FINANCIAL MARKETS

Unit 1: Introduction

N Vera Chau
Assistant Professor of Finance

February 11, 2025

Swiss Finance Institute & Geneva Finance Research Institute

INTRODUCTION TO FINANCIAL SYSTEMS & FINANCIAL ECONOMICS

1. The Financial System

2. Studying the Financial System ( Financial Economics)

3. Types of Markets

1
OVERVIEW OF THE FINANCIAL SYSTEM
WHY DO WE NEED A FINANCIAL SYSTEM?

3
FINANCE: ONE DEFINITION

Finance: System to trade off consumption and costs over time and between people/space
(often both)

Ex:

p Savings: consumption today (cost) → consumption tomorrow (time)

p Stocks: consumption by investors today (cost) & operating capital by firms today →
future (time) consumption if successful

p Insurance: pay premiums (cost) to firm holding risk → not holding all the risk yourself

4
ONE DEFINITION OF FINANCIAL ASSETS

Financial Assets: Claim of ownership to various pieces of that “trade”.

Ex: You buy a unit of stock

p You buy stock instead of going to a nice dinner → traded consumption today

p The firm invests in a new manufacturing plant

p The “stock” = claim to future consumption

- Firm needs money now → you don’t need nice dinner
- If the plant is successful → get yourself even nicer dinner later (after the exam when you
really need it!)

5
PROPERTIES OF FINANCIAL ASSETS

What determines the price?

p Physical assets (property, gold): some inherent value + some value to the “claim” or trade

p Financial assets: value in the claim

p Like pricing goods → supply and demand for the trade

p Time dimension → introduces risk

- How to price this correctly?
- ex: Insurance premium (price) for home flood insurance in Florida? fire insurance in
California?
- ex: Value of stock if company goes bankrupt?

6
IS THIS FINANCE?

Understandably, people find this kind of boring... (not me of course!)

7
EXAMPLE: HOUSEHOLD FINANCE

p Finance = hedge funds, banks?

- Intermediaries: really important players
- Provide liquidity to the system
- Bigger picture?

p A huge % of financial market smooths consumption for households → only 36% of Swiss
households report holding stocks

p Important even if financial institutions/concepts seem irrelevant or boring!

p Close link between financial markets & real economy not always obvious
- See Great financial crisis of 2008

8
HOUSEHOLD SMOOTHING EXAMPLES: SAVINGS

p Income from job →

p Don’t need to spend it all right away →

p Firms need money to buy machines to make stuff →

p Loan income to a bank at a price (interest) →

p Banks lend money to firms that need it →

p You have more money in the future to spend

9
HOUSEHOLD SMOOTHING EXAMPLES: HOUSING

p Housing is extremely valuable asset →

p but firms don’t want to own a million homes that need to be maintained →

p but individuals can’t afford it →

p Pool 1,000 mortgages into a security →

p Mortgage markets (MBS): Firms lend money for homes without dealing with individuals
→

p Individual households get to borrow money to buy house

10
WHO CAN BE A FINANCIAL INTERMEDIARY? BUY NOW PAY LATER

p Only banks can lend money right?

p Buy now pay later
p Firms “lend” you the money by allowing you to pay over time
p Klarna? How does it make money?

11
OKAY... SO DO WE HAVE A DEFINITION OF FINANCE YET?

p System for allocating resources across time and space

p Usually occurs with some risk

- Time =⇒ change: economic conditions (labor, underlying supply and demand for
goods), interest rates
- Space =⇒ Counter-party risk: Financial assets = claims → other people need to honor
claim

p Definition too broad?

p Maybe but... economic problem that finance solves → now the methods for solving
problem (stock trading)

p Methods/instruments evolve over time

12
... SOME OTHER DEFINITIONS

“ Finance is the study and discipline of money, currency and capital assets. It is related to,
but not synonymous with economics, which is the study of production, distribution, and
consumption of goods and services; the discipline of financial economics bridges the two.
Financial activities take place in financial systems at various scopes; thus, the field can be

roughly divided into personal, corporate, and public finance. ”

- Wikipedia

Q: Does Bitcoin fall under money, currency, or capital assets?? Is it a financial asset then?

13
... SOME OTHER DEFINITIONS

2024: “ Finance is a broad term that refers to the management of money, investments,
and other financial assets. It encompasses a range of activities, principles, and systems
related to the generation, allocation, and utilization of resources. Finance is a critical aspect of

both individual and institutional decision-making processes. ”

2025: “ Finance is the study and management of money, investments, and financial systems.
It involves the processes of acquiring, allocating, and managing funds to maximize value and
minimize risk (??). Finance plays a crucial role in decision-making for individuals, businesses,

and governments. ”
- ChatGPT
14
... SOME OTHER DEFINITIONS

“ Finance is a term for matters regarding the management, creation, and study of money and
investments. It involves the use of credit and debt, securities, and investment to
finance current projects using future income flows. Because of this temporal aspect,

finance is closely linked to the time value of money, interest rates, and other related topics. ”
- Investopedia

p This is not a terrible definition

p Q: What is as an investment? Well, it’s whatever is used to finance current projects using
future income flows. The definition sort of uses its own terms to define itself?

