Financial markets and institutions, Sbobinature di Economia E Tecnica Dei Mercati Finanziari

Scarica Financial markets and institutions e più Sbobinature in PDF di Economia E Tecnica Dei Mercati Finanziari solo su Docsity! FINANCIAL MARKETS AND INSTITUTIONS CHAPTER 1 Activities in financial markets have direct effects on individuals’ wealth, the behavior of businesses, and the efficiency of our economy. Three financial markets deserve particular attention: the bond market (where interest rates (*) are determines), the stock market (which has a major effect on people’s wealth and on firms’ investment decisions; in which claims on the earnings of corporations (shares of stock) are traded), and the foreign exchange market (because fluctuations in the foreign exchange rate have major consequences for the U.S. economy). (*) An interest rate is the cost of borrowing or the price paid for the rental of funds (usually expressed as a percentage of the rental of $100 per year). On a personal level, high interest rates could deter you from buying a house or a car because the cost of financing it would be high. Conversely, high interest rates could encourage you to save because you can earn more interest income by putting aside some of your earnings as savings. On a more general level, interest rates have an impact on the overall health of the economy because they affect not only consumers’ willingness to spend or save but also businesses’ investment decisions. Debt markets and interest rates (*) A security (also called a financial instrument) is a claim on the issuer’s future income or assets (any financial claim or piece of propriety that is subject to ownership). A bond is a debt security that promises to make payments periodically for a specified period of time. Debt markets (also referred to generically as the bond market) are important to economic activity because they enable corporations and governments to borrow in order to finance their activities. The stock market A common stock (or stock) represents a share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corporation. Issuing stock and selling it to the public is a way for corporations to raise funds to finance their activities. The stock market is also an important factor in business investment decisions because the price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. A higher price for a firm’s shares means that is can raise a larger amount of funds, which can be used to buy production facilities and equipment. The foreign exchange market (secondary market) For funds to be transferred from one country to another, they have to be converted from the currency in the country of origin (say, dollars) into the currency of the country they are going to (say, euros). The foreign exchange market is where this conversion takes place, so it is instrumental in moving funds between countries. It is also important because it is where the foreign exchange rate, the price of one country’s currency in terms of another’s is determined. Financial institutions Financial institutions are what make financial markets work. Without them, financial markets would not be able to move funds from people who save to people who have productive investment opportunities. Structure of the financial system The financial system is complex, comprising many types of private-sector financial institutions, including banks, insurance companies, mutual funds, financial companies, and investment banks – all of which are heavily regulated by the government. If you wanted to make a loan you would lend indirectly through financial intermediaries, institutions such as commercial banks, savings and loan associations, mutual savings banks, credit unions, insurance companies, mutual funds, pension funds, and finance companies that borrow funds from people who have saved and in turn make loans to others. Financial crises At times, the financial system seizes up and produces financial crises, major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms. Defaults in subprime residential mortgages led to major losses in financial institutions, not only producing numerous bank failures but also leading to the demise of Bear Stearns and Lekman Brothers, two of the largest investment banks in the United States. Central banks and the conduct of monetary policy The most important financial institution in the financial system is the central bank, the government agency responsible for the conduct of monetary policy, which in the United States is the Federal Reserve System (or “The Fed”). Monetary policy involves the management of interest rates and the quantity of money, also referred to as the money supply (defined as anything that is generally accepted in payment for goods and services or in the repayment of debt. Banks Banks are financial institutions that accept deposits and make loans. Included under the term banks are firms such as commercial banks, savings and loan associations, mutual savings banks, and credit unions. Banks are the financial intermediaries that the average person interacts with most frequently. A person who needs a loan to buy a house or a car usually obtains it from a local bank. Financial innovation Financial innovation, the development of new financial products and services, can be an important force for good by making the financial system more efficient. But financial innovation can have a dark side: it can lead to devasting financial crises. e-finance → improvements in information technology have led to new financial products and the ability to deliver financial services electronically. Applied managerial perspective Understanding how financial institutions are managed is important because there will be many times in your life, as an individual, an employee, or the owner of a business, when you will interact with them. “The Practicing Manager” cases not only provide analytic tools that are useful if you choose a career with a financial institution but also give you a feel for what a job as the manager of a financial institution is all about. and higher risk) is thee market in which longer-term debt (maturity ≥ 1 year) and equity instruments are traded. Internationalization of financial markets An important trend in recent years is the growing internationalization of financial markets. The traditional instruments in the international bond market are known as foreign bonds. Foreign bonds are sold in a foreign country and are denominated in that country’s currency. A more recent innovation in the international bond market is the Eurobond, a bond denominated in a currency other than that of the country in which it is sold. A variant of the Eurobond is Eurocurrencies, which are foreign currencies deposited in banks outside the home country. The most important of the Eurocurrencies are Eurodollars, which are U.S dollars deposited in foreign banks outside the United States of in foreign branches of U.S. banks. A bond denominated in euros is called a Eurobond only if it is sold outside the countries that have adopted the euro. In fact, most Eurobonds are not denominated in euros but are instead denominated in U.S. dollars. Similarly, Eurodollars have nothing to do with euros, but are instead U.S. dollars deposited in banks outside the United States. Function of financial intermediaries: indirect finance Funds can also move from lenders to borrowers by a second route called indirect-finance because it involves a financial intermediary that stands between the lender-savers and the borrower-spender and helps transfer funds from one to the other. The process of indirect finance using financial intermediaries, called financial intermediation, is the primary route for moving funds from lenders to borrowers. Financial intermediaries are financial institutions that acquire funds by issuing liabilities and, in turn, use those funds to acquire assets by purchasing securities or making loans. Financial intermediaries play an important role in the financial system because they reduce transaction costs, allow risk sharing, and solve problems created by adverse selection and moral hazard. TRANSACTION COSTS: Transaction costs, the time and money spent in carrying out financial transactions, are a major problem for people who have excess funds to lend. Financial intermediaries can substantially reduce transaction costs because they have developed expertise in lowering them and because their large size allows them to take advantage of economies of scale, the reduction in transaction costs per dollar of transactions as the size (scale) of transactions increases. Because financial intermediaries are able to reduce transaction costs substantially, they make it possible for you to provide funds indirectly to people with productive investment opportunities. In addition, a financial intermediary’s low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions. RISK SHARING: Another benefit made possible by the low transaction costs of financial institutions is that they can help reduce the exposure of investors to risk – that is, uncertainty about the returns investors will earn on assets. Financial intermediaries do this through the process known as risk sharing: they create and sell assets with risk characteristics that people are comfortable with, and the intermediaries then use the funds they acquire by selling these assets to purchase other assets that may have far more risk. Low transaction costs allow financial intermediaries to share risk at low cost, enabling them to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold. This process of risk sharing is also referred to as asset transformation (because risky assets are turned into safer assets for investors). Financial intermediaries also promote risk sharing by helping individuals to diversify and thereby lower the amount of risk to which they are exposed. Diversification entails investing in a collection (portfolio) of assets whose returns do not always move together, with the result that overall risk is lower than for individual assets. Low transaction costs allow financial intermediaries to do this by pooling a collection of assets into a new asset and then selling it to individuals. ASYMMETRIC INFORMATION: ADVERSE SELECTION AND MORAL HAZARD: The presence of transaction costs in financial markets explains, in part, why financial intermediaries and indirect finance play such an important role in financial markets. An additional reason is that in financial markets, one party often does not know enough about the other party to make accurate decisions. This inequality is called asymmetric information (a borrower who takes out a loan usually has better information than the lenders does (potential returns, risks)). Lack of information creates problems in the financial system both before and after the transaction is entered into. Adverse selection is the problem created by asymmetric information before the transaction occurs. Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome – the bad credit risk – are the ones who most actively seek out a loan and are thus most likely to be selected. So lenders may decide not to make any loans even though good credit risks exist in the marketplace. Moral hazard is the problem created by asymmetric information after the transaction occurs. Moral hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender’s point of view because they make it less likely that the loan will be paid back. Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan. The problems created by adverse selection and moral hazard are significant impediments to well- functioning financial markets. Again, financial intermediaries can alleviate these problems. With financial intermediaries in the economy, small savers can provide their funds to the financial markets by lending these funds to a trustworthy intermediary which in turn lends the funds out either by making loans or by buying securities (stock or bonds). Successful financial intermediaries have higher earnings on their investments than do small savers because they are better equipped than individuals to screen out bad credit risks from good ones, thereby reducing losses due to adverse selection. In addition, financial intermediaries have high earnings because they develop expertise in monitoring the parties they lend to, thus reducing losses due to moral hazard. The result is that financial intermediaries can afford to pay lender-savers interest or provide substantial services and still earn profit. Financial intermediaries play a key role in improving economic efficiency because they help financial markets channel funds from lender-savers to people with productive investment opportunities. ECONOMIES OF SCOPE AND CONFLICTS OF INTEREST: Another reason why financial intermediaries play such an important role in the economy is that by providing multiple financial services to their customers, such as offering them bank loans or selling their bonds for them, they can also achieve economies of scope; that is, they can lower the cost of information production for each service by applying one information resource to many different services. Although the presence of economies of scope may benefit financial institutions, it also creates potential costs in terms of conflicts of interest. Conflicts of interest are a type of moral hazard problem that arise when a person or institution has multiple objectives (interests) and, as a result, has conflicts between those objectives. Types of financial intermediaries The principal financial intermediaries fall into three categories: depository institutions (banks), contractual savings institutions, and investment intermediaries. DEPOSITORY INSTITUTIONS Depository institutions (banks) are financial intermediaries that accept deposits from individuals and institutions and make loans. These institutions include commercial banks and the so-called thrift institutions (thrifts): savings and loan associations, mutual savings banks, and credit unions. Commercial banks: these financial intermediaries raise funds primarily by issuing checkable deposits (deposits on which checks can be written), savings deposits (deposits that are payable on demand but do not allow their owner to write checks), and time deposits (deposits with fixed terms to maturity). They then use these funds to make commercial, consumer, and mortgage loans and to buy U.S. government securities and municipal bonds. They are the largest financial intermediary and have the most diversified portfolios (collections) of assets. Savings and loan associations (S&Ls) and mutual savings banks: these depository institutions obtain funds primarily through savings deposits (often called shares) and time and checkable deposits. Credit unions: these financial institutions are typically very small cooperative lending institutions organized around a particular group: union members, employees of a particular firm, and so forth. They acquire funds from deposits called shares and primarily make consumer loans. CONTRACTUAL SAVINGS INSTITUTIONS Contractual savings institutions, such as insurance companies and pension funds, are financial intermediaries that acquire funds at periodic intervals on a contractual basis. They can predict with reasonable accuracy how much they will have to pay out in benefits in the coming years. As a result, the liquidity of assets is not as important a consideration for them as it is for depository institutions, and they tend to invest their funds primarily in long-term securities such as corporate bonds, stocks, and mortgages. Life insurance companies: they insure people against financial hazards following a death and sell annuities (annual income payments upon retirement). They acquire funds from the premiums that people pay to keep their policies in force and use them mainly to buy corporate bonds and mortgages. They also purchase stocks but are restricted in the amount that they can hold. Fire and casualty insurance companies: these companies insure their policyholders against loss from theft, fire, and accidents. They are very much like life insurance companies, receiving funds through premiums for their policies, but they have a greater possibility of loss of funds if major disasters occur. For this reason, they use their funds to buy more liquid assets than life insurance companies do. Their largest holding of assets consists of municipal bonds; they also hold corporate bonds and stocks and U.S. government securities. Pension funds and government retirement funds: private pension funds and state and local retirement funds provide retirement income in the form of annuities to employees who are covered by a pension plan. Funds are acquired by contributions from employers and from employees, who either have a contribution automatically deducted from their paychecks or contribute voluntarily. The largest asset holdings of pension funds are corporate bonds and stocks. The establishment of pension funds has been actively In the case of a simple loan like this one, the interest payment divided by the amount of the loan is a natural way to measure the interest rate. This measure of the so-called simple interest rate, i, is i = $10 $100 = 0.10 = 10% We can see that at the end of n years, your $100 would turn into: $100 × (1 + i)n The process of calculating today’s value of dollars received in the future is called discounting the future. PV = CF (1 + i)n → future cash flow The concept of present value is extremely useful because it enables us to figure out today’s value of a credit market instrument at a given simple interest rate i by just adding up the present value of all the future cash flows received. The present value concept allows us to compare the value of two instruments with very different timing of their cash flows. FOUR TYPES OF CREDIT MARKET INSTRUMENTS In terms of the timing of their cash flows, there are four basic types of credit market instruments. 1. A simple loan (already discussed). Many money market instruments are of this type, for example commercial loans to businesses. 2. A fixed-payment loan (also called a fully amortized loan) in which the lender provides the borrower with an amount of funds, which must be repaid by making the same payment every period (such as a month). Installment loans (such as auto loans) and mortgages are frequently of the fixed- payment type. 3. A coupon bond pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when a specified final amount (face value or par value) is repaid. A coupon bond is identified by three pieces of information. First is the corporation or government agency that issues the bond. Second is the maturity date of the bond. Third is the bond’s coupon rate, the dollar amount of the yearly coupon payment expresses as a percentage of the face value of the bond ( coupon payment face value ). Capital market instruments such as U.S. Treasury bonds and notes and corporate bonds are examples of coupon bonds. 4. A discount bond (also called a zero-coupon bond) is bought at a price below its face value (at a discount), and the face value is repaid at the maturity date. A discount bond does not make any interest payments; it just pays off the face value. Treasury bills, U.S. savings bonds, and long-term zero-coupon bonds are examples of discount bonds. Simple loans and discount bonds make payment only at their maturity dates, whereas fixed-payment loans and coupon bonds have payments periodically until maturity. How would you decide which of these instruments would provide you with more income? We use the concept of present value to provide us with a procedure for measuring interest rates on these types of instruments. YIELD TO MATURITY Of the several common ways of calculating interest rates, the most important is the yield to maturity, the interest rate that equates the present value of cash flows received from a debt instrument with its value today. It is the most accurate measure of interest rates. We now look at how it is calculated for the four types of credit market instruments. The key to understanding the calculation of the yield to maturity is equating today’s value of the debt instrument with the present value of all of its future cash flow payments. Simple loan: for the one-year loan we discussed, today’s value is $100, and the cash flow in one year’s time would be $110 (the repayment of $100 + the interest payment of $10). We can use this information to solve for the yield to maturity i by recognizing that the present value of the future payments must equal today’s value of a loan. Solution: the yield to maturity on the loan is 10% PV = CF (1 + i)n → $100 = $110 (1 + i) i = 1.10 − 1 = 0.10 = 10% The calculation of the yield to maturity equals the simple interest rate on the loan. An important point to recognize is that for simple loans, the simple interest rate equals the yield to maturity. Fixed-payment loan: this type of loan has the same cash flow payment every year throughout the life of the loan. To calculate the yield to maturity for a fixed-payment loan, we follow the same strategy we used for the simple loan – we equate today’s value of the loan with its present value. Because the fixed-payment loan involves more than one cash flow payment, the present value of the fixed-payment loan is calculated as the sum of the present values of all cash flows. Generally, for any fixed-payment loan, LV = FP 1 + i + FP (1 + i)2 + FP (1 + 3)3 + ⋯ + FP (1 + i)n LV = loan value FP = fixed yearly cash flow payment n = number of years until maturity For a fixed-payment loan amount, the fixed yearly payment and the number of years until maturity are known quantities, and only the yield to maturity is not. So we can solve this equation for the yield to maturity i. Because this calculation is not easy, many pocket calculators have programs that allow you to find i given the loan’s numbers for LV, FP, and n. Coupon bond: to calculate the yield to maturity for a coupon bond, follow the same strategy used for the fixed-payment loan: equate today’s value of the bond with its present value. Because coupon bonds also have more than one cash flow payment, the present value of the bond is calculated as the sum of the present values of payment of the face value of the bond. Generally, for any coupon bond, P = C (1 + i) + C (1 + i)2 + C (1 + i)3 + ⋯ + C (1 + i)n + F (1 + i)n P = price of coupon bond C = yearly coupon payment n = years to maturity date F = face value of the bond The coupon payment, the face value, the years to maturity, and the price of the bond are known quantities, and only the yield to maturity is not. Hence we can solve this equation for the yield to maturity i2. As in the case of the fixed-payment loan, this calculation is not easy, so there are programs that solve this equation for you. Three interesting facts: 1. When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate. 2. The price of a coupon bond and the yield to maturity are negatively related: as the yield to maturity rises, the price of the bond falls. If the yield to maturity falls, the price of the bond rises. 