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FINANCIAL INSTITUTIONS FINANCIAL INSTITUTIONS & MARKETS& MARKETS

B. Murat Buket B. Murat Buket

FINANCIAL INSTITUTIONS FINANCIAL INSTITUTIONS & MARKETS& MARKETS

B. Murat Buket B. Murat Buket

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MarketsMarkets

Anayasa Madde 167:

Devlet, piyasaları düzenlemek ve tekelleşmeyi önlemekle yükümlüdür

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MarketsMarkets

Product Markets - Goods - Services Factor Markets - Natural resources - Land - Entrepreneur - Labor - Capital Financial markets

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Financial marketsFinancial markets

FINANCIAL MARKETS

Money markets Foreign exchange markets Capital markets Precious metal markets (gold, silver, platin)

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Financial system : is the major tool to maintain fund flow from savings to investments

Financial markets : supplying and demanding funds meet in a marketplace

Financial intermediaries : are the institutions who intermediate the required fund flows from savings to investments

Financial instruments : are the necessary tools to realize fund flow

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Financial marketsFinancial markets Organized markets Over The Counter (OTC) markets

Primary markets Secondary markets

Spot markets Future markets

Money markets Capital markets

Open markets Negotiated markets

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Functions of Global Financial System and Financial Markets

1. Saving function : Conduit for the public’s savings through financial instruments

2. Wealth function : Accumulated savings create store of wealth through stock of assets

. Company enterprise values

. Real estate values

. Other financial assets’ values

Net financial wealth = Financial assets – Financial debts

USA (2003) : Financial assets : $ 80 Tr.

Net financial wealth : $ 65 Tr. (stored purchasing power)

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3. Liquidity function : Cost of holding extra liquidity is high

4. Credit function : Consumption, investment reasons

5. Payment function : The payment and settlement mechanism for purchasing goods & services (credit cards : S/T debt instrument)

6. Risk hedging function :

against life, health, income, property risks

- Insurance policies

- Derivative instruments

7. Policy function : Economic stabilization and inflation

- Monetary policy

- Fiscal policy

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Financial Markets Financial Markets TerminologyTerminology

Market Making (market makers)

Manipulation

Speculation

Arbitrage

Long-short-square positions

Short selling

Margin trading

Underwriting

Syndication

Market efficiency

Asymmetric information

Moral hazard

Adverse selection

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Market Maker :Market Maker : Market makers are major players who buy/sell securities when

prices are too low/high. They try to hold security market demand at acceptable levels. The major function of a market maker is maintaining price stability.

Asymmetric Information :Asymmetric Information : Different players in the market operate with different sets of

information

Manipulation :Manipulation : The act of artificially inflating or deflating the price of a security. In

most cases, manipulation is illegal. It is much easier to manipulate the share price of smaller companies, because they are not as closely watched by analysts as the large-sized firms.

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Financial Markets Financial Markets TerminologyTerminologySpeculation :Speculation : The process of selecting investments with higher risk in order to

make profit from an anticipated price movement. Speculation should not be considered purely a form of gambling, as speculators do make an informed decision before choosing to acquire the additional risks. Additionally, speculation cannot be categorized as a traditional investment because the acquired risk is higher than average. Moreover, speculators are necessary for creating demand

More sophisticated investors will also use a hedging strategy in combination with their speculative investment in order to limit potential losses.

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Arbitrage :Arbitrage : The simultaneous purchase and sale of an asset in order to profit from

a difference in the price. This usually takes place on different exchanges or marketplaces also utilizing geographical and financial product differentiation.

Also known as a "riskless profit". Here's an example of arbitrage: A domestic stock also trades on a

foreign exchange in another country in GDR form, where it hasn't adjusted for the constantly changing exchange rate. A trader purchases the stock where it is undervalued and short sells the stock where it is overvalued, thus profiting from the difference. Arbitrage is recommended for experienced investors only.

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Long-short-square positions :Long-short-square positions : Holding (buying-excess), selling (deficit) or carrying equal amounts of

different kinds of financial assets in balance sheet positions

Short selling :Short selling : The selling of a security that the seller does not own, or any sale that is

completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower price at which they sold short. Selling short is the opposite of going long. That is, short sellers make money if the stock goes down in price.

This is an advanced trading strategy with many unique risks .

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Financial Markets Financial Markets TerminologyTerminologyMarginMargin TradingTrading : Margin trading occurs when a specific amount of securities

(usually stocks) borrowed by the investor with the purpose of creating transaction profit

Margin Call Margin Call :: A broker's demand on an investor using margin to deposit

additional money or securities so that the margin account is brought up to the minimum maintenance margin.

Investor would receive a margin call from a broker if one or more of the securities he had bought (with borrowed money) decreased in value past a certain point. Investor would be forced either to deposit more money in the account or to sell off some of his assets.

