GLOBAL FINANCIAL MARKETS

Johansen Meyer Tapia MSc, MA, LLM

FINANCIAL MARKETS
STRUCTURE
1. MAIN FUNCTIONS OF THE
GLOBAL FINANCIAL SYSTEM
1.1. Achievement of purposes for entities

Save money for future use

Borrow money for current use

Raise equity capital

Manage risks

Exchange assets for immediate and

future deliveries

Trade on estimates of asset values

Johansen Meyer Tapia MSc, MA, LLM

1.1.1 Save money for future use
 Saving involves moving money from the present
to the future (foregoing current consumption).

 The financial system facilitates savings when

institutions create investment vehicles, such as
bank deposits, notes, stocks, and mutual funds,
that investors can acquire and sell without paying
substantial transaction costs.

Johansen Meyer Tapia MSc, MA, LLM

1.1.2. Borrow money for current use
The financial system facilitates borrowing by lenders
aggregating from savers the funds that borrowers
require.

Borrowing is also facilitated via the collection,

analysis, and dissemination of credit information.

Johansen Meyer Tapia MSc, MA, LLM

 1.1.3. Raise equity capital

The financial system assists in issuing and valuing securities and

provides the necessary information for financial reporting.

Johansen Meyer Tapia MSc, MA, LLM

1.1.4. Manage risks
The financial system facilitates risk management when liquid
markets exist in which risk managers can trade instruments
that are correlated (or inversely correlated) with the risks that
concern them without incurring substantial transaction costs.

Johansen Meyer Tapia MSc, MA, LLM

1.1.5. Exchange assets for
immediate and future deliveries

The financial system facilitates spot market exchanges when

liquid markets exist in which people can arrange and settle
trades without substantial transaction costs.
For example dollars for euros in currency markets

Johansen Meyer Tapia MSc, MA, LLM

1.1.6. Trade on estimates of asset values

The financial system facilitates information-motivated trading

when liquid markets allow active managers to trade without
significant transaction costs.

Investors with information expect to earn a return on that

information.

Johansen Meyer Tapia MSc, MA, LLM

 1.2. Return Determination

Money
demanded by
borrowers and
equity sellers
Equilibrium
interest
rate
Money
supplied by
savers

Johansen Meyer Tapia MSc, MA, LLM

 1.2. Return Determination
An equilibrium interest rate is the rate where the supply of funds saved
and the aggregate demand for funds through borrowing and equity
issuing will be made equal.

High rates of return increase saving but reduce borrowing

In equilibrium, the expected rate of return for savers will be equal to

the cost of borrowing or giving up equity ownership.

Johansen Meyer Tapia MSc, MA, LLM

 1.3. Allocation of Capital

Economies are said to be allocationally efficient when their financial

systems allocate capital to those uses that are most productive and
efficient uses.

Johansen Meyer Tapia MSc, MA, LLM

2. CLASSIFICATION OF
ASSETS AND MARKETS
2.1. Classification of Assets
Financial Assets Real Assets
 Stocks  Real Estate

 Bonds  Equipment

 Derivative Contracts  Commodities

 Currencies  Other Physical assets

Johansen Meyer Tapia MSc, MA, LLM

2.1.1. Classification of Financial Assets
Debt Equity
 Promises to repay  Represent ownership
borrowed funds position
 Bonds  Common Stocks
 comercial paper  Preferred Stocks

Johansen Meyer Tapia MSc, MA, LLM

2.1.1. Classification of Financial Assets
Public Private
 Traded on exchanges  Are not traded in
or through securities public markets
dealers  Iliquid
 Liquid  Not subject to
 Subject to regulation regulation
 Venture capital is private
equity that investors
supply to companies
when or shortly after they
are founded.
Johansen Meyer Tapia MSc, MA, LLM
2.1.1. Classification of Financial Assets
Financial Derivative Physical Derivative
Contracts Contracts (stil a f.a.)

 Traded on exchanges  Are not traded in

or through securities public markets
dealers  Iliquid
 Liquid  Not subject to
 Subject to regulation regulation

Johansen Meyer Tapia MSc, MA, LLM

2.2. Classification of Financial Markets

Category Category Category Category

1 2 3 4
• Spot • Primary • Money • Traditional
markets markets markets investment
• Forward • Secondary • Capital markets
and futures markets markets • Alternative
markets investment
• Options markets
markets

Johansen Meyer Tapia MSc, MA, LLM

2.2. Classification of Financial Markets
Immediate Delivery
 Spot markets are
those markets where
assets are traded for
immediate delivery.
Future Delivery
 Assets trade for future
delivery in forward
and futures markets.
 Assets also trade for
future delivery in
options markets but
delivery is contingent
on the option being
exercised.

