Financial Economics (notes), Appunti di Finanza

Scarica Financial Economics (notes) e più Appunti in PDF di Finanza solo su Docsity! 📈 FINANCIAL ECONOMICS📉 LECTURE 1: INTRODUCTION ABOUT FINANCIAL MARKETS FUNCTION OF FINANCIAL MARKETS: • Lender-savers: those who have saved and are lending funds • Borrower-spenders: those who must borrow funds to finance their spending Securities are assets for the person who buys them and liabilities for the individual or firm that issues them BOND = a debt security that promises to make payments periodically for a specified period of time STOCK = a security that entitles the owner to a share of the company’s profits and assets FINANCIAL MARKETS: • Essential to promote economic efficiency • Critical for producing an efficient allocation of capital, which contributes to higher production and efficiency for the overall economy STRUCTURE OF FINANCIAL MARKETS: • Debt markets: contractual agreement by the borrower to pay the holder of the instrument fixed amounts at regular intervals until a specified date when a final payment is made (ex. bond or mortgage) - Short term: maturity is less than 1 year - Intermediate term: maturity is between 1 and 10 years - Long term: maturity is 10 years or longer • Equity markets: periodic payments (dividends) to their holders and are considered long term securities because they have no maturity date (represents an ownership claim of the firm so gives the right to vote) (ex. stocks) - Pro: equity holders benefit directly from any increases in the corporation’s profitability - Con: equity holders are residual claimants so the corporation must pay all its debt holders before it pays its equity holders • Primary market: financial market in which new issues of a security are sold to initial buyers • Secondary market: financial market in which securities that have been previously issued can be resold • Money market: financial market in which only short term debt instruments are traded • Capital market: financial market in which long term debt instruments and equity are traded BROKERS = buy and sell for clients DEALERS = buy and sell on their behalf EXCHANGES = buyers and sellers of securities meet in one central location to conduct trades 1 OVER-THE-COUNTER MARKETS = dealers at different locations who have an inventory of securities stand ready to buy and sell securities ‘over-the-counter’ to anyone interested INTERNATIONALIZATION OF FINANCIAL MARKETS: • Foreign bonds: bonds sold in a foreign country and denominated in the foreign country’s currency • Eurobonds: bonds sold in a foreign country but denominated in the home country’s currency • Eurocurrencies: foreign currencies deposited in banks outside the home countries FINANCIAL INTERMEDIARIES: stand between the lender-savers and the borrower-spenders and help transfer funds from one to the other (primary route for moving funds) • Functions of financial intermediaries: - Transaction costs: time and money spent in currying out financial transactions - financial intermediaries can substantially reduce transactions costs because they have developed expertise in lowering them and because their large size allows them to take advantage of economies of scale (reduction in transaction costs as the size of transactions increases) - Risk sharing: risky assets are turned into safer assets for investors (reducing the exposure of investors to risk) - diversification is the creation of a portfolio of assets whose risk is lower than for the individual assets - Asymmetric information: one party does not know enough about the other party to make accurate decisions - Adverse selection: problem created by asymmetric information before the transaction occurs - Moral hazard: problem created by asymmetric information after the transaction occurs - Economies of scope: lowering the production cost of information by using the information for multiple services - Conflicts of interest: moral hazard problem that arises when an individual or institution has multiple interests and, as a result, has conflicts between objectives • Types of financial intermediaries: - Finance companies: raise funds by selling commercial paper (short term debt instrument) and by issuing stocks and bonds - Mutual funds: acquire funds by selling shares and use the proceeds to purchase diversified portfolios of stocks and bonds - Money market mutual funds: offer deposit-type accounts that are then used to buy money market instruments that are both safe and very liquid - Investment banks: helps corporations by advising on which type of securities to issue and by selling the securities (purchasing securities from the corporation and reselling them in the market) • Regulations for financial intermediaries: - Restrictions on entry: tight regulations governing who is allowed to set up a financial intermediary - Disclosure: financial intermediaries are required to report certain information - Restrictions on assets and activities: