ECO2049 Financial Economics 1 Lecture and Textbook Notes PDF

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Warning: TT: undefined function: 32 The Financial System and how the Discount Rate is set What is Finance about? Finance studies – how people optimally allocate limited resources over time, subject to some constraintsWhen we make financial decisions: Costs and benefits spread over time Costs and ben...

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ECO2049: Financial Economics 1

Umberto Garfagnini

The Financial System and how the Discount Rate is set What is Finance about? Finance studies – how people optimally allocate limited resources over time, subject to some constraints When we make financial decisions: • Costs and benefits spread over time • Costs and benefits usually not known with certainty o As soon as you start trading assets, the certainty will be lost/¯ o Starting a family, saving for retirement, R&D Discount Rate • Any investment requires a simple trade-off o Give up some consumption today, in exchange for some (uncertain) consumption tomorrow • Why do some people borrow and some lend? o Because of different rates of time preference Rate of time preference – measures the willingness of an individual to sacrifice present for future consumption • The higher it is, the more an individual prefers present consumption Example • Individual 1 à rate of time preference is 10% o To give up £10 worth of consumption (without compensation [woc]) today, need to promise £11 woc tomorrow • Individual 2 à rate of time preference is 30% o To give up £10 woc today, need to promise £13 woc tomorrow • The higher the rate of time preference, the higher the return that has to be promised • Indifference curve is convex – rate of time preference is the slope of the curve • Points A, B bring the same utility o The amount that you are giving today and the amount you are using tomorrow compensate • As we move to the left along the IC, future consumption has to " at an " rate to compensate for the loss of current consumption • The slope of the IC measures the marginal rate of time preference Interest rate measures the price required for an individual to transfer resources across time periods • Low interest rates à more people willing to borrow than to lend • High interest rates à more people willing to lend than to borrow • Central banks slashed the cos of borrowing during the financial crisis – wanted people to borrow after the crisis so that they can make investments (help get the economy back on track) • What determines the interest rate? o Ultimately supply and demand • Assumptions: Two periods, no inflation, no risk Equilibrium Real interest rate (r) • Rate of interest will keep changing until whatever is demanded in terms of consumption today is compensated • -(1+r) – budget line Real interest rate (r) determination • Start with individual people/banks/govts o These entities will have different preferences for shifting consumption across time o This is the price I am willing to charge to allow someone to shift their consumption o Interest rates are the cost to borrow today and to sell tomorrow

©Shankary Ravichelvam 2018

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ECO2049: Financial Economics 1

Umberto Garfagnini

Optimal for A is A1 where his/her marginal rate of time preference = the interest rate o Where the IC is tangent to the budget line BL • If interest is high then more people would like to lend à puts downward pressure on the interest rate o BL line is steep • If the interest rate is low then more people would like to borrow à the interest rate " o BL line is flat • The equilibrium real interest rate equates the supply of funds for lending with the demanded finds for borrowing Why do we care so much about interest rates? • Cost of borrowing/investing • Stock prices • Exchange rates o US Federal Reserve meeting minutes – revealed there was a lot of support for interest rates to be " in the future • Opportunity cost of holding certain commodities o Interest rates affect the value of bonds The Case of Gold • Considered safe-haven asset • Yields no interest o Higher interest rates " opportunity cost of holding gold o Holding an asset that has intrinsic value but you get no cash flow or interest of any kind à if transferred into bonds then you will make money of it o Higher interest rates " opportunity cost of holding gold • Priced in US dollars o Strong US dollar makes gold expensive in other currencies o From when Trump got elected, US dollar value has been ¯ and price of gold " The expected inflation rate Inflation – the price of a good tomorrow is different from the price of the same good today • Skyrocketing inflation means that your money is practically worthless • If I lend money today, I will have to wait until repayment (tomorrow) to purchase a good whose price may have changed • If tomorrow the price of the same good is higher, it will cost me more to buy the same amount I could have bought yesterday à I need to compensated for lending Example • Suppose the real interest rate is r (annual) • Suppose that I borrow £1 • In a year, the lender will demand: 𝐸 [𝑃𝑟𝑖𝑐𝑒%𝑙𝑒𝑣𝑒𝑙%𝑃𝑒𝑟𝑖𝑜𝑑%2 ] 𝐿𝑜𝑎𝑛%𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = £1 ∙ ( 1 + r) ∙ = (1 + 𝑟) 𝑃𝑟𝑖𝑐𝑒%𝑙𝑒𝑣𝑒𝑙%𝑃𝑒𝑟𝑖𝑜𝑑%1 •

