Appunti Financial Markets and Institutions, Appunti di Economia E Tecnica Dei Mercati Finanziari

Scarica Appunti Financial Markets and Institutions e più Appunti in PDF di Economia E Tecnica Dei Mercati Finanziari solo su Docsity! Financial Literacy Financial literacy is an essential life skill that enables individuals to make informed financial decisions and improve their financial well-being. The OECD-INFE methodology defines financial literacy as “A combination of awareness, knowledge, skill, attitude and behaviour necessary to make sound financial decisions and ultimately achieve individual financial well-being”. OECD proposes a methodology that includes three main components to measure financial literacy: - Financial Knowledge. It refers to the understanding of financial concepts and procedures necessary to resolve financial issues, in particular inflation, interest rate, risk diversification. - Financial Behaviour. It refers to the ability to recognize and comprehend the impacts of financial decisions, and to make informed decisions about financial matters. o FB1 - Expense management and budgeting o FB2 - Savings over 12 months o FB3 - Before buying I consider if I can afford it o FB4 - Punctuality in paying bills o FB5 - Control of expenses o FB6 - Long-term goals o FB7 - Financial products o FB8 - Negative savings - Financial Attitude. It is the predisposition to behave in a particular manner based on economic and non- economic beliefs, thinking about the future, plan expenses and save money. Improving personal financial literacy is crucial for several reasons: - Participation in financial markets: Financial markets are complex and ever-changing, and individuals who lack financial literacy may be hesitant to participate in them. However, having a good understanding of financial concepts and products can empower individuals to invest wisely, make informed decisions, and potentially earn higher returns. - Planning for retirement: Retirement planning is a critical aspect of financial management, and individuals with good financial literacy are more likely to plan and save for their retirement. This can help ensure financial security in later years and avoid the risk of running out of money in retirement. - Avoiding over-indebtedness: Over-indebtedness can be a significant source of financial stress and can lead to long-term financial difficulties. Individuals who understand financial concepts such as interest rates, credit scores, and debt management strategies are less likely to fall into debt traps. - Positive impact on economic policy choices: Financial literacy at the individual level can have a positive impact on economic policy choices at the macro level. People who are financially literate are better equipped to understand the implications of economic policies and make informed decisions that can contribute to sustainable public finances and economic stability. - Meeting the challenges of structural changes: The ongoing structural changes in the financial sector require individuals to make informed choices. The increasing complexity and interconnectivity of financial markets, the aging of the population, and the growing digitization of financial services all make it more important than ever to have a good understanding of financial concepts and products. In Italy, there is evidence of a positive correlation between financial knowledge and virtuous behaviour. However, vulnerable groups, such as small businesses, women, migrants, and young people, often lack financial literacy and are more likely to experience financial difficulties. The "costs" of Financial Illiteracy - Over-indebtedness and risk of predatory conditions; - Poor investment choices and negatively affecting portfolio diversification and stock market participation; - Limiting propensity to save and accumulate capital; - Hindering the recognition of propitious times to enter or exit the market and identifying possible conflicts of interest by intermediaries; - Predisposing to fraud; - Hindering the overall economic growth of countries and the stability of FS at the macroeconomic level; - Reinforcing existing economic gender inequalities in the case of women, reducing the possibility of achieving real independence and empowerment, hindering the full realization of women's general well-being, and hindering the formation of a new generation of financially literate women. Financial illiteracy can have significant and long-lasting effects on individuals and society as a whole, especially for vulnerable groups such as women. Increase Financial Literacy One of the primary goals of financial education programs is to improve people's level of financial literacy and, related to that, their level of financial well-being. According to CFPB (Consumer Financial Protection Bureau 2015), the elements that define financial well-being are 1) daily and monthly monitoring of your finances; 2) the ability to absorb a financial shock; 3) feeling "on track" to achieve your financial goals; 4) the perception of having the satisfactory financial freedom to make the choices that allow you to enjoy your life. For example, in Italy, several financial education initiatives have been promoted. The Committee for the planning and coordination of financial education activities is a body established in 2017 by the decree of the Minister of Economy and Finance, in agreement with the Minister of Education, University and Research and the Minister of Economic Development. Its creation was in implementation of Law No. 15/2017, which aims to protect savings in the credit sector. The Committee's primary purpose is to promote and coordinate initiatives aimed at increasing the financial literacy of the population. This includes developing programs that will enhance the knowledge and skills of finance, insurance, and social security, and ultimately improve the ability of individuals to make choices consistent with their goals and conditions. Financial System A financial system is a set of institutions, such as banks, insurance companies, and stock exchanges, that permit the exchange of funds (and risks) through financial instruments. The FS is a complex structure composed of four elements: - Financial instruments: financial contracts between the parties involved (duties and rights). Financial instruments can take many forms, such as stocks, bonds, options, and derivatives, and they allow individuals and organizations to transfer financial risk and allocate capital efficiently. - Financial markets: a place where the trading of securities occurs. Financial markets, such as stock exchanges and bond markets, provide a platform for buyers and sellers to exchange these instruments and determine their prices. - Financial intermediaries: institutions that act as a middleman between two parties in order to facilitate a financial transaction. Financial intermediaries, such as banks, insurance companies, and investment funds, play an important role in the FS by pooling and managing funds from different investors, and providing a range of financial services to customers. They also help to reduce transaction costs and provide liquidity to financial markets. - Supervisory authority (rules and regulation): the supervisory authority, typically the central bank and other regulatory bodies, is responsible for overseeing the financial system, setting rules and regulations, and ensuring that the system is stable and resilient. This includes monitoring the activities of financial institutions, enforcing prudential standards, and responding to financial crises. The functioning of FS The main function of the FS is to channel funds from a person or business with a surplus of funds and without investment opportunities (i.e., lender-savers) to a person or business with a shortage of funds and with investment opportunities (i.e., borrower-spenders). The two primary modes of financing in the FS are: 1. Direct Finance: borrowers sell financial instruments, such as stocks, bonds, or other securities, to lenders directly in financial markets. This allows borrowers to bypass intermediaries and access funds directly from lenders. Direct Financial institutions play a crucial role in the economy by providing financial services, and producing, holding, and trading financial assets (FAs) to meet the financial needs of economic agents. The core of their balance sheet consists of financial assets and liabilities, and earnings on FAs constitute the most important income from ordinary operations. In a given scenario, the firm Delta is a borrower of the bank (bank loans) and issuer of corporate bonds, while the bank and the firm Omega are bondholders of corporate bonds issued by Delta. Additionally, the bank is the lender of Delta through bank loans. This illustrates the various ways in which financial institutions intermediate and meet the financial needs of economic agents. Financial institutions are exposed to financial risk due to the nature of their business activities. They may face credit risk, market risk, liquidity risk, operational risk, and other types of risks. Therefore, they need to manage their risks carefully to ensure their financial stability and protect their customers' interests. Financial institutions are also highly regulated to ensure their soundness and protect the interests of customers and the wider economy. They are subject to various regulations and supervisory requirements that govern their operations, risk management practices, capital adequacy, and disclosure standards. Compliance with these regulations is critical to maintaining their reputation and preserving public trust. Financial intermediaries exist to overcome various market imperfections and frictions that prevent smooth and efficient allocation of capital and risk. The theory of financial intermediation (an analytical corpus developed since the second half of the last century and consisting of several complementary theoretical strands) explains that FIs are necessary due to the presence of transaction costs, information asymmetries, uncertainty, limited rationality, and divergent preferences among market participants. One of the primary functions of FIs is to reduce transaction costs associated with financial transactions - FIs make profits by reducing transactions costs. Transactions costs are incurred when lenders and borrowers try to directly exchange funds. FIs can reduce these costs by pooling funds from many savers and then lending them to borrowers. By developing expertise and taking advantage of economies of scale, FIs can lower the cost of acquiring and processing information, monitoring and enforcing contracts, and managing risks. This allows them to offer liquidity services to customers, such as checking and savings accounts, that makes it easier for them to conduct transactions and access funds whenever needed: banks provide depositors with checking accounts; depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary. FIs provide other financial services such as payment processing, account management, and investment advice, which can further reduce transactions costs. Another key function of FIs is to facilitate risk sharing and asset transformation. By pooling funds from many investors, FIs can create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party. This process is referred to as asset transformation because risky assets are turned into safer assets for investors. FIs can also help investors diversify their asset holdings by investing in a range of assets, pooling them, and selling rights to the diversified pool to individuals. For example, banks diversify their loan portfolios across many borrowers and industries to reduce the risk of default. This allows savers to earn a return on their investments without taking on excessive risk. Similarly, borrowers can access funds at a lower cost than if they were to borrow directly from individual investors. Asymmetric information is another reason for the existence of FIs. Adverse selection occurs when one party has more information than the other party, and this leads to an imbalance of information in the market. FIs can help mitigate adverse selection by screening and selecting borrowers based on