Finance module 2 (Financial markets and institutions) - Bocconi, Appunti di Economia E Tecnica Dei Mercati Finanziari

Scarica Finance module 2 (Financial markets and institutions) - Bocconi e più Appunti in PDF di Economia E Tecnica Dei Mercati Finanziari solo su Docsity! Finance – Module 2 Financial markets and institutions 30434 A.A. 2021-2022 Prof. Cecilia Marchesi 1 1. Introduction Overview of financial markets Financial markets are structured through which funds flow. They can be distinguished along two major dimensions: 1. Primary versus secondary markets 2. Money versus capital markets Primary markets versus secondary markets Primary markets are markets in which users of funds raise funds for new issues of financial instruments such as stocks and bonds. Fund users have new projects but do not have sufficient internally generated funds to support these needs. Thus, the fund users issue securities in the external primary markets to raise additional funds. Most primary market transactions in the United States are arranged through financial institutions called investment banks that serve as intermediaries between the issuing corporations and investors. The first-time issues of equity by firms initially going public are usually referred to as initial public offerings (IPOs). Once financial instruments such as stocks are issued in primary markets, they are then traded in secondary markets. Buyers of secondary market securities are economic agents with excess funds. Sellers in secondary market financial instruments are economic agents in need of funds. Markets provide a centralized marketplace where economic agents know they can transact quickly and efficiently. In addition to stock and bonds, secondary markets also exist for financial instruments backed by mortgages and other assets, foreign exchange and futures and options. Corporate security issuers are not directly involved in the transfer of funds or instruments in the secondary markets. Secondary markets offer buyers and sellers liquidity (the ability to tourn an asset into cash quickly at its fair market value) as well as information about the prices or the value of their investments. Increase liquidity makes it more desirable and easier for the issuing firm to sell a security initially in the primary market. Money markets versus capital markets Money markets are markets that trade debt securities or instruments with maturities of one year or less. In the United States, money markets do not operate in a specific location, thus, they are said to be over the counter markets. Money market instruments: 2 • Insurance Companies: FIs that protect individuals and corporations from adverse events • Investment Banks: FIs that help firm issue securities and related activities (i.e. brokerage) • Finance Companies: intermediaries that make loans to both individuals and businesses • Investment funds: FIs that pool financial resources of individuals and firms to invest in a diversified portfolio • Pension Funds: FIs offering saving plans to individuals • Fintechs: institutions that use technology to deliver financial solutions in a manner that competes with traditional financial methods. A direct transfer happens when a corporation sells its stock or debt directly to investors without going through a financial institution. The FIs play a crucial role within the system by tackling the three key issues underlying a well- functioning financial market: 1) monitoring costs 2) liquidity costs 3) price risks  the average investor in a world without FIs would likely view direct investment in financial claims in markets as an attractive proposition and prefer to hold cash. As a result, financial market activity would likely remain quite low. However, the financial system has developed an alternative and indirect way for investors to channel funds to users of funds. This is the indirect transfer of funds to the ultimate user of funds via FIs. Benefiting of suppliers of funds: • Monitoring costs • Liquidity and Price Risks • Transaction cost services • Maturity intermediation • Denomination intermediation. Benefiting the overall economy: • Money supply transmission • Credit allocation • Intergenerational wealth transfers • Payment services. The FIs in performing the services to suppliers of funds and the overall economy incur in different type of risks: • Credit risk: the risks that some assets are potentially subject to default (i.e. Loans, stocks, and bonds) • Foreign exchange risk: the risk that the value of certain assets may change due to changes in the value of two different currencies 5 • Country risk: the risk of investing or lending in a country, arising from possible changes in the business environment that may adversely affect operating profits or the value of assets in the country • Interest rate risk: the risk related to the maturity mismatch between assets and liabilities in the FIs financial statements • Price risk: is the potential risk for the decline in the price of an asset or security relative to the rest of the market • Liquidity risk: the risk that a FIs may be unable to meet short term financial demands due to the inability to convert a security or hard asset to cash without a loss of capital and/or income in the process • Insolvency risk: the risk that a firm will be unable to satisfy its debts Regulation of FIs The FIs are regulated in order to prevent market failures and the cost they would impose on the economy and society at large. Regulations provide social benefits and welfare, but also impose private costs on individual FI owners and managers. 6 6. Money markets Money markets are markets that trade debt securities or instruments with maturities of one year or less. Most U.S. Money markets are said to be over-the-counter. In money markets, short term debt instruments are issued by economic agents that require short term funds and are purchased by economic agents that have access to short term funds. Once issued, money market instruments traded in active secondary markets, to meet investors’ short-term liquidity needs  reallocation of relatively fixed amounts of liquid funds available in the market at any particular time. Money Markets played a major role during the financial crisis: as mortgage and mortgage- back securities markets started to experience large losses, money markets froze, and banks stopped lending each other at anything but high overnight rates. The LIBOR more than doubled in one night. Money markets The need for money markets arises because the immediate cash needs of individuals, corporations and governments do not necessarily coincide with their receipts of cash. Because excessive holdings of cash balances involve a cost in the form of foregone interest, called opportunity cost, those economic units with excess cash usually keep such balances to the minimum needed to meet their day-to-day transaction requirements. Consequently, holders of cash invest «excess» cash funds in financial securities that can be quickly and «costlessly» converted back into cash, with little risk of loss of value over the short term horizon.  a money market instrument, provides an investment opportunity that generates a higher rate of interest (return) than holding cash, but it is also very liquid and has relatively low default risk. Money markets and money markets securities or instruments have three basic characteristics: 1. Money market instruments are generally sold in larger denominations  Sell in large denomination (units of $1 million - $10 million). Most money mkt participants want or need to borrow large amount of cash, so transaction costs are low relative to the interest paid. The size of the initial transactions allows indirect individuals’ investment, through money mkt mutual funds for example. 2. Money market instruments have low default risk (the risk of late or non-payment of principal or interest)  The risk of late or non- payment of principal or interest is very small. Money mkt instruments can generally be issued only by high- quality borrowers with little risk of default (cash lent in the money mkt must be available for a quick return to the lender) 3. Money market securities must have an original maturity of one year or less  The longer the maturity of a debt security, the greater is its interest rate risk and the higher is its required rate of return. 7 iT−bill , be=[ P f−P0 P0 ]× 365n To calculate the T-bill’s price we have 2 options: P0=P f−(iT−bill ,d× n 360 ×P f ) P0=P f / [1+(iT−bill , be× n 365 )] Federal funds Federal funds are short term loans between financial institutions, usually for a period of one day  one commercial bank may have short of reserves, requiring it to borrow excess reserves from another bank that has surplus, because banks have to close at night with a minimum amount of reserves. Correspondent banks are banks with reciprocal accounts and agreements. Overnight Fed funds loans will likely be based on an oral agreement between the two parties and they're generally unsecured loans. The overnight interest rate in the interbank lending market, is the federal funds rate. This rate is established by the Central bank based on monetary policies and it is the basis of all other interest rates. Fed funds are single-payment (or “bullet”) loans and use single-payment yields. They quote all rates on annual basis assuming a 360-day year. Repurchase agreements A repurchase agreement is an agreement involving the purchase of securities by one party to another party with a promise to sell the securities at a specified price and on a specified date in the future. Master repurchase agreements are collateralized with the seller holding securities to back the transaction. The repo buyer requires title to the securities for the term of the agreement  A repurchase agreement is essentially a collateralized Fed funds loan.  