SUMMARY: Financial Markets and Institutions PDF

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Financial Markets and InstitutionsOverviewYou can classify the types of markets by transacting parties: Primary markets → companies sell new securities for the first time (i. IPO) Secondary markets → investors trade already issued securities among each other; they make securities more liquid and det...

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Financial Markets and Institutions Overview You can classify the types of markets by transacting parties: • Primary markets → companies sell new securities for the first time (i.e. IPO) • Secondary markets → investors trade already issued securities among each other; they make securities more liquid and determine the price of securities sold in the primary market (i.e. NYSE, NASDAQ) Direct vs indirect finance: • Direct finance → where borrowers borrow funds directly from lenders • Indirect finance → where borrowers borrow funds from the financial market through a financial intermediary Term security vs demand deposit: • Term security → it has a specific maturity date • Demand deposit → it doesn’t have a specific maturity date, it can be withdrawn at any time OTC vs organized exchanges: OTC (over-the-counter) exchanges • Participants trade directly between two parties, without the use of a central exchange or other third party; • No physical locations • Market makers set the bid price (price they pay) and the ask price (price at which they sell) and they gain by the spread between the bid price and ask price, together with commissions on trades • Example: NASDAQ Organized exchanges • Physical location, even if nowadays exchanges are conducted mainly electronically • Floor traders (brokerage firms with buy and sell orders) are specialists that matches buyers with sellers in a group of stocks; they meet at the trading post on the exchange and learn about current bid and ask prices. • Example: NYSE Long vs short position • Long position → you benefit when asset price ↑ (i.e. you have a house) • Short position → you benefit when asset price ↓ (i.e. you will need to buy something in the future)

Are Financial Markets Efficient? ARBITRAGE • It is the opportunity to make riskless profit by exploiting mispricing in the market • Soon after you start your arbitrage activity it will disappear because prices will adjust • Short selling → an investor borrows a security and sells it on the open market, planning to buy it back later for less money EFFICIENT MARKET HYPOTHESIS The semi-strong form of this hypothesis implies that: • Prices of securities reflect all available public information • Current prices will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return • In an efficient market, all unexploited profit opportunities will be eliminated (= no arbitrage). • Future prices are not predictable: o Prices follow a random walk o Technical analysis, that is studying past stock price data and search for patterns such as trends and regular cycles is useless o It is impossible to beat the market and having performed well in the past does not indicate that an investment adviser or a mutual fund will perform well in the future

However, there is also a strong form of this hypothesis which states that: • Prices of securities are always correct; they reflect market fundamentals (= items that have a direct impact on future income streams of the securities) and all available information, both public and private • It rules out the existence of speculative bubbles (it would mean that an asset is priced above fundamentals) • One investment is as good as any other because the securities’ prices are correct • Security prices can be used by managers to assess their cost of capital (= cost of financing their investments) Evidence against the efficient market hypothesis: • Small firm effect → studies show that small firms have earned abnormally high returns in the long run. • January effect → a price rise from December to January is predictable and hence inconsistent with the randomwalk behavior; this is probably due to tax issues. • Market overreaction → stock prices may overreact to news announcements and that the pricing errors are corrected only slowly. • Excessive volatility → stock market shows excessive volatility; fluctuations in stock prices may be much greater than fluctuations in their fundamental value. • Mean reversion → stocks with low returns today tend to have high returns in the future, and vice versa. • New information is not always immediately incorporated into stock prices, which continue to rise for some time after the announcement of unexpectedly high profits, and they continue to fall after surprisingly low profit announcements. BEHAVIORAL FINANCE • People are sadder when they suffer losses than they are happy from making gains • People tend to be overconfident in their own judgments → overconfidence and social contagion explain stock market bubbles • Most people are risk averse, so very little short selling actually takes place → this can explain why stock prices sometimes get overvalued

Interest rates PRESENT VALUE Simple loan (interbank loans) 𝐹+𝐼 𝑃𝑉 = (1+𝑖)𝑛 Fixed-payment loan (fixed rate mortgages, car loans) 𝑃𝑉 = ∑

𝑛

𝐹𝑃 𝑘 𝑘=1 (1+𝑖)

Zero coupon bond (treasury bills, commercial paper) 𝐹 𝑃𝑉 = (1+𝑖)𝑛

𝐹 = face value (price the issuer pays at maturity) 𝐼 = interest payment 𝐹𝑃 = fixed payment 𝑖 = interest rate 𝐶 = coupon payment 𝐶𝐹 = cash flow 𝑛 = year

Coupon bond (long-term corporate and government debt) If there is no default risk, then coupon bonds are risk-free instruments because their cash flows are known in advance 𝑛−1

