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

Scarica Financial Markets and Economic Activity e più Appunti in PDF di Economia E Tecnica Dei Mercati Finanziari solo su Docsity! Introduc on to financial systems 2 Financial structures 8 How Financial Markets should work 13 Uncertainty and risk 22 Households finance: saving and borrowing 31 Households finance: Risk aversion and por olio selec on 40 Corporate finance and investment - Firms 44 Anomalies – How financial markets may fail 49 Considera ons on the origin and nature of public debt 61 Monetary crea on, Safe assets, and Cryptocurrencies 72 Introduction to financial systems What financial system does We can say that trading activity of goods, services and production factors is achieved through monetary payments or through obligations (debits/credits). So, we have the real economic system on one side and the financial system on the other side. Financial systems produce and exchange financial instruments, provide transfer and allocation of funds from resources to users; and provide regulation and control over these activities. Ad we can see the financial system is between the resources and the uses or lenders and the borrowers.  The relationship between these two can be direct or can be intermediated by the market intermediaries (i.e., insurance or pension plan) Four fundamental functions The financial system performs a variety of functions, essentially four, that are crucial for the well (or bad) functioning of modern market (capitalist) economies 1) Borrowing and lending  function of allowing the choice of the time profile of expenditure: the lender wants to postpone his expenses and the borrower wants to advance his expenses with respect to the available funds. 2) Ownership and control allocation: the financial system makes possible to associate a wide array of lenders collecting their financial means  important for firms’ efficiency, they can increase their financial scale in an easier way.  But this can affect the firm’s ownership and decision structure (i.e., stock exchange company) 3) Diversification of wealth, differentiation of risk propensity, general assumption is that agents are risk- adverse  risk self-insurance, performed by the agent by themselves 4) Saving and investment coordination 1) seen on a larger scale macroeconomic stability and growth Each of these functions can be examined: - Theoretically: how can it be realized in the best possible way? The conditions whereby the financial system provides these functions in the best possible way are key to the fundamental notion of financial market efficiency - Empirically: how is it realized in practice? Each of these functions is related with the others: if one fails, all others may also fail. Actors: institutions Domestic sector  Economic sector  provide real goods and services  Monetary and financial sector Foreign sector  financial transactions abroad The economy as a whole – Stock and flows Each sector is entitling of assets (A) and liabilities (L), NFP is equal to assets – liabilities for each sector. Usually, households’ NFP is positive for all the advanced economies For each asset there must be a liability !! NB: the foreign sector has to be considered separately Total financial wealth 𝑇𝐹𝑊 = ∑ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝐴𝑠𝑠𝑒𝑡𝑠 = 13.673,2 𝑏𝑙𝑛 Net financial wealth NFW = 𝑇𝐹𝑊 − ∑ 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = 10.922,5 𝑏𝑙𝑛 Foreign Financial position 𝐹𝐹𝑃 = 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = ∑ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑁𝐹𝑃 = −101.6 𝑏𝑙𝑛  Italy is a net debtor: - net debtor; + net creditor Only the public sector has a negative financial balance, as it increases the liabilities more than the assets ΔTotal financial wealth Δ𝑇𝐹𝑊 = ∑ Δ𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝐴𝑠𝑠𝑒𝑡𝑠 = 432,6 𝑏𝑙𝑛 ΔNet financial wealth ΔNFW = Δ 𝑇𝐹𝑊 − ∑ Δ𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = 339,5 𝑏𝑙𝑛 ΔForeign Financial position Δ𝐹𝐹𝑃 = Δ𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 − Δ𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = ∑ ΔD𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑁𝐹𝑃 = 49.9 𝑏𝑙𝑛 The account of financial resources and users The financial flow accounts can be reorganized in order to highlight how the economy is financed: looking at the sectors that create (lend) financial resources vs the sectors that use (borrow) them. Financial resources  Σ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑛𝑒𝑡 𝑙𝑒𝑛𝑑𝑖𝑛𝑔 𝑠𝑒𝑐𝑡𝑜𝑟 + 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 Financial users  Σ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑛𝑒𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑠𝑒𝑐𝑡𝑜𝑟𝑠 + 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑙𝑒𝑛𝑑𝑖𝑛𝑔 Only the public sector absorbed resources as seen before This account also highlights the relationship between domestic lending/borrowing and foreign lending/borrowing A country is net foreign lender (or borrower) if domestic net lending is greater (or smaller) than domestic net borrowing Composition of financial flows Normally, firms and households are net lender and the State a net borrower.  a major anomaly of the crisis: non- financial corporations as net lenders  Monetary instruments (typical liquid form) and also bank loans have declined sharply  decline of traditional banking intermediation;  All the less liquid, and riskier, financial instruments dealt by financial markets and markets intermediaries have gained space overall. Given that capital movement “opened” during the 80s and 90s  IT and Internet revolution  bank instruments  less liquidity and more risk Households’ assets (portfolio structure) This plot confirms the shift to less liquid and risky asset. Monetary instruments have been replaced by the increase of direct market instruments and by indirect ones (i.e., bonds) High quota of bank deposits reduced because of inflation (the inflation before wasn’t a problem) Firms’ labilities (capital structure) How can firms finance their activity? a) By resources generated by the company (internal) b) Equities (shares)  ownership rights c) Debt Global financial crisis (2008) International comparisons “Bank systems” vs “Market systems”  From 1980 to 2015 we denote a sharp decrease of bank loans (as seen for the households);  Equities shares increased, bit lower in 2010 than 2015 because of the financial crisis; While in 1980 there was a balanced situation between debt and equities, now companies’ structure is more oriented towards equity and market instruments  financialization same as households, increase in financial capacity. Are all financial systems alike? “Banks” and “Market” denote two different ways of organizing financial transaction creating financial instruments. Since the beginning of the XX century, disaggregation of data by countries has shown two distinct groups according to the relative incidence of "Banks" and "Markets":  US, UK, Canada, with smaller role of the bank sector and larger share of market instruments "market systems" ("Anglo-Saxon model")  Japan, Germany, France and Italy have larger share of the banks sector and bank instruments "bank systems" ("Continental model") Is this pattern still relevant today? - BS vs. MS difference much less marked, only to some extent still present. - Both types of systems have moved towards market instruments (direct and/or intermediated) ("Transnational model"), - This pattern is common to all developed countries. However, there are differences of intensity Differences Liquidity in a financial market = market is liquid when there are a lot of transaction and the fee to borrow/ask for money is little The differences between systems have decreased over the period analyzed, in general in ‘80s bank instruments were the majority in both systems, while the opposite is true for 2015. The Japanese case is the clearest case of banking system, although the shares of other countries are also consistent with the different system types. To better analyze the division of those two systems we need to add up the portion allocated in bonds and equity to the one allocated to market intermediaries  only in the French case the difference is hardly observable. Market equilibrium: when demand equals supply at a single interest rate (market interest rate). No transaction takes place at a different rate. Market mechanisms Security markets and prices – more realistic environment Introducing security prices We know that some financial instruments ("securities") are traded at a price in organized markets. In these markets, transactions modify the price of the security. The interest rate on these instruments should be computed in a particular way- the rate of return - that takes the role of price into account. How does the security market mechanism work? Same information  same formula to calculate the rate of return Context without uncertainty Rate of return We suppose a share issued by a company; we have an investor that invest at a time (t) The formula of the return rate (RR) of any security (k)  pkt= purchase price at time t  pkt+1 = market price at time t+1 (e.g., one year);  ykt+1 = payments (per euro) per time unit (a fixed interest rate r for bonds, a variable di+1 dividend for equities) Capital gains and losses The formula can also be expressed as follows, distinguishing the yield rate and the capital gain yield rate >0 capital gain; < 0 capital loss The future value Another formulation is the following: the sum of the future payments (Vkt+1) and the future market price yield the future value of the security Therefore, The return rate of a security is inversely proportional to its price, for its given future value Note: the formula of the RR has the simple meaning that you invest €pkt to get €Vkt+1 in one year Example The current price of the shares of company k is pkt = €2. The one-year dividend is dkt+1=€0.2 per share, and the resale price is pkt+1=€2.1. 