FINA 3010

FINANCIAL MARKETS
Lecture Note 1: Introduction

Fall 2024
WHO ARE WE?
JEUNG, Jinoug (鄭鎭旭), Assistant Professor of Finance
• BS in Mathematics and Economics (HKUST) and MS in Finance (Seoul National University)

• PhD in Finance (Emory University)

• Banking and Public Finance

• Email: [email protected]
• Please write the course code in your subject (e.g., [FINA3010] Question Regarding Coursework).

• Office: Room 1238, 12/F Cheng Yu Tung Building

• Please make an appointment before your visit to ensure I am available.

YAN, Shujia (Ivy) & HUANG, Huang (William), Teaching Assistants

• PhD Students in Finance at CUHK Business School

• Email: [email protected] & [email protected]

• Office: Room 735, 7/F Cheng Yu Tung Building

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WHO ARE WE? (cont’d)

We highly value your feedback.

Feel free to contact us if you have any questions or need any help.
Any issues pertaining to academic matters
- Understanding Course Material
- Exam Preparation
- Grade and Feedback

- …

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SYLLABUS

Refer to syllabus

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OUTLINE
Introduction to This Course
• What do we study in this course?

• Why do we study this course?

• How do we study this course?

Introduction to Financial Markets & Institutions

• What are financial markets and institutions?

• Why do you study financial markets?

• Why do you study financial institutions?

• Financial crises and regulations

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WHAT DO WE STUDY IN THIS COURSE?
Introduction: Overview

Part 1: Financial Markets

• Bond market

• Stock market

• Foreign exchange (FX) market

Part 2: Financial Institutions

• Commercial banks

• Central banks

• Money creation

Part 3: Financial Crises and Regulations

• Economic cycle

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WHAT DO WE STUDY IN THIS COURSE? (cont’d)
ENHANCE your understanding about financial markets and institutions
• What financial markets and institutions are.

• How financial markets operate

• How financial markets determine the value of various financial instruments

• How financial institutions operate

• How commercial banks run their business using deposits

• How financial markets and institutions interact each other

• How firms secure funds to invest in new projects
• How central banks affects dynamics of financial markets and institutions

• How financial markets and institutions contribute to financial crises and regulations

• …

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WHY DO WE STUDY THIS COURSE?

For those seeking careers within finance industry:

• This course will help you identify a specific sector within the finance industry that you wish to pursue.
• Areas: Equity, Fixed Income, and Derivatives Markets
• Positions: Analyst, Trader, Fund Manager, Finance Manager, Risk Manager, Loan Officer, Regulator

For those seeking careers outside finance industry:

• NO ONE CAN AVOID FINANCIAL DECISIONS – personal finance, retirement plans
• Financial literacy leads to a healthier life ☺

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WHY DO WE STUDY THIS COURSE? (cont’d)
2022 Survey by National Financial Educators Council

“The cost of financial illiteracy is growing. In 2021, the average cost was $1,389 per person, meaning there was a 40% increase in
financial mistakes in just one year. For some, the consequences were even worse: 15% of people said their lack of financial
knowledge cost them $10,000 or more in a single year. This group grew by 50% compared to the previous year, showing a
worrying trend of rising financial mismanagement.”

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WHY DO WE STUDY THIS COURSE? (cont’d)
58% of US households invest in the stock market either directly or indirectly.1

• HEShare negatively forecasts 5-year excess returns on the aggregate US stock market (Household mistiming). 2
• Household Equity Share (HEShare): the share of household equity assets in total financial assets
1. Survey of Consumer Finances, 2023
2. Be Fearful When Households Are Greedy: The Household Equity Share and Expected Market Returns (Yang, 2019) 10
WHY DO WE STUDY THIS COURSE? (cont’d)
Equity diversification of retail investors in Denmark.1

• Most investors face the issue of underdiversification.

• Investors with low education, low income, and low wealth are more likely to underdiversify.

1. The aggregate cost of equity underdiversification (Florentsen et al., 2019) 11

HOW DO WE STUDY THIS COURSE?
FOCUS on conceptual ideas and qualitative/quantitative analyses
• Functions and structures of financial markets and institutions

• Efficient market hypothesis and behavioral finance

• Determinations of asset prices

• Money creations and economic cycles

• …

REFER to academic research and industry practices for further insights

• Journals, media articles, and case studies

• …

APPLY our learning to real-world economic/financial events

• 2008 Global financial crisis, 2023 Banking Crisis, Meme-stock Booming, FinTech Emergence

• …

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OUTLINE
Introduction to This Course
• What do we study in this course?

