SLide financial markets and institutions

Well functioning financial markets are key factors in producing high economic growth Financial institutions are needed because of transactions costs, risk sharing, and asymmetric informa

Chapter 1:

Introduction

OUTLINE

1 Why study financial markets and institutions?

2 Overview of financial markets

3 Overview of financial institutions

1 Why Study Financial Markets and Institutions?

Financial markets and institutions are primary channels to

allocate capital in our society

Proper capital allocation leads to growth in:

Societal wealth

Income

Economic opportunity

Well functioning financial markets are key factors in producing

high economic growth

Financial institutions are needed because of transactions costs,

risk sharing, and asymmetric information

2 Overview of Financial Markets

A financial market is a market in which financial assets (securities) can

be purchased or soldFinancial markets facilitate financing and investing by households, firms, and government agencies

Financial markets are one type of structure through which funds flow: Channels funds from person or business without investment opportunities (i.e., “Lender-Savers”) to one who has them (i.e.,

“Borrower-Spenders”) Improves economic efficiency

•1-4

Financial Markets Funds Transferees

2 Indirect Finance

Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower’s future income or assets

Financial markets can be distinguished along a variety of dimensions:

primary versus secondary markets

money versus capital markets

debt versus equity markets

Primary versus Secondary Markets

Primary markets

Markets in which users of funds (e.g., corporations) raise funds by

issuing new financial instruments (e.g., stocks and bonds)

Secondary markets

Markets where existing financial instruments are traded among

investors (e.g., exchange traded: NYSE and over-the-counter:

ts Primary and Secondary Market Transfer of Funds Time Line

Primary versus Secondary Markets Concluded

How were primary markets affected by the financial crisis?

Do secondary markets add value to society or are they simply a

legalized form of gambling?

How does the existence of secondary markets affect primary

Money versus Capital Markets

Money markets

Markets that trade debt securities with maturities of one year or

less (e.g., C D s and U.S Treasury bills)

little or no risk of capital loss, but low return

Capital markets

Markets that trade debt (bonds) and equity (stock) instruments

with maturities of more than one year

substantial risk of capital loss, but higher promised return

•1-Money Market Instruments Outstanding

Source: Federal Board, “Financial Accounts of the United States,” Statistical Releases, Washington, D C, various issues, www.federalreserve.gov.

Capital Market Instruments Outstanding

Source: Federal Reserve Board, “Financial Accounts of the United States,” Statistical Releases, Washington, DC,

various issues www.federalreserve.gov.

Debt markets versus Equity markets

1 Debt Markets

Short-Term (maturity < 1 year)Long-Term (maturity > 10 year)Intermediate term (maturity in-between)

2 Equity Markets

Pay dividends, in theory foreverRepresents an ownership claim in the firm

Foreign Exchange (FX) Markets

the exchange of currencies in the future on a specific date and at a

pre-specified exchange rate

Derivative Security Markets

Derivative security

A financial security whose payoff is linked to (i.e., “derived” from) another, previously issued security such as a security traded in capital or foreign exchange markets

Generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future

The main purpose of the derivatives markets is to transfer risk between market participants

Derivatives and the Crisis

Subprime mortgage losses were large, reaching over $700 billion

The “Great Recession” was the worst since the “Great Depression”

of the 1930s

Trillions $ global wealth lost, peak to trough stock prices fell over 50%

in the U.S

Lingering high unemployment and below trend growth in the U.S

Sovereign debt levels in developed economies reached post-war

all-time highs

Valuation of Securities in Financial Markets

Securities are valued as the present value of their expected cash flows, discounted at a rate that reflects their

uncertainty Market pricing of securities

Different investors may value the same security differently based

on their interpretation of information

Impact of valuations on pricing

Every security has an equilibrium market price at which demand and supply for the security are equal

Favorable information results in upward valuation revisions;

unfavorable information results in downward revisionsSecurities reach a new equilibrium price as new information becomes available

3 Overview of Financial Institutions

Markets are imperfect

Financial institutions are needed to resolve problems

created by market imperfections

Financial Institutions

Institutions through which suppliers channel money to users of funds

Non-Intermediated (Direct) Flows of Funds

Flow of Funds in a World without FIsDirect Financing

Financial Claims (equity and debt instruments)

•1-Figure 1-7 Flow of Funds in a World with Fls

We describe and illustrate this flow of funds in Chapter 2

Access the long description slide.

