Financial Markets and Institutions PDF

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Warning: TT: undefined function: 32FINANCIAL MARKETSANDINSTITUTIONSTable of Contents Overview of the Financial System Interest Rates and Valuation The Determinants of Interest Rates The Money Market The Bond Market The Stock Market Valuation of a Stock Derivatives: Futures and Forwards Derivatives: ...

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FINANCIAL MARKETS AND INSTITUTIONS

Table of Contents Overview of the Financial System ................................................................................................ 3 Interest Rates and Valuation ....................................................................................................... 5 The Determinants of Interest Rates ............................................................................................. 8 The Money Market .................................................................................................................... 10 The Bond Market ...................................................................................................................... 12 The Stock Market ...................................................................................................................... 15 Valuation of a Stock .................................................................................................................. 17 Derivatives: Futures and Forwards ............................................................................................ 18 Derivatives: Options .................................................................................................................. 21 Why do Financial Institutions exist? .......................................................................................... 24 Commercial Banking ................................................................................................................. 25 Central Bank and Monetary Policy ............................................................................................ 28 Mutual Funds ............................................................................................................................ 29 Investment Banks ...................................................................................................................... 31 Risk Management ..................................................................................................................... 32 Financial Regulations ................................................................................................................ 34 The Theory of Financial Crises ................................................................................................... 35

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Overview of the Financial System In finance we have two type of people: •

Borrowers: people who “need” money for a project/productive use

•

Lenders: people who have money but no productive use

Lenders give money to borrowers and will have it back in the future with interests. Lenders therefore buy borrowers a financial asset with a promise to future payments (future profits for stocks, interest for debt)

What is an asset? An asset is something that has a value. It can be divided in real asset or financial asset. A real asset is an entity producing flow of goods and services such as lands, factories, machineries, workers, people etc. that are called tangible assets and ideas, patents etc. which are called intangible assets. A financial asset is a contract to future payments such as: 1. Stocks (% of future profits) 2. Debt/Bonds (fixed future payment) 3. Derivatives (financial assets based on other financial assets) 4. Cash/Currencies (issued by central banks) 5. Bank account/Deposits 6. Insurance contracts

Financial market players

$ LENDERS

$ BORROWERS

REAL ECONOMY

FINANCIAL

REAL

ASSET

GOODS

Operations between lenders and borrowers can be: •

Direct: they exchange directly (financial markets)

•

Indirect: they exchange via financial intermediaries such as banks, insurance companies, mutual funds or investment banks

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Structure of Financial Markets 1. Type of security (debt, equity, derivatives, …) 2. Issuance market 3. Maturity Bonds are issued by companies and governments and give interest rates. Equities are an ownership claim in the firm. It can pay dividends. Derivatives are financial instruments that depend on other assets. Issuance markets can be: •

Primary markets: new securities are sold to initial buyers

•

Secondary markets: securities previously issued are bought and sold

Maturity can be: •

Money market: short-term (1 year)

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Interest Rates and Valuation Face value = promise that will be paid at maturity Price = price of the bond we pay today Interest Rate The lower is the price, the higher is the interest rate

Present Value Present Value: express in today’s money future money

Present Value

Interest rate (or yield to maturity) is NOT the rate of return!

Coupon Bonds Coupon bond: bond that makes a fixed payment (coupon) at specific dates plus a final amount (face or par value) at maturity. The coupon is expressed as a % of the face value.

Price of a coupon bond

If P=FV à Par Bond If PFV à Bond at premium If n à ∞ we call it perpetuity (or consol)

Price of a perpetuity

Current yield

Coupon yield 5

Zero-Coupon Bond Zero-Coupon bond (discount bond): bond that doesn’t give any coupon but only the face value at maturity Yield to Maturity for 1-year zero-coupon bond Usually the zero-coupon bond is lower than the face value Price and YTM of a zero-coupon bond

Interest rate ≠ Rate of Return

Interest Rate Risk (IRR) For long-term bonds, prices are very volatile. For the same D i, D P is more negative for long-term bonds. This risk of losing money is called interest rate risk. If you hold the bond to maturity, there’s no IRR because i=return.