their creditworthiness and risk profile. Moral hazard arises when one party takes on more risk than the other party intended or agreed upon. FIs can help manage moral hazard by monitoring and enforcing contracts and imposing penalties for non-performance. Types of Financial Institutions - Commercial banks: depository institution whose major assets are loans and whose major liabilities are deposits. Commercial banks’ loans are broader in range, including consumer, commercial and real estate loans, than are those of other depository institutions. Commercial banks’ liabilities include more non-deposit sources of funds, such as subordinate notes and debentures, than do those of other depository institutions. - Thrifts: depository institutions in the form of savings associations, saving banks, and credit unions. Thrifts generally perform services similar to commercial banks, but they tend to concentrate their loans in one segment, such as real estate loans or consumer loans. - Insurance companies: financial institutions that offer a range of insurance products to individuals and businesses, such as life insurance, health insurance, property insurance, and liability insurance. They generate revenue by collecting premiums and investing the funds in a diversified portfolio of assets. - Securities firms and investment banks: institutions that help companies raise capital by underwriting and issuing securities such as stocks and bonds. They also provide financial advice and services to institutional and individual investors. - Finance companies: they specialize in providing loans to consumers and businesses, often for specific purposes such as purchasing equipment or financing a car. They typically charge higher interest rates than traditional banks to compensate for the higher risk of their loans. Unlike depository institutions, finance companies do not accept deposits but instead rely on short- and long-term debt for funding. - Investment funds: they pool money from individual investors to invest in a diversified portfolio of assets, including stocks, bonds, and real estate. - Pension funds: financial institutions that manage retirement savings on behalf of employees. They offer saving plans through which fund participants accumulate savings during their working years before withdrawing them during their retirement years. Funds originally invested in and accumulated in pension funds are exempt from current taxation. - FinTechs: technology companies that provide financial services and products, often using digital platforms and mobile apps. They may offer services such as online banking, payment processing, and investment management, and may compete with traditional financial institutions. 4. Supervisory Authorities Supervisory authorities play a crucial role in ensuring the stability and integrity of financial systems. These authorities are responsible for regulating and supervising financial institutions, such as banks, insurance companies, and investment firms, to ensure that they operate in a safe and sound manner and comply with applicable laws and regulations. The critical nature of the functions performed by financial systems and the potential for failures underscores the need for extensive regulatory activity. The costs of financial crises can be significant and can have a severe impact on the trust of participants and on the development of economies. Therefore, supervisory authorities must remain vigilant and take proactive measures to prevent such failures from occurring. In addition to preventing failures, supervisory authorities also play a vital role in promoting financial stability and ensuring fair and transparent markets. They monitor market conditions, assess systemic risks, and develop policies to mitigate potential threats to the financial system. This includes setting capital and liquidity requirements, conducting stress tests, and establishing resolution frameworks. Given the globalization of financial intermediation, it has become increasingly important to increase coordination among supervisory authorities and harmonize regulations at the international level. This helps ensure a level playing field for FIs, reduce regulatory arbitrage, and enhance the effectiveness of supervisory activities. International bodies such as the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS) have been established to facilitate such coordination and harmonization efforts. Financial Crises A financial crisis is a major disruption in financial markets that is typically characterized by a sharp decline in asset prices and the failure of financial firms. These disruptions occur when there is a breakdown in the flow of information between savers and firms with productive investment opportunities. In particular, asymmetric information creates barriers that can lead to adverse selection and moral hazard, which are the primary drivers of financial crises. Adverse selection occurs when one party in a transaction has more information than the other party, leading to a situation where the party with less information incurs losses. For example, in the context of financial markets, borrowers may have more information about their ability to repay a loan than lenders, leading to a situation where lenders may make loans to borrowers who are unable to repay them. Moral hazard occurs when one party takes risks that are borne by another party. For example, in the context of financial markets, banks may take on excessive risks because they know that they will be bailed out by the government if they run into trouble. Financial crises have been widespread throughout history, both in the United States and in many other countries. They are almost always followed by severe contractions in economic activity because they lead to a sharp reduction in the availability of credit and a loss of confidence in the financial system. This, in turn, leads to a sharp reduction in investment and economic activity. Several historical cases of financial crises can be considered. Among the most important are the Great Depression and the Global Financial Crisis of 2007–2009. Financial Crises in advanced economies 1. Initial phase A financial crisis can begin in several ways. - Credit Boom. During a credit boom, there is a rapid expansion of credit, often fuelled by a relaxation of regulations or the introduction of new financial products. This can lead to excessive risk-taking by financial institutions, as they assume that their loans will be repaid and that they will be able to generate profits from the interest. However, as the risk builds up, loan defaults increase, asset values fall, and FIs cut back on lending (deleveraging), leading to a contraction of credit and a reduction in economic activity. Banking funding falls as well. No one is left to evaluate firms and the FS losses its primary institution to address adverse selection and moral hazard. - Asset-Price Boom. A financial crisis can also begin with an asset-price boom. A pricing bubble starts when asset values exceed their fundamental values. When the bubble bursts and prices fall, corporate net worth falls as well. Moral hazard increases as firms have little to lose. FIs also see a fall in their assets, leading again to deleveraging. - Increase in uncertainty. A financial crisis can begin with an increase in uncertainty. Periods of high uncertainty can lead to crises, such as stock market crashes or the failure of a major financial institution. With information hard to come by, moral hazard and adverse selection problems increase, reducing lending and economic activity. 2. Banking crisis Once a financial crisis has started, it can quickly turn into a banking crisis. As asset prices fall and borrowers default on their loans, FIs that have lent heavily to these borrowers begin to experience losses. As losses mount, FIs may become insolvent, meaning that their liabilities exceed their assets. Insolvency can lead to a run on the bank (bank panic), as depositors withdraw their funds in fear of losing them. This further weakens the bank's financial position and can ultimately lead to its failure. Banking crises can be particularly dangerous because they can spread from one institution to another. If one bank fails, it can cause other banks to fail as well, leading to a domino effect. This can create a panic in the financial system, where everyone rushes to withdraw their money from banks, leading to a collapse of the entire banking system. - The default of an intermediary does not only affect the intermediary and its stakeholders but potentially the overall FS. - The functioning of the FS is based on the “trust” of economic operators and the collapse of an institution can therefore cause a collapse in public confidence, with the consequent phenomenon of “bank runs” and the potential contagion of the entire system (domino effect). - As cash balances fall, FIs must sell assets quickly, further deteriorating their balance sheet. - Adverse selection and moral hazard become severe - it takes years for a full recovery. 3. Debt deflation Once a banking crisis has occurred, it can lead to a debt deflation cycle. As banks fail, the money supply contracts, leading to a decrease in economic activity. This can lead to a decrease in prices, which in turn leads to an increase in the real value of debt. As the real value of debt increases, it becomes more difficult for borrowers to repay their loans. This can lead to further defaults and bankruptcies, leading to a downward spiral in economic activity. Parties to the contract 1. Insurer (Primary Insurer, Co-insurance, Reinsurance) The insurer is the party that provides the insurance coverage and assumes the risk of potential financial losses specified in the insurance policy. The insurer can be: - Primary Insurer: This is the IC that sells insurance policies directly to individuals or businesses. It assumes the risk of potential claims and is responsible for paying out any covered losses. - Reinsurer: Reinsurance companies provide insurance coverage to primary insurers. Reinsurers assume a portion of the risk from the primary insurer in exchange for a portion of the premium. Reinsurance helps primary insurers spread their risk and protect themselves from large losses. - Co-insurer: In some cases, multiple insurers may jointly provide insurance coverage to an insured. Each co- insurer assumes a portion of the risk and receives a proportionate share of the premium. 