Topic 1
Introduction to Financial
Markets
María Gutiérrez and David Moreno
Universidad Carlos III
Financial Economics
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Topic 1 Introduction to Financial Markets
Table of contents:
1.1 Introduction to Finance
1.2 The concept of Investment
•Investment
•Types of Investments
1.3 Introduction to Financial Markets
•Improving people’s life
•Types of Financial Assets
•Operations in the Financial Markets
•Types of Financial Markets
•Who is who in the Financial Markets
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Topic 1 Introduction to Financial Markets
Learning Objectives:
1. Understand why Finance is important for wealth
creation in the economy.
2. Analyse the concept of Investment and the types of
Investments available in the economy.
3. Get a basic knowledge of how Financial Markets
work and the role of the different market
participants.
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1.1 Introduction to Finance
What is “Finance”?
It is an area of Economics that analyses investment
and financing decisions and the exchange of funds
that these decisions generate.
These are fundamental for the well-being and economic
development of society. Can you explain why?
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1.1 Introduction to Finance
Finance can be split into three main areas:
Area DESCRIPTION COURSES AT UC3M
Asset Valuation Investment decisions in real Financial Economics
and financial assets.
Financial Institutions that enable the Financial System and
Institutions flow of funds (markets, Banking
banks, legal system...).
Financing and Financing decisions of Financial Management
Corporate firms. and Corporate Finance
Governance
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1.1 Introduction to Finance
What are we going to study in this course?
Asset Valuation: Investment decisions in real and
financial assets.
1. Introduction to Financial Markets
2. Time Value of Money: Financial Mathematics
3. Investment Appraisal: NPV and IRR
4. Fixed Income Securities
5. Risk and Return
6. Portfolio Theory
7. Market Valuation: CAPM
8. Derivatives: Futures and options
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1.2 The concept of Investment
Investment:
“Technology” that transforms current wealth into
future wealth.
Types of investments: (Give examples)
Real Assets: tangible and intangible goods that, if
put to productive use, generate future wealth.
Financial Assets: contracts that give the right to
receive a future payment in exchange for a payment
today.
Speculative Assets: unproductive goods whose
value changes over time.
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1.3 Financial markets: improving people’s life
Financial markets are fundamental to allow people to
make better consumption and investment decisions.
Can you explain why?
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1.3 Financial markets: financial assets
Debt contract (loan, bond, bill, etc):
Contract that entitles the purchasing side the right to
receive a future stream of predetermined periodical
payments.
Equity contract (shares/stocks):
Contract that entitles the purchasing side the right to:
A share of the company profits (when applicable).
Control corporate decisions via voting rights.
Derivative contract (futures, options, etc):
Contractual bet on the future value of the asset(s)
they are linked to.
Is it good to have people bet?
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1.3 Financial markets: operations
Buy: When do we buy an asset?
Sell: When do we sell an asset?
Short selling: We borrow a financial asset in order to sell it now
and purchase it later (to give it back to the original
owner/lender) at a lower price (hopefully).
Imagine you own 1 share of stock in a company. Which is your net
position after you buy/sell? What is the name of this position? What
would happen if your initial position were 0?:
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1.3 Financial markets: operations
Example (short selling): Three investors have €1,000 euros each and different amounts of
Telefónica shares (valued at 5 euros each).
Carmen obtains beneficial terms from the bank for giving up her shares’ political rights.
She keeps her share ownership in the long term.
Ana believes the share price will go down and wants to sell.
Pedro believes the share price will go up and wants to buy.
Ana Pedro Carmen
Initial balance Balance 1000 1000 1000
Nº of shares 0 0 100
Ana short sells 100 shares to Pedro for Balance 1500 500 1000
Nº of shares -100 100 100
€5.00
Dividend payment of €0.10 per share Balance 1490 510 1010
Nº of shares -100 100 100
Ana buys 100 shares to Juan for €4.00 Balance 1090 510 1010
Nº of shares 0 100 100
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1.3 Financial markets: types of markets
Financial Markets: Markets where financial assets are
issued and exchanged. Classified in different ways.
