Financial market Study Guide

📖 Core Concepts Financial Market – A venue (exchange or electronic platform) where securities and derivatives are bought and sold with low transaction costs. Primary vs. Secondary Market – Primary: first sale of new securities; Secondary: trading of existing securities, providing liquidity. Capital vs. Money Market – Capital markets fund long‑term projects (stocks, bonds); Money markets fund short‑term needs (≤ 1 yr debt). Derivative – A contract whose value derives from an underlying asset (stock, bond, currency, rate, etc.) and is used to hedge or speculate risk. Liquidity – Ability to sell an asset quickly without a material price drop; high liquidity = many buyers/sellers. Price Discovery – The process where market participants’ buying and selling set the current price of an asset. 📌 Must Remember Securities Types: Equity (shares), Debt (bonds), Commodities (soft/hard), Derivatives (futures, forwards, options, swaps). Key Derivative Features Futures: standardized, exchange‑traded. Forwards: customized, OTC. Options: right, not obligation, to buy (call) or sell (put). Swaps: exchange of cash‑flow streams (e.g., interest‑rate swap). Regulatory Milestones – Dodd‑Frank (U.S.) → central clearing of OTC derivatives; MiFID II (EU) → transparency & investor protection. FX Basics – Banks dominate trading; pip = smallest price move; bid‑ask spread = buyer‑seller price gap. Technical vs. Random Walk – Technical analysis assumes trends predict short‑term moves; Random Walk asserts price changes are independent. Volatility – Measures magnitude of price changes over a period; higher volatility = higher risk. Basis Point – 0.01 % (1 bp = 0.0001). 🔄 Key Processes Raising Capital via Primary Market Issuer → Investment bank → Underwrites → New securities sold to investors → Funds flow to issuer. Secondary Market Trading Investor A places sell order → Exchange matches with buyer B → Trade executes → Ownership transfers, price updates. Derivative Contract Lifecycle (Futures) Contract creation → Margin posting → Daily mark‑to‑market → Final settlement (cash or physical). FX Spot Transaction Agree on exchange rate → Immediate (usually T+2) delivery of currency → Settlement via interbank system. 🔍 Key Comparisons Futures vs. Forwards Standardization: Futures ✔︎, Forwards ✖︎ Trading venue: Exchange ✔︎, OTC ✖︎ Credit risk: Cleared by clearinghouse ✔︎, Counterparty risk ✖︎ Primary vs. Secondary Market Purpose: Capital raising vs. Liquidity provision. Price setting: Issuer‑set offering price vs. Market‑determined price. Technical Analysis vs. Random Walk Assumption: Trends predict future moves vs. Each change independent. Implication: Pattern‑based trading vs. Passive indexing. ⚠️ Common Misunderstandings “Derivatives are only for speculation.” – They are also essential risk‑management tools (hedging). “All bonds are the same.” – Bond terms (maturity, coupon, credit quality) vastly affect price and yield. “Higher liquidity means higher returns.” – Liquidity reduces transaction cost; it does not guarantee higher returns. “FX spot = same as forward.” – Spot settles immediately; forwards lock in a future rate. 🧠 Mental Models / Intuition “Market as a two‑sided auction.” Buyers and sellers submit bids/asks; the crossing point is the market price. “Derivatives as insurance policies.” Pay a premium (option premium) to protect against adverse price moves. “Liquidity ≈ number of participants.” More participants → tighter bid‑ask spreads → easier entry/exit. 🚩 Exceptions & Edge Cases Negative interest‑rate environments – Bonds can trade at yields below 0 %; traditional “price rises as yield falls” still holds but with negative yields. Hard‑to‑value commodities – Weather‑dependent soft commodities may have supply shocks that break usual price‑inflation links. OTC derivatives without clearing – Still exist for bespoke contracts; higher counterparty risk despite Dodd‑Frank. 📍 When to Use Which Choose Futures when you need a standardized contract, want daily margining, and prefer exchange clearing. Choose Forwards for customized settlement dates, amounts, or assets not available on exchanges. Choose Options to limit downside (protective puts) while retaining upside potential. Use Money‑Market instruments for cash‑equivalent, short‑term financing (≤ 1 yr). Use Capital‑Market instruments for long‑term funding (equity for ownership, bonds for debt). 👀 Patterns to Recognize Rising commodity prices → Potential inflation → Higher equity prices (especially for commodity‑linked firms). Tightening bid‑ask spread + high volume → Strong liquidity → Less price impact from trades. Sudden spike in volatility → Likely news event or market stress; consider risk‑off positioning. Consistent upward/downward trends in price charts → May signal technical‑analysis‑driven momentum (if you accept that model). 🗂️ Exam Traps Confusing “spot” with “forward” rates – Spot settles immediately; forward locks in a future rate. Assuming all derivatives are exchange‑traded – Forwards and many swaps remain OTC. Mixing up “primary” and “secondary” market liquidity – Primary markets provide capital, not ongoing liquidity. Thinking “higher volatility = higher expected return” – Volatility is risk, not a guarantee of higher return. Misidentifying “pip” vs. “basis point” – Pip applies to FX price moves; basis point applies to interest‑rate changes.