𝐶+𝐹 𝐶 ] + (1+𝑖)𝑛 𝑘 ( ) 1+𝑖 𝑘=1

𝑃𝑉 = [∑ Perpetuity 𝑃𝑉 = ∑

∞ 𝑘=1

𝐶 (1+𝑖)𝑘

=

𝐶 𝑖

DURATION It is the weighted average of the maturities of cash payments to calculate the interest rate risk of a bond. 𝐷↑  𝑖↓ if 𝑖 decreases it means that a smaller amount of cash payments are made earlier in the life of a bond, which makes 𝐷 (and therefore interest rate risk) increase. We need to considerate the years left to maturity, not the total amount of years 𝐷=

∑ ∑

𝑛

𝐶𝐹 𝑡 𝑡 𝑡=1 (1+𝑖) 𝑛 𝐶𝐹 𝑡 𝑡=1 (1+𝑖)

=∑

𝑛

𝑡

𝑡=1

𝑃𝑉𝑡 𝑃𝑉𝑡𝑜𝑡

The higher 𝐷 (and the longer the time to maturity), the greater the 𝛥𝑃 relative to a 𝛥𝑖. 𝛥𝑃 𝑃

𝛥𝑖

≈ −𝐷 × 1+𝑖

YIELD TO MATURITY (YTM) It’s the 𝑖 at which the sum of all future cash flows from the bond = the current price of the bond In the same company, the 𝑖 is the same for all securities 𝑃𝑡 = ∑

𝑛

𝐶𝐹𝑡 𝑡 𝑡=1 (1+𝑖)

COUPON RATE (C) 𝐶 𝑐= 𝐹 RATE OF RETURN (R) 𝐶 +𝑃 −𝑃 𝐶 𝑃 −𝑃 𝑅 = 𝑡 𝑡+1 𝑡 = 𝑡 + 𝑡+1 𝑡 𝑃𝑡

𝑃𝑡

𝑃𝑡

Where: 𝐶 𝑖𝑐 = 𝑡 → CURRENT YIELD (≈ yield to maturity because it’s the same formula of the 𝑖 of a perpetuity) 𝑔=

𝑃𝑡 𝑃𝑡+1−𝑃𝑡 𝑃𝑡

=

𝛥𝑃 𝑃

→ RATE OF CAPITAL GAIN

Since you can’t know 𝑃𝑡+1 so you have to compute the expected rate of return → 𝑅 ⅇ = ∑ 𝑛𝑘=1𝑝𝑘 𝑅𝑘 However, you there is the risk to assign wrong probabilities 𝑝𝑘 , and this riskiness can be calculated using the standard deviation of returns → 𝜎 = √∑ 𝑛𝑘=1 𝑃𝑘 (𝑅𝑘 − 𝑅ⅇ ) YTM vs coupon rate If P↑ YTM↓ and vice versa: P = F  coupon rate = YTM P < F  coupon rate < YTM (discount) P > F  coupon rate > YTM (premium)

YTM vs rate of return (R) Time to maturity = Holding period → certainty ➢ R = YTM Time to maturity > Holding period → interest rate risk ➢ You want 𝑖↓ P↑ because you will sell the bond Time to maturity < Holding period → interest rate risk + reinvestment risk ➢ You want 𝑖↑ P↓ because you will reinvest in another bond

Types of Financial Markets The Money Market Characteristics • Securities are sold in large denomination (= wholesale market) • OTC exchanges • Risk → low default risk • Maturity → within 1 year or less Advantages Money market instruments are used to: • Fill short term financial needs (supply side) • Temporarily “warehouse” surplus funds (demand side)

The Glass-Steagall Act (1933) imposed interest rate ceilings on savings deposits of banks, which meant that when market interest exceeded the deposit rate ceiling, money markets became very attractive. The interest rate ceilings were abandoned in 1986, but money markets enjoy a cost advantage over banks (for example, no reserve holding requirements) Instruments 1. TREASURY BILLS • Short-term obligations (maturities: 28, 91, or 182 days) • Issued by the U.S. government • Basically riskless • Very liquid and deep (=many buyers and sellers) market • Issued at discount (= price < face value) → it does not pay interest, but you gain from the price increase 𝐹−𝑃 360 Discount rate: 𝑖𝑑 = × 𝑛 𝐹 𝐹−𝑃

