TOPIC 1: FINANCIAL MARKETS

1. Financial markets
Financial market allows economic agents to exchange financial asset. The most common assets are:
- Stocks: Endesa, GM, Telefónica, etc.
- Fixed Income Securities: Treasury bills, bonds, obligations, etc. (public or private).
- Derivatives: options, futures, etc
They are used to bring together those who need financial resources (MONEY) with those who have them.
1.2. Characteristics of the stock markets
They are official markets, whose members are the only ones that can negotiate into financial markets. They
have exclusive negotiation of the member agents, and non-member agents carry out transaction through an
intermediary.
Regulated markets, which means that everything is very regulated. In all countries there is at least one public
institution that supervises and inspects the financial markets and ensures transparency, the correct price
formation, and investor protection. How? Through legal measures that ensure the solvency of the
participants (minimum capital requirements), and the prohibition of the use of privileged information. In
Spain is Banco de España and CNMV, but in Europe:

 European System of Central Banks (ESCB), which is composed of the European Central Bank and the
national central banks of the Member States of the European Union (EU). Its main functions are the
design and execution of monetary policy (manipulate interest rates using macroeconomic variables)
of the countries that make up the Euro Area.
Its main objective is to maintain price stability, without prejudice to "supporting the general economic
policies of the Community" (each country is different)  to stop inflation.
Markets that facilitate negotiation, in which information diffusion process was through first Members 
then, Specialized public  lastly, General public. Normally, it was non-free information on trading prices,
volumes, number of trades crosses, etc.

 They facilitate the settlement process, as the stock market is the counterpart of any transaction (the
Stock Exchange always complies with the one it contracts).
 They minimize agency problems as well, where the non-member investor (the principal) must
necessarily act through an agent which will be an intermediary. Markets oblige intermediaries to
provide book prices to clients who request them.
1.3. Types of financial markets
1. Depending on the assets transferred, we find two types:
Money Market: is traded with money or with financial assets with short-term maturity and with high liquidity,
generally assets with a term of less than one year (Euribor).
Capital markets: financial assets with medium and long-term maturity are traded. We see three different
markets within this section:

 Stock Markets: provide financing through the issue of shares and allow their subsequent exchange.
  Fixed Income Markets: provide financing through the issue of bonds and allow their subsequent
exchange.
 Derivatives Markets allows the issue and purchase/sale of derivatives. All countries with developed
financial markets have created Derivatives Markets where they are traded:
 Futures/Forwards contracts on interest rates, currencies, and stock indices.
 Option contracts on currencies, interest rates, stock indices, stocks.
EXAMPLE: The Official Futures and Financial Options Market in Spain called “Mercado Oficial de Futuros y
Opciones Financieros” (MEFF). It is an organized market regulated, controlled, and supervised by the CNMV
(which supervises smaller companies) and the Ministry of Economy of Spain in which different financial
derivatives are traded. The products traded are Futures and Options on the IBEX-35 stock index; and Futures
and Options on the most important Spanish shares.
2. Depending on their structure, they can be:
Organized Markets: where there are many assets traded simultaneously, usually in one place (physical place),
and following a certain regulation. EXAMPLE: the Stock Market.
Non-organized Markets or OTC (Over The Counter) Markets: transactions take place outside the stock
exchanges and organized markets, without submitting to a specific regulation, and between agents or
intermediaries who exchange assets directly, without defining a physical place where to carry out the
transaction. EXAMPLE: SG Warrants Spain, NASDAQ.
3. Depending on the trading phase of financial assets
Primary markets: it is for financing for the issuing agent (company or Government). It always involves creating
a new title or increasing the number of titles in circulation from existing ones. EXAMPLE: new government
bond issues (Treasury Market).
Secondary Markets: only existing financial assets are exchanged, which were issued at an earlier time, so we
only trade or exchange the existing assets. EXAMPLE 1: Annotated Debt Market (“Mercado de Deuda
Anotada”)  market governed initially by the Bank of Spain, and now integrated into the SENAF platform, in
which bonds, obligations and Treasury bills are traded, as well as debt issued by the Autonomous
Communities and some public organisms. EXAMPLE 2: Stocks are traded on the secondary stock market.
4. Another markets
Markets for raw materials and merchandise (“commodities”): EXAMPLES OF GOODS: Metals (gold, silver,
copper), energy (oil, natural gas), food (sugar, cotton, cocoa, coffee), grains (corn, wheat, chickpeas) and
livestock (pork, beef.).
The merchandise can be negotiated directly (in cash), but it is not the usual thing. Or if not, in commodity
markets. EXAMPLE: El Corte Inglés can buy electricity in a “traditional” way or at OMIE (OMIE is the
designated electricity market operator (NEMO, according to European terminology) for managing the daily
and intraday electricity market in the Iberian Peninsula).
In practically all such organized markets, commodity futures and futures options are traded. EXAMPLES:
OMIE: Iberian Electricity Market, OMIP, New York Mercantile Exchange (NYMEX), London Metal Exchange:
mostly aluminum, iron, copper are traded, NORDPOOL: Most important market for electrical derivatives in
the world.
Currency Market: (Money Market and Capital Market): EXAMPLE (Money market): centralized markets in
London and NY (concentration of banks).
EXAMPLE (Capital Market): Forex: Foreign Exchange. It is traded for cash and many currency futures and
options on futures. It exists wherever a currency is traded with another one (like an exchange house). It is the
largest market in the world in terms of cash value traded. It includes trading between large banks, central
banks, large or small speculators, multinational corporations, governments, and other financial markets and
institutions.
1.4. Functioning of the stock market (Spain)
Two trading systems are distinguished in the Spanish Stock Exchanges:

 “Corro” system (extinguished): The negotiation is carried out by voice.

 SIBE (present): electronic trading system through which more than 95% of the total effective volume of
shares is contracted on the Spanish Stock Market.
Spanish Stock Market Interconnection System, “Sistema de Interconexión Bursátil Español” (SIBE)  It is
the electronic trading platform for the four Spanish stock exchanges (Madrid, Barcelona, Bilbao and
Valencia). The SIBE interconnects the four exchanges, allowing them to operate as a single market:
Spanish Continuous Market that allows a security to be listed on the Madrid, Barcelona, Bilbao, and
Valencia markets at the same time. How? Thanks to the modern computer system that allows to
centralize in real time the different orders to buy and sell securities.
The Continuous Market was created in 1989, replacing the previous trading systems of the Stock Exchange.
The computer technologies used:
1. CATS or Computer Assisted Trading System: acquired by the Madrid Stock Exchange from the Toronto
Stock Exchange in 1989.
2. SIBE or Spanish Stock Market Interconnection System: it was developed by the Madrid Stock Exchange
in 1995.
What are the advantages? Continuous negotiation of the shares of the most representative companies of the
Spanish economy and with the highest volume of contracts; and it provides real-time information on the
activity and trend of each security (transparency for investors)
Who manages the SIBE? The “Sociedad de Bolsas” (BME Group company), whose capital is distributed
equally among the Governing Companies of the four Spanish Stock Exchanges. It is also the owner of the IBEX
35 index and in charge of its management, calculation, dissemination as well as the revision of its
composition.
BME: “Bolsas y Mercados Españoles” is the operator of all the securities markets and financial systems in
Spain. It has been listed on the Stock Exchange since July 14, 2006. It has been part of the IBEX 35® index
since July 2007.
How is it organized? It consists of seven business units that represent the widest and most varied offer of
products and services that a company in this sector can currently offer to the financial community: Equities,
Public and Corporate Debt, Derivatives, Clearing and Settlement, Information Dissemination, Consulting, New
Technologies, and Training.
2. Financial instruments
2.1. Fixed income instruments
They are debt issues carried out by states (Public Debt) and companies (Private Debt) aimed at a wide
market. OBJECTIVE: OBTAINING FINANCING: They are generally issued in definite quantities, with an
expiration date (maturity: T), they have a coupon (C), a principal (or face value: N) and a regularity in the
payment of the coupon (every 6 months, every year, etc.). There is an issuer and a buyer (issuer is the one
who obtains liquidity, and the buyer is the one who obtains a return), and there exist the price and the IRR.
2.2. Most common fixed income securities
Obligations: long-term fixed income products (usually 10 years or more). They confer on their holders the
right to collect interest (coupon) and the principal on the amortization date.  Objective: to obtain funds
(financing) directly from the financial markets. There exist several types of obligations:
a. Fixed interest: the bondholder knows that they will receive a fixed percentage during each year of the
obligation's life.
b. Non-constant fixed interest: for example, 6% the first year, 7% the second, 8% the third, etc.
c. Variable interest: the interest for each year is determined a posteriori and based on a market
reference; for example, an interest equal to Euribor + 0.5%.
d. Zero coupon: issues where periodic interest is not paid, but is accumulated and paid, together with
the return of the principal, on the date of amortization of the obligation. They are also called pure
coupon codes.
Bonds: they are medium-term fixed income products (between 3 and 10 years). They can be issued by
a. Public institution: State, Regional Government, Municipality.
b. Private institution: industrial, commercial, or service company.
c. Supranational institution: European Investment Bank.
They confer on their holders the right to collect interest (coupon) and the principal on the expiration date.
They work the same as obligations. Its most frequent face value or principal is multiple of 100. The issuer
agrees to return the nominal amount together with the interest, called coupon. This interest can be fixed or
