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FINANCIAL MARKETS and their implications in the Economy

Financial markets ‘transfer’ funds from surplus to deficit units in a way desirable to both the participants and profitable to financial institutions.

This is mainly due to the fact that the financial institutions take advantage of scale economies that have succeeded by transferring funds from agents with a surplus of funds to those who are short of funds.

Finally, the financial intermediaries ask for a higher rate of return on their primary security[1] portfolios than the lending rate they must pay on their own secondary securities[2]. In this respect, we can argue the following factors as the main determinants of the financial intermediaries’ characteristics. That also represent the major differences between the institutions in question and the individual householders.

Market imperfection

Undoubtedly, the financial intermediaries due to their larger volume of transaction, are able to reduce their average fixed cost and consequently to lessen the exchange cost per unit.

Diversification

Indisputably, we can state that the larger the volume of financial portfolio the greater the diversification[3] that can be achieved, which in turn results in the reduction of risk.

For example, one can put assets in different categories: bonds, stocks, precious metals, and real estate.

Certainly, such a diversification can be much easily achieved from financial intermediaries than from individual householders.

Specialisation

The operation of the financial intermediaries is entrusted to professional staff with expertise in portfolio management, asset selection, negotiation, and general financial services. On the contrary, it is not anticipated from individuals to have a similar expertise.

Certainty

Due to their volume of transactions, the financial institutions of financial markets, as earlier stated, reduce the risk through the diversification and at the same time because of a better scheduling of inflows-outflows, reduce the uncertainty to the individuals.

Miscellaneous services

In addition to their main role in financial intermediation, the financial institutions can offer non-income services tailor made to the specific needs of the ultimate wealth-owners. For example, the financial markets can offer different types of mutual funds oriented to specific group needs, i.e. age, income, time frame, and tolerance to risk.

Manolis Anastopoulos, Economist, Financial Analysis, University of Leicester

[1] Primary securities are issued by a firm to raise new capital and are exchanged via an underwriter in the primary market.

[2] Secondary securities are claims against financial intermediaries who are holders of financial assets and are exchanged in the secondary market.

[3] A well-worn adage, states “do not put all your eggs in one basket”

Risk Management – Part A

Manolis Anastopoulos @ University of Leicester - Risk Management

Introduction

It is a historically known fact that people instead of keeping their cash with a zero return, decided to lend their surplus funds from the moment that the borrowers were willing to offer them a return.

On the other hand, as we know from economics, in order to acquire something we have to pay the price of having less of something else. As stated in their book, (Parking & King 1992), ‘More corn can be grown only by paying the price of having less cloth’.

In other words, it is a prerequisite for the surplus units to loose certainty, i.e. to accept risk, in order to gain return. This is the meaning of ‘risk’, the probability of ‘losing money’.

However, it can be generally argued that the majority of investors like to avoid risk whenever possible; they are risk–averse. As stated in their book, (Gitman & Madura 2001), ‘Given two choices with similar expected returns, they (the investors) prefer the less risky one.’  Consequently, investors are willing to accept increased risk only if they will be compensated with an increased rate of return. In other words, there is always a positive link between any claim’s uncertainty (risk) attached to its future performance and the required rate of return.

 

Portfolio Theory - Modern Portfolio Theory (MPT)

Investors, before the 1950s - based on the aforementioned ‘rules’ - used to focus on assessing the risk of individual securities in order to construct their portfolios[1]. For example, if an investor considers that the bank’s XX stocks were offering a satisfactory risk – reward characteristics, then he might construct his portfolio entirely of the stocks in question.

Later, in 1952, Harry Markowitz with his paper ‘Portfolio Selection’[2] introduced what is known as Modern Portfolio Theory.  Based on the concept of ‘diversification’ of the risk and ‘correlation’ of securities, he proposed that investors should select portfolios taking into consideration the portfolio’s overall risk – reward characteristics. More specifically, he argued that instead of tracing the risk’s level of individual securities, investors should measure their portfolios’ overall risk.

 

[1] Portfolios are usually constructed by different assets, such as: stocks, mutual funds, bonds and cash.

[2] Markowitz’s paper ‘Portfolio Selection’ published in 1952 by ‘The Journal of Finance.’