• Why do we study this course?

• How do we study this course?

Introduction to Financial Markets & Institutions

• What are financial markets and institutions?

• Why do you study financial markets?

• Importance of financial markets
• Types of financial markets (or instruments)

• Why do you study financial institutions?

• Function of financial institutions

• Financial crises and regulations

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WHAT ARE FINANCIAL MARKETS AND INSTITUTIONS?
Fund Flows Between Lender (Savers) and Borrowers (Spenders)

• Financial Markets: Borrow directly from lenders by selling financial instruments

• IPO, corporate bond issuance, …

• Financial Institutions: Borrow indirectly from lenders via financial intermediaries by issuing financial instruments
• Bank loan, private equity, mutual/hedge funds, …
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WHY DO YOU STUDY FINANCIAL MARKETS?

Suppose Federal Reserve raises the federal fund rate.

• Stock? Bond? US dollar? Bitcoin?

• Good time for a firm to invest?

• Good time for an individual to buy a house?

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IMPORTANCE OF FINANCIAL MARKETS
Suppose
• You own $10M. Clair and Paul have business projects that cost $4M and $6M, respectively, but they lack the necessary
funds.

• You have no personal connections with Clair and Paul.

Questions
• What would happen to you, Clair, Paul, and economy itself if financial markets didn’t exist?
• What if Clair was your friend? Would you lend $4M to Clair?
• Information asymmetry
• Transaction costs (e.g., legal fee)

• What would happen to you, Clair, Paul, and economy if financial markets exist?
• Information disclosure
• Economies of scale
• What would happen if you required 3% returns on both projects, which ultimately generated 10% profits?
• Beneficial for everyone & Economic growth ↑

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IMPORTANCE OF FINANCIAL MARKETS (cont’d)
Efficient Allocation of Capital
• Transfer funds from people who have an excess of available funds (“Savers”) to people who have a shortage (“Investors”)
• Enhance economic efficiency by facilitating the availability of funds for productive purposes
• Contribute to economic growth1
• Not really for developed countries!

• Activities in financial markets have direct effects on

• Personal wealth
• Behavior of businesses and consumers
• Cyclical performance of economy

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1. Rethinking Financial Deepening: Stability and Growth in Emerging Markets (IMF, 2015)
PRIMARY MARKET
Markets where securities are created.
• New issues of a security (e.g., bond, stock) are sold to initial buyers by entities borrowing the funds.
• First-day IPO return is on average 16% (e.g., Ritter, 1984; Carter and Manaster, 1990)
• Good investment strategies to invest in all IPOs?

“Underwrite” securities
Due Diligence, Market Demand, Price Determination

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Source: CFI, Statista
PRIMARY MARKET (cont’d)
IPO Investment & Winner’s Curse
• Winner’s curse happens due to information asymmetry.

• Application of Winner’s Curse to IPO Investments

• Retail investors bid for an IPO → The maximum number of shares they want to purchase at a given IPO price
• Shares are allotted to the investors based on the level of competition.
• 2 shares allotted from a 100-share bid versus 50 shares allotted from 100-share bid

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Source: WallStreetMojo
SECONDARY MARKET
Markets where previously issued securities are traded.
• Brokers & Dealers are crucial to well-functioning secondary markets.
• Brokers are agents of investors who match buyers with sellers of securities.
• Dealers (or “market maker”) trade securities at stated prices to link buyers and sellers.

• Issuers acquire new funds only in the primary markets.

• Why are the secondary markets important to issuers then?
• Liquidity to shareholders
• Price discovery
• Perceived fair value of an issuer’s security, which is valuable information to share/stakeholders
• Market timing (e.g., Baker and Wurgler, 2002)

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Source: Yahoo Finance
BOND MARKET
Bond (or debt security) guarantees periodic payments for a specific period of time.
• Interest rate (or borrowing cost) is determined by characteristics of an issuer and its bond.

• Treasury rate is commonly known as the risk-free interest rate. Why?