Overnight repos  one-day maturity  Term repos  repos with longer maturities Collateral pledged in a repurchase agreement has a haircut applied, which means the loan is likely smaller than the market value of securities pledged. This haircut reflects the underlying risk of the collateral and protects the repo buyer against a change in the value of the collateral. A reverse repurchase agreement is the lender's position in the repo transaction (an agreement involving the purchase of securities by one party from another, with the promise to sell them back at a given date in the future). Maturities  1-14 days. But there is a growing market for repost from 1 to 3 months. Repos with a maturity of less than one week generally involve denominations of $25 million or more. Longer term repos are more often in denominations of $10 million. 10 Commercial paper Commercial paper is an unsecured short term promissory note issued by a corporation to raise short term cash, often to finance working capital requirements. Commercial paper is generally sold in denominations of $100,000, $250,000, $500,000, and $1 million. Maturities generally range from 1 to 270 days. Commercial paper can be sold directly by the issuers to buyer, such as a mutual fund or can be sold indirectly by dealers in the commercial paper market  no intermediation. Commercial paper is generally held by investors from the time of issue until maturity  There is no active secondary market for commercial paper. Yields on commercial paper are quoted on a discount basis (using a 360-day year). Asset backed commercial paper (ABCP) is paper backed by assets of the issuing firms. It grew very rapidly prior to the financial crisis peaking at $2.16 trillion, much of it was backed by mortgage investments. The market collapsed during the financial crisis. Negotiable certificates of deposit A negotiable certificate of deposit is a bank issued time deposit that specifies an interest rate and maturity date, and it is negotiable in the secondary market. A negotiable CD is a bearer instrument  An instrument in which the holder at maturity receives the principal and interest (hence, they are traded in the secondary market). Negotiable CDs have denominations that range from $100,000 to $10 million ($1 million is the most common). They are often purchased by money market mutual funds with pools of funds from individual investors. Banker’s acceptances A banker’s acceptance is a time draft payable to a seller of goods with payment guaranteed by a bank. They rise from international trade transactions and the underlying letter of credit that are used to finance trade in goods that have yet to be shipped from a foreign explorer to a domestic importer ( In the past there was the risk that goods will not arrive to the buyer or that it will change its mind). Foreign exporters prefer that banks act as payment guarantors before sending goods to importers. Banker’s acceptances are bearer instruments and thus are salable in secondary markets. 11 Money market participants 1. US treasury  Issuer of T- bills, the most actively traded of the money mkt securities. T- bills allow US government to raise money to meet unavoidable short- term expenditure needs prior to the receipt of tax revenues. 2. Federal reserve  it is the most important participant in the money markets. a. T-bills: Open market transactions – purchase to increase money supply and sell to decrease b. Repurchase agreements: to smooth interest rates and money supply c. It targets the federal fund rates, affecting money market rates d. It operates the discount window, influencing the supply of bank reserves to commercial banks 3. Commercial banks  They participate as issuers and investors. a. Need to meet reserve requirements imposed by regulation. b. In economic expansion, heavy loan demand can produce reserve deficiencies for banks (reserves holding below the minimum). Additional reserves can be obtained borrowing fed funds from other banks, engaging in rep. agreem, selling negotiable CDs or comm. Paper. c. In contractionary period, excess of reserves, purchase of treasury securities, trade fed funds. 4. Money market mutual funds  They purchase large amount of money mkt securities and sell shares in these pools based on the value of their underlying money market securities. a. They allow small investors to invest in money mkt instruments. b. They are an alternative to interest- bearing deposits at commercial banks 5. Brokers and dealers  23 primary government security dealers: key role in marketing the new issues of Treasury bills and in making their market, buying securities from the FED when they are issued and selling them in the secondary market (trading room). Money & security brokers: they never trade for their own. When government securities dealers trade with each other, they use them as intermediaries. 6. Corporations  Rise of funds primarily in the form of commercial paper. They often invest excess cash funds in money market securities. 12 STRIPS STRIPS is a treasury security in which the period interest payment is separated from the final principal payment. Strips create 2 separate sets of securities:  One set for each semiannual interest payment  zero bonds  One for the final principal payment  zero coupon bonds Investors in the individual components only receive the single stripped payments in which they invest. Stripped treasury notes and bonds may be purchased only through financial institutions and government securities brokers and dealers, who create STRIPS components after purchasing the original T-notes or bonds in Treasury auctions. The components of a STRIPS are sold with the minimum face value of $100 and increasing in multiples of $100. When an investor buys a T-note or bond between coupon payments, the buyer must compensate the seller for that portion of the coupon payment accrued between the last coupon payment and the settlement day, while the seller was still the owner of the security: Accrued interest= ∫ ¿ 2 × actual number ofdays since last coupon payment actual number of days∈coupon period ¿ At settlement, the buyer must pay the seller the purchase price of the T-note or bond plus accrued interest. The sum of these 2 is called full price or dirty price. Corporate bonds Corporate bonds are long-term bonds issued by corporations. The minimum denomination on publicly traded corporate bonds is $1,000 and coupon-paying corporate bonds generally pay interest semiannually. The bond indenture is the legal contract that specifies the rights and obligations of the bond issuer and the bond holders. Bond indentures contains covenant that are rules and restrictions (but also rights) placed on the bond issuer and the bond holders. Defining rights and restrictions legally helps lowering the risk and interest cost of the bond issue. The signature of a trustee on the bonds, that protects the interests of the bond holder, is a guarantee of the bond’s authenticity. The trustee also acts as the transfer agent for the bonds when ownership changes as a result of secondary market sales and when the interest payments are made from the bond issuer to the bonds holder. The risk of the bond is associated with the credit worthiness of the company (defined by the credit rating). Bond characteristics 1. Bearer vs registered bonds: 15 a. With bearer bonds, coupons are attached to the bond. The holder presents the coupons to the issuer for payments when they come due. b. With registered bonds, the owner is registered by the issuer. Coupon payments are directly mailed to the registered owner 2. Term vs serial bonds: a. Term bonds are bonds in which the entire issue matures on a single date. b. Serial bonds mature on a series of dates, with a portion of the issue paid off on each. 3. Mortgage bonds: they are issued to finance specific projects, which are pledged as collateral for the bond issue. Because mortgage bonds are backed with a claim to specific assets, they are less risky investments than unsecured bonds. 4. Debentures and subordinate securities: a. Debentures are bonds backed solely by the general creditworthiness of the issuing firm (unsecured) b. Subordinated debentures are unsecured as debentures but junior in the rights to mortgage bonds and regular debentures (high- yield or junk bonds – below investment grade credit ratings). 5. Convertible bonds: they are bonds that may be exchanged for another security of the issuing firm at the discretion of the bond holders. If the market value of the securities the bond holders receives with conversion exceed the market value of the bond, the bond holder can return the bond to the issuer in exchange of the new securities and make a profit. 6. Bonds with stock warrants: Bonds issued with stock warrants attached give the bond holder an opportunity to purchase common stock at a specified price up to a specified date. Bond holders will exercise the warrant if the market value of the stocks is greater than the price at which the stock can be purchased through the warrant. the bond holder keeps the bond and pays the specified price for additional stocks. (no return of the underlying bond to the issuer) 7. Callable bonds: they are bonds which include a call provision. A call provision allows the issuer to require the bond holder to sell the bond back to the issuer at a given price (usually set above the par value). Callable bonds are usually called by the issuer when interest rate drop so that the issuer can issue new debt at a lower cost. 8. Sinking fund provision: they represent a requirement that the issuer retire a certain amount of the bond issue early over a number of years. The sinking fund is then used to retire the bond issue at maturity or periodically by purchasing bonds in the open market. Since the fund provision reduces the probability of default at the maturity date, it is an attractive feature to bond holders. Trading process for corporate bonds Primary sales of corporate bond issues occur through either a public sale (issue) or a private placement. There are two secondary markets that trade corporate bonds: the exchange market and the over-the counter market (OTC).  