restrict financial intermediaries from engaging in certain risky activities - Deposit insurance: insure people’s deposits so that they do not suffer great financial losses if the financial intermediary that holds these deposits should fail - Limits on competition: competition among financial intermediaries promotes failures that will harm the public - Restrictions on interest rates: competition has also been limited by regulations that impose restrictions on interest rates that can be paid on deposits Central banks: important role as coordinator/facilitator/initiator LECTURE 2: ASSETS’ DEMAND AND SUPPLY FINANCIAL RISKS: financial transactions under uncertainty • Market risk: risk of unexpected changes in prices or rates 2 PROFITING FROM INTEREST RATES FORECAST: • Make decisions about assets to hold: 1. Forecast i will decrease - buy long bonds 2. Forecast i will increase - buy short bonds • Make decisions about assets to borrow: 3. Forecast i will decrease - borrow short 4. Forecast i will increase - borrow long LECTURE 3: BONDS BONDS: • Long term debt securities that are issued by government agencies or corporations • The issuer of a bond is obligated to pay interest (coupons) payments periodically and the par value (principal) at maturity • Bonds are transferable and valued based on current interest rates • Types of issuers: - Government bonds: issued by the national government in the country’s currency; their have low credit risk and therefore low interest rates - Municipal bonds: issued by a city or local government - Corporate bonds: long term debt securities issued by corporations that promise the owner coupon payments (coupons) periodically; default risk is higher than that for government bonds (differs from company to company and depends on the seniority of the bonds) 1. Senior secured bonds: have a collateral attached, so in case of default the assets are sold 2. Senior unsecured bonds (debentures): no collateral, in case of default bondholders must go to court to take possession of assets 3. Subordinated bonds: similar to debentures, but in the event of default subordinated bondholders are paid only after non subordinated bondholders are paid • Types of coupons: - Fixed coupon bonds: the issuer promises to make fixed interest payment on the principal amount - Fixed coupon bonds (ZCB): a zero coupon bonds is a special case in which the issuer does not pay any coupons, only the principal amount is repaid at maturity - Floating rate notes: the coupons are variable, as the interest rate fluctuates (interest rates adjust to the prevailing level of interest rates) MATURITY = date when principal and final coupon is due COUPON RATE = interest rate fixed for the period of the bond PRICE = present value of all the discounted cash flows YIELD TO MATURITY = internal rate of return PRESENT VALUE: enables to figure out today’s value of a market instrument at a given interest rate by adding up the present value of all the future cash flows received • Loan principal: the amount of funds that the lender provides to the borrower • Maturity date: the date at which the loan must be repaid • Interest payment: the additional amount that the borrower must pay the lender for the use of the loan principal • Simple interest rate: the interest payment divided by the loan principal (interest/principal) TYPES OF MARKET INSTITUTIONS: • Simple loan: the lender provides the borrower with an amount of funds, which must be repaid to the lender at maturity date along with an additional payment for the interest • Fixed-payment loan: the lender provides the borrower with an amount of funds, which must be repaid by making the same payment every period, consisting of part of the principal and interest 5 • Coupon bond: the owner of the bond receives a fixed interest payment (coupon payment) every year until the maturity date, when a specified final amount is repaid • Discount bond (ZCB): bought at a price below the face value, and the face value is repaid at the maturity date DISTINCTION BETWEEN INTEREST RATES AD RETURNS: the return on a bond will not necessarily equal the interest rate on that bond • R = coupon payment + price of bond at t1 - price of bond at t0 / price of bond at t0 = current yield + rate of capital gain RISK STRUCTURE OF INTEREST RATES (default risk, liquidity, income tax considerations) • Default risk: the issuer of the bond is unable or unwilling to make interest payments when promised or to pay off the face value at maturity date • Default-free bonds: bonds with no default risk (ex. Treasury bonds) • Risk premium: indicates how much additional interest people must earn to be willing to hold that risky asset RESPONSE TO AN INCREASE IN DEFAULT RISK: 1. An increase in the default risk shifts the demand curve for corporate bonds to the left 2. The demand curve for Treasury bonds shifts to the right 3. Price of corporate bonds decreases and price of Treasury bonds increases, as a result interest rate