Intermediated Flows of Funds

Flow of Funds in a World with FIs

•1-24

Access the long description slide

Indirect finance

Financial intermediation is actually the primary means of

moving funds from lenders to borrowers

More important source of finance than securities markets (such

2 Reduce transactions costs by developing expertise and taking

advantage of economies of scale

Function of Financial Institutions: Indirect Finance

Risk sharing

FIs create and sell assets with lesser risk to one party in order to buy assets with greater risk from another partyThis process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors

Function of Financial

Intermediaries: Indirect Finance

Another reason FIs exist is to reduce the impact of asymmetric

information

One party lacks crucial information about another party,

impacting decision-making

We usually discuss this problem along two fronts: adverse

selection and moral hazard

Asymmetric information: Adverse selection and Moral hazard

Before the transaction occur Asymmetric transaction occurAfter the

information

Adverse selection hazardMoral

Asymmetric information: Adverse selection

Before the

transaction occur Asymmetric transaction occurAfter the

information

Adverse

selection hazardMoral

Potential borrowers who are the

most likely to produce an undesirable (adverse) outcome – the

bad credit risks – are the most likely

to be selected

Function of Financial Intermediaries

Adverse Selection

1 Before transaction occurs

2 Potential borrowers most likely to produce adverse outcome are ones most likely to seek a loan

3 Similar problems occur with insurance where unhealthy people want their known medical problems covered

Asymmetric information: Moral hazard

Before the transaction occurAsymmetric transaction occurAfter the

information

Adverse

selection hazardMoral

The risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender’s point of view

Function of Financial Intermediaries

Moral Hazard

1 After transaction occurs

2 Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back

3 Again, with insurance, people may engage in risky activities only after being insured

4 Another view is a conflict of interest

Asymmetric Information: Adverse Selection and

Moral Hazard

Financial intermediaries reduce adverse selection and moral

hazard problems, enabling them to make profits How they

accomplish this is covered in many of the chapters to come

Economies of Scope and Conflicts of Interest

FIs are able to lower the production cost of information by using the information for multiple services: bank accounts, loans, auto insurance, retirement savings, etc This is called economies of scope.

But, providing multiple services may lead to conflicts of interest, perhaps causing one area of the FI to hide or conceal

information from another area (or the economy as a whole)

This may actually make financial markets less efficient!

Financial Institutions are distinguished by:

Whether they accept insured deposits

Depository versus non-depository financial institutions

Whether they receive contractual payments from customers

Types of Financial Institutions

Depository versus Non-Depository FIs

securities firms and investment banks, mutual funds

FIs Benefit Suppliers of Funds

Reduce monitoring costs

Increase liquidity and lower price risk

Reduce transaction costs

Provide maturity intermediation

Provide denomination intermediation

FIs Benefit the Overall Economy

Conduit through which Federal Reserve conducts monetary

policy

Provides efficient credit allocation

Provide for intergenerational wealth transfers

Provide payment services

Risks Faced by Financial Institutions

Regulation of Financial Institutions

FIs are heavily regulated to protect society at large from market

failures

Regulations impose a burden on FIs; before the financial crisis,

U.S regulatory changes were deregulatory in nature

Regulators attempt to maximize social welfare while minimizing

the burden imposed by regulation

Globalization of Financial Markets and Institutions

The pool of savings from foreign investors is increasing and investors look to diversify globally now more than ever before

