FINANCIAL ECONOMICS for Professionals and Undergraduates by Numan lk

PREFACE
Among academicians, Financial Economics refers to the study of economic theories of asset pricing. As such, its scope includes extensions, empirical tests and debate on the validity of these theories. Unfortunately, these asset pricing theories have low explanatory power of empirical observations and do not sufficiently address the variety of financial market issues encountered by real life practitioners. The content is typically too abstract and less relevant for undergraduate students and practitioners. We define Financial Economics to mean: 1) the study of the bilateral interaction between the financial markets and the real economy, 2) the study of a multitude of financial market phenomena employing the principles and methodology of economic analysis. Thus, our scope is not stuck to the debate on the validity of asset pricing theories. Rather, we cover a rich scope of financial market issues of high relevance to practitioners in real life and comprehensible to senior undergraduate students. The book is organized to elaborate a comprehensive number of separate but interrelated issues on financial markets in each chapter.

Chapter 1: Introduction to the Financial System

1.1. Players
Surplus units (net lenders) are those units who have had more income than expenditure in the past so as to accumulate net savings, hence they are net suppliers of funding, Typically, households, some businesses. Deficit units (net borrowers) are those units who have more expenditure than income, so they are in need of financing. Typically, business firms, governments and some households.

1.2. The Process of Financing

The function of financial system is to efficiently and effectively channel financing from surplus units to deficit units. (Efficiency means low costs, i.e., small spread between the yield earned by surplus units and cost of financing to deficit units. Effectiveness means the allocation of funds to those deficit units who will utilize them most productively and that all projects that produce economic value get financed.) The process of financing is actualized in two ways: Direct finance is the process whereby the surplus units and deficits unit match together in the market place with the facilitation of financial intermediaries. Examples: IPO, bonds. The key characteristic of the direct finance is that the surplus unit directly takes the risk of the deficit unit. Indirect finance is the process whereby financial intermediaries borrow funds from surplus units and place, at their own risk, at deficit units. Example: banks. Direct and indirect finance segments their own supervisory boards (e.g. in USA, SEC oversees the direct finance process, Fed oversees the banking system, In UK both functions are combined under FSA). Financial markets 1) enable consumption timing, 2) facilitate business investment (alter its timing), 3) enable transfer of risk, 4) signal future macroeconomic activity. 1.3. Classification of Financial Instruments, Markets and Institutions * Three broad types of financial instruments: 1) Fixed income securities 2) Equity There are also many hybrids such as preferred stock, convertible bond. * Financial Markets can be grouped based on the maturity of the instrument traded: 1) Money market, where instrument with less than 1 year to maturity are traded, 2) Capital Markets, where instruments with more than 1 year to maturity are traded. * Primary markets: a security is issued and offered to the public/investors for the first time (e.g., IPOs, private placements, treasury auctions) Secondary markets: second-hand trading of previously issued securities (e.g., regular trading in stock and bond markets). 3) Derivatives

1.4. The process of matching deficit and surplus units Direct search: Buyer and surplus units spend their own effort to find the counterparty, some organizations may faclilitate (e.g. classifieds,). Brokered markets: Brokers bring together the surplus and deficit unit, facilitate their transaction and charge a fee for their services. They do not take any risk, they do not assume the ownership of the traded instrument. Dealer markets: Dealers provide immediate liquidity to both buyers and sellers by acting as counterparty. To do so, they maintain an inventory of the security and cash. They take risk and take temporary ownership of the security for which they are market-making. They typically profit from bid-ask spreads (i.e., the difference between their (lower) buying and (higher) selling prices. Auction markets: all buyers and sellers submit orders in an organized facility (organized exchange, electronic platform, etc.). Then, the orders are matched by a well-defined procedure. Organization of Markets: Organized Exchange: is a legal entity, has a physical location, administration, and precise rules of operating. OTC (over-the-counter) market: not necessarily has a certain physical location (e.g. can be a telephone network), a number of dealers / market makers by submitting quotations, no legal entity, no written rules but probably well-established conventions. Third market: OTC trading outside the opening hours. Fourth market: block trades outside the market mechanism in an organized exchange Trading systems: Batch processing: buy and sell orders are accumulated, and processed in batches at some time points. One single price that maximizes traded volume is set by the batch experts (or computer algorithms). Continuous auction: buyers and sellers can submit limit and market orders at any time during the designated trading hours, and tradable orders are automatically matched by a procedure. continuous auctions can be conducted under three systems: 1) open out-cry: floor traders trade with each other based on floor conventions, 2) specialist systems: all orders are accumulated in the specialist / market makers order book, and this information is only available to the specialist. The specialist continuously provides liquidity by submitting quotations. 3) electronic order book, blind matching: all orders are accumulated in an electronic order book, information of buy and sell orders can be shared with the public, tradable orders are automatically matched by a computer procedure.

1.5. Transaction Costs: They may consist of three components: 1) commissions paid to the broker that facilitates trading, 2) Bid-ask spread: the difference between the price at which a trader can buy and sell (the former higher such that it is a profit for the dealer providing liquidity and a cost for the trader consuming this liquidity), 3) Price impact: large orders may move the price beyond the currently available best bid and ask prices, so their effective bid-ask spread will be larger. 1.6. Order Types: Limit order: specifies the highest price a trader is willing to buy or the lowest price at which a trader is willing to sell. Execution of the order is uncertain. Market order: ensures immediate execution but the transaction price is not specified (takes the best bid or ask available in the market). Duration of the order: Day order: a limit order will remain valid until the close of the current trading session/day. GTC order: good-till-cancel remains working unless canceled. MOC: market order at close. guaranteed execution at the closing price (unknown at the time of submitting the order). Stop-loss order: A buy (sell) order above (below) the current price, which will be activated and transformed into a market order once the trigger price is hit by the market. Take-profit order: A buy (sell) order below (above) the current price, which will be activated and transformed into a market order once the trigger price is hit by the market. Now, there are limit order versions of stop orders. Fill-or-kill order: A limit order which is either filled immediately and if cannot be filled immediately to be canceled.

Chapter 2: Forecasting Financial Markets and Efficient Markets Theory

Three approaches prevail to forecasting financial markets: 1) Fundamental analysis (FA): Using any news about the factors that can affect the value of a financial instrument to predict its future price changes. 2) Technical analysis (TA): Using past price action and trading statistics to predict future changes. 3) Efficient markets theory: the academic view that argues all information is already reflected into market prices so that it is not possible to systemically earn profits using any information. Hence, according to EMT, both FA and TA are useless. 2.1.. Efficient Markets Theory E( ) = 0 these forecasts. Early proponents of EMT define three forms of market efficiency based on the type of information () that must be already reflected in market prices: i) weak-form: all information about past prices is already reflected, ii) semi-strong form: publicly available fundamental information is already reflected, iii) strong-form: private information is already reflected. Contemporaneous financial markets are considered to be somewhere between semi-strong and strong form of market efficiency. Publicly available fundamental information is usually instantaneously priced-in, however some behavioral factors may lead to deviations from full-information equilibrium (underreaction, overreaction). Private information is usually only partially priced-in. All finance theory, in particular asset pricing theories describing the relationship between risk and return, are based on the assumption of efficient markets. 2.2. Technical Analysis (tutorial in class) where is economic profits net of transaction costs and adjusted for profits; is a particular information set to used to formulate forecast and corresponding trading strategies to exploit

TA has been discarded in early academic literature. However, the seminal paper of Brock et al. (1992) triggered renewed interest in testing technical trading rules, and since then a large academic literature on TA has emerged.