13.3 Financial Markets and Instruments
3 min read•july 31, 2024
Financial markets are the backbone of our economic system, channeling money from savers to borrowers. They're like a bustling marketplace where , , and other assets are bought and sold, helping companies raise cash and investors grow their wealth.
These markets play a crucial role in our economy, influencing everything from interest rates to job creation. By understanding how they work, we can better grasp the forces shaping our financial world and make smarter decisions with our money.
Financial markets: Resource allocation and investment
Intermediation and price discovery
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- Financial markets channel funds from surplus units to deficit units in an economy
- Provide platform for price discovery determining financial asset values based on supply and demand
- Enhance allowing investors to buy and sell assets quickly reducing transaction costs
- Facilitate capital formation enabling companies to raise funds through stock and bond issuance ()
- Contribute to risk management offering instruments for and transferring risk (options, futures)
Economic policy and information
- Play crucial role in monetary policy transmission as central banks implement and adjust policies
- Provide valuable information about economic conditions and expectations
- Influence decision-making processes for businesses, investors, and policymakers
- Support economic growth and development by efficiently allocating resources
- Reflect market sentiment and investor confidence ( indices)
Primary vs secondary markets: A comparison
Primary markets: New security issuance
- Facilitate issuance of new securities allowing companies and governments to raise capital directly
- (IPOs) introduce new stocks to the market
- Bond auctions allow governments to issue new debt securities
- Private placements offer securities to a select group of investors
- Underwriting process ensures proper pricing and distribution of new securities
Secondary markets: Trading existing securities
- Involve trading of previously issued securities providing liquidity
- Enable price discovery for existing financial instruments
- Stock exchanges (, ) facilitate trading of publicly listed companies
- Over-the-counter (OTC) markets allow trading of unlisted securities
- Electronic trading platforms increase market accessibility and efficiency
- Affect overall efficiency and stability of the financial system
Capital vs money markets
- Capital markets focus on long-term instruments with maturities exceeding one year (stocks, bonds)
- Money markets deal with short-term instruments with maturities of one year or less (, )
- Capital markets finance long-term investments and economic growth
- Money markets support short-term liquidity needs and cash management
- Distinction impacts investment strategies, risk management, and regulatory frameworks
Financial instruments: Characteristics and functions
Equity and debt instruments
- Stocks represent ownership in a company providing voting rights and potential dividends
- Stock values fluctuate based on company performance and market conditions
- Bonds are debt instruments issued by corporations or governments
- Bonds offer fixed interest payments and principal repayment at maturity
- Bond risk levels vary depending on issuer's creditworthiness (government vs corporate bonds)
Derivatives and pooled investments
- are financial contracts whose value derives from underlying assets (commodities, currencies, interest rates)
- Options give the right to buy or sell an asset at a predetermined price within a specific timeframe
- Futures contracts obligate parties to buy or sell an asset at a future date and predetermined price
- () offer diversified investment options tracking specific indices or sectors
- pool funds from multiple investors to invest in a basket of securities
- Money market instruments provide short-term liquidity (Treasury bills, certificates of deposit)
Risk, return, and diversification in investment strategies
Risk-return relationship
- Risk-return tradeoff states higher potential returns associate with higher levels of risk
- (market risk) affects all securities and cannot be eliminated through
- Unsystematic risk is specific to individual securities and can be mitigated through portfolio diversification
- () provides framework for understanding relationship between systematic risk and
- Risk measures quantify and compare risk profiles of investments (, , )
Portfolio theory and diversification
- () emphasizes importance of diversification in maximizing returns for given risk level
- Efficient frontier represents set of optimal portfolios offering highest expected return for given risk level
- Diversification across asset classes reduces portfolio volatility (stocks, bonds, real estate)
- Geographic diversification protects against country-specific risks (international investments)
- Sector diversification mitigates industry-specific risks (technology, healthcare, finance)
- Rebalancing maintains desired asset allocation as market conditions change
Key Terms to Review (36)
2008 financial crisis: The 2008 financial crisis was a severe worldwide economic crisis that originated in the United States, primarily due to the collapse of the housing market and the proliferation of subprime mortgage lending. This event triggered a chain reaction across global financial markets, leading to significant bank failures, drastic declines in consumer wealth, and ultimately, a deep recession. The crisis highlighted systemic vulnerabilities within financial institutions and led to a reevaluation of regulatory frameworks.