𝑉 = 0.2 + 2.1 = 2.3 𝑟 = 2.3 2 − 1 = 0.15 = 15% Now suppose that a) the current price falls to €1.8 𝑟 = 2.3 1.8 − 1 = 0.278 = 27.8% b) at the initial price, the on-year dividend is revised downwards to dkt+1 = €0.1 𝑉 = 0.1 + 2.1 = 2.2 𝑟 = 2.2 2 − 1 = 0.1 = 10% Demand and supply w.r.t. price We can now translate demand and supply of funds into demand and supply of securities. First, consider that those who demand funds: - issue (supply) securities demand for funds is decreasing in return rate. - return rate is decreasing in the security price security - Opening price p10=80, p20=160 𝑟 = − 1 = 25%, 𝑟 = − 1 = −6,2%, Investors start to buy security one and sell security 2  arbitrage process Three important questions and explanations 1) Why are security prices different? They reflect the (market information of) future value of securities; securities with higher future value command a higher price than those with lower future value. This is called informational efficiency 2) Why are security prices so variable ("volatile")? They react quickly to changes in r and V. "News" about changes in V are the most important factor. Note: V are future, unobservable variables, assessed by investors 3) If you're so smart, why aren't you so rich? "Smart traders" present themselves as being able to make systematically higher return rate than the others. Arbitrage and informational efficiency make this impossible (at least on average), or: "you can't beat the market". In fact, the equilibrium price formula means that anyone in the market who buys security k at price pt upon the information that its future value is Vkt+1 will earn no more (no less) than the market rate r. Fundamental valuation Arbitrage and informational efficiency have another important implication: the truly smart trader is the one who chooses high yield securities given all available information, not the one who seeks to speculate (i.e., make conjectures) on unknowable future prices. This is aka the principle of fundamental valuation. Can we aim (rationally) at pure "speculative" capital gains? look at the yield not at the capital gain Why? Changes in future prices are unpredictable (rationally) Let us extend our view beyond one year. The investor who buys the security k in t and holds it for a number of years up to T, can expect to obtain the compound value of its stream of future payoffs net of changes in the price each year. Is there a rational basis to foresee the future price? Here is one: everybody knows the security price formula where we use a more correct notation for the future value V (𝑉𝑘𝑡 + 1| 𝐼𝑡) reads: the t+1 value of k is computed according to all available information It, and is the best possible forecast, as of t. What then will Pkt+1 be? By the same reasoning. Hence, to foresee pk+1 you would need foresee (𝑉𝑘𝑡 + 2|𝐼𝑡 + 1). This is the future value of k recomputed in 𝑡 + 1 if news arrive (𝐼𝑡 + 1) that are unknown in t. Hence, to foresee 𝑃𝑘𝑡 + 1 as of t, you would need know now the information that will arrive in 𝑡 + 1. This is clearly impossible! Indeed, if 𝐼𝑡 + 1 were predictable in t, it would be used immediately, and the price would rise in 𝑡, not 𝑡 + 1. Therefore, in an efficient market, the only source of the return rate to a security that investors can rationally expect is its stream of future payments As a result, the equilibrium price formula for any number of years n = 1, ..., T is The fundamental equilibrium price of a security reflects the present value of the stream of its future payments Uncertainty and risk In the previous part we have associated financial market operations to perfect information on a single factor determining the value of a security: its future payments. Now we shall probe into the problem of uncertainty about the future. Uncertainty defines a general characteristic of human reasoning arising from limitations concerning our knowledge and information.  we are uncertain because we do not know with certainty the future value of the relevant economic variable or of the factors that may determine it. Risk is a specific treatment of uncertainty in probabilistic terms. Understanding knowledge and information Knowledge = all factors, and their relationships, that determine the phenomenon of interest (a.k.a. "the model" (economists) or "data generation process" (statisticians)) Information = the state of all the relevant factors in a specific circumstance (e.g., when, where, ...) Both let arise uncertainty, as for knowledge uncertainty arise when the model generating the forecast is not certain, while for information uncertainty arise whenever the value of the values is not certain. Call Y the variable on which your decision depends (e.g., the return to an investment to decide whether to invest or not). An orderly and rational decision process looks like the following We may buy shares of company k at time t at the market price pkt = €2. What will be the return rate next year? We know that the RR of a security is Hence, we face two sources of uncertainty - the future payment 𝑦 - the future rate of change of the price 𝛿𝑝 If the market is efficient, we know that the best prediction of 𝛿𝑝 is zero.  only relevant forecast variable is 𝑦 .  Uncertainty takes the form of different possible values 𝑦 , and consequently of 𝑟 . Specification: whatever the reason of uncertainty, the set of different possible outcomes of the relevant variable, and the realization of any one of them, is independent of our will or action (what is also called "exogenous uncertainty"). From uncertainty to risk NB: Probability risk  asked in every exam Suppose that given our available information about kt+1, and the current price Pkt = €2, we obtain this set of possible values of 𝑟 (for notation simplicity we drop the subscript k). The EV gives you the best statistical forecast of the outcome of a random variable. 1) The EV is not necessarily the most probable outcome. 2) The EV may be none of the possible outcomes. This is a key notion because it makes it clear that knowing the EV of a random variable does not prevent you from making forecast errors! In our example, all possible return rates have the same probability, and yet you have one single EV = 6.2%, which is not among the possible outcomes.  The correct interpretation of the EV is that if you hold this investment (under invariant conditions) for a long time, you will end up with an average return rate of 6.2% per year. If you use relative frequencies the EV formula is the same, where frequencies f(ri) replaces probabilities In the example of National Dept. Stores, EV= 0.81. So here the EV is not the most probable (frequent) one (which was -5.8 < r <-2.8, with f=15.4%) The variance As just seen above, by the very definition of probability distribution and of EV, you should be certain that only one of the possible outcomes will realize, and that none of these may be equal to your EV. The only information you can get in advance is by how much the EV will be wrong. In the probability framework, risk has this precise meaning, and the relevant measure is the variance of the probability distribution.  The variance of a random variable is the expected value of the square forecast errors of possible values (the weighted sum of the square forecast errors of possible value with their respective probabilities) The variance is an aggregate measure of risk, because it encompasses all possible forecast errors and no single ones. It is also an absolute measure, because it yields a pure number (no relation to the unit of measure of outcomes) that encompasses both negative (ri < EV) and positive (ri; > EV) forecast errors. Financial applications generally make use of standard error (standard deviation) as measure of risk. This is the square root of the variance One reason for the use of SE is that its order of magnitude is commensurate to that of the EV. The SE is usually denoted by the statistical operator 𝜎. If you use relative frequencies, the Var formula is the same, where frequencies f(ri) replaces probabilities In the example of National Dept. Store, the SE is 9.04 How large (small) is SE? Rule of thumb: compare it with the EV. A "small" ("large) SE is smaller (larger) than the EV Return-risk analysis Return-risk analysis is based on the idea that any security is identified by its expected return rate (ERR) and risk (SE). On the vertical axe we have the percentage of return and on the horizontal one the time series. The German bound rate of return is structurally lower  considered less risky. Before 2011’s subprime debt crisis the spread between German and Italian/Spain wasn’t this wide. Map of securities Return-risk analysis can conveniently be done by means of a "map" of securities, i.e., a Cartesian plan measuring SE and ERR. The Fundamental Law of Finance More return goes with more risk (Average RR and SE of equities and bonds, G7 countries, 1967-95) Bonds tend to be associated with lower lever of standard error  lower return. There are still some outliers that do not follow the series. In this case also the seniority has to be taken into account: bonds are paid before equities if a firm fails. Portfolio of risky securities Return-Risk analysis can be applied to portfolios of securities. A portfolio is a combination of securities in given proportions ("portfolio shares"). A portfolio is still identified by its own ERR-SE, and can be plotted in the security map. The ERR-SE of a portfolio results from the ERR-SE of the underlying securities ERR of a portfolio The ER of a portfolio (P) is the weighted average of the expected return rates (ERRs) of the underlying securities (k) with the respective shares (𝑞 ). 𝐸𝑅𝑅(𝑃) = 𝐸𝑅𝑅(𝑘) ∗ 𝑞 Note. Given two or more securities, we can obtain as many portfolios as many combinations of shares of securities. Let us compute the ERR of portfolios consisting of German and Spanish State bonds (see above the table of EV and SE). Denote GER=1, SPA=2 Since we have only 2 securities, the share q2 = 1- q1. Hence ERR(P) = ERR(1)xq1 + ERR(2)×(1 – q1) SE of a portfolio The ES of a portfolio is the square root of its variance. T h e variance of the portfolio is the joint variance of the ERRs of the underlying securities. The joint variance of ERRs is a statistical measure that requires the new concept of covariance. Covariance (as the name suggests) arises from the fact that the ERRs of different securities can move simultaneously in the same direction (positive covariance) or in opposite direction (negative covariance). The formula of the variance of a portfolio of two securities is 𝑉𝑎𝑟(𝑃) = 𝑉𝑎𝑟(1) ∗ 𝑞 + 𝑉𝑎𝑟(2) ∗ 𝑞 + 2𝐶𝑜𝑣(1,2) ∗ 𝑞 ∗ 𝑞 Finally, according to the previous definition 𝑆𝐸(𝑃) = 𝑉𝑎𝑟(𝑃) Covariance is the key factor in portfolio management! Combine securities with negative covariance. In fact: as long as covariance is negative, the SE, i.e., the risk, of a portfolio is less than the sum of the SEs of the underlying securities. Correlation coefficient The covariance of the RR is often translated into the so-called correlation coefficient of the RR: 𝑐 = 𝑐𝑜𝑣(1,2) + 𝑆𝐸(1) ∗ 𝑆𝐸(2) This index has the same sign of the covariance, but the advantage that -1< c < 1 C = 1- perfect negative correlation c= 1 perfect positive correlation C = 0 no correlation The c.c. is a simpler indicator for the risk management of securities in portfolios. The movement of the yield of the two security was pretty similar looking at the first plot. The covariance shows a positive relation between these two securities ‘return rates.  0.84 indicates a high correlation These implications do not tell us what point along the CML a single individual saver will choose. This is a subjective choice which depends on his/her attitude towards risk, i.e., how much safe security he/she wish to hold against the risky portfolio. The financial data that we have seen show that savers generally do hold both safe and risky securities. Is risk a source of malfunctioning financial markets? Does risk disrupt financial efficiency? To the extent that risk and its management obey to the principles expounded above, the answer is no. Indeed, efficient risk management was presented as one of the fundamental functions of financial systems. 1) Recall the conditions for financial efficiency: perfect competition, no transaction costs, perfect information. The mere existence of risk does not violate these conditions, provided that the relevant risk parameters of all securities are included in the information set of all investors. 2) Return-risk analysis does not violate the basic mechanisms of financial efficiency, arbitrage and fundamental valuation, provided that: a) Fundamental valuation is corrected for risk, i.e., the future stream of payments of a security is reformulated in terms of its EV and SE b) Securities are classified, and compared, in homogeneous risk classes, i.e., under both dimensions of ERR and SE. Rethink of arbitrage as seeking for the best ERR: this makes sense only comparing securities in the same risk class (i.e., the same SE), otherwise portfolio theory suggests that securities with different return-risk should be combined together. As a result, the principles of fundamental valuation, arbitrage and uniform rate of return still apply within homogeneous risk classes of securities. Households finance: saving and borrowing Units that own production factors and assets, ear the related income, and have consumption as an aim. From financial data we have seen that, in most countries, household as a whole are net lenders. Yet, individually, households may well lend or borrow. In the former case, they need to save, in the second case they may borrow from themselves (dissaving) or from others. This mainly depends on the level of household’s income, type of consumptions and on the level of inflation rate faced.  