In contrast to treasury securities, secondary market trading of corporate bonds can involve a significant degree of liquidity risk. 16  The trading OTC makes investors skeptical about the reliability of the prices reported Bond ratings Rating agencies rank bonds based on the perceived probability of issuer default and assign a rating based on a letter grade. Junk bonds are bonds rated as speculative or less than investment grade (they are very risky but pay high interest). Credit rating is expressed in terms of 2 dimensions: 1. Credit rating of the borrower (company) 2. Credit worthiness of the specific debt of the year. We have a split rating when the 3 rating agencies do not agree on the same rating for a bond. Bond market participants Bond markets bring together suppliers and demanders of long-term funds. Major issuers of debt market securities are federal, state and local governments and corporations. The major purchasers of capital market securities are households, businesses, government units and foreign investors. International aspects of bond markets International bond markets are those markets that trade bonds that are underwritten by an international syndicate, offer bonds to investors in different countries, issue bonds outside the jurisdiction of any single country and offer bonds in unregistered form. Investors: • Adding international bonds to a fixed-income portfolio can be a way to diversify risk in a domestically based portfolio. • International sovereign bonds have historically exhibited low correlation in returns with U.S. and international stocks. Issuers: • The existence of sophisticated international bond markets increases the available financing options and range of assets. 17 stocks for a profit and pay capital gain taxes – lower than ordinary income taxes on dividend income. The return to a stockholder over a period t-1 can be written as: Rt= P t−Pt−1 P t−1 + Dt Pt−1 The first part of the equation is the capital gain and the second one is the return associated with dividends. 2. Residual claim In the event of liquidation, common stockholders have the lowest priority in terms of any cash distribution ( employees, bondholders, taxes, preferred stockholders, common stockholders) 3. Limited liability Limited liability implies that common stockholder losses are limited to the amount of their original investment in the firm if the company’s asset value falls to less than the value of the debt it owes. In contrast, when liability is unlimited, stockholders may be liable for the firm debts out of their total private wealth holdings if the company gets in difficulties (sole proprietorship or partnership stocks). 4. Voting rights While common stockholders do not exercise control over the firm’s daily activities, they do exercise control over the firm’s activities indirectly through the election of the board of the directors. Stockholders also votes on major changes pertaining to the firm. Voting arrangements:  One vote per share of common stock  Dual-class firm: two classes of common stock are outstanding, with differential voting and/or dividend rights assigned to each class. Methods of election of the Board:  Cumulative voting  all directors up for election are voted at the same time. The number of votes assigned to each stockholder equals the number of shares held multiplied by the number of directors to be elected. The number of shares needed to elect p directors, Np, is: N p=[ ( p x¿of votes available ) (¿of directors¿be elected+1) ]+1  Straight voting  the vote of each director occurs one director at a time. The number of votes eligible for each director is the number of shares outstanding (50% ownership advantage) Preferred stock Preferred stock is a hybrid security that has characteristics of both bonds and common stock. Typically, preferred stock is nonparticipating and cumulative. 20 Nonparticipating preferred stock means that the dividend is fixed regardless of any increase or decrease in the issuing firm’s profits. Cumulative preferred stock means that the missed dividend payments go into arrears and must be made up before any common dividends can be paid. Participating preferred stock means that actual dividends paid in any year may be greater than the promised dividends. Noncumulative preferred stock means that dividends payments do not go into arrears and are never paid. Primary and secondary stock markets Primary stocks markets are markets in which corporations raise funds through new issues of stocks. The new stock securities are sold to initial investors (suppliers of funds) in exchange for funds (money) that the issuer (user of funds) needs. The investment bank can conduct a primary market sale of stock using: • A firm commitment underwriting, where the investment bank guarantees the corporation a price for newly issued securities by buying the whole issue at a fixed price (net proceeds) from the corporate issuer. Then it resells them to investors at a higher price (gross proceeds). The difference between net and gross proceeds is named underwriter’s spread. • A best effort underwriting, where the underwriter does not guarantee a price to the issuer and acts more as a placing or distribution agent for a fee. A primary market sale may be a first-time issue by a private firm going public (initial public offering – IPO) or a seasoned offering, in which the firm already has shares of the stock trading in the secondary market. In some states, corporate law gives shareholders preemptive rights to the new shares of stock when they are issued. Before a seasoned offering of stock can be sold to outsiders, the new shares must first be offered to existing shareholders in such a way that they can maintain their proportional ownership in the corporation. Registration in a public sale of stock, once the issuing firm and the investment bank have agreed on the details of the stock issue, the investment bank must get SEC approval. The process starts with the preparation of the registration statement which includes information on the nature of the issuer’s business, the key provisions and the features of the security to be issued, the risks involved with the security and background on the management. At the same time that the issuer and the bank prepare the registration statement, they prepare the preliminary version of the public’s offering prospectus (red herring prospectus  it is a preliminary version of the official prospectus that will be printed upon SEC registration of the issue and makes up the bulk of the registration statement). 21 After submission of the registration statement, the SEC has 20 days to request additional information or changes to the registration statement (companies that know the registration process well can generally obtain registration in a few days). This period is called waiting period. Once the SEC registers the issue, the issuer can set the final price on the shares, it prints the official prospectus and sends it to all potential buyers. The period of time between the company’s filing of the registration statement and the selling of shares is referred to as the quiet period. In order to reduce the time and cost of registration the SEC allows for shelf registration. Shelf registration allows firms that plan to offer multiple issues of stock over a 2-year period to submit one registration statement summarizing the firm’s financing plans for the period. Shelf registration allows firms to get stock into the market quickly if they feel conditions are right, without the time lag associated with SEC registration. Secondary stock markets Secondary stock markets are markets in which stocks, once issued, are traded (bought and sold by investors). Each stock is assigned a special market maker (a specialist). The market maker is like a monopolist with the power to arrange the market for the stock. In return, the specialist has an affirmative obligation to stabilize the order flow and prices for the stock in times when the market becomes turbulent. Three types of transactions can occur at a given post: 1. Brokers trade on behalf of customers at the market price (market order); a market order is an order for the broker and the designated market maker to transact at the best price available when the order reaches the post. 2. Limit orders are left with a specialist to be executed; limit orders are orders to transact only at a specified price (the limit price). When the current price is not near to the limit price, the limit order is entered on the order book. 3. Specialists transact for their own account. 