on corporate bonds increases and interest rate on Treasury bonds decreases CREDIT-RATING AGENCIES: rate the quality of corporate and municipal bonds in terms of the probability of default • Investment grade: bonds that have a rating of Baa (or BBB) and above have relatively low risk of default • Speculative grade: bonds that have a rating below Baa (or BBB) have higher risk of default DEFAULT = every loan that is 90 days past due DETERMINANTS OF RATING • New retail customers: - Date of birth (age) - Education - Marital status - Employment - Duration of client relationship with the bank - Current level of debt at bank - Amount of the applied loan • New company clients: - Limited vs unlimited liability - Turnover and profit - Number of employees 6 - Foundation date of the company • Existing clients: - Overdue amount - Overdue since - Maximum overdue amount - Number of times overdue - Date of last default MEASURES OF DEFAULT • Loss given default (LGD): percentage of loss that is expected in the case of default of the borrower (maximum loss/loan principal) • Exposure at default (EAD): the expected exposure (amount owed by the customer) at the time of default • Expected loss (EL): probability of default x loss given default x exposure at default • Value at risk (VaR): worst loss that is expected over a given time horizon for a given confidence level LIQUIDITY: a liquid asset is one that can be quickly and cheaply be converted into cash (US Treasury bonds are the most liquid, corporate bonds are not as liquid) 1. If the corporate bond becomes less liquid, the demand curve for corporate bonds shifts to the left 2. The demand curve for Treasury bonds shifts to the right 3. Price of corporate bonds decreases and price of Treasury bonds increases, as a result interest rate on corporate bonds increases and interest rate on Treasury bonds decreases DISTINCTION BETWEEN REAL AND NOMINAL INTEREST RATES: real interest rate = nominal interest rate - inflation rate TERM STRUCTURE FACTS • Yield curve: describes the term structure of interest rates for particular types of bonds - Upward sloping: the long term interest rates are above the short term interest rates - Flat: the long term interest rates and the short term interest rates are the same - Downward sloping: the long term interest rates are below the short term interest rates EXPECTATIONS THEORY: explains that the reason why interest rates in bonds of different maturities differ is because short term interest rates are expected to have different values at different future dates • Perfect substitutes: bonds with different maturities that have the same expected return • N-period bond: int = it + iet+1 + iet+2 + … + iet+(t-1) / n • example: one-year interest rates over the next five years are expected to be 5%, 6%, 7%, 8% and 9%. What are the interest rates on a two-year bond and a five-year bond? - i2t = 5% + 6% / 2 = 5.5% - i5t = 5% + 6% + 7% + 8% + 9% / 5 = 7% 7 MARKET MAKERS • Matching up buy and sell orders on the New York Stock Exchange • Market makers gain from accommodating orders because their bid and ask prices differ • Market makers take positions to capitalize on the discrepancy between the prevailing stock price and their own valuation of the stock TYPE OF ORDERS • Market orders: no price indication (instruction to trade a quality at the best price currently available in the market) - Pro = quick - Con = may get worse price • Limit orders: price indication (instruction to trade at the best price available if it is no worse than specified limit price) - Pro = may get good price for trade - Con = may not execute PLATFORMS • Direct access broker: platform that allows investors to trade stocks without the use of a broker • Dark pools: platforms that use software to connect buyers and sellers of stocks COMPUTING THE PRICE OF COMMON STOCK: determine the cash flows and discount them to the present SHORT-SELLING: investors place an order to sell a stock that they do not own ONE-PERIOD VALUATION MODEL: buying the stock, holding it for one period to get a dividend, then selling the stock • P0 = D1 / (1+Ke) + P1 / (1+Ke) • Where P0 is the current price, D1 is the dividend, Ke is the return on investments and P1 is the price at the end of year 1 GENERALIZED DIVIDEND VALUATION MODEL: the value of the stock is the present value of all future cash flows (dividends and final sales price when the stock is ultimately sold) • P0 = D1 / (1+Ke) + D2 / (1+Ke)2 + … + Dn / (1+Ke)n + Pn / (1+Ke)n GORDON GROWTH MODEL: dividends are assumed to continue growing at a constant rate forever (growth rate is assumed to be less than the required return on equity Ke) • P0 = D0 x (1+g)1 / (1+Ke) + D0 x (1+g)2 / (1+Ke)2 + … + D0 x (1+g)n / (1+Ke)n PRICE EARNINGS VALUATION METHOD: the price earnings ratio approach is useful for valuing privately held firms and firms that do not pay dividends • P = P / E x E ERRORS IN VALUATION: • Estimating growth • Forecasting dividends • Security