Introduction
Tianyue Ruan
NUS Business School
FIN3703A Financial Markets
Semester 2, AY 2023/2024
Outline
• Why study financial markets?
• What are financial assets?
• What are financial markets?
• What are financial institutions?
Why study financial markets?
• Finance is crucial to our economy: channel funds from
surplus spending units to deficit spending units →
allocate scarce resources and promote economic
efficiency
• Market activities affect personal wealth, business
firms, and economy
• Well-functioning financial markets are key factors in
producing high economic growth
Basic definitions
• Financial assets are legal claims to future benefits
which have monetary values.
• Financial markets are structures where financial assets
are traded.
• Financial institutions are institutions or business
entities which provide financial services.
What are financial assets?
• Assets: Any possession that has value in an exchange
▪ Tangible assets have values based on physical
properties
• Examples: land, buildings, machinery, vehicles
▪ Intangible assets are legal claims to future benefits
• Examples: financial assets such as stocks and
bonds
Roles of financial assets
• Reallocation of scarce resources from non-productive
to productive use
• Pooling of funds
• Distribution of ownership (e.g., limited liability)
• Management of risk
Types of financial assets
• Debt: Fixed payment
▪ Bank loans
▪ Government bonds
▪ Corporate bonds
• Equity: Payment is based on earnings:
▪ Common stocks
▪ Preferred stocks
• Others: Combination or derivation of the above two
▪ Convertible securities, e.g., convertible bonds
▪ Derivatives, e.g., futures, options, swaps
Properties of financial assets
• Moneyness (money or near money)
▪ Money: cash or check (demand deposit or checking
account)
▪ Near money: saving deposits, fixed (or time)
deposits, T-bills
• Divisibility: minimum size for liquidation or exchange
for money
▪ Deposits: (almost) infinitely divisible
▪ Equity shares:
• US: 100 shares per lot (round lot 100 shares,
odd lot <100 shares)
• Singapore: 100 shares per lot from Jan 2015
(previously 1,000)
▪ T-bills and bonds: US$1,000 or S$1000
Properties of financial assets
• Reversibility or round-trip cost (cost of getting in and
out)
▪ Bid-ask spread
• Difference between the price where the market
(or market maker) is willing to buy and sell
• Function of risk
Market: buy sell
Bid Ask
$9.00 $9.50
Trader: sell buy
DIY: Foreign exchange bid-ask spread
Go to any online currency converter you’d like to use. If
you do not know where to start, you can check out DBS
Currency Converter at:
https://www.dbs.com.sg/personal/rates-online/foreign-
currency-foreign-exchange.page
1. If you have 100 SGD, how much USD can you get?
2. Take the USD you get in step 1 and convert back to
SGD, how much SGD can you get? Is it higher or
lower than the 100 SGD you started with?
3. (optional take-home DIY) How do the FX rates
compare with other currency converters?
Properties of financial assets
• Reversibility or round-trip cost (cost of getting in and
out)
▪ Bid-ask spread
• Difference between the price where the market
(or market maker) is willing to buy and sell
• Function of risk
▪ Commission or brokerage fee
▪ Stamp fee/duty
▪ Loadings
• Negotiability (negotiable = ownership can be
transferred from one party to another party vs non-
negotiable)
Properties of financial assets
• Term to maturity (time interval to final payment)
▪ Demand instruments: Payment at any time, e.g.,
checking account deposits (a.k.a. demand
deposits)
▪ Short term: T-bills
▪ Long term: Bonds
▪ Infinite maturity: Perpetuities or Consols (UK),
Equities
• Liquidity (thickness of the market)
▪ Loss due to immediate liquidation
▪ Number of ready buyers and sellers
▪ Affects the bid-ask spread
Properties of financial assets
• Currency
▪ Examples: US$, €, £, ¥, S$
▪ Exchange rate exposure and risk
• Risk
▪ Measurement of the uncertainty of the occurrence
of an event.
▪ Measure of risk: volatility, beta, etc.
• Convertibility
▪ Convertible bonds, convertible preferred stocks
• Tax status
▪ Capital gain tax, dividend tax, etc.
Outline
• Why study financial markets?
• What are financial assets?
• What are financial markets?
• What are financial institutions?
What are financial markets?
Structures where financial assets are exchanged or
traded
Role of financial markets
Provision of liquidity
Provide a place of gathering of willing buyers and
sellers
Price discovery process
Determination of price or return of financial assets
Influence by many factors (e.g., risk, liquidity,
information, transaction process)
Reduction of transaction costs
Reduce search time and cost
Reducing contracting cost and risk
Source: Mishkin and Eakins (2018) Figure 2.1, part.