22 10. Valuing bonds Bonds are long- term loans. If you own a bond, you are entitled to a fixed set of cash payoffs. Every year until the bond matures, you collect regular interest payments. At maturity, when you get the final interest payment, you also get back the face value of the bond (bond’s principal). PV (bond )=PV (annuity of coupon payments )+PV ( final payment of principal ) PV=∑ (r×100) (1+ y )t−n + 100+(r ×100) (1+ y )t  A bond that is priced above the face value sells at a premium  A bond that is priced below the face value sells at discount  When the yield to maturity is less than the coupon (and the current yield), the bond sells at a premium  When the yield to maturity is greater than the coupon (and the current yield), the bond sells at a discount How bond prices vary with interest rates As interest rates change, so do bond prices  Interest rate and price move in opposite directions (A higher interest rate results in a lower price). The yield to maturity is our measure of the interest rate of a bond, and it is the discount rate that explain the bond price.  When bond prices fall, interest rates rise, when interest rates rise, bond prices fall. rate of return= couponincome+ price change investment Duration and volatility Duration is the weighted average of the times to each of the cash payments. The weight for each year is the PV of the cash flow received at that time divided by the total PV of the bond: Duration= 1×PV (C1) PV + 2×PV (C2) PV +…+ T ×PV (CT ) PV tot Modified duration measures the percentage change in bond price for a 1 percentage- point change in yield. The modified duration is also called volatility and it is the duration divided by one plus the yield to maturity: Modified duration=volaitlity (% )= duration 1+ y 25 The term structure of interest rates The relationship between short and long-term interest rates is called the term structure of interest rates. Consider a loan that pays $1 at the end of one year. To find the PV of this loan you need to discount the cash flow by the one-year rate of interest (r1): PV= 1 1+r1 This rate r1 is called the one-year spot rate. To find the PV of a loan that pays $1 at the end of 2 years, you need to discount by the 2-year spot rate (r2): PV= 1 (1+r2) 2 The 1st year cash flow is discounted at today’s one-year spot rate and the second year’s flow is discounted at today’s 2-year spot rate. The series of spot rates traces of the term structure of interest rates. If we have 2 different spot rates, we need 2 discount rates to calculate present value: PV= 1 1+r1 + 1 (1+r 2) 2 Once we have the PV, we can use it to calculate the yield to maturity: PV= 1 (1+ y ) + 1 (1+ y)2 The law of one price states that the same commodity must sell at the same price in well- functioning market  all safe cash payments delivered on the same date must be discounted at the same spot rate. The expectations theory of the term structure tells that bonds are priced so that an investor who holds a succession of short term bonds can expect the same return as another investor who holds a long bond. It predicts an upward- sloping term structure only when future short- term interest rates are expected to rise. Arbitrage If we know how the returns on bonds with different maturities move together, then we can make some useful statements about the relative prices of these bonds.  If you know how bond prices movetogether, you may be able to construct a package of two bonds that will provide identical payoffs to a third bond that allows you to value one bond given the prices of the other 2 bonds. 26 13. Derivatives and securities markets Derivative securities A derivative is a financial security whose payoff is linked to another, previously issued security. Derivative securities generally involve an agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future. As the value of the underlying security to be exchanged changes, the value of the derivative security changes. Forwards and futures Spot markets A spot contract is an agreement between a buyer and a seller at time 0, when the seller of the asset agrees to deliver it immediately and the buyer agrees to pay for that asset immediately. The unique feature of a spot market is the immediate and simultaneous exchange of cash for securities, or what is often called delivery versus payment. Forward markets A forward contract is a contractual agreement between a buyer and a seller at time 0 to exchange a prespecified asset for cash at some later date at a price set at time 0. Market participants take a position in forward contracts because the future (spot) price or interest rate on an asset is uncertain. Rather than risk that the future spot price will move against them—that the asset will become more expensive to buy in the future—forward traders pay a financial institution a fee to arrange a forward contract. Such a contract lets the market participant hedge the risk that future spot prices on an asset will move against him or her by guaranteeing a future price for the asset today. Futures markets A futures contract, like a forward contract, is an agreement between a buyer and a seller at time 0 to exchange a standardized, prespecified asset at some later date at a price set at time 0. Thus, a futures contract is very similar to a forward contract. One difference between forwards and futures is that forward contracts are bilateral contracts subject to counterparty default risk, but the default risk on futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties against credit or default risk. Another difference relates to the contract’s price, which in a forward contract is fixed over the life of the contract, whereas a futures contract is marked to market daily. The contract’s price is adjusted each day as the price of the asset underlying the futures contract changes and as the contract approaches expiration. Therefore, actual daily cash settlements occur between the buyer and seller in response to these price changes (this is called marking to market). 27 1. If conditions are never profitable for an exercise (the option remains “out of the money”), the option holder can let the option expire unexercised. 2. If conditions are right for exercise (the option is “in the money”), the holder can take the opposite side of the transaction. Thus, an option buyer can sell options on the underlying asset with the same exercise price and the same expiration date. 3. The option holder can exercise the option, enforcing the terms of the option. For an American option, this exercise can occur at any time before and on the expiration date, while for a European option, this exercise can occur only on the expiration date. Option values The Black-Scholes option pricing model (the model most commonly used to price and value options) is a function of: • the spot price of the underlying asset. • the exercise price on the option. • the option’s exercise date. • the price volatility of the underlying asset. • the risk-free rate of interest. The intrinsic value of an option is the difference between an option’s exercise price and the underlying asset’s price. Intrinsic value of a call option:  stock price−exercise price  if SP > EP (option is in the money)  zero  if SP ≤ EP (option is out of or at the money) Intrinsic value of a put option:  exercise price−stock price if SP < EP (option is in the money)  zero if SP ≥ EP (option is out of or at the money) At expiration, an option’s value is equal to its intrinsic value. The time value of an option is the difference between an option’s price and its intrinsic value. The time value of an option is the value associated with the probability that the intrinsic value (i.e., the stock price) could increase (if the underlying asset’s price moves favorably) between the option’s purchase and the option’s expiration date. The time value of an option is a function of the price volatility of the underlying asset and the time until the option matures (its expiration date). As price volatility increases, the chance that the stock will go up or down in value increases. The owner of the call option benefits from price increases but has limited downside risk if the stock price decreases, since the loss of value of an option can never exceed the call premium. Thus, over any given period of time, the greater the price volatility of the underlying asset, the greater the chance the stock price will increase and the greater the time value of the option. 30 Further, the greater the time to maturity, the greater (longer in time) the opportunity for the underlying stock price to increase; thus, the time value of the option increases.  as an option moves toward expiration, its time value goes to zero. At any point in time, the time value of an option can be calculated by subtracting its intrinsic value from its current market price or premium. The risk-free rate of interest affects the value of an option in a less than clear-cut way. All else constant, as the risk-free rate increases, the growth rate of the stock price increases. However, the present value of any future cash flows received by the option holder decreases. For a call option, the first effect tends to increase the price of the option, while the second effect tends to decrease the price. It can be shown that the first effect always dominates the second effect. That is, the price of a call option always increases as the risk-free rate increases.  The two effects both tend to decrease the value of a put option. Thus, the price of a put option decreases as the risk-free rate increases. Regulation of futures and options markets The Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) are often viewed as “functional” regulators.  The SEC regulates all securities traded on national securities exchanges, including several exchange-traded derivatives. The SEC’s regulation of derivatives includes price reporting requirements, antimanipulation regulations, position limits, audit trail requirements, and margin requirements.  