3. The yield to maturity is greater than the coupon rate when the bond price is below its face value. One special case of a coupon bond that is worth discussing because its yield to maturity is particularly easy to calculate is called a perpetuity, or a consol; it is a perpetual bond with no maturity date and no repayment of principal that makes fixed coupon payments of $C forever. PC = C iC PC = price of the perpetuity (consol) C = yearly payment IC = yield to maturity of the perpetuity (consol) One nice feature of perpetuities is that you can immediately see that as iC goes up, the price of the bond falls. We can also rewrite this formula as iC = C PC This formula, which describes the calculation of the yield to maturity for a perpetuity, also provides a useful approximation for the yield to maturity on coupon bonds. When a coupon bond has a long term to maturity (say, 20 years or more), it is very much like a perpetuity, which pays coupon payments forever. This is because the cash flows more than 20 years in the future have such small present discounted values that the value of a long-term coupon bond is very close to the value of a perpetuity with the same coupon rate. Thus, iC will be very close to the yield to maturity for any long-term bond. For this reason, iC, the yearly coupon payment divided by the price of the security, has been given the name current yield and is frequently used as an approximation to describe interest rates on long-term bonds. Discount bond: the yield-to-maturity calculation for a discount bond is similar to that for the simple loan. Generally, for any one-year discount bond, the yield to maturity can be written as i = F − P P F = face value of the discount bond P = current price of the discount bond In normal circumstances, investors earn positive returns from holding these securities and so they sell at a discount, meaning that the current price of the bond is below the face value. Therefore, F – P should be positive, and the yield to maturity should be positive as well. However, this is not always the case. An important feature of this equation is that it indicates that for a discount bond, the yield to maturity is negatively related to the current bond price (this is the same for a coupon bond). A rise in the bond price (from 900 to 950) means that the bond will have a smaller increase in its price over its lifetime, and the yield to maturity falls. Similarly, a fall in the yield to maturity means that the price of the discount bond has risen. Our calculations of the yield to maturity for a variety of bonds reveal the important fact that current bond prices and interest rates are negatively related: when the interest rate rises, the price of the bond falls, and vice versa. Calculating duration To calculate the duration or effective maturity on any debt security, it was invented the concept of duration. Because a zero-coupon bond makes no cash payments before the bond matures, it makes sense to define its effective maturity as equal to its actual term to maturity. We could measure the effective maturity of a coupon bond by recognizing that a coupon bond is equivalent to a set of zero-coupon discount bonds. To get the effective maturity of this set of zero-coupon bonds, we would want to sum up the effective maturity of each zero-coupon bond, weighting it by the percentage of the total value of all the bonds that it represents. So the duration of this set of zero-coupon bonds is the weighted average of the effective maturities of the individual zero-coupon bonds, with the weights equaling the proportion of the total value represented by each zero-coupon bond. So duration is a weighted average of the maturities of the cash payments DUR = ∑ t n t=1 CPt (1 + i)t ∑ CPt (1 + i)t n t=1 ⁄ DUR = duration n = years to maturity of the security CPt = cash payment (interest plus principal) at time t i = interest rate t = years until cash payment is made To summarize, the calculations of duration for coupon bonds have revealed four facts: 1. The longer the term to maturity of a bond, everything else being equal, the greater its duration. 2. When interest rate rise, everything else being equal, the duration of a coupon bond falls. 3. The higher the coupon rate on the bond, everything else being equal, the shorter the bond’s duration. 4. Duration is additive (additive property of duration): the duration of a portfolio of securities is the weighted average of the durations of the individual securities, with the weights reflecting the proportion of the portfolio invested in each (the duration of a portfolio of securities is easy to calculate from the durations of the individual securities). DURATION AND INTEREST-RATE RISK Duration is a particularly useful concept because it provides a good approximation, particularly when interest-rate changes are small, for how much the security price changes for a given change in interest rates, as the following formula indicates: %ΔP ≈ −DUR × Δi 1 + i %ΔP = (Pt+1−Pt) Pt = percentage change in the price of the security from t to t+1 = rate of capital gain DUR = duration i = interest rate The greater the duration of a security, the greater the percentage change in the market value of the security for a given change in interest rates. Therefore, the greater the duration of a security, the greater its interest-rate risk. This reasoning applies equally to a portfolio of securities. CHAPTER 4 – WHY DO INTEREST RATES CHANGE Determinants of asset demand An asset is a piece of property that is a store of value. Items such as money, bonds, stocks, art, land, houses, farm equipment, and manufacturing machinery are all assets. Facing the question of whether to buy and hold an asset or whether to buy an asset rather than another, an individual must consider the following factors: 1. Wealth, the total resources owned by the individual, including all assets. 2. Expected return (the return expected over the next period) on one asset relative to alternative assets. 3. Risk (the degree of uncertainty associated with the return) on one asset relative to alternative assets. 4. Liquidity (the ease and speed with which an asset can be turned into cash) relative to alternative assets. WEALTH When we find that out wealth has increased, we have more resources available with which to purchase assets and so the quantity of assets we demand increases. EXPECTED RETURNS (the return on an asset (such as a bond) measures how much we gain from holding that asset) The expected return on an asset is the weighted average of all possible returns, where the weights are the probabilities of occurrence of that return: Re = p1R1 + p2R2 + ⋯ + pnRn Re = expected return n = number of possible outcomes (state of nature) Ri = return in the ith state of nature pi = probability of occurrence of the return Ri An increase in an asset’s expected return relative to that of an alternative asset, holding everything else unchanged, raises the quantity demanded of the asset. RISK The degree of risk or uncertainty of an asset’s returns also affects demand for the asset. We can use a measure of risk called the standard deviation. The formula for the standard deviation, σ, is thus: σ = √p1(R1 − Re)2 + p2(R2 − Re)2 + ⋯ + pn(Rn − Re)2 The higher the standard deviation, σ, the greater the risk of an asset. A risk-averse person prefers stock in the sure thing to stock of the riskier asset, even though the stocks have the same expected return. By contrast, a person who prefers risk is a risk preferer or risk lover. Most people are risk-averse, especially in their financial decisions: everything else being equal, they prefer to hold the less risky asset. Hence, holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall. LIQUIDITY Another factor that affects the demand for an asset is how quickly it can be converted into cash at low cost – its liquidity. An asset is liquid if the market in which it is traded has many buyers and sellers. The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is, and the greater will be the quantity demanded. THEORY OF PORTFOLIO CHOICE All the determining factors we have just discussed can be assembled into the theory of portfolio choices, which tells us how much of an asset people want to hold in their portfolio. It states that, holding all the other factors constant: 1. The quantity demanded of an asset is usually positively related to wealth, with the response being greater if the asset is a luxury than if it is a necessity. 2. The quantity demanded of an asset is positively related to its expected return relative to alternative assets. 3. The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets. 4. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets. Supply and demand in the bond market We approach the analysis of interest-rate determination by studying the supply of and the demand for bonds. The first step is to use the analysis to obtain a demand curve, which shows the relationship between the quantity demanded and the price when all other economic variables are held constant (that is, values of other variables are taken as given). DEMAND CURVE Let’s consider the demand for one-year discount bonds, which make no coupon payments but pay the owner the $1,000 face value in a year. If the holding period is one year the return on the bonds is known absolutely and is equal to the interest rate as measured by the yield to maturity. This means that the expected return on this bond is equal to the interest rate i, which is i = Re = F − P P i = interest rate = yield to maturity Re = expected return F = face value of the discount bond P = initial purchase price of the discount bond This formula shows that a particular value of the interest rate corresponds to each bond price. If the bond sells for $950, the interest rate and expected return are $1,000 − $950 $950 = 0.053 = 5.3% This result let us assume that the quantity of bonds demanded is $100 billion, which is plotted as point A in the figure. At a price of $900, $1,000 − $900 $900 = 0.111 = 11.1% (relative to the expected return on real assets today) and thus cause the demand for bonds to fall. Alternatively, we can think of the rise in expected inflation as lowering the real interest rate on bonds, and the resulting decline in the relative expected return on bonds will cause the demand for bonds to fall. An increase in the expected rate of inflation lowers the expected return for bonds, causing their demand to decline and the demand curve to shift to the left. Risk: if prices in the bond market become more volatile, the risk associated with bonds increases, and bonds become a less attractive asset. An increase in the riskiness of bonds causes the demand for bonds to fall and the demand curve to shift to the left. Conversely, an increase in the volatility of prices in another asset market, such as the stock market, would make bonds more attractive. An increase in the riskiness of alternative assets causes the demand for bonds to rise and the demand curve to shift to the right (as in the figure). Liquidity: if more people started trading in the bond market, and as a result it became easier to sell bonds quickly, the increase in their liquidity would cause the quantity of bonds demanded at each interest rate to rise. Increased liquidity of bonds results in an increased demand for bonds, and the demand curve shifts to the right (see the figure). Similarly, increased liquidity of alternative assets lowers the demand for bonds and shifts the demand curve to the left. SHIFTS IN THE SUPPLY OF BONDS Certain factors can cause the supply curve for bonds to shift, among them these: 1. Expected profitability of investment opportunities 2. Expected inflation 3. Government budget How does the supply curve shift when each of these factors changes (all other remaining constant)? Expected profitability of investment opportunities: in a business cycle expansion, the supply of bonds increases, and the supply curve shifts to the right. Likewise, in a recession, when far fewer profitable investment opportunities are expected, the supply of bonds falls, and the supply curve shifts to the left (see the figure). Expected inflation: the real cost of borrowing is more accurately measured by the real interest rate, which equals the (nominal) interest rate minus the expected inflation rate. An increase in expected inflation (real cost of borrowing falls) causes the supply of bonds to increase and the supply curve to shift to the right (see the figure). Government budget: the activities of the government can influence the supply of bonds in several ways. Higher government deficits increase the supply of bonds and shift the supply curve to the right (see the figure). On the other hand, government surpluses, as occurred in the late 1990s, decrease the supply of bonds and shift the supply curve to the left. State and local governments and other government agencies also issue bonds to finance their expenditures, and this can affect the supply of bonds as well. CHAPTER 5 – HOW DO RISK AND TERM STRUCTURE AFFECT INTEREST RATE? Risk structure of interest rates Two important features of interest-rate behavior for bonds of the same maturity: interest rates on different categories of bonds differ from one another in any given year, and the spread (or difference) between the interest rates varies over time. This is because of three factors: default risk, liquidity, and tax considerations. DEFAULT RISK The risk of default occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or to pay off the face value when the bond matures. Bonds with no default tisk are called default-free bonds. the spread between the interest rate on bonds with default risk and default-free bonds, both of the same maturity, called the risk premium, indicates how much additional interest people must earn to be willing to hold that risky bond. The supply-and-demand analysis of the bond market can be used to explain why a bond with default risk always has a positive risk premium and why the higher the default risk is, the larger the risk premium will be. To examine the effect of default risk on interest rates, let’s look at the figure. Let’s assume that initially corporate bonds have the same default risk as U.S Treasury bonds. In this case, these two bonds have the same attributes (identical risk and maturity); their equilibrium prices and interest rates will initially be equal (PC 1 = PT 1 and iC1 = iT1), and the risk premium on corporate bonds (iC1 – iT1) will be zero. If the possibility of a default increases because a corporation begins to suffer large losses, the default risk on corporate bonds will increase, and the expected return on these bonds will decrease. In addition, the corporate bond’s return will be more uncertain. The theory of portfolio choice predicts that because the expected return on the corporate bond falls relative to the expected return on the default-free Treasury bond while its relative riskiness rises, the corporate bond is less desirable, and demand for it will fall. Another way of thinking about this is that if you were an investor, you would want to hold (demand) a smaller amount of corporate bonds. The demand curve for corporate bonds then shifts from DC 1 to DC 2. At the same time, the expected return on default-free Treasury bonds increases relative to the expected return on corporate bonds, while their relative riskiness declines. The Treasury bonds thus become more desirable, and demand rises from DT 1 to DT 2. The equilibrium price for corporate bonds falls from PC 1 to PC 2, and since the bond price is negatively related to the interest rate, the equilibrium interest rate on corporate bonds rises to iC 2. At the same time the equilibrium price for the Treasury bonds rises from PT 1 to PT 2, and the equilibrium interest rate falls to iT2. The spread between the interest rates on corporate and default-free bonds – that is, the risk premium on corporate bonds – has risen from zero to iC 2 – iT2. We can now conclude that a bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium. Because default risk is so important to the size of the risk premium, purchasers of bonds need to know whether a corporation is likely to default on its bonds. This information is provided by credit-rating agencies, investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default. Bonds with relatively low risk of default are called investment-grade securities and have a rating of Baa (credit rating) (or BBB) and above. Bonds with ratings below Baa (or BBB) have higher default risk and have been aptly dubbed speculative-grade or junk bonds. Because these bonds always have higher interest rates than investment-grade securities, they are also referred to as high-yield bonds. LIQUIDITY (the greater liquidity of Treasury bonds explains why their interest rates are lower than those on less liquid bonds) Another attribute of a bond that influences its interest rate is its liquidity. A liquid asset is one that can be quickly and cheaply converted into cash if the need arises. The more liquid an asset is, the more desirable it is (holding everything else constant). U.S. Treasury bonds are the most liquid of all long-term bonds; because they are so widely traded, they are the easiest to sell quickly and the cost of selling them is low. Corporate bonds are not as liquid because fewer bonds for any one corporation are traded; thus, it can be costly to sell these bonds in an emergency because it might be hard to find buyers quickly. The differences between interest rates on corporate bonds and Treasury bonds (that is, the risk premiums) reflect not only the corporate bond’s default risk but also its liquidity. This is why a risk premium is more accurately a “risk and liquidity premium”, but convention dictates that it is called a risk premium. INCOME TAX CONSIDERATION If a bond has a favorable tax treatment, as do municipal bonds, whose interest payments are exempt from federal income taxes, its interest rate will be lower. Another way of understanding why municipal bonds have lower interest rates than Treasury bonds is to use the supply- and-demand analysis (see the figure). We assume that municipal and Treasury bonds have identical attributes and so have the same bond prices Pm 1 = PT 1 and the same interest rates. Once the municipal bonds are given a tax advantage that raises their after-tax expected return relative to Treasury bonds and makes them more desirable, demand for them rises, and their demand curve shifts to the right, from Dm 1 to Dm 2. The result is that their equilibrium bond price rises from Pm 1 to Pm 2 and their equilibrium interest rate falls. By contrast, Treasury bonds have now become less desirable relative to municipal bonds; demand for Treasury bonds decreases, and DT 1 shifts to DT 2. The Treasury bond price falls from PT 1 to PT 2. Term structure of interest rates Another factor that influences the interest rate (we have seen how risk, liquidity and tax considerations can inflence interest rates) on a bond is its term to maturity: bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different. A plot of the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations is called a yield curve, and it describes the term structure of interest rates for particular types of bonds, such as government bonds. Yield curves can be classified as upward-sloping, flat, and downward-sloping (the last sort is often referred to as an inverted yield curve). When yield curves slope upward, the long-term interest rates are above the short-term interest rates; when yield curves are flat, short-and long-term interest rates are the same; and when yield curves are inverted, long-term interest rates are below short-term interest rates. Besides explaining why yield curves take on different shapes at different times, a good theory of the term structure of interest rates must explain the following three important facts: 1. Interest rates on bonds of different maturities move together over time. This theory cannot explain facts 1 and 2. Because each of our two theories explains empiritcal facts that the other cannot, a logical step is to combine the theories, which leads us to the liquidity premium theory. LIQUIDITY PREMIUM THEORY