Wednesday, 31 October 2012

Finance terms

financial markets
financial markets are - any type of financial transaction that you can think of that helps businesses grow and investors make money. Here is an overview of the financial markets, from the simple to the complex
Broad term describing any marketplace where buyers and sellers participate in the trade of assets such as equities, bonds, currencies and derivatives. Financial markets are typically defined by having transparent pricing, basic regulations on trading, costs and fees and market forces determining the prices of securities that trade.

Some financial markets only allow participants that meet certain criteria, which can be based on factors like the amount of money held, the investor’s geographical location, knowledge of the markets or the profession of the participant.  

Financial markets can be found in nearly every nation in the world. Some are very small, with only a few participants, while others – like the New York Stock Exchange (NYSE) and the forex markets – trade trillions of dollars daily. 

Most financial markets have periods of heavy trading and demand for securities; in these periods, prices may rise above historical norms. The converse is also true – downturns may cause prices to fall past levels of intrinsic value, based on low levels of demand or other macroeconomic forces like tax rates, national production or employment levels.

Information transparency is important to increase the confidence of participants and therefore foster an efficient financial marketplace.

Capital Markets'
A market in which individuals and institutions trade financial securities. Organizations/institutions in the public and private sectors also often sell securities on the capital markets in order to raise funds. Thus, this type of market is composed of both the primary and secondary markets.  
Both the stock and bond markets are parts of the capital markets. For example, when a company conducts an IPO, it is tapping the investing public for capital and is therefore using the capital markets. This is also true when a country's government issues Treasury bonds in the bond market to fund its spending initiatives. 

Definition of 'Money Market'
A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Money market securities consist of negotiable certificates of deposit (CDs), bankers acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos).
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The money market is used by a wide array of participants, from a company raising money by selling commercial paper into the market to an investor purchasing CDs as a safe place to park money in the short term. The money market is typically seen as a safe place to put money due the highly liquid nature of the securities and short maturities, but there are risks in the market that any investor needs to be aware of including the risk of default on securities such as commercial paper.
Capital Markets'
        A market in which individuals and institutions trade financial securities. Organizations/institutions in the public and private sectors also often sell securities on the capital markets in order to raise funds. Thus, this type of market is composed of both the primary and secondary markets.
         Both the stock and bond markets are parts of the capital markets. For example, when a company conducts an IPO, it is tapping the investing public for capital and is therefore using the capital markets. This is also true when a country's government issues Treasury bonds in the bond market to fund its spending initiatives.
Major participants and players in financial markets
 Major participants and players in financial markets
In the financial markets, there is a flow of funds from one group of parties (funds-surplus units) known as investors to another group (funds-deficit units) which require funds. However, often these groups do not have direct link. The link is provided by market intermediaries such as brokers, mutual funds, leasing and finance companies, etc. In all, there is a very large number of players and participants in the financial market. These can be grouped as follows :
The individuals: These are net savers and purchase the securities issued by corporates. Individuals provide funds by subscribing to these security or by making other investments.
The Firms or corporates: The corporates are net borrowers. They require funds for different projects from time to time. They offer different types of securities to suit the risk preferences of investors’ Sometimes, the corporates invest excess funds, as individuals do. The funds raised by issue of securities are invested in real assets like plant and machinery. The income generated by these real assets is distributed as interest or dividends to the investors who own the securities.
Government: Government may borrow funds to take care of the budget deficit or as a measure of controlling the liquidity, etc. Government may require funds for long terms (which are raised by issue of Government loans) or for short-terms (for maintaining liquidity) in the money market. Government makes initial investments in public sector enterprises by subscribing to the shares, however, these investments (shares) may be sold to public through the process of disinvestments.
Regulators: Financial system is regulated by different government agencies. The relationships among other participants, the trading mechanism and the overall flow of funds are managed, supervised and controlled by these statutory agencies. In India, two basic agencies regulating the financial market are the  Reserve Bank of India  (RBI ) and Securities and Exchange Board of India (SEBI). Reserve Bank of India, being the Central Bank, has the primary responsibility of maintaining liquidity in the money market’ It undertakes the sale and purchase of T-Bills on behalf of the Government of India. SEBI has a primary responsibility of regulating and supervising the capital market. It has issued a number of Guidelines and Rules for the control and supervision of capital market and investors’ protection. Besides, there is an array of legislations and government departments also to regulate the operations in the financial system.
Market Intermediaries: There are a number of market intermediaries known as financial intermediaries or merchant bankers, operating in financial system. These are also known as investment managers or investment bankers. The objective of these intermediaries is to smoothen the process of investment and to establish a link between the investors and the users of funds. Corporations and Governments do not market their securities directly to the investors. Instead, they hire the services of the market intermediaries to represent them to the investors. Investors, particularly small investors, find it difficult to make direct investment. A small investor desiring to invest may not find a willing and desirable borrower. He may not be able to diversify across borrowers to reduce risk. He may not be equipped to assess and monitor the credit risk of borrowers. Market intermediaries help investors to select investments by providing investment consultancy, market analysis and credit rating of investment instruments. In order to operate in secondary market, the investors have to transact through share brokers. Mutual funds and investment companies pool the funds(savings) of investors and invest the corpus in different investment alternatives. Some of the market intermediaries are:
  • Lead Managers
  • Bankers to the Issue
  • Registrar and Share Transfer Agents
  • Depositories
  • Clearing Corporations
  • Share brokers
  • Credit Rating Agencies
  • Underwriters
  • Custodians
  • Portfolio Managers
  • Mutual Funds
  • Investment Companies
These market intermediaries provide different types of financial services to the investors. They provide expertise to the securities issuers. They are constantly operating in the financial market. Small investors in particular and other investors too, rely on them. It is in their (market intermediaries) own interest to behave rationally, maintain integrity and to protect and maintain reputation, otherwise the investors would not be trusting them next time. In principle, these intermediaries bring efficiency to corporate fund raising by developing expertise in pricing new issues and marketing them to the investors.