The CFTC has exclusive jurisdiction over all exchange-traded derivative securities. It therefore regulates all national futures exchanges, as well as all futures and options contracts. The CFTC’s regulations include minimum capital requirements for traders, reporting and transparency requirements, antifraud and antimanipulation regulations, and minimum standards for clearinghouse organizations. Since January 1, 2000, the main regulator of accounting standards (the Financial Accounting Standards Board, or FASB) has required all FIs (and nonfinancial firms) to reflect the mark to market value of their derivative positions in their financial statements. This means that FIs must immediately recognize all gains and losses on such contracts and disclose those gains and losses to shareholders and regulators. Further, firms must show whether they are using derivatives to hedge risks connected to their business or whether they are just taking an open (risky) position. The main bank regulators—the Federal Reserve, the FDIC, and the Comptroller of the Currency —also have issued uniform guidelines for banks that trade in futures and forwards. These guidelines require a bank to: 1. establish internal guidelines regarding its hedging activity, 2. establish trading limits, and 3. disclose large contract positions that materially affect bank risk to shareholders and outside investors. Overall, the policy of regulators is to encourage the use of futures for hedging and discourage their use for speculation, although on a practical basis it is often difficult to distinguish between 31 the two. Further, exchange-traded derivative securities such as futures contracts are not subject to risk-based capital requirements. By contrast, OTC derivative securities such as forward contracts are potentially subject to capital requirements. Swaps A swap is an agreement between two parties (called counterparties) to exchange specified periodic cash flows in the future based on some underlying instrument or price (e.g., a fixed or floating rate on a bond or note). • Interest rate swaps are long term contracts that can be used to hedge interest rate risk exposure  there is no exchange of principal, only interest. • Currency swaps can immunize against foreign exchange rate risk when firms mismatch the currencies of their assets and liabilities. In an interest rate swap contract, the swap buyer agrees to make a number of fixed interest rate payments based on a principal contractual amount on periodic settlement dates to the swap seller. The swap seller, in turn, agrees to make floating rate payments, tied to some interest rate, to the swap buyer on the same periodic settlement dates. A firm, for example, would want to enter into a currency swap by which it sends annual payments in pounds to a swap dealer and receives dollar payments from the swap agent. As a result of the swap, the firm transforms its fixed rate dollar liabilities into fixed rate sterling liabilities that better match the fixed rate sterling cash flows from its asset portfolio  the 2 financial institutions are exposed to opposing currency risks. Credit swaps 1. Total return credit swaps involve swapping an obligation to pay interest at a specified fixed or floating rate for payments representing the total return on a loan of a specified amount (they contain both interest rate and credit risks) 2. Pure credit swaps are an alternative to strip out the interest rate risk from the swap. It is like buying credit insurance and/or a multiperiod credit option. Credit swaps are important for 2 reasons: 1. Credit risk is still more likely to cause a FI to fail than either interest rate risk or foreign exchange risk 2. Credit swaps allow FIs to maintain long term customer lending relationships without bearing the full credit risk exposure from those relationships Swaps are not standardized contracts. Swap dealers (usually financial institutions) keep markets liquid by matching counterparties or by taking positions themselves. Unlike futures and options markets, swap markets were historically governed by very little regulation. The International Swaps and Derivatives Association (I S D A) is an association among 56 countries that sets codes of standards for swap documentation 32 Even if the losses due to credit risk increase, financial institutions continue to willingly give loans. FIs charges a rate of interest on a loan that compensates for the risk of the loan. Liquidity risk It is the risk that a FIs may be unable to meet short term financial demands due to the inability to convert a security or hard asset to cash without a loss of capital and/or income in the process. Liquidity risk is the risk that a sudden and unexpected increase in liability withdrawals may require an FI to liquidate assets in a very short period of time and at low prices. Day-to-day withdrawals and loan demand are generally predictable. To meet the demand for cash by liability holders, FIs must either liquidate assets or borrow additional funds. Purchased funds include short-term borrowings, such as federal funds loans and brokered deposits. Unusually large withdrawals by liability holders can create liquidity problems. In these cases: • The cost of purchased and/or borrowed funds rises for FIs. • The supply of purchased or borrowed funds declines. • FIs may be forced to sell less liquid assets at “fire-sale” prices Interest rate risk It is the risk related to the maturity mismatch between assets and liabilities in the FIs financial statements, and when interest rates are volatile. Asset transformation involves an FI buying primary securities or assets and issuing secondary securities or liabilities to fund the assets. The primary securities that FIs purchase often have maturity characteristics different from the secondary securities that FIs sell (mismatch of maturities, that exposed the Fi to interest rate risk): • If an FI’s assets are longer-term relative to its liabilities, it faces refinancing risk: the risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments. • If an FI’s assets are shorter-term relative to its liabilities, it faces reinvestment risk: the risk that the returns on funds to be reinvested will fall below the cost of funds Price risk is the risk that the price of the security will change when interest rates change. Rising interest rates increase the discount rate on future asset cash flows and reduce the market price or PV of that asset or liability. Market risk It is the risk incurred in trading assets and liabilities due to changes in interest rates, exchange in rates and other asset prices. Market risk is closely related to interest rate and foreign exchange risk in that as these risks increase or decrease, the overall risk of the FI is affected. It is the incremental risk incurred by a FI when interest rates and foreign exchange risks are combined with an active trading strategy, especially one that involves short trading horizons such as a day. 35 • Closely related to interest rate and foreign exchange risk • Adds risk of trading activity —that is market risk is the incremental risk incurred by an FI (in addition to interest rate or foreign exchange risk) caused by an active trading strategy. FIs’ trading portfolios are differentiated from their investment portfolios on the basis of time horizon and liquidity: • Trading assets, liabilities, and derivatives are highly liquid. • Investment portfolios are relatively illiquid and are usually held for longer periods of time. FIs are concerned with fluctuations in trading account assets and liabilities. Value at risk (VAR): fluctuations in value and daily earnings at risk (DEAR): fluctuation in value of trading account assets and liabilities for periods as short as one day, are measures used to assess market risk exposure. Off-balance sheet risk It is the risk incurred by a FIs as the result of activities related to contingent assets and liabilities (eg: a letter of credit, where payments are contingent to a future event). Off-balance sheet activities affect the future shape of an FI’s balance sheet. They involve the creation of contingent assets and liabilities that give rise to their potential placement in the future on the BS. They have a direct impact on the FI’s future profitability and performance. Large commercial banks engage in OBS activity: the losses on OBS commitments in the financial crisis indicate that banks had excessive risks in their derivatives activities and did not have sufficient capital to back these commitments. A letter of credit (LOC) is a credit guarantee issued by an FI for a fee on which payment is contingent on some future event occurring, most notably default of the agent that purchases the LOC. Other examples include: • Loan commitments by banks. • Mortgage servicing contracts by savings institutions. • Positions in forwards, futures, swaps, and other derivatives held by almost all large FIs. Foreign exchange rate risk It is the risk that the value of certain assets may change due to changes in the value of two different currencies. Foreign exchange (FX) risk is the risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in foreign currencies. FIs can reduce risk through domestic- foreign activity/investment diversification. FIs expand globally through: • Acquiring foreign firms or opening new branches in foreign countries. • Investing in foreign financial assets. 