Johansen Meyer Tapia MSc, MA, LLM

2.2. Classification of Financial Markets
Primary Markets Secondary Markets
 Issuers sell securities  Investors sell
to investors in primary securities to other
markets. investors in secondary
markets.

 Auction markets
 Dealer markets (OTC)

Johansen Meyer Tapia MSc, MA, LLM

2.2. Classification of Financial Markets
Money Markets Capital Markets
 They trade debt  They trade instruments
instruments maturing in of longer duration, such
one year or less. as bonds and equities.

Johansen Meyer Tapia MSc, MA, LLM

2.2. Classification of Financial Markets
Traditional investments
Markets
 Traditional investments
include all publicly traded
debts and equities and
shares in pooled
investment vehicles that
hold publicly traded debts
and/or equities..
Alternative investments
Markets
 Alternative investments
include hedge funds, private
equities (including venture
capital), commodities, real
estate securities and real
estate properties,
securitized debts, operating
leases, machinery,
collectibles, and precious
gems.

 They usually are illiquid and

extra hard to value

Johansen Meyer Tapia MSc, MA, LLM

3. ASSETS THAT TRADE IN
ORGANIZED MARKETS
Assets that trade in organized markets

Securities

Currencies

Assets Contracts

Commodities

Real assets

Johansen Meyer Tapia MSc, MA, LLM

3.1. Securities

Fixed
income

Securities

Pooled
Equity
investments

Johansen Meyer Tapia MSc, MA, LLM

3.1.1. Fixed Income Securities
• . Fixed income securities are promises to repay
borrowed money.

• Fixed-income securities generate income on a

regular schedule and they derive their value from
the promise to pay a scheduled cash flow.

• The most common fixed-income securities are

promises made by people, companies, and
governments to repay loans.

Johansen Meyer Tapia MSc, MA, LLM

 3.1.1. Fixed Income Securities
• Term

• Immediate: a few days: - REPO: Right and obligation to buyback

• Short: Less than 1 year – Bills, Commercial papper, C.D.

• Intermediate: 2 - 5 year – Notes

• Long: More than 5 years - Bonds

Johansen Meyer Tapia MSc, MA, LLM

3.1.2. Equity Securities
Common Stocks
• They represent residual ownership in companies after all other
claims—including any fixed-income liabilities of the company—
have been satisfied.

Preferred Stocks:
• They tipically have scheduled dividends that must be paid
before dividends on C.S.
• On liquidation, claims of preferred equities typically have priority
over the claims of common equities.

Warrants
• Give the option to buy shares at a fixed exercised price before
the warrant expiration

Johansen Meyer Tapia MSc, MA, LLM

 3.1.3. Pooled Investments Vehicles

Individual securities can be combined in Pooled investments vehicles.

Johansen Meyer Tapia MSc, MA, LLM

3.1.3. Pooled Investments Vehicles
Pooled investments represent ownership of an undivided
interest in an investment portfolio. The portfolio may include
securities, currencies, contracts, commodities, or real assets.

Pooled investment vehicles issue securities that represent

shared ownership in the assets that these entities hold. The
securities created by mutual funds, trusts, depositories,

People invest in pooled investment vehicles to benefit from the

investment management services of their managers and from
diversification opportunities that are not readily available to
them on an individual basis.

Johansen Meyer Tapia MSc, MA, LLM

3.1.3.1. Mutual Funds

Pooled investment vehicles where investors

can purchase shares, either from the:
• Fund itself (open-end funds)
• Secondary market (closed – end funds)

Johansen Meyer Tapia MSc, MA, LLM

3.1.3.2. ETF`s and ETN`s (depositories)

They trade like close end funds but have

special provisions allowing conversion into
individual portfolio securities or exchange of
portfolio shares for ETF`s shares.

Johansen Meyer Tapia MSc, MA, LLM

3.1.3.3. Asset – Backed Securities

Represent a claim to a portion of a pool of

financial assets, such as mortgages, car
loans, credit card debt (asset – backed).

The returns are passed to the investor

with different levels of risk

Johansen Meyer Tapia MSc, MA, LLM

3.1.3.4. Hedge Funds
Are organized as limited partnerships, where
the investor is the limited partner and the fund
manager the general partner.

Often use leverage, and are directed to

individuals of substantial wealth.

Hedge managers are compensated on the

amount of assets and on investments results.