pay attention not only aggregated analysis but also disaggregate one. Accounting principles of consumption plans The value of consumption plan A consumption plan is a sequence of consumption expenditures (in real goods and services) to be realized over a given period of time (𝐶 , 𝐶 , … , 𝐶 ). Two dimensions: a) The time profile of consumption preferred by the household how much it wishes to consume in each period b) The resources in each period, these represent the budget constraints of the plan The plan can be revised as soon as new information become available Budget constraint The resources for consumption in each period consist of these main items Total income (net of assets) 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 𝑓𝑟𝑜𝑚 𝑎𝑠𝑠𝑒𝑡𝑠 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑜𝑛 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑙𝑎𝑏𝑜𝑟 𝑖𝑛𝑐𝑜𝑚𝑒 𝐶 = 𝑌𝐿 + 𝑌𝐹 − 𝑆 𝐶  consumption, 𝑌𝐿  labor income, 𝑌𝐹  financial income  𝑆 > 0  saving; 𝑆 < 0  borrowing (dissaving) Example 1 Consider family Rossi. At the beginning of the year, they have financial assets for €40,000 and no liabilities. Given an interest rate of 5%, they also reckon on €2,000 of net financial incomes. They also earn year net labor incomes for €70,000. For the current year they plan to have ordinary consumption for €62,000 62.000 = 70.000 + 2.000 − 𝑆 → 𝑆 = 10.000 Suppose the household plans to have extra-expenditures for €20,000. Note that now the consumption plan exceeds total incomes, so that they need to gather additional resources. This may come from borrowing (e.g., a bank loan) or dissaving (sale of assets). 82.000 ≠ 70.000 + 2.000 − 10.000 Time chain of budgets in the consumption plan As long as 𝑆 ≠ 0, the budget of one period is linked to the other. Recall that saving increases assets and future interest revenues while borrowing increases liabilities and future interest payments  the household should also figure out what level of assets and liabilities is wanted at the end of the consumption plan. Case where no assets are held and neither liability or assets should be left In a two-period plan (0,1) this implies this chain of budgets: 𝐶 = 𝑌 − 𝑆 ; 𝐶 = 𝑌 − 𝑆 (1 + 𝑟) Example 2 - If this household saves €10,000 in year 0,with r = 5%. it can consume up to €10,500 more in year 1 (capital + interests). If it borrows €10,000, it should consume €10,500 less in year 1 (debt + interests). In both cases, at the end of the plan the household has neither liabilities nor assets. A key question in consumption planning is: what is the total value of the consumption plan? Recall that 𝑆 ≠ 0. Substitute 𝑆 in the year 1 budget: 𝐶 = 𝑌 + (𝑌 − 𝐶 )(1 + 𝑟) total future value 𝐶 + 𝐶 (1 + 𝑟) = 𝑌 + 𝑌 (1 + 𝑟) The total future value of the consumption plan cannot exceed the capitalized value of non-financial incomes. If we want to measure the total value of the plan now, it is necessary to use the technique of the present value of future sums. Therefore, divide by (1 + r): 𝐶 + 𝐶 (1 + 𝑟) = 𝑌 + 𝑌 1 + 𝑟 The present future value of the consumption plan cannot exceed the present value of non-financial incomes. The general intertemporal budget constraint 0 0 1 1(1 ) (1 ) T T t t t t t t C YC Y r r= = + = + + +   Example 3 Consider again Example 1 with only labor income, and discover that whatever financial decision is made in year 0, the total present value of consumable resources cannot exceed 70,000 + 70,000/(1.05) = 136,666.7. Geometry of intertemporal budgeting 𝑡𝑜𝑡𝑎𝑙 𝑓𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝐶 + 𝐶 (1 + 𝑟) = 𝑌 + 𝑌 (1 + 𝑟) 𝐶 𝑑𝑒𝑝𝑒𝑛𝑑𝑒𝑛𝑡 𝑜𝑛 𝑡ℎ𝑒 𝑐ℎ𝑜𝑖𝑐𝑒 𝑜𝑓 𝐶 𝐶 = 𝑌 + 𝑌 (1 + 𝑟) − 𝐶 (1 + 𝑟) The intertemporal budgeting line identifies the set of possible options regarding the composition of the plan. 𝑌 > 𝐶∗ 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔; 𝑌 < 𝐶∗ 𝑠𝑎𝑣𝑖𝑛𝑔 Intercept with x-axe is the option where all consumption is done in period t; while the intercept with the y-axe is the option where consumption is all done in period t+1. The point A is always present  plan where the present consumption = present income, future consumption = future income The interest rate is the "rate of exchange" between present and future consumption Define ∆𝐶 = 𝐶 − 𝑌 in each year, then, by intertemporal budgeting 𝑆 = 𝑌 − 𝐶 = −∆𝐶 𝑆 (1 + 𝑟) = 𝐶 − 𝑌 = ∆𝐶 1 + 𝑟 = − ∆𝐶 ∆𝐶 Therefore €1 of saving 𝑆 > 0 (less consumption) buys €(1+r) of future consumption; €1 of borrowing 𝑆 < 0 (more consumption) costs €(1+r) of future consumption. Note: if there is inflation, i.e., the price level of consumption goods increases from one year to the next, it is necessary to use the real interest rate, which is (nominal rate − inflation rate) 1) Consumption plan for year 0 Labour income €70,000  Saving   € €60,000 Consumption plan for year 1 Labour incomes €70,000 Capital and interests €10,500 €80,500 2) Consumption plan for year 0 Labour incomes €70,000 Bank loan €10,000 €80,000 Consumption plan for year 1 Labour incomes €70,000 Debts and interests €10,500 €59,500 Life-cycle planning with three income stages: youth (20 x 3y.), maturity (100 x 8y.), retirement (70 x 5y.) (interest rate 4%, PVI =890.7, C* = 73.5) Assumptions:  The present value of the consumption and income in each period is discounted to the rate of return equal to 4%  In this case (simplified) the human knows exactly when he dies Life-cycle planning with constant consumption implies three financial phases Youth  debt Maturity  saving Retirement  dissaving Is this result consistent with the general rule of saving/borrowing determined by the rate of growth of consumption with regards to incomes? Remember: saving S0 > 0, if gc > gy: consumption grows more than future incomes borrowing S0 < 0, if gc < gy: future incomes grow more than consumption and constant consumption means gc = 0 Time profile of wealth is hump-shaped, it’s negative/low during youth, highest during maturity, low during retirement  real data Wealth effects Wealth accumulation (decumulation) is integral part of the consumption plan. Wealth may rise or fall for exogenous reasons like stock market booms or crashes etc. These affect the value of consumable resources, and are particularly important when they are deemed permanent. Unexpected (temporary) income shocks (up and down) have limited effects on the consumption path: saving and borrowing act as buffers. Unexpected income falls by 50% in period 6.  Negative saving in period 6  Then saving increases and wealth decreases (last period is 0) Given the present value of our income we have to set the value of our consumption Over short periods of time, changes in consumption are poorly correlated with changes in income However, they react more than expected on a theoretical basis (correlation should be in the dimension of the interest rate but it is in the order of 50-60%) When income is high the households tend to consume more, so the correlation is positive but the correlation is not 0 Implications for finance of the aggregate household sector Demography  composition of population by age Economic organization and institutions  labor market organization (access and exit rules, time profile of careers and salaries)  regulation and efficiency of financial markets (access to borrowing and saving)  pension systems (age, private and public systems) Culture and values  intergenerational behavior (cultural, religious, values that affect rules and customs in the family relationships) What determines the preferred consumption path? We have seen that saving or borrowing result from the desire to delink the time path of consumption from that of income. This attitude entails an exchange between (more or less) present consumption and (less or more) future consumption. So far, we have taken this attitude as given without investigation. Can we learn more about it? The reference answer in financial analysis is based on three hypotheses  households' choices are driven by the pursuit of the maximal well-being from consumption  in any moment in time, higher consumption generates higher well-being, but with decreasing intensity i.e., Hamburger example  the more you eat the less utility you “gain”  the timing of consumption affects well-being; generally, sooner is better than later (so note that if savers wish to exchange less present consumption for future consumption, this may not be "costless"). The three hypotheses in a single plot Consumption is a source of personal well-being, called utility. The relationship between consumption and utility is conceived of as: - Do we have evidence of these hypotheses? Qualitatively yes, there is broad agreement (e.g. between economic analysis and psychologists). Much more disagreement on the "details" (e.g. the quantification of the effects, or the competence and consistency of people about their choices over time) Households finance: Risk aversion and portfolio selection How do people select securities? According to efficient risk management, any portfolio containing a share of safe security and of efficient risky portfolio can be chosen All portfolios on CML are efficient portfolio What about the real data? Composition of assets of households, G7 average, 1980-2007-2010  Households diversify their assets selecting different instruments;  With financial development, households have shifted to less liquid/ more risky portfolios Risk–return choice The first step is to start from the hypothesis that households are rational, perfectly informed, and operate in efficient markets. Then, consider what we have seen as to the consumption-saving choice. This kind of households save and lend as much as is necessary to achieve their preferred consumption path over time, given the market interest rate. In force of arbitrage, this is the highest possible rate in the given conditions. Now let us introduce uncertainty. How does this modify the picture? Households face the whole set of safe and risky securities in the market, each with its return-risk combination. Does rationality still imply that all households will put all their savings into the highest return security? Not necessarily, because the relationship between financial wealth and consumption gives relevance to risk as well. What is your risk attitude? As frequent visitor, a website selects you and offers the following options A: win €50 B: get for free a lottery ticket with the following chances  you can win €100 with 75% probability  you can lose €100 with 25% probability Which is your choice? A classification of risk attitude First, understand the gamble correctly. You know your actual wealth, say F, and then you face three possible states A: F + €50 B1: (F + €100)x0.75 B2: (F - €100)x0.25 Expected wealth if you choose B:E(F) = (F + €100)x0.75 + (F - €100)x0.25 =F + €50 This is a "fair gamble": the EV of your wealth after the gamble is the same as the actual wealth that you have for sure.  Risk aversion: an individual is risk averse if he/she prefers a sure sum of money instead of a risky prospect with the same EV (refuse the gamble).  Risk neutrality: an individual is risk neutral if he/she is indifferent between a sure sum of money and a risky prospect with the same EV.  