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> [?@ABC%DCECD%?C@AFG %H]

Let p = expected inflation rate = −1 ?@ABC %DCECD%?C@AFG %I o Inflation is simply the expected chance in the price level Let r = nominal interest rate Fisher equation for the nominal interest rate: 1+r = (1+r)(1+p) = 1+r+p+rp » 1+r+p Then, r»r+ p We don’t want inflation to be 0% because it gives you some leeway, the more you can manoeuvre interest rates

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ECO2049: Financial Economics 1

Umberto Garfagnini

Japan – central bank had to keep slashing interest rates all the way to 0%, effectively the real interest rate is negative • China – requirement that less people hold cash/assets in their pockets à banks able to lend more • Why do central banks set positive inflation targets? o Main reason is related to the Phillips curve The yield curve and expected liquidity premium • Most lenders prefer to lend for short periods – short term securities are more liquid • Most borrowers prefer to borrow for longer periods – less rollover risk • Yield curve – plot of the “term structure of interest rates” • l – liquidity premium o Intuitively it’s going to " over time • r=r+ p + l The yield curve and expected risk premium Specific/Idiosyncratic risk – risk of default of borrower • Specific risk is not priced in efficient markets – diversification Market risk (s) – risk generated by dependence of earnings on market/economic conditions • It cannot be eliminated through diversification •

The Financial System • Participants • Securities • Markets • Trading Arrangements • Regulations Participants • End-users o Households – primary lenders (from a micro perspective) o Firms – ultimate borrowers • Financial Intermediaries o Generalist o Specialist • Market-makers Households Households maximise the expected utility derived from their current and future consumption • Financial Assets are a way to “smooth” consumption over time, taking into account: o Uncertainty about the future – risk aversion o Preference for liquidity • Households want to lend their surplus funds with a short horizon Firms Firms maximise the sum of their current and future profits, i.e. maximise their long-term value • Replacement investment – to replace obsolete equipment • Net investment – to expand its level of activity • Net + Replacement = Gross investment • How do firms finance necessary investment? o Retained earnings o Bank loans

©Shankary Ravichelvam 2018

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ECO2049: Financial Economics 1

Umberto Garfagnini

New equity Bond Issuing Cash & Equivalence – money lying in banks across the country à can be seen on balance sheets of Apple and Google • Firms want to finance projects with a long horizon o Lenders willing to lend for short periods of time and borrowers who want to borrow for long periods of time – there is a mismatch So, where is the problem? • Well, there is a mismatch between the maturity for lending preferred by households, and the maturity for borrowing preferred by firms • What about the price mechanism? Why doesn’t it solve the problem? o Short rates could ¯ o Long rates could " • The catch: o At low short rates, households would not save much o At high long rates, firms would not invest much • Hence, there is a role for financial intermediaries – they are agents between households and firms Asset Transformation • Read diagram to the right from bottom to top Functions of FIs 1. Maturity Transformation • Holding less liquid (long-term) assets à issue more liquid (short-term) liabilities 2. Transaction costs transformation • Lower search costs • Economies of scale • Provision of standardised forms of securities • Closes the gap between interest rates of households and interest rate the govt uses* 3. Risk transformation • Risky liabilities issued by the borrowers à safe assets for primary lenders • What does risky mean? o Default/credit risk – inability of borrower to repay loan and/or interest o Equity risk – failure of the investment made with loan • Risk spreading, relative to default risk o Spreading a risky investment across a large number of lenders o Big projects spread across several different banks, so they can form a syndicate to finance different investments o Diversification • Risk pooling, relative to equity risk o Constructing portfolios of assets that exploit any offsetting risks between asset returns (diversification) Types of Financial Intermediaries Bank FIs (BFIs) • Retail banks o Deal with households, small businesses o They issue deposits and make loans • Investment banks o Deal with institutional investors, large corporations, govts, etc. o What they do: § Corporate finance – corporate loans, bond issues, initial floatation, M&As, etc.) § Asset management – private banking = managing long-term equity and bond portfolios for private and institutional clients o o o