Johansen Meyer Tapia MSc, MA, LLM

 3.2 Currencies
• Currencies are monies issued by
national monetary authorities;
approximately 175 currencies are
currently in use throughout the world.

• A reserve currency is a currency that

is held in significant quantities by
many governments and institutions
as part of their foreign exchange
reserves.

• It also tends to be a international

pricing currency for products or
commodities traded in the global
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• Primary reserve currencies are the U.S.
dollar and the euro.
• Secondary reserve currencies include
the British pound, Japanese yen, and
Swiss franc.

Johansen Meyer Tapia MSc, MA, LLM

 3.3. Contracts
Forwards

Insurance Futures
Contracts

Options Swaps

A contract is an agreement among traders to do something in the future.

Values of most contracts depend on the value of the underlying asset
Johansen Meyer Tapia MSc, MA, LLM
3.3.1. Forwards
A forward contract is an agreement to trade the underlying
asset in the future at a price agreed upon today.
Forward contract holders face two major risks in addition to the
risk associated with the underlying asset:

• Counterparty risk problem: Counterparty risk is the risk that

the other party to a contract will fail to honor the terms of the
contract.

• Liquidity problem: Trading out of a forward contract is very

difficult because it can only be done with the consent of the
other party.

Johansen Meyer Tapia MSc, MA,

LLM
3.3.1. Forwards

Johansen Meyer Tapia MSc, MA,

LLM
3.3.1. Forwards

In the case, if the price of wheat falls, the wheat farmer’s crop will drop in value
on the spot market but he has a contract to sell wheat in the future at a higher
fixed price. The forward contract has become more valuable to the farmer.

Conversely, if the price of wheat rises, the miller’s future obligation to sell flour
will become more burdensome because of the high price he would have to pay
for wheat on the spot market, but the miller has a contract to buy wheat at a
lower fixed price. The forward contract has become more valuable to the miller.

In both cases, fluctuations in the spot price are hedged by the forward
contract. The forward contract offsets the operating risks that the hedgers face.

Johansen Meyer Tapia MSc, MA,

LLM
3.3.2. Futures

A futures contract is a standardized forward contract for which a clearinghouse

guarantees the performance of all buyers and sellers.

The clearinghouse reduces the counterparty risk problem. The clearinghouse

allows a buyer who has bought a contract from one person and sold the same
contract to another person to net out the two obligations so that she is no
longer liable for either side of the contract; the positions are closed.

The ability to trade futures contracts provides liquidity in futures contracts

compared with forward contracts.

Johansen Meyer Tapia MSc, MA,

LLM
3.3.2. Futures

Johansen Meyer Tapia MSc, MA,

LLM
3.3.2. Futures

Futures contracts have vastly improved the efficiency of forward

contracting markets.

Traders can trade standardized futures contracts with anyone without

worrying about counterparty risk, and they can close their positions by
arranging offsetting trades.

They simply offset (close out) their futures positions, at the same time
they enter spot contracts on which they make or take ultimate delivery.

Clearinghouses arrange for final settlement of trades.

Johansen Meyer Tapia MSc, MA, LLM

 3.3.3. Swaps
A swap contract is an agreement to exchange payments of periodic cash
flows that depend on future asset prices or interest rates.

Both swap and forward contracts provide for the exchange of cash
payments in the future. A forward contract only has a single cash payment
at the end that depends on an underlying price or index at the end.

 3.3.3.1. Interest rate swap: fixed interest payments are exchanged for
variable interest payments.

 3.3.3.2. Currency swap: parties exchange payments denominated in

different currencies. Payments may be fixed or variable.

 3.3.3.3. Equity swap: fixed payments are exchanged for payments

dependent on the returns to a stock or stock index.

. Johansen Meyer Tapia MSc, MA, LLM

3.3.4. Options

Option to call

Option to put

Johansen Meyer Tapia MSc, MA, LLM

3.3.4. Options
Right, but not the obligation to
- buy (call option)
- sell (put option)
the underlying instrument at some time in the future.

The writer of an option contract must trade the underlying

instrument if the holder exercises the option.

In contrast, the two parties to a forward contract must trade the

underlying instrument (or its equivalent value for a cash-settled
contract) at some time in the future

Johansen Meyer Tapia MSc, MA, LLM

3.3.4. Options
If the holders can exercise their contracts only when they
mature, they are European-style contracts.

If they can exercise the contracts earlier, they are American-

style contracts.

The price that traders pay for an option is the option premium.

Options can be quite expensive because, unlike forward and

futures contracts, they do not impose any liability on the holder.