Risk seeking: an individual is risk seeker if he/she prefers a risky prospect with the same EV as a sure sum of money (accept the gamble). Utility based risk-return choice The level of wealth at a point, relates to the future level of consumption. The principle of diminishing marginal utility from consumption (concave utility function) implies that wealth losses reduce utility more than wealth gains of the same dimension increase utility. As a consequence, when presented with risky prospects, this kind of individual displays risk aversion 𝑈(𝐹 + €100)𝑥0.75 + 𝑈(𝐹 − €100)𝑥0.25 < 𝑈( 𝐹 + €50) Loss in utility > gain in utility for the same amount Risk premium The risk premium is the additional ER that a risky security should pay for an individual to shift from a safe security to the risky security The attitude towards risk of an individual can be measured by his/her risk-premium curve or return-risk indifference curve, which, for any risky investment indicates how much ER he/she wants in order to hold that investment. A risk-premium curve consistent with the foregoing characteristics should be increasing in the SE of securities, and the slope of the curve indicates the ER/SE trade-off demanded by the saver. The logic of the choice of the optimal portfolio is analogous to the case of the choice of the time profile of consumption: the correspondence between the subject's desired trade-off and the one offered by the market. In this case, the trade-off that is matter of choice is between return and risk:  the saver's preference is measured as the slope of his/her risk-premium curve  the market trade-off is embodied in the slope of the CML The optimal portfolio chosen by the saver is the one such that the market return-risk satisfies his/her preferred one. On the CML graph, this is the point of tangency with the saver's risk-premium curve. Markets for risky and safe securities The principles of risk aversion and portfolio selection can be represented by means of demand functions for securities 𝐾 = 𝐾(𝐸𝑅𝑘(+), 𝐸𝑅𝑗(−), 𝑆𝐸𝑘(−), 𝑆𝐸𝑗(+), 𝐹(+)) 𝐽 = 𝐽(𝐸𝑅𝑘−), 𝐸𝑅(+), 𝑆𝐸𝑘(+), 𝑆𝐸𝑗(−), 𝐹(+)) 𝐽 + 𝐾 = 𝐹 The demand for each security depends on its own ER and SE, as well as on the ER and SE of all other securities. Explaining interest rate spreads The Fundamental Law of Finance wants that higher risk securities should pay higher return. The extent of the risk premium or "spread" (w.r.t. lower risk securities) is governed by the riskiness of securities and the degree of risk aversion of savers. A diagram that explains the widening spread between Italian (K) and German (J) State bonds. An investment with zero NPV is called "marginal (or break-even) investment" We say 0 but nobody would do that for less than 10% Internal Rate of Return (IRR) Given an investment of cost I, and future profit streams 𝜋t , ...., the internal rate of return of the investment is the rate 𝜌 such that its NPV is zero Hence, the IRR is also the highest interest rate (cost of capital) that the investment can sustain (clearly, for any r > 𝜌, NPV < 0). For an investment to be profitable the cost of capital should not exceed the IRR Consider an infinitely lived investment, t  ∞, with constant year profit stream 𝜋. Then, the IRR is also equivalent to the rate of return to investment (ROI). and 𝜋/ 𝜌 - It = 0 implies 𝜌 = 𝜋 /It  ROI Measuring the cost of capital A critical issue in investment valuation concerns the measurement of the cost of capital. First, we see how to measure the cost of capital for each possible financial instrument, and how this compares with the IRR rule. Consider the standard case of infinitely-lived investment of value I with constant year profit 𝜋. Internal funds Internal resources come from retained or non-distributed profits. Hence, firms' owners decide to reinvest the sum I in their own firm, instead of investing it otherwise. Let  be the IRR of I, and rm be the market rate of return to an alternative investment  firms' owners know that they can expect the following profit streams from the two alternative investments Clearly, investment in the firm is preferred to any alternative investment if  > m; that is 𝝆 > 𝟎 𝒓𝒎 Note: the cost of capital of internal funds is an "opportunity cost", i.e., the rate of return to an alternative investment at the market rate. Debt We do not distinguish here between market debt (e.g., bonds) and non-market debt (e.g., bank loans), and assume that the interest rate on debt is rd. Therefore, debt is chosen only if debt service does not exceed profit streams, that is Equity The cost of capital of a new investment in terms of new equities, re, is the ratio of the year profit to the equity value of the investment 𝒓𝒆 = 𝝅 𝑽 The equity (or market) value of the investment is the amount of funds that the firm can collect from the stock market by selling new shares, that is, the price p of a single share times the number A of shares 𝑉 = 𝐴𝑝 Hence the cost of equity capital depends on the market price of new shares p. For the investment to be financed in this way, it must be that 𝑉 ≥ 𝐼. Since 𝑉 = and 𝐼 = 𝜋/𝜌, equity finance is feasible if 𝜌 ≥ 𝑟 . Composite cost of capital If a firm pools different financial instruments, the cost of capital is the weighted average of the costs of the different instruments. Define with qf, qd, qe the proportions of investment I financed by internal funds, debt and equity (qf + qd + qe = 1), then For any financial instrument, or combination of financial instruments, it is confirmed the general principle that the investment is profitable only if the cost of capital does not exceed the IRR of the investment. The irrelevance of investment finance – Modigliani-Miller Theorem Since investment valuation depends on the cost of capital, an investment may or may not be undertaken depending on the financial instrument used and its relative cost. Also, we should expect that firms seek to minimize the cost of capital by seeking the cheapest financial instrument. However, Modigliani and Miller have shown that: if financial markets are efficient, all financial instruments have the same cost for all firms, and investments do not depend on the choice of financial instruments. The efficient market hypothesis at work Consider many firms k, each with an infinitely-lived investment project of amount Ik, with constant year profit 𝜋k. For each firm, the formula of the composite cost of capital yields Now let us see how financial market efficiency operates on the cost of capital. Recall the two fundamental mechanisms of efficiency: perfect information and arbitrage. Perfect information implies that − everybody knows the future profit streams of all investments in the market; given the amount of each investment Ik, the market also knows each IRR, − everybody also knows the market rate rm Equity market We have seen that the equity cost capital depends on the market value of the investment Equity holders are interested in dividends. All know the year profit 𝜋k and translate it into the year dividends, so that dividends per share are Arbitrage will set the equity price equal to the present value of year dividends discounted with the market rate. For perpetual constant dividends, Therefore Debt market The same reasoning applies to debt. As long as rm > rd, firms will choose debt and vice versa. Consequently, the debt market will have incentive to raise rd when it is lower than the equity market return rate and vice versa. Hence, in the end, Composite cost of capital The conclusion is that for any financial instruments, or composition of different financial instruments, all firms face the same cost of capital equal to the market rate Corollary. The valuation of each single investment in the market, and the amount of investments undertaken in the economy, are only determined by their IRR with respect to the market rate, and not by choosing different combinations of financial instruments. Aggregate investment We consider aggregate investment in the economy at time t as the sum of single investments of single firms k, Ikt, each of which has its own IRR, 𝜋kt. In a Cartesian plane, investment projects can be ordered along the horizontal axis from the highest IRR to the lowest IRR, so that IRR is measured on the vertical axis along a decreasing line (investment function). Two key determinants of investment: market interest rate and internal rate of return (expected future profits) Investing and saving Now we can examine aggregate investment vis-à-vis saving and how they interact in the financial system. Financial hierarchy and constraints Firms, in general, pursue active diversification of their investment finance instruments (financial hierarchy or "pecking order"; violation of Modigliani-Miller theorem); the stock market is less used than expected; relatively few firms become stock companies. Some classes of firms (notably small ones) are financially constrained, i.e., they are unable to access all financial sources, and typically they resort to internal funds and bank loans. Great variety, but 2/3 of countries use more internal than external resources. More advanced countries tend to use roughly half and half Equity finance, also in advanced countries, is a residual source of investment finance. Investments and macroeconomic stability Inelasticity. Investments seem poorly related to interest rates, and too strongly dependent on internal funds (cash flow, retained dividends, etc.) "A large body of empirical research offer mixed evidence, at best, for a substantial interstate effect on investment. Among the more than 500 responses to the special questions, we find that most firms claim to be quite insensitive to decreases in interest rates, and only mildly more responsive to interest rate increases" Procyclicality. In an efficient capital market, investment and consumption should move in opposite directions while a strong positive correlation is generally observed. This indicates that the market tends to amplify shocks instead of the damping them. Security markets and informational problems The "no trade paradox" At equilibrium arbitrage prices, no trade takes place, hence if prices are continuously at (instantly adjusted to) equilibrium, how can we explain large daily and intra-day exchange volumes? Are security prices driven by fundamentals? Remember the arbitrage price of a security k, for a given future market value Vkt+1 , such that k and all other securities yield the same market rate of return r and the so-called "fundamental valuation", based on the principles that 1) Vkt+1 is the sum of the future earnings of the security ykt+1 (dividends, interests, etc.) and its sale price pkt+1, 2) future prices are unpredictable, so that, in a long-term view, the only rational valuation of a security is the present value of its future of earnings What is the evidence? Do observed security prices closely track anticipated future earnings? Three types of empirical notions and tests of efficiency - Good evidence of weak efficiency: prices adjust quickly to new information, and are in fact unpredictable, e.g., they follow a random walk. It is not possible to gain systematically higher returns than the market rate r by simply extrapolating trends from past prices (past prices give no information on future prices). But what kind of information does the market react to? - Some evidence of semi-strong efficiency: prices adjust quickly to the arrival of new publicly available information that the market believes relevant for the future value. By means of public information (e.g. publication of balance sheets, announcements of profits and dividends, press releases, etc.) it is not possible to gain systematically higher returns than the market rate r. Is this sufficient for efficiency? - Poor evidence of strong efficiency: prices poorly satisfy fundamental valuation in a strict sense, that is only anticipation of future earnings ykt+1, ….). This is a critical finding because we do not want the market to be just a fast processor of whatever