Beta: Beta is a financial metric that measures the volatility or risk of a security or a portfolio in comparison to the market as a whole. A beta value greater than 1 indicates that the security is more volatile than the market, while a value less than 1 means it is less volatile. This concept helps investors understand how much risk they are taking on relative to market movements, which is essential for making informed investment decisions.
Bond market: The bond market is a financial market where participants can issue new debt or buy and sell existing debt securities, primarily bonds. It plays a crucial role in the economy as it enables governments, corporations, and other entities to raise funds for various projects and operations by borrowing from investors in exchange for periodic interest payments and the return of principal at maturity.
Bonds: Bonds are fixed-income securities that represent a loan made by an investor to a borrower, typically a corporation or government. When you buy a bond, you are essentially lending money in exchange for periodic interest payments and the return of the bond's face value at maturity. Bonds play a vital role in capital markets by providing a way for borrowers to raise funds while offering investors a relatively stable income stream.
Capital Asset Pricing Model: The Capital Asset Pricing Model (CAPM) is a financial model that establishes a relationship between the expected return of an asset and its risk, measured by beta. It helps investors understand the expected return on an investment given its level of systematic risk, which is crucial for making informed investment decisions. CAPM is widely used to determine the appropriate required rate of return for an asset, helping to assess whether it is fairly valued in the context of market conditions.
CAPM: CAPM, or the Capital Asset Pricing Model, is a financial model that establishes a linear relationship between the expected return of an asset and its systematic risk, represented by beta. It is widely used in finance to estimate an investment's potential return while considering the risk involved, making it essential for asset pricing and portfolio management.
Commercial Paper: Commercial paper is a short-term, unsecured promissory note issued by corporations to raise funds for working capital and other short-term financial needs. It typically has maturities ranging from a few days to up to 270 days and is often used by businesses as a means of financing their operational expenses without having to resort to bank loans or other credit facilities.
Derivatives: Derivatives are financial instruments whose value is derived from the performance of underlying assets, such as stocks, bonds, commodities, or interest rates. They are used for various purposes, including hedging against risks, speculating on price movements, and enhancing portfolio management. By allowing parties to enter into contracts based on future prices, derivatives can help manage financial exposure and create opportunities for profit.
Diversification: Diversification is an investment strategy that involves spreading investments across various financial instruments, industries, and other categories to reduce risk. By not putting all eggs in one basket, diversification helps to mitigate the impact of poor performance in any single investment. This approach is essential in both capital markets and financial markets as it enhances portfolio resilience and potentially improves returns.
ETFs: ETFs, or Exchange-Traded Funds, are investment funds that are traded on stock exchanges, much like individual stocks. They hold a collection of assets, such as stocks, bonds, or commodities, and offer investors a way to buy a diversified portfolio without having to purchase each asset individually. ETFs have gained popularity due to their low fees, tax efficiency, and flexibility in trading throughout the day.
Exchange-traded funds: Exchange-traded funds (ETFs) are investment funds that are traded on stock exchanges, much like individual stocks. They hold a collection of assets such as stocks, bonds, or commodities and aim to track the performance of a specific index or asset class. ETFs offer investors a flexible and cost-effective way to diversify their portfolios and access various markets without having to buy individual securities.
Expected return: Expected return is the anticipated return on an investment over a specific period, calculated as the weighted average of all possible returns, with probabilities assigned to each outcome. This concept is vital in assessing investments, as it helps investors determine the potential profitability of various financial instruments and make informed decisions about their portfolios.
Federal Reserve: The Federal Reserve, often referred to as the Fed, is the central banking system of the United States, established in 1913 to provide the country with a safer and more flexible monetary and financial system. It plays a crucial role in managing the economy by regulating banks, controlling the money supply, and acting as a lender of last resort during financial crises. The Fed also influences interest rates, impacting capital markets and the overall economy.