2. Insured (Policyholder, Insured, Beneficiary) The insured is the individual or entity that purchases the insurance policy from the insurance company. The term “insured” is often used in life insurance or health insurance to indicate the person whose life or health is covered by the insurance policy. They are the party that seeks financial protection from potential losses covered by the policy. Depending on the type of insurance policy, the insured can also be referred to as: - Policyholder: This term is commonly used in general insurance, such as auto insurance or property insurance. The policyholder is the individual or entity that owns the insurance policy and pays the premium to the insurance company. - Beneficiary: In life insurance, the beneficiary is the person or entity designated to receive the insurance benefits or proceeds upon the death of the insured. Adverse selection and moral hazard in insurance Adverse selection and moral hazard are two important issues that arise due to information asymmetry. - Adverse selection occurs when those most likely to suffer a loss are more likely to purchase insurance, leading to an imbalance in the risk pool. - Moral hazard occurs when insured individuals take on more risk because they are protected by the insurance policy, leading to increased losses for the insurer. ICs have found various solutions to address these problems. For instance, ICs may require a physical examination for health insurance policies to ensure that pre-existing conditions are not covered. Additionally, insurance policies may exclude certain high-risk activities or offer higher premiums for such activities. Furthermore, insurers may use deductibles and co-payments to encourage policyholders to take precautions to avoid losses and minimize claims. Types of Insurance Insurance is classified by which type of undesirable event is covered: - Life insurance policies financial protection for the insured's family in the event of the policyholder's untimely death, or in some cases, in the event of critical illness or disability. It can also serve as a means of saving or investing money for retirement. - Property-casualty insurance covers a wide range of risks, including automobile accidents, home and property damage, liability arising from personal injury or damage caused to others, and more. In addition to these insurance products, many insurance companies also offer a variety of investment products, similar to other financial service firms. However, ICs are regulated differently than other financial service firms, so it's important to carefully evaluate the risks and benefits of any investment product before making a decision. The insurer “performance” typically has a character of uncertainty: if and/or when and/or how. Life Insurance Companies Life insurance companies provide valuable services to individuals by pooling risks and offering insurance services at a lower cost than an individual could achieve on their own. There are four main types of life insurance policies: 1. Ordinary life insurance is marketed on an individual basis, usually in units of $1,000; policyholders make periodic premium payments in exchange for coverage. o Term life is the closest to pure life insurance; has no savings element attached and the beneficiary receives a pay-out at the time of the individual’s death during the coverage period. o Whole life protects the individual over an entire lifetime and allows for borrowing against the cash value of the policy. o Endowment life combines a pure (term) insurance element with a savings element. If the insured dies before the endowment's maturity, the policy's face value ("death benefit") is paid in a lump sum to any beneficiaries. However, if the insured is still alive at the time of an endowment's maturity, the face value returns to the policyholder. o Variable life invests fixed premium payments in mutual funds of stocks, bonds, and money market instruments and offers a variable pay-out based on the return on the investments. 1. Group life insurance covers a large number of insured persons under a single policy, usually offered to corporate employers and can be either contributory or non-contributory. Contributory requires both the employer and employee to cover a share of the employee’s cost of insurance; non-contributory means the cost of the employee’s insurance is paid entirely by the employer. 2. Credit life insurance protects lenders against a borrower’s death prior to the repayment of a debt contract, such as a mortgage or car loan. Usually, the face amount of the policy reflects the outstanding principal and interest on the loan. 3. Other activities include the sale of annuities, private pension plans, and accident and health insurance. Annuities represent the reverse of life insurance principles: life insurance involves building up a fund and eventually paying out a lump sum, while annuities involve different methods of liquidating a fund over a long period of time. They are popular mechanism for retirement savings because annual annuity contributions are not capped and are not affected by the policyholder’s income level. Actuaries play a critical role in the life insurance industry by analysing mortality and other contingencies to reduce the risks of underwriting and selling life insurance. With traditional life insurance, actuaries analyse mortality, produce life tables, and apply time value of money concepts to produce life insurance, annuities, and endowment policies. With health insurance, actuaries analyse rates of disability, morbidity, mortality, fertility, and other contingencies. Health Insurance Adverse selection is a significant problem in the health insurance market, and it occurs when individuals with higher health risks are more likely to seek insurance coverage, leading to higher overall costs for the insurer. To offset these higher costs, insurers often charge higher premiums for individual policies or offer group policies that spread the risk across a larger pool of individuals. In the United States, health insurance is a contentious issue in the political environment, with debates focusing on the increasing costs of coverage and access to health care. Some insurance programs are attempting to shift costs to employers, while others are using Health Maintenance Organizations (HMOs) to control costs. In Italy, the health insurance market is not yet as developed as in the USA because public health coverage is still widely available. However, there are private insurance options available for those who wish to supplement their public coverage or receive additional benefits. Balance Sheets - Assets: life insurance companies invest heavily in long-term assets such as corporate bonds, equities, and government securities because they have long-term liabilities. This investment strategy helps ensure that they can meet their obligations to policyholders in the event of a claim. In 2018, life insurance companies in the USA had 6.8% of their assets invested in government securities, 63.5% in corporate bonds and stocks, and 8.1% in mortgages Liabilities: having a significant capital and surplus reserve fund is important for life insurers to withstand unexpected future losses. This fund helps to ensure the insurer can continue to meet its policy obligations even during difficult economic conditions. Net policy reserves made up $5.4 trillion, or 76.9% of total liabilities and capital, while capital and surplus reserves amounted to $418.7 billion, or 6% of their total liabilities and capital, in 2018 (USA). Property and Casualty Insurance Property insurance protects businesses and owners from risks associated with ownership, such as damage to property due to fire, theft, or natural disasters. There are two types of property insurance policies: - Named-peril policies cover only losses from perils specifically named in the policy; - Open-peril policies cover losses from all perils except those specifically excluded in the policy. Casualty insurance, also known as liability insurance, protects against financial losses resulting from a claim of negligence, including bodily injury, property damage, and personal injury. This type of insurance is typically purchased by businesses and individuals to protect against the risk of lawsuits. Reinsurance is a practice where an IC allocates a portion of the risk it has assumed to another IC in exchange for a portion of the premium. This helps the original IC manage its risk exposure and potentially increases its capacity to underwrite more policies. Main P&C Lines - Fire insurance and allied lines protect against the perils of fire, lightning, and removal of property damaged in a fire. - Homeowners’ multiple perils (MP) insurance protects against multiple perils of damage to a personal dwelling and personal property, as well as liability coverage against the financial consequences of legal liability resulting from injury to others. - Commercial multiple peril (MP) insurance protects commercial firms against perils similar to homeowners MP insurance. - Automobile liability and physical damage (PD) insurance provide protection against losses resulting from legal liability due to the ownership/use of the vehicle and theft or damage to vehicles. - Liability insurance (other than auto) provides coverage against legal liability resulting from bodily injury, property damage, or personal injury caused to others by the policyholder or their employees. Balance Sheets - Assets: P&C insurers invest most of their assets in long-term securities, although the proportion held in common stock is lower than that of life insurance companies. Bonds, preferred stock, and common stock represented 71.7% of total assets in 2018 (USA). - Liabilities: loss reserves (funds set aside to meet expected losses from underwriting the P&C lines) and loss adjustment expenses (the expected administrative and related costs of adjusting settling claims) are major components (33.2% of total liabilities and capital - USA). Unearned premiums are 13.6% of total liabilities and capital. Underwriting Risk Underwriting risk is the risk that an insurance company will experience losses due to inadequate premiums to cover claims and expenses. This can occur due to various factors such as: - Unexpected increases in loss rates, due to an increase in the frequency or severity of claims, changes in legal or regulatory environments, or changes in the external environment such as natural disasters or pandemics. - Unexpected increases in expenses, due to rising costs of labour, materials, or other inputs, changes in legal or regulatory requirements, or changes in market conditions. - Unexpected decreases in investment yields or returns, due to changes in interest rates, economic downturns, or changes in market conditions. It's important for ICs to properly manage underwriting risk by setting appropriate premiums, closely monitoring and managing expenses, and effectively managing their investment portfolio to generate adequate investment income. Loss Risk The key feature of claims loss risk is the actuarial predictability of losses relative to premiums earned, which are premiums received and earned on insurance contracts because time has passed without a claim being filed. Loss risk is a critical aspect of the insurance industry, and actuarial science plays a crucial role in predicting and managing losses. Actuaries use statistical models to analyse past loss data and project future losses based on various factors, such as the type of coverage, policy limits, deductibles, and the insured's risk characteristics. Property lines tend to have more predictable loss levels than liability lines because they typically result from a limited set of events, such as natural disasters, theft, or fire, which can be more easily quantified and predicted. In contrast, liability losses can arise from a wide range of events, such as accidents, lawsuits, and claims, which are more difficult to forecast with precision. Furthermore, losses on low-severity, high-frequency lines such as auto or workers' compensation insurance, tend to be more predictable than on high-severity, low-frequency lines such as product liability - Defined contribution plans. The regular contribution paid is fixed and the value of the policyholder’s pension wealth depends on the performance of the pension funds’ investments. The employer and/or the employee agree to make a specified contribution to the PF during the employee’s working years and benefits are based on the amounts credited to the individual account + any investment earnings on the money in the account. Future benefits fluctuate on the basis of investment earnings: variable-income funds, all profits and losses on the underlying securities are passed through to the fund participants. Public sector Public sector pension plans in the Euro area countries often provide first-pillar pension plans under a pay-as-you-go (PAYG) approach. This means that current workers' contributions are used to pay the pensions of current retirees. There is thus a key relationship between the number of workers and the number of pensioners in the scheme. This is different from a funded pension plan, where contributions are invested and used to pay for future retirement benefits. Second, while the number of workers and pensioners is important for determining the financial sustainability of a PAYG pension plan, it's not the only factor. Other factors such as life expectancy, retirement age, and benefit levels also play a role in determining the long-term viability of the system. A PAYG system is one in which workers pay for a service before receiving benefits and benefits are limited by the amount they've paid in. Areas of reform There are several areas of reform that could be considered for pension funds: - Social security funding: to increase required contributions to the social security system and decrease benefits. This could help to ensure the long-term