Money and Capital markets

The Financial System

-Financial system is combination of financial markets and institutions.

The three parts of the financial system:

1.Financial Markets- where lenders and borrowers meet. Money

markets and stock exchanges

2.Financial Intermediaries- stays in a middle, for example: bank

(collects the money who have it and gives money who needs it, helps to
transfers the funds in the system). such as banks, insurance companies
and other institutional investors that direct funds from those willing to
invest/lend to those who want to borrow.

3.Financial infrastructure: Perfect mechanism, trading mechanism.

through which money and financial assets flow between buyers and
sellers. Examples are payment systems and security settlement systems.
Market is the place- where people buy and sell products. is the «
institutional mechanism » (if you prefer the « trading rules ») that allows
buyers and sellers to trade goods or financial securities.

A good is the product that is used to satisfy the needs and wants

Financial market- a market in which people buy and sell financial

products. (Bonds and Stocks)

Security=Payment=Instrument

Bond is the financial borrowing document: how much I am borrowing,

when I’m going to pay back. (borrowing duration should be at least one
year)

If the borrowing duration is less than 1 year- Money market instrument.

(for short term borrowings)

If he buys the bond, he becomes the bondholder (his interest is to gain

interest), (If I’m selling the bond)- I will be borrower (borc aliram)( my
interest to get money). The transaction takes place in bond market.

Issuer are always the one borrower and who sells the paper

Maturity- Deadline of the contract.

Stocks do not have maturity. (no one promises to pay back)

Combination of Stock and Bond markets= Capital Markets

Issuing = Creating

Issuer= Creator or Borrower

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As supply and demand are changing over time-> stock prices frequently
changing.

To make sure the markets are working properly

1. Property rights are satisfied-are correctly enforced

2. Transparency – lenders should know how prices are constructed

3. Confidence- People should have confidence to government, bank

An important source of market disruption: lack of trust

Purpose of financial markets=> making sense that money is transferred.\

Slide 14 and 20, 23, 32, 37,41

Bonds are safe. Stocks are riskier because price changes over time and
people do not know what will happen.

There is no maturity.

Bonds:
-do not offer ownership, it is only about long-term borrowing contract

-Fixed maturity, you exactly know when you will get your money
(everything written on paper)

-Contractual Payment

Risk related to the information that is coming to company

Stocks:

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 Price discovery. Establish a price for the securities and enabling
prices to quickly reflect information. Secondary markets determine the
prices of the stocks. Demand and supply intersect gives us practical
price. Important Information changes demand and supply and then they
change prices. Prices are reflected by the sensitivity of the information.

 Provide liquidity: Buying and selling. Higher liquidity means that it’s
easier to buy stock and sell stock. that is, making it easy to buy or sell
quickly financial securities without substantially affecting the asset’s
price.

It is usual to distinguish markets on the basis of the maturity of the

securities traded.

The money market is a financial market in which only short-term debt

instruments (with maturity of less than 1Y) are traded.

The capital market is the market in which longer- term debt and equity
instruments are traded.

markets

 US Treasury bills, which are short-term debt of the US government to

finance the federal government. See the AFT (Agency France Tensor
website) for the case of France.

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http://www.aft.gouv.fr/

 Commercial paper, which is a short-term debt instrument issued by

large banks and well-known corporations.

As government is not private, they could not issue stocks.

 Stocks, which are claims of the net income and assets of a

corporation.

 Corporate bonds, which are long-term debt issued by corporation.

These bonds may be rated by rating agencies.

 US government securities, which are long-term debt instruments to

finance the deficits of the (federal) government (see the AFT for the case
of France).

Corporate bonds are riskier than government bonds, as the lender

because of that you need to give more composition- more interest rate.

Another important class of securities:

derivatives

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A derivative is a financial instrument (contract) whose value are derived
from the value(s) of underlying asset(s) (e.g., a stock). Protects you from
inclining risk (price decline). However, its expensive(disadvantage)

Financial derivatives are useful instruments that can be used to reduce or

eliminate a risk (interest rate risk, a default risk...). This is generally
called risk management.

