Pointers to Review in Financial Markets

Financial Market- any marketplace where the trading of securities occurs, including the stock
market and bond market that is crucial to promoting greater economic efficiency by channeling
funds from individuals who do not have a productive use for them to those individuals who do.
Securities- a financial instrument that is a claim on the issuer’s future income/assets.
Debt Market - commonly known as bond market where debt instruments are traded.
Interest Rate- cost of borrowing or the price paid for the rental funds.
Stock- other known as common stock that represents a share of ownership in a corporation.
Foreign Exchange Market- is an over-the-counter marketplace that determines the exchange
rate for global currencies.
Foreign Exchange Rate- is the price of one’s country’s country in terms of another.
Indirect Finance- funds also can move from lenders to borrowers by a second route, because it
involves a financial intermediary that stands between the lender-savers and the
borrower-spenders and helps transfer funds from one to the other.
Financial intermediaries
(commercial banks, insurance companies, credit unions)
Financial crises:
Great Depression on 1929
Great Recession on 2007
Central banks - Federal Reserve
Monetary policy - the management of interest rates and the quantity of money.
Banks - financial institutions that accept deposits and make loans
Maturity of debt - is a contractual agreement by the borrower to pay the holder of the
instrument
fixed dollar amounts at regular intervals (interest and principal payments) until a specified date.
Primary market- is a financial market in which there are new issues of security.
Secondary market- is a financial market in which securities that have been previously issued
can be resold.
Brokers- are agents of investors who match buyers with sellers of securities.
Dealers- are middlemen between buyers and sellers who buy and sell securities at stated prices.
Exchanges - buyers and sellers of securities (or their agents or brokers) meet in one central
location to conduct trades.
Over-the-counter (OTC) market - dealers at different locations who have an inventory of
securities stand ready to buy and sell securities.
Money market- is a financial market in which only short-term debt instruments (generally those
with original maturity of less than one year) are traded.
Capital market- is the market in which longer-term debt (generally with original maturity of
one year or greater) and equity instruments are traded.
Foreign bonds - bonds denominated in the country’s currency
Eurobond - bond denominated in a currency other than that of the country in which it is sold.
Financial intermediation- it is the process of indirect finance using financial intermediaries and
the primary route for moving funds from lenders to borrowers.
● To answer , why are financial intermediaries and indirect finance so important in
financial markets? What are the three roles that we need to understand?
1. Transaction Cost
2. Risk Sharing
3. Information Cost in Financial Markets
Transaction costs- it is the expenses using time and money in carrying out financial
transactions.
Risk Sharing- also known as “ risk distribution” allowing savers to hold many assets.
Adverse selection- it is the problem created by asymmetric information before the transaction
occurs
Moral hazard - it is the problem created by asymmetric information after the transaction occur
Depository Institutions- it is a type of financial intermediary that accepts deposits from
individuals and institutions and makes loans. These institutions include commercial banks and
the so-called thrift institutions .
Contractual Savings Institutions- a type of financial intermediaries such as insurance
companies and pension funds, are financial intermediaries that acquire funds at periodic intervals
on a contractual basis.
Investment Intermediaries- This category of financial intermediaries includes finance
companies, mutual funds, and money market mutual funds.
Present Value/ Present Discounted Value- is based on the commonsense notion that the amount
paid in one year from now is less valuable than the amount paid today.
Present Value Analysis- it is the process of determining the yield to maturity or interest rate of a
debt instrument by analyzing the quantity and timing of the instrument's cash flows.
Types of Credit Market Instruments
● Simple loans
● Fixed payment loans
● Coupon bonds
● Discount bond
Yield to maturity - the interest rate that equates the present value of cash flows received from a
debt instrument with its value today.
Real Interest Rate- it is the rate of interest after adjusting for inflation.
Nominal Interest Rate- it is the interest rate that is not adjusted for inflation.
Ex ante real interest rate- it is adjusted for expected changes in price level.
Ex post real interest rate-it is adjusted for actual changes in price level.
Return - amount added on top of the investment
Rate of return - the measure of added amount
Interest rate risk - risk associated with changes in interest rates
Reinvestment risk - proceeds from the short-term bond need to be reinvested at a future interest
rate that is uncertain.

Duration- a measure of the sensitivity of the price of a bond or other debt instrument to a change
in interest rates.
Duration- the average lifetime of a debt security’s stream of payments, is a measure of effective
maturity, the term to maturity that accurately measures interest rate risk
● Calculations of Duration for Coupon Bonds have revealed four facts:
1. The longer the term to maturity of a bond, everything else being equal, the greater its
duration.
2. When interest rates rise, everything else being equal, the duration of a coupon bond falls.
3. The higher the coupon rate on the bond, everything else being equal, the shorter the bond’s
duration.
