Contents

Understanding Financial Markets

General Introduction and Key Concepts

Investment Management in a nutshell

Investment management is about managing risk!

The key to successful Investment Management is to constantly be aware of the underlying risks:

• Country risk
• Market risk
• Currency risk
• Liquidity risk
• Inflation risk
• Shortfall risk

The key is diversification!

The role of financial markets

Financial Market Participants

• Firms
• Investors
• Government
• Financial Intermediaries

Primary vs. Secondary Market

Investopedia

• Primary market: investors buy securities directly from the company issuing them
• Secondary market: investors trade securities among themselves (the company does not participate in the transaction)

Functions of the financial system

“the primary function of any financial system is to facilitate the allocation and deployment of economic resources, both across borders and across time, in an uncertain environment” - Merton & Bodie (1995)

1. Pooling resources & subdividing shares: allow big investors (firms) to invest lot of money but also allow small investors

2. Transferring resources across time & space: invest in different countries, invest for the future

3. Managing Risk:

   • diversified portfolio.
   • derivative products that allow you to insure your portfolio against a drop
   • securitization

4. Providing Information: prices, values …

Desirable criteria of financial markets:

• transparent: all participants have all the relevant information on the prices, the volume traded, the beta spreads, the order book …
• fair: e.g traditional traders vs. high frequency traders
• avoid insider trading: some people could have privileged information
• prevent market abuse: fixing prices …

Well functioning financial markets should provide access to the following and to everybody:

• trading information (price, volume, order book, …)
• trading technology (higher speed access, …)
• company information (insider trading, …)
• market opportunities (fixing FOREX & LIBOR markets)

Basic concepts in finance

• Return (rate of return):

• where

  • $V_{f}$: final value, including dividends and interest
  • $V_{i}$: initial value

• often in %

• average return of a time period is important

• A risk-free asset: future returns are certain (return doesn’t change)

• tradeoff between return and risk: ratio between average return and risk

• Histogram:

  • horizontal axis is divided into intervals
  • divide the number of observations in an interval by the total number of observations
  • vertical axis indicates this probability or (relative) frequency

Major Financial Markets

Equities

How much is a company worth on the stock market?

• Net Present Value (NVP, Kapitalwert, Nettobarwert)

  • $NPV(i,N)=\sum _{t=0}^{N}{\frac {R_{t}}{(1+i)^{t}}}$

    • $t$: time of the cash flow
    • $i$: discount rate, i.e. the return that could be earned per unit of time
    • $R_t$: net cash flow (cash inflow - cash outflow) at time $t$

  • invest in projects with a positive NPV

  • do not invest in projects with negative NPV

  • Investopedia

  • Wikipedia