•

2. • • •

• • •

365

Investment rate: 𝑖𝑖 = × 𝑛 𝑃 Price is determined through auctions: o Uncompetitive bidding → they specify the amount they want to buy, but not the price o Competitive bidding → they specify both the amount and the maximum price at which they want to buy Uncompetitive bidders are served first and then they serve those competitive bidders who offered more, until there are no more treasury bills to sell. However, in the end every bidder pays the same price, which is the lowest price among those who got to buy the treasury bills. FEDERAL FUNDS Short-term funds (usually ≤ 1 day, overnight) They are held by banks at the Federal Reserve Financial institutions with excess funds loan them to other banks to: o Meet reserve requirement that the Federal Reserve has set to banks o Pay transactions They are usually unsecured They are definitive money (= money that is not convertible into any other form of money) and they can be spent immediately Interest rate → The Federal Reserve cannot directly control fed funds rates. It indirectly influences them by adjusting the level of reserves available to banks in the system. If the FED buys securities from an investor, ↑$ in the investor’s account at the FED, ↑reserves, ↓interest rate If the FED sells securities to an investor, ↓$ in the investor’s account at the FED, ↓reserves, ↑interest rate Eurodollars • Dollar-denominated deposits in British banks • They are an alternative to Federal Funds • They were born because during the Cold War, there was fear that deposits held on U.S. soil could be expropriated • London interbank bid rate (LIBID) → the rate paid by banks buying funds is the funds • London interbank offer rate (LIBOR) → the rate at which funds are offered for sale

3. • • • •

NEGOTIABLE CERTIFICATE OF DEPOSIT (CD) Time deposit with specified interest rate and maturity date Issued by a bank, that opens a saving account and sells it Bearer instrument (= whoever hold it at maturity receives the principal and interest) Low risk and low interest rates, but large banks can offer even lower interest rate because many investors believe that the government would never allow one largest bank to fail

4. REPURCHASE AGREEMENTS (REPO) • Agreement for the sale of securities by one party to another with a promise to repurchase the securities at a specified date and price • Useful to manage liquidity and take advantages of anticipated changes in interest rates • Short term (3-14 days) • Low risk, due to treasury security as collateral 5. COMMERCIAL PAPER • Short-term promissory notes (maturity 1 year) • Risk → default and interest rate risk • Bond → security that represents a debt owed by the issuer to the investor The issuer pays: (1) the face (or par) value at maturity, (2) periodic interest payments (= coupon payments) at the coupon rate (usually fixed, ≠ market 𝑖) Advantages • Issuing long term bonds allows firms to ↓risk that 𝑖 ↑ before they pay off their debt (= ↓volatility). However, this comes at a cost: long-term 𝑖 > short-term 𝑖, due to risk premiums. • Generally, the longer the time until maturity, the higher the changes in the price of the bond: this does not cause losses to investors who are not going to sell the bond, but most investors don’t hold the bond until maturity and if 𝑖↓ they would receive less than what they paid. Determinants of bond demand ↑ Wealth of investors ↑ Liquidity ↓ Expected interest rate: 𝑖 ⅇ ↑ means 𝑃ⅇ ↓ and expected returns↓ ↓ Risk ↓ Expected inflation: because the bond would pay less in real terms Determinants of bond supply ↑ Expected profitability of investment opportunities ↑ Expected inflation: it ↓cost of borrowings in real terms ↑ Government deficit: in case of deficit the government sells more bonds

Fisher effect When expected inflation 𝜋 ⅇ ↑, 𝑖 ↑ and vice versa, why? If 𝜋 ⅇ ↓ demand↑, but supply↓ (going from point 1 to point 2) This makes P↑ and therefore 𝑖↓ Instruments 1. TREASURY NOTES AND BONDS • Issued by the government to fund the national debt • Practically no default risk because the government could print more $ if necessary • Maturity → notes 1-10 years, bonds 10-30 years • TIPS (Treasury Inflation-Protected Securities) → the 𝑖 is fixed, but the principal changes according to the consumer price index to remove inflation risk. • STRIPS (Separate Trading of Registered Interest and Principal Securities) → each coupon and principal payment of the treasury bond becomes a separate zero-coupon bond of its own, so that the same bond can belong to different people. 2. • • • • •

MUNICIPAL BONDS Issued by local, county, and state governments to finance public interest projects Higher default risk than treasury bonds because they can’t print more $ They may be tax exempt → 𝑖𝑡𝑎𝑥-𝑓𝑟ⅇⅇ = 𝑖 × (1 − tax rate) Municipalities borrow at ↓ cost because investors accept ↓𝑖 if bonds are tax exempt They can be: o General obligation bonds → unsecured, no asset pledged as security o Revenue bonds → the revenues of the project will repay investors

3. • • • •

AGENCY BONDS Issued by government-sponsored enterprises (GSEs) to raise funds for purposes of national interests GSEs are protected by the government → this ↓ borrowing cost of GSEs but ↑ moral hazard GSEs sell bonds and buy mortgages from banks which now can make new loans Examples: o the Student Loan Marketing Association (Sallie Mae) o the Federal National Mortgage Association (Fannie Mae) o the Federal Home Loan Mortgage Corporation (Freddie Mac)