36 Returns on domestic and foreign direct investments and portfolio investments are not perfectly correlated • Underlying technologies of various economies differ, as do the firms in those economies. • Exchange rate changes are not perfectly correlated across countries. A net long position in a foreign currency involves holding more foreign assets than foreign liabilities. • FI loses when foreign currency falls relative to the U.S. dollar. • FI gains when foreign currency appreciates relative to the U.S. dollar. A net short position in a foreign currency involves holding fewer foreign assets than foreign liabilities. • FI gains when foreign currency falls relative to the U.S. dollar. • FI loses when foreign currency appreciates relative to the U.S. dollar. An FI is fully hedged if it holds an equal amount of foreign currency denominated assets and liabilities (that have the same maturities). Country or sovereign risk It is the risk of investing or lending in a country, arising from possible changes in the business environment that may adversely affect operating profits or the value of assets in the country. Country, or sovereign, risk is the risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments  Foreign corporations may be unable to pay principal and interest even if they desire to do so. Foreign governments may limit or prohibit debt repayment due to foreign currency shortages or adverse political events. Measuring sovereign risk includes analyzing: • The trade policy of the foreign government. • The fiscal stance (deficit or surplus) of the foreign government. • Government intervention in the economy. • The foreign government’s monetary policy. • Capital flows and foreign investment. • Inflation. • The structure of the foreign country’s financial system. Technology and operational risk Technology risk: the risk incurred by a FI when its technological investments do not produce anticipated cost savings (in terms of economies of scale or of scope). Operational risk: the risk that existing technology or support systems may malfunction or break down. Insolvency risk It is the risk that a firm will be unable to satisfy its debts. A FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities. 37 • Impact on their exposure to risk and their ability to grow – both on and off the balance sheet – over time • Regulators require banks to hold a minimum level of equity capital to act as a buffer against losses from their on- and off- balance-sheet activities • Because of relatively low cost of deposit funding, banks tend to hold equity close to the minimum level set by regulators Off-balance sheet activities The balance sheet does not reflect the total scope of bank activities. Banks conduct many fee- related activities off the balance sheet. Off-balance-sheet (OBS) activities are becoming increasingly important, in terms of their dollar value and the income they generate for banks – especially as the ability of banks to attract high- quality loan applicants and deposits become ever more difficult. Depending on the nature, it is possible to distinguish between of two types of OBS: • Off-balance-sheet (OBS) assets • Off-balance-sheet (OBS) liabilities  Off-balance-sheet (OBS) activities, however, can involve risks that add to the overall insolvency exposure of a financial intermediary (FI). Other fee-generating activities Commercial banks engage in other fee-generating activities that cannot be easily identified from analyzing their on- and off-balance sheet accounts. 1. Trust services  the trust department of a commercial bank holds and manages assets for individuals or corporations 2. Correspondent banking  it is the provision of banking services to other banks that do not have the staff to perform the services themselves. Size, structure, and composition of the industry Recently, there has been the emergence of a new trend, the so-called: shadow banking. Shadow banking involves the activities of nonfinancial services firms that perform banking services. In the shadow banking system, saver place their fund with money market mutual and similar funds, which invest these funds in the liabilities of shadow banks. Borrowers get loans and leases from shadow banks rather than from banks. Like the traditional banking system, the shadow banking system intermediates the flow of funds between net savers and net borrowers.  cost efficiency and lack of regulation till 2016. Bank size and concentration A comparison of asset concentration by bank size indicates that the recent consolidation in banking appears to have reduced the asset share of the smallest bank (under $1 billion) from 36.6% in 1984 to 7.1% in 2016. • Community bank: a bank that specializes in retail or consumer banking. 40 • Retail banking: consumer- oriented banking, such as providing residential and consumer loans and accepting smaller deposits.  This group is decreasing in number and in importance • Regional or superregional banks: a bank that engages in a complete array of wholesale commercial banking activities. • Wholesale banking: commercial- oriented banking, such as providing commercial and industrial loans funded with purchase funds  These banks have access to the market of purchase funds, such as the interbank or federal funds market, to finance their lending and investment activities. The bank size traditionally affected the type of activities and financial performance of commercial banks: • Small banks generally concentrate on the retail side of the business (make loans and issue deposits to consumers and small businesses). • Large banks engage in both retail and wholesale banking and have an easier access to purchase funds and capital markets (less equity).  The interest rate spread (lending rates – deposit rates) and net interest margin ((interest income – interest expenses)/ earning assets) usually narrower. 41 4. Securities firms and investment banks Services offered by securities firms vs investment banks Securities firms and investment banks primarily help net suppliers of funds transfer funds to net users of funds at a low cost and with a maximum degree efficiency.  Firms in this industry help bring new issues of debt and equity to the financial markets. The industry facilitates the trading and market making of securities after they are issued (They do not transform the securities issued into more attractive claims: they act as brokers). 1. Securities firms: a. Retail service to investors b. Securities trading (brokerage service or market making) c. Retail side: purchase, sale and brokerage of existing securities 2. Investment banks: a. Commercial side: originating, underwriting and distributing issues of new securities in money and capital markets for corporate and government issuers. b. Corporate finance activities Investment banks (IBs) help corporations and governments raise capital through debt and equity security issues in the primary market  Underwriting is assisting in issuing new securities. IBs also advise on mergers and acquisitions (M&As) and corporate restructuring. Securities firms assist in the trading of securities in secondary markets  Broker-dealers assist in the trading of existing securities. Size, structure, and composition of the industry Because of the emphasis on securities trading and underwriting rather than longer-term investment in securities, the size of the industry is usually measured by the equity capital of the firms participating in the industry rather than by asset size. • Securities trading and underwriting  it is a financial service that requires relatively little investment in asset or liability funding. It is a profit-generating activity that does not require that FIs actually hold or invest in the securities they trade or issue for their customers. • Largest firms  Diversified financial services or nationally full-service investment banks that serve both retail costumers (broker- dealers) and corporate costumers (underwriters). 3 categories: 1. Commercial banks or financial services holding companies a. Largest of the full-service investment banks. b. Extensive domestic and international operations. 42 Most of these accounts allow customers to write checks against some type of mutual funds account. They can be directly or indirectly covered by federal deposit insurance. As a result of CMAs the distinction between commercial banks and investment banks became blurred.  The advantage of brokerage firm CMAs over commercial bank deposit accounts is that they make easier to buy and sell securities M&A IBs frequently provide advice on, and assistance in, mergers and acquisitions. • Assist in finding merger partners. • Underwrite any new securities to be issued by the merged firms. • Assess the value of target firms. • Recommend terms of the merger agreement. • Assist target firms in preventing a merger. Other service function • Custody and escrow services. • Clearance and settlement services. • Research and advisory services.  IBs are making increasing inroads into traditional bank service areas, such as small-business lending and the trading of loans. Recent trends • Industry trends depend heavily on the state of the stock market and the economy. • Commission income fell after the 1987 stock market crash. • Improvements in the U.S. economy in the mid-2000s led to increases in commission income, but income fell with the stock market in 2006 to 2008 because of rising oil prices and the subprime mortgage collapse. • Commission income again rose to between 15 and 20 percent of total revenues as the economy and the stock market recovered in the early- and mid-2010s. • By the mid-2010s, while the industry had put most problems from the financial crisis behind it, the industry was affected by post-crisis consequences, with increased regulation on risk taking and capital requirements. • This has led to balance sheet reductions, as well as downsizing or disposition of select businesses, trading products, and investments. • Corporate strategies increasingly focus on client services and away from making large bets through principal investments. Balance sheet Many of the assets appearing on the balance sheets of securities firms are cash like money market instruments, not capital market positions. In the case of depository institutions assets tend to be medium term from the lending position of the depository institutions. 