Chapter One

Introduction

McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Why study Financial Markets and Institutions?

Markets and institutions are primary channels to allocate capital in our society

Proper capital allocation leads to growth in: Societal Wealth Income Economic opportunity

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Why study Financial Markets and Institutions?

In this text we will examine:

the structure of domestic and international markets the flow of funds through domestic and international markets an overview of the strategies used to manage risks faced by investors and savers

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Financial Markets

Financial markets are one type of structure through which funds flow Financial markets can be distinguished along two dimensions:

primary versus secondary markets money versus capital markets

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Primary versus Secondary Markets

Primary markets

markets in which users of funds (e.g., corporations and governments) raise funds by issuing financial instruments (e.g., stocks and bonds) markets where financial instruments are traded among investors (e.g., NYSE and Nasdaq)

Secondary markets

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Primary versus Secondary Markets

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Primary versus Secondary Markets

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 markets?

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Money versus Capital Markets

Money markets

markets that trade debt securities with maturities of one year or less (e.g., CDs and U.S. Treasury bills) little or no risk of capital loss, but low return 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

Capital markets

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Money Market Instruments Outstanding, ($Bn)

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Capital Market Instruments Outstanding, ($Bn)

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Foreign Exchange (FX) Markets

FX markets

trading one currency for another (e.g., dollar for yen) the immediate exchange of currencies at current exchange rates the exchange of currencies in the future on a specific date and at a pre-specified exchange rate

Spot FX

Forward FX

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Derivative Security Markets

Derivative security

a financial security whose payoff is linked to (i.e., derived from) another security or commodity, 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.

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Derivative Security Markets

Selected examples of derivative securities

Exchange listed derivatives

Many options, futures contracts Forward contracts Forward rate agreements Swaps Securitized loans

Over the counter derivatives

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Derivatives and the Crisis1.

Mortgage derivatives allowed a larger amount of mortgage credit to be created in the mid-2000s. Mortgage derivatives spread the risk of mortgages to a broader base of investors. Change in banking from originate and hold loans to originate and sell loans.

2.

3.

Decline in underwriting standards on loans

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Derivatives and the Crisis1.

Subprime mortgage losses have been quite 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 in the U.S. Sovereign debt levels in developed economies at alltime highs

2.

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Financial Market Regulation

The Securities Act of 1933

full and fair disclosure and securities registration Securities and Exchange Commission (SEC) is the main regulator of securities markets

The Securities Exchange Act of 1934

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Financial Institutions (FIs)

Financial Institutions

institutions through which suppliers channel money to users of funds whether they accept insured deposits, depository versus non-depository financial institutions whether they receive contractual payments from customers.

Financial Institutions are distinguished by:

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Asset Size and Number of Selected U.S. Financial Institutions 2010NUMBER OF FEDERALLY INSURED INSTITUTIONS

INSTITUTION

TOTAL ASSETS (BILL $)

Commercial Banks Savings Associations Credit Unions Insurance Companies Private Pension Funds Finance Companies Mutual Funds Money Market Mutual Funds

$12,130 $ 1,253 $ 885 $ 6,459 $ 5,661 $ 1,613 $ 7,376 $ 2,746

6,622 1,138 7,554

Data from September 2010, data sources include Federal Reserve Board, Flow of Funds Accounts, Levels Tables, FDIC Stats at a Glance and the NCUA website. The mutual funds category excludes money market funds.

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Non-Intermediated (Direct) Flows of FundsFlow of Funds in a World without FIsDirect Financing

Financial Claims (equity and debt instruments)Users of Funds (corporations) Suppliers of Funds (households)

Cash

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Intermediated Flows of FundsFlow of Funds in a World with FIsUsers of Funds Intermediated Financing FIs Suppliers of Funds (brokers)

Cash

Financial Claims (equity and debt securities)

FIs (asset transformers)

Cash

Financial Claims (deposits and insurance policies)

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Depository versus Non-Depository FIs

Depository institutions:

commercial banks, savings associations, savings banks, credit unions Contractual: insurance companies, pension funds, Non-contractual: securities firms and investment banks, mutual funds.