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Financial Markets Financial Markets TerminologyTerminologyUnderwriting :Underwriting : The process by which investment bankers raise investment capital from

investors on behalf of corporations and governments that are issuing securities (both equity and debt).

The word "underwriter" is said to have come from the practice of having each risk-taker write his or her name under the total amount of risk that he was willing to accept at a specified premium. As new issues are usually brought to market by an underwriting syndicate in which each firm takes the responsibility (and risk) of selling its specific allotment.

Full Underwriting Stand by Underwriting Best Effort Basis

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Syndication : Syndication : The process of involving several different underwriters in

providing various portions of an issue Mainly used in big size issues, syndication allows any one

underwriter to guarantee a portion while maintaining a more prudent and manageable credit exposure because the lead manager isn't the only intermediator.

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Market Efficiency :Market Efficiency : Allocation Efficiency :Allocation Efficiency :

- Is production factors’ allocation efficient ?

- Pareto optimality and theory of second-best

- Ex: True companies goes to public (IPO) or not ? Operational Efficiency :Operational Efficiency :

- Is it possible to buy/sell securities whenever it’s possible ?

- Market rules (rules of the game)

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Financial Markets Financial Markets TerminologyTerminology Information efficiency :Information efficiency :

- Is relevant information about market and financial products disclosed to the public timely and thoroughly ?

- Is public’s ability to evaluate and interprete market info adequate

- Three major problems which lead public’ (investors) ability to incorrectly interprete market info :

. Asymmetric information

. Moral hazard

. Adverse selection

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Financial Markets Financial Markets TerminologyTerminology E. Fama & Mc Beth : Market efficiency tests – 1970 Yield analysis tests and event studies – 1992 Market Anomalies : The unexpected and unpredictable price

movements based on existing information (i.e. January Effect) P2 = f (P1 , t) Pt = Pt-1 + e e : Information effect Major Rule : Market information is reflected in the prices. If it’s

true, than market is efficient How can we estimate the degree of information reflection at the

prices ? - If we can freeze time and ask all stocks’ prices to each investor - Sometimes the information is important but it does not affect

prices - Investors must have the ability to interprete past, today and

near future of the company to decide on price when new info comes

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Financial Markets Financial Markets TerminologyTerminologyStrong Form Efficiency Strong Form Efficiency :: The strongest version of market efficiency. It states all

information in a market, whether public or private, whether disclosed to the public or not, is accounted for in a stock price. Not even insider information could give an investor to make extra profit. This degree of market efficiency implies that profits exceeding normal returns cannot be made, regardless of the amount of research or information investors have access to.

Conditions of strong form of efficiency : - Market info is available for all investors, every investor has the

same knowledge and info - The ability to interprete news and disclosures are evenly

distributed - Making profit exceeding normal returns is impossible except for

random transactions

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Semi-Strong Form EfficiencySemi-Strong Form Efficiency:: A class of EMH (Efficient Market Hypothesis) implies all public

information is calculated into a stock's current share price. Meaning that neither fundamental nor technical analysis can be used to achieve superior gains. This class of EMH suggests that only information that is not publicly available can benefit investors seeking to earn abnormal returns on investments. All other information is accounted for in the stocks price and, regardless of the amount of fundamental and technical analysis one performs, above normal returns will not be had.

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Financial Markets Financial Markets TerminologyTerminologyWeak Form EfficiencyWeak Form Efficiency : One of the different degrees of efficient market hypothesis

(EMH) that claims all past prices of a stock are reflected in today's stock price. Therefore, technical analysis cannot be used to predict and beat a market. Theoretical in nature, weak form efficiency implies that fundamental analysis can be used to identify stocks that are undervalued and overvalued. Therefore, keen investors looking for profitable companies can earn profits by researching financial statements.

Therefore if an investor systematically makes extra profit by utilizing past price/volume movements, than we can talk about weak form efficient market

if this is not possible, the market is inefficient

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Financial Markets Financial Markets TerminologyTerminologyMoral HazardMoral Hazard : :

The risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, liabilities or credit capacity, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.

Moral hazard can be present any time two parties come into agreement with one another. Each party in a contract may have the opportunity to gain from acting contrary to the principles laid out by the agreement.

For example, when a salesperson is paid a flat salary with no commissions for his or her sales, there is a danger that the he may not try very hard to sell the business owner's goods because the wage stays the same regardless of how much or how little the owner benefits from the salesperson's work.

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Financial Markets Financial Markets TerminologyTerminology Another example : A mortgage thrift institution sells it’s

mortgage pools in secondary market with pass-through mechanism, may not behave precisely and risk cautious during credit approval process. The reason for that is the amount of risk will be transferred to SPV

Adverse SelectionAdverse Selection ::

A situation where sellers have information that buyers don't (or vice versa) about some aspect of a financial product’s quality.

A mortgage thrift institution would like to sell (pass-through) more risky mortgage pools to SPV’s (vice versa)

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