Financial markets
Financial markets
This domain tests the instruments, pricing relationships and informational features of financial markets, and why intermediaries exist despite creating risk.
Core rules
- Money markets are short-dated (Treasury bills, certificates of deposit, commercial paper); capital markets cover bonds and equities. Primary markets raise funds; secondary markets provide liquidity and price discovery.
- A bond's price is the present value of coupons and redemption discounted at the yield. Price and yield move inversely; longer duration and lower coupons increase price sensitivity.
- Term structure theories: expectations, liquidity preference and market segmentation. An inverted yield curve is a classic recession signal.
- Equities are valued by dividend discount models, earnings multiples and risk premia. The efficient markets hypothesis has weak, semi-strong and strong forms.
- Intermediaries perform maturity transformation, liquidity insurance, screening and monitoring, but are vulnerable to runs and create systemic linkages.
- Asymmetric information: adverse selection arises before contracting, moral hazard afterwards, and the principal–agent problem afflicts delegated management. Signalling and screening mitigate them.
- Derivatives - forwards, futures, options, swaps - transfer risk but carry counterparty and margin risk.
Worked example
A three-year bond pays a 5% annual coupon on a par of 100 and yields 4%. Price = 5/1.04 + 5/1.04² + 105/1.04³ = 4.81 + 4.62 + 93.35 = 102.78. It trades at a premium because the coupon exceeds the yield. If the yield rises to 6%, the price falls to roughly 97.33, illustrating the inverse relationship.
Traps
- Claiming bond prices and yields move together.
- Discounting coupons at the coupon rate instead of the market yield.
- Reading the semi-strong form as 'prices are always correct'.
- Ignoring counterparty and collateral risk in derivative positions.