Information on foreign markets and investments is becoming readily accessible and deregulation across the globe is allowing even greater access to foreign markets

International mutual funds allow diversified foreign investment with low transactions costs

Global capital flows are larger than ever

Chapter 2:

Determinants of Interest rates

OUTLINE

1 Interest Rate Fundamentals

2 Loanable Funds Theory

3 Economic Forces That Affect Interest Rates

1 Interest Rate Fundamentals

Nominal interest rates: the interest rates actually observed in

Real Riskless Interest Rates

Additional purchasing power required to forego current consumption

What causes differences in nominal and real interest rates?

If you wish to earn a 3% real return and prices are expected to increase by 2%, what rate must you charge?

Irving Fisher first postulated that interest rates contain a premium for expected inflation

•2-4

2 Loanable Funds Theory

Loanable funds theory explains interest rates and interest rate

movements

Views level of interest rates as resulting from factors that affect the

supply of and demand for loanable funds

Categorizes financial market participants – e.g., consumers, businesses,

governments, and foreign participants – as net suppliers or demanders

Net Supply & Demand of Funds in U.S in 2016

TABLE 2–1 Funds Supplied and Demanded by Various Groups (in trillions of dollars)

Source: Federal Reserve Board website, “Financial Accounts of the United States,” May 2016 www.federalreserve.gov

Determinants of Household Savings

Interest rates and tax policy

Income and wealth: the greater the wealth or income, the greater the amount saved

Attitudes about saving versus borrowing

Credit availability: the greater the amount of easily obtainable consumer credit the lower the need to save

Job security and belief in soundness of entitlements

•2-8

Business Demand for Funds

Level of interest rates:

When the cost of loanable funds is high (i.e., interest rates are high),

businesses finance internally

Expected future profitability vs risk:

The greater the number of profitable projects available to businesses, the

greater the demand for loanable funds

Expected economic growth

•2-9

Federal Government Demand for Funds Concluded

Governments borrow heavily in the markets for loanable funds

$23.19 trillion in 2016

United States

National debt was $19.21 trillion in 2016

National debt (and interest payments on the national debt) have to be financed in large part by additional borrowing

•2-10

Determinants of Foreign Funds Invested in the U.S

Relative interest rates and returns on global investments

Expected exchange rate changes

Safe haven status of U.S investments

Foreign central bank investments in the U.S

Figure The Effect on Interest Rates from a Shift in the Supply Curve

of or Demand Curve for Loanable Funds(a) Increase in the supply of loanable funds

Loanable Funds Theory (cont’d)

Supply of loanable funds

Funds are provided to financial markets byHouseholds (net suppliers of funds)Government units and businesses (net borrowers of funds)Suppliers of loanable funds supply more funds at higher interest rates

•15

Loanable Funds Theory (cont’d)

Supply of loanable funds (cont’d)

Foreign households, governments, and corporations supply funds by

purchasing Treasury securities

Foreign households have a high savings rate

The supply is influenced by monetary policy implemented by the

Federal Reserve System

The Fed controls the amount of reserves held by depository institutions

The supply curve can shift in response to economic conditions

Households would save more funds during a strong economy

•16

Loanable Funds Theory (cont’d)

Aggregate Supply

Equilibrium interest rate - algebraic

The aggregate demand can be written as

The aggregate supply can be written as

f m g b h

f m g b h

Shifts the demand schedule outward (to the right)

There is no obvious impact on the supply schedule

Supply could increase if income increases as a result of the expansion

The combined effect is an increase in the equilibrium interest rate

Economic Forces That Affect Interest Rates

(cont’d)

Inflation

Shifts the supply schedule inward (to the left)

Households increase consumption now if inflation is expected to

increase

Shifts the demand schedule outward (to the right)

Households and businesses borrow more to purchase products before

Nominal interest payments compensate savers for:

Reduced purchasing power

A premium for forgoing present consumption

The relationship between interest rates and expected inflation is

often referred to as the Fisher effect

Economic Forces That Affect

Interest Rates (cont’d)

Foreign flows of funds

The interest rate for a currency is determined by the

demand for and supply of that currency

Impacted by the economic forces that affect the equilibrium

interest rate in a given country, such as:

Economic growth

Inflation

Shifts in the flows of funds between countries cause

adjustments in the supply of funds available in each

country

•26

Economic Forces That Affect Interest Rates (cont’d)

Explaining the variation in interest rates over time

Late 1970s: high interest rates as a result of strong economy and inflationary expectations

Early 1980s: recession led to a decline in interest ratesLate 1980s: interest rates increased in response to a strong economy

Early 1990s: interest rates declined as a result of a weak economy1994: interest rates increased as economic growth increasedDrifted lower for next several years despite strong economic growth, partly due to the U.S budget surplus

Chapter 3

1 The term structure of interest rates

a describes the relationship between maturity and yield for similar

securities

b ranks security yield according to the default risk structure

c describes how interest rates vary over time

d describes the pattern of interest rates over the business cycle

2 The yield curve is a plot of

a maturity changes as risk changes

b yields by varied risk-taking of varied bond issuers

c yields by maturity of securities with similar default risk

d interest rates over time past

3 An upward sloping yield curve indicates that security investors expect future

interest rates to _ and security prices to

a fall; fall

b fall; rise

c rise; fall

d rise; rise

4 Calculate the one-year forward rate three years from now if three- and four-year

rates are 5.50% and 5.80%, respectively?

a The rate cannot be calculated from the information above

5 If three-year securities are yielding 6% and two-year securities are yielding 5.5%,

future short-term rates are expected to , and outstanding security prices are expected to

a fall; fall

b rise; fall

c fall; rise

d rise; rise

6 With reference to the question above, what is the expected one-year rate two years

from now as implied by the two actual rates above?

7 If the interest-rate on a taxable bond is 8%, and the income tax rate for a typical

bondholder is 25%, then a tax-free bond with the same risk and maturity will offer a yield of:

E) None of the above is correct

8 Under the expectations hypothesis, a downward sloping yield curve indicates that people believe that short-term interest rates will:

A) rise over time

B) fall over time

D) change in an unpredictable manner over time

Chapter 3:

Structure of Interest rates

•2

Chapter Outline

1 Characteristics of debt securities that cause their yields to vary

2 Explaining actual yield differentials

3 Estimating the appropriate yield

4 A closer look at the term structure

1 Characteristics of debt securities that cause

their yields to vary

 Credit (default) risk

Characteristics of Debt Securities

a Credit (default) risk

Securities with a higher degree of risk have to offer higher yields to be chosen

Credit risk is especially relevant for longer-term securities Investors must consider the creditworthiness of the security issuer

Can use bond ratings of rating agenciesThe higher the rating, the lower the perceived credit riskRatings can change over time as economic conditions changeRatings for different bond issues by the same issuer can vary

Characteristics of Debt Securities (cont’d)

Credit (default) risk (cont’d)

Rating agencies

Moody’s Investor Service and Standard and Poor’s Corporation

are the most popular

Agencies use different methods to assess the creditworthiness

of firms and state governments

A particular bond issue could have different ratings from each

agency, but differences are usually small

Financial institutions may be required to invest only in

investment-grade bonds rated Baa or better by Moody’s and

BBB or better by Standard and Poor’s

•6

Characteristics of Debt Securities (cont’d)

Ratings Assigned by:

Description of Security Moody’s Standard and Poor’s

•7

Characteristics of Debt Securities (cont’d)

Credit (default) risk (cont’d)

Shifts in credit risk premiums

The risk premium corresponding to a particular bond rating can chance

over time

Accuracy of credit ratings

In general, credit ratings have served as reasonable indicators of the