The liquidity premium theory of the term structure states that the interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium (or term premium) that responds to supply-and-demand conditions for that bond. The liquidity premium theory’s key assumption is that bonds of different maturities are substitutes (substitutes but not perfect substitutes), which means that the expected return on one bond does influence the expected return on a bond of a different maturity, but it allows invvestors to prefer one bond maturity over another. The liquidity premium theory is written as: int = it + it+1 e + it+2 e + ⋯ + it+(n−1) e n + lnt where lnt is the liquidity (term) premium for the n-period bond at time t, which is always positive and rises with the term to maturity of the bond, n. The relationship between the expectations theory and the liquidity premium theory is shown in the figure. Because the liquidity premium is always positive and typically grows as the term to maturity increases, the yield curve implied by the liquidity premium theory is always above the yield curve implied by the expectations theory and generally has a steeper slope. The liquidity premium theory explains fact 1, which states that interest rates on different maturity bonds move together over time. The theory explains also why yield curves tend to have an especially steep upward slope when short-term interest rates are low and to be inverted when short-term rates are high (fact 2). The theory explains fact 3, which states that yield curves typically slope upward, by recognizing that the liquidity premium rises with a bond’s maturity because of investors’ preferences for short-term bonds. Even if short-term interest rates are expected to stay the same on average in the future, long-term interest rates will be above short-term interest rates, and yield curves will typically slope upward. A particular feature of the liquidity premium theory is that it tells you what the market is predicting about future short-term interest rates just from the slope of the yield curve. A steeply rising yield curve, as in panel (a) of the figure, indicates that short- term interest rates are expected to rise in the future. A moderately steep yield curve, as in panel (b), indicates that short-term interest rates are not expected to rise or fall much in the future. A flat yield curve, as in panel (c), indicates that short-term rates are expected to fall moderately in the future. An inverted yield curve, as in panel (d), indicates that short-term interest rates are expected to fall sharply in the future. EVIDENCE ON THE TERM STRUCTURE The term structure contains quite a bit of information for the very short run (over the next several months) and the long run (over several years) but it unreliable at predicting movements in interest rates over the intermediate term (the time in between). The yield curve helps forecast future inflation and business cycles. CHAPTER 6 – ARE FINANCIAL MARKETS EFFICIENT? The efficient market hypothesis To understand how expectations affect securities prices, we need to look at how information in the market affects these prices. To do this we examine the efficient market hypothesis, which states that prices of securities in financial markets fully reflect all available information. The rate of return from holding a security equals the sum of the capital gain on the security (the change in the price) plus any cash payments, divided by the initial purchase price of the security: R = Pt+1 − Pt + C Pt R = rate of return on the security held from time t to time t+1 Pt+1 = price of the security at time t+1, the end of the holding period Pt = the price of the security at time t, the beginning of the holding period C = cash payment (coupon or dividend payments) made in the period t to t+1 Let’s look at the expectation of this return at time t, the beginning of the holding period. Because the current price and the cash payment C are known at the beginning, the only variable in the definition of the return that is uncertain is the price next period, Pt+1. Denoting the expectation of the security’s price at the end of the holding period as Pe t+1, the expected return Re is Re = Pt+1 e − Pt + C Pt The efficient market hypothesis views expectations as equal to optimal forecasts using all available information. An optimal forecast is the best guess of the future using all available information. This does not mean that the forecast is perfectly accurate, but only that it is the best possible given the available information. This can be written as Pt+1 e = Pt+1 of which in turn implies that the expected return on the security will equal the optimal forecast of the return: Re = Rof The supply-and-demand analysis of the bond market shows us that the expected return on a security will have a tendency to head toward the equilibrium return that equates the quantity demanded to the quantity supplied. The expected return on a security Re equals the equilibrium return R*, which equates the quantity of the security demanded to the quantity supplied; that is, Re = R∗ We can derive an equation to describe pricing behavior in an efficient market by using the equilibrium condition to replace Re with R* Rof = R∗ which tells us that current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return. More simply: a security’s price fully reflects all available information in an efficient market. RATIONALE BEHIND THE HYPOTHESIS To see why the efficient market hypothesis makes sense, we make use of the concept of arbitrage, in which market participants (arbitrageurs) eliminate unexploited profit opportunities (returns on a security that are larger than what is justified). Arbitrage is of two types: pure arbitrage, in which the elimination of unexploited profit opportunities involves no risk, and the type of arbitrage we discuss here, in which the arbitrageur takes on some risk when eliminating the unexploited profit opportunities. To see how arbitrage leads to the efficient market hypothesis: Rof > R∗ → Pt ↑ → Rof ↓ Rof < R∗ → Pt ↓ → Rof ↑ } until Rof = R∗ Another way to state the efficient market condition is this: in an efficient market, all unexploited profit opportunities will be eliminated. Not everyone in a financial market must be well informed about a security for its price to be driven to the point at which the efficient market condition holds. As long as a few participants (often referred to as “smart money”) keep their eyes open for unexploited profit opportunities, they will eliminate the profit opportunities that appear because in so doing, they make a profit. Evidence on the efficient market hypothesis The hypothesis may not always be entirely correct. Let’s first look at the earlier evidence in favor of the hypothesis and then examine some of the more recent evidence that casts some doubt on it. EVIDENCE IN FAVOR OF MARKET EFFICIENCY Evidence in favor of market efficiency has examined the performance of investment analysts and mutual funds, whether stock prices reflect publicly available information, the random-walk behavior of stock prices, and the success of so-called technical analysis. Performance of investment analysts and mutual funds: one implication of the efficient market hypothesis is that when purchasing a security, you cannot expect to earn an abnormally high return, a return greater than the equilibrium return: it is impossible to beat the market. Many studies shed light on whether investment advisers and mutual funds beat the market. One common test that has been performed is to take buy and sell recommendations from a group of advisers or mutual funds and compare the performance of the resulting selection of stocks with the market as a whole. Did the advisers win? The dartboard beat them as often as they beat the dartboard. Furthermore, even when the comparison included only advisers who had been successful in the past in predicting the stock market, the advisers still didn’t regularly beat the dartboard. So mutual funds are also not found to beat the market. Mutual funds not only do not outperform the market on average, but when they are separated into groups according to whether they had the highest or lowest profits in a chosen period, the mutual funds that did well in the first period did not beat the market in the second period. The conclusion is this: having performed well in the past does not indicate that an investment adviser or a mutual fund will perform well in the future. Some advisers will be lucky and some will be unlucky. CHAPTER 7 – WHY DO FINANCIAL INSTITUTIONS EXIST? Basic facts about financial structure throughout the world The financial system includes many types of institutions: banks, insurance companies, mutual funds, stock and bond markets, and so on – all of which are regulated by government. If we take a close look at financial structure all over the world, we find eight basic facts that we need to explain to understand how the financial system works: 1. Stocks are not the most important source of external financing for businesses: because so much attention in the media is focused on the stock market, many people have the impression that stocks are the most important source of financing for American corporations. However, the stock market accounted for only a small fraction of the external financing of American businesses (11%). 2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations: bonds are a far more important source of financing than stocks in the United States (32% versus 11%). However, stocks and bonds combined (43%), which make up the total share of marketable securities, still supply less than one-half of the external funds corporations need to finance their activities. The fact that issuing marketable securities is not the most important source of financing is true elsewhere in the world as well. 3. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets: direct finance involves the same to households of marketable securities such as stocks and bonds. Since 1970 less than 5% of newly issued corporate bonds and commercial paper and less than one-third of stocks have been sold directly to American households. The rest of these securities have been bought primarily by financial intermediaries. This indicate that direct finance is used in less than 10% of the external funding of American business. Direct finance is also far less important than indirect finance in the rest of the world. 4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses: the primary source of external funds for businesses throughout the world comprises loans made by banks and other nonbank financial intermediaries. In other industrialized countries, bank loans are the largest category of sources of external finance. In developing countries, banks play an even more important role in the financial system than they do in industrialized countries. 5. The financial system is among the most heavily regulated sectors of the economy: governments regulate financial markets primarily to promote the provision of information and to ensure the soundness (stability) of the financial system. 6. Only large, well-established corporations have easy access to securities markets to finance their activities: individuals and smaller businesses that are not well established are less likely to raise funds by issuing marketable securities. Instead, they most often obtain their financing from banks. 7. Collateral is a prevalent feature of debt contracts for both households and businesses: collateral is property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments. Collateralized debt (also known as secured debt) is the predominant form of household debt and is used in business borrowing as well. 8. Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behavior of the borrower: in all countries, bond or loan contracts typically are long legal documents with provisions (called restrictive covenants) that restrict and specify certain activities that the borrower can engage in. An important feature of financial markets is that they have substantial transaction and information costs. An economic analysis of how these costs affect financial markets provides us with explanations of the eight facts, which in turn enable a much deeper understanding of how our financial system works. Transaction costs Transaction costs are a major problem in financial markets. HOW TRANSACTION COSTS INFLUENCE FINANCIAL STRUCTURE Say you have $5,000 and you think about investing in the stock market. Because you have only $5,000, you can buy only a small number of shares. Your purchase is so small that the brokerage commission for buying the stock you picked will be a large percentage of the purchase price of the shares. If instead you decide to buy a bond, the smallest denomination for some bonds you might want to buy is as much as $10,000 and you do not have that much to invest. You will not be able to use financial markets to earn a return on your savings. You can take some consolation: only around one-half of American households own any securities. Another problem related to transaction costs: because you have only a small amount of funds available, you can make only a restricted number of investments because a large number of small transactions would result in very high transaction costs. HOW FINANCIAL INTERMEDIARIES REDUCE TRANSACTION COSTS Fortunately, financial intermediaries, an important part of the financial structure, have evolved to reduce transaction costs and allow small savers and borrowers to benefit from the existence of financial markets. Economies of scale: one solution to the problem of high transaction costs is to bundle the funds of many investors together so that they can take advantage of economies of scale, the reduction in transaction costs per dollar of investment as the size (scale) of transactions increases. Bundling investors’ funds together reduces transaction costs for the individual investors. Economies of scale exist because the total cost of carrying out a transaction in financial markets increases only a little as the size of the transaction grows. The clearest example of a financial intermediary that arose because of economies of scale is a mutual fund. A mutual fund is a financial intermediary that sells shares to individuals and then invests the proceeds in bonds or stocks. A mutual fund can take advantage of lower transaction costs. An additional benefit for individual investors is that a mutual fund is large enough to purchase a widely diversified portfolio of securities. The increased diversification for individual investors reduces their risk. Economies of scale are also important in lowering the costs of things such as computer technology. Expertise: financial intermediaries are also better able to develop expertise to lower transaction costs. An important outcome of a financial intermediary’s low transaction costs is the ability to provide its customers with liquidity services, services that make it easier for customers to conduct transactions. Asymmetric information: adverse selection and moral hazard To understand financial structure more fully we turn to the role of information in financial markets. Asymmetric information is a situation that arises when one party’s insufficient knowledge about the other party involved in a transaction makes it impossible to make accurate decisions when conducting the transaction. The problem of asymmetric information leads to adverse selection and moral hazard problems. Adverse selection is an asymmetric information problem that occurs before the transaction: potential bad credit risks are the ones who most actively seek out loans. Thus, the parties who are the most likely to produce an undesirable outcome are the ones most likely to want to engage in the transaction. Because adverse selection increases the chances that a loan might be made to a bad credit risk, lenders might decide not to make any loans, even though good credit risks can be found in the marketplace. Moral hazard arises after the transaction occurs: the lender runs the risk that the borrower will engage in activities that are undesirable from the lender’s point of view because they make it less likely that the loan will be paid back. Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan. The analysis of how asymmetric information problems affect economic behavior is called agency theory. The lemons problem: how adverse selection influences financial structure A particular aspect of the way the adverse selection problem interferes with the efficient functioning of a market is called the “lemon problem” because it resembles the problem created by lemons in the used-car market. Potential buyers of used cars frequently can’t tell whether a particular used car is one that will run well or a lemon that will continually give them grief. The price that a buyer pays must therefore reflect the average quality of the cars in the market, somewhere between the low value of a lemon and the high value of a good car. The owner of a used car, by contrast, is more likely to know whether the car is a peach or a lemon. If the car is a lemon, the owner is more than happy to sell it at the price the buyer is willing to pay, which is greater than the lemon’s value. However, if the car is a peach, the owner knows that the car is undervalued at the price the buyer is willing to pay, and so the owner may not want to sell it. LEMONS IN THE STOCK AND BOND MARKETS A similar lemons problem arises in the debt (bond) and equity (stock) markets. Suppose that our friend Irving the investor can’t distinguish between good firms with high expected profits and low risk and bad firms with low expected profits and high risk. Irving will be willing to pay only a price that lies between the value of securities from bad firms and the value of those from good firms. If the owners of a good firm have better information than Irving and know that they have a good firm, they know that their securities are undervalued and will not want to sell them to Irving at the price he is willing to pay. The only firms willing to sell Irving securities will be bad firms. Irving does not want to hold securities in bad firms, and hence he will decide not to purchase securities in the market. This securities market will not work very well because few firms will sell securities in it to raise capital. If Irving considers purchasing a corporate debt instrument in the bond market, he will buy a bond only if its interest rate is high enough to compensate him for the average default risk of the good and bad firms trying to sell the debt. The owners of a good firm realize that they will be paying a higher interest rate than they should, so they are unlikely to want to borrow in this market. Only the bad firms will be willing to borrow, and because Irving will not buy bonds issued by bad firms, they will probably not buy any bonds at all. Few bonds are likely to sell in this market. TOOLS TO HELP SOLVE ADVERSE SELECTION PROBLEMS In the absence of asymmetric information, the lemons problem goes away. If buyers know as much about the quality of used cars as sellers, they can now get a fair price and they will be willing to sell them in the market. Similarly, if purchasers of securities can distinguish good firms from bad, they will pay the full value of securities issued by good firms, and good firms will sell their securities in the market. The securities market will then be able to move funds to the good firms. Private production and sale of information: the system of private production and sale of information does not completely solve the adverse selection problem in securities markets because of the free-rider problem. The free-rider problem occurs when people who do not pay for information take advantage of the information that other people have paid for. The free-rider problem suggests that the private sale of information will be only a partial solution to the lemons problem. The weakened ability to private firms to profit from selling information will mean that less information is produced in the marketplace, so adverse selection (the lemon problem) will still interfere with the efficient functioning of securities markets. How moral hazard influences financial structure in debt markets Even with the advantages just described, debt contracts are still subject to moral hazard. Because a debt contract requires the borrowers to pay out a fixed amount and lets them keep any profits above this amount, the borrowers have an incentive to take on investment projects that are riskier than the lenders would like. TOOLS TO HELP SOLVE MORAL HAZARD IN DEBT CONTRACTS Net worth and collateral: when borrowers have more at stake because their net worth (A-L) is high or the collateral they have pledged to the lender is valuable, the risk of moral hazard will be greatly reduced because the borrowers themselves have a lot to lose. Another way to say this is that if borrowers have more “skin in the game” because they have higher net worth or pledge collateral, they are likely to take less risk at the lender’s expense. One way of describing the solution that high net worth and collateral provides to the moral hazard problem is to say that it makes the debt contract incentive compatible; that is, it aligns the incentives of the borrower with those of the lender. The greater the borrower’s net worth and collateral pledged, the greater the borrower’s incentive to behave in the way that the lender expects and desires, the smaller the moral hazard problem in the debt contract, and the easier it is for the firm or household to borrow. Monitoring and enforcement of restrictive covenants: restrictive covenants (provisions into the debt contract that restrict the firm’s activities) are directed at reducing moral hazard either by ruling out undesirable behavior or by encouraging desirable behavior. There are four types of restrictive covenants: 1. Covenants to discourage undesirable behavior: covenants can be designed to lower moral hazard by keeping the borrower from engaging in the undesirable behavior of undertaking risky investment projects. 