investment strategies to generate high returns for accredited investors
• Sovereign wealth funds are state-owned investment funds that manage a country's excess reserves and invest in various assets globally

Role of Central Banks

• Central banks are responsible for conducting monetary policy to maintain price stability and promote economic growth
  • They set short-term interest rates (federal funds rate in the US) to influence borrowing and lending activity
  • They engage in open market operations, buying and selling government securities to control the money supply
• Central banks act as lenders of last resort, providing liquidity to financial institutions during times of crisis to prevent systemic failures
• They regulate and supervise the banking system to ensure its stability and protect consumers
• Central banks manage the country's foreign exchange reserves and intervene in currency markets to stabilize exchange rates
• They oversee payment and settlement systems to ensure the smooth functioning of financial transactions
• Central banks conduct research and provide economic analysis to inform policymaking and public understanding of the economy

Financial Instruments and Securities

• Stocks represent ownership in a company and entitle shareholders to a portion of its profits (dividends) and voting rights
• Bonds are debt securities that obligate the issuer to make periodic interest payments and repay the principal at maturity
  • Government bonds are issued by national governments and are considered low-risk investments (Treasury bonds)
  • Corporate bonds are issued by companies and offer higher yields but carry more credit risk
• Derivatives are financial contracts whose value is derived from an underlying asset, such as stocks, bonds, commodities, or currencies
  • Futures contracts obligate buyers and sellers to transact at a predetermined price on a specific future date
  • Options give the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a predetermined price
• Asset-backed securities (ABS) are created by pooling together loans or other financial assets and selling them as tradable securities
  • Mortgage-backed securities (MBS) are a type of ABS backed by a pool of mortgages
• Exchange-traded funds (ETFs) are investment vehicles that track an index, sector, or asset class and can be traded on stock exchanges like individual stocks

Market Efficiency and Regulation

• Efficient market hypothesis (EMH) suggests that market prices fully reflect all available information, making it difficult to consistently outperform the market
  • Weak-form efficiency implies that prices reflect all historical information
  • Semi-strong form efficiency suggests that prices quickly adjust to new public information
  • Strong-form efficiency asserts that prices reflect all public and private information
• Regulation aims to promote market integrity, protect investors, and maintain financial stability
  • Securities and Exchange Commission (SEC) oversees the US securities markets and enforces disclosure requirements and fair trading practices
  • Federal Reserve regulates the banking system and sets monetary policy
  • Financial Industry Regulatory Authority (FINRA) is a self-regulatory organization that oversees broker-dealers and market activity
• Insider trading, the use of non-public information for personal gain, is prohibited and subject to legal penalties
• Disclosure requirements ensure that companies provide accurate and timely information to investors through financial statements and other filings
• Capital requirements ensure that financial institutions maintain sufficient reserves to absorb potential losses and protect depositors and the financial system

Global Financial System

• International financial markets facilitate cross-border capital flows and investment
  • Foreign direct investment (FDI) involves establishing a lasting interest in a foreign enterprise
  • Portfolio investment refers to the purchase of foreign securities for financial gain
• Exchange rates determine the value of one currency relative to another and affect international trade and investment
  • Fixed exchange rates are pegged to another currency or a basket of currencies
  • Floating exchange rates are determined by market forces of supply and demand
• International monetary system provides a framework for global financial transactions and stability
  • International Monetary Fund (IMF) promotes global monetary cooperation, financial stability, and provides assistance to countries in financial distress
  • World Bank provides loans and technical assistance to developing countries to promote economic development and poverty reduction
• Globalization has increased the interconnectedness of financial markets, allowing for greater capital mobility but also amplifying the transmission of financial shocks
• Emerging markets, such as those in developing countries, offer high growth potential but also carry higher risks due to political, economic, and currency instability

Current Trends and Challenges

• Fintech (financial technology) is transforming the financial industry through innovations such as mobile banking, digital payments, and robo-advisors
  • Blockchain technology enables secure, decentralized record-keeping and has applications in financial services (cryptocurrencies, smart contracts)
• Sustainable finance and ESG (environmental, social, and governance) investing are gaining prominence as investors seek to align their investments with social and environmental objectives
• Low interest rate environment poses challenges for investors seeking yield and may encourage excessive risk-taking
• Demographic shifts, such as aging populations in developed countries, have implications for pension systems, savings, and investment patterns
• Cybersecurity threats pose risks to financial institutions and markets, necessitating robust security measures and risk management practices
• Financial inclusion efforts aim to expand access to financial services for underserved populations, particularly in developing countries
• Regulatory changes, such as the Basel III framework for bank capital and liquidity requirements, aim to strengthen the resilience of the financial system
• Geopolitical risks, such as trade tensions and political instability, can impact financial markets and global economic growth