sustainability of the system and prevent future shortfalls in funding. - Vesting of benefits: to implement measures to encourage later retirement. One way to do this is to provide incentives for employees to work longer and delay claiming their pension benefits. For example, a vesting period could be introduced, where employees would need to work for a certain period of time before they become eligible to receive their full pension benefits. - Fiscal incentives for supplementary pensions: to boost the development of forms of supplementary retirement savings, governments could offer fiscal incentives to encourage individuals to save more for retirement. This could include tax deductions or credits for contributions made to private pension plans or other types of retirement savings accounts. Data Public pension benefits differ considerably in terms of their level and nature, ranging from “poverty protection” in some Member States to replacement of up to 80% of final salaries in others. The level and nature of public pension benefits can have a significant impact on the financial security and well-being of retirees. Countries with higher replacement rates of final salaries in their pension systems may provide greater financial security for retirees, while those with lower replacement rates may struggle to provide adequate support. The concentration of PFs in certain countries also has implications for the stability and efficiency of the pension system. Countries with a large number of pension funds may be able to achieve greater diversification and risk management, while those with fewer funds may be more vulnerable to market fluctuations and other risks. The Euro area pension fund sector is highly concentrated in a few countries. The Netherlands stands out for its exceptionally large share, followed by Germany. There is a disparity in the number of reporting institutions, as in some countries there are large reporting populations made up of small pension funds (for instance Ireland and Cyprus) while in other countries there are just a few pension funds. Pension funds in Italy Legislative Decree No. 124 of 1993 established the Pension Funds Supervisory Authority (COVIP) and defined the tasks and powers of the authority. This legislation also regulated the establishment and operation of new pension funds, which had to be funded and based on the defined contribution method. Defined benefit plans were restricted to pre- existing funds. Legislative Decree No. 252 of 2005 is considered the masterpiece of the PFs sector's legislation. It required private employees to choose whether to transfer their Termination indemnity payments (TFR) to a pension plan or to keep it in their company. TFR is a sort of severance pay scheme that the employer has to pay to the employee in the case of dismissal or retirement. The employer sets aside 6.91% of the gross salary of the employee on a monthly basis. If the employee doesn't make an active choice within six months, the TFR is automatically paid into a PF, with a less risky portfolio set as the default option for tacit adhesion. Employees can decide to add further contributions on a collective basis to get matching contributions from the employer. The PFs are divided into: - Closed-end funds are intended for specific categories of workers, such as employees of a single company or a group, self-employed workers belonging to a particular professional area, and individuals who carry out their work within a specific territorial area. Closed-end PFs are typically funded not only by workers but also by employers, and can be made through contracts and collective agreements between workers and employers, corporate regulations, or agreements between employers and trade unions or trade associations. The financial management is delegated to one or more financial institutions authorized to asset management. - Open pension funds may include all employees, private and public, self-employed, as well as unemployed. Open PFs are established by FIs such as banks, asset management companies, and insurance companies. The financial management is delegated to one or more financial institutions authorized to asset management. PFs, both open and closed-end, are voluntary pension schemes. However, if any, it is convenient to adhere to closed- end funds rather than open-ended funds: the employer is required to make a contribution to the pension scheme which the employee has joined, helping to raise the payments made on the individual account. The cost of PFs differs widely, and the Synthetic Cost Indicator (SCI) provides a calculation method that aims to favour immediate comparability between different pension funds. The average SCI is calculated according to a common methodology set by COVIP. The SCI of each investment option has to be displayed on the information document to be made available to members and on the COVIP website. Areas of reform The areas of reform for public and mandatory pension systems since the 1990s have been primarily focused on addressing the challenges of increasing life expectancy and slow economic growth. These reforms aim to ensure the sustainability of public accounts, and they have included changes to retirement age, minimum contribution periods, and the way pensions are calculated and adjusted over time. One significant change has been the increase in the age required to retire and the minimum contribution period, which reflects the fact that people are living longer and need to support themselves for a more extended period in retirement. In addition, the amount of the pension is now linked to the contributions paid during the working life and no longer to the last salaries received. To ensure the sustainability of public accounts, the amount of the pension is also linked to the growth of Gross Domestic Product (GDP) and life expectancy at the time of retirement. This means that pension payments will be adjusted according to changes in these factors over time. Another key reform has been to limit the revaluation of pensions to inflation only, rather than tying them to the growth of salaries or other factors. This helps to ensure that pension payments remain affordable over time. Given the lower replacement rate for new pensions compared to those of current pensioners, a second pillar is being added to the compulsory pension: the complementary pension. This pillar is designed to provide additional income in retirement and help people achieve a more comfortable standard of living. PFs benefits Each PF must indicate its line of investment. PFs offer several benefits to their members: - Tax Benefits: during the contribution phase, payments made to a PF are deductible from income up to a certain ceiling. The sum deducted from taxation will be resumed during the withdrawal phase. Moreover, benefits paid at maturity are subject to a tax rate lower than the individual income tax rate, which is currently set at 15% (with a further reduction of 0.3% per year for each year of participation in the pension scheme over the 15 years, up to a maximum reduction of 6 basis points). This tax rate can be further reduced to 9% if the member chooses to receive the benefits as an annuity or capital payment. - Capitalization of Contributions: benefits are defined according to the principle of capitalization. The benefits achieved by each member are related to payments made over the years, revalued with the performance of the capital markets. This means that contributions made by members are invested in the financial markets and grow over time, resulting in higher benefits at the time of retirement. - Potential Financial Returns: during the contribution phase, members' contributions are invested in various financial instruments, such as stocks, bonds, and mutual funds, which generate potential financial returns in the form of dividends, interests, and capital gains. The tax rate on these returns is currently set at 20% (with a lower rate of 12.5% for government bonds). - Retirement Planning: PFs help individuals plan for their retirement by providing a systematic way to save for the future. Members can choose from different investment options, depending on their risk tolerance and investment goals. This helps them achieve their retirement goals by ensuring that they have sufficient funds to support their lifestyle after retirement. PFs constraints The PFs constraints involve several rules related to the distribution of performance benefits to members. The benefits are provided in the form of an annuity, which can be partially converted into a lump sum by the subscribers. However, the amount paid in capital cannot exceed 50% of the total amount due. The withdrawal phase cannot be initiated by the member and is instead tied to the retirement age established by the public social security scheme. However, participants who have spent a certain number of years in the fund can request redemption of benefits in the case of specific economic needs, such as health expenses or the purchase or renovation of a house. In case of the death of the participant: - If the event happens during the payment phase, the total amount accrued until that moment is given to the surviving heirs. - If the payment phase ends before the conversion of the total amount accrued in an annuity, the participant must decide the procedure in the case of death. They can choose to apply a maximum rate of conversion, which results in the total loss of annuities in the case of death, or a lower rate of conversion that includes the possibility of giving the unpaid residual amount to heirs in the event of death. The Future of Pension Funds The future of pension funds is likely to be shaped by a number of factors, including demographic trends, market conditions, and regulatory changes. While it is difficult to predict the future with certainty, there are several trends that suggest that pension funds will continue to play an important role in the financial landscape. First, as the average population continues to grow and age, there will likely be increased demand for retirement savings vehicles such as PFs. This trend is particularly pronounced in developed countries where aging populations are putting pressure on government-run social security systems. As a result, individuals are likely to turn to private pension funds as a way to ensure a secure retirement. Second, as pension funds grow in popularity, we may see an increase in the variety of PF offerings available to investors. This could include new types of funds that invest in alternative assets, such as real estate, infrastructure, or private equity. It could also involve the development of new investment strategies that seek to achieve specific financial goals, such as generating income or preserving capital. Third, pension funds may gain significant control over corporations as their stock holdings increase. This could give PFs more influence over corporate governance and potentially lead to changes in corporate behaviour. However, it is important to note that PFs are typically passive investors and are unlikely to engage in aggressive activism or hostile takeovers. PEPP According to a study carried out in 2018 by the European Insurance and Occupational Pensions Authority (EIOPA), 27% of European citizens aged 25 to 59 years, or 67 million individuals, have taken out a supplementary pension plan. PEPP, or the pan-European personal pension product, is a voluntary retirement savings product that was proposed by the European Commission in 2017 and approved by the European Parliament in 2019, in order to expand the current offering. It is a complementary product to state-based and occupational pensions and is applicable to everyone, including employed, part-time, full-time self-employed, and unemployed individuals. Market Making Market making is a process in which a securities firm or investment bank creates a secondary market for an asset by providing liquidity, thereby allowing investors to buy and sell the asset easily. Market making can involve agency transactions, in which the market maker acts as an intermediary between buyers and sellers, executing trades on behalf of customers, and earning a commission on each transaction. Alternatively, market making can involve principal transactions, in which the market maker takes a position in the asset and seeks to profit from the price movements of the security. In this case, the market maker buys and holds inventory of the asset in order to sell it at a higher price, or sells inventory that it does not currently own in order to buy it back at a lower price. Market makers play an important role in financial markets by providing liquidity and narrowing bid-ask spreads, which makes it easier for investors to trade and helps ensure that prices reflect true market value. Trading Trading is closely related to market-making. Traders take an active net position in an underlying instrument or asset, which means they are either long (buying) or short (selling) a particular asset, with the aim of profiting from changes in the price of the asset. There are at least six types of trading activities: 1. Position trading involves purchasing large blocks of securities with the expectation of a favourable price movement. 