• According to type of financial asset negotiated:
• Public or private debt markets
• Stock markets
• Derivatives markets
• According to level of regulation: (Is regulation good?)
• Organized markets: regulated markets where
operations are standardized.
• Unregulated markets and OTC (over-the-
counter): each operation is unique.
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1.3 Financial markets: types of markets
• According to its function:
• Primary markets: markets where financial assets
are issued and sellers obtain funds.
• Secondary markets: already issued assets are
exchanged, providing liquidity to their
owners.
Would you buy a financial asset that cannot be traded in a
secondary market?
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1.3 Financial markets: who is who?
Investor: Person or institution that buys or sells financial assets.
Speculator: Person or institution that buys or sells financial
assets in order to profit from favorable fluctuations in prices.
Regulator: Institution responsible for determining the laws and
rules that govern financial institutions and markets.
Commercial Bank: Institution whose main business is to accept
deposits and to give loans.
Investment Bank: Institution that enables corporate financing
processes (IPOs, debt issuance…).
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1.3 Financial markets: who is who?
Company: Corporations are one of the main issuers of
financial assets. Who are the other main issuers?
They invest in real assets and finance those
imvestments issuing financial assets.
A company can be defined as a set of investment and
financing decisions. How do we draw a company?
Two types:
Listed Company: bonds and shares are quoted and
traded in regulated secondary markets.
Unlisted Company
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1.3 Financial markets: who is who?
Rating agency: Entity that analyses the credit quality of debt
issuers. Who are they? Who used this information? Who pays for it?
Moody’s S&P Interpretation
Aaa AAA Maximum safety
Aa1 AA+
Aa2 AA Very high safety
Aa3 AA-
A1 A+
A2 A High safety
A3 A-
Baa1 BBB+
Baa2 BBB Acceptable safety
Baa3 BBB-
Ba1 BB+
Ba2 BB Low safety, speculative
Ba3 BB-
B1 B+
Very low safety, highly
B2 B
speculative
B3 B-
CCC+
Substantial risk of
Caa CCC
default
CCC-
CC
Ca
C Imminent default
C
CI
D Default 16
1.3 Financial markets: who is who?
Analyst: individual who analyses asset characteristics to estimate
asset values and write reports with a buy, sell or hold
recommendation.
Study annual accounts, information and meet key people.
Specialized by industries and companies.
Work for investment funds, brokers, or investment banks to
inform their (or their customers) investment decisions.
Two types of analysis:
Fundamental analysis main focus on financial reports
and “qualitative” parameters (management, competitive
advantages, potential risks…)
Technical analysis main focus on market historical data
(prices and volumes); charts are widely used.
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1.3 Financial markets: who is who?
Trader individual who buys or sells financial assets for himself
or the institutions it works for.
Broker Individual or company that intermediates a transaction
between a buyer and a seller.
Investment Fund Manager Individual or company that
manages a group of investors’ funds, who receive in turn
proportional shares (participations) in the fund.
Active Management: select best investment
opportunities based on prior analysis.
Passive Management: buy and hold a portfolio
representing a specific market/index.
How do you think they are/should be paid?
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1.3 Financial markets: who is who?
Arbitrageur: individual or machine who looks for arbitrage
opportunities and usually works for investment banks or
investment funds
An arbitrage opportunity allows investors to obtain
riskless profits at no initial cost with no initial capital
outlay.
If an asset is quoted in two different markets at a different
prices there is an arbitrage opportunity since it is possible
to buy in the cheap market via short-selling in the
expensive one.
If the market works correctly, the arbitrage opportunity
gradually disappears (by a supply-demand argument).
Example: let’s assume that the exchange rates (including market fees) in
Frankfurt are €10 = $13 =£5, while in London £5= $15= €12.
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