Finance lecture 2 - ECON 3050A Introduction to Financial...

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ECON 3050A Introduction to Financial Economics Lecture 2 The Asset Market Microstructure We had previously argued that the market price of an asset was determined by investors willing to hold the existing stock of an asset in total i.e. its total supply. An alternative approach to asset price determination is to consider the flow of asset purchases equal to the flow of sales over a given time interval. This implies that the total demand by investors who wish to increase their holdings of this asset equals the total supply by investors who want to reduce their holdings. We start by considering the functions and participants of Financial Markets. What is a Market? It is a set of arrangements that allows participants to reach voluntary agreements. We would define; • A set of arrangements - that including largely unorganized markets e.g. foreign exchange markets - also includes highly organized markets such as Future Markets • Agreements - may be formal or informal contracts - they are voluntary with the implication that the sanctions of the law can be invoked to ensure compliance. Functions Performed by Markets 1. Spread information to promote “Price Discovery” i.e. prices at which trades can be made. 2. Provides a “Trading Mechanism” that makes possible agreements to take place. This would include buyers being able to communicate with sellers. 3. Enables the “execution of agreements” i.e. there is a contract settlement function that ensures that terms of the agreement are honored, and (i) confirms transactions (ii) clears the trade i.e. new ownership is registered (iii) there is a settlement of account i.e. money payment.
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Financial Exchanges are associated with a designated Clearing House that supervises and administers procedures for contract settlement and the safe custody of assets. The market functions are performed by its participants. In addition to authorities that regulate markets, there are 3 broad groups; 1. Public Investors – own the assets and are motivated by return from holding assets. They are individuals, trusts, pension funds, other institutions. 2. Brokers - act as agents for public investors and are motivated by commission fees for services, do not trade on their own account, but for others. 3. Dealers – do trade for their own account, make a profit there, not from holding the asset. They make a profit from the difference in the bid/ask price i.e. the spread. They are not mutually exclusive; brokers may act as dealers as well as hold assets of their own. Also, in many markets there are designated dealers who ensure that the trading mechanism functions smoothly – they act as market makers. In return they are granted privileged access to market information. In the 1990’s with the emergence of electronic communication networks, exchanges largely replaced this
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Finance lecture 2 - ECON 3050A Introduction to Financial...

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