4. • • • •

CORPORATE BONDS Issued by firms to borrow funds for long periods of time Heterogeneous default risk because it depends on the company’s health Bond indenture → contract that states the lender’s rights and privileges and the borrower’s obligations Restrictive covenants → rules that make manager willing to protect bondholders’ interests (instead of only shareholders’ interest). For example, limiting dividends, limiting the issuing of additional debt, make restrictions. Sinking fund → requirement to pay off a portion of the bond issue each year; it makes the bond more attractive, so 𝑖↓. Conversion to stock → bondholders may be able to choose to convert their bond into a share of the firm when stock prices increase. This is useful also for the firm because, while selling stocks gives the idea that the firm is insecure of its financial situation, issuing convertible bonds does not give this impression to investors. Call provision → bonds may be callable (= the issuer buys the bond back before maturity). Why should the firm call the bond? a) If 𝑖↓ P↑ and P > call price b) Sinking funds make 𝑖↓ c) Too many restrictive covenants d) It wants to change its capital structure Bearer and registered bonds → bearer bonds (= payments are made to whoever had physical possession of the bonds) were substituted by registered bonds (= the bondholder must register with the firm to receive interest payments).

• •

•

•

Protection in case of default (↑protection = ↓𝑖) • Secured bonds o Mortgage bonds (collateral = building) o Equipment trust certificates (collateral = tangible non-real-estate property) • Unsecured bonds o Debentures → lower priority than secured bonds o Subordinated debentures → lower priority than debenture Financial guarantees • Insurance → the firm uses it only if cost of insurance < interest savings • Credit Default Swaps (CDS) → it’s an insurance that you can buy it even if you don’t own the bond

The Stock Market A firm issuing stock can decide: 1. Pay dividends to stockholders and get financed with bank loans  stockholders receive $ from dividends 2. Don’t pay dividends and get financed with stockholders’ money  stockholders receive $ from the increased stock price Stock vs Bond • Dividends are not tax deductible, while coupon payments are tax deductible → equity more expensive • Stocks are riskier than bonds → stockholders require higher rate of return • Stocks do not mature Type of stocks 1. Common stocks • It represents an ownership interest in the firm • It gives you to a discretionary dividend payment • It gives you the right of a residual claimant (after bondholders and preferred stockholders) → stockholders have a claim on all assets and income left over after all other claimants have been satisfied • Stockholders have limited liabilities • Stockholders have the right to vote in the board of directors 2. Preferred stocks • Form of equity from a legal and tax standpoint • It gives you fixed periodic payments (similar to a bond), but firms can miss a payment without going into bankruptcy • Stockholders have no voting right (unless dividend payments are missed) a) Participating → actual dividends may be higher in case of high profit Non-participating → dividends are equal to the promised amount b) Cumulative → missed dividends must be paid Non-cumulative → missed dividends are not paid How stocks are sold Organizations that gain profit from trading fees and concessions. 1. Organized Securities Exchanges (NYSE Euronext) • There is a physical trading floor • Every trading post has specialists (market makers), who stabilize order flow and prices; they belong to specialist firms and pay concession fees to NYSE • Commission brokers and floor brokers trade at the trade posts with other brokers or with the specialists: o Market orders (executed at market price) o Limit orders (stored in the order book and executed once price satisfies limit condition) • Program trading → online trading, whose automatization can be risky sometimes; this is why circuit breakers limit extreme losses, since they are forced trading pauses triggered by well-defined conditions. • NYSE advantages → liquid market and prestige • The NYSE merged with Archipelago, an Electronic Communication Network (ECN) firm

•

NYSE requirements: o Market capitalization > $100 million o Number of shares outstanding > 1,100,000 o Stock price > 4$ o Fees

2. • • • • •

Over-the-Counter Markets (NASDAQ) Trading occurs over sophisticated telecommunications networks Fewer requirements Fully electronic (no trade floor) System transmits quotes Dealers (= market makers) quote two prices: o Bid price → at which they buy o Ask price → at which they sell After entering bid and ask prices, dealers must trade a minimum quantity of shares at those prices

3. Exchange Traded Funds (ETF) 4. Alternative Trading Systems (ATSs) and Multilateral Trading Facilities (MTFs) • They are trading systems that bypass traditional exchanges and allow for buyers and sellers of securities to deal directly with each other. • They are typically used for large transactions among institutional investors. • A subset of these trading facilities is Electronic Communications Networks (ECNs), which are ATSs that are fully electronic (i.e. Instinet). • The major exchanges are fighting the ECNs by expanding their own automatic trading systems. o ECN’s advantages: ▪ Transparency → all unfilled orders are available for review by ECN traders. ▪ Cost reduction → because the middleman and the commission are cut out of the deal, transaction costs can be lower for trades executed over an ECN. ▪ Faster execution → since ECNs are fully automated, trades are matched and confirmed faster than can be done when there is human involvement. ▪ After-hours trading → prior to the advent of ECNs only institutional traders had access to trading securities after the exchanges had closed for the day. Many news reports and information become available after the major exchanges have closed, and smal...