2. Covenants to encourage desirable behavior: one restrictive covenant of this type requires the breadwinner in a household to carry life insurance that pays off the mortgage upon that person’s death. Restrictive covenants of this type for business focus on encouraging the borrowing firm to keep its net worth high because higher borrower net worth reduces moral hazard and makes it less likely that the lender will suffer losses. These restrictive covenants typically specify that the firm must maintain minimum holdings of certain assets relative to the firm’s size. 3. Covenants to keep collateral valuable: because collateral is an important protection for the lender, restrictive covenants can encourage the borrower to keep the collateral in good condition and make sure that it stays in the possession of the borrower. This is the type of covenant ordinary people encounter most often (automobile loan contracts, for example). 4. Covenants to provide information: restrictive covenants also require a borrowing firm to provide information about its activities periodically in the form of quarterly accounting and income reports, thereby making it easier for the lender to monitor the firm and reduce moral hazard. Financial intermediation: although restrictive covenants help reduce the moral hazard problem, they do not eliminate is. It is almost impossible to write covenants that rule out every risky activity. Another problem with restrictive covenants is that they must be monitored and enforced. Because monitoring and enforcement of restrictive covenants are costly, the free-rider problem arises in the debt securities (bond) market just as it does in the stock market. Moral hazard therefore continues to be a severe problem for marketable debt. As we have seen, financial intermediaries have the ability to avoid the free-rider problem as long as they make primarily private loans. Private loans are not traded, so o one else can free-ride on the intermediary’s monitoring and enforcement of the restrictive covenants. The intermediary making private loans thus receives the benefits of monitoring and enforcement and will work to shrink the moral hazard problem inherent in debt contracts. Conflicts of interest Financial institutions’ expertise in interpreting signals and collecting information from their customers gives them a cost advantage in the production of information. Furthermore, because they are collecting, producing, and distributing this information, financial institutions can use the information over and over again, thereby realizing economies of scale. By providing multiple financial services to their customers, they can also achieve economies of scope; that is, they can lower the cost of information production for each service by applying one information resource to many different services. Additionally, by providing multiple financial services to their customers, financial institutions develop longer-term relationships with firms. There relationships both reduce the cost of producing information and increase economies of scope. WHAT ARE CONFLICTS OF INTEREST AND WHY DO WE CARE? Although the presence of economies of scope may benefit financial institutions, it also creates potential costs in terms of conflicts of interest. Conflicts of interest are a type of moral hazard problem that arise when a person or institution has multiple objectives (interests) and, as a result, has conflicts among those objectives. Conflicts of interest are especially likely to occur when a financial institution provides multiple services. The potentially competing interests of those services may lead an individual or firm to conceal information or disseminate misleading information. We care about conflicts of interest because the financial markets and the economy become less efficient. WHY DO CONFLICTS OF INTEREST ARISE? Three types of financial service activities have led to prominent conflicts-of-interest problems in financial markets in recent years: underwriting and research in investment banks, auditing and consulting in accounting firms, and credit assessment and consulting in credit rating agencies. Underwriting and research in investment banking: investment banks perform two tasks: they research companies issuing securities, and they underwrite these securities by selling them to the public on behalf of the issuing corporations. Investment banks often combine these distinct financial services because information synergies are possible. A conflict of interest arises between the brokerage and underwriting services because the banks are attempting to simultaneously serve two client groups – the security-issuing firms and the security-buying investors. These client groups have different information needs. However, the same information will be produced for both groups to take advantages of economies of scope. When the potential revenues from underwriting greatly exceed the brokerage commissions from selling, the bank will have a strong incentive to alter the information provided to investors to favor the issuing firm’s needs or else risk losing the firm’s business to competing investment banks. Such actions diminish the efficiency of securities markets. Another common practice that exploits conflicts of interest is spinning. Spinning occurs when an investment bank allocates hot, but underpriced, initial public offerings (IPOs) – shares of newly issued stock – to executives of other companies in return for their companies’ future business with the investment banks. Spinning is a form of kickback meant to persuade executives to use that investment bank, which is not necessarily the investment bank that would get the highest price for the company’s securities. This practice may raise the cost of capital for the firm, thereby diminishing the efficiency of the capital market. Auditing and consulting in accounting firms: traditionally, an auditor checks the books of companies and monitors the quality of the information produced by firms to reduce the inevitable information asymmetry. The conflict of interest occurs when an accounting firm provides its client with both auditing services and nonaudit consulting services. Supplying clients with multiple services allows for economies of scale and scope but creates two potential sources of conflicts of interest. First, auditors may be willing to skew their judgments and opinions to win consulting business from these same clients. Seconds, auditors may be auditing information systems or tax and financial plans put in place by their nonaudit counterparts within the firm and therefore may be reluctant to criticize the systems or advice. The result is that less reliable information is available in financial markets and investors find it difficult to allocate capital efficiently. Another conflict of interest arises when an auditor provides an overly favorable audit to solicit or retain audit business. Credit assessment and consulting in credit rating agencies: investors use credit ratings that reflect the probability of default to determine the creditworthiness of particular debt securities. Conflicts of interest can arise when multiple users with divergent interests depend on the credit ratings. In the credit rating industry, the issuers of securities pay a rating firm to have their securities rated. Because the issuers are the parties paying the credit rating agency, investors and regulators worry that the agency may bias its ratings upward to attract more business from the issuer. Another kind of conflict of interest may arise when credit rating agencies also provide ancillary consulting services. Debt issuers often ask rating agencies to advise them on how to structure their debt issues, with the goal of securing a favorable rating. In this situation, the credit rating agencies would be auditing their own work and would experience a conflict of interest that provide both auditing and consulting services. Furthermore, credit rating agencies may deliver favorable ratings to garner new clients for the ancillary consulting business. The possible decline in the quality of credit assessments issued by rating agencies could increase asymmetric information in financial markets, diminishing their ability to allocate credit. WHAT HAS BEEN DONE TO REMEDY CONFLICTS OF INTEREST? Two major policy measures have been implemented to deal with conflicts of interest: the Sarbanes-Oxley Act of 2002 and the Global Legal Settlement of 2002, which arose from a lawsuit by the New York attorney general against the 10 largest investment banks. CHAPTER 8 – WHY DO FINANCIAL CRISES OCCUR AND WHY ARE THEY SO DAMAGING TO THE ECONOMY? What is a financial crisis? A fully functioning financial system is critical to a robust economy. The financial system performs the essential function of channeling funds to individuals or businesses with productive investment opportunities. If capital goes to the wrong uses or does not flow at all, the economy will operate inefficiently or go into an economic downturn. AGENCY THEORY AND THE DEFINITION OF A FINANCIAL CRISIS The analysis of how asymmetric information problems can generate adverse selection and moral hazard problems is called agency theory. Agency theory provides the basis for our definition of a financial crisis. Asymmetric information problems act as a barrier to financial markets channeling funds efficiently from savers to households and firms with productive investment opportunities and are often described as financial frictions. When financial frictions increase, lenders need to charge a higher interest rate to protect themselves against the possibility that the borrower may not pay back the loan, which leads to a higher credit spread. A financial crisis occurs when information flows in financial markets experience a large disruption, with the result that financial frictions and credit spreads increase sharply and financial markets stop functioning. Then economic activity will collapse. a central bank resulted in the demise of the first two experiments in central banking, whose function was to police the banking system: The First Bank of the United States was disbanded in 1811, and the national charter of the Second Bank of the United States expired in 1836. The termination of the Second Bank’s national charter created a problem for American financial markets because there was no lender of last resort that could provide reserves to the banking system to avert a bank panic. The hostility of the American public to banks and centralized authority created great opposition to the establishment of a single central bank like the Bank of England. There was fear that the moneyed interests on Wall Street would be able to manipulate such an institution to gain control over the economy and that federal operation of the central bank might result in too much government intervention in the affairs of private banks. Serious disagreements existed over whether the central bank should be a private bank or a government institution. Congress wrote an elaborate system of checks and balances into the Federal Reserve Act of 1913, which created the Federal Reserve System with its twelve regional Federal Reserve banks. Structure of the Federal Reserve System The writers of the Federal Reserve Act wanted to diffuse power. This initial diffusion of power has resulted in the evolution of the Federal Reserve System to include the following entities: the Federal Reserve banks, the Board of Governors of the Federal Reserve System, the Federal Open Market Committee (FOMC), the Federal Advisory Council, and around 2,000 member commercial banks. The figure outlines the relationships of these entities to one another and to the three policy tools of the Fed (open market operations, the discount rate, and reserve requirements). FEDERAL RESERVE BANKS Each of the 12 Federal Reserve districts has one main Federal Reserve bank, which may have branches in other cities in the district. The locations of these districts, the Federal Reserve banks, and their branches are shown in the figure. The three largest Federal Reserve banks in terms of assets are those of New York, Chicago, and San Francisco. Each of the Federal Reserve banks is a quasi-public (part private, part government) institution owned by the private commercial banks in the district that are members of the Federal Reserve System. These member banks have purchased stock in their district Federal Reserve bank, and the dividends paid by that stock are limited by law to 6% annually. The member banks elect six directors for each district bank; three more are appointed by the Board of Governors. The directors of a district bank are classified into three categories: A, B, and C. The three A directors (elected by the member banks) are professional bankers, and the three B directors (elected by the member banks) are prominent leaders from industry, labor, agriculture, or the consumer sector. The three C directors (appointed by the Board of Governors to represent the public interest) are not allowed to be officers, employees, or stockholders of banks. The most important job of the directors is to appoint the president of the bank. Up until 2010, all nine directors participated in this decision, but the Dodd-Frank legislation in July 2010 excluded the three class A directors from involvement in choosing the president of the bank because Congress viewed it as inappropriate for bankers to be involved in such decision. The twelve Federal Reserve banks are involved in monetary policy in several ways: • Their directors “establish” the discount rate. • They decide which banks, member and nonmember alike, can obtain discount loans from the Federal Reserve bank. • Their directors select one commercial banker from each bank’s district to serve on the Federal Advisory Council, which consults with the Board of Governors and provides information that helps in the conduct of monetary policy. • Five of the 12 bank presidents each have a vote on the Federal Open Market Committee, which directs open market operations (the purchase and sale of government securities that affect both interest rates and the amount of reserves in the banking system). Because the president of the New York Fed is a permanent member of the FOMC, he always has a vote on the FOMC, making it the most important of the banks; the other four votes allocated to the district banks rotate annually among the remaining 11 presidents. The 12 Federal Reserve banks perform the following functions: • Clear checks • Issue new currency and withdraw damaged currency from circulation • Administer and make discount loans to banks in their districts • Evaluate proposed mergers and applications for banks to expand their activities • Act as liaisons between the business community and the Federal Reserve System • Examine bank holding companies and state-chartered member banks • Collect data on local business conditions • Use their staffs of professional economists to research topics related to the conduct of monetary policy MEMBER BANKS All national banks (commercial banks chartered by the Office of the Comptroller of the Currency) are required to be members of the Federal Reserve System. Commercial banks chartered by the states are not required to be members, but they can choose to join. Before 1980, only member banks were required to keep reserves as deposits at the Federal Reserve banks. Nonmember banks were subject to reserve requirements determined by their states, which typically allowed them to hold much of their reserves in interest-bearing securities. Because at the time no interest was paid on reserves deposited at the Federal Reserve banks, it was costly to be a member of the system, and as interest rates rose, the relative cost of membership rose, and more and more banks left the system. This decline in Fed membership was a major concern of the Board of Governors: one reason was that is lessened the Fed’s control over the money supply, making it more difficult for the Fed to conduct monetary policy. The chair of the Board of Governors called for new legislation requiring all commercial banks to be members of the Federal Reserve System. One result of the Fed’s pressure on Congress was a provision in the Depository Institutions Deregulation and Monetary Control Act of 1980: All depository institutions became subject (by 1987) to the same requirements to keep deposits at the Fed. In addition, all depository institutions were given access to the Federal Reserve facilities, such as the discount window and Fed check clearing. BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM At the head of the Federal Reserve System is the seven-member Board of Governors. Each governor is appointed by the president of the United States and confirmed by the Senate. The governors can serve one nonrenewable, 14-year term plus part of another term, with one governor’s term expiring every other January. The governors are required to come from different Federal Reserve districts to prevent the interests of one region of the country from being overrepresented. The chair of the Board of Governors is chosen from among the seven governors and serves a four-year, renewable term. Once a new chair is chosen, the old chair resigns from the Board of Governors, even if there are many years left to his term as a governor. The Board of Governors is actively involved in decisions concerning the conduct of monetary policy in the following ways: • All seven governors are members of the FOMC and vote on the conduct of open market operations. Because only 12 voting members are on this committee, the Board has the majority of the votes. • It sets reserve requirements and effectively controls the discount rate by the “review and determination” process, whereby it approves or disapproves the discount rate “established” by the Federal Reserve banks. • The chair of the Board advises the president of the United States on economic policy, testifies in Congress, and speaks for the Federal Reserve System to the media. Through legislation, the Board of Governors has often been given duties not directly related to the conduct of monetary policy, which are as follows: • Sets margin requirements, the fraction of the purchase price of securities that has to be paid for with cash rather than borrowed funds. • Sets the salary of the president and all officers of each Federal Reserve bank and reviews each bank’s budget. • Approves bank mergers and applications for new activities, specifies the permissible activities of bank holding companies, and supervises the activities of foreign banks in the United States. • Has a staff of professional economists, which provides economic analysis that the Board of Governors uses in making its decisions. FEDERAL OPEN MARKET COMMITTEE (FOMC) The FOMC usually meets eight times a year and makes decisions regarding the conduct of open market operations and the setting of the policy interest rate, the federal funds rate, which is the interest rate on overnight loans from one bank to another. Indeed, the FOMC is often referred to as the “Fed” in the press: when the media say that the Fed is meeting, they actually mean that the FOMC is meeting. The committee consists of the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and the presidents of four other Federal Reserve banks. The chair of the Board of Governors also presides as the chair of the FOMC. Even though only the presidents of five of the Federal Reserve banks are voting members of the FOMC, the other seven presidents of the district banks attend FOMC meetings and participate in discussions. Because open market operations are the most important policy tool the Fed has for controlling interest rates and the money supply and because it is where decisions about tightening of monetary policy (a rise in the federal funds rate) or an easing of monetary policy (a lowering of the federal funds rate) are made, the FOMC is the focal point for policy making in the Federal Reserve System. Although reserve requirements and the discount rate are not actually set by the FOMC, decisions in regard to these policy tools are effectively made there. The FOMC does not actually carry out securities purchases or sales. Instead, it No consensus has yet been reached on whether central bank independence is a good thing, although public support for independence of the central bank seems to have been growing in both the U.S. and abroad. CENTRAL BANK INDEPENDENCE AND MACROECONOMIC PERFORMANCE THROUGHOUT THE WORLD When central banks are ranked from least independent to most independent, inflation performance is found to be the best for countries with the most independent central banks. Although a more independent central bank appears to lead to a lower inflation rate, this is not achieved at the expense of poorer real economic performance. Countries with independent central banks are no more likely to have high unemployment or greater output fluctuations than countries with less independent central banks. EXPLAINING CENTRAL BANK BEHAVIOR Bureaucracies serve the public interest (the public interest view). Yet some economists have developed a theory of bureaucratic behavior that