information is publicly available (fads, fashions, sunspots, bubbles …). For the market to channel financial resources to best profitable uses, it should be able to extract and transmit only information about each user's capacity to generate future earnings. Three puzzles Wrong fundamental valuation Stock prices present prolonged periods of over/under-valuation w.r.t. fundamental valuation (R. J. Shiller) Excess volatility Stock prices are more volatile (large variance) than the underlying fundamental variable (ykt+1) (R. J. Shiller). Bubbles "Bubbles" are self-sustained, persistent, but temporary unidirectional movements of the price of a security or of an index of securities. Not only financial bubbles The housing market bubble at the origin of the 2008 crisis Financial hierarchy Information costs Information costs are a critical kind of TC that deserve a special treatment and have become crucial in modern finance. First of all, remember that "all relevant information" (the information necessary to carry on an optimal transaction) is the most critical input. For one aspect, information costs may take the form of operation costs: e.g., the cost of buying a newspaper or of a PC session to know the price of your securities or the opinion of experts; the cost for a bank to learn the merit of credit of an applicant for a loan. But there is much more than that. Let us recall what "all relevant information" means: it is a wide collection of different inputs. The information paradox (or "the impossibility of informationally efficient markets"). Costly information has a major logical implication for efficiency (Arrow, Grossman, Stiglitz). We know that in efficient markets, equilibrium prices should reveal "all the relevant information" and no further profitable trade can be done. Hence information is a public good. Once "informed people" use their information in the market, everybody knows it just looking at prices, so anyone can make as good deals as the "informed people", and in force of arbitrage these cannot make any extra profit above the market return rate. But the "informed people" (experts, gurus, etc. …) have paid to be informed. So: who is going to invest in information? "Informed people" are important in order to have a well-functioning market, but information costs are borne only if one may earn an extra-profit above the market return rate. Hence the market cannot be informationally efficient. Major examples in the industrial sector: investments in research & development, inventions, innovations, etc. are protected by patents. Solving the “no trade” paradox Different information about the "fundamentals" of a financial transactions (the future profitability of stock, its riskiness, etc.) offer a key explanation to large volumes of exchanges that are observed in financial markets. Of course, not all traders may turn to be right at the same time. Hence, when information differs, there is always an "inefficient" (zero-sum) redistribution of wealth between winners (better informed) and losers (badly informed). This is the way in which better information is rewarded, though at the cost of some inefficiency. Types of imperfect information We have seen that imperfect information is characterized by heterogeneity, i.e., individuals having different information inputs for their decisions. Different setups can be considered according to Noisy information in the stock market. "Noise traders" vs. "smart money" Consider the market for a stock k. Recall that in force of the basic mechanism of arbitrage, an efficient market would set the price according to the fundamental valuation principle, where Vkt+1 is the future value of the stock determined uniquely by its generation of dividends ("strong efficiency"). Traders have different information about this future value fundamental info. V1 = 100, available to fraction (1 – n) of "smart traders" noisy information V2 = 150, available to fraction n of "noise traders" The mkt. return rate is r = 10% Therefore, smart traders and noise traders expect two different stock prices p1 = V1/(1+r) = 90.9 p2 = V2/(1+r) = 136.4 During the trading session the stock price changes in response to demand and supply. Trades are driven by different information − smart traders buy when p < 90.9 and sell when p > 90.9 − noise traders sell when p > 136.4 and buy when p < 136.4  the price is a weighted average of fundamental and non-fundamental valuation (wrong valuation)  in response to valuation mistakes, prices fluctuate more widely (excess volatility)  if the proportion of noise traders is small, smart traders make extra-profits at the expense of noise traders (but there may always be a flow a new noise traders) (private information is rewarded)  if the proportion of noise traders is large, fundamental information becomes worthless. Asymmetric information Most financial relationships (contracts) involve a so-called "principal-agent" relationship, where the outcome for the principal depends, in part or entirely, on the behavior of agent. In finance, the principal is typically an investor and the agent is a borrower or administrator of the principal's funds. Hence, we focus on internal information. The extent of information on both factors determines the extent and nature of uncertainty over the contract performance. • uncertainty on external factors  exogenous risks • uncertainty on internal factors  endogenous risks In finance most typically agents are fund users and principals are fund suppliers AI generates endogenous risks because the extent to which the user is exposed to adverse selection or opportunism also depends on his/her own behavior Adverse selection at Wall Street Adverse pooling Owing to the loss risk 𝛼ε, the market undervalues (lemon premium) all firms (notice the similarity with the previous example) Would you therefore think that stock options are a good incentive for honest behavior for managers? Some implications for corporate governance • Large public companies with small shareholders may not exert efficiency control on managers. • The market under A.I. does not incentivize good managers with high equity prices (low cost of capital). How can good managers signal their quality? • Collective action problem. Even if one or more shareholders have the incentive to control, why should they bear the cost of control to the advantage of everybody? If they do control, they have incentive to compensate the private cost of control with some private benefit from information (e.g. coalitions with managers) • Ownership structure: Managers should be controlled by concentrated ownership, or large (external) stakeholders (large creditors, others?). Do they share the benefits with small shareholders? Does concentrated (non-contendible) ownership grant the efficiency of the firm? • Who protects the interest of small shareholders? − Legal instruments (protection of minority shareholders, access to collective actions) − Ethical codes and corporate social responsibility Considerations on the origin and nature of public debt Barry Eichengreen  financial historian, book in defense of public debt (Regan – Thatcher) From fiery rhetoric, the [republican] senator [Rand Paul] pivoted to economic analysis. “Today’s money is gone,” he explained, “so Congress is spending tomorrow’s money… When we talk about spending tomorrow’s money, this is not just money we will need next month; this is money we will need in a decade— money we will need in one, two, and three generations from now. For national defense. For infrastructure. This is money that your children and grandchildren will pay back with interest[…] Instead of enjoying the same wealth and opportunity that we have enjoyed in this country; our children will be stuck paying our bills— with interest.” Senator Paul’s appeal built on an important insight, namely that government is the steward of the nation’s finances. If it mismanages them by borrowing excessively, worrisome economic and financial consequences will follow. But the implication he drew— that the government should balance its budget, just as a household should balance its budget in order to avoid mortgaging the future— was fundamentally flawed. Indeed, a government that did not borrow in order to provide essential services during a deadly pandemic— or to ensure the national defense during a security emergency, or to invest adequately in the productive infrastructure of which Senator Paul spoke— would be accused of dereliction, and rightly so. Methodological premise. Is public debt different (and safer) than private debt? The time horizon of a State as both political and economic actor Since the Renaissance, the West knows that "Dignitas non moritur". The dignity of a sovereign body goes beyond the lifetime of those who exert the power. The state is a ‘body publick’ (a legal person, persona juridica), not subject to "death".  in this sense can be considered safer Stock-Flow nature of public debt Public debt: "debt which the community owes to itself, [...] debt of the right hand to the left hand, and therefore [...] radically different from private debts" When you have a public debtor, you symmetrically have private creditors (and bank reserves generated by the private purchase of public debt) Here lies the historical advantage of public debt: since "dignitas non moritur" modern public debt, from its very inception in 16th century England, has been made not to be repaid but to be rolled-over and serviced Public debt implies a relationship with time that is different from private debt. But it is precisely this different relationship that makes it a debt and hence an asset which is structurally safer than private debt. Definition of safe asset: "a safe asset is a simple debt instrument that is expected to preserve its value during adverse systemic events"  The "extreme systemic events " (2007 crisis, Covid crisis, War crises) are those in which the solvency of most private debtors is threatened. Add to this longer term, infrastructural investments, which fall well beyond the “patience” of private investors  private won’t wait such a long time in order to reach the break-even point Debt and perpetuality However, if the expenditure is to be incurred with present efforts and means, it does not necessarily follow that the payment thereof must be made with the money of taxpayers now living. Everyone who has to meet an extraordinary expense in a given year and cannot do so with ordinary income, will resort to debt which he will later repay in instalments. This is how the state can operate. In order not to overburden the taxpayers during the year of war it enters into a debt with those of the taxpayers who are endowed with capital and who are able to divert it in part from old uses, and who have it still in part available. Instead of distributing among the taxpayers for one year a total extraordinary tax of 12,000 lire per year, it will suffice to distribute annually in perpetuity, if the debt was contracted at 5%, an ordinary tax surcharge of 600 lire. It is evident that the State can, through debt, more easily obtain the sum it needs for the conduct of the war than through extraordinary taxation. The latter would reduce the taxpayers to despair and leave them a sum insufficient to live on. The treasury is, it is true, charged with a perpetual burden, at 5%, of annual interest; but it easily obtains it, distributing it every year over the taxpayers, by increasing the normal rate of taxation. What is more, the sacrifice is voluntarily distributed according to the possibilities of each citizen. [...] Debt is thus a useful method of maximizing the contributory capacity of citizens, easily obtaining what it would be impossible to obtain by means of