FNCE102 Financial Instruments, Institutions and Markets PDF

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29 April Study Financial Markets Institutions Markets and institutions are primary channels to allocate capital in our Proper capital allocation leads to growth in: Societal wealth Income Economic Provides a detailed overview and analysis of the financial system in which financial managers and indiv...

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1- Introduction Wednesday, 29 April 2015

19:30

Why Study Financial Markets & Institutions (FIs)? - Markets and institutions are primary channels to allocate capital in our society ○ Proper capital allocation leads to growth in: Societal wealth | Income | Economic opportunity - Provides a detailed overview and analysis of the financial system in which financial managers and individual investors operate ○ Investment and financing decisions requires understanding of the flow of funds in the economy as well as the operation and structure of domestic and international financial markets ○ Analyse risks faced by investors and savers and strategize ways to control and manage them ▪ Newer areas of operations such as asset securitization, derivative securities, and internationalization of financial services ○ Know impact of financial crisis on the various financial markets and the FIs that operate in them - Provides an overview of the structure and operations of various financial markets and FIs ○ Financial markets are differentiated by the characteristics maturity of the financial instruments that are exchanged ▪ Each financial market, in turn, depends in part or in whole on FIs □ FIs often provide the least costly and most efficient way to channel funds to and from financial markets Financial Markets: structures through which funds flow - Primary Markets vs Secondary Markets

○ Primary markets: markets in which corporations raise funds through new issues of securities ▪ Firms issue securities in external primary markets to raise funds as internally generated funds retained earnings are insufficient for new projects or expanded production needs ▪ Most primary market transactions are arranged through FIs called investment banks □ Provides securities issuer with advice on the issue offer price, number to issue and attracts initial public buyers for the issuer □ Issuer saves the risk and cost of creating a market for its securities on its own ▪ Primary market sale can take the form of a private placement □ Securities issuer seeks an institutional buyer pension fund or group of buyers to buy the whole issue □ Privately placed securities are among the most illiquid securities, with only the largest FI or institutional investors being able or willing to buy and hold them ▪ Primary market financial instruments include issues of equity by firms initially going public allowing their equity to be publicly traded on stock markets for the first time □ Initial public offerings (IPOs): first public issue of financial instruments by a firm □ Seasoned equity offering (SEO): issue of additional equity or debt instruments of an already publicly traded firm ▪ How were primary markets affected by the financial crisis? □ Primary market issuance declined sharply during the crisis although with low interest rates bond issuance boomed after marketuncertainty declined in 2010 □ Stock issuance remained weaker longer, recovering in 2012 and 2013 ○ Secondary markets: market that trades financial instruments (rebought and resold) once they are issued NYSE, NASDAQ ▪ Buyers of secondary market securities are economic agents consumers, businesses, governments with excess funds □ Sellers are economic agents in need of funds ▪ Provide a centralized marketplace where economic agents can transact quickly and efficiently □ Save them the search and other costs of seeking buyers or sellers on their own □ Usually with the securities broker acting as an intermediary  Original issuer of the instrument is not involved in this transfer ▪ Secondary markets also exist for financial instruments backed by mortgages and other assets, foreign exchange, and futures and options (derivative securities) □ Derivative security: financial security whose payoffs are linked to other, previously issued securities or commodities ▪ Benefits □ For investors, secondary markets provide the opportunity to trade securities at market values quickly as well as to buy securities with varying risk-return characteristics □ Issuer obtains information about the current market value of the financial instruments (value of the corporation perceived by investors) by tracking theprices  Allows issuers to evaluate how well they are using the funds generated from the financial instruments they have already issue d  Provides information on how well any subsequent offerings of debt or equity might do in terms of raising additional money (an d at what cost) □ Offer buyers and sellers liquidity as well as information about the prices or the value of their investments  Increased liquidity makes it more desirable and easier for the issuing firm to sell a security initially in the primary marke t  Allows investors to trade at low transaction costs - Money Markets vs Capital Markets