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ECO2049: Financial Economics 1 § § § §

Umberto Garfagnini

Agency brokerage & market-making Proprietary trading – trading activity on bank’s own account to make profits Equity banking – bank makes a direct investment in a company International investment advice

Non-BFIs • Finance houses – finance short-term durable expenditure of members of the household sector o Hire purchase agreements – type of leasing agreement where the buyer pays a monthly rate to use the good and becomes the owner of the good at the end of the period • Building societies – finance long-term durable expenditure of members of the household sector o Mortgages • Pension funds • Insurance companies • Collective Investment Schemes – investment trusts, unit trusts, open-end investment companies (OEIC) o Large and complex portfolios of financial assets o Value of portfolio divided in units (unit trusts)/shares (investment trusts/OEIC) •

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Specialist FIs o Arbitrageurs – perform fundamental analysis and check for deviations from fair price § Before, FI had traders (computed discrepancies across prices of different assets) § Fewer mismatches because of computer trading § Arbitrageurs try to look for deviations in current prices and then make transactions that exploit these transactions in order to make profits § Lot of short selling of assets will push the prices down § At some point, you have to cover all the short-term decisions with a long-term decision o Hedgers – using futures, options (derivatives securities) they minimise the risk of their positions § Share prices falling § Debt obligations’ interest going up § Adverse forex movements § If you are outside the UK, pay in another currency and you’ll be worried about the volatility of currency exchange rates – hedging using financial instruments o Speculators – take views on prices § Make money from exploiting ups and downs in market – traders Market-makers – do not act as agents between end-users but they buy and sell securities for their own account o Always going to be willing to buy and sell assets o Make money by constantly buying and selling assets

Soros vs. The Bank of England • September 1992 – George Soros, chairman of the Quantum group of funds, and his clients cleared a cool $1.5bn in just one month as a result of the upheaval in Europe’s markets • They bet that the pound and the other weaker European currencies were overpriced against the deutsche mark o They bet that the politicians and the central banks could not maintain artificially high exchange rates in the interests of European unity much longer • Soros and the others who won big when the market overwhelmed the banks were mostly involved in one variation or another on a basic technique – go short on the weakest currencies • Central banks decided to fix exchange rates o Would ideally like to fix the state of the economy as well, but not all economies are strong so this is difficult § Stronger economies – more buying of currency o Soro make a bet that there was a huge amount of difference in these exchange rates

©Shankary Ravichelvam 2018

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ECO2049: Financial Economics 1 o o

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Umberto Garfagnini

Started putting pressure on the weakest currency – put pressure on central banks on controlling the currency because they ran out in their reserves This similar situation happened in Asia as well – late 90s*

Participants Securities Markets Trading Arrangements Regulations

Securities • A claim to some underlying asset – financial or physical o Stocks are just claims on assets • Issuer o Domestic, foreign govts: govt bonds = gilts o Domestic, foreign corporations: corporate bonds, stock • Currency of denomination o Domestic bonds (£ denominated, issued in the UK) o Bulldog bonds (£ denominated, issued by a foreign issuer) o Eurobonds (traded in the UK, but denominated in currencies other than £) • Ownership and participation rights (both profit + decision making) o Common stock – ownership and participation o Preference stock – just ownership o Debt – none • Collateral o Debentures – debt instrument for medium/long-term borrowing, secured against specific assets of the firm (UK) o Unsecured o Sometimes results in houses being repossessed (when house is used as collateral) • Maturity o Short-term (< 1yr), long-term § Assets grow with maturity § Callable – we agreed on 10yrs for repaying loan but then the lenders says ‘I need my money back now’ o Callables, puttables – redeemable at the option of the issuer/holder o Perpetuities – current and deposit accounts, perpetual bonds, preference shares, equity • Income payments o Fixed variable o Monthly, quarterly (certain deposit accounts), semi-annual (govt and local authority bonds), annually (Eurobonds, certificates of deposit), etc. § Money market securities do not pay any interest o No explicit payments: sell at discount to their face value (Treasury bills, zero-coupon bonds, etc.) • Predictability of capital value o Deposits (value of principal = certain), bonds (at maturity, capital value = certain), shares (capital value is never certain) • Degree of liquidity and degree of reversibility o Liquidity – time and/or cost of converting a security into cash o Reversibility – possibility to move cash-asset-cash, without high costs (bid-offer spread) o This is a characteristic of securities – liquidity makes it easier to buy and sell assets • Tax treatment o Income from securities (dividends, interests…) subject to income/corporation tax o Capital gains tax o If you decide to buy gold in bars and then sell it, you have to pay capital gains tax

