05 Financial Markets

1. Types of financial markets

• the inter-bank market

• the market for commercial papers

• the market for treasury bills

• the bond market

• the stock market

• Organizations raise funds on the primary markets. The proceeds go to the company

• Existing shareholders can exit their investments by selling on the primary market. The proceeds go to the existing shareholders (e.g. VC exit)

• Organizations and individuals raising fund on the primary markets are the ultimate fund users

• Participation on the secondary markets is for the trading purposes rather than for fund raising or exiting

• These participants are not ultimate fund users

• Trading is centralized on these markets. Such as the London Stock Exchange (LSE), the New York Stock Exchange (NYSE)

• An OTC market is an electronic network connecting traders. Such as the OTC Bulletin Board (OTCBB)

• Such as the Chicago Mercantile Exchange (CME)

• The main boards of the London Stock Exchange and the New York Stock Exchange

• A market maker quotes bid prices and ask prices
• A seller sells to the market maker at the bid price
• A buyer buy from the market maker at the ask price

• Bid-ask spread: A spread exists between the bid and ask prices, with the bid price lower than the ask price
• The bid-ask price constitutes the profit for a market maker
• For traders, the bid-ask spread is the transaction cost
• The bid-ask spread is also a measure for liquidity

2. Claims on Different Financial Markets

2.1 Money Market Securities

• These are debts securities with a term to maturity of less than a year

• These securities usually have low risk and low expected return

• Treasury bills
• have maturities of 1 month, 3 months, 6 months, and 1 year
• are issued by the central government
• investors of treasury bills include households, companies, and financial institutions
• Treasury bills are actively traded on the secondary market. Good liquidity

• Certificates of deposit (CD) has a maturity up to five years
• Most CDs have a maturity less than six months. So CDs can be either money market claims or capital market claims
• Financial institutions like deposit taking institutions issue CDs
• Households invest in CDs
• CDs are negotiable, which overcomes the rigidity of deposits
• However, there is no organized markets for CDs and the liquidity is low

• Commercial papaers
• Unsecured short-term debt securities
• have maturities ranging between 1-270 days
• Large banks and large companies issue commercial papers to meet their short-term financing needs such as paying accounts payable, inventories, repaying other short-term liabilities
• Investors in commercial papers are companies
• Although commercial papers are transferable, the secondary market is inactive

2.2 Capital Market Securities

• Capital market securities are financial claims with a term to maturity of at least a year

• These securities usually involve higher risk and higher expected returns compared to money market securities

• Treasury notes and treasury bonds:
• maturities range from 3 to 30 years
• are issued by the central government
• Investors include households, companies, financial institutions, and foreign government
• Secondary markets for treasury notes and bonds are very active

• Municipal bonds
• maturities range from 10 to 30 years
• Local government issued municipal bonds
• Investors include households, companies
• The secondary markets for municipal bonds are moderately active

• Coporate bonds
• maturities range from 10 to 30 years
• Companies issue corporate bonds
• Investors include households, companies
• The secondary market for corporate bonds are moderately active. The liquidity vary according to issuers. Issuers with better transparency and credit rating usually have better liquidity

• Securitized mortgages
• maturities range from 15 to 30 years
• Mortgage lenders issue securitized mortgages. These financial institutions package mortgages into Mortgage Backed Securities (MBS)
• An MBS may contain less than one, one, or more mortgages
• Banks can take mortgages off their balance sheet after securitization, recovering cash
• Investors are usually financial institutions
• The secondary market for MBS was moderately active before the crisis but inactive after

• Equity
• has an indefinite maturity
• Companies issue equity to shareholders
• Investors include households, companies, and financial institutes
• Liquidity on the secondary market vary across companies
• Shares listed on organized markets usually have an active secondary market
• Shares listed on the OTC market have a moderately active secondary market
• The markets for privately held shares are inactive

2.3 Derivatives Market Securities

• Derivatives are designed based on the underlying claims and their values are derived based on the value of underlying claims. Such as forwards, futures, options, swaps, convertibles, exchangeables, etc.

• are often highly risky and have high expected returns

• maturities are often less than a year

• The liquidity of secondary market for derivatives vary across securities

3. Activities in the financial markets

4. Efficient Market Hypothesis

• Historical share prices, historical trading volume, historical liquidity, the financial crisis etc

• dividend announcement, merger announment, BOE announces interest rate unchanged

• earnings prior to announcement; merger proposal being privately discussed

• Weak form efficiency: all historical information is incorporated in market prices

• Semi-strong form efficiency: all historical and public information is incorporated in market price

• Strong form efficiency: all information is reflected in market price, including historical, public and insider information

• Asset price changes instantly in response to new information
• Current public information can change the price under weak form
• Insider information can change the price under semi-strong form
• nothing information can change the price under strong form

• No one can make excess or abnormal return/profit consistently
• There is no arbitrage opportunity on an efficient market
• All returns are justfiable by risk
• In weak form EMH: no excess return can be earned based on historical information
• In semi-strong form EMH: no excess return can be earned based on public information or historical information
• In strong form EMH: no excess return can be earned based on any information