Primary Market'
A market that issues new securities on an exchange. Companies, governments and other groups obtain financing through debt or equity based securities. Primary markets are facilitated by underwriting groups, which consist of investment banks that will set a beginning price range for a given security and then oversee its sale directly to investors.  
Also known as "new issue market" (NIM).
The primary markets are where investors can get first crack at a new security issuance. The issuing company or group receives cash proceeds from the sale, which is then used to fund operations or expand the business. Exchanges have varying levels of requirements which must be met before a security can be sold.  

Once the initial sale is complete, further trading is said to conduct on the secondary market, which is where the bulk of exchange trading occurs each day. Primary markets can see increased volatility over secondary markets because it is difficult to accurately gauge investor demand for a new security until several days of trading have occurred
Secondary Market'
A market where investors purchase securities or assets from other investors, rather than from issuing companies themselves. The national exchanges - such as the New York Stock Exchange and the NASDAQ are secondary markets.
Secondary markets exist for other securities as well, such as when funds, investment banks, or entities such as Fannie Mae purchase mortgages from issuing lenders. In any secondary market trade, the cash proceeds go to an investor rather than to the underlying company/entity directly.
A newly issued IPO will be considered a primary market trade when the shares are first purchased by investors directly from the underwriting investment bank; after that any shares traded will be on the secondary market, between investors themselves. In the primary market prices are often set beforehand, whereas in the secondary market only basic forces like supply and demand determine the price of the security.