2. Pure arbitrage involves exploiting price differences between two markets by buying an asset in one market and immediately selling it in another market at a higher price. 3. Risk arbitrage involves buying securities in anticipation of some information release, such as a merger or takeover announcement. 4. Program trading is the use of computer programs to simultaneously buy and sell a portfolio of at least 15 different stocks valued at more than $1 million. 5. Stock brokerage involves trading securities on behalf of customers. 6. Electronic brokerage involves direct access to the trading floor via the Internet bypassing traditional brokers. Investing and Cash Management Investing involves managing pools of assets such as closed- and open-end mutual funds, where securities firms act either as agents for other investors or as principals for themselves and their stockholders. The objective of fund management is to select asset portfolios that can outperform certain benchmarks, such as the S&P 500 Index, while managing risk. In addition, securities firms and investment banks offer cash management accounts (CMAs) and money market mutual funds that offer check writing privileges. These types of accounts are designed to provide a bank deposit-like experience with competitive interest rates and easy access to funds while providing potential liquidity and capital preservation. These accounts can be used for cash management purposes, such as holding cash reserves, paying bills, or making investments. Mergers and Acquisitions Investment banks play a significant role in the mergers and acquisitions (M&A) process. They provide various services to both the acquirer and the target company, including strategic advice, valuation, due diligence, and negotiation support. Some of the key services that investment banks offer in the M&A process are: - Finding Merger Partners: investment banks help companies identify and evaluate potential merger partners. They use their industry knowledge, network, and research capabilities to identify potential targets that align with the acquirer's strategic objectives. - Underwriting New Securities: investment banks underwrite any new securities issued by the merged firms, including equity, debt, and hybrid securities. They help the merged company raise capital by marketing the securities to investors and managing the issuance process. - Assessing the Value of Target Firms: investment banks conduct detailed financial analysis and valuation of target companies to determine their value. They consider various factors, such as financial performance, market conditions, industry trends, and competitive landscape, to assess the fair value of the target company. - Recommending Terms of the Merger Agreement: investment banks help negotiate the terms of the merger agreement, including the purchase price, payment structure, governance, and other terms and conditions. - Assisting Target Firms in Preventing a Merger: investment banks also work with target firms to defend against hostile takeovers and unwanted merger offers. They provide strategic advice, help identify potential white knight buyers, and develop other defensive strategies. M&A activity is a significant part of the investment banking industry, with the total global deal value reaching $1.82 trillion in 2019. Investment banks earn fees for their M&A services, typically based on the deal value or the amount of capital raised. Other Service Functions - Custody and escrow services provided by investment banks involve the safekeeping of securities and other financial assets on behalf of clients. Investment banks act as custodians and provide secure storage, record- keeping, and reporting services for these assets. - Clearance and settlement services provided by investment banks involve the processing and settlement of securities transactions. Investment banks act as intermediaries between buyers and sellers, ensuring that securities are delivered and payment is received on time and in accordance with the terms of the transaction. - Research and advisory services provided by investment banks involve the provision of advice and information to clients regarding investment opportunities and market trends. Investment banks employ research analysts who provide insights into companies and industries, make recommendations on investment strategies, and help clients make informed decisions about their investments. In performing these functions, investment banks normally act as agents for a fee. Fees charged are often based on the total bundle of services performed for the client by the firm. Portion of the fee or commission allocated to research and advisory services is called soft dollars. Investment banks are also expanding into traditional bank services areas, such as small-business lending and the trading of loans. This allows investment banks to diversify their revenue streams and offer a wider range of services to clients. However, investment banks may face increased competition and regulatory scrutiny in these areas. Balance Sheets - Assets: the assets are largely cash-like money market instruments, receivables from other broker-dealers, and reverse repurchase agreements. Long positions in securities and commodities are also a significant asset. - Liabilities: securities firms hold high levels of debt and tend to use short-term, market-based funding sources. Repurchase agreements are a major source of funds, along with payables to customers and other broker- dealers, and securities and commodities sold short for future delivery. - Equities: equity capital makes up a small portion of total assets, at only 6.1%. Total capital, which includes both equity capital and subordinated liabilities, accounts for 9.1% of total assets. FinTech The use of technology in the financial sector is not new, and it has been a part of the industry for several decades. However, the rapid pace of technological advancement in recent years has resulted in the emergence of innovative financial products and services, and new players in the financial industry known as FinTech companies. The financial crisis of 2008-2009, caused by the collapse of Lehman Brothers, was a turning point for the financial industry. It led to a loss of trust in the traditional banking system and created a demand for alternative financial services. FinTech companies were able to capitalize on this demand by offering innovative financial products and services that were often more convenient, efficient, and cost-effective than those offered by traditional financial institutions. Since then, the FinTech industry has grown rapidly, attracting significant investment and disrupting the traditional financial industry. FinTech innovations such as mobile banking, peer-to-peer lending, robo-advisors, and blockchain technology are changing the way financial services are delivered, consumed, and regulated. An initial definition is provided by Arner et al., who highlight that “FinTech refers to the application of technology to finance”, underlining that nowadays, unregulated entities use technology to provide financial solutions that in the past were only offered by regulated financial intermediaries. The definition of the FSB (2017) is more precise: “FinTech is defined as technology-enabled innovation in financial services that could result in new business models, applications, processes or products with an associated material effect on the provision of financial services”. This definition emphasizes that FinTech is not limited to a specific type of innovation but is rather a broad term that covers a wide range of financial services and technologies. It is also true that the financial sector has always been a big user of technology, but what is different now is that the traditional closed approach has given way to an open approach, where ideas, skills, and capital from outside the financial sector are driving technological innovation. This open approach has created opportunities for new entrants to disrupt the traditional financial services industry, leading to the emergence of innovative products and services. The evolution of FinTech has been a long and varied journey, dating back to the 19th century with the invention of the Pantelegraph, a precursor to the fax machine. The subsequent establishment of the trans-Atlantic telegraph cable in 1866 and the Fedwire in 1918 set the foundation for the development of financial technology. The 1930s saw the German Reich mail service trial the world's first telex network, followed by Western Union's launch of a similar network in the U.S. in 1958. The 1960s saw the introduction of Quotron, an electronic system providing real-time stock quotes to stockbrokers and money managers. By the late 1960s and 1970s, rapid advances in electronic payment systems were made, and the telex network replaced the telegraph as the standard for long-distance communication of information. The establishment of NASDAQ in 1971 marked a significant milestone in the development of electronic trading. The 1980s saw the rise of bank mainframe computers and more sophisticated data and record-keeping systems. The 1990s saw the proliferation of the internet and e-commerce business models. The early 2000s brought stock market decimalization, algorithmic trading, and high-frequency trading (HFT), further advancing financial technology. In recent years, we have witnessed an intense and rapid diffusion of technological innovations in financial intermediation products and processes. This has led to the emergence of new FinTech firms, new business models, and a significant transformation of the financial sector. Technological evolution The FinTech industry emerged as a result of the technological evolution, increased computing power and the growth of the digital economy. The rapid technological development of recent years, commonly referred to as the "fourth industrial revolution", has created an environment in which technology can connect, create and coordinate services of different natures. This has resulted in the digitisation of economic and social relations, leading to the development of environmental conditions that have greatly expanded the reach of individuals and small businesses, enabling access to markets even for those previously neglected or excluded. One of the main drivers of the FinTech industry is the increasing use of digital technologies in finance. This includes online banking, mobile payments, digital wallets, and peer-to-peer lending, among other services. With the growing use of digital technologies, there has been a shift in the way financial services are delivered, making them more accessible, affordable, and convenient for customers. Another factor that has contributed to the growth of the FinTech industry is the increasing demand for personalised and innovative financial services. FinTech companies have leveraged data analytics, machine learning, and artificial intelligence to create personalised financial products and services tailored to the needs of individual customers. This has helped to drive customer adoption and loyalty. The Re-definition of FS Financial technology is a term used to describe