Duration It’s the weighted average of the maturities of the cash payments. It’s like an effective maturity. The longer the duration, the bigger the Interest Rate Risk Duration For zero-coupon bonds: Duration = Maturity For coupon bonds: Duration < Maturity Duration will increase if: •

Maturity increases

•

CP=C/FV (coupon rate) decreases

•

Interest rate decreases

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With the duration we can approximate the price change:

% price change We can then say that the greater the duration, the greater its IRR Duration of a portfolio: weighted average of the durations of the securities in proportions of their market values on the portfolio.

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The Determinants of Interest Rates Which are the determinants of an Asset Demand? 1. Wealth: total resources owned by the individual 2. Expected Return: relatively to other assets 3. Risk: relatively to other assets 4. Liquidity: the ease and speed you can turn the asset into cash

Wealth It has a positive effect on demand. Increase in wealth à increase in demand Expected Return It is the average return across all states of nature

Expected Return It is additive such that:

Expected Return of a portfolio

An increase in expected return increases the demand for an asset. However, high expected return means high risk.

Risk We measure risk with the standard deviation of an asset return Standard Deviation (Risk) Risk-averse: person that doesn’t like risk Risk-lover: person that likes risk Usually people are risk averse so increase in risk à decrease in demand

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Liquidity Ease and speed with which an asset is turned into cash. Increase in liquidity à increase in demand Supply & Demand in the Bond Market Determination of interest rates happen through demand and supply. Remarking that:

As price lowers, i is higher and therefore there is more demand (downward sloping).

Demand and Supply

If the expected return is lower, and so price is higher, the supply will be higher because issuers have less costs (upward sloping). Market equilibrium: when demand and supply are equal Shifts in demand occur when these factors change: 1. Wealth + 2. Expected future interest rate – 3. Riskiness – 4. Expected future inflation – 5. Liquidity + Shifts in supply occur when these factors change: 1. Probability of investments (productivity) + 2. Expected future inflation + 3. Government deficit +

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The Money Market Money markets are financial assets that look like cash à High liquidity. Money markets have 3 key characteristics: 1. Usually sold in large denomination 2. Low default risk 3. Original maturity of 1Y or less Which are the purposes? -

For lenders/buyers: warehouse surplus funds for short period of time

-

For borrowers/sellers: low-cost source of temporary funds

We find many Money Markets instruments: -

T-bills

-

Federal Funds

-

Repurchase agreements

-

Negotiable certificates of deposits

-

Commercial paper

-

Eurodollars

Treasury Bills Borrowed by US Government to basically everyone. It has 4 types of maturities: 1M, 3M, 6M, 12M. T-bills are auctioned to primary dealers. In a competitive bid, dealers put in quantity and prices. The bids are accepted in ascending order of yields until offering amount is reached. T-bills will be sold at the highest yield (lower price). In noncompetitive bids, bidders only provide amount, not price. All offers are accepted, paying the price determined by the competitive bid. The dealers will then sell T-bills to the public (secondary market)

Federal Funds Short-term funds loaned or borrowed between financial institutions, usually overnight. Central Bank “controls” the Fed funds market, deciding the “target FedFunds rate”. It is a “target” because the effective rate is determined by demand and supply, but it moves around.

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Repurchase Agreements (Repo) It is an agreement where a financial instrument is sold and bought back at a later date. Example: borrower sells T-bills for X to the lender and agrees to buy them back at a future date for Y>X. !"# #

is called the repo-rate and it is like a discount rate. $"#

If P is the market price for T-bills,

#

is the haircut

Certificates of Deposits It is a bank issued deposit that specifies the interest rate and the maturity date. It is a term deposit, meaning that you cannot withdraw before maturity. They are negotiated in very large volumes.