○ Money Markets (MM): markets that trade debt securities or instruments with maturities of ≤ 1 year CDs, T-bills ▪ Economic agents with short-term excess supplies of funds can lend (buy MM instruments) to those who have short-term needs or shortages of funds (sell MM instruments) □ Short-term nature means that fluctuations in their prices in the secondary markets in which they trade are usually quite small ▪ Over-the-counter (OTC) markets: markets that do not operate in a specific fixed location (transactions occur via telephones, wire tran sfers, and computer trading) ▪ Money Market Instruments

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Treasury Bills: short-term obligations issued by the government Federal Funds: short-term funds transferred between FIs usually for no more than one day Repurchase Agreements: agreements involving sale of securities with a promise by seller to repurchase the securities from the buyer at a specifieddate and price Commercial Paper: short-term unsecured promissory notes issued by a company to raise short-term cash  Alternative to a bank loan and may provide a cheaper source of financing for large well-known companies □ Negotiable Certificates of Deposit: bank-issued time deposit that specifies an interest rate and maturity date and is negotiable (can be sold by the holder to another party)

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□ Banker’s Acceptance: time draft payable to a seller of goods, with payment guaranteed by a bank ○ Capital markets: markets that trade debt (bonds) and equity (stocks) instruments with maturities of > 1 year ▪ Substantial risk of capital loss, but higher promised return ▪ Major suppliers of capital market securities are corporations and governments □ Households are the major suppliers of funds for these securities ▪ Given their longer maturity, these instruments experience wider price fluctuations in the secondary markets in which they trade than do MM instruments □ All else constant, long term maturity debt instruments experience wider price fluctuations for a given change in interest rates than short-term maturity debt instruments ▪ Capital Market Instruments

□ Corporate stock: fundamental ownership claim in a public corporation □ Mortgages: loans to individuals or businesses to purchase a home, land, or other real property  Securitized mortgages: mortgages that FIs have packaged together and sold as bonds backed by mortgage cash flows interest and principal repayments □ Corporate bonds: long-term bonds issued by corporations □ Treasury bonds: long-term bonds issued by the government Treasury □ State and local government bonds: long-term bonds issued by state and local governments □ Government agencies: long-term bonds collateralized by a pool of assets and issued by agencies of the government □ Bank and consumer loans: loans to commercial banks and individuals - Foreign Exchange (FX) Markets: markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted ○ Cash flows from asset sales denominated in foreign currencies expose firms and investors to FX risk ▪ FX risk: sensitivity of the value of cash flows on foreign investments to changes in the foreign currency’s price in terms of dollars □ There are techniques for managing such risk derivative securities such as FX futures, options, and swaps ▪ Actual amount of dollars received on a foreign investment depends on exchange rate between the currencies when the cash flow is converted □ If a foreign currency depreciates (declines in value) relative to the dollar over the investment period, the dollar value of cash flows received will fall □ If the foreign currency appreciates (rises in value) relative to the dollar, the dollar value of cash flows received on the foreign investment will increase ○ Foreign currency ER are flexible (vary daily with demand and supply for dollars) but central governments may intervene in FX markets directly or ER indirectly by altering interest rates ○ Spot FX: immediate (delivery within one or two business days) exchange of currencies at current exchange rates ○ Forward FX: exchange of currencies in the future on a specific date and at a pre-specified exchange rate ○ Arbitrages ▪ Carry trade: strategy in which an investor borrows money at a low interest rate to invest in an asset that is likely to provide a higher return □ Very common in the FX market - Derivative Security Markets: markets in which derivative securities trade ○ Derivative securities usually involve an agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price at a specified date in future ▪ As the value of the underlying security to be exchanged changes, the value of the derivative security changes ▪ Potentially the riskiest of the financial securities ○ Main purpose of the derivatives markets is to transfer risk between market participants ○ Derivative Contracts Held by Commercial Banks, by Contract Product (in billions of dollars)

