financial markets and institutions week 2 slide

8/11/2019 Financial Markets and Institutions Week 2 Slide

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Week Two

The demand for financial assets.

Primary, secondary and tertiary (orderivative) markets.

Market organisation.

Factors influencing markets

Market analysis and forecasting The Assignment

– A discussion on ‘Endnote’



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Last Week We :

Described the role performed by the financialsystem

Explained the concept of a financial assetand identify the main types of financial assets

Discussed the functions of financial markets.

Explained how financial markets transferfunds

Defined intermediation vs. direct financing.



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The Market Mechanism

Objectives for this lecture

– Define the idea of a financial asset – The factors affecting demand for a financial asset

– Primary issue and secondary transfer markets

– How trading is organised

– Forecasting methods – Define Fundamental Analysis

– Identify Various forms of Technical Analysis



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What is a Financial Asset?

From last week’s lecture

– A claim to a real asset or to the cash flows thatreal asset will generate

Ongoing payments (dividend, coupon)

Residual value

– Characteristics

Risk

Return

Liquidity



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Financial Markets

1. Matching principle

2. Primary and secondary market transactions3. Direct and intermediated financial flow

markets

4. Wholesale and retail markets

5. Money markets

6. Capital markets



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1. Matching Principle

Short-term assets should be funded with

short-term (money market) liabilities, e.g. – Seasonal inventory needs funded by overdraft

Longer-term assets should be funded with

equity or longer-term (capital market)liabilities, e.g.

– Equipment funded by debentures



2. Primary and Secondary market

transactions

Primary market transaction

– The issue of a new financial instrument to raisefunds to purchase goods, services or assets by

Businesses

– Company shares or debentures

Governments

– Treasury notes or bonds

Individuals

– Mortgage

– Funds are obtained by the issuer



2. Primary and Secondary market

transactions (cont.)

Secondary market transaction

– The buying and selling of existing financialsecurities

No new funds raised and thus no direct impact on

original issuer of security

Transfer of ownership from one saver to another saver

Provides liquidity, which facilitates the restructuring ofportfolios of security owners



3. Direct and Intermediated

Markets

Direct Markets

– Bond, Share markets especially – Predominantly (but not exclusively) wholesale

markets

Intermediated Markets

– Banks are main intermediaries – Predominantly (but not exclusively) retail markets

– Many derivatives can be intermediated



4. Wholesale and retail markets

Wholesale markets

– Direct financial flow transactions betweeninstitutional investors and borrowers

Involves larger transactions

Retail markets

– Transactions conducted primarily with financialintermediaries by the household and small to

medium-sized business sectors

Involves smaller transactions



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5. Money markets

Wholesale markets in which short-term securities are

issued (primary market transaction) and traded

(secondary market transaction)

– Securities highly liquid

Term to maturity of one year or less

Highly standardised form

Deep secondary market

– No specific infrastructure or trading place

– Enable participants to manage liquidity



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5. Money markets (cont.)



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5. Money markets (cont.)

Money market submarkets exist for – Central bank: system liquidity and monetary

policy

– Inter-bank market

– Bills market – Commercial paper market

– Negotiable certificates of deposit (CDs) market



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6. Capital markets

Markets in which longer-term securities are issued

and traded with original term-to-maturity in excess of

one year

– Equity markets

– Corporate debt markets

– Government debt markets

Also incorporate use of foreign exchange markets and

derivatives markets

Participants include individuals, business, government

and overseas sectors



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Forecasting & Analysis

Price ultimately defined by supply anddemand

Several techniques used to forecast prices

Fundamental Analysis – Top down approach

– Bottom up approach Technical Analysis (Charting)

Psychological Factors and Sentiment



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Fundamental Analysis

Top down approach

A macro-economic viewpoint which attempts to

forecast the industry or country’s economic

environment in which the company operates

Bottom up approach

A micro-economic viewpoint which attempts to

forecast a company’s operational well-being by the

use of various accounting/investment ratios



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Top down approach

A macro-economic viewpoint looking at

– Industry Sectors – The impact of international economies

– The rate of economic growth

– The effect of exchange rates

– Interest rates, domestically and internationally – Balance of payments – current account