Johansen Meyer Tapia MSc, MA, LLM

3.3.5. Insurance
It pays a cash amount if a future event occurs.

Examples: life, liability and automobile insurance.

Credit Default Swaps are a form of insurance

Johansen Meyer Tapia MSc, MA,

LLM
3.4. Commodities

• They include precious metals, energy products, industrial

metals, agricultural products, and carbon credits.

• Commodities trade in spot, forward and futures markets (the

underlyng asset is a commodity).

Johansen Meyer Tapia MSc, MA,

LLM
3.5. Real Assets
Real assets include such tangible properties as real estate,
airplanes, machinery, or lumber stands

You can invest:

Directly:
• For income tax advantage and diversification, but they require substantial due
diligence and are illiquid.

Indirectly:
• Maybe through a Real Estate Investment Fund (PIV), so the investor buys
participation on the PIV that holds the assets.

• Maybe buying equity securities of a company with large quantities of real

assets..

Johansen Meyer Tapia MSc, MA, LLM

4. FINANCIAL INTERMEDIARIES
4.1.1. Brokers and Dealers
Brokers
 Help their clients
finding counterparties
 Block Brokers: They
deal with large trades
without moving the
market
Johansen Meyer Tapia MSc, MA, LLM
Dealers
 They buy and sell from
their own inventory
They profit from the
difference between the
bid – ask spread.
 Primary Dealers: They
trade with central Banks
to affect the money
supply
 4.1.1. Brokers and Dealers

Broker – Dealers: They ―want‖ the best deal for their

clients but they profit from the spread….

Inherent conflict of interest, so restrictions are made

(traders place limits on how their orders are fullfiled)

Johansen Meyer Tapia MSc, MA, LLM

4.1.2. Exchanges and Alternative Trading Systems

Johansen Meyer Tapia MSc, MA, LLM

4.2. Securitizers

The process of buying assets, placing them in a pool and then selling
securities that represent ownership of the pool is called securitization)

Johansen Meyer Tapia MSc, MA, LLM

 4.2. Securitizers
Securitization greatly improves liquidity because it allows
investors to buy assets indirectly that they otherwise wouldn’t
buy directly.

Mortgage banks commonly originate hundreds or thousands of residential

mortgages by lending money to homeowners.

They then place the mortgages in a pool and sell shares of the pool to
investors as mortgage pass-through securities, which are also known as
mortgage-backed securities.

All payments of principal and interest are passed through to the investors
each month, after deducting the costs of servicing the mortgages.

Investors who purchase these pass-through securities obtain securities

that in aggregate have the same net cash flows and associated risks as
the pool of mortgages.
Johansen Meyer Tapia MSc, MA, LLM
 4.2. Securitizers
A financial intermediary can avoid placing the assets
and liabilities on its balance sheet by setting up a
special corporation or trust that buys the assets and
issues the securities: special purpose vehicles (SPVs)
or alternatively special purpose entities (SPEs).

Besides mortgages, banks securitize car loans, credit

card receivables, bank loans, etc…

Different tranches have different rights to the cash

flows from the asset pool.

Johansen Meyer Tapia MSc, MA, LLM

 4.3. Depository Institutions

Depository institutions raise funds from depositors and other investors and lend it to
borrowers.

Subject to market discipline

Johansen Meyer Tapia MSc, MA, LLM

4.4. Insurance Companies

Johansen Meyer Tapia MSc, MA, LLM

4.4. Insurance Companies
Insurers are financial intermediaries because they
connect the buyers of their insurance contracts
with those parties who are willing to bear the
insured risks.

Loss rates for well-diversified portfolios of insurance

contracts are much more predictable than for single
contracts. Insurance premiums primarily reflect the
expected loss rate in the portfolio plus the costs of
running and financing the company.

They face
- Moral Hazard
- Adverse Selection

Johansen Meyer Tapia MSc, MA, LLM

4.5. Arbitrageurs
Arbitrageurs provide liquidity to
buyers and sellers who arrive at
different markets at the same time.
They move liquidity across markets.

Arbitrageurs are financial

Dealers provide
liquidity to buyers and
sellers who arrive at
the same market at
different times. They
move liquidity through
time.
intermediaries because they
connect buyers in one market to
sellers in another market.
Arbitrageurs often trade securities
or contracts whose values depend
on the same underlying factors,
e.g., sell calls and buy shares on
the stock underlying the calls.
Buying a risk in one form and
selling it another form involves a
process called replication.

Johansen Meyer Tapia MSc, MA, LLM