Great Depression: The Great Depression was a severe worldwide economic downturn that lasted from 1929 to the late 1930s, marked by a dramatic decline in economic activity, massive unemployment, and widespread poverty. This period was characterized by the collapse of financial markets, particularly the stock market crash of 1929, which led to a cascade of bank failures and a significant contraction in consumer spending and investment.
Hedging: Hedging is a risk management strategy used by investors and businesses to offset potential losses in their investments or operations. By taking an opposing position in a related asset, it helps protect against unfavorable price movements. This approach is crucial for maintaining stability in financial markets and managing exposure to various risks.
Initial Public Offerings: An initial public offering (IPO) is the process through which a private company offers its shares to the public for the first time, allowing it to raise capital from public investors. This transition from a private to a public company can significantly enhance a firm's visibility and access to larger pools of capital while also subjecting it to regulatory scrutiny and increased reporting requirements.
Institutional investors: Institutional investors are organizations that invest large sums of money into various financial assets, including stocks, bonds, and real estate. These entities, which include pension funds, insurance companies, and mutual funds, play a crucial role in financial markets by providing liquidity and stability. Their significant capital and investment expertise allow them to influence market trends and drive the demand for various financial instruments.
IPOs: An IPO, or Initial Public Offering, is the process through which a private company offers shares to the public for the first time. This transition from private to public status allows companies to raise capital from a broader investor base and provides liquidity for early investors and employees. Through an IPO, companies can enhance their visibility and credibility in the market, potentially leading to increased business opportunities.
Liquidity: Liquidity refers to the ease with which an asset can be converted into cash without significantly affecting its price. It is a critical concept in finance and economics, impacting how money functions, the ability of banks to create loans, and how financial markets operate. High liquidity means that assets can be quickly sold or traded, while low liquidity suggests that it may take longer to convert assets to cash, often at a lower price.
Market efficiency: Market efficiency refers to the extent to which asset prices reflect all available information. In an efficient market, prices adjust quickly and accurately to new information, ensuring that investors cannot consistently achieve higher returns without taking on additional risk. This concept is crucial for understanding how capital and financial markets function, as it impacts pricing, investment strategies, and the overall allocation of resources in an economy.
Modern portfolio theory: Modern portfolio theory (MPT) is a financial model that helps investors maximize returns by diversifying their investments across different assets to minimize risk. It emphasizes the importance of the correlation between asset returns, suggesting that a well-structured portfolio can achieve a more favorable risk-return tradeoff. MPT introduces the concept of the efficient frontier, which showcases the optimal portfolios that offer the highest expected return for a given level of risk.
MPT: MPT, or Modern Portfolio Theory, is an investment theory that seeks to maximize returns for a given level of risk by carefully choosing a mix of assets. The theory emphasizes the importance of diversification in reducing portfolio risk and suggests that an investor can achieve optimal asset allocation by considering the expected returns, volatility, and correlations between different asset classes. This approach is foundational in financial markets, as it helps investors make informed decisions regarding their investment strategies.
Mutual funds: Mutual funds are investment vehicles that pool money from many investors to purchase a diversified portfolio of stocks, bonds, or other securities. They are managed by professional portfolio managers who allocate the fund's assets and attempt to produce capital gains or income for the investors. This pooling of resources allows individual investors to access a wider range of investments than they might be able to on their own, making mutual funds an essential part of financial markets.
Nasdaq: The NASDAQ (National Association of Securities Dealers Automated Quotations) is an American stock exchange that is known for being the first electronic exchange and is a key player in the global financial markets. It focuses primarily on technology and growth companies, making it a popular choice for investors seeking exposure to innovation. The NASDAQ operates as a dealer market where multiple dealers provide quotes for buyers and sellers, facilitating faster trades and improved market efficiency.