In the case of assets like mortgages, several secondary markets may exist, as bundles of mortgages are often re-packaged into securities like GNMA Pools and re-sold to investors.
 Intercompany market
The intercompany involves direct lending between companies. The supply of funds in the intercompany market comes from companies that have cash flows surplus to their current requirements. The demand for funds comes from companies who do not have cash flows sufficient to meet their current obligations. Given the nature of trading within the market, it is regarded as an example of a money market.
Financial Intermediaries
Most people do not enter financial markets directly but use intermediaries or middlemen. Commercial banks are the financial intermediary we meet most often in macroeconomics, but mutual funds, pension funds, credit unions, savings and loan associations, and to some extent insurance companies are also important financial intermediaries.1 When people deposit money in a bank, the bank uses the funds to make loans to home buyers for mortgages, to students so they can pay for their education, to business to finance inventories, and to anyone else who needs to borrow. A person who has extra money could, of course, seek out borrowers himself and bypass the intermediary. By eliminating the middleman, the saver could get a higher return. Why, then, do so many people use financial intermediaries?
Financial intermediaries provide two important advantages to savers. First, lending through an intermediary is usually less risky than lending directly. The major reason for reduced risk is that a financial intermediary can diversify. It makes a great many loans, and even though some of those loans will be mistakes, the losses will be largely offset by loans that are sound. In contrast, an average saver could directly make only a few loans, and any bad loans would substantially affect his wealth. Because an intermediary can put its "eggs" in many "baskets," it insures its depositors from substantial losses.
Another reason financial intermediaries reduce risk is that by making many loans, they learn how to better predict which of the people who want to borrow money will be able to repay. Someone who does not specialize in this lending may be a poor judge of which loans are worth making and which are not, though even a specialist will make some mistakes.
A second advantage financial intermediaries give savers is liquidity. Liquidity is the ability to convert assets into a spendable form--money--quickly. A house is an illiquid asset; selling one can take a great deal of time. If an individual saver has lent money directly to another person, the loan can also be an illiquid asset. If the lender suddenly needs cash, he must either persuade the borrower to repay quickly, which may not be possible, or he must find someone else who will buy the loan from him, which may be very difficult. Although the intermediary may use its funds to make illiquid loans, its size allows it to hold some funds idle as cash to provide liquidity to individual depositors. Only when a great many depositors want to withdraw deposits at the same time, which happens when there is a "run" on the institution, will the financial intermediary be unable to provide liquidity. Unless it can obtain help from the government or other institutions, it will be forced to suspend payments to depositors.
In addition to lending money to individuals and groups, there are other ways in which banks are part of financial markets. Banks borrow and lend funds among themselves in the federal-funds market. They buy and sell foreign exchange. They buy and sell government and commercial debt. And finally, one form of bank debt serves as money in modern economies, and banks create this debt as a result of their financial transactions.
Economists are concerned that financial intermediaries can be a source of shocks to the economy, bumps that can disrupt the normal flow of economic life. This concern arises for at least two reasons. First, bank debt serves as money, so disruptions to banks can affect the amount of money in circulation. We explore this idea in later chapters. Second, financial intermediaries are tied together through chains of debts and assets. Because of these linkages, the failure of one financial intermediary can weaken others, increasing their chances of failure. As a result, there is the possibility that if a key financial intermediary fails, that failure can create a domino effect that could cause other financial institutions to fail, ultimately causing the financial sector to "seize up" and stop functioning. Serious disruption of the financial markets will disrupt the rest of the economy. We will develop this idea a bit further in later sections of this chapter.