extraordinary taxation. [...] The good household narrative pushes an analogy between the State and private borrower and is the main justification for fiscal consolidation in good and in bad times. Nevertheless, once sustainability replaces solvency as the guiding principle, the narrative simply collapses: ‘not all debt has been created equal’. Solvency is not an issue simply because, whereas every private actor has a finite horizon for its income capacity and therefore must eventually repay its debts, states generally do not. This specificity, which marked the history of public debt financing since its inception in late 17th century England, is finally resurfacing in the public debate. What is crucial about public debt are the effective conditions for its refinancing. For whatever debtor, debt sustainability depends on the capacity to service it, i.e., on the future stream of income. In the case of the state, its income (fiscal revenues) is certainly finite in each period but indefinite in its duration. The intrinsic non-payability as a positive virtue of public debt was already very clear to classical liberal economists and was forgotten with Barro’s ‘Ricardian equivalence’, i.e., with the idea that any increase of public deficit will have to be sooner or later repaid by an equivalent tax increase. Even if we model the equivalence within an infinite time horizon, there will always exist a ‘last period’ (a transversality condition) which will put the public debtor on the same foot as private debtors. But, as Sardoni notes, precisely in that case the state would cease to be a state. The states’ operational horizon is indefinite, certainly not because they cannot end, but because they do not end for ‘natural’ and therefore somehow predictable causes (it is not possible to calculate their life expectancy). At any time of the ‘life’ of a state, an additional period can be introduced, postponing payment. This does not mean that states are “eternal”, but that they enjoy an essentially perpetual nature, i.e., they are intrinsically capable of continuing. This also means that as long as the debt is sustainable (i.e., it can be serviced), it will always be priced as if its maturity structure was irrelevant. From a mathematical point of view – Hilbert paradox If the end of the world is shifted to infinity, this does not change the picture. Once 𝛀 = ∞ is conceptual impossible to know the date of payment  that can be indefinitely postponed Example Hotel Financial intermediaries and the bank Financial intermediaries (FI) are the key actors in modern financial systems. But a number of questions arise. • Why do we need FI in the first place? • Is it not the case that they create costly transactions? • Why two types of FI have developed over time: market intermediaries and banks? • Is this distinction still important? Why do financial intermediaries exist? Again, on transaction costs Intermediation is a costly activity, and (private) FI seek to obtain profits from it. For instance, it is well-know that banks pay depositors a lower rate than they charge onto borrowers. We have seen that differences between borrowing and lending rates are a symptom of market inefficiency. Hence, are FI a cause of inefficiency or a remedy? (*) Search and matching: time and risk − short-term lenders vs. long-term borrowers (liquidity transformation) − risk-averse lenders vs. risk-seeking borrowers (risk transformation) The bank as a specialized FI in A.I. The standard debt contracts • No ownership and control • Fixed interest • Fixed duration • Default clauses − upon receiving I, the borrower is committed to paying back capital and interest within the fixed time − if the borrower declares solvency is not audited and pays the amount due − if the borrower declares insolvency is audited and the bank appropriates the residual resources Some implications • The bank minimizes auditing to the sole cases of (true) insolvency. The insolvency risk is only due to the exogenous random factor (pure credit risk) • The bank centralizes auditing (one auditor for many different borrowers  economies of scale, no collective action problem). The bank's depositors obtain a safe return with no auditing costs (no endogenous risk, pure credit risk transferred to the bank  risk transformation). Efficient allocation of credit through screening Let us now consider a bank facing a large population of potential applicants (firms) for a loan to finance an investment of cost I (for simplicity I is the same for all firms). The investment of each firm k has the following probabilistic outcome: Firms' risk-return distribution follows the fundamental Law of Finance: high-profit investments Expected rate of profit, and interest rate policy of the bank The bank can know the characteristics of each firm k ( ) bearing the cost of screening S = sI, (i.e., proportional to the scale of investment). The bank raises deposits at the market rate i. It has a loan portfolio with as many loans of equal value I as many firms k. Hence, the expected rate of return to the portfolio is just the sum of the ERR to each loan The efficient, competitive (break-even) interest rate on each type of loan is Low risk (high 𝛼) firms are charged a lower interest rate (e.g. prime rate) Note. Given this interest rate, only the firms with (in case of success) 𝘱k > r k will apply for a loan. Some implications Perfect discrimination of borrowers: in the presence of firm-specific risk, each firm pays a specific interest rate (perfect competition in the credit market does not imply a unique interest rate) The specific interest rate on loans exceeds the interest rate on deposits: − in order to cover A.I. (screening) costs − to reflect firm-specific quality (rk decreases as 𝛼k increases) The ability of the bank to charge firm-specific interest rates is the means to transfer risk away from depositors. Mutual information interest between bank and borrower. Information disclosed to the bank is not disclosed to the market; high quality firms have an incentive to choose bank debt instead of equity; bank debt can also be a signal of quality. Information disclosure may be a lung-run process (e.g., large technical projects, reputation building problems, etc.); mutual interest arises also for long-run relationships (relationship banking). Also banks may fail on A.I. Information activities are costly. Also banks can try to save on information costs, and much evidence they do: • data show that use of discriminating interest rates is not as developed (personalized) as it should be. • banks (especially large banks) operate on a standardized basis. Borrowers are pooled in risk classes on the basis of (low-cost) "observable" characteristics. This minimizes information costs, but then the bank faces an adverse selection risk Two main questions: • how do banks deal with A.I. risks? • is the result efficient for the credit market? Two main cases: • credit rationing • collateral Credit rationing Technically, CR means that a borrower is denied a loan (totally or partially) at the current interest rate (and related conditions). In principle, CR violates one of the market efficiency properties: anyone is free to borrow (lend) any amount at the market conditions. CR is a typical symptom of banks that face adverse selection risk. Recall that the bank faces a pool of potential borrowers such that high-profit investments (high IRR 𝘱k) are more risky (low 𝛼k). High grow of total assets Less credit more marketable financial assets Less secured funds, more marketable financial liabilities More leverage More leverage, more ROE Financial development: bank or market? Monetary creation, Safe assets, and Cryptocurrencies Monetary creation How the majority of money in the modern economy is created by commercial banks making loans. Money creation in practice differs from some popular misconceptions: banks do not act simply as intermediaries and nor do they ‘multiply up’ central bank money to create new loans and deposits. The amount of money created in the economy ultimately depends on the monetary policy of the central bank.  In normal times, this is carried out by setting interest rates  affecting the inflation rate, employing rate  The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’. In reality  Lending creates deposits and not vice versa  broad money determination at the aggregate level.  Broad Money is a measure of the total amount of money held by households and companies in the economy.  Broad Money is made up of bank deposits and currency  Of the two types of broad money, bank deposits make up the vast majority  97% of the amount currently in circulation  And in the modern economy, those bank deposits are mostly created by commercial banks themselves. Balance Sheet before and after money creation + Commodity money system (i.e., gold standard) vs system fiat money system Cryptocurrencies as a challenge to the traditional financial system and to central banks IMF has categorized cryptocurrencies as a subset of virtual currencies, which it defines as digital representations of value, issued by private developers and denominated in their own unit of account. According to the IMF, the concept of virtual currencies covers a wider array of ‘currencies’, virtual currencies backed by assets such as gold, and cryptocurrencies such as Bitcoin. Bitcoin Distributed Ledger Bitcoin Fixed Supply Mining and Electricity Consumption A currency or a speculative asset?…..the rationale for stablecoins….and for CBDC Blockchain: distributed ledger technology Bitcoin supply Fixed number Specultative asset Too high volatility This gives the floor to stablecoins, connected to another currency (usually dollar) CBDC – Central Bank Digital Currencies In order to compete with these new emerging currencies, the CBDC has been working in implementing a digital currency too.  Digital Euro (not launched yet) What’s a CBDC? - a digital currency - issued by a central bank - not as an instrument of reserve and settlement between banks - but as a means of retail payment for households and businesses Why issue a CBDC? counter the rise of virtual private currencies, particularly global stablecoins - offer a cheap and clean alternative to physical cash - continue to provide money as a common good in a cashless society - gain and maintain more direct control over the money supply - enable targeted and effective liquidity injections - break the zero lower bound on interest rates - promote the use abroad of a domestic currency - counter the spread within the country of a foreign CBDC. a. Credit view: with imperfect capital markets the effects of monetary policy depend on access to finance. b. Money view: interest rates affect consumption and investment  institution do not matter Money view and credit view Monetary policy transitions channel: channel that allows monetary aggregates to influence product and prices Monetary policy can influence oriducy and process through 2 classical channels (2 views): - Interest rate  money view: when monetary aggregates increase this means it’s easier to do investments  positive effect on the economy - Internal credit  credit view: focalize on the banks, if the monetary aggregates increase then bank’s reserve increase and bank has too much liquidity, we have an increase in loans (it’s silly to keep too much reserve for banks) These two views focalize on different aspects, so the effectiveness of the channels depends on the type of financial system structure. Bank based financial system  credit view Market based financial system  money view Bank-based financial systems Countries: Italy, France, Germany and Japan Banks play the central role, the main driver of economic growth as they finance