Financial Economics lecture slides notes:
Financial markets include a variety of institutions, formal and informal, that facilitate the
exchange of assets. Assets are traded across time with uncertainty
Capital markets include:
• Equity (stock) markets
• Bond markets (long-term securities)
• Money markets (short-term securities)
• Commodity markets
• Physical Asset Markets (Real estate etc)
• Foreign exchange markets
• Derivative markets
• Insurance Markets
• Financial Intermediaries (banks)
Functions of financial markets:
1. Disseminate information (price discovery). In decentralised economies all
information is transmitted through prices.
2. Providing a trading mechanism. Bringing the two sides of the market (buyers and
sellers) together.
3. Pool resources for diversification – not putting all eggs in one basket
4. Manage risk
5. Enable the execution of agreements. The whole institutional structure is important;
this includes the legal system that facilitates the enforcement of agreements.
6. Deal with incentive problems. Through financial innovation new instruments are
developed to deal with market imperfections. Markets can be imperfect because of (a)
lack of information about individual risks, (b) non-observability of actions, and (c)
complexity of the environment. However, financial innovation can also be
destructive!
7. Allocative efficiency. A better allocation of resources would lead to higher aggregate
output. Pareto efficiency is where it is impossible to improve the welfare of one agent
without decreasing the welfare of at least one other agent. Complete vs incomplete
markets depends on the degree of uncertainty and complexity of the environment.
8. Operational efficiency – levels of transaction costs
9. Informational efficiency – how efficiently do prices transmit information? Crucial for
making investment decisions.
10. Portfolio efficiency. Mean-Variance trade off: Investors prefer high returns but low
risk.
Quote-driven (dealer) markets are where dealers quote (bid) and ask (offer) prices at which
they are prepared to buy or sell specified quantities of the asset. Trades take place
sequentially and thus the observed transaction price depends on whether a sale or purchase
takes place, e.g. NASDAQ, NY
Order-driven (agency or auction) markets are where participants issue orders to buy or sell at
a stated price. Discrete trading (call markets) with an auctioneer adjusting the price
(tatonnement), e.g. London stock exchange, NY stock exchange.
The balance sheet shows everything that an entity (household, firm, financial institution)
owns (assets) and everything it owes (liabilities).
Assets = Liabilities (always)
Because: Equity = Assets – other Liabilities
When equity is positive the firm is solvent and when equity is negative the firm is insolvent
(bankrupt).
