FIN 4140 Financial Markets & Institutions Lecture 1-2

Overview of Financial Markets  Financial markets transfer funds from those who have excess funds to those who need funds. Households and businesses that supply funds to financial markets earn a return on their investment; the return is necessary to ensure that funds are supplied to the financial markets.  The main participants in financial markets can be classified as households, businesses, and govt. agencies. 2Mohammad Kamrul Arefin, MSc. in Quantitative Finance, University of Glasgow

 Surplus units: those participants who provide funds to the financial markets are called surplus units. Household are the main type of surplus units.  Deficit units: Participants who use financial markets to obtain funds are called deficit units.  Many deficit units issue (sell) securities to surplus units in order to obtain funds. A security is a certificate that represents a claim on the issuer. Securities are a form of debt. They specify a maturity date when the issuer will repay the surplus units. 3Mohammad Kamrul Arefin, MSc. in Quantitative Finance, University of Glasgow

Types of Financial Markets  There are many different types of financial markets and each market can be distinguished by the maturity structure and trading structure of its securities.  Money markets vs Capital markets: The financial market that facilitate the transfer of debt securities are commonly classified by the maturity of the securities. Those financial markets that facilitate the flow of short term funds ( with maturity less than one year) are known as money markets, while those that facilitate the flow of long term funds are known as capital markets. 4Mohammad Kamrul Arefin, MSc. in Quantitative Finance, University of Glasgow

 Primary markets vs Secondary markets:  Primary markets facilitate the issuance of new securities, while secondary markets facilitate the trading of existing securities.  Primary market transactions provide funds to the initial issuer of securities while secondary market transactions do not.  The issuance of new corporate stock or new treasury securities is a primary market transaction, while the sale of existing corporate stock or treasury security holdings by any business or individual is a secondary market transaction. 5Mohammad Kamrul Arefin, MSc. in Quantitative Finance, University of Glasgow

 An important characteristic of securities that are traded in the secondary markets is liquidity, which is the degree to which securities can easily be liquidated or sold without a loss of value.  Some securities have active secondary market meaning that there are many willing buyers and sellers of the security at a given point in time. Investors prefer liquid securities so that they can easily sell the securities whenever they want (without a loss in value). If a security is illiquid, investors may not be able to find a willing buyer for it in the secondary market and may have to sell the security at a large discount just to attract a buyer. 6Mohammad Kamrul Arefin, MSc. in Quantitative Finance, University of Glasgow

 Organized markets vs Over-the-Counter markets:  Some secondary stock market transactions occur at an organized exchange, or a visible marketplace for secondary market transactions. E.g. Dhaka Stock Exchange, New York Stock Exchange, etc.  Over the counter market is a virtual market where the transactions are done using telecommunications network (telephone, internet) 7Mohammad Kamrul Arefin, MSc. in Quantitative Finance, University of Glasgow

Securities Traded in Financial Markets  Securities can be classified as:  Money Market Securities  Capital Market Securities  Derivative Securities 8Mohammad Kamrul Arefin, MSc. in Quantitative Finance, University of Glasgow  Money market securities are debt securities that have a maturity of one year or less. They generally have a relatively high degree of liquidity. Money market securities tend to have a low expected return but also a low degree of risk.

 Table: Money Market Securities 9Mohammad Kamrul Arefin, MSc. in Quantitative Finance, University of Glasgow Money Market Securities Issued byCommon InvestorsCommon Maturities Sec. Mkt Activity Treasury BillsGovtHH, Firms, FI13/26 wks, 1 yr High Retail Certificates of Deposit Banks, savings inst. HH7days-5yrs or longer None Negotiable Certificate of Deposit Large banks and savings inst. Firms2wks-1yrModerate Commercial PaperBanks, finance companies Firms1day-270dayLow Eurodollar DepositBanks located outside US Firms, Govt1day-1yrNone Banker’s AcceptanceBanksFirms daysHigh Federal FundsDepository Inst 1-7 daysNone Repurchase Agreements Firms & Fin. Inst.Firms, FI1-15 daysNone

10Mohammad Kamrul Arefin, MSc. in Quantitative Finance, University of Glasgow  Capital Market Securities: Securities with a maturity more than one year are called capital market securities. Three common type of capital market securities are bonds, mortgages, and stocks.  Bonds & Mortgages:  Bonds are long term debt obligations issued by corporations and govt to support their operations.  Mortgages are long term debt obligations created to finance the purchase of real estate.  Bonds provide a return to investors in the form of interest income (coupon payments) every six months  Bonds and mortgages specify the amount and timing of interest and principal payments to investors who purchase them.  At maturity investors holding the debt securities are paid principal. Debt securities can be sold in the secondary market if investors do not want to hold them until maturity.  Long term debt securities tend to have a higher expected return than money market securities but they have more risk as well.

 Table: Capital Market Securities 11Mohammad Kamrul Arefin, MSc. in Quantitative Finance, University of Glasgow Capital Market Securities Issued byCommon Investors Common Maturities Sec. Mkt Activity Treasury notes & Bonds Fed GovtHH, Firms, FI3-30 yrsHigh Municipal BondsState/local govt HH, Firms10-30 yrsModerate Corporate BondsFirmsHH, Firms10-30 yrsModerate MortgagesIndividuals, Firms FI15-30 yrsModerate Equity SecuritiesFirmsHH, FirmsNoneHigh

12Mohammad Kamrul Arefin, MSc. in Quantitative Finance, University of Glasgow  Stocks:  Stocks (also referred to as equity securities) are certificates representing partial ownership in the corporations that issued them.  Stocks are classified as capital market securities because they have no maturity and therefore serve as a long term source of funds.  Some corporations provide income to their stockholders by distributing a portion of their quarterly or yearly income in the form of dividends while others retain and reinvest all of their earnings, which allows them more potential for growth.  Investors can earn a return from stocks in the form of periodic dividends and a capital gain when they sell the stock.  Equity securities have a higher expected return than most long term debt securities but also exhibit a higher degree of risk.

13Mohammad Kamrul Arefin, MSc. in Quantitative Finance, University of Glasgow  Derivative Securities:  Derivative securities are financial contracts whose values are derived from the values of underlying assets (such as debt securities or equity securities). Many derivative securities enable investors to engage in speculation and risk management.