the use of technology to improve and automate financial services. FinTech is changing the way we think about and interact with financial systems. It has the potential to redefine the traditional financial system by making financial services more accessible, efficient, and user-friendly. One of the main ways FinTech is redefining the financial system is by improving the speed and efficiency of financial transactions. With the use of blockchain technology, for example, transactions can be completed instantly, without the need for intermediaries such as banks. This can help reduce transaction costs and increase the speed of transactions, making it easier for people to conduct business and transfer money. FinTech is also changing the way people access financial services. With the rise of mobile banking and digital wallets, people can access financial services from anywhere, at any time. This is especially important for people who may not have access to traditional banking services, such as those living in remote or underserved areas. - Credit, Deposit, and Capital-Raising Services: FinTech innovations have significantly impacted the traditional banking and financial services sector, particularly in the areas of credit, deposit, and capital-raising services. Crowdfunding is a method of raising capital through the collective effort of individuals, usually through an online platform, to fund a project or venture. Crowdfunding platforms such as Kickstarter, CrowdCube, Indiegogo, and GoFundMe have enabled entrepreneurs, artists, and innovators to bypass traditional financing sources such as banks, venture capitalists, and angel investors. Lending marketplaces, also known as peer-to-peer (P2P) lending platforms, are nonbank lending platforms that connect borrowers directly with investors. These platforms use technology to evaluate credit risk and match borrowers with investors who are willing to lend money for a return on investment. Some of the most popular lending marketplaces include LendingClub, OnDeck, Avant, GreenSky, Kabbage, and SoFi. Mobile banks are digital-only banks that allow customers to perform banking transactions such as account opening, deposits, withdrawals, and money transfers using their mobile devices. Some popular mobile banks include Chime, Revolut, N26, and Monzo. Lastly, credit scoring is another area where FinTech has made significant inroads. Many FinTech startups have developed algorithms and models that use non-traditional data sources to evaluate creditworthiness, such as social media activity, online purchasing behaviour, and even smartphone usage. These innovations have made it possible for underserved populations to access credit and have enabled lenders to make more informed lending decisions. - Investment Management Services: Investment management FinTechs provide a range of services for both individual and institutional investors. High-frequency trading (HFT) uses advanced algorithms to execute trades in fractions of a second, enabling traders to profit from small price movements in a very short period of time. Copy trading allows novice traders to automatically copy the trades of more experienced traders, allowing them to benefit from their expertise and hopefully make better investment decisions. Platforms such as Trade360, FxPro, eToro, ZuluTrade, and TradingFloor are popular examples of copy trading platforms. Robo-advice is an online service providing automated portfolio management based on a client's risk tolerance, investment goals, and other preferences. The service is often provided at a lower cost than traditional wealth management services, making it accessible to a wider range of investors. Regulatory approaches to FinTech: international regulations Two significant changes to EU regulations have given the FinTech industry a major shot in the arm and strengthened its position as a competitor to traditional banking: - General Data Protection Regulation (GDPR) is the world’s strongest set of data protection rules, giving individuals more control over their personal data and limiting what organizations can do with that data. This has led to increased trust in FinTech companies that handle personal data and has created new opportunities for innovative data-driven services. - Payment Services Directive 2 (PSD2) has also had a significant impact on the FinTech industry by promoting competition and innovation in the payments space. The directive requires banks to provide third-party providers with access to customer account information and payment initiation services through open APIs, which has led to the emergence of new FinTech companies that specialize in payment services. The Open Banking phenomenon, which emerged from PSD2, has also been a major driver of innovation in the FinTech industry. Open Banking has enabled FinTech companies to access bank data and create new products and services that are more personalized and tailored to individual customers' needs. It has also given customers more control over their financial data, allowing them to share it with other trusted organizations to access new services. Overall, these regulatory changes have created a more favourable environment for FinTech innovation in Europe, allowing new players to enter the market and compete with established banks. As a result, the FinTech industry is becoming increasingly important in the financial ecosystem and is likely to continue to drive innovation and growth in the years to come. The money markets The term "money market" is a misnomer in the sense that actual money or currency is not traded in these markets. Instead, the securities traded in the money market are highly liquid and short-term, making them close to being money. Money markets are typically comprised of securities that are sold in large denominations of $1,000,000 or more, have low default risk, and mature in 1 year or less from their issue date, although most mature in less than 120 days. So, why do we need money markets? While the banking industry should handle the needs for short-term funding, banks are heavily regulated and have an information disadvantage compared to the players in the money market. This creates a distinct cost advantage for money markets over banks. Investors in the money market use it to warehouse surplus funds for short periods of time, while borrowers from the money market provide a low-cost source of temporary funds. Corporations and the U.S. government also use these markets because the timing of cash inflows and outflows are not well synchronized. Money markets provide a way to solve these cash-timing problems. Who participates in the Money Markets? The money market is a segment of the financial market where short-term financial instruments are traded, including treasury bills, commercial paper, certificates of deposit, and repurchase agreements. Participants in the money markets include: - The US Treasury Department and the Federal Reserve System are key players in the money markets as they issue and regulate the supply of money, respectively. - Commercial banks also participate in the money markets by lending and borrowing short-term funds to meet their reserve requirements and manage liquidity. - Businesses may participate in the money markets to invest surplus cash, manage their short-term funding needs, or raise capital through the issuance of short-term debt securities. - Investment companies such as brokerage firms, may participate in the money markets to manage the short-term cash balances of their clients and provide liquidity to the markets. - Finance companies, such as commercial leasing companies, may also participate in the money markets to raise capital and manage their short-term funding needs. - Insurance companies (property and casualty) can invest their policyholders' premiums in the money markets to generate income. - Pension funds may invest in the money markets to earn returns on their surplus cash and manage their liquidity needs. - Individuals may participate in the money markets through money market mutual funds, which invest in short-term debt securities issued by government entities, banks, and corporations. Overall, the money market is an essential part of the financial system, providing a mechanism for short-term borrowing and lending and facilitating efficient cash management for various entities. Money Market instruments - Treasury Bills: these are short-term debt instruments issued by the US government to finance its operations. They have a maturity of less than one year and are sold at a discount to their face value. - Federal Funds: these are overnight loans between banks to meet their reserve requirements. The interest rate for these loans is called the federal funds rate and it is set by the Federal Reserve. - Repurchase Agreements (Repo): a repo is a short-term loan where one party (usually a bank) sells securities to another party (usually a money market fund) and agrees to buy them back at a future date. It's a way for banks to borrow money for short periods of time. - Negotiable Certificates of Deposit (CDs): these are certificates issued by banks with a specified maturity date (usually less than one year) and a fixed interest rate. They are negotiable, meaning that they can be bought and sold on the secondary market. - Commercial Paper: these are short-term unsecured promissory notes issued by corporations to finance their short-term cash needs. They have a maturity of less than 270 days and are typically sold at a discount to their face value. - Banker’s Acceptance: these are short-term debt instruments issued by a company that has been guaranteed by a bank. They are often used in international trade to finance the purchase of goods and services. - Eurodollars: these are US dollar-denominated deposits held in banks outside of the US. They are not subject to US banking regulations and are often used by international corporations and banks to finance their operations. 1. Treasury Bills Treasury bills (T-bills) are short-term debt securities issued by the U.S. Treasury with maturities ranging from 28 days to 12 months. They are considered one of the safest investments because they are backed by the full faith and credit of the U.S. government. T-bills are sold at a discount to their face value (discounting), meaning that investors pay less for the security than they will receive when the bill matures. For example, if an investor buys a $1,000 T- bill at a discount price of $990 and holds it until maturity, they will receive $1,000 when the bill matures, resulting in a $10 return. T-bills are sold at weekly auctions to registered primary dealers, who then resell them to investors. The auctions take place every Thursday and the Treasury can accept both competitive and non-competitive bids. - In a competitive bid, the investor specifies the yield they are willing to accept and the amount they want to invest. The Treasury then accepts the bids with the highest yield until it has sold enough bills to meet its financing needs. The yield on the highest accepted bid is the discount rate used to determine the price at which all investors will purchase the bills. - In a non-competitive bid, the investor agrees to accept the yield determined by the auction and receives the bill at the average price of all accepted competitive bids. This means that non-competitive bidders are guaranteed to receive T- bills, but may not receive the full amount they requested if the auction is oversubscribed. 