variable, based on a reference index such as Euribor.
Treasury bills: they are short-term fixed income products (between 3 months and a year). They are issued by
the State for financing. They are known, generically, as State Debt. They are issued “at discount”, that is, the
investor buys a bill with a face value amount of 10,000 euros but pays only 9,650 euros; At the end of the life
of the bill, you will receive the principal amount (10,000 euros). They are zero coupon or pure discount
bonds.
Where are the fixed income instruments negociated (Spain)?
- Association of Financial Assets Intermediaries AIAF (“Asociación de Intermediarios de Activos
Financieros”) Mercado de Renta Fija S.A.: It is an organized fixed incommarket in which the assets that
industrial-type companies, financial entities, and Territorial Public Administrations issue to raise funds to
finance their activity are listed and traded.
- Annotated Debt Market “Mercado de Deuda Anotada”: it was created within the Bank of Spain.  State
Bonds and CCAA and some municipal ones participate in this market.
3. Market efficiency
3.1. Efficient market concept
An efficient market is a fair game in which all investors have an equal chance of winning or losing. An efficient
market is one in which an investor cannot obtain extraordinary long-term or systematic returns beyond those
generated by the market. To beat the market in the long term, you must assume a greater risk, and therefore
you must be willing to lose more than the market. "It is a market that cannot be beaten".
Why is the market unbeatable? There is a model in Financial Economics (CAPM) that shows that it is very
easy to invest and earn the same as the market. If someone wins more systematically, it means that someone
is winning less systematically. Which implies that an inefficient market could exist if many of its participants
were extraordinarily naive.
3.2. Versions and interpretations of the market efficiency hypothesis
Market efficiency hypothesis: This hypothesis can manifest itself in different ways. Each form has different
implications for the functioning of markets:
1. Weak form of the market efficiency hypothesis  “The returns on a financial asset in periods that do not
overlap are independent random variables.” EXAMPLE: The variation and profitability of the IBEX 35
yesterday is independent of the variation and profitability of the IBEX 35 today. "The Stock Market has no
memory." There is no independence in levels (in what we win / lose).
Why is this efficiency? Because I cannot beat the market by predicting its behavior based on what it has
done recently
2. Semi-strong form of the market efficiency hypothesis  Markets value well, in the sense that they use all
available public information. Asset prices are consistent with all information made public and no better
than market performance can be achieved using such information. EXAMPLE: The price that Telefónica
gives you is the good one and you cannot beat it. Fundamental analysis techniques will not be able to
outperform the market.
3. Strong form of the market efficiency hypothesis  The prices of financial assets include even privileged
and confidential information. Asset prices reflect all information, and no one can outperform the market.
Contrast of the 3 versions: Do they work?
1. The strong version is not true in general. It is not supported by empirical experience. It has been observed
that there are agents who obtain higher returns using private information. EXAMPLE: Studies in the US
market show that speculating using this type of information is relatively common.
2. The semi-strong version is true in general, although there are some imperfections. There are experts who
analyze financial assets and companies very well and then find imbalances and take advantage of them,
but by taking advantage of them they undo the positions. EXAMPLE: People who see undervalued things
can buy them, overvalued they can sell them.
3. The weak version is true. Especially when taking periods longer than 3 days. If weekly correlations are
taken, zero correlation (independence) almost always occurs. When it is not zero, the serial correlation
occurs, for example, day by day.
HOW IS IT SOLVED? With capital requirements, and higher supervision.
All this has questioned the efficiency of the markets. Semi-strong hypothesis has not been fulfilled. Much
mistrust is generated (no credit): increased unemployment, no consumption, companies continue to lose
money...: the economy collapses.