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Why do we need financial markets? What instruments are traded? Who are the participants? What are hedging, speculation and arbitrage transactions? The origins of the current financial crisis?
Managing and sharing risks Efficient allocation of resources. Channelling surplus funds to productive uses. Separate company ownership and management (equity) Market function: Liquidity, Price discovery, Network, Regulation / Surveillance
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Terminology
- Capital market: - long-term instruments (equities/bonds) - whereby companies/governments raise funds. - Money market: - short-term debt (maturity of less than one year). - Mainly wholesale (i.e. large scale transactions) where firms and financial institutions manage their short-term liquidity needs.
01/10/2013
Terminology
Primary market: - the new issues of a security (either debt or equity) are sold to initial buyers. Secondary market: - where the securities that have previously been issued are traded. - Exchange trading versus Over-the-counter - Electronic trading, telephone, face-to-face
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Instruments / Securities
Equity stocks Money markets bills, commercial paper Fixed Income bonds Foreign exchange Derivatives forwards, futures, options, swaps Risk transfer instruments: Asset backed securities Credit derivatives
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Participants
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Depositary institutions Investment banks Mutual funds (unit trusts) Pension funds Hedge funds Insurance companies Individual investors Governments, Regulators, Rating Agencies
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01/10/2013
Speculation
Purchase (sale) of an asset for later resale (purchase) in expectation that price change will yield profit. Speculators take risky open positions to exploit profit opportunities. May be based on fundamentals equivalent to risky arbitrage. Examples? Speculators and risky arbitrage keep prices at efficient levels i.e. reflecting information
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Arbitrage
An arbitrage opportunity takes advantage of price differentials in different markets. Can be spatial (i.e. between different markets at the same time) or temporal (i.e. over time). With spatial arbitrage, a profit is guaranteed if price differentials occur. It is an investment strategy that guarantees a positive pay-off (no risk of negative pay-off).
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Arbitrage
Its importance lies in:
Ensuring rational pricing (risky arbitrage) Equalising prices of identical assets (risk-free arbitrage)
Reading List
Cuthbertson and Nitzsche (2008) chapters 1-5 Bodie et al (2008) chapters 1-4 Elton et al (2007) chapters 1-3
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Arbitrage opportunities will normally be shortlived because the actions of arbitrage demand will cause prices to move to appropriate levels.
Important in many of our later topics
Reading List
In order to perform well on the module assessment, you need to read from the textbooks and other sources on a regular basis. You should consult the reading list both prior to, and after, each lecture topic.
Homework
On Blackboard, you should access Worksheet 1
See Lectures tab on the left hand side, then Worksheets folder
Based on your reading for Topic 1, you should be able to answer Questions 1-7 on Worksheet 1 The answers will be provided on Blackboard next week
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01/10/2013
Sources of the crisis What are the origins of the current financial crisis?
The next 5 slides give you some background information to help you start on the assessed essay
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Prior to 2007, the low interest rate environment led to a search for high yield Integration of housing finance into capital markets Increasingly irresponsible lending sub-prime mortgages Inappropriate incentive structures e.g. in investment funds and rating agencies Inadequate regulation? Or regulation failing to keep up with innovation?
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