Non-depository institutions

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FIs Benefit Suppliers of Funds

Reduce monitoring costs Increase liquidity and lower price risk Reduce transaction costs Provide maturity intermediation Provide denomination intermediation

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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

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Risks Faced by Financial Institutions

Credit Foreign exchange Country or sovereign Interest rate Market

Off-balance-sheet Liquidity Technology Operational Insolvency

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Regulation of Financial Institutions

FIs are heavily regulated to protect society at large from market failures Regulations impose a burden on FIs and before the financial crisis, recent U.S. regulatory changes were deregulatory in nature Regulators attempt to maximize social welfare while minimizing the burden imposed by regulation

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Regulation of Financial Institutions

New Dodd-Frank Bill1.

Promote robust supervision of FIs Financial Service Oversight Council to identify and limit systemic risk, Broader authority for Federal Reserve (Fed) to oversee non-bank FIs, Higher equity capital requirements, Registration of hedge funds and private equity funds.

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Regulation of Financial Institutions1.

New Dodd-Frank Bill1.

Comprehensive supervision of financial markets New regulations for securitization and over the counter derivatives Additional oversight by Fed of payment systems Establishes a new Consumer Financial Protection Agency

2.

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Regulation of Financial Institutions

New Dodd-Frank Bill1.

New methods to resolve non-bank financial crises More oversight of Fed bailout decisions Increase international capital standards and increased oversight of international operations of FIs.

2.

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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, International mutual funds allow diversified foreign investment with low transactions costs, Global capital flows are larger than ever.

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Appendix: FIs and the CrisisTimeline of events Home prices decline in late 2006 and early 2007

Delinquencies on subprime mortgages increase Huge losses on mortgage-backed securities (MBS) announced by institutions

Bear Stearns fails and is bought out by J.P. Morgan Chase for $2 a share (deal had government backing).1-30

Appendix: FIs and the CrisisTimeline of events September 2008, the government seizes governmentsponsored mortgage agencies Fannie Mae and Freddie Mac

The two had $9 billion in losses in the second half 2007 Now run by Federal Housing Finance Agency (FHFA)

September 2008, Lehman Brothers files for bankruptcy; Dow drops 500 points

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Appendix: FIs and the Crisis

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Appendix: FIs and the Crisis

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Appendix: Government Rescue Plan

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Appendix: Government Rescue Plan

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Appendix: Government Rescue Plan

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Chapter Two

Determinants of Interest Rates

McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Interest Rate Fundamentals

Nominal interest rates: the interest rates actually observed in financial markets

Used to determine fair present value and prices of securities Two types of components Opportunity cost Adjustments for individual security characteristics

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Real 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.

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Loanable Funds Theory

Loanable funds theory explains interest rates and interest rate movements Views level of interest rates in financial markets as a result of the supply and demand for loanable funds Domestic and foreign households, businesses, and governments all supply and demand loanable funds

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Supply and Demand of Loanable FundsDemand Interest Rate Supply

Quantity of Loanable Funds Supplied and Demanded2-41

Net Supply of Funds in U.S. in 2010Source Federal Reserve Flow of Funds Matrix Net Supply in Billions Year 2010 data of Dollars Households & NPOs $ 786.9 Business Nonfinancial 75.3 State & Local Govt. -19.3 Federal Government -1378.6 Financial Sector -178.3 Foreign 324.3 Totals (Discrepancy) -$389.7

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Source: Federal Reserve Bank of St. Louis

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Determinants of Household Savings1. 2.

3. 4.

5.

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,

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Determinants of Foreign Funds Invested in the U.S.1.

2. 3. 4.

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.

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Determinants of Foreign Funds Invested in the U.S.Country China Saudi Arabia Russia Taiwan S. KoreaSource: Economist, February 2011

Foreign Currency Reserves (all $ in billions) $2,847 456 444 382 292

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Federal Government Demand for Funds

Source: 2011 report, http://www.cbo.gov/ftpdocs/74xx/doc7492/08-17Source: CBO CBO 2011 report BudgetUpdate.pdf

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Federal Government Demand for Funds

Federal debt held by the public was at $9.0 trillion at end of 2010 (62% GDP) and is projected to grow to $17.4 trillion by 2020 (76% of projected 2020 GDP, 120% of current GDP)

Large potential for crowding out and/or dependence on foreign investment

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Federal Government Demand for Funds

Total Federal Debt is currently $14.1 trillion (97% GDP) and is projected to grow to $23.1 trillion by 2020 (64% increase)o