15
WHO ARE THE MAJOR PLAYERS? FIRMS

p Need resources to make investments for output

p Can use internal cash or raise money from external

sources

p Raise equity, debt, private bank loans

p Alternatives: joint ventures, mergers & acquisitions

p Private equity buyouts - Fund buys a firm (usually

with debt) and takes the firm private

16
WHO ARE THE MAJOR PLAYERS? INTERMEDIARIES

p “Middlemen (person)” in financial transactions

p Commercial banks, Investment banks, brokers,

exchanges, investment funds

p broker-dealer: specific type of institution who trades

securities on behalf of clients but also itself

p investment bank: “sponsor” or underwrite deals.

- Firms approach an I-bank
- I-bank evaluates the opportunity and assumes some
risk
- Sell the deal to investors

17
WHO ARE THE MAJOR PLAYERS? GOVERNMENT

p Monetary Policy
- Balance unemployment and inflation
- Main lever = setting interest rates

p Fiscal policy
- Taxes
- Government spending

p Financial Regulation
- Regulate securities industry
- Fraud, embezzlement, money laundering
- Antitrust

p Public Finance
18
WHO ARE THE MAJOR PLAYERS? HOUSEHOLDS

p Save money

p Invest/plan for retirement

p Borrow for consumption

- mortgages
- auto loans
- credit cards
- consumer credit

19
WHO ARE THE MAJOR PLAYERS? INSTITUTIONAL INVESTORS

p Households borrow but also lend/invest

p investors buy and sell securities

p Households can be investors directly (Robinhood, e-trade, Swissquote) but most

participate through institutional investors (how?)

p We call them retail vs. institutional investors

p Professional portfolio managers → invest for clients

p ex: Mutual funds, hedge funds, private equity funds, index funds, family offices

20
INSTITUTIONAL INVESTORS CONT’D

p “sophisticated”: have more information and work with huge sums of money

p ... but most clients are households!

- Pension funds manage the pensions for employees. These are some of the largest and
most powerful institutional investors
- Mutual funds are managed by professionals but funds accessible

p Private equity, hedge funds, family offices not accessible to retail investors

p Commercial banks, investment banks, insurance companies also large institutional

investors but not just asset managers.
- Invest for clients (wealth management) and themselves (“prop trading”
- Insurance companies invest premiums

21
SOME HELPFUL RESULTS OF A WELL-FUNCTIONING FINANCIAL MARKET

p Standardize way to trade

- Two sandwiches in exchange for a stake in your investment? vs. stock

p Pooling mechanism: Firms need a lot of money... raise from many investors

p Mechanism for risk-sharing and hedging

p Price discovery... I think renewable energy is a good sector for growth but how much
should I pay for a wind farm?

p Solve asymmetric information problems

22
SPECIFIC PROBLEMS WHEN ALLOCATING RESOURCES ACROSS TIME/SPACE

p Risk: Counterparties might not hold up their end of the bargain, unpredictable outcomes

p Liquidity: No one wants to buy your asset (art?)

p Information asymmetry: Agents withhold information from others

p Moral hazard: “People wearing seatbelts sometimes drive less safely because they think
they’re protected in case of an accident”
- ex: bank bailouts, deposit insurance

p Adverse Selection: “The people who buy insurance are the ones who are most likely to
need it”
- ex: subprime mortgage crisis → risky borrowers more likely to apply for lightly screened
mortgages

23
STUDYING THE FINANCIAL SYSTEM (FINANCIAL ECONOMICS)
QUESTION IN FINANCE

p Two broad fields: asset pricing and corporate finance

p We’ll address some of these this semester, you’ll see most of these in APCF I and II.

p Questions revolve around understanding

1. What is the right “price” for trades over time and space?
2. What determines these prices?
3. How much should people be compensated for taking on risk? ex: investors in a project
4. How should we structure these trades (debt vs. equity)? Does it matter for how we use the
proceeds?
5. How do the intermediaries impact prices? For example, what if your bank is extremely
risk-averse? It has nothing to do with the riskiness of your project...

25
CORPORATE FINANCE

p The “firm” side (perspective) of financial markets

p Concerned with firm’s investment and financing (how to pay) decisions

Some big ideas that have come out of corporate finance (ex):

p Modigliani-Miller - Should the way that you finance investments affect the value of the
firm?
p Debt Overhang - Investment opportunity good for firm but they do not take it because of
debt.
p Pecking Order Theory (Myers and Majluf) - A theory of how manager’s decide which
source of financing to access first (internal → debt → equity).
Why? internal → debt → equity
Inf o Asymmetry→

26
OTHER TOPICS THAT TEND TO FALL UNDER CORPORATE FINANCE

p Capital budgeting

p Managerial incentives

p Entrepreneurial finance

p Household finance

p Labor and finance

27
ASSET PRICING

p Asset pricing deals with market outcomes

p Try to understand the prices and returns of assets

p Investors in the market or how the market itself is structured (ex: over the counter vs.
NYSE)

Some big ideas that have come out of asset pricing (ex):

p Efficient market hypothesis - Asset prices reflect all available information.