▪ Exchange listed derivatives: Many options, futures contracts □ Exchange listed are more regulated, more transparent, and generally involve no default risk for the counterparty ▪ OTC derivatives: Forward contracts | Forward rate agreements | Swaps | Securitized loans □ OTC derivatives are nonstandard, largely unregulated and may involve substantial counterparty credit risk □ Forward rate agreements are prearranged loan contracts with the loan terms set now, drawdowns in the future ○ Can be used to stabilize stocks - Financial Market Regulation ○ Financial instruments are subject to regulations imposed by regulatory agencies Securities and Exchange Commission (SEC) ▪ Main emphasis of SEC regulations is on full and fair disclosure of information on securities issues to actual and potential investors Securities Act of 1933 □ Firms planning to issue new public securities must register their securities with the SEC and to fully describe the issue, risks associated with the issue, in a prospectus ▪ SEC monitors trading on the major exchanges (along with the exchanges themselves) to prevent insider trading Securities Exchange Act of 1934 ▪ SEC impose regulations on financial markets in an effort to reduce excessive price fluctuations NYSE operates under a series of “circuit breakers” Financial Institutions (FI): Institutions that perform the essential function of channelling funds from fund suppliers to fund users - FIs are distinguished by: 1. If they accept insured deposits (Depository vs Non-depository) ▪ FIs that accept insured deposits must be regulated by the government to offset the government’s liability □ Insured deposits are a low cost source of financing, but the regulatory burden increases these costs significantly 2. If they receive contractual payments from customers ▪ FIs that receive contractual payments life insurers, pension funds, property and casualty insurers have steady premium income to invest □ This allows them to take on more risk in their investment portfolio ○ Depository institutions ▪ Commercial banks: depository institutions whose major assets are loans and whose major liabilities are deposits □ Their loans are broader in range (including consumer, commercial, real estate loans) than those of other depository institutions □ Their liabilities include more non-deposit sources of funds subordinate notes and debentures than those of other depository institutions □ Banks are the nation’s largest intermediary, although their relative importance has declined over time  Securitization has allowed other institutions to participate in traditional bank lending activities, known as “Shadow Banking System” ▪ Thrifts: depository institutions in the form of savings associations, savings banks, and credit unions □ Perform services similar to commercial banks, but they tend to concentrate their loans in one segment real estate loans, consumer loans ○ Non-depository institutions ▪ Contractual □ Insurance companies: FIs that protect individuals and corporations (policyholders) from adverse events □ Pension funds: FIs that offer savings plans through which fund participants accumulate savings during their working years before withdrawing them at retirement years  Funds originally invested in and accumulated in a pension fund are exempt from current taxation ▪ Non-contractual

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□ Securities firms and investment banks: FIs that help firms issue securities and engage in related activities securities brokerage and securities trading □ Finance companies: FIs that make loans to both individuals and businesses  Unlike depository institutions, finance companies do not accept deposits but instead rely on short- and long-term debt for funding □ Mutual funds: FIs that pool financial resources of individuals and companies and invest those resources in diversified portfolios of assets □ Hedge funds: FIs that pool funds from a limited number of wealthy individuals and other investors commercial banks and invest these funds on their behalf  Usually keeps a large proportion (commonly 20%) of any upside return and charging a fee 2% on the amount invested - Direct transfer: corporation sells its stock or debt directly to investors without going through a FI

○ Level of funds flowing between fund suppliers (aim to maximize return on funds subject to risk) and fund users (aim to minimize cost of borrowing subject to risk) is likely to be low 1. Fund suppliers need to keep monitoring fund users to prevent them from stealing or wasting the funds (lowers chances of being repaid and/or earning positive ROI dividends) □ Monitoring is extremely costly as it requires much time, expense, and effort to collect this information relative to the size of the average fund supplier’s investment  Thus, fund suppliers would likely prefer to leave, or delegate, the monitoring of fund borrowers to others ◊ Resulting lack of monitoring increases the risk of directly investing in financial claims 2. Fund suppliers may choose to hold cash for liquidity reasons □ The relatively long-term nature of many financial claims stock, bonds creates disincentive for fund suppliers to hold the direct financial claims issued by fund users 3. Fund suppliers face a price risk upon the sale of securities when trading among themselves □ Price risk: risk that an asset’s sale price will be lower than its purchase price □ Secondary market trading of securities also involves various transaction costs  Price at which investors can sell a security on secondary markets NYSE may differ from the price they initially paid for the security ◊ As investors change their valuation of the security between the time it was bought and when it was sold and/or ◊ As dealers, acting as intermediaries between buyers and sellers, charge transaction costs for completing a trade - Indirect transfer: transfer of funds between suppliers and users of funds through a financial intermediary