2. Federal Funds Federal funds are short-term funds that banks and other financial institutions transfer between each other to meet short- term reserve requirements. These funds are usually loaned or borrowed for a period of one day, although they can be extended for up to a week in some cases. - Let's say the U.S. Treasury is auctioning a 6-month Treasury Bill with a face value of $10,000. The Treasury sets a discount rate of 2%, which means that the Treasury Bill will be sold at a discount and investors will pay less than the face value. - Investor A places a competitive bid for $9,900, which means that they will pay $9,900 for the Treasury Bill. Investor B places a non-competitive bid for the full-face value of $10,000. - The Treasury accepts both bids and sets the highest yield paid to any accepted bid at 2%. Since Investor A's bid was lower than the face value, they will receive a return on their investment when the Treasury Bill matures in 6 months. - To calculate Investor A's return, we use the discount rate of 2% to determine the price the Treasury Bill will be worth at maturity. $10,000 x (1 - 0.02) = $9,800 - Therefore, when the Treasury Bill matures in 6 months, Investor A will receive $9,800, which is a return of $9,800 - $9,900 = -$100. - On the other hand, Investor B will receive the full-face value of $10,000 when the Treasury Bill matures in 6 months since they paid the full amount upfront. - Treasury notes and bonds are issued by the U.S. government and are considered to be the safest type of bond. - Municipal bonds are issued by local governments to finance public projects, such as schools and hospitals. - Corporate bonds are issued by companies to raise funds for expansion or to pay off existing debt. Financial guarantees, such as insurance policies, can be used to protect investors in the event of a default on a bond. These guarantees can be provided by a third party or by the issuer of the bond itself. The bond market is overseen by regulatory bodies such as the Securities and Exchange Commission (SEC) in the United States. These bodies ensure that the market operates fairly and transparently. Investing in bonds can provide a steady stream of income for investors, as well as a relatively low-risk investment option. The current yield of a bond can be calculated by dividing the annual interest payment by the current market price of the bond. The value of a coupon bond can be calculated by discounting the future cash flows of the bond back to the present using an appropriate interest rate. Capital Market participants Capital markets involve various participants, including primary issuers, purchasers, and traders of securities. Primary issuers of securities can include federal and local governments, which typically issue debt securities to fund various public projects and initiatives. Corporations may also issue both equity and debt securities to raise funds for their business activities. The largest purchasers of securities can be individual investors, institutional investors such as pension funds and hedge funds, as well as central banks and sovereign wealth funds. Capital Market trading Capital market trading occurs in two main markets: - The primary market, where initial public offerings (IPOs) take place, which is the first time a company offers its shares to the public. - The secondary market, where previously issued securities are traded among investors, can be divided into two categories: o Over-the-counter (OTC) market, where securities are traded directly between two parties, outside of organized exchanges. o Organized exchanges, such as the New York Stock Exchange (NYSE), where securities are traded on a centralized platform and regulated by a governing body. Types of Bonds Bonds are financial instruments that represent a loan from an investor to a borrower (typically a company, government or municipality) and are used to raise capital. There are several types of bonds, including: - Long-term government bonds (T-bonds): These are bonds issued by the government with a maturity of 10 years or more. They are considered to be one of the safest investments as they are backed by the full faith and credit of the government. - Municipal bonds: These are issued by local governments or municipalities to finance public projects such as schools, hospitals, and infrastructure. Municipal bonds can be general obligation bonds, which are backed by the issuer's ability to tax, or revenue bonds, which are backed by the revenue generated from the project being financed. - Corporate bonds: These are issued by companies to raise capital for various purposes such as expansion, mergers and acquisitions, or debt refinancing. Corporate bonds are generally riskier than government or municipal bonds, but offer higher yields as compensation for the additional risk. Other types of bonds include agency bonds (issued by government-sponsored entities such as Fannie Mae and Freddie Mac), zero-coupon bonds (which do not pay regular interest but are sold at a discount to their face value), and convertible bonds (which can be converted into shares of the issuer's stock). Treasury Notes and Bonds Treasury notes and bonds are debt securities issued by the U.S. Treasury Department to finance government operations. Treasury bonds are long-term securities with a maturity of 10 years or more, while Treasury notes have maturities of 1 to 10 years. Both are considered safe investments since they are backed by the full faith and credit of the U.S. government, which can print money to pay off the debt. Treasury bonds usually have lower interest rates than other types of bonds due to their low default risk. However, investors still face inflation risk, which could erode the value of their investment over time. Treasury inflation-indexed securities (TIPS) were introduced as a way to protect investors from inflation. TIPS adjust the principal amount of the security based on changes in the Consumer Price Index (CPI), thus preserving the purchasing power of the investment. Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) are another innovation in Treasury securities. STRIPS are created by separating the coupon and principal payments from a Treasury bond and selling them as individual zero-coupon bonds. This allows investors to customize their investments by buying only the portion of the bond that meets their specific needs. Overall, Treasury securities are considered a safe investment option, particularly for investors who prioritize capital preservation over high returns. Municipal Bonds Municipal bonds, also known as "munis," are debt securities issued by local, county, and state governments to finance public interest projects such as schools, hospitals, highways, and water treatment plants. There are two main types of municipal bonds: - General obligation bonds are backed by the full faith and credit of the issuer and are typically used to fund projects that benefit the community as a whole, such as public schools or libraries. In the event that the issuer cannot make payments on the bonds, they have the ability to raise taxes or cut spending to meet their obligations. - Revenue bonds are backed by specific revenue streams such as tolls, fees, or lease payments from the project being funded. These bonds are typically used to finance projects that generate revenue, such as sports stadiums or parking garages. If the revenue generated by the project is insufficient to make payments on the bonds, the bondholders do not have recourse to the issuer's general funds. One advantage of municipal bonds is that they are typically exempt from federal income tax and, in some cases, state and local taxes as well. This makes them particularly attractive to investors in higher tax brackets, as the tax-free municipal interest rate is often higher than the after-tax yield on other types of bonds. The formula to calculate the after-tax yield on a municipal bond is: tax- free municipal interest rate = taxable interest rate × (1 − marginal tax rate). Overall, municipal bonds can be a good investment for those looking for a relatively safe, tax-free way to earn a steady income. However, as with any investment, it is important to carefully consider the risks and potential returns before investing in municipal bonds. Corporate Bonds Corporate bonds are debt securities issued by companies to raise capital. They have a face value, which is the principal amount that will be repaid at maturity, and pay interest semi-annually. Corporate bonds can have a face value of $1,000, $5,000, or $10,000. The risk associated with corporate bonds varies depending on the credit rating assigned by rating agencies. Bonds with a higher risk of default have a lower credit rating and require a higher interest rate to compensate investors for the increased risk. Bonds with a credit rating below BBB are considered sub-investment grade or "junk" debt. - Registered bonds are a type of corporate bond that replaced bearer bonds, which were unregistered and could be transferred by physical delivery. Registered bonds allow the issuer to track interest income and include restrictive covenants that limit the company's actions, such as limiting dividends or new debt. - Call provisions allow the issuer to redeem the bonds before maturity, usually at a premium to the face value. Call provisions are typically included in bonds with a higher interest rate to give the issuer flexibility to manage their debt obligations. - Secured bonds are backed by specific assets, such as a mortgage or equipment, while unsecured bonds rely on the issuer's general creditworthiness. Debentures and subordinated debentures are types of unsecured bonds. Variable-rate bonds have an interest rate that is tied to a benchmark rate, such as LIBOR. - Junk bonds are debt securities with a credit rating below BBB. They offer a higher yield to compensate for the increased risk of default. Junk bonds were popularized in the 1980s by Michael Milken, but he was subsequently convicted of insider trading. Trusts and insurance companies are often not permitted to invest in junk debt due to the higher risk involved. Debt Rating descriptions Standard & Poor's (S&P) and Moody's are two prominent credit rating agencies that assess the creditworthiness of various entities, such as governments, corporations, and financial instruments. These agencies assign ratings to indicate the risk associated with debt issued by these entities. Standard & Poor's (S&P) and Moody’s Ratings: - AAA/Aaa: Best quality and extremely strong capacity to pay interest and repay principal, with the lowest level of investment risk. - AA/Aa: High quality and very strong capacity to pay interest and repay principal. Many favourable investment attributes and upper-medium-grade obligations but slightly more susceptible to adverse economic conditions. - A: Strong capacity to pay interest and repay principal but more susceptible to adverse economic conditions. - BBB/Baa: Medium-grade obligations. Neither highly protected nor poorly secured. Adequate capacity to pay interest and repay principal. May lack long-term reliability and protective elements to secure interest and principal payments. - BB/Ba: Moderate ability to pay interest and repay principal. Have speculative elements and future cannot be considered well assured. Adverse business, economic, and financial conditions could lead to inability to meet financial obligations. - B: Lack characteristics of desirable investment. Assurance of interest and principal payments over long period of time may be small. Adverse conditions likely to impair ability to meet financial obligations. - CCC/Caa: Poor standing. Identifiable vulnerability to default and dependent on favourable business, economic, and financial conditions to meet timely payment of interest and repayment of principal. - CC/Ca: Represent obligations that are speculative to a high degree. Issues often default and have other marked shortcomings. - C: Lowest-rated class of bonds. Have extremely poor prospects of attaining any real investment standard. May be used to cover a situation where bankruptcy petition has been filed, but debt service payments are continued. - CI/Caa: Reserved for income bonds on which no interest is being paid. - D/Ca: Payment default. - NR: No public rating has been requested. It's important to note that both agencies may also use "+" and "-" symbols to further refine ratings from AA to CCC, indicating relative positions within the rating categories. Additionally, both agencies may have other rating scales for specific types of debt or financial instruments. Financial Guarantees for Bonds Financial guarantees, such as credit default swaps (CDS), can be used by debt issuers to reduce the risk associated with their debt. A CDS is a financial contract in which one party agrees to compensate another party for any losses incurred on a specific debt instrument, such as a bond, due