Interest expense is projected to grow to 3.5% of GDP by 2020

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Shifts in Supply and Demand Curves change Equilibrium Interest RatesIncreased supply of loanable fundsInterest Rate

Increased demand for loanable fundsInterest Rate

DD

SS SS*

DD* DD

SS

i** i* i** Q* Q** E E* E i*

E*

Quantity of Funds Supplied

Q* Q**

Quantity of Funds Demanded

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Factors that Cause Supply and Demand Curves to ShiftIncrease in Affect on Supply Affect on Demand Wealth & income Increase N/A As wealth and income increase, funds suppliers are more willing to supply funds to markets. Result: lower interest rates Risk Decrease Decrease As the risk of an investment decreases, funds suppliers are less willing to purchase the claim. All else equal, demanders of funds would be less willing to borrow as well. Result: higher interest rates Near term spending needs Decrease N/A As current spending needs increase, funds suppliers are less willing to invest. Result: higher interest rates Monetary expansion Increase N/A As the central bank increases the supply of money in the economy, this directly increases the supply of funds available for lending. Result: lower interest rates

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Factors that Cause Supply and Demand Curves to ShiftIncrease in Affect on Supply Affect on Demand Economic growth Increase Increase With stronger economic growth, wealth and incomes rise, increasing the supply of funds available. As U.S. economic strength improves relative to the rest of the world, foreign supply of funds is also increased. Business demand for funds increases as more projects are profitable. Result: indeterminate effect on interest rates, but at more rapid growth rates interest rates tend to rise. Utility derived from assets Decrease Increase As utility from owning assets increases, funds suppliers are less willing to invest and postpone consumption whereas funds demanders are more willing to borrow. Result: higher interest rates Restrictive covenants Increase Decrease As loan or bond covenants become more restrictive, borrowers reduce their demand for funds. Result: lower interest rates

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Factors that Cause Supply and Demand Curves to ShiftIncrease in Affect on Supply Affect on Demand Tax Increase Decrease Increase Taxes on interest and capital gains reduce the returns to savers and the incentive to save. The tax deductibility of interest paid on debt increases borrowing demand. Result: Higher interest rates Currency Appreciation Increase N/A Foreign suppliers of funds would earn a higher rate of return if the currency appreciates and a lower rate of return measured in their own currency if the dollar depreciates. Foreign central banks often buy U.S. Treasury securities as part of their attempts to prevent their currency from appreciating against the dollar. Result: Lower interest rates Expected inflation Decrease Increase An increase in expected inflation implies that suppliers will be repaid with dollars that will have less purchasing power than originally anticipated. Suppliers lose purchasing power and borrowers gain more than originally anticipated. This implies that supply will be reduced and demand increased. Result: Higher interest rates

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Determinants of Interest Rates for Individual Securities ij*

= f(IP, RIR, DRPj, LRPj, SCPj, MPj) Inflation (IP)IP = [(CPIt+1) (CPIt)]/(CPIt) x (100/1)

Real Interest Rate (RIR) and the Fisher effectRIR = i Expected (IP)

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Determinants of Interest Rates for Individual Securities (contd)

Default Risk Premium (DRP)DRPj = ijt iTt ijt = interest rate on security j at time t iTt = interest rate on similar maturity U.S. Treasury security at time t

Liquidity Risk (LRP) Special Provisions (SCP) Term to Maturity (MP)

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Term Structure of Interest Rates: the Yield CurveYield to Maturity

(a) Upward sloping (b) Inverted or downward sloping (c) Flat (a) (c)

(b)Time to Maturity

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Unbiased Expectations Theory

Long-term interest rates are geometric averages of current and expected future short-term interest rates1

RN ! [(11 R1 )(1 E ( 2 r1 ))...(1 E ( N r1 ))]1RN

1/ N

1

= actual N-period rate today N = term to maturity, N = 1, 2, , 4, 1R1 = actual current one-year rate today E(ir1) = expected one-year rates for years, i = 1 to N

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Liquidity Premium Theory

Long-term interest rates are geometric averages of current and expected future short-term interest rates plus liquidity risk premiums that increase with maturity

RN ! [(11 R1 )(1 E ( 2 r1 ) L2 )...(1 E ( N r1 ) LN )]1/ N 1 1Lt = liquidity premium for period t L2 < L3 <