- Services of FIs Benefiting Suppliers of Funds ○ Reduce monitoring costs ▪ An important part of these FIs’ functions is their ability and incentive to monitor ultimate fund users ▪ The relatively large size of the FI allows this collection of information to be accomplished at a lower average cost (economies of scale) ▪ Aggregation of funds by fund suppliers in a FI resolves a number of problems 1) The “large” FI has a much greater incentive to hire employees with superior skills and training in monitoring  Expertise can be used to collect information and monitor ultimate fund user’s actions as the FI has more at stake than any sm all individual fund supplier 2) The monitoring by the FI alleviates the “free-rider” problem that exists when small fund suppliers leave it to each other to collect information and monitor ○ Increase liquidity and lower price risk ▪ FIs buy financial claims issued by fund users and finance these purchases by selling financial claims to household investors and other fund suppliers deposits, insurance policies □ Asset transformers: financial claims issued by an FI that are more attractive to investors than are the claims directly issued by corporations ▪ Claims issued by FIs often have liquidity attributes that are superior to those of primary securities ▪ In reducing the liquidity risk of investing funds for fund suppliers, the FI transfers this risk to its own balance sheet □ Offer highly liquid, low price-risk securities to fund suppliers on the liability side of their balance sheets □ Invest in relatively less liquid and higher price-risk securities debt and equity issued by fund users on the asset side ▪ FIs can provide liquidity services and gain fund suppliers' trust regarding the liquidity and safety of their investments due to diversification □ Diversify: reduce risk by holding a number of securities in a portfolio □ If the returns on different investments are not perfectly positively correlated, spreading investments across a number of assets can diversify away lots of portfolio risk  For equal investments in different securities, as the number of securities in an FI’s asset portfolio increases, portfolio risk falls (at a diminishing rate)  FIs can diversify portfolio risk much better as individual fund suppliers are constrained to holding relatively undiversified portfolios due to their smaller wealth size ◊ Ability to predict more accurately expected return and risk on investment portfolio to provide highly liquid claims with little price risk ○ Reduced transaction costs ▪ FIs' average cost of collecting relevant information is lower than for the individual investor due to economies of scale □ Economies of scale: cost reduction in trading and other transaction services results from increased efficiency when FIs perform these services ▪ But as a result of technological advances, the costs of direct access to financial markets are falling and the relative benefits to individual savers of investing through FIs are falling □ Ability to reduce transactions costs with an etrade on the Internet rather than using a traditional stockbroker and paying brokerage fees  Etrade: buying and selling shares on the Internet □ Private placement, in which corporations sell securities directly to investors, often occurs without using underwriters  Also, some companies allow investors to buy their stock directly without using a broker ○ Maturity intermediation — FIs can better bear the risk of mismatching the maturities of their assets and liabilities ▪ FIs offer maturity intermediation services to the rest of the economy □ By maturity mismatching, FIs can produce new types of contracts mortgage loans to households, while still raising funds with short-term liability contracts deposits □ Although such mismatches is subject to interest rate risk, a large FI can better manage this risk via its superior access to markets and instruments for hedging the risks ○ Denomination intermediation — FIs allow small investors to overcome constraints to buying assets imposed by large minimum denomination size mutual funds ▪ As many assets are sold in very large denominations, they are either out of reach of individual savers or would result in savers holding very undiversified asset portfolios □ By pooling the funds of many small savers, individual small savers overcome constraints to buying assets imposed by large minimum denomination size  Such indirect access to these markets may allow small savers to generate higher returns (and lower ris...