to default. The party purchasing the CDS pays a fee to the other party in exchange for the guarantee. While financial guarantees can be useful, they can also be misused and create unintended consequences. The rapid growth of the CDS market and the lack of oversight led to significant risks and losses during the 2008 financial crisis. The widespread use of CDSs to insure against losses on mortgage-backed securities led to huge pay-outs when the housing market collapsed, causing widespread financial turmoil. Stocks Stocks represent ownership in a company or corporation. When an individual buys a stock, they are essentially buying a small portion of the company and become a shareholder. Stockholders can earn a return on their investment in two ways. Firstly, the price of the stock can appreciate over time, resulting in capital gains when the stock is sold. Secondly, the company may distribute a portion of its profits as dividends to the stockholders. Stockholders have a claim on all assets of the company. If the company were to liquidate, the stockholders would be entitled to a portion of the proceeds after all debts and obligations have been paid off. Stockholders have the right to vote on certain issues, such as the election of directors or major decisions that require shareholder approval. The number of votes a stockholder has is proportional to the number of shares they own. There are two main types of stocks: common stock and preferred stock. Common stockholders have the right to vote on company decisions and receive dividends when they are declared. Preferred stockholders, on the other hand, typically receive a fixed dividend but do not usually have voting rights. Selling Stocks: Organized exchanges vs OTC Organized exchanges, such as the New York Stock Exchange (NYSE), have traditionally been physical locations where brokers and traders gathered to buy and sell securities. However, with the rise of electronic communication networks (ECNs), this concept has evolved. Today, the term "organized" refers more broadly to the system and rules that govern trading on the exchange. The NYSE is one of the most well-known organized exchanges, with daily trading volume that can reach up to 10 billion shares. Other examples of organized exchanges include the American Stock Exchange (ASE) in the United States, as well as international exchanges like the Nikkei, London Stock Exchange (LSE), and DAX. Organized exchanges typically have strict listing requirements that exclude small firms. This is because larger firms are seen as more stable and less risky for investors. These requirements may include financial metrics like revenue and profitability, as well as governance standards like independent boards of directors. In contrast, over-the-counter (OTC) markets are decentralized and operate without a central trading location. The best-known example of an OTC market is the NASDAQ, which is home to around 3,000 different securities. Dealers in the OTC market stand ready to make a market in these securities, which means they are willing to buy or sell at any time. This is especially important for thinly-traded securities, which may be difficult to trade without a dealer ready to facilitate transactions. In general, investing in organized exchanges is considered to be more reliable and transparent than investing in OTC markets. Organized exchanges are regulated by the Securities and Exchange Commission (SEC) and have strict listing requirements, which help ensure that listed companies meet certain standards of financial reporting and disclosure. In addition, the auction process on organized exchanges allows for price discovery and price transparency, which can benefit investors. OTC markets, on the other hand, are less regulated than organized exchanges, and companies listed on OTC markets may not meet the same standards of financial reporting and disclosure as those listed on organized exchanges. The lack of centralized price discovery and transparency can also make it more difficult for investors to determine the fair value of a stock. That being said, investing in OTC markets can also offer some advantages. OTC markets are generally more accessible to smaller companies that may not meet the listing requirements of organized exchanges. In addition, the multiple market makers and dealers on OTC markets can create more liquidity and potentially offer better prices than those available on organized exchanges. Ultimately, the choice between investing in organized exchanges or OTC markets depends on the individual investor's preferences and risk tolerance. Both options have their advantages and disadvantages, and investors should carefully consider these factors before making any investment decisions. Investing in Stocks Electronic Communication Networks (ECNs) ECNs, ATSs and MTFs have revolutionized the way securities are traded by providing direct access to buyers and sellers without the need for a middleman. This has resulted in increased transparency, reduced costs, faster execution, and after-hours trading. However, ECNs may not work as well with thinly-traded stocks because there may not be enough liquidity to match buyers and sellers effectively. Additionally, with many ECNs competing for volume, it can be challenging for traders to choose the best ECN to execute their trades. Finally, major exchanges may view ECNs as a threat to their business and may attempt to limit their growth or force them to comply with regulations that could limit their effectiveness. Despite these potential drawbacks, ECNs, ATSs, and MTFs have become an integral part of the modern financial landscape and are likely to continue to play a significant role in the future of securities trading. Exchange-Traded Funds (ETFs) Exchange-Traded Funds (ETFs) are a relatively recent innovation in the world of investing and have gained popularity among investors as a cost-effective and diversified investment option. ETFs represent a basket of securities that are traded on a major exchange and are designed to track a specific portfolio or index, such as the S&P 500, the Dow Jones Industrial Average, or the Nasdaq Composite. One of the advantages of ETFs is that they typically have lower management fees compared to mutual funds because they are designed to track an index, rather than actively managed by a portfolio manager. However, investors may still have to pay commissions to buy and sell ETFs, so it's important to consider these costs when evaluating the overall cost-effectiveness of investing in ETFs. Another advantage of ETFs is that the exact content of the basket is known, which means that valuation is certain. This transparency can help investors to make informed investment decisions and avoid any surprises. Computing the Price of Common Stock Valuing common stock is a bit more complicated than valuing debt securities because it requires making assumptions about the future cash flows that the stock will generate. Here are the four methods commonly used for valuing stocks. The One-Period Valuation Model To calculate the price of the stock using the one-period valuation model, we simply add the expected dividend and price over the next year and then discount the total amount by the required rate of return, which is also known as the discount rate. The formula for the One-Period Valuation Model is: Price = Div1/(1 + ke) + P/(1 + ke) - Div1: Expected dividend for next year - P: Expected price of the stock at the end of next year - ke: Required rate of return or discount rate Using the values provided in the question, we have: Div1 = $0.16, P = $60 ke = 12% Substituting the values into the formula, we get: Price = (0.16 + 60)/(1 + 0.12) = 53.71 Therefore, the price for a stock with an expected dividend and price next year of $0.16 and $60, respectively, using the One-Period Valuation Model and a 12% discount rate is $53.71. The Generalized Dividend Valuation Model This method assumes that the value of a stock is equal to the present value of all future dividends that the stock will pay out. To use the DDM, you need to estimate the future dividends and the appropriate discount rate to use. The advantage of this method is that it is relatively simple and easy to understand. The drawback is that it only works well for companies that pay regular dividends. The Gordon Growth Model The Gordon Growth Model is a financial model used to estimate the intrinsic value of a stock based on its expected future dividends. The model assumes that the dividends of the stock will grow at a constant rate forever, and that this growth rate is less than the required return on equity. The formula for the Gordon Growth Model is: Price = DIV1 / (ke - g) - DIV1 is the expected dividend per share in the next period; - ke is the required return on equity (also known as the cost of equity); - g is the expected growth rate of dividends. This means that the company is expected to continue to grow and generate profits in the future, and that investors require a certain return on their investment to compensate for the risk they are taking. The Gordon Growth Model is useful in estimating the intrinsic value of a stock, but it has limitations. One limitation is that it assumes a constant growth rate forever, which is unlikely in reality. Additionally, the model relies on accurate assumptions for the growth rate and the required return on equity, which can be difficult to estimate. As with any financial model, the results should be interpreted with caution and used in conjunction with other analysis techniques. The Price-to-Earnings (P/E) Valuation Method The price earnings (PE) ratio is a commonly used valuation method that measures how much the market is willing to pay for each dollar of earnings generated by a company. This method looks at the current market price of a stock relative to its earnings per share (EPS). To use this method, you need to compare the P/E ratio of the stock to that of other similar stocks or to the market average. The advantage of this method is that it is widely used and can be a good way to compare stocks in the same industry. The drawback is that it assumes that the stock's earnings will remain constant, which may not be the case. To calculate the stock price using the PE ratio, you simply multiply the earnings per share (EPS) by the PE ratio. In this case, if the industry PE ratio for a firm is 16 and the earnings per share is $1.13, then the stock price can be calculated as: Price = PE ratio x Earnings per share Price = 16 x $1.13 Price = $18.08 Therefore, the current stock price for a firm with earnings of $1.13 per share and an industry PE ratio of 16 is $18.08. How the Market sets Security Prices In general, security prices are set in the financial markets by the interaction of buyers and sellers. The price of a security is determined by the market's consensus of its value, based on factors such as its financial performance, perceived risks and benefits, and overall supply and demand. In a competitive market, the price is usually set by the buyer who is willing to pay the highest price for the security. This buyer is typically the one who can make the best use of the security or has the most valuable information about its potential value. For example, let's consider a stock with certain dividends but different perceived risks, and three investors with varying discount rates who are interested in buying the stock: You, Jennifer, and Bud. You are willing to pay up to $16.67 for the stock with a discount rate of 15%, while Jennifer is willing to pay up to $22.22 with a discount rate of 12%. Bud, who perceives the lowest risk, is willing to pay up to $50.00 with a discount rate of 7%. In this case, Bud would be willing to pay the most for the stock and would likely determine the "market" price. However, it's important to note that market prices are not always efficient or accurate reflections of a security's true value. Factors such as market sentiment, speculation, and unexpected events can all influence security prices, leading to fluctuations and even mispricing. As such, investors should always conduct their own research and analysis to make informed decisions about buying and selling securities.