Notesale: Turn your study into money

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Financial markets
Monday, 17 October 2016

1:21 pm

Objectives:
- Demand and supply principle for various financial products
- Classification of financial markets
- Market mechanisms
- Types of financial risks
- Financial innovation
Introduction:
Nobel prize for economics winner (2014) Professor Jean Tirole acknowledges that
banking is difficult to regulate and academics and academics need to do more work
on it
...
(graph- slide 6)
- It started because banks decided to relax their lending standards, which
increased demand
...
(subprime mortgages)
- Mortgages were packaged into financial products
...

This caused the real estate prices in US to fall and financial products created
from mortgages, previously viewed as sade, began to be seen as risky

- Features of the market
○ 100% mortgages
§ Loan that covers the entire purchase price of the property
○ Liar loans
§ A loan designed for borrowers who have difficulties producing
documents to verify their income and asset statements, such as
prior tax returns/ untraditional sources of income
§ Some of the features included stated income/stated assets (SISA)
loans where income and assets are simply stated on the loan
application or no income/ no asset (NINA) loans where no
income nor assets are given on the loan application from
...
There is a conflict of interest
between analysts and institutions
...

- Be wary of irrational exuberance - the housing bubble
Financial markets:
- Exchange
○ Open- electronic trading has become the norm
○ More transparent
○ Contracts are standard; defined
○ Virtually no credit risk
§ Risk of default on a debt due to borrower failing to make
required payments
- OTC
○ Closed
○ Eg
...
HSBC calling GS to negotiate a deal
○ Computer and telephone linked network of dealers at financial
institutions, corporations and fund managers
○ Contracts can be bargained, non standard
○ There is some credit risk
- Regulators are trying to move OTC markets into exchanges; standardization
to avoid discrimination among investors (larger institutions can take
advantage in OTC markets)
- The forex markets consists of both markets, currency pairs can be traded
privately or in the open
Types of traders:
- Market makers
○ A broker - dealer firm that assumes the risk of holding a certain number
of shares of a company in order to facilitate the trading of that security
and maintain liquidity
○ They compete for customer order flow by displaying buy and sell
quotations for a fixed number of shares
○ institutions like HSBC
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prices fluctuate throughout the day;
high frequency
...
Options, swaps, futures and forwards contracts)
that are derived from underlying assets (eg, bonds, commodities,
currencies, indices, interest rates)
§ Enables for precise calculations of risk
§ Requires a measure of specialization and capital
○ Hedging through diversification
○ people that hedge for risk
...
Benefit from change

○ people that hedge for risk
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Benefit from change
in prices
...
Less risk
than speculating
...
If one were to trade in an
exchange they would be screened, ensuring that the trade happens in the
best possible situation
- They stand between traders in the exchange and require that they post
pash/marketable securities as collateral - the margin is set to be sufficiently
high so that the exchange is unlikely to lose money
- In otc, there is no such guarantee, it is more based on the relationship with
the dealer but there is no insurance if the dealer collapses
- The margin is determined by how risky one is, in a financial crisis the margins
get wider from each contract; increase in transaction costs
- Clearing houses take a sum of money as 'insurance' between traders and
exchange
- Based in exchanges
Central clearing parties (CCPs):
- Clearing houses used in the OTC
- If there is no such institution, one cannot be sure that the trade is how it is
supposed to be and make sure that the trade is as it should be; if not people
will be relying solely on reputation etc
- The otc requires all derivatives trades are cleared through CCPs, they screen
investors for leverage, financial situation etc to mitigate risk in trading in the
OTC
- However, they (CCPs) are at risk of default as well but they are bearing risk as
well so they are subject to bankruptcy
...
This occurs without the
CCP
...
If one bank were to default, they absorb the shock and
prevent contagion by closing positions/ transferring them to other members
...
With the function of the CCP, one has to be cleared by the CCP between
any transaction
...

Derivative markets:
- The volume traded on the OTC far surpasses that on exchanges
Short sale:
- Involves selling securities you do not own
- Securities are borrowed and sold in the usual way
- Must be bought back to be replaced
- Borrowing fee is paid to the lender
- Benefit in the difference in value through speculation
- Problematic as it creates pressure for prices to go down

Disintermediation:
- The removal of intermediaries from the market
- Its becoming increasingly importance due to the increasing use of securities
to raise capital from capital markets, instead of from banks
- A borrower can borrow directly for individuals by selling bonds and stocks
through electronic platforms instead of banks - bypassing the banks
Key summary:
- Regulation in financial markets are important
○ Transparency, limiting contagion
§ Clearing houses and CCPs
- Short sale restriction- prevent shorting shares when the market declines to
prevent panic when share prices fall
- Disintermediation and financial innovation brings an end to traditional
banking
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Notes:
- Shorting
- Differences between hedgers and speculators?



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