Commercial Papers Unsecured promissory notes issued by corporations with maturity 1Y maturity. Bond market + Stock market = Capital Market Primary issuers are: -

Government (debt only)

-

Corporations (equity and debt)

Largest buyers: households (through banks etc.) We will be looking at: 1. Government bonds (Treasuries) 2. Municipal bonds (issued by US states/cities) 3. Agency bonds (issued by quasi-public entities) 4. Corporate bonds

Government Bonds We have three types: 1. T-bills (Maturity 10Y) Us government bonds are considered risk-free assets. T-bills even more because it has a short maturity. Not all government bonds are risk-free (Greece, Italy etc.) and there is still inflation risk

Municipal Bonds Bonds issued by local, county and state governments. There are 2 types: 1. Revenue bonds: backed by the cash flow of a particular project 2. General obligation bonds: do not have a project. Backed by “full faith and credit of the government” Municipal bonds are tax-free! Muni rate = other bond * (1 – marginal tax rate)

Agency Bonds Bonds issued by US government-sponsored enterprises (GSE). GSEs are private companies that can issue “government securities” – agency bonds. Then they buy mortgages from banks and sell insurance. GSEs acted with implicit guarantee that US government would not let them default (explicit after 2008) 12

Corporate Bonds Bonds issued by (largest) corporations, They have a higher default risk than government bonds, but a lot of firm heterogeneity. Risk is assessed by credit-rating agencies like Moody’s, S&P, Fitch etc. Ratings can be of two type: 1. Investment Grade (from AAA (low risk) to BBB (high risk) 2. High Yield/ Junk/ Speculative (from BB to C, D) Bonds have a bond indenture, which is a contract stating lender’s rights and borrower’s obligations. For example: 1. Restrictive covenants: a bond where lenders/holders can place a limit on company’s actions. It is more restrictive à more safe à lower i 2. Call provisions: a bond that can be called back by the issuer at pre-specified prices (say FV). It has a higher I since lender has less rights. When i decreases, company buys back and re issue at a lower rate. 3. Convertible bonds: bond that can be transformed int equity by lender. i will be lower since lender has more rights

Seniority It is the order in which vendors get paid back in bankruptcy. At the lowest level there are the stockholders. Above them there are bondholders that can be junior or senior holders. Senior get paid first. And between senior bondholders we have senior secured (paid first) and senior unsecured. Above bondholders we then have: bank loans, suppliers/workers and above all we have government. As we go up in the pyramid, yield decreases. Government

Suppliers/workers

Bank loans

Bond senior secured

Bond senior unsecured

Bond junior

Stockholders

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Semi-Annual Bonds Bonds that pay a semi-annual coupon Price of a semi-annual coupon bond Where C and i are annual, and n is the number of years to maturity They make a difference because of compounding Ex.

$1000 with annual 10% becomes: 1000 * 1,1 = $1100 $1000 with semi-annual 5% becomes: 1000 * 1,05 * 1,05 = $1102,50

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The Stock Market The stock market is the other capital market together with the bond market. It receives a lot of attention because the gains are potentially infinite.

Equity/Stock/Share A share represents ownership in a firm. Ownership entitles the stockholder to say something on firm’s actions (vote) and a share of profits (dividends). They also earn if stock price increases. It is much riskier than bonds because neither dividends nor price rises are guaranteed. There is no maturity. Debt is senior to equity (i.e. it gets paid first in case of default) Stocks can be: -

Common (right to vote)

-

Preferred: o Fixed dividend o Price is stable o No voting rights o Higher seniority than common

Stocks vs Bonds Stocks and bonds have a balanced trade-off of control rights and cash-flows: 1. Stocks: high control rights and uncertain cash flow 2. Bonds: low control rights and certain cash flow Equity funding is more costly than debt funding since it’s not tax deductible