long-term projects  control the decisions of enterprises Advantages Risks • Protection of savings • Information processing protection • Quality investment selection  prudence • Business monitoring and control  in order to receive money they have to have guarantees • Long-term relationships between enterprises and banks  cooperation important for prosperity of economy • Collusion risk  pursue different goals that can be harmful to the economic system • Few innovation  banks typically, if they are too prudent, finance just projects that guarantee certain stability and innovation instead is kind of risky • Too risk-averse (related to few innovations) Market-based financial system Countries: USA, UK The main actor is the market: financial intermediaries different in respect from the bank  trust in the market: “the market is the best in resource allocation” – free market Advantages Risks • Competition  free competition ensures efficiency • Efficiency • No collusion bank managers  as bank is not the main actor, enterprise can collect resources also from the market • More innovation  markets are not as risk-averse as the banks • Information diffusion • Instability • Dispersion of information • Few controls and less monitoring of enterprise  collusion among other actors present in the market) Bank-based Market-based Bank-based view according to which we have a philosophy that focalize on the capability of banks to protect/mange information in an efficient way and control enterprises Focalize on the protentional of the free market to promote efficiency, competition and innovation. Which one is better? Long debate, but it seems that this type of classification is not sufficient in order to understand the structure of the financial system. Different financial structures – classification in the empirical analysis Despite globalization, different financial structures exist The authors compare the financial systems of: • Euro area • UK • USA • Japan  sort of special case in respect to the others • Non-Japan Asia (Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand). Categorizing financial structure: long-term financing structure Figure a - 1995 Figure b - 2003  It can be seen from figure a that in 1995 the euro-area had small stock markets but large bank loans, and in that sense, could be considered bank-based. However, it also had a significant bond market.  The UK was different, with a large stock market and bank loans but small bond market, particularly in terms of private-sector debt  seems to be both market and bank-based.  The main features of the US are small amount of bank loans, a significant stock market and a much larger bond market.  Japan has significant amount of finance in all categories  seems to be both systems  Non-Japan Asia is more similar to the UK The structure is basically the same. The main difference is that Japanese government debt has increased significantly. The financial structure in non-Japan Asia has not changed significantly, despite the Asian crises. Households and Non-financial corporations - Another way of looking at bank-based or market-based financial systems - EU: households have few financial assets; most assets are held in banks. - UK: similar to EU but investment in insurance and pension funds is higher (lower state pension). - USA: outlier in direct holding of shares (little assets bank)  bank present but not so important, households less risk adverse, no freedom to go to market (vs. Europe) - Japan outlier in assets held in banks (also insurance)  households prefer to go “talk” with banks Large differences also across non-financial corporations (b) - EU and UK: similar except for the number of shares and other equity held. - USA: much less investments than the others except for the “other” category. - Japan: the most different, it has significantly more assets in banks and more trade credit. Contribution of the paper What can we say about differences in the financial structure? Different financial structures imply different impacts on the efficiency, stability and transmission channels of the system. Large literature on the role of financial structure in different countries Two aspects have received little attention in the literature: 1. role of financial institutions 2. role of real-estate and mortgage markets 1. Role of financial institutional investors Majority of assets are held by financial intermediaries (exception for USA), which are also important financial- market participants. This implies they are important for the efficiency and stability of financial systems. 3 categories of financial investors: 1) Monetary financial institutions (MFIs) 2) Insurance corporations and pension funds (ICPFs) 3) Other Financial Intermediaries (OFIs): securities, derivatives dealers, mutual funds government intermediaries (Japan). Korea: government policy directed the housing market  different situation Focus on the mortgage market Most transactions in the housing market involve a corresponding transaction in the mortgage market. Mortgage market reflect several deregulation measures (from 1980s). Main fact observed  differences between countries in EU (type of mortgage contracts, regulatory differences...) • Denmark, Netherlands, UK have the most complete mortgage markets (range of products and alternative interest rates). • Share of Ownership housing high in southern European countries: reflect tax incentives and different access to mortgage financing. • Spain and Italy: countries with the highest number of owner-occupied houses and least developed mortgage markets...why? Intergenerational transfers and bequests. Mortgage equity withdrawal Another reason why it is important to consider also the housing and mortgage markets is the mortgage equity withdrawal phenomenon: the consumers’ decision to borrow money against the real value of their houses. A rise in housing prices is going to affect household consumption if households can effectively spend the extra liquidity on consumption goods or invest in financial assets. How? 1) Households can refinance an existing mortgage loan and take out more debt. 2) Households can borrow more from the overall credit system when they transact with each other in the housing market, because the collateral value of their assets has risen. Housing prices have risen in most countries but at widely different rates. But possible falls in house prices imply a systemic risk. Discussion and conclusions Traditional measures of financial structure: are they consistent with traditional classification? In addition:2. 1) Majority of assets are held by financial intermediaries. Institutional investors are important in order to understand the role of the structure of the financial system for the efficiency-stability of the economy. 2) It is crucial to consider housing and mortgage markets as part of the financial structure: a. Importance of housing for household’s wealth b. Effects of boom-bust cycles on financial stability c. Mortgage features and transmission of monetary policy Which financial structure is the best? Need more research on this topic in order to answer. But sure bank-based and market-based classification is not enough, we need more research in order to answer.  Situation really heterogeneous (i.e., Asia) On the efficiency of the financial system – J.Tobin (1984) Introduction to the topic In 1984: • Finance: growing sector (USA, UK despite the declining position) • Even more human and monetary resources are devoted to the financial sector... • All this, in the hope that financial systems are efficient and can improve economic growth...is it true? Paper topic I decided to use the rostrum which you have given me [...] to voice some skeptical views of the efficiency of our vast system of financial markets and institutions. These views run against current tides – not only the general enthusiasm for deregulation and unfettered competition but my profession’s intellectual admiration for the efficiency of financial markets. Efficiency 1. Information-arbitrage efficiency - yes A market is efficient if it is on average impossible to gain from trading on the basis of generally available public information. In efficient markets only insiders can make money. “Professor, there are $20 on the side walk, should I pick them up?” “No, if they were really there, it would already been picked up” In this sense markets are efficient according to the paper  first study to indicate this result was by Alfred Cowles An investment advisor, annoyed by the stock market's variations from 1928 to 1933, showed statistically that an investor would have done at least as well choosing stocks at random as following professional advices.  Prices are a random walk (respond promptly and fully to new information): their correlations with past histories are too weak to be exploited profitably. o Random walk theory: this theory states that stocks take a random and unpredictable path. Both technical analysis and fundamental analysis are useless o Fundamental analysis: method of evaluating, a security through the study of micro and macro factors. This allows to understand if the security is undervalued or overvalued and to invest in the companies that result stronger. o Technical analysis: the past price changes of a security are better indicators of its future movements than its intrinsic value. Market price movements are not purely random but moves in identifiable patterns and trends that repeat over time. Efficiency in information-based arbitrage does not come free. It requires resource inputs from arbitrageurs, specialists, market-makers. Random walking does not, of course, mean that prices are unresponsive to new information. To the contrary, it means that they respond promptly and fully- with little or no trading. 2. Fundamental-valuation efficiency A market in a financial asset is efficient if its valuations reflect accurately the future payments to which the asset gives title (fundamental value).  if the price of assets is based on rational expectations of those payments and reflect the fundamental value. The author is skeptical in defining markets efficient in the fundamental-valuation efficiency sense: markets are too volatile to be justified by fundamental value movements (an empirical investigation is presented by Shiller, 1979, 1981). This is true for equity prices, bond prices and exchange rates Other inexplicable phenomena Irrational downward bias: chronic undervaluation of equity prices with respect to their present value. Household saving rate in the EU: Why do they differ so much? - S. Rocher, M.H. Stierle (2015) Abstract This paper investigates factors which may help explain the persistent differences in household saving rate across the EU, which in 2013 ranged from –10% of household income in Romania to +16% in Germany. 1) caution is needed when comparing household saving rates across countries  institutional differences and data reliability are likely to hinder the international comparability of saving rates. 