• Any relationship between treasury rate and economic conditions?
• Key to understand the overall health of the economy (e.g., consumers’ spending & businesses’ financial decisions)

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Source: Board of Governors of the Federal Reserve System (US)
EQUITY MARKET
Stock is a share of ownership in a corporation.
• A claim on the earnings and assets of a corporation
• Periodic payments (“Dividends”) ≈ long-term bonds
• A place where people can get rich or poor quickly (e.g., Meme stock such as GameStop)
• [+] Can benefit directly from any increases in a corporation’s profitability or asset value
• [–] Residual claimant: debts first and equities later

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Source: Congressional Research Service
FOREIGN EXCHANGE MARKET
Foreign exchange rate is the price of one country’s currency in terms of another’s.
• Conversion from the currency in one country (say “dollars”) to that in another country (“euros”) takes place.

• How does the FX rate shape the economy?

• Dollar appreciation (↑ Euro per Dollar) → Cost of foreign goods ↓ (good for US consumers) & Demands for exported
goods ↓ (bad for US companies)
• Foreign investments need to be adjusted for foreign exchange rates.

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Source: Board of Governors of the Federal Reserve System (US)
WHY DO YOU STUCY FINANCIAL INSTITUTIONS (FIs)?
Similar to the importance of financial markets,
• Suppose you own $10M. Clair and Paul have business projects that cost $4M and $6M, respectively, but they lack the
necessary funds. You and Clair are friends and have no personal connection with Paul.
• You & Clair
• Economies of scale
• What if transaction costs (e.g., legal expenses) are too high?
• You & Paul
• Information asymmetry
• Adverse selection & Moral hazard

FIs address these concerns and thus help move funds between different entities →
efficiency of the economy ↑

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FUNCTION OF FINANCIAL INSTITUTIONS
FIs play as middle men (i.e., Financial Intermediation).
• FIs obtain funds from savers (such as deposits) and then makes loans or investments to borrowers.
• Depository institutions (e.g., retail and commercial banks)
• non-Depository institutions (e.g., central banks, mortgage companies)

• FIs mitigate concerns regarding transaction costs, risk appetites, and asymmetric information.
• Important source of finance, especially for households and private companies

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FUNCTION OF FINANCIAL INSTITUTIONS (cont’d)
Transaction costs
• Financial institutions make profits by reducing transaction costs.
• Economies of scale (e.g., a single loan contract ($500) versus a lawyer ($5,000) for 2,000 loans)
• Economies of scope?

• Low transaction costs provide customers with liquidity service (e.g., deposit transfers, debit cards)

Risk sharing
• Financial institutions help reduce the exposure of investors to risk.
• Deposit insurance: Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000.
• Asset transformation: financial institutions sell assets with lesser risk to one party (such as deposits) in order to buy
assets with greater risk from another party (such as corporate loans).
• Financial institutions promote risk sharing by helping individuals to diversify and thereby lower their risk exposures.
• Diversification (risk = systematic risk + idiosyncratic risk)
• Risk transfer (e.g., by securitizing loans, the risk of default is transferred from depositors to investors.)

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FUNCTION OF FINANCIAL INSTITUTIONS (cont’d)
Information asymmetry
• One party lacks crucial information about another party, impeding accurate decision-making.

• Information asymmetry problems occur both “before” and “after” a transaction comes.
• Adverse selection “before” the transaction
• Lemons problem (e.g., unhealthy people are more likely to apply for health insurances.)
• Due diligence & specialization
• Moral hazard “after” the transaction
• Borrowers have incentives to engage in undesirable or immoral activities, which increases the likelihood that they
will not repay loans. (e.g., people are more likely to engage in risky activities after being insured.)
• Monitoring

Financial institutions mitigate adverse selection and moral hazard problems!

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FINANCIAL CRISES AND REGULATIONS
Different phases of debt cycle
• Normal: debt growth, economic growth, and inflation are neither too hot nor too cold.

• Bubble: debt growth ↑ → income, net-worth, and asset growths ↑ → borrowing capacity ↑ → debt growth ↑ → …

• Depression: debt level >> money available to service debt

Main reasons for regulation

• Increase information to investors to enhance the efficiency of the markets
• Adverse selection and moral hazard problems ↓

• Ensure the soundness of financial institutions

• For example, depositors have doubts about the overall health of banks, bank run may happen (e.g., SVB Collapse).

• For examples, restrictions on entry, disclosure, restrictions on assets and activities, deposit insurance, limits on
competition, restrictions on interest rates

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