indicates other factors influencing how bureaucracies operate. The theory of bureaucratic behavior suggests that the objective of a bureaucracy is to maximize its own welfare, which is related to its power and prestige. What predictions does this view of a central bank like the Fed indicate? One is that the Federal Reserve will fight to preserve its autonomy, a prediction verified time and time again as the Fed has continually counterattacked congressional attempts to control its budget. Another prediction is that the Federal Reserve will try to avoid conflict with powerful groups that might threaten to curtail its power and reduce its autonomy. The Fed wishes to avoid a conflict with the president and Congress over increases in interest rates. The desire to avoid conflict with Congress and the president may explain why in the past the Fed has not embraced transparency. The desire of the Fed to hold as much power as possible also explains why it pursued a campaign to gain control over more banks. The campaign culminated in legislation that expanded jurisdiction of the Fed’s reserve requirements to all banks by 1987. The Fed conduct monetary policy in the public interest. However, much uncertainty and disagreement exist over what monetary policy should be. When it is unclear what is in the public interest, other motives may influence the Fed’s behavior. In these situations, the theory of bureaucratic behavior may be a useful guide to predicting what motivates the Fed and other central banks. Structure and independence of the European central bank Until recently, the Federal Reserve had no rivals in terms of its importance in the central banking world. However, this situation changed in January 1999 with the start-up of the European Central Bank (ECB) and European System of Central Banks (ESCB), which now conducts monetary policy for countries that are members of the European Monetary Union. These countries, taken together, have a population that exceeds that in the U.S. and a GDP comparable to that of the U.S. The Maastricht Treaty patterned these institutions after the Federal Reserve in that central banks for each country (referred to as National Central Banks, or NCBs) have a similar role to that of the Federal Reserve banks. The ECB (housed in Frankfurt) has an Executive Board that is similar in structure to the Board of Governors of the Federal Reserve; it is made up of the president, the vice president, and four other members, who are appointed to eight-year, nonrenewable terms. The Governing Council, which comprises the Executive Board and the presidents of the NCBs is similar to the FOMC and makes the decisions on monetary policy. While the president of the NCBs are appointed by their countries’ governments, the members of the Executive Board are appointed by a committee consisting of the heads of state of all the countries that are part of the European Monetary Union. DIFFERENCES BETWEEN THE EUROPEAN SYSTEM OF CENTRAL BANKS AND THE FEDERAL RESERVE SYSTEM The ESCB is usually referred to as the European Central Bank (ECB), even though it would be more accurate to refer to it as the Eurosystem. Although the structure of the Eurosystem is similar to that of the Federal Reserve System, some important differences distinguish the two. First, the budgets of the Federal Reserve Banks are controlled by the Board of Governors, whereas the NCBs control their own budgets and the budget of the ECB in Frankfurt. The ECB in the Eurosystem therefore has less power than does the Board of Governors in the Federal Reserve System. Second, the monetary operations of the Eurosystem are conducted by the NCBs in each country, so monetary operations are not centralized. Third, the ECB is not involved in supervision and regulation of financial institutions; these tasks are left to the individual countries in the European Monetary Union. GOVERNING COUNCIL The Governing Council meets monthly at the ECB in Frankfurt to make decisions on monetary policy. Currently, 17 countries are members of the European Monetary Union, and the head of each of the 17 NCBs has one vote in the Governing Council; each of the six Executive Board members also has one vote. In contrast to FOMC meetings, only the 23 members of the Governing Council attend the meetings, with no staff present. The Governing Council operates by consensus because of worries that the casting of individual votes might lead the heads of NCBs to support a monetary policy that would be appropriate for their individual countries but not necessarily for the countries in the European Monetary Union as a whole. The ECB releases the Governing Council’s decision after the meeting concludes (announcing the target for a similar short-term interest rate for interbank loans). Immediately after the decision is announced, the ECB has a press conference in which the president and vice president take questions from the news media. The large number of members in the Governing Council presents a dilemma. To deal with this problem, the Governing Council has decided on a system of rotation, in which NCBs from the larger countries will vote more often than NCBs from the smaller countries. HOW INDEPENDENT IS THE ECB? The members of the Executive Board have long terms (eight years), while heads of NCBs are required to have terms at least five years long. Like the Fed, the Eurosystem determines its own budget, and the governments of the member countries are not allowed to issue instructions to the ECB. These elements make the ECB highly independent. The Maastricht Treaty specifies that long-term goal of the ECB is price stability, which means that the goal for the Eurosystem is more clearly specified than it is for the Federal Reserve System. However, the Maastricht Treaty did not specify exactly what “price stability” means. The Eurosystem has defined the quantitative goal for monetary policy to be an inflation rate less than 2%. In one way, the ECB is substantially more goal-independent than the Federal Reserve System. The Eurosystem’s charter can be changed only by revision of the Maastricht Treaty – a difficult process because all signatories to the treaty must agree to accept any proposed change. Structure and independence of other foreign central banks We examine the structure and degree of independence of three other important foreign central banks: the Bank of Canada, the Bank of England, and the Bank of Japan. BANK OF CANADA The Bank of Canada was founded in 1934. Its directors are appointed by the government to three-years terms, and they appoint the governor, who has a seven-year term. A governing council (four deputy governors and the governor) is the policy-making body that makes decisions about monetary policy. On paper, the Bank of Canada is not as instrument-independent as the Federal Reserve. However, the Bank of Canada does essentially control monetary policy. In the event of a disagreement between the bank and the government, the minister of finance can issue a directive that the bank must follow. The goal for monetary policy, a target for inflation, is set jointly by the Bank of Canada and the government, so the Bank of Canada has less goal independence than the Fed. BANK OF ENGLAND The Bank of England was founded in 1694. The Court of the Bank of England is made up of the governor and two deputy governors, who are appointed for five-year terms, and 16 nonexecutive directors, who are appointed for three-year terms. Until 1997, the Bank of England was the least independent of the central banks examined. All of this changed when the current Labor government came to power in May 1997. At this time, the Chancellor of the Exchequer, Gordon Brown, announced that the Bank of England would have the power to set interest rates. The government can overrule the Bank and set rates “in extreme economic circumstances” and “for a limited period”. Because the UK is not a member of the European Monetary Union, the Bank of England makes its monetary policy decisions independently from the ECB. The decision to set interest rates resides in the Monetary Policy Committee, made up of the governor, two deputy governors, two members appointed by the governor after consultation with the chancellor, plus four outside economic experts appointed by the chancellor. The inflation target for the Bank of England is set by the Chancellor of the Exchequer, so the Bank of England is also less goal-independent than the Fed. BANK OF JAPAN The Bank of Japan was founded in 1882. Monetary policy is determined by the Policy Board, which is composed of the governor, two vice-governors, and six outside members appointed by the cabinet and approved by the parliament, all of whom serve for five-year terms. Until recently, the Bank of Japan was not formally independent of the government, with the ultimate power residing with the Ministry of Finance. However, in 1998 this situation changed. In addition to stipulating that the objective of monetary policy is to attain price stability, the law granted greater instrument and goal independence to the Bank of Japan. The government may send two representatives from these agencies to board meetings, but they no longer have voting rights, although they do have the ability to request delays in monetary policy decisions. However, the Ministry of Finance continues to have control over the part of the Bank’s budget that is unrelated to monetary policy. So the Bank of Japan’s independence is limited. CHAPTER 10 – CONDUCT OF MONETARY POLICY: TOOLS, GOALS, STRATEGY, AND TACTICS The Federal Reserve’s balance sheet The conduct of monetary policy by the Federal Reserve involves actions that affect its balance sheet. Since 2008, the Fed has paid interest on reserves at a level that is set at a fixed amount below the federal funds rate target and therefore changes when the target changes. When the federal funds rate is above the rate paid on excess reserves, ior, the opportunity cost of holding excess reserves falls. Holding everything else constant, the quantity of reserves demanded rises. The demand curve for reserves, Rd, slopes downward (see the figure). If the federal funds rate begins to fall below the interest rate paid on reserves ior, banks would not lend in the overnight market at a lower interest rate. They would just keep on adding to their holdings of excess reserves indefinitely. The demand curve for reserves, Rd, becomes flat at ior. Supply curve: two components: the amount of reserves that are supplied by the Fed’s open market operations, nonborrowed reserves (NBR), and the amount of reserves borrowed from the Fed, called borrowed reserves (BR). The primary cost of borrowing from the Fed is the interest rate the Fed charges on these loans, the discount rate (id). If the federal funds rate iff is below he discount rate id, then banks will not borrow from the Fed and borrowed reserves will be zero because borrowing in the federal funds market is cheaper. The supply of reserves will just equal the amount of nonborrowed reserves supplied by the Fed, NBR, and so the supply curve will be vertical (see the figure above). If the federal funds rate were to rise above the discount rate, banks would want to keep borrowing more and more at id and then lending out the proceeds in the federal funds market at the higher rate, iff. The supply curve become flat at id. Market equilibrium: market equilibrium occurs when the quantity of reserves demanded equals the quantity supplied, Rs=Rd. Equilibrium occurs at the intersection of the demand curve Rd and the supply curve Rs at point 1, with an equilibrium federal funds rate of iff *. When the federal funds rate is above the equilibrium rate at i2 ff, more reserves are supplied than demanded and so the federal funds rate falls to iff*. When the federal funds rate is below the equilibrium rate at i1 ff, more reserves are demanded than supplied and so the federal funds rate rises. HOW CHANGES IN THE TOOLS OF MONETARY POLICY AFFECT THE FEDERAL FUNDS RATE Open market operations and discount lending affect the federal funds rate by changing the supply of reserves, while the reserve requirements affect the federal funds rate by changing the demand for reserves, and interest rate paid on reserves affects the federal funds rate by changing the interest paid on reserves. Open market operations: An open market purchase increases nonborrowed reserves and hence the reserves supplied, and shifts the supply curve from Rs 1 to Rs 2. So an open market purchase causes the federal funds rate to fall, whereas an open market sale causes the federal funds rate to raise. In panel (a), the equilibrium moves from point 1 to point 2, lowering the federal funds rate from i1 ff to i2ff. In panel (b), the equilibrium moves from point 1 to point 2, but the federal funds rate remains unchanged, i1ff = i2ff = ior, because the interest rate paid on reserves, ior, sets a floor for the federal funds rate. Discount lending: In panel (a) when the discount rate is lowered by the Fed from i1d to i2d the horizontal section of the supply curve falls, as in Rs 2, and the equilibrium federal funds rate remains unchanged at i1 ff. The conclusion is that most changes in the discount rate have no effect on the federal funds rate. In panel (b) when the discount rate is lowered by the Fed from i1 d to i2d, the horizontal section of the supply curve Rs 2 falls, and the equilibrium federal funds rate falls from i1 ff to i2ff as borrowed reserves increase. Reserves requirements: When the Fed raises reserve requirements, required reserves increase, which increases the demand for reserves. The demand curve shifts from Rd 1 to Rd 2, the equilibrium moves from point 1 to point 2, and the federal fund rate rises from i1 ff to i2ff. The result is that when the Fed raises reserve requirements, the federal funds rate rises. A decline in the required reserve ratio lowers the quantity of reserves demanded, shifts the demand curve to the left, and causes the federal funds rate to fall. Interest on reserves: In panel (a) when the equilibrium federal funds rate is above the interest rate paid on reserves, a rise in the interest rate on reserves from i1 or to i2or raises the horizontal section of the demand curve, as in Rd 2, but the equilibrium federal funds rate remains unchanged at i1ff. In panel (b) when the equilibrium federal funds rate is at the interest rate paid on reserves, a rise in the interest rate on reserves from i1or to i2or raises the equilibrium federal funds rate i1ff = i1or to i2ff = i2or. So when the federal funds rate is at the interest rate paid on reserves, a rise in the interest rate on reserves raises the federal funds rate. Conventional monetary policy tools During normal times, the Federal Reserve uses three tools of monetary policy – open market operations, discount lending, and reserve requirements – to control the money supply and interest rates, and these are referred to as conventional monetary policy tools. OPEN MARKET OPERATIONS Open market operations are of two types: Dynamic open market operations are intended to change the level of reserves and the monetary base, and defensive open market operations are intended to offset movements in other factors that affect reserves and the monetary base. The Fed conducts most of its open market operations in Treasury securities because the market for these securities is the most liquid and has the largest trading volume. It has the capacity to absorb the Fed’s substantial volume of transactions without experiencing excessive price fluctuations that would disrupt the market. The decision-making authority for open market operations is the Federal Open Market Committee (FOMC), which sets a target for the federal funds rate. The actual execution of these operations is conducted by the trading desk at the Federal Reserve Bank of New York. Temporary open-market operations are the main way the Fed affects reserves in the banking system and they are of two basic types. In a repurchase agreement (often called a repo), the Fed purchases securities with an agreement that the seller will repurchase them in a short period of time, from one to fifteen days from the original date of purchase. When the Fed wants to conduct a temporary open market sale, it engages in a matched sale-purchase transaction (called also reverse repo) in which the Fed sells securities and the buyer agrees to sell them back to the Fed in the near future. DISCOUNT POLICY AND THE LENDER OF LAST RESORT The facility at which banks can borrow reserves from the Federal Reserve is called the discount window. Operation of the discount window: the Fed’s discount loans to banks are of three types: primary credit, secondary credit, and seasonal credit. Primary credit is the discount lending that plays the most important role in monetary policy. Healthy banks can borrow all they want at very short maturities from the primary credit facility, and it is referred to as a standing lending facility. The interest rate on thee loans is the discount rate, and it is set higher than the federal funds rate target, usually by 100 basis points because the Fed prefers that banks borrow from each other in the federal funds market so that they monitor each other for credit risk. The facility is intended to be a backup source of liquidity for sound banks so that the federal funds rate never rises too far above the federal funds target set by the FOMC. Secondary credit is given to banks that are in financial trouble and are experiencing severe liquidity problems. The interest rate on secondary credit is set at 50 basis points above the discount rate. The interest rate on these loans is set at a higher rate to reflect the less-sound condition of these borrowers. Seasonal credit is given to meet the needs of a limited number of small banks in vacation and agricultural areas that have a seasonal pattern of deposits. The interest is tied to the average of the federal funds rate and certificate of deposit rates. Lender of last resort: when the Federal Reserve System was created, its most important role was intended to be lender of last resort; to prevent bank failures from spinning out of control, it was to provide reserves to banks when no one else would, thereby preventing bank and financial panics. Discounting is an effective way to provide reserves to the banking system during a banking crisis because reserves are immediately channeled to the banks that need them most. At a first glance, it might seem that the presence of the FDIC, which insures depositors up to a limit of $250,000 per account from losses due to a bank’s failure, would make the lender-of-last-resort function of the Fed superfluous. This is not the case for two reasons. First, the FDIC’s insurance fund amounts to about 1% of the amount of these deposits outstanding. If many banks failed, the FDIC would not be able to cover all the depositors’ losses. Second, the $1.1 trillion of large- denomination deposits in the banking system are not guaranteed by the FDIC because they exceed the $250,000 limit. A loss of confidence in the banking system could still lead to runs on banks from the large- denomination depositors, and bank panics could still occur despite the existence of the FDIC. Not only can the Fed be a lender of last resort to banks, but it can also play the same role for the financial system as a whole. The Fed’s role as the lender of last resort have a cost. If a bank expects that the Fed will provide it with discount loans when it gets into trouble, it will be willing to take on more risk knowing that the Fed will come to the rescue. The Fed’s lender-of-last-resort role has thus created a moral hazard problem: Federal Reserve actions to prevent financial panic may encourage financial institutions other than banks to take on greater risk. They expect the Fed to ensure that they could get loans if a financial panic seems imminent. When the Fed considers using the discount weapon to prevent panics, it needs to consider the trade-off between the moral hazard cost of its role and the benefit of preventing financial panics. thereby causing the long-term interest rate to fall. This strategy is referred to as management of expectations. The Fed pursued this strategy when it announced after its FOMC meeting on December 16, 2008, that not only would it lower the federal funds rate target, but also that “the Committee anticipates that weak economic conditions are likely to warrant low levels of the federal funds rate for some time”. Although long-term interest rates on Treasury securities did subsequently fall with these announcements, it is not clear how much of this decline was due to the Fed’s attempt to manage expectations versus weakness in the economy. There are two types of commitments to future policy actions: conditional and unconditional. The commitment to keep the federal funds rate at zero for an extended period starting in 2008 was conditional because it mentioned that the decision was predicated on a weak economy going forward. If economic circumstances changed, the FOMC was indicating that if might abandon the commitment. Alternatively, the Fed could have made an unconditional commitment by just stating that it would keep the federal funds rate at zero for an extended period without indicating that this decision was based on the state of the economy. An unconditional commitment is stronger because it does not suggest that the commitment will be abandoned and so is likely to have a larger effect on long-term interest rates. It has the disadvantage that even if circumstances change in such a way that it would be better to abandon the commitment, the Fed may feel it cannot go