Financial markets
Financial markets connect savers with borrowers, price risk, and let people buy and sell ownership of companies and claims on future income.
The role of financial markets
Financial markets channel funds from savers to borrowers who can use them productively, help people share and manage risk, provide liquidity (the ability to sell assets quickly), and produce prices that convey information about the value of firms and the economy.
Bonds
A bond is a loan to a government or company that pays interest (the coupon) and returns the principal at maturity. Bond prices and interest rates move in opposite directions: if rates rise, existing bonds paying lower coupons become less attractive, so their prices fall.
Bond prices and yields
Suppose a bond pays 50 dollars a year forever (a perpetuity). Its price is the payment divided by the interest rate: at 5%, \(\frac{50}{0.05} = 1{,}000\) dollars; if rates rise to 10%, the price falls to 500 dollars. Long-term bonds are more sensitive to interest rate changes than short-term ones.
Shares
A share (stock) is a unit of ownership in a company, giving a claim on its profits, paid as dividends or reinvested. Share prices reflect expectations of future profits and the return investors require for bearing risk. Shares have historically earned higher average returns than bonds over long periods, but with much greater volatility.
Risk and return
Investors generally demand higher expected returns for taking more risk. Diversification, spreading investments across many assets, reduces risk without necessarily lowering expected return, because bad outcomes in some assets are offset by good outcomes in others. Index funds offer cheap diversification across a whole market.
The efficient markets hypothesis
The efficient markets hypothesis, associated with Eugene Fama, says asset prices reflect all available information, so it is hard to consistently beat the market. Evidence that most actively managed funds underperform index funds after fees supports a version of it. Bubbles and crashes, emphasised by Robert Shiller, suggest prices can also stray far from fundamentals.
Other markets and institutions
Other key parts of the financial system include money markets for short-term borrowing, foreign exchange markets, derivatives (contracts whose value depends on other assets, used to hedge or speculate), insurance companies, pension funds, and investment funds. 'Shadow banks', non-bank lenders, have grown in importance and can also suffer runs.
Worked example
An investor puts 10,000 dollars into a single company's shares, and the company fails: she loses everything. If she instead spread the money across an index of 500 companies, one failure would cost her about 0.2% of her investment. Diversification protects against the risk specific to individual firms, though not against market-wide falls.
Key takeaways
Financial markets channel saving to investment, share risk, and provide liquidity and information. Bonds pay interest; their prices move opposite to interest rates. Shares are ownership claims with higher long-run returns and higher volatility. Higher risk demands higher expected return; diversification reduces risk. Markets are hard to beat consistently, but bubbles show prices can deviate from fundamentals.
Flashcard
Connect savers and borrowers
Check your understanding
If market interest rates rise, what happens to the price of existing bonds?