Role of financial markets
• Provision of liquidity
▪ Provide a place of gathering of willing buyers and
sellers
• Price discovery process
▪ Determination of price or return of financial assets
▪ Influence by many factors (e.g., risk, liquidity,
information, transaction process)
• Reduction of transaction costs
▪ Reduce search time and cost
▪ Reducing contracting cost and risk
Structure of financial markets: basic categorizations
1. Primary and secondary markets
▪ Primary: New issue of securities
• Private placements
• IPOs and SEOs
▪ Secondary: Trading of issued (existing) assets
2. By asset class
▪ Debt
▪ Equity
▪ Foreign exchange
▪ Derivatives
▪ etc
Structure of financial markets: basic categorizations
3. Money and capital markets
▪ Money market
• Short-term: maturity 1 year or less
• Example: T-bills
• Example: Short-term municipal securities
• Example: Certificates of deposits (negotiable
and non-negotiable)
• Example: Repurchase agreement, or “repo”
• Example: Commercial papers (short-term
unsecured promissory notes issued by
corporations)
• Additional examples in the weekly quiz
Example of a repurchase agreement (repo)
• What it does: acquires immediately available funds by
selling securities and simultaneously agreeing to
repurchase the same or similar securities after a
specified time at a given price
Sell T-bills
Time = t
Borrower Lender
$$
Example of a repurchase agreement (repo)
• What it does: acquires immediately available funds by
selling securities and simultaneously agreeing to
repurchase the same or similar securities after a
specified time at a given price
$$+interest
Time = t+1
Borrower Lender
Buy back T-bills
Example of commercial papers
Source: https://fred.stlouisfed.org/graph/?g=kRGb, accessed on 15 Jan 2024.
25
What is discount yield?
Buy at P1, sell at P2 or get P2 upon maturity
• yield/return/holding period return
𝑃2 − 𝑃1
𝑃1
• [For money market instrument] discount yield
𝑃2 − 𝑃1
𝑷𝟐
What is discount yield? An example
Example: 3-month T-bill with face value of $1,000 &
discount yield of 5%
• Hold to maturity: P2 = par value
• Days count convention for annualization: 360/360 for T-
bills
𝑃𝑎𝑟−𝑃𝑟𝑖𝑐𝑒 90
• 3-month T-bill: 𝑖 = ÷
𝑃𝑎𝑟 360
1,000−𝑃 90
• In this case, 5% = ÷
1,000 360
• P = 1,000×[1 - 0.05(90/360)] = $987.5
Question: What is the normal yield for this T-bill? Can
you think of why the discount yield is commonly used for
money market instruments?
Structure of financial markets: basic categorizations
3. Money and capital markets
▪ Capital market
• Longer-term: maturity greater than 1 year
• Example: Stocks and bonds
• Finer categorization in later lectures
4. Exchange and over-the-counter (OTC) markets
▪ Exchange market
• Trade, clear, and settle in and by an exchange (or its
clearing house)
• Products traded on the exchange must be well
standardized.
▪ OTC or off-exchange market
• Trade is done directly between two parties, without
the supervision of an exchange.
• The price is not necessarily publicly disclosed.
• Counterparty risk: What is it?
Structure of financial markets: basic categorizations
5. Spot and forward markets
▪ Spot market: Immediate delivery
▪ Forward market: Future delivery
Structure of financial markets: summary
Classification methods
Stage Primary market (--- Secondary market (---
issuing) trading)
Instrument Equity market Debt market
Time to maturity Money market (1 year Capital market (longer
or less) than 1 year)
Trading Exchange Over-the-counter
(OTC) market
Delivery Spot market Forward market
Outline
• Why study financial markets?
• What are financial assets?
• What are financial markets?
• What are financial institutions?
Indirect finance via financial institutions
Source: Mishkin and Eakins (2018) Figure 2.1.
What are financial institutions?
Institutions or business entities which provide financial
services.
Roles of financial institutions:
• Economy of scale
• Economy of scope
• Risk sharing
• Alleviate problems caused by asymmetric information
• But, there could be conflict of interests. This is why the
financial services industry is heavily regulated in most
countries.
Types of financial institutions
They are categorized by sources of funds:
Type Primary Liabilities Primary Assets
(Sources of Funds) (Uses of Funds)
Depository institutions Deposits Financial assets that
Examples: commercial could include loans,
banks, S&Ls, credit bonds, stocks, money
unions market instruments,
Non-depository Something other than foreign currencies, and
institutions deposits many other assets
Examples: insurance
companies, pension
funds
Lecture summary
• What are financial assets?
▪ Legal claims to future benefits which have
monetary values
▪ Debt, equity, and others
• What are financial markets?
▪ Structures where financial assets are traded
▪ Roles: liquidity provision, price discovery,
transaction cost reduction
▪ Types by stage, instrument, maturity, trading, and
delivery
• What are financial institutions?
▪ Institutions or business entities which provide
financial services
▪ Depository and non-depository institutions differ by
source of funds