2) various determinants of household saving behavior, traditional explanatory variables like income levels, age dependency and uncertainty can explain more than half of the cross-section variance in saving rates. However, large unobserved country fixed effects (e.g., because of institutional differences and measurement error) appear to be present. Theoretical framework Why do households save? • Life cycle hypothesis: households tend to smooth their consumption expenditures over the life cycle. Young workers save during their working life and consume their savings during retirement (Modigliani, 1957). • Precautionary reasons: covering unexpected future income losses. • Big tickets: purchase of expensive consumer goods (e.g., durables) often preceded by the accumulation of household savings. Why is household saving important? • Availability of credit to finance investments by enterprises and the government (economic growth) • A country with low household savings must necessarily finance its investments by using foreign savings • Potential lack of finance • Vulnerability to external shocks How is the situation in Europe? Saving levels are very different between European countries • Do they really reflect the economic situation of European countries? • Do negative savings rates imply high levels of debt? Insufficient household saving may therefore hinder investment and dampen economic growth. The disparity in household saving rates may suggest that some countries rely more on foreign savings to finance domestic investments making these countries more vulnerable to external shocks. Investment in these countries may even be depressed due to the lack of finance. In countries as Germany, France and Belgium, households save a relatively large share of their disposable income. On the other hand, households in Romania and Bulgaria seem to spend often more than they earn, resulting in negative saving rates. Household saving rates need to be read with care due to data reliability and limited international comparability - Bulgaria vs Romania Saving rates have been negative over the last 15 years in Bulgaria (-11%) and Romania (-6%) as shown in Figure 2 (panel A). This would imply that households in these countries spend significantly and persistently more than they earn. However, it might not be fully reflecting economic reality as households ́ debt-to-income ratios remain rather low in these countries as depicted in Figure 2 (panel B) and even have been decreasing since 2009. Paper goals Research question: Why households saving rates in the EU differ so much? ( = Which factors drive the differences in saving rates?) Paper goals • Explain why savings rates are so different within the EU through an empirical study (analysis of the saving rate determinants). • Investigate the factors that may affect a correct computation of the saving rates and a correct international comparison. Literature review: expected effects Based on economic theory, we can formulate expectations on the effects of some potential determinants: 1. Income the marginal propensity to save increases as the available income increases. • level of real GDP per capita (positive) • Per capita GDP growth rate (ambiguous effect) • Terms of trade (positive) • Income inequality (positive): due to the income effect at the aggregate level (richer people save more). 1. Wealth (negative): as wealth increases, savings decrease (buffer). 2. Demographic factors (negative): according to the life cycle hypothesis, an "old" society will have low savings rates (but beware of the "life expectancy" factor). 3. Rates of rates (ambiguous): remuneration of savings, but pay attention to the income effect. 4. Uncertainty (positive): negative outlooks can lead households to save more • Inflation rate (positive) • Unemployment rate (positive) 5. Fiscal policy (positive): Ricardian equivalence hypothesis  anticipation of future tax increases (expected future income ↓  saving rate ↑) • Government surplus, government saving, government expenditure/consumption, direct taxation (negative) 6. Pension system (negative) 7. Financial market sophistication - money stock and private sector credit (ambiguous): more opportunities for households saving allocation but also greater access to credit, and hence potentially higher debt 8. International financial integration – current account deficit (ambiguous): as the previous point. Household saving in national accounts Geographical focus: the paper considers EU countries  Empirical results are largely dependent on the country sample  Only a very limited number analyses household saving behavior in the EU Statistical definitions Different statistical definitions can affect international comparisons Household sector: includes the non-profit organization serving households (charities and trade unions). Gross saving = gross disposable income – final consumption expenditure + Δ net equity in pension fund reserves. Saving rate = Gross saving/ (gross disposable income + Δ net equity in pension fund reserves). Saving rates comparability Institutional differences between European countries can lead to different saving rates also with similar levels of consumption and savings: • Each country considers institutional factors differently within their national accounts (calculation problem) • In addition, errors and omissions in consumption estimates, available income and the actual size of the shadow economy led to errors in calculating saving rates. Comparability issues: a) institutional differences 1. Pension system a. Most EU countries have developed a 3-pillar pension system: mandatory pension schemes, collective occupational pension plans, individual pension products. b. Towards funded pension schemes (first pillar bis schemes): pensions within the first pillar are often based on the pay-as-you-go principle where contributions of current employees are used to finance the pension benefits of current retirees. However, funded pension schemes (or capitalization plans) became more important across the EU as countries prepare for increasing pension expenditures as a result of demographic changes (each employee contributes to a fund from which his/her future pension will be paid).  In countries where the first pillar is still predominant savings rate is apparently lower (changes in pension fund reserves are not considered as saving). The role of the change in pension fund equity is particularly important in countries with large pension funds. This difference is particularly large in countries with large pension fund assets like Sweden (-6.2 pp.), the Netherlands (-5.4 pp.) and Denmark (-5.4 pp.). 2. Degree of social services provided by the government (education and health) The savings rate is higher in countries with greater state social services: disposable income will be lower as these households have to pay taxes. In return, they benefit from social services and have lower consumption expenditures.  only household consumption expenditure (and not disposable income) is affected in the absence of government provision of social services in kind, since households then pay a higher amount for the same level of social services. Since disposable income is the denominator, the household saving ratio is likely to be higher in countries with a generous public provision of social services in kind. Financing patterns around the world: Are small firms different? - T. Beck, A.D. Kunt, V. Maksimovic (2008) Firms’ investments and investment financing When do firms decide to invest? A potential investment is profitable only if its cost does not exceed its profitability.  A potential investment is profitable if the cost of capital does not exceed the IRR (internal rate of return – rate for which NPV=0) of the investment.  The NPV (net present value) is the difference between the present value of future profits (discounted using the cost of capital) and its initial value. How can firms finance themselves? Different ways in which firms can finance themselves (different financial instruments): • Debt in the form of bonds • Debt in the form of loans • Shares issued on the equity market • Internal funds (non-distributed profits) If a firm pools different financing sources, the cost of capital is the weighted average of the costs of different financial instruments. Cost of capital and Modigliani-Miller Theorem • Each composition of financial instruments is associated to a particular cost of capital. • If cost of capital is low, it is more likely that the investment is profitable (cost of capital < IRR). • We would expect that firms try to minimize the cost of capital by seeking the cheapest financial instrument. BUT investment financing structure is irrelevant: 1. If financial markets are efficient, all financing sources have the same cost for all firms, and investments do not depend on the choice of financial instruments. 2. The value (NPV) of the investment does not depend on the particular financial structure adopted. Empirical evidence - Is the Modigliani-Miller theorem verified in real markets? In real markets firms diversify their capital structure and use mostly internal funds • Financial hierarchy (“pecking order theory”): claims that the cost of financing increases with asymmetric information, so the order is: (1) internal funds (cheapest) (2) debt (3) equity. • Financing constraints: not all firms have access to all financial instruments. Financing structure is important for investment  What factors influence financing structure? Early literature on the determinants of financing patterns Focus: • Role of financial development on access to external finance • Influence of legal systems (investors’ rights enforcement) on external financing Limitations: • Data on listed firms (mostly large firms): what about small firms? • Narrow definition of external financing (equity and debt): are there any potential substitute financing sources? Topic of the paper «Using a firm-level survey database covering 48 countries, we investigate how financial and institutional development affects financing of large and small firms.» In particular, the paper investigates: • Whether the financing patterns of small firms differ from those of large firms in terms of: o Internal/external financing o Traditional/alternative sources • Relationship between firms’ external financing and a country’s financial and legal institutions. • Whether the relationship between firms’ financing patterns and firm size varies across different levels of financial and institutional development. Data and methodology Database Firm level data (WBES - World Business Environment Survey) - World Bank (Year: 1999) 3000 firms (80% small and medium size) for developed and developing countries (48 countries). Advantages: • Indicators of financial constraints. • Different sources of financing (leasing, trade credit, finance from government and informal sources). Disadvantages: Limited financial information: 2. Financing patterns are expressed as proportions on investment (not D/A). 3. No complete set of firm-level variables (e.g., profitability of firms). Methodology • Descriptive (firms' financing patterns and relations with other firms and country characteristics) • Regression analysis: (1) country fixed effects, (2) financial and institutional development, (3) the role of size. External financing Different sources of external financing, classified into 6 groups: 1. Bank finance (financing from local and foreign banks) 2. Equity finance (financing through issue of stock or ownership stakes in general - no retained earnings) 3. Leasing finance 4. Trade finance (supplier credit) 5. Development finance (funding from special development institutions or other state services) 6. Informal finance (moneylenders and other traditional sources). Some descriptive evidence from the data 1. In most countries (also developed ones such as US, UK, GER) firms use internal resources to finance a significant portion of their investments. 2. Countries with similar overall external financing proportion can have very different financing patterns.  Nicaragua and Chile have a very similar financing proportion (external finance 57% but different financing patterns (Chilean firms use more bank finance, in Nicaragua more funds from development banks and supplier credit).  Italy: external finance 77%, bank finance 50% Table 1: firm-level financing patterns averaged over all firms in each country.