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ECO2049: Financial Economics 1

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Umberto Garfagnini

o But if you buy coins and then sell, you don’t pay any VAT or capital income tax Are they derivatives? o Derivative – delivers a security (underlying asset) at some future time o Financial futures, options, etc. Do they involve composite securities? o Composite security – mixture of 2 or more securities o Convertible bonds, swaps etc.

• Participants • Securities • Markets • Trading Arrangements • Regulations Markets Markets – a system/place through which securities are created and transferred (meet to exchange assets) • Maturity of securities o Money markets ( 1 year, interest paid annually Can be traded so more liquid than MMDs o They are traded – you end up with a liquidity cash, you can go to the market and sell the security and liquidate your position o Won’t necessarily make money but still a value

CDs: Fair value; Yield • If you hold them until maturity they are exactly like money market securities o But if you need the money through t, you can sell it, how do we compute the price we sell it at? • What you don’t know is the IR prevailing today: o Price will be future value of security, discounted back to settlement day and rate of securities with same risk class and maturity o d = r at issue

Where: • F = maturity value • r = current yield • Nsm = # of days between settlement and maturity • M = face value • d = coupon rate (annualised) • Nim = # of days between issue and maturity • Nis = # of days between issue and settlement • •

d is not necessarily equal to r because CDs are traded and their prices are not fixed (except at time of issue) With CDs you can sell them – so if you end up with a liquidity shock, d is likely to be different to r

Example – what is the effect of an " in money market interest rates? M = £1,000,000 d = 8% r = 9% à IR has gone up by 1%, you sold it just after 30 days Nim = 91 Nsm = 61

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Makes sense that it’s above a million because IR have " o As you get closer to maturity, discounting is over small amount of time so prices converge to what security pay o Would you buy a security that gives you 8% if prevailing IR is 9% - no

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ECO2049: Financial Economics 1

Umberto Garfagnini

Inverse relationship between IR and prices, so securities issued now for 9 months should cost less than this security Consider an investor’s actions at the end of the first month. MM interest rates have gone up to 9%. The investor can purchase a 2-month CD hat yields 9% or buy the CD with the 8% coupon payment as long as she purchases it at a lower price, so that it yields 9% o

Accrued interest = M x d x (Nis / 365) • How much security has already generated, you will buy what the security has generated and what it will generate Principal = P – accrued interest • Effective price at which you’re selling the security = different between current price and interest accrued • Net of what security has generated so far • CLEAN PRICE Using example: Accrued interest = £1,000,000 x 0.08 x (30/365) = £6,575.34 Principal = £1,004,831.44 - £6,575.34 = £998,256.10 • If you net out what piggybank contains, you are effectively selling it for less than you paid for it initially o This is right because you can’t charge £1mil plus interest as this is more than what you’d pay if you bought a new security for the same length of time and risk class o So " in IR has depressed price of security o IR change intrinsic value of the security CDs: Holding period yield

• Need to work out return if you buy after issue but sell before maturity Let • Npm = # of days between purchase and maturity • Nsm = # of days between sale and maturity • Rp = yield at purchase • Rs = yield at sale If you keep the CD until maturity, then Nsm = 0 and rh = rp Otherwise, let: • P0 = price paid at purchase • P1 = sale price • rp = yield at purchase • rs = yield at sale • rh = holding period yield

Want to transform this into an annualised rate

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ECO2049: Financial Economics 1

Umberto Garfagnini

III. Quoted on a discount basis Ø Return fixed amount at end, so now need to play with price you pay for them in order to work out your return o IR is front loaded • • •

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Treasury Bills o Issued by the govt: 3, 6 months Bills of exchange o Similar to TBs but issued by companies against the sale of goods Banker’s acceptances o Written promise by a borrower to a bank to ...