back on its word. The problem of an unconditional commitment: in 2003 the Fed became worried that inflation was too low and that the probability of a deflation was significant. In August 12, 2003, the FOMC stated “In these circumstances, the Committee believe that policy accommodation can be maintained for a considerable period”. Then, in June 30, 2004, the FOMC changed its statement to “policy accommodation can be removed at a pace that is likely to be measured”. Then for the next ten FOMC meetings through June 2006, the Fed raised the federal funds rate target by exactly ¼ percentage point at every meeting. The market interpreted the FOMC’s statements as indicating an unconditional commitment, and this is why the Fed may have been constrained not to deviate from ¼ percentage point moves at every FOMC meeting. To avoid the problems with an unconditional commitment, in December of 2012 the Fed changed its statement by indicating that the “exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-½ percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal. This conditional approach is not without problems. First, it may be viewed as a Federal Reserve commitment to achieve a specific unemployment rate regardless of the monetary stimulus required to reach it (this kind of commitment got the Fed into trouble in the 1970s and produced the escalation in inflation that became known as “Great Inflation”). Second, this approach may be viewed as increasing the inflation target from 2% to 2.5% and a weakening of the Federal Reserve’s credibility to keep inflation low and stable. Monetary policy tools of the European Central Bank The ECB also signals the stance of its monetary policy by setting a target financing rate, which in turn sets a target for the overnight cash rate. Like the federal funds rate, the overnight cash rate is the interest rate for very short-term interbank loans. OPEN MARKEET OPERATIONS The ECB also uses open market operations as its primary tool for conducting monetary policy and setting the overnight cash rate at the target financing rate. Main refinancing operations are the predominant form of open market operations. They involve weekly reverse transactions (purchase or sale of eligible assets under repurchase or credit operations against eligible assets as collateral) that are reversed within two weeks. Credit institutions submit bids, and the ECB accepts the most attractively priced bids and makes purchases or sales to the point where the desired amount of reserves are supplied. In contrast to the Federal Reserve, the ECB decentralizes open market operations by having them be conducted by the individual national central banks. A second category of open market operations is the longer-term refinancing operations, which are a much smaller source of liquidity for the euro-area banking system and are similar to the Fed’s outright purchases or sales of securities. These operations are carried out monthly and typically involve purchases or sales of securities with a maturity of three months. They are aimed at providing euro-area banks with additional longer-term refinancing. LENDING TO BANKS The next most important tool of monetary policy for the ECB involves lending to banking institutions, which is carried out by the national central banks. This lending takes place through a standing lending facility called the marginal lending facility. There, banks can borrow overnight loans from the national central banks at the marginal lending rate, which is set at 100 basis points above the target financing rate. The marginal lending rate provides a ceiling for the overnight market interest rate in the European Monetary Union. The Eurosystem has another standing facility, the deposit facility, in which banks are paid a fixed interest rate that is 100 basis points below the target financial rate. The prespecified interest rate on the deposit facility provides a floor for the overnight market interest rate, while the marginal lending rate sets a ceiling. RESERVE REQUIREMENTS The ECB imposes reserve requirements such that all deposit-taking institutions are required to hold 2% of the total amount of checking deposits and other short-term deposits in reserve accounts with national CBs. The price stability goal and the nominal anchor Price stability, which central bankers define as low and stable inflation, is increasingly viewed as the most important goal of monetary policy. Price stability is desirable because a rising price level (inflation) creates uncertainty in the economy, and that uncertainty might hamper economic growth. When the overall level of prices is changing, the information conveyed by the prices of goods and services is harder to interpret, thereby leading to a less efficient financial system. The most extreme example of unstable prices is hyperinflation, which has proved to be very damaging to the workings of the economy. Inflation also makes it difficult to plan for the future. Furthermore, inflation can strain a country’s social fabric: Conflict might result because each group in the society may compete with other groups to make sure that its income keeps up with the rising level of prices. THE ROLE OF A NOMINAL ANCHOR Because price stability is so crucial, a central element is successful monetary policy is the use of a nominal anchor, a nominal variable such as the inflation rate or the money supply, which ties down the price level to achieve price stability. It can limit the time-inconsistency problem, in which monetary policy conducted on a discretionary, day-by-day basis leads to poor long-run outcomes. THE TIME-INCONSISTENCY PROBLEM We often have a plan that we know will produce a good outcome in the long run, but when tomorrow comes, we just can’t help ourselves and we renege on our plan because doing so has short-run gains. Monetary policy makers face the time-inconsistency problem. They are always tempted to pursue a discretionary monetary policy that is more expansionary than firms or people expect because such a policy would boost economic output (or lower unemployment) in the short run. The best policy is not to pursue expansionary policy because decisions about wages and prices reflect workers’ and firms’ expectations about policy; when they see a central bank pursuing expansionary policy, workers and firms will raise their expectations about inflation, driving wages and prices up, which will lead to higher inflation but will not result in higher output on average. A central bank will have better inflation performance in the long run if it does not try to surprise people with an unexpectedly expansionary policy but instead keeps inflation under control. Even if a central bank recognizes that discretionary policy will lead to a poor outcome, it still may not be able to pursue the better policy of inflation control because politicians are likely to apply pressure on the central bank to try to boost output with overly expansionary monetary policy. A nominal anchor can help prevent the time-inconsistency problem in monetary policy by providing an expected constraint on discretionary policy. Other goals on monetary policy Five other goals are mentioned by central bank officials when they discuss the objectives of monetary policy: high employment, economic growth, stability of financial markets, interest-rate stability, and stability in foreign exchange markets. HIGH EMPLOYMENT AND OUTPUT STABILITY High employment is a worthy goal for two reasons: the alternative situation – high unemployment – causes much human misery, and when unemployment is high, the economy has both idle workers and idle resources, resulting in a loss of output (lower GDP). It might seem that full employment is the point at which not worker is out of a job – that is, when unemployment is zero. But this definition ignores the fact that some unemployment, called frictional unemployment, which involves searches by workers and firms to find suitable matchups, is beneficial to the economy. Another reason that unemployment is not zero when the economy is at full employment is structural unemployment, a mismatch between job requirements and the skills or availability of local workers. This goal for high employment is not an unemployment level of zero but a level above zero consistent with full employment at which the demand for labor equals the supply of labor. This level is called the natural rate of unemployment. Current estimates of the natural rate of unemployment place it between 4.5% and 6%, but even this estimate is subject to much uncertainty and disagreement. It is possible, for example, that appropriate government policy might decrease the natural rate of unemployment. The high unemployment goal can be thought of in another way. Because the level of unemployment is tied to the level of economic activity in the economy, a level of output is produced at the natural rate of unemployment, which is referred to as the natural rate of output but is more often referred as potential output. Trying to achieve the goal of high employment thus means that central banks should try to stabilize the level of output around its natural rate. ECONOMIC GROWTH Businesses are more likely to invest in capital equipment to increase productivity and economic growth when unemployment is low. Conversely, if unemployment is high, it does not pay for a firm to invest in Too much rigidity: Some economists believe inflation targeting imposes a rigid rule on monetary policy makers and limits their ability to respond to unforeseen circumstances. However, useful policy strategies exist that are “rule-like”, in that they involve forward-looking behavior that limits policy makers from engaging in policies with undesirable long-run consequences. Such policies avoid the time-inconsistency problem and would best be described as “constrained discretion”. Inflation targeting is far from rigid and is better described as “flexible inflation targeting”. First, inflation targeting requires the central bank to use all available information to determine which policy actions are appropriate to achieve the inflation target. It never requires the central bank to focus solely on one key variable. Second, inflation targeting contains a substantial degree of policy discretion. Inflation targets have been modified depending on economic circumstances. Potential for increased output fluctuations: An important criticism of inflation targeting is that a sole focus on inflation may lead to monetary policy that is too tight when inflation is above target and thus may lead to larger output fluctuations. Inflation targeting does not, however, require a sole focus on inflation. Inflation targeters have chosen inflation targets above zero (typically around 2%), and this reflects the concern of monetary policy makers that particularly low inflation can have negative effects on real economic activity. Deflation is especially to be feared because of the possibility that it may promote financial instability and precipitate a severe economic contraction. Targeting inflation rates of above zero makes periods of deflation less likely. Inflation targeting also does not ignore traditional stabilization goals. Central bankers in inflation-targeting countries continue to express their concern about fluctuations in output and employment, and the ability to accommodate short-run stabilization goals to some degree is built into all inflation-targeting regimes. Low economic growth: Inflation targeting will lead to low growth in output and employment. Although inflation reduction has been associated with below-normal output during disinflationary phases in inflation- targeting regimes, one low inflation levels were achieved, output and employment returned to levels at least as high as they were before. Once low inflation is achieved, inflation targeting is not harmful to the real economy. Inflation targeting promotes real economic growth, in addition to controlling inflation. Should central banks respond to asset-price bubbles? Lessons from the Global Financial Crisis Over the centuries, economies have been periodically subject to asset-price bubbles, pronounced increases in asset prices that depart from fundamental values, which eventually burst resoundingly. The story of the 2007-2009 financial crisis indicates how costly these bubbles can be. The bursting of the asset-price bubble in the housing market brought down the financial system, leading to an economic downturn, a rise in unemployment, and disrupted communities. Because asset prices affect business and household spending and hence economic activity, monetary policy needs to respond to asset prices in order to stabilize the economy. The issue is whether it should respond at a level over and above that called for in terms of the objectives of stabilizing inflation and employment. Another way of defining the issue is whether monetary policy should try to pop, or slow, the growth of possibly developing asset-price bubbles to minimize damage to the economy when these bubbles burst. Alternatively, should the monetary authorities respond to asset-price declines only after a bubble burst, to stabilize both output and inflation? These opposing positions have been characterized as leaning against asset-price bubbles versus cleaning up after the bubble bursts, and so the debate over what to do is often referred to as the “lean versus clean” debate. TWO TYPES OF ASSET-PRICE BUBBLES There are two types of asset-price bubbles: one that is driven by credit and a second that is driven by overly optimistic expectations. Credit-driven bubbles: When a credit boom begins, it can spill over into an asset-price bubble: easier credit can be used to purchase particular assets and thereby raise their prices. The rise in asset values encourages further lending for these assets, either because it increases the value of collateral, making it easier to borrow, or because it raises the value of capital at financial institutions, which gives them more capacity to lend. The lending for these assets can then increase demand for them further and hence raise their prices even more. The feedback loop can generate a bubble in which asset prices rise well above their fundamental values. Credit-driven bubbles are dangerous. When asset prices come back down to Earth and the bubble bursts, the collapse in asset prices then leads to a reversal of the feedback loop in which loans go sour, lenders cut back on credit supply, the demand for assets declines further, and prices drop even more. The resulting losses on subprime loans and securities eroded the balance sheets of financial institutions, causing a decline in credit (deleveraging) and a sharp fall in business and household spending, and therefore in economic activity Bubbles driven solely by irrational exuberance: Bubbles that are driven solely by overly optimistic expectations, but which are not associated with a credit boom, pose much less risk to the financial system. THE DEBATE OVER WHETHER CENTRAL BANKS SHOULD TRY TO POP BUBBLES Whether central banks should try to pop, or prick, bubbles was actively debated before the crisis, with Alan Greenspan arguing against. We look at the pro and con arguments. Con: why central banks should not try to pop bubbles: Alan Greenspan’s arguments that central banks should not take actions to prick bubbles became known as the “Greenspan doctrine”. His position reflected five arguments. 1. Asset-price bubbles are nearly impossible to identify. If central banks or government officials knew that a bubble was in progress. Then a bubble would be unlikely to develop because market participants would know that prices were getting out of line with fundamentals. Unless central bank or government officials are smarter than market participants, which is unlikely given the high wages that market participants garner, they will be unlikely to identify when bubbles of this type are occurring. 2. Raising interest rates may be very ineffective in restraining the bubble because market participants expect such high rates of return from buying bubble-driven assets. Furthermore, raising interest rates has often been found to cause a bubble to burst more severely, thereby increasing the damage to the economy. 3. Many different asset prices exist, and at any one time a bubble may be present in only a fraction of assets. Monetary policy actions are a very blunt instrument in such a case, as such actions would be likely to affect asset prices in general, rather than the specific assets that are experiencing a bubble. 4. Monetary policy actions to prick bubbles can have harmful effects on the aggregate economy. If interest rates are raised to curtail a bubble, the economy will slow, people will lose jobs, and inflation can fall below its desirable level. Indeed, the rise in interest rates necessary to prick a bubble may be so high that it can only be done at great cost to workers and the economy. This is not to say that monetary policy should not respond to asset prices per se. the level of asset prices does affect the evolution of the economy. Monetary policy should react to fluctuations in asset prices to the extent that they affect inflation and economic activity. 5. As long as monetary policy responds in a timely fashion, by easing monetary policy aggressively after an asset bubble bursts, the harmful effects of a bursting bubble could be kept at a manageable level. Pro: why central banks should try to pop bubbles: The recent crisis has demonstrated that the bursting of credit-driven bubble can be not only extremely costly but also very hard to clean up after. Rather than leaning against potential asset-price bubbles, which would include both credit-driven and irrational exuberance-type bubbles, the case is much stronger for leaning against credit bubbles, which would involve leaning against credit-driven asset-price bubbles but not irrational exuberance asset-price bubbles. It is much easier to identify credit bubbles than asset-price bubbles. When asset-price bubbles are rising at the same time that credit is booming, the likelihood is greater that asset prices are deviating from fundamentals because laxer credit standards are driving asset prices upward. In this case, central bank or government officials have a greater likelihood of identifying that a bubble is in progress. Macroprudential policies: Only when risk taking is excessive are credit bubbles likely to develop, and so it is natural to look to prudential regulatory measures to constrain credit bubbles. Regulatory policy to affect what is happening in credit markets in the aggregate is referred to as macroprudential regulation. Financial regulation and supervision, with the usual elements of a well-functioning prudential regulatory and supervisory system, can prevent excessive risk taking that can trigger a credit boom, which in turn leads to an asset-price bubble. These elements include adequate disclosure and capital requirements, prompt corrective action, close monitoring of financial institutions’ risk management procedures, and close supervision to enforce compliance with regulations. As the global financial crisis demonstrated, the rise in asset prices that accompanied the credit boom resulted in higher capital buffers at financial institutions, supporting further lending in the context of unchanging capital requirements, which led to higher asset prices, and so on; the value of the capital dropped, leading to a cut in lending. Capital requirements that are countercyclical, that is, adjusted upward during a boom and downward during a bust, might help eliminate the feedback loops that promote credit-driven bubbles. A rise in asset prices accompanied by a credit boom provides a signal that market failures or poor financial regulation and supervision might be causing a bubble to form. Monetary policy: Although it is far from clear that the Federal Reserve is primarily to blame for the housing bubble, research does suggest that low interest rates can encourage excessive risk taking in what has been called the “risk-taking channel of monetary policy”. Low interest rates may increase the incentives for asset managers in financial institutions to search for yield and hence increase risk taking. Low interest rates may also increase the demand for assets, raising their prices and leading to increased valuation of collateral, which encourages lenders to lend to riskier borrowers. The risk-taking channel of monetary policy suggests that monetary policy should be used to lean against credit bubbles. However, many of the objections to using monetary policy to prick bubbles behind the Greenspan doctrine are still valid, so wouldn’t it be better to use macroprudential supervision to constrain credit bubbles, leaving monetary policy to focus on price and output stability? Prudential supervision is subject to more political pressure than monetary policy because it affects the bottom line of financial institutions more directly. In addition, financial institutions are often very good at finding loopholes to avoid regulation, and so macroprudential supervision may not be effective. Thus, monetary policy has to be used instead. Tactics: choosing the policy instrument Central banks directly control the conventional tools of monetary policy but knowing the tools and the strategies for implementing a monetary policy does not tell us whether policy is easy or tight. The policy instrument (also called an operating instrument) is a variable that responds to the central bank’s tools and indicates the stance of monetary policy. A central bank like the Fed has at its disposal two basic types of policy