Financial intermediation consists of “channeling funds between surplus and deficit agents”. A financial intermediary is a financial institution that connects surplus and deficit agents. The classic example of a financial intermediary is a bank that transforms bank deposits into bank loans.
Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities. As such, financial intermediaries channel funds from people who have extra money (savers) to those who do not have enough money to carry out a desired activity (borrowers).
In the U.S., a financial intermediary is typically an institution that facilitates the channeling of funds between lenders and borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such as a bank), and that institution gives those funds to spenders (borrowers). This may be in the form of loans or mortgages.[3] Alternatively, they may lend the money directly via the financial markets, which is known as financial disintermediation.
Functions performed by financial intermediaries
Financial intermediaries provide 3 major functions:
  1. Maturity transformation
    Converting short-term liabilities to long term assets (banks deal with large number of lenders and borrowers, and reconcile their conflicting needs)
  2. Risk transformation
    Converting risky investments into relatively risk-free ones. (lending to multiple borrowers to spread the risk)
  3. Convenience denomination
    Matching small deposits with large loans and large deposits with small loans
Advantages of financial intermediaries
There are 2 essential advantages from using financial intermediaries:
  1. Cost advantage over direct lending/borrowingMarket failure protection the conflicting needs of lenders and borrowers are reconciled, preventingmarket failure
The cost advantages of using financial intermediaries include:
  1. Reconciling conflicting preferences of lenders and borrowers
  2. Risk aversion intermediaries help spread out and decrease the risks
  3. Economies of scale using financial intermediaries reduces the costs of lending and borrowing
  4. Economies of scope intermediaries concentrate on the demands of the lenders and borrowers and are able to enhance their products and services (use same inputs to produce different outputs)
The Eurobond market
The Eurobond market is made up of investors, banks, borrowers, and trading agents that buy, sell, and transfer Eurobonds. Eurobonds are a special kind of bond issued by European governments and companies, but often denominated in non-European currencies such as dollars and yen. They are also issued by international bodies such as the World Bank. The creation of the unified European currency, the euro, has stimulated strong interest in euro-denominated bonds as well; however, some observers warn that new European Union tax harmonization policies may lessen the bonds' appeal.
Eurobonds are unique and complex instruments of relatively recent origin. They debuted in 1963, but didn't gain international significance until the early 1980s. Since then, they have become a large and active component of international finance. Similar to foreign bonds, but with important differences, Eurobonds became popular with issuers and investors because they could offer certain tax shelters and anonymity to their buyers. They could also offer borrowers favorable interest rates and international exchange rates.
The Eurobond market consists of several layers of participants. First there is the issuer, or borrower, that needs to raise funds by selling bonds. The borrower, which could be a bank, a business, an international organization, or a government, approaches a bank and asks for help in issuing its bonds. This bank is known as the lead manager and may ask other banks to join it to form a managing group that will negotiate the terms of the bonds and manage issuing the bonds. The managing group will then sell the bonds to an underwriter or directly to a selling group. The three levels—managers, underwriters, and sellers—are known collectively as the syndicate. The underwriter will actually purchase the bonds at a minimum price and assume the risk that it may not be possible to sell them on the market at a higher price. The underwriter (or the managing group if there is no underwriter) sells the bonds to a selling group that then places bonds with investors. The syndicate companies and their investor clients are considered the primary market for Eurobonds; once they are resold to general investors, the bonds enter the secondary market. Participants in the market are organized under the International Primary Market Association (IPMA) of London and the Zurich-based International Security Market Association (ISMA)
Eurocurrency Market'
The market where financial banking institutions provide banking services denominated in foreign currencies. They may accept deposits and provide loans. Unlike Eurocredit markets, however, loans in this market are made short-term.
The money market in which Eurocurrency, currency held in banks outside of the country where it is legal tender, is borrowed and lent by banks in Europe. The Eurocurrency market is utilized by large firms and extremely wealthy individuals who wish to circumvent regulatory requirements, tax laws and interest rate caps that are often present in domestic banking, particularly in the United States.
 'Eurocurrency Market'
Rates on deposits in the Eurocurrency market are typically higher than in the domestic market, because the depositor is not protected by domestic banking laws and does not have governmental deposit insurance. Rates on loans in the Eurocurrency market are typically lower than those in the domestic market, because banks are not subject to reserve requirements on Eurocurrency and do not have to pay deposit insurance premiums.

'Inverted Yield Curve'

An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession.
A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

 Partial inversion occurs when only some of the short-term Treasuries (five or 10 years) have higher yields than the 30-year Treasuries do. An inverted yield curve is sometimes referred to as a "negative yield curve 

Historically, inversions of the yield curve have preceded many of the U.S. recessions. Due to this historical correlation, the yield curve is often seen as an accurate forecast of the turning points of the business cycle. A recent example is when the U.S. Treasury yield curve inverted in 2000 just before the U.S. equity markets collapsed. An inverse yield curve predicts lower interest rates in the future as longer-term bonds are being demanded, sending the yields down.

inverse yield curve

Yield CInverted Yield Curveurve'




Yield Curve

Yield Curve'

The shape of the yield curve is closely scrutinized because it helps to give an idea of future interest rate change and economic activity. There are three main types of yield curve shapes: normal, inverted and flat (or humped). A normal yield curve (pictured here) is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of upcoming recession. A flat (or humped) yield curve is one in which the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic transition. The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.

Certificate Of Deposit - CD'

A savings certificate entitling the bearer to receive interest. A CD bears a maturity date, a specified fixed interest rate and can be issued in any denomination. CDs are generally issued by commercial banks and are insured by the FDIC. The term of a CD generally ranges from one month to five years. A certificate of deposit is a promissory note issued by a bank. It is a time deposit that restricts holders from withdrawing funds on demand. Although it is still possible to withdraw the money, this action will often incur a penalty.

For example, let's say that you purchase a $10,000 CD with an interest rate of 5% compounded annually and a term of one year. At year's end,  the CD will have grown to $10,500 ($10,000 * 1.05).

CDs of less than $100,000 are called "small CDs"; CDs for more than $100,000 are called "large CDs" or "jumbo CDs". Almost all large CDs, as well as some small CDs, are negotiable.
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