45 5. Investment companies Open-end mutual funds sell new shares to investors and redeem outstanding shares on demand at their fair market values. Hedge funds (HFs) are a type of investment pool that solicits funds from (wealthy) individuals and other investors (example: commercial banks) and invests these funds on their behalf. Cash flows into MFs are highly correlated with the return on stock markets: • Growth has also resulted from the rise in retirement funds under management by MFs. • MFs manage ~25% of retirement fund assets. MFs are the second most important group of FIs as measured by asset size, second only to depository institutions: • Banks’ share of all MF assets was 5% in 2016. • Insurance companies managed 5% of MF industry assets in 2016.  The barriers to entry in the MF industry are low Mutual fund industry The MF industry has two sectors: • Short-term funds invest in securities with original maturities of less than one year: • Money market mutual funds (MMMFs) are funds consisting of various mixtures of money market securities. • Tax-exempt money market mutual funds contain various mixed of those money market securities with an original maturity of less than one year. • Long-term funds invest in portfolios of securities with original maturities of more than one year: • Equity funds consist of common and preferred stock. • Bond funds consist of fixed-income capital market debt securities (subject to high interest rate risk)  Hybrid funds consist of both stock and bond securities. Funds specialized in one or more industries face market risk and specific risk of the industry. MMMFs are highly regulated with respect to hedge funds, moreover they allow for a greater diversification and have lower transaction costs. Money market mutual funds (MMMFs) provide an alternative investment to interest-bearing deposits at commercial banks. Other types of investment company funds An open-end MF is a fund for which the supply of shares is not fixed but can increase or decrease daily with purchases and redemptions of shares. Shares are redeemable  meaning that investors buy and sell shares from and to the mutual fund company at their appropriate net asset value that is once a day, after markets close. NAV= value of assetsunder mngt (−liabilities ) number of sharesoutstanding 46 A closed-end investment company is a specialized investment company that has a fixed supply of outstanding shares but invests in the securities and assets of other firms. Since the number of shares available for purchase at any moment in time is fixed, the NAV of the fund’s shares is determined by the value of the underlying shares as well as by the demand for the investment company’s shares themselves. When demand for the investment company’s shares is high the shares can trade for more than the NAV of the securities held in the fund’s asset portfolio (in this case the fund is said to be trading at a premium). When demand for the shares is low, the value of the closed-end fund’s shares can fall to less than the NAV of its assets (its shares are said to be trading at a discount). A unit investment trust, such as a real estate investment trust, is a fund that sells a fixed number of redeemable shares that are redeemed on a set termination date. An index fund is a long-term mutual fund in which fund managers buy securities in proportions similar to those included in a specified major stock index. These funds have lower transaction costs due to the fact that managers have less work to do, and the sole aim is to overperform the index in question. Mutual fund returns and costs Investor returns from MF ownership reflect three components. • Income and dividends on portfolio assets. • Capital gains on assets bought and sold at higher prices. • Capital appreciation on assets held in the fund. MFs charge investors fees for the services they provide: • Sales loads (front end or back end). • 12b-1 fees are fees related to the distribution costs of MF shares: • Marking and distribution expenses cannot exceed 0.75% of a fund’s average net assets per year. • FINRA also imposes an annual cap of 0.25% on shareholder service fees. • MFs may offer different share classes with different combinations of loads. A load fund is an MF with an up-front sales or commission charge that the investor must pay. A no-load fund is an MF that does not charge up-front sales or commission charges on the sale of mutual fund shares to investors. Hedge funds Hedge funds are investment pools that invest funds for wealthy individuals and other investors (e.g. commercial banks). They are similar to mutual funds: they are pooled investment vehicles that accept investors’ money and generally invest it on a collective basis. They are not subject to the numerous regulations that apply to mutual funds. 47 14. The Federal Reserve system Central banks determine, implement and control the monetary policy in their home countries. The Federal Reserve is the central bank of the United States. It was founded by Congress under the Federal Reserve Act in 1913. Fed original duties were to provide the nation with a safer, more flexible and more stable monetary and financial system  economic growth, high level of employment, stable prices. An independent central bank–its decisions do not have to be ratified by the President or Congress. The Fed is required to work within the framework of the overall objectives of economic and financial policies established by the U.S. government.  The Fed System has evolved into one of the most powerful economic bodies in the world. It was critical in implementing policies to address the worldwide financial crisis. It has 4 major functions: a. Conducting monetary policy b. Supervising and regulating depository institutions c. Maintaining the stability of the financial system: • The Wall Street Reform and Consumer Protection Act of July 2010 requires the Fed to supervise complex financial institutions that could generate systemic risk to the economy. • The Fed (and others) has now been given broader powers to seize or break up institutions whose actions could harm the economy. • Implementing federal laws designed to protect consumers in credit and other financial transactions. • Implementing regulations to ensure compliance, investigating complaints, and ensuring availability of services to low- and moderate-income groups and certain geographic regions. d. Providing payment and other financial services to the US government, the public, FIs and foreign official institutions. Structure of the federal reserve system The Federal Reserve System consists of 12 Federal Reserve Banks located in major cities throughout the US and a seven-member Board of Governors located in Washington DC, which has the role of supervision. The Office of the Comptroller of the Currency (OCC) charters national banks, which are members of the Federal Reserve System (FRS). Board of governors It is a seven-member board headquartered in Washington DC. Each member is appointed by the president of the US and must be confirmed by the Senate. Board members serve a nonrenewable 14-year term. The president also designated 2 members to be the chair and the vice chair for 4-year terms. 50 The primary responsibilities of the board are the formulation and conduct of monetary policy and the supervision and regulation of banks. All seven board members sit on the Federal Open Market Committee. The board also has primary responsibility for the supervision and regulation of: 1. All bank holding companies 2. State-chartered banks that are members of the Federal reserve system 3. Edge Act and agreement corporations Federal Open Market Committee The FOMC is the major monetary policy-making body of the Federal Reserve System. The FOMC consists of 12 members: 7 Board members, the president of the Federal Reserve Bank of NY and the president of 4 other Federal Reserve Banks. The main responsibilities of the FOMC are to formulate policies to promote full employment, economic growth, price stability, and a sustainable pattern of international trade. The FOMC seeks to accomplish this by setting guidelines regarding open market operations (purchases and sales of US government and federal agency securities by the Fed). There can be tradeoffs between these goals. The Fed must balance expansive monetary policy that tends to generate growth and higher employment against inflationary pressures in the economy. When unemployment is high the Fed’s attempt to stimulate the economy to generate additional jobs may result in inflation. There are also tradeoffs in U.S. monetary policy and the value of the dollar. A simulative U.S. policy may cause the dollar to drop, particularly if U.S. growth remains slow. If the Fed keeps U.S. inflation below the rest of the world, then the U.S. dollar will tend to strengthen, all else equal, and with strong dollar U.S. imports are likely to exceed U.S. exports, leading to a trade deficit. This is why international monetary policy cooperation is needed and the Group of 20 meets periodically to coordinate policies.  The FOMC sets ranges for growth of monetary aggregates and the Fed funds rate, and also directs operations in FX markets. Functions performed by the Federal Reserve Banks 1. Assist in the conduct of monetary policy: • Set and change the discount rate (must be approved by the Board of Governors). • Make discount window loans to depository institutions. 