IFM CHEATSHEET CHAPTER 1

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 CHAPTER 1: INTRODUCTION TO FINANCIAL MARKETS 


WHAT ARE FINANCIAL MARKETS? 

They are the place (physical or virtual) where financial instruments are issued, bought, and sold.

  • Goal: allocate scarce resources efficiently → channel savings (investors) to productive uses (borrowers).

Core functions:

  1. Mobilize savings 2. Provide liquidity 3. Price discovery 4. Manage risk 5. Facilitate trade 


  • Being rational VS. being IRRATIONAL: emotional (being human beings which have experience, and live according to it) → behavioural finance: we are not created to invest, but to avoid risk. 


FM OVERVIEW I: MONEY→ Central Banks & Banks (Chapter 2)

  • Money: is any asset accepted as/ to: 1. Medium of exchange 2. Unit of account & 3. Store value

MONETARY AGGREGATES – ECB

M0→ currency in circulation ( + banks reserves at CBs)

M1→ currency in circulation + deposits

M2→ M1 + Deposits < 2 years

M3→ M2 + REPOS + Money Market fund + Short term debt

TYPES OF RISK

  1. Market risk: risk losses due to movement in market prices

    1. SYSTEMATIC: risk you CAN’T diversify away

    2. INTEREST RATE: rates change asset values. 

    3. CREDIT/ DEFAULT: fluctuations in foreign currency exchange rates. 

  2. Cash flow risk: uncertainty of repayment of the principal and time of expected cash flow. 

  3. Counterparty risk: the other party in a contract doesn’t perform. 

  4. Liquidity risk: you can’t sell quickly at a fair price

  5. Operational risk (Barings case): process/ systems failures, human error, external events…

  6. ESG risk (Enron case): Government – high debt/ losses via off balance sheets (they hided debt)

Others: Legal risk, reputational risk, political risk, cyber risk, geopolitical risk, fraud risk. 

FM OVERVIEW II: PARTICIPANTS

  1. ISSUERS/ BORROWERS: are the ones who demand money. They create financial products to raise capital. 

  2. INTERMEDIARIES: between issuers and borrowers. Different types depending on how they do it: 

  • Broker: it's a pure intermediary, gains money with commissions. They do not transform financial products, nor assume risk. They CAN’T be a dealer, market maker (Agencia de Valores y Bolsa).

  • Dealer: trades on their own account, buys & sells, assumes risks. Earned with the bid-ask spread (Sociedad de Valores y Bolsa). A dealer can be a broker and can be a market maker. 

  • Market maker (not in the stock exchange market): is a special type of dealer which has an obligation to always accept quotes to provide liquidity. It could be by 1) Law (fixed income for public debt) or 2) Volunteering.

New York (NYSE) or Spain (BME) have market makers, they use special firms to guarantee trading. 

  1. INVESTORS:  are the ones who buy the financial products. 

  • Arbitrage: exploit temporary mispricings across venues/ products with near risk free strategies to push back prices to a fair value. IMPROVING MARKET EFFICIENCY.

  • Speculation: buy or sell assets for quick profits in the short term based on expectation and prediction about future prices. Not like arbitrage: high risk and takes longer time to do it. 

  • Hedging: uses derivatives to reduce an existing risk. 


FM OVERVIEW III: TYPES OF MARKETS

  1. BY ORGANIZATION/ VENUE:

    1. OFFICIAL MARKETS: The ones which have a LEGAL SUPERVISOR (in UE is ECB), reducing bankruptcy risk.  They ensure transparency, investor protection, standardization rules and clearing systems. 

    2. OTC (Over the Counter) markets: are bilateral agreements (no rules– higher counterparty risk). 

  2. BY TIME HORIZON:

    1. MONETARY MARKETS – short term (< 1 year): interbank deposits, T-Bills, REPOS. Provides liquidity and working capital. 

    2. CAPITAL MARKETS – long term (> 1 year): debt market, stock exchange, derivatives, commodities. 

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