instruments: reserve aggregates (total reserves, nonborrowed reserves, the monetary base, and the nonborrowed base) and interest rates (federal funds rate and other short-term interest rates). Central banks in small countries can choose another policy instrument, the exchange rate. The policy instrument might be linked to an intermediate target, such as a monetary aggregate or a long-term interest rate. Intermediate targets stand between the policy instrument and the goals of monetary policy; they are not as directly affected by the tools of monetary policy but might be more closely linked to the goals of monetary policy. Can the central bank accounts and limited the interest that could be paid on time deposits. The limits on interest rates were not relevant until the late 1950s. The limits became especially troublesome to banks in the late 1970s and early 1980s when inflation pushed short-term interest rates above the level that banks could legally pay. Investors pulled their money out of banks and put it into money market security accounts offered by many brokerage firms. Banks continue to provide valuable intermediation. In some situations, however, the cost structure of the banking industry makes it unable to compete effectively in the market for short-term funds against the less restricted money markets. The purpose of the money markets Most investors use the money market as an interim investment that provides a higher return than holding cash or money in banks. They may feel that market conditions are not right to warrant the purchase of additional stock, or they may expect interest rates to rise and hence not want to purchase bonds. Holding idle surplus cash is expensive for an investor because cash balances earn no income for the owner. Idle cash represents an opportunity cost in terms of lost interest income (an asset’s opportunity cost is the amount of interest sacrificed by not holding an alternative asset). The money markets provide a means to invest idle funds and to reduce this opportunity cost. Investment advisers often hold some funds in the money market so that they will be able to act quickly to take advantage of investment opportunities they might identify. Most investment funds also hold money market securities to meet investment or deposit outflows. The seller of money market securities find that the money market provides a low-cost source of temporary funds. Why do corporations and the U.S. government sometimes need to get their hands on funds quickly? The primary reason is that cash inflows and outflows are rarely synchronized. Businesses also face problems caused by revenues and expenses occurring at different times. They money markets provide an efficient, low-cost way of solving these problems. Who participates in the money markets? We can identify the primary money market players and discuss their roles. U.S. TREASURY DEPARTMENT The U.S. Treasury Department is unique because it is always a demander of money market funds and never a supplier. It issues Treasury bills (often called T-bills) and other securities that are popular with other money market participants. Short-term issues enable the government to raise funds until tax revenues are received. The Treasury also issues T-bills to replace maturing issues. FEDERAL RESERVE SYSTEM The Federal Reserve is the Treasury’s agent for the distribution of all government securities. The Fed holds vast quantities of Treasury securities that it sells if it believes the money supply should be reduced. Similarly, the Fed will purchase Treasury securities if it believes the money supply should be expanded. COMMERCIAL BANKS Commercial banks hold a percentage of U.S. government securities second only to pension funds. This is because of regulations that limit the investment opportunities available to banks. Banks are prohibited from owning risky securities, such as stocks or corporate bonds. There are no restrictions against holding Treasury securities because of their low risk and high liquidity. Banks are also the major issuer of negotiable certificates of deposit (CDs), banker’s acceptances, federal funds, and repurchase agreements. In addition to using money market securities to help manage their own liquidity, many banks trade on behalf of their customers. Not all commercial banks deal in the secondary money market for their customers. The ones that do are among the largest in the country and are often referred to as money center banks. BUSINESSES Many businesses buy and sell securities in the money markets. Such activity is usually limited to major corporations because of the large dollar amounts involved. INVESTMENT AND SECURITIES FIRMS Investment companies: large diversified brokerage firms are active in the money markets. The primary function of these dealers is to “make a market” for money market securities by maintaining an inventory from which to buy or sell. These firms are very important to the liquidity of the money market because they ensure that sellers can readily market their securities. Finance companies: finance companies raise funds in the money markets primarily by selling commercial paper. They then lend the funds to consumer for the purchase of durable goods such as cars, boats, and home improvements. Insurance companies: property and casualty insurance companies must maintain liquidity because of their unpredictable need for funds. Pension funds: pension funds invest a portion of their cash in the money markets so that they can take advantage of investment opportunities that they may identify in the stock or bond markets. Pension funds must have sufficient liquidity to meet their obligations. However, because their obligations are predictable, large money market security holdings are unnecessary. INDIVIDUALS Individuals but money market mutual funds. The advantage of money market mutual funds is that they allow small investors to participate in the money market by aggregating their funds to invest in large- denomination money market securities. Money market instruments A variety of money market instruments are available to meet the diverse needs of market participants. TREASURY BILLS To finance the national debt, the U.S. Treasury Department issues a variety of debt securities. The most widely held and most liquid security is the Treasury bill. The Fed has set up a direct purchase option that individuals may use to purchase Treasury bills over the Internet. This method of buying securities represented an effort to make Treasury securities more widely available. The government does not actually pay interest on Treasury bills. Instead, they are issued at a discount from par (their value at maturity). The investor’s yield comes from the increase in the value of the security between the time it was purchased and the time it matures. The discount rate % is computed as: idiscount = F − P F x 360 n idiscount = annualized discount rate % P = purchase price F = face or maturity value n = number of days until maturity The investment rate is computed as: iinvestment = F − P P x 365 n Risk: treasury bills have virtually zero default risk because even if the government ran out of money, it could print more to redeem them when they mature. The risk of unexpected changes in inflation is also low because of the short term to maturity. The market for T-bills is deep and liquid. A deep market is one with many different buyers and sellers. A liquid market is one in which securities can be bought and sold quickly and with low transaction costs. Investors in markets that are deep and liquid have little risk that they will not be able to sell their securities when they want to. Treasury bill auctions: each week the Treasury announces how many and what kind of Treasury bills it will offer for sale. The Treasury accepts the bids offering the highest price. The Treasury accepts competitive bids in ascending order of yield until the accepted bids reach the offering amount. Each accepted bid is then awarded at the highest yield paid to any accepted bid. As an alternative to the competitive bidding procedure, the Treasury also permits noncompetitive bidding. When competitive bids are offered, investors state both the amount of securities desired and the price they are willing to pay. Noncompetitive bids include only the amount of securities the investor wants. The Treasury accepts all noncompetitive bids. The price is set as the highest yield paid to any accepted competitive bid. The difference between the two methods is that competitive bidders may or may not end up buying securities whereas the noncompetitive bidders are guaranteed to do so. In 1976 the Treasury switched the entire marketable portion of the federal debt over to book entry securities. In a book entry system, ownership of Treasury securities is documented only in the Fed’s computer: a ledger entry replaces the actual security. This procedure reduces the cost of issuing Treasury securities as well as the cost of transferring them as they are bought and sold in the secondary market. To ensure proper levels of competition, no one dealer is allowed to purchase more than 35% of any one issue. About 40 primary dealers regularly participate in the auction. Treasury bill interest rates: the interest rate earned on Treasury bill securities is among the lowest in the economy. Investors in Treasury bills have found that in some years, their earnings did non even compensate them for changes in purchasing power due to inflation. The T-bill is not an investment to be used for anything but temporary storage of excess funds because it may not even keep up with inflation. FEDERAL FUNDS Federal funds are short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day. These funds are held at the Federal Reserve bank. The fed funds market began in the 1920s when banks with excess reserves loaned them to banks that needed them. Purpose of fed funds: the Federal Reserve has set minimum reserve requirements that all banks must maintain. To meet these reserve requirements, banks must keep a certain percentage of their total deposits with the Federal Reserve. The main purpose for fed funds is to provide banks with an immediate infusion of reserves should they be short. Banks can borrow directly from the Federal Reserve, but the Fed discourages banks from regularly borrowing from it. Terms for fed funds: banks analyze their reserve position daily and either borrow or invest in fed funds, depending on whether they have deficit or excess reserves. The bank will sell its excess funds to the bank that offers the highest rate. Once an agreement has been reached, the bank with excess funds will communicate to the Federal Reserve bank instructions to take funds out of the seller’s account at the Fed and deposit the funds in the borrower’s account. The next day, the funds are transferred back, and the process begins again. EURODOLLARS Many contracts around the world call for payment in U.S. dollars due to the dollar’s stability. For this reason, many companies and governments choose to hold dollars. Prior to World War II, most of these deposits were held in New York money center banks. However, as a result of the Cold War, some large London banks offered to hold dollar-denominated deposits in British banks. These deposits were dubbed Eurodollars. The Eurodollar market has continued to grow. The primary reason in that depositors receive a higher rate of return on a dollar deposit in the Eurodollar market than in the domestic market. The borrower is able to receive a more favorable rate in the Eurodollar market than in the domestic market. London interbank market: some large London banks act as brokers in the interbank Eurodollar market. Eurodollars are an alternative to fed funds. Banks from around the world buy and sell overnight funds in this market. The rate paid by banks buying funds is the London interbank bid rate (LIBID). Funds are offered for sale in this market at the London interbank offer rate (LIBOR). Because many banks participate in this market, it is competitive. The spread between the bid and the offer rate seldom exceeds 0.125%. Eurodollars deposits cannot be withdrawn for a specified period of time. Each maturity has a different rate. The overnight LIBOR and the fed funds rate tend to be very close to each other because they are near- perfect substitutes. The Eurodollar market is not limited to London banks anymore. The primary brokers in this market maintain offices in all of the major financial center worldwide. Eurodollars certificates of deposit: because Eurodollars are time deposits with fixed maturities, they are illiquid. The financial markets created new types of securities to combat this problem. These new securities were transferable negotiable certificates of deposit. Because most Eurodollar deposits have a relatively short term to begin with, the market for Eurodollar negotiable CDs is limited (less than 10% of the amount). Other Eurocurrencies: the Eurodollar market is not limited to dollars. It is possible to have an account denominated in Japanese yen held in a London or New York bank. Other Euro currencies are possible as well. If market participants have a need for a particular security and are willing to pay for it, the financial markets stand ready and willing to create it. Comparing money market securities Although money market securities share many characteristics, such as liquidity, safety, and short maturities, they all differ in some aspects. INTEREST RATES All of the money market instruments appear to move very closely together over time. This is because all have very low risk and a short term. They all have deep markets and so are priced competitively. Because these instruments have so many of the same risk and term characteristics, they are close substitutes. If one rate should temporarily depart from the others, market supply-and-demand forces would soon cause a correction. LIQUIDITY The depth of the secondary market where the security can be resold determines its liquidity. The depth of the secondary market is not as critical for money market securities as it is for long-term securities such as stocks and bonds. This is because money market securities are short-term to start with. Nevertheless, many investors desire liquidity intervention: they seek an intermediary to provide liquidity where it did not previously exist. CHAPTER 12 – THE BOND MARKET Purpose of the capital market Firms and individuals use the capital markets for long-term investments. Suppose that your firm chooses to finance a new plant to meet the increased demand for its produces by issuing money market securities, such as commercial paper. As long as interest rates do not rise, all is well: when these short-term securities mature, they can be reissued at the same interest rate. However, if interest rate rise, the firm will still have to reissue, now at a higher rate. If long-term securities, such as bonds or stock, had been used, the increased interest rates would not have been as critical. The primary reason that individuals and firms choose to borrow long-term is to reduce the risk that interest rates will rise before they pay off their debt. Capital market participants The primary issuers of capital market securities are federal and local government and corporations. The federal government issues long-term notes and bonds to fund the national debt. State and municipal governments to finance capital projects. Governments never issue stock because they cannot sell ownership claims. Corporations issue both bonds and stock. One of the most difficult decisions a firm faces can be whether it should finance its growth with debt or equity. The distribution of a firm’s capital between debt and equity is called its capital structure. Corporations may enter the capital markets because they do not have sufficient capital to fund their investment opportunities. Alternatively, firms may choose to enter the capital markets because they want to preserve their capital to protect against unexpected needs. The largest purchasers of capital market securities are households. Individuals and households deposit funds in financial institutions that use the funds to purchase capital market instruments such as bonds or stock. Capital market trading Capital market trading occurs in either the primary market or the secondary market. The primary market is where new issues of stocks and bonds are introduced. You can think of a primary market transaction as one where the issuer of the security receives the proceeds of the sale. when firms sell securities for the very first time, the issue is an initial public offering (IPO). A secondary market is where the sale of previously issued securities takes place. Secondary markets are critical in capital markets because most investors plan to sell long-term bonds at some point. There are two types of exchanges in the secondary market for capital securities: organized exchanges and over-the- counter exchanges. An organized exchange has a building where securities trade. Types of bonds Bonds are securities that represent a debt owed by the issuer to the investor. Bonds obligate the issuer to pay a specified amount at a given date, with periodic interest payments. The coupon rate is the rate of interest that the issuer must pay, and this periodic interest payment is often called the coupon payment. If the repayment terms of a bond are not met, the holder of a bond has a claim on the assets of the issuer. Long-term bonds traded in the capital market include long-term government notes and bonds, municipal bonds, and corporate bonds. Treasury notes and bonds The U.S. Treasury issues notes and bonds to finance the national debt. The difference is that notes have an original maturity of 1 to 10 years while bonds have an original maturity of 10 to 30 years. (Treasury bills mature in less than one year.) Federal government notes and bonds are free of default risk because the government can always print money to pay off the debt if necessary. This does not mean that these securities are risk-free. TREASURY BOND INTEREST RATES Treasury bonds have very low interest rates because they have no default risk. Most of the time the interest rate on Treasury notes and bonds is above that on money market securities because of interest- rate risk. TREASURY INFLATION-PROTECTED SECURITIES (TIPS) In 1997 the Treasury Department began offering an innovative bond designed to remove inflation risk from holding treasury securities. The inflation-indexed bonds have an interest rate that does not change throughout the term of the security. However, the principal amount used to compute the interest payment does change based on the consumer price index. The advantage of inflation-indexed securities is that they give both individual and institutional investors a chance to buy a security whose value won’t be eroded by inflation. TREASURY STRIPS In addition to bonds, notes, and bills, in 1985 the Treasury began issuing to depository institutions bonds in book entry form called Separate Trading of Registered Interest and Principal Securities (STRIPS). A STRIPS separates the period interest payments from the final principal repayment. When a Treasury fixed-principal or inflation-indexed note or bond is “stripped”, each interest payment and the principal payment becomes a separate zero-coupon security. Each component has its own identifying number and can be held or traded separately. STRIPS are also called zero-coupon securities because the only time an investor receives a payment during the life of a STRIPS is when it matures. AGENCY BONDS Congress has authorized a number of U.S. agencies to issue bonds, also known as government-sponsored enterprises (GSEs). These agencies issue bonds to raise funds that are used for purposes that Congress has deemed to be in the national interest. The risk on agency bonds is very low. They are usually secured by the loans that are made with the funds raised by the bond sales. In addition, the federal agencies may use their lines of credit with the Treasury Department should they have trouble meeting their obligations. Finally, it is unlikely that the federal government would permit its agencies to default on their obligations. Municipal bonds Municipal bonds are securities issued by local, country, and state governments. The proceeds from these bonds are used to finance public interest projects such as schools, utilities, and transportation systems. They are exempt from federal taxation. This allows the municipality to borrow at a lower cost because investors will be satisfied with lower interest rates on tax-exempt bonds. To determine what tax-free rate of interest is equivalent to a taxable rate use this equation: Equivalent taxfree rate = taxable interest rate × (1 − marginal tax rate) There are two types of municipal bonds: general obligation bonds and revenue bonds. General obligation bonds do not have specific assets pledged as security or a specific source of revenue allocated for their repayment. The issuer promises to use every resource available to repay the bond as promised. Revenue bonds are backed by the cash flow of a particular revenue-generating project. If the revenues are not sufficient to repay the bonds, they may go into default, and investors may suffer losses. which made Drexel the most profitable firm on Wall Street in 1987. Both Milken and Drexel were caught and convicted of insider trading. With Drexel unable to support the junk bon market, 250 companies defaulted between 1989 and 1991. The junk bond market recovered since its low in 1990, but the financial crisis in 2008 again reduced the demand for riskier securities. Financial guarantees for bonds Financial weaker security issuers frequently purchase financial guarantees to lower the risk of their bonds. A financial guarantee ensure that the bond purchaser will be paid both principal and interest in the even the issuer defaults. The credit rating of the insurer is substituted for the credit rating of the issuer. The resulting reduction in risk lowers the interest rate demanded by bond buyers. Issuers must pay a fee to the insurance company for the guarantee. Financial guarantees make sense only when the cost of the insurance is less than the interest savings that result. In 1995 Morgan introduced a new way to insure bonds called the credit default swap (CDS). A CDS provides insurance against default in the principle and interest payments of a credit instrument. In 2000 Congress passed the Commodity Futures Modernization Act, which removed derivative securities, such as CDSs, from regulatory oversight. The effect was to make it possible for investors to speculate on the possibility of default on securities they did not own. Thus, speculators could legally bet on whether a firm or security would fail in the future. Current yield calculation If you buy a bond and hold it until it matures, you will earn the yield to maturity. CURRENT YIELD The current yield is an approximation of the yield to maturity on coupon bonds that is often reported because it is easily calculated. ic = C P ic = current yield P = price of the coupon bond C = yearly coupon payment The current yield better approximates the yield to maturity when the bond’s price is nearer to the bond’s par value and the maturity of the bond is longer. It becomes a worse approximation when the bond’s price is further from the bond’s par value and the bond’s maturity is shorter. Regardless of whether the current yield is a good approximation of the yield to maturity, a change in the current yield always signals a change in the same direction of the yield to maturity. Finding the value of coupon bonds How to find the value of a security: 1. Identify the cash flows that result from owning the security. 