2. Supervise and regulate F R S member banks: • Conduct examinations and inspections of member banks. • Issue warnings when banking activity is unsafe or unsound. • Approve bank mergers and acquisitions. 3. Provide government services: Act as the commercial banks of the U.S. Treasury. 4. Issue new currency: Collect and replace currency in circulation as necessary. 5. Clear checks: Act as a central clearing system for U.S. banks. 6. Perform banking sector and economic research: Used in the formulation of monetary policy. 7. Provide wire transfer services: 51 • Fedwire. • Automated Clearinghouse (A C H). The monetary policy tools are: • open market operations • discount rate changes • reserve requirement ratio changes.  These tools are used to manage the following targets: Money supply (bank reserves) and interest rates (fed funds rate). These tools and targets are used to make changes in the financial markets such as change in bank reserves, change in money supply, change in credit availability, change in interest rates, change in borrowing, change in security prices, and change in foreign exchange rates. The objectives are price stability, economic growth, low inflation, full employment, sustainable pattern of international trade. They receive analysis and feedback on these objectives and then re-evaluate. Balance sheet of the Federal Reserve The major liabilities of the Fed’s BS are currency in circulation and reserves (depository institutions’ vault cash plus reserves deposited at Federal Reserve Banks). Their sum is referred to as monetary base. Total reserves can be classified into 2 categories: 1. required reserves  reserves that the Fed requires banks to hold by law 2. excess reserves  additional reserves over and above required reserves The major assets on the Fed’s BS are Treasury and government agency securities, treasury currency and gold and foreign exchange. Monetary policy tools Monetary policy affects the macroeconomy by influencing the supply and demand for excess bank reserves. It influences the money supply and the level of short-term and long-term interest rates, and it affects foreign exchange rates, the amount of money and credit in the economy, and the levels of employment, output, and prices. Depository institutions trade excess reserves held at their local Fed Banks among themselves. Banks with excess reserves have an incentive to lend these funds (overnight) to banks in need of reserves since excess reserves held in the vault of the Fed earn little or no interest. The rate of interest on these interbank transactions is a benchmark interest rate (fed funds rate), which is used in the US to guide monetary policy. Financial Services Regulatory Relief Act of 2006  Authorized Federal Reserve to pay interest on reserve balances held by depository institutions. 52 • High unemployment. • High debt levels. Excessive money creation may reduce the value of the dollar and generate inflation. • Inflation can cause interest rates to increase, hurting growth. • Loss in confidence of foreign investors could cause higher interest rates, hurting growth. International monetary policy and strategies The Federal Reserve generally allows foreign exchange rates to fluctuate freely. Foreign exchange intervention: • Commitments between countries about the institutional aspects of their intervention in the foreign exchange markets. • Similar to open market purchases and sales of Treasury securities. Responses by major central banks to the financial crisis: • Expansion of retail deposit insurance  increased retail bank deposit insurance coverage was widely used during the crisis to ensure continued access to deposit funding. • Direct injections of capital to improve lender’s balance sheets • Debt guarantees  as financial markets froze, so did the wholesale funding market used by banks to support lending activities • Asset purchases or asset guarantees  asset purchase programs removed distressed assets from bank BS • Stress tests of bank Quantitative easing A QE strategy is often employed during a crisis and when open market operations have failed. For example, the interest rate may already be at zero, but there is still a slowdown in lending and economic activity. In such situations, the central bank might buy a variety of securities to revive them: long-term treasuries, private securities, or securities in a particular area of the market.  The idea is to again boost economic activity, introduce money into the system, lower the yield, and ease out specific markets, such as mortgage-based securities, by reducing the risk spread. QE increases the central bank's balance sheet considerably and exposes it to greater risk. Quantitative easing (QE) is a form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment. Buying these securities adds new money to the economy, and also serves to lower interest rates by bidding up fixed-income securities. It also expands the central bank's balance sheet. When short-term interest rates are either at or approaching zero, the normal open market operations of a central bank, which target interest rates, are no longer effective. Instead, a central bank can target specified amounts of assets to purchase. 55  Quantitative easing increases the money supply by purchasing assets with newly created bank reserves in order to provide banks with more liquidity. To execute quantitative easing, central banks increase the supply of money by buying government bonds and other securities. Increasing the supply of money lowers the cost of money—the same effect as increasing the supply of any other asset in the market. A lower cost of money leads to lower interest rates. When interest rates are lower, banks can lend with easier terms. Quantitative easing is typically implemented when interest rates are approaching zero because, at this point, central banks have fewer tools to influence economic growth. If QE itself loses effectiveness, a government's fiscal policy may also be used to further expand the money supply. As a method, quantitative easing can be a combination of both monetary and fiscal policy; for example, if a government purchases assets that consist of long-term government bonds that are being issued in order to finance counter-cyclical deficit spending. Potential negative consequences: • if central banks increase the money supply, it can create inflation. The worst possible scenario for a central bank is that its quantitative easing strategy may cause inflation without the intended economic growth. An economic situation where there is inflation, but no economic growth, is called stagflation. • it can devalue the domestic currency. While a devalued currency can help domestic manufacturers because exported goods are cheaper in the global market (and this may help stimulate growth), a falling currency value makes imports more expensive. This can increase the cost of production and consumer price levels. Although most central banks are created by their countries' governments and have some regulatory oversight, they cannot force banks in their country to increase their lending activities. Similarly, central banks cannot force borrowers to seek loans and invest. If the increased money supply created by QE does not work its way through the banks and into the economy, quantitative easing may not be effective. From 2008 until 2014, the U.S. Federal Reserve ran a quantitative easing program by increasing the money supply. This had the effect of increasing the asset side of the Federal Reserve's balance sheet, as it purchased bonds, mortgages, and other assets. The Federal Reserve's liabilities, primarily at U.S. banks, grew by the same amount, and stood at over $4 trillion by 2017. The goal of this program was for banks to lend and invest those reserves in order to stimulate overall economic growth. 56  However, what actually happened was that banks held onto much of that money as excess reserves. At its pre-coronavirus peak, U.S. banks held $2.7 trillion in excess reserves, which was an unexpected outcome of the Federal Reserve's quantitative easing program. The 2008 crisis QE was used following the 2008 financial crisis to improve the health of the economy after widespread subprime defaults caused major losses resulting in broad economic damage. In general, policy easing refers to taking actions to reduce borrowing rates to help stimulate growth in the economy.  Quantitative easing is the opposite of quantitative tightening which seeks to increase borrowing rates to manage an overheated economy. From September 2007 through December 2018, the Federal Reserve took quantitative easing steps, reducing the federal funds rate from 5.25% to 0% to 0.25%, where it stayed for seven years. In addition to decreasing the federal funds rate and holding it at 0% to 0.25%, the Fed also used open market operations. In this case of quantitative easing, the Fed used both federal funds rate manipulation and open market operations to help reduce rates across maturities. The federal funds rate reduction focused on short-term borrowing, but the use of open market operations allowed the Fed to also decrease intermediate and longer-term rates as well. As mentioned, buying debt in the open market pushes prices up and rates down. The Fed implemented large-scale asset purchases in multiple rounds from 2008 to 2013. After four years of holding the new assets on the balance sheet, the Fed’s QE goals had reportedly been achieved and were markedly successful. As such, the Fed began the process of normalization in 2017 with an end to principal reinvestments. In the years following 2017, the Fed plans to use open market operations in somewhat of a tightening mode with staged plans for selling balance sheet assets in the open market. 57