valuation is not an exact science and stock prices cannot be predicted 2007-2009 FINANCIAL CRISIS: • The crisis lowered ‘g’ in the Gordon Growth model driving down prices • General fall in stock prices • The expectations were optimistic at the start of the crisis, but became severe and prices plummeted LECTURE 5: EXCHANGE RATES FOREIGN EXCHANGE MARKET 10 • Most countries have their own currencies • Trade between countries involves the mutual exchange of different currencies • The trading of currencies and bank deposits denominated in particular currencies takes place in the foreign exchange market TWO TYPES OF EXCHANGE RATE TRANSACTIONS • Spot transactions: immediate (two-day) exchange of bank deposits (spot exchange rate is the exchange rate for the spot transaction) • Forward transactions: exchange of bank deposits at some specified future date (forward exchange rate is the exchange rate for the forward transaction) WHY ARE EXCHANGE RATES IMPORTANT? • They affect the relative price of domestic and foreign goods • example: the dollar price of French goods to an American is determined by the interaction of two factors: - The price of French goods in euros - The euro-dollar exchange rate • When a country’s currency appreciates (rises in value relative to other currencies), the country’s goods abroad become more expensive and foreign goods become cheaper • When a country’s currency depreciates (falls in value relative to other currencies), the country’s goods abroad become cheaper and foreign goods become more expensive HOW IS FOREIGN EXCHANGE TRADED? • Currencies are not traded on exchanges such as the New York Stock Exchange • Over-the-counter markets: dealers (mostly banks) stand ready to buy and sell deposits denominated in foreign currencies • Because retail prices are higher than wholesale, when we buy foreign exchange, we obtain fewer units of foreign currency (we pay a higher price for foreign currency than the exchange rates quote) EXCHANGE RATES IN THE LONG RUN: like the price of any good or asset in a free market, exchange rates are determined by the interaction of supply and demand LAW OF ONE PRICE = if two countries produce an identical good, the price of the good should be the same thought the world no matter which country produces it THEORY OF PURCHASING POWER PARITY • Exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries • Real exchange rate: the rate at which domestic goods can be exchanged for foreign goods (price of domestic goods relative to the price of foreign goods denominated in the domestic currency) • PPP predicts that the real exchange rate is always equal to 1, so that the purchasing power of the dollar is the same as that of other currencies FACTORS AFFECTING EXCHANGE RATES IN THE LONG RUN • In the long run, four major factors affect the exchange rate: - Relative price levels - Tariffs and quotas - Preferences for domestic versus foreign goods - Productivity • If a factor increases the demand for domestic goods relative to foreign goods, the domestic currency will appreciate • If a factor decreases the demand for domestic goods relative to foreign goods, the domestic currency will depreciate • Relative price levels: in the long run, a rise in a country’s price level (relative to the foreign price level) causes its currency to depreciate; whereas a fall in a country’s price level (relative to the foreign price level) causes it currency to appreciate 11 • Trade barriers: increasing trade barriers causes a country’s currency to appreciate in the long run • Preferences for domestic versus foreign goods: increased demand for a country’s exports causes its currency to appreciate in the long run; whereas increased demand for a country’s imports causes the domestic currency to depreciate in the long run • Productivity: in the long run, as a country becomes more productive relative to other countries, its currency appreciates EXCHANGE RATES IN THE SHORT RUN • Demand curve: traces out the quantity demanded at each current exchange rate holding everything else constant Excess supply: causes the value of the dollar to fall Excess demand: causes the value of the dollar to rise EQUILIBRIUM IN THE SHORT RUN • When the quantity of dollar assets demanded equals the quantity supplied • Current exchange rate > equilibrium, supply > demand • Current exchange rate < equilibrium, supply < demand TRIANGULAR ARBITRAGE • 0.6649$ per euro and 0.07940$ per yen • Cross exchange rate is 0.6649/0.07940=8.374yen/euro and 0.07940/0.6649=0.01194euro/yen LECTURE 6: DERIVATIVES FINANCIAL DERIVATIVES: assets whose value is defined by other assets (underlying assets) • Pros: - Risk management strategies (to hedge or reduce risk) - Speculative positions (to speculate on the price) - Monitor and transfer risk (risk tolerant to risk averse) • Cons: huge losses • example: gold future contract (derivative) ☞ gold (underlying asset) DERIVATIVE MARKETS: • Over-the-counter market • Exchange 12