4. Duration is additive: The duration of a portfolio of securities is the weighted average of the
durations of the individual securities, with the weights reflecting the proportion of the portfolio
invested in each.
● When quantity demanded (or supplied) changes because of a change in the price of the
bond (or, equivalently, a change in the interest rate), we have a movement along the
demand (or supply) curve.
● A shift in the demand (or supply) curve, by contrast, occurs when the quantity demanded
(or supplied) changes at each given price (or interest rate) of the bond in response to a
change in some other factor besides the bond’s price or interest rate.
● When one of these factors changes, causing a shift in the demand or supply curve, there
will be a new equilibrium value for the interest rate.
Wealth - the total resources owned by the individual, including all assets.
Expected return - the return expected over the next period on one asset relative to alternative
assets.
Risk - the degree of uncertainty associated with the return on one asset relative to alternative
assets.
Liquidity - the ease and speed with which an asset can be turned into cash relative to alternative
assets.
Demand curve - shows the relationship between the quantity demanded and the price.
Supply curve - relationship between the quantity supplied and the price.
Market equilibrium - when the amount that people are willing to buy (demand) equals the
amount that people are willing to sell (supply) at a given price.
The 4 Factors that affect the shifts of demands are:
● WEALTH
● EXPECTED RETURNS
● LIQUIDITY OF BONDS
● THE RISK OF BONDS
Default Risk- one of the factors affecting risk structure of interest rates that occurs when the
issuer of the bond is unable or unwilling to make interest payments when promised.
Income Tax Consideration- it is the financial instrument that is exempted from taxation for
interest payments or capital gains and also one of the factors affecting risk structure of interest
rate of the instrument.
Default-free bonds- is a bonds with no default risk
Risk Premium- it is spread between the interest rates on bonds with default risk and default-free
bonds, both of the same maturity.
Investment-grade securities- bonds with relatively low risk of default and have above rating of
Baa (BBB).
Junk Bonds- bonds that have higher default risk and have below rating of Baa (BBB).
Liquidity Premium- other called as risk premium.
Interest Payments on Municipal Bonds- bonds that are exempt from federal taxes.
Treasury Bonds- bonds that are exempt from state and income taxes.
Interest Payments from Corporate Bonds- bonds that are fully taxable
Credit Rating Agencies- it is an investment advisory firm that rates the quality of corporate and
municipal bonds in terms of the probability of default.
Yield curve - bonds with differing terms to maturity but the same risk, liquidity, and tax
considerations.
Expectation Theory - theory that explains why the term structure of interest rates (as
represented by yield curves) changes at different times
Market Segmentation theory - theory suggest that bonds of different maturities are not
substitutes at all, so the expected return from holding a bond of one maturity has no effect on the
demand for a bond of another maturity.
Liquidity premium theory - bonds of different maturities are substitutes, which means that the
expected return on one bond does influence the expected return on a bond of a different maturity,
but it allows investors to prefer one bond maturity over another.
Efficiency market hypothesis - states that prices of securities in financial markets fully reflect
all available information.
Evidence on the Efficient Market
● in Favor of Market Efficiency
● Against Market Efficiency
Behavioral Finance- it is a new concept that applies from other social sciences, such as
anthropology, sociology, and particularly psychology, to understand the behavior of securities
prices.
Practical Guide in Investing to the Market
● How valuable are published reports by investment advisors?
● Should You Be Skeptical of Hot Tips?
 ● Do stock prices always rise when there is good news?
● Efficient Markets prescription for investor.
8 Facts of Financial Structure throughout the World
1. Stocks are not the most important source of finance for business
2. Marketable securities is not the primary funding source for businesses
3. Financial Intermediation is far more important that direct finance
4. Banks are most important source of external finance
5. The financial sector is among the most heavily regulated
6. Only large, well-established firms have access to securities markets
7. Collateral is a prevalent feature of debt contracts
8. Debt contracts are typically extremely complicated legal documents with restrictive
covenants.
Asymmetric information – it occurs when one party to a transaction has more information than
the other.
Agency Theory- is an analysis of how asymmetric information problems affect behavior.
Adverse selection- it occurs when one party in a transaction has better information than the
other party.
Moral Hazard- it occurs when one party has an incentive to behave differently once an
agreement is made between parties.
Free rider problem - occurs when people who do not pay for information take advantage of the
information that other people have paid for.
Collateral - property promised to the lender.
Net Worth - the difference between a firm’s assets and its liabilities
Covenant - written provisions that prevents moral hazards in activities
Conflict of interest - conflicts arising between multiple objectives of a company
Major policy measure in conflict of interest:
● Sarbanes-Oxley Act of 2002
● Global Legal Settlement of 2002