NYSE: The New York Stock Exchange (NYSE) is one of the largest and most prestigious stock exchanges in the world, where shares of publicly traded companies are bought and sold. It plays a crucial role in financial markets by facilitating the trading of stocks, bonds, and other securities, providing a platform for companies to raise capital and investors to buy shares. The NYSE's auction-based system and strict listing requirements contribute to its reputation as a key player in global finance.
Over-the-counter markets: Over-the-counter markets are decentralized platforms where financial instruments, such as stocks, bonds, and derivatives, are traded directly between two parties without a centralized exchange or broker. These markets enable participants to negotiate prices and terms privately, facilitating the trading of less liquid or more specialized financial assets that may not be available on formal exchanges.
Price-to-earnings ratio: The price-to-earnings (P/E) ratio is a financial metric that compares a company's current share price to its earnings per share (EPS), providing insight into how much investors are willing to pay for each dollar of earnings. A high P/E ratio can indicate that the market expects future growth, while a low P/E may suggest the stock is undervalued or that the company is facing challenges. This ratio is widely used in evaluating stocks within financial markets to assess their relative value and potential for investment.
Retail investors: Retail investors are individual investors who buy and sell securities for their personal accounts, as opposed to institutional investors who manage large sums of money on behalf of others. They often participate in financial markets by purchasing stocks, bonds, and mutual funds through brokerage accounts, usually with smaller amounts of capital than institutions. Retail investors play a crucial role in providing liquidity and can influence market trends through their trading activities.
Securities and Exchange Commission: The Securities and Exchange Commission (SEC) is a U.S. government agency responsible for enforcing federal securities laws and regulating the securities industry. Its primary mission is to protect investors, maintain fair and orderly functioning of the securities markets, and facilitate capital formation. By overseeing the capital markets and various financial instruments, the SEC plays a crucial role in ensuring transparency and preventing fraud in financial transactions.
Standard Deviation: Standard deviation is a statistical measure that quantifies the amount of variation or dispersion in a set of values. In the context of financial markets, it helps investors understand the risk associated with a particular asset or portfolio by indicating how much the returns can deviate from the expected return. A higher standard deviation signifies greater volatility, while a lower value suggests more stability.
Stock market: The stock market is a collection of markets where shares of publicly traded companies are bought and sold. It plays a crucial role in the economy by facilitating capital formation, allowing companies to raise funds for growth, while providing investors with opportunities to buy ownership stakes in these companies and potentially profit from their performance.
Stocks: Stocks are financial instruments that represent ownership in a company. When someone buys a stock, they are essentially purchasing a small piece of that company, which can entitle them to a portion of the profits and sometimes even voting rights in corporate decisions. Stocks are traded on exchanges and can fluctuate in value based on market conditions, company performance, and investor sentiment.
Systematic risk: Systematic risk refers to the inherent risk associated with the entire market or a particular market segment, which cannot be eliminated through diversification. This type of risk affects all securities in the market and is often driven by factors such as economic downturns, political instability, and changes in interest rates. Understanding systematic risk is crucial for investors and financial analysts as it helps them gauge potential impacts on their investment portfolios and overall market performance.
Treasury Bills: Treasury bills, commonly referred to as T-bills, are short-term government securities issued by the U.S. Department of the Treasury with maturities ranging from a few days to one year. They are sold at a discount to their face value, meaning investors receive less than the bill's par amount when purchasing it, and they earn the difference when the bill matures, making them a low-risk investment option.
Value at Risk: Value at Risk (VaR) is a financial metric used to assess the potential loss in value of an asset or portfolio over a defined time period for a given confidence interval. It helps investors and risk managers understand the amount of risk associated with investments, allowing them to make informed decisions about asset allocation and risk management strategies. VaR is commonly utilized in financial markets and instruments to quantify market risk, enabling institutions to gauge the likelihood of losses and plan accordingly.
Yield Curve: The yield curve is a graphical representation that shows the relationship between interest rates and the time to maturity of debt securities, typically government bonds. It illustrates how the yields of bonds vary based on their maturities, and it can indicate market expectations about future interest rates and economic activity. A normal upward-sloping yield curve suggests that longer-term debt instruments have higher yields than short-term ones, reflecting the risk premium associated with longer time horizons.