Example of derivatives: forward contracts, futures, options, swaps,

credit default swaps...

Strategies: Arbitrage versus speculation

Arbitrage involves locking a riskless profit at no cost.

An arbitrage can be seen as a deterministic money-making operation. It

means that there is something wrong in the market, that is, mispricing.
Different between prices of same security. No risk. Buy low sell high.

Speculation involves risky positions in the market. The investor is

betting that the price of an asset will go in the favorable direction for
him/her. You speculate the market.

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But manipulation is illegal.

Should work efficiently that funds can circulate

Direct finance=lenders give money to borrowers; you have the market

which helps you to complete the interaction between buyer and seller.

Indirect finance=financial intermediaries/financial institutions=

Vabk-30-35%

which one most common? – Financial institutions

14 20 23 32 33 37 41 44 46
A world without FI
If there is no financial market or financial system, we cannot make
transfer, 1. we cannot have circulation of funds which is the key
problem.

2. more costly for buyers and sellers.

3. Asymmetrical Information: The problem that lenders do not have the

full information about borrower.

Corporation knows what happened in the past however bank manager

does not know about it.

One of the drivers of financial crisis. In order to eliminate it they can

contact security agencies, insurance or government.

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Households->mortgage, stock buying

Nesta versus NY Stock exchange= both are stock markets.

NY is the physical location

NASTAQ->Stock market but over the counter market=platform,

computer system

Difference: adverse selection is before the transaction happens

Moral hazard occurs after

Helps the payments to be transferred= helps the transactions to be

executed or completed.

Risk premium= you need to composite yourself. reward if you take

additional risk. How can you increase your risk premium? With interest
rates

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In the money markets=The amount of borrowing= the price of security.

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Treasury bills are very liquid

If you have the treasure bills issued by government, then it’s so safe,
default risk of is extremely low.

Fed funds= the system of banks that interacts with each other. It is called
interbank system. Not only 2 or 3 banks. Issued by fed

Interest rate= fed funds rate

Why these rates are important?

They change funds to change relationships with banks.

When banks have difficulty and cannot bower, you should decrease the
interest rate, it will create the incentive on banks by they will pay a lot.

In what type of situations, it would be better to increase the interest rate?

- Inflation. If the economy is stagnant, you need to inject some

energy, we have to make sure that it will go again.
- Only Central bank can increase and decrease
- It has nothing to do with political associations and government,
because it would be risky

Monetary Policy= changing the interest rates

In practice libor is more important

They check libid and libor and look at the difference.

In crisis period you will expect the difference to be.

Compensation=risk premium

Interest rate is extremely high in inflation period

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Because borrowing becomes harder, lenders is expecting higher and
higher

P 30-31

Tenor= maturity

Interest rates changes depending on maturity, the longer the maturity the
higher the maturity.

*Negative interest rates-

Price=99$

PAR (or face value) = 100$ (I said you that I will give you 100$ next
week) he amounts of money that the borrower gives to lender at
maturity.

Y=Investment rate, Interest rate or yield

Comparing money market securities:

We look at yield. We can compare them in terms of:

-Maturity

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-Liquidity
-Issuer
- Terms
-Risk
-Return
Yield affect to the riskiness of the product. When interest rate is
higher it means that maybe that company is doing riskier work.
Inflation and T-bills Most of time they move together meaning
disadvantage of inflation ( bzim bildiymz). Positive correlation=
bc higher inflation, lower value of the money and higher interest
rate to compensate. (like maturity= higher maturity, higher risk)

Fed Fund effect entire bank system, NCD affect only

commercial bank system
46-50

Comparing money market instruments:

Yield: Investment rate of T-Bill

For tbills the yield called investment rate is calculated as follows:

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The Bond Market

Valuation=pricing!!!
How we can have idea about value? We can calculate the price
Who can issue bonds-
-The US Treasury
-corporate
-federal and local government
*Treasury is not central bank
They are bought by:
-institutional investors
-households

Characteristics:
-Par value= fixed and money will be payed only at maturity
time.

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-Coupon is the periodic cash payment before maturity.
Annually, semi-annually. Everything specified with contract.df

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