p Stochastic discount factor - Way of comparing assets with uncertainty which incorporates
investors’ preferences

p Equity Premium puzzle - An empirical observation that risk premium for stocks seems
much higher than explained by models
28
OTHER TOPICS THAT TEND TO FALL UNDER ASSET PRICING

p Market Micro Structure

p Behavioral Finance

p Trading Strategies

p Portfolio Theory

p Equity valuation

p Fixed income securities

29
TYPES OF ASSETS & MARKETS
TYPES OF ASSETS

p Debt: (bonds or bank loans)

- External funding where full amount (principal) due at maturity.

p Equity: (stocks)
- External funding in exchange for claim to the firm

p Cash or Cash equivalent: (commercial paper, CDs, etc...)

- Can be quickly and easily converted to cash

p Asset-backed Securities: (MBS)

- “pools” of payments obligated from individual debt like mortgages, credit cards, etc...

p Derivatives (options)
- Bet on underlying asset value: If AAPL ↑, you make 10CHF

31
DISCUSSION OF ASSETS TYPES

p Debt and Equity are the most commonly used and studied asset classes. (focus of this
class)

p derivatives and ABS in APCF and real estate finance

p Assets can be traded in a variety of ways

- publicly traded
- Over the counter
- privately traded

p Purchased in primary vs. secondary markets

32
PUBLIC VS. PRIVATE

p Publicly traded companies

- Public exchanges like NYSE
- Note! Does not have to represent 100% of the company’s shares!
- Public exchanges regulated, “underwriting” process to list and disclose regular
information on financial activities
- Publicly traded companies can have debt too

p Privately traded companies

- Shares are not publicly available
- Can be held by founder owner, board, or private investors
- Private investors can include private equity funds, banks, etc...
- Again, can be stocks or bonds
33
PRIMARY VS. SECONDARY

p Primary Markets - firms issue shares for the first time (Initial public offering or “IPO”)
- This is when firms can access capital or borrow money

p Secondary Markets - people trade assets they own

- Buying from other investors, not the firm

Why secondary markets?

p Provide liquidity: Makes it more desirable for investors to buy on primary markets if
there’s “exit strategy”

p Price Discovery: When securities are traded, the prices that people are willing to buy/sell
provide information (like perceived riskiness) of firms

p Risk Sharing: Makes it easier to diversify across different assets

34
REGULATED VS. LIGHTLY REGULATED

p Regulation should help make investments more transparent and less risky
- Rigorous screening process
- Everyone has the same rules/definitions for accounting

p But more creative securities (“Financial engineering”) tends to happen in markets that
aren’t as regulated

p Some huge markets aren’t well regulated: Private capital, Crypto

p OTC markets are lightly regulated

35
HOW TO THINK ABOUT THESE MARKETS? GLOBAL CHANGES

36
HOW TO THINK ABOUT THESE MARKETS? RELATIVE SIZE OF ASSET TYPES

37
HOW TO THINK ABOUT THESE MARKETS?

p Are there other factors we should care about?

p ex: Commercial real estate loans = 17% to 36% of US bank balance sheets
- Contagion risk
- Weak balance sheets =⇒ deposit rates, willingness to lend, etc...

p Economic impact?
- Many people (in the US) employed by small (unlikely to be public) firms
- Labor is extremely important to the economy...

38
LARGE (MORE LIKELY PUBLIC) FIRMS WEREN’T ALWAYS THE LARGEST EMPLOYER

39
REAL WORLD EXAMPLES
FINANCIALIZATION OF CARBON MARKETS

41
ARE CARBON MARKETS A GOOD IDEA?

p Carbon markets: financial markets for buying and trading carbon credits

p Carbon credits allows firms to emit greenhouse gases, governments can control the
allotment

p Generally, thought to be a good policy tool

p However, many carbon markets do not restrict who can trade

p Speculators have gotten involved in these markets... is that good or bad?

- Provide liquidity
- Distorts prices

42
REPO MARKETS

43
WHAT ARE REPO MARKETS AND DO THEY MATTER?

p Here’s a market you’ve probably never heard of before

p ... yet central banks are watching it closely enough that they might react to it! That
reaction has an impact on the rest of the economy as well!

p Repo: “Repurchase Agreement”. Super short term loan (overnight)

p Borrower sells government securities to investors (lender) and agrees to buy them back at
a higher price

p The price difference is the overnight interest rate... extremely important rate

44
SWISS REPO MARKET

p In Switzerland, the overnight rate is known as SARON (Swiss average overnight rate)

p It’s the rate banks pay when they borrow from SNB or provide excess liquidity

45
REPO MARKETS DISCUSSION

p “Borrower” sells repo, “lender” buys

p Collateralized loan: collateral = exchanged security

p Short-term liquidity (i.e. bank needs capital fast)

p Lots of differerent types of repo

p When banks borrow from the government, used to control money supply
- Repo rates ≈ the cost of borrowing for banks
- When more expensive to borrow money, banks raise the interest rates when you want to
borrow from them
- People borrow less, consume less
- Opposite also holds

46