Shares terminology Authorized shares: maximum number of shares the company can issue during its lifetime. Decided at the time the firm files the registration statement. It can be changed with shareholders’ vote Outstanding shares: nº of shares issued by a company Restricted shares: cannot be bought or sold by the public, usually given to employees, type of stocks for non-listed companies Float shares: freely bought and sold without restrictions Market Capitalization = price per share * outstanding shares

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Primary Market New securities issues are sold to initial buyers. It is done by Investment Banking that arranges the sale of securities. We never hear about primary market except for famous IPOs

Secondary Market Securities previously issued are bought and sold. It can be an organized exchange (like NYSE) that makes profit with trading fees, or non-organized: over-the-counter market

Organized Exchanges It is organized since there is a specific trading location it basically works like an auction market. Floor traders/brokers go to exchange, trading with other brokers through a specialist (market maker). Market orders: executed immediately at market price Limit orders: buy or sell at a specific price

Over-the-counter Markets (OTC) No trade floor, all electronic. Low listing requirements. Dealers have an inventory of stocks and are ready to buy at bid and sell at the ask, earning bid-ask spread and commission fees.

Indexes Used to monitor the behavior of a group of stocks. They are averages of stocks composing the index. Underlying stocks’ basket changes over time. Price weighted index

Dow jones has also some adjustments: DJIA formula S&P500 is a value weighted index: S&P500 formula It is weighted over a base year: if index=2929 it means that is 2929 times higher than base year

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Valuation of a Stock Stock price follows the valuation of debt prices: 1. Determine the cash flow 2. Discount them to present 3. Price them at their PV However, this is all theory since the factors that compose stocks’ cash flows are not certain. We can simplify the price valuation by computing next years expected price and dividend: Price of a Stock (1 Year valuation) Where: -

Po is the price today

-

P1 is the price next year

-

Div1 is the expected dividend next year

-

Ke is the required return on equity (like YTM but higher)

Using the same logic, extended to n periods:

As n grows, last item in the sum gets smaller and so: The Generalized Dividend Valuation Model We assume that dividend grows at a constant rate g so that Divt+1 = (1+g)*Divt And we finally conclude: The Gordon Growth Model With Ke > g always. Div1 can be interpreted as any cash flow stockholders are entitled to.

Price Earnings Valuation Measure of how much the market is willing to pay for $1.00 of earnings

With P/E that is the price earnings and E are expected earnings per share A high PE has two interpretations: E is going to rise in future compared to lower PE companies and company has lower risk. 17

Derivatives: Futures and Forwards Derivatives are a financial instrument designed to manage risk (hedging). They are financial contracts whose price and cash flows are determined by other, underlying items. Derivatives hedge risk for the market as a whole but can also concentrate risk in hands of a few that if linked to everyone, a small problem can lead to a collapse of the system. Even if there are many derivatives, we will be looking at: 1. Forwards 2. Futures 3. Options But before, we should look first at how hedging works.

Hedging Hedging involves engaging in a financial transaction that reduces or eliminates risk. The idea is to enter another financial contract with a risk that is opposite with the original risk. We define two notions for the “sides” of the risk: 1. Long position: you profit if the price goes up 2. Short position: you profit if the price goes down Being long means that you run the risk that price goes down. Being short means that you run the risk that price goes up. You hedge a long position by entering a short position and vice versa

Forwards A forward is an agreement to enter a transaction at some future date. It is not standardized but it should specify: 1. Item delivered 2. How much 3. At what price 4. Date It eliminates uncertainty about future price but there is always a winner and a loser (zero-sum game).

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Profits: -

Selling a forward (short)

Where F is the price agreed and St is the spot market price at maturity

-

Buying a forward (long)

Forwards happen both on real assets and financial assets Example: A bank agrees to deliver $5 mln in face value of 6% coupon T-bills maturing in 2032. An insurance company agrees to pay $5 ml...