Financial Systems

Cheat Sheet de Sistemas Financieros

Basic definitions

Financial markets: Markets in which funds are transferred from people who have excess funds to people who have a shortage. Funding can be direct (from lenders to borrowers) or indirect (through financial intermediaries). They help promote growth and economic efficiency. If they did not exist, lenders would be sitting on money and losing interest payments and borrowers would be stuck.

Primary markets: Financial market in which new issues of a security (bond or stock) are sold to initial buyers by the corporation or government agency borrowing the funds. They are closed to the public. An investment bank typically assists the initial sale.

Secondary markets: Financial market in which securities that have previously been issued are resold. Examples: stock markets, forex markets, etc. Security brokers and dealers are essential. In secondary markets, issuers do not acquire new funds. However, secondary markets are important because they make financial instruments more liquid, and help determine the price of a new issuance.

Financial institutions: These are institutions that make financial markets work. Funds can be transferred from lenders to borrowers through financial intermediaries (indirect finance). Examples: banks, contractual saving institutions, investment intermediaries. Financial intermediaries are helpful because they reduce transaction costs (from economies of scale and expertise), increase risk sharing (from diversification), and cut asymmetric information. They can also be helpful because they apply economies of scope (they use the same resources to provide different services), but this increases conflict of interest.

Market efficiency

Efficient market hypothesis: Prices of securities in financial markets fully reflect all available information. It views expectations as the optimal forecast using all available information, so current prices will be set such that the optimal forecast equals the equilibrium price. This works because of arbitrage: some agents eliminate unexploited profits and bring their forecast to reality. In equilibrium, all unexploited profits are eliminated. It is important to notice that not everyone in the market must be well-informed for the hypothesis to work.

Evidence for: The following facts support the hypothesis: the weak performance of investment analysts (they cannot constantly beat the market or expect to win abnormally high returns) and the null effect on prices of firms’ announcements (information is already public). The fact that some investors constantly beat the market with inside information (illegally) does not contradict the hypothesis because they are not using public information.

Evidence Against: These include the small firm effect, the calendar effect, timing and market overreaction (overshooting). It is important to recognise, additionally, that the market behaves according to what people expect of the firms in question. Usually this expectation will be based on fundamentals, but sometimes it may not.