– Inflationary pressures and wages growth



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Bottom up approach

A micro-economic snapshot using various

accounting/investment ratios, for example: – Capital structure

Gearing, equity

– Liquidity and debt coverage

– Profitability – Management quality

– Current share price, prospects and risk



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Top down approach or a Bottom up approach

– You should consult Viney Chapter 7.1 to 7.2 and form your

own opinion. Conventional wisdom has it that acombination of both approaches works well

1. Identify industries and economies with good value

or growth prospects through a top down approach

2. Use a bottom up approach to identify the specificcompanies and their shares which are likely to

perform best



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Technical Analysis

Explains and forecasts share price

movements based on past price behaviour Assumes markets are dominated at certain

times by a mass psychology, from which

regular patterns emerge

Two main forecasting models – Moving averages (MA)

– Charting



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Moving Averages (MA) Models

Smooth out a series facilitating the

identification of trends in the series

Calculation of MA

– Assuming a five-day moving average, the MA is

calculated by taking the average of the priceseries for the preceding five days



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(cont.)

Trading rules

– Buy when the price series cuts the MA from below – Buy when the MA series is rising strongly and the

price series cuts or touches the MA from above

for only a few observations

– Sell when the MA flattens or declines and theprice series cuts MA from above

– Sell when the MA is in decline and the price

series cuts or touches the MA from below for only

a few observations



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(cont.)

Typically for daily price series both 10-day

(short-term) and 30-day (medium-term)moving averages are calculated

Weighted MA

– The most recent information is given the greatest

weight



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Charting

Investigating patterns in price charts

Several techniques

– Trend lines

– Support and resistance lines

– Continuation patterns

– Reversal patterns



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Charting –

Trend Lines

Trends are regular movements in share prices

Two types of trends

– Uptrend line—connecting the lower points of rising price

series

– Downtrend line—connecting the higher points of falling price

series

Return line—line drawn parallel to a trend line to create atrend channel

Critical issue is to determine when the trend line is

going to change



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This chart has been taken from http://www.dailyfx.com/FinanceChart.html



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Charting- Support and Resistance lines

Support levels—where there is sufficient

demand to halt further price falls

Resistance levels—where there is sufficient

supply to halt further price increases

‘Strong’ levels—historical support and

resistance

‘Weak’ levels—support and resistance based

on more recent activity



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Charting - Continuation Patterns

Sideways share trading that does not

normally signal a change in a trend; 2 types

– Triangles—composed of a series of price

fluctuations, each smaller than its predecessor

Symmetrical triangle (no change in trend); ascending

triangle (uptrend); descending triangle (downtrend)

– Pennants and flags—formed during a sharp rise in

prices (‘the pole’); trading volume then reduces

and then increases suddenly to take prices

sharply higher



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Charting - Reversal patterns

Occur after a major market move

Result in a ‘head and shoulders’ pattern – Three successive rallies and reactions, the second

rally being stronger than the first and third rallies

Left shoulder —formed by volume-strong rally on uptrend,

followed by reduced-volume reaction

Head—second rally increases price before reaction

moves price back to previous low

Right shoulder —final rally marked by reduced volume

indicating price weakness



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Charting - Elliott Wave Theory

The existence of distinctive wave patterns

that characterise share-market cycles

Key proposition is that a bull market consists

of three major waves upwards, followed by

two major down-legs, resulting in a reversion

of share prices to about 60% of the peak Consult Viney Ch 7.3.2 for more on Charting



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Technical or Fundamental Analysis

Validity of technical analysis – Even where techniques have no apparent underlying

validity, if they are followed by enough participants they mayimpact share price behaviour at times

More likely to forecast successfully when shareprices move out of a range explained by economicand financial fundamentals

Technical Analysis can be very effective indetermining timing once fundamental reasons to buyhave been established



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Program Trading

Refers to buy and sell strategies generated

by computer programs

Programs range between

– Simple buy/sell orders based on moving averages

– Complex monitoring of both derivatives and share

markets for the purpose of hedging a shareportfolio

Program trading increases the speed at

which prices change



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Next Week - Week Three

Mathematics of Finance Revisited

Short, medium and long-term debt Structure of the money markets.

Interest bearing securities

Discount securities.

Securitisation

The Assignment

financial markets and institutions week 2 slide

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