2. Determine the discount rate required to compensate the investor for holding the security. 3. Find the present value of the cash flows estimated in step 1 using the discount rate determined in step 2. FINDING THE PRICE OF SEMIANNUAL BONDS The first step in finding the value of the bond is to identify the cash flows the holder of the bond will receive. The value of the bond is the present value of these cash flows. The cash flows consist of the interest payments and the final lump sum repayment. In the second step these cash flows are discounted back to the present using an interest rate that represents the yield available on other bonds of like risk and maturity. Most bonds pay interest semiannually. To adjust cash flows for semiannual payments, divide the coupon payment by 2. Similarly, to find the interest rate effective during one-half of the year, the market interest rate must be divided by 2. The final adjustment is to double the number of periods because there will be two periods per year. To compute the price of a semiannual bond: 𝑃𝑠𝑒𝑚𝑖 = 𝐶 2⁄ 1 + 𝑖 + 𝐶 2⁄ (1 + 𝑖)2 + 𝐶 2⁄ (1 + 𝑖)3 + ⋯ + 𝐶 2⁄ (1 + 𝑖)2𝑛 + 𝐹 (1 + 𝑖)2𝑛 Psemi = price of semiannual coupon bond C = yearly coupon payment F = face value of the bond n = years to maturity date i = ½ annual market interest rate When the bond sells for less than the par value, it is selling at a discount. When the market price exceeds the par value, the bond is selling at a premium. As interest rates available in the market on new bonds fall, the value of old fixed-interest-rate bonds rises. Investing in bonds Many investors think that bonds represent a low risk investment since the cash flows are relatively certain. However, bond investors face fluctuations in price due to market interest-rate movements in the economy. As interest rates rise and fall, the value of bonds changes in the opposite direction. The possibility of suffering a loss because of interest-rate changes is called interest-rate risk. The longer the time until the bond matures, the greater will be the change in price. This does not cause a loss to those investors who do not sell their bonds; however, many investors do not hold their bonds until maturity. If they attempt to sell their bonds after interest rates have risen, they will receive less than they paid. CHAPTER 13 – THE STOCK MARKET Investing in stocks A share of stock in a firm represents ownership. A stockholder owns a percentage interest in a firm, consistent with the percentage of outstanding stock held. Investors can earn a return from stock in one of two ways. Either the price of the stock rises over time or the firm pays the stockholders dividends. Stock is riskier than bonds because stockholders have a lower priority than bondholders when the firm is in trouble, dividends are less assured, and stock price increases are not guaranteed. Stock does not mature. One stockholder’s right is the right of a residual claimant: stockholders have a claim on all assets and income left over after all other claimants have been satisfied. Most stockholders have the right to vote for directors and on certain issues, such as amendments to the corporate charter and whether new shares should be issued. COMMON STOCK VS. PREFERRED STOCK There are two types of stock, common and preferred. A share of common stock in a firm represents an ownership interest in that firm. Common stockholders vote, receive dividends, and hope that the price of their stock will rise. Preferred stock is a form of equity from a legal and tax standpoint. It differs from common stock in several ways. First, because preferred stockholders receive a fixed dividend that never changes, a share of preferred stock is a much like a bond as it is like common stock. Second, because the dividend does not change, the price of preferred stock is stable. Third, preferred stockholders do not usually vote unless the firm has failed to pay the promised dividend. Finally, preferred stockholders hold a claim on assets that has priority over the claims of common shareholders but after that of creditors such as bondholders. Preferred dividends are not tax-deductible to the firm like bond interest payments. Consequently, issuing preferred stock usually costs the firm more than issuing debt. HOW STOCK ARE SOLD The flow of information through the stock market is a critical feature of well-developed and efficient markets. This efficiency encourages investors to buy stocks and to provide equity capital to businesses with valuable growth opportunities Organized securities exchanges: the New York Stock Exchange (NYSE) has been the best known of the organized exchanges. The definition of an organized exchange is that there is a specified location where buyers and sellers meet on a regular basis to trade securities using an open-outcry auction model. As more sophisticated technology has been adapter to securities trading, this model is becoming less frequently used. To have a stock listed for trading on one of the organized exchanges, a firm must file an application and meet certain criteria set by the exchange designed to enhance trading. Generally, the firm must have substantial earnings and market value (greater than $10 million per year and $100 million market value). Over 8,000 companies around the world list their shares on the NYSE Euronext. Over-the-counter markets: securities not listed on one of the exchanges trade in the over-the-counter (OTC) market. Trading occur over telecommunications networks. One such network is called the National Association of Securities Dealers Automated Quotation System (NASDAQ). Dealers “make a market” in these stocks by buying for inventory when investors want to sell and selling from inventory when investors want to buy. These dealers provide small stocks with the liquidity that is essential to their acceptance in the market. Not all publicly traded stocks list on one of the organized exchanges or on NASDAQ. Securities that trade frequently or trade primarily in one region of the country are usually handled by the regional offices of various brokerage houses. Dealers that make a market for stocks that trade in low volume are important to the success of the over-the-counter market. Without these dealers standing ready to buy or sell shares, investors would be reluctant to buy shares of stock in regional or unknown firms, and it would be difficult for start-up firms to raise needed capital. Organized vs. over-the-counter trading: organized exchanges are characterized as auction markets that use floor traders who specialize in particular stocks. Floor traders meet at the trading post on the exchange and learn about current bid and ask prices. These quotes are called out load. The specialist may match buyers with sellers or they may intervene by taking ownership of the stock themselves or by selling stock from inventory. Whereas organized exchanges have specialists who facilitate trading, over-the-counter markets have market makers. They trade on an electronic network where bid and ask prices are set by the market makers. They each enter their bid and ask quotes. Then, they are obligated to buy or sell at least 1,000 securities at that price. Once this is done, they may enter a new bid and ask quote. They assure there is continuous liquidity for every stock, even those with little transaction volume. Market makers are 1. A higher-than-average PE may mean that the market expects earnings to rise in the future. This would return the PE to a more normal level. 2. A high PE may indicate that the market feels the firm’s earnings are low risk and is therefore willing to pay a premium for them. The PE ration can be used to estimate the value of a firm’s stock. P E × E = P How the market sets security prices First, the price is set by the buyer willing to pay the highest price. Second, the market price will be set by the buyer who can take best advantage of the asset. Superior information about an asset can increase its value by reducing its risk when you consider buying a stock, there are many unknowns about the future cash flows. The buyer who has the best information about these cash flows will discount them at a lower interest rate than will a buyer who is very uncertain. The point is that the players in the market, bidding against each other, establish the market price. When new information is released about a firm, expectations change, and with them, prices change. Since market participants are constantly receiving new information and constantly revising their expectations, stock prices are constantly changing as well. Errors in valuation PROBLEMS WITH ESTIMATING GROWTH The constant growth model requires the analyst to estimate the constant rate of growth the firm will experience. You may estimate future growth by computing the historical growth rate in dividends, sales, or net profits. This approach fails to consider any changes in the firm or economy that may affect the growth rate. Robert Haugen demonstrates that the stock prices of historically high-growth firms tend to reflect a continuation of the high growth rate. The result is that investors in these firms receive lower returns than they would by investing in mature firms. PROBLEMS WITH ESTIMATING RISK The dividend valuation model requires the analyst to estimate the required return for the firm’s equity. Stock price is highly dependent on the required return, despite our uncertainty regarding how it is found. PROBLEMS WITH FORECASTING DIVIDENDS Many factors can influence the dividend payout ratio. These will include the firm’s future growth opportunities and management’s concern over future cash flows. Does all this mean that you should not invest in the market? No, it only means that short-term fluctuations in stock prices are expected and natural. Over the long-term, the stock price will adjust to reflect the true earnings of the firm. Stock market indexes A stock market index is used to monitor the behavior of a group of stocks. Investors can gain some insight as to how a broad group of stocks may have performed. The most commonly quoted index is the Dow Jones Industrial Average (DJIA), an index based on the performance of the stocks of 30 large companies. Buying foreign stocks The problem with buying foreign stocks is that most foreign companies are not listed on any of the U.S. stock exchanges, so the purchase of shares is difficult. Intermediaries have found a way to solve this problem by selling American depository receipts (ADRs). A U.S. bank buys the shares of a foreign company and places them in its vault. The bank then issues receipts against these shares, and these receipts can be traded domestically, usually on the NASDAQ. Trade in ADRs is conducted entirely in U.S. dollars. One advantage is that it allows foreign firms to trade in the United States without the firms having to meet the disclosure rules required by the SEC. Regulation of the stock market For an economy to flourish, firms must be able to raise funds to take advantage of growth opportunities as they become available. For these to function properly investors must be able to trust the information that is released about the firms that are using them. Markets can collapse in the absence of this trust. The most notable example of this was the Great Depression. Public faith had to be restored. So, Congress passed the Securities Act of 1933 and the Securities Act of 1934. The main purpose of these laws was to (1) require firms to tell the public the truth about their businesses and (2) require brokers, dealers, and exchanges to treat investors fairly. Congress established the Securities and Exchange Commission to enforce these laws. THE SECURITIES AND EXCHANGE COMMISSION (SEC) The primary mission of the U.S. SEC is to protect investors and maintain the integrity of the securities markets. It accomplishes this task by assuring a constant, timely, and accurate flow of information to investors. Thus, the SEC is primarily focused on promoting disclosure of information and reducing asymmetric information. The SEC is organized around four divisions and 18 offices and employs about 3,100 people. One way to understand how it accomplishes its goals is to review the duties assigned to each division. • To Division of Corporate Finance is responsible for collecting the many documents that public companies are required to file. The division reviews these filings to check for compliance with the regulations. It does not verify the truth or accuracy of filings. The division also provides companies with help interpreting the regulations and recommends new rules for adoption. • The Division of Market Regulation established and maintains standards for an orderly and efficient market by regulating the major securities market participants. This is the division that reviews and approves new rules and changes to existing rules. • The Division of Investment Management oversees and regulates the investment management industry. This division establishes rules governing investment companies. • The Division of Enforcement investigates the violation of any of the rules and regulations established by the other divisions. CHAPTER 14 – THE MORTGAGE MARKETS What are mortgages? A mortgage is a long-term loan secured by real estate. A developer may obtain a mortgage loan to finance the construction of an office building, or a family may obtain a mortgage loan to finance the purchase of a home. In either case, the loan is amortized: the borrower pays it off over time in some combination of principal and interest payments that result in full payment of the debt by maturity. Most mortgage contracts in the past were arranged between individuals, usually with the help of a lawyer who brought the parties together and drew up the papers. By 1880 mortgage bankers had learned to streamline their operations by selling bonds to raise the long- term funds they lent. Many of these loans were used to finance agricultural expansion in the Midwest. Unfortunately, an agricultural recession in the 1890s resulted in many defaults. Land prices fell, and a large number of the mortgage bankers went bankrupt. It became very difficult to obtain long-term loans until after World War I, when national banks were authorized to make mortgage loans. The mortgage market was again devastated by the Great Depression in the 1930s. This led to foreclosures and land sales that caused property values to collapse. One reason that so many borrowers defaulted on their loans was the type of mortgage loan they had. Most mortgages in this period were balloon loans: the borrower paid only interest for three to five years, at which time the entire loan amount became due. The lender was usually willing to renew the debt with some reduction in principal. However, if the borrower were unemployed, the lender would not renew, and the borrower would default. Characteristics of the residential mortgage One of the biggest changes is the development of an active secondary market for mortgage contracts. More recently, many loan production offices arose that competed in real estate financing. Some of these offices are subsidiaries of banks, and others are independently owned. As a result of the competition, borrowers could choose from a variety of terms and options. Many of these mortgage businesses were organized around the originate-to-distribute model where the broker originated the loan and sold it to an investor as quickly as possible. This model increased the principal-agent problem since the originator had little concern whether the loan was actually paid off. MORTGAGE INTEREST RATES The interest rate on the loan is determined by three factors: 1. Market rates. Long-term market rates are determined by the supply of and demand for long-term funds, which are in turn influenced by a number of global, national, and regional factors. 2. Term. Longer-term mortgages have higher interest rates than shorter-term mortgages. The usual mortgage lifetime is either 15 or 30 years. 3. Discount points. Discount points are interest payments made at the beginning of a loan. A loan with one discount point means that the borrower pays 1% of the loan amount at closing, the moment when the borrower signs the loan paper and receives the proceeds of the loan. In exchange for the points, the lender reduces the interest rate on the loan. Typically, discount points should not be paid if the borrower will pay off the loan in five years or less. This breakeven point is not surprising since the average home sells every five years. LOAN TERMS Mortgage loan contracts contain many legal and financial terms, most of which protect the lender from financial loss. Collateral: one characteristic common to mortgage loans is the requirement that collateral, usually the real estate being financed, be pledged as security. The lending institutions will place a lien against the property, and this remains in effect until the loan is paid off. A lien is a public record that attaches to the title of the property, advising that the property is security for a loan, and it gives the lender the right to sell the property if the loan defaults. If you try to sell the property without paying off the loan, the lien would remain attached to the title or deed to the property. No one would buy it unless you paid off the loan. Until the 1970s, interest rates remained stable, and when fluctuations did occur, they tended to be small and short-lived. But in the 1970s, interest rates rose rapidly, along with inflation, and thrifts became the victims of interest-rate risk: the value of their fixed-rate mortgages loan portfolios fell. Another problem was that thrift institutions were restricted from nationwide branching by federal and state laws and were forbidden to lend outside of their normal lending territory, about 100 miles from their offices. When that region had economic problems, many of the loans would default at the same time. Loan servicing Many of the institutions making mortgage loans do not want to hold large portfolios of long-term securities. Commercial banks, thrifts, and most other loan originators do, however, make money through the fees that they earn by packaging loans for other investors to hold. Loan origination fees are typically 1% of the loan amount. Once a loan has been made, many lenders sell the loan to another investor. The borrower may not even be aware that the original lender transferred the loan. By selling the loan, the originator frees up funds that can be lent to another borrower, thereby generating additional fee income. Some of the originators also provide servicing of the loan. The loan-servicing agent collects payment from the borrower, passes the principal and interest on to the investor, keeps required records of the transaction, and maintains reserve accounts. Reserve accounts are established to permit the lender to make tax and insurance payments for the borrower because they protect the security of the loan. Loan- servicing agents usually earn 0.5% per year of the total loan amount for their efforts. In summary, there are three distinct elements to most mortgage loans: 1. The originator packages the loan for an investor. 2. The investor holds the loan. 3. The servicing agent handles the paperwork. One, two, or three different intermediaries may provide these functions for any particular loan. Mortgage loans are increasingly obtained from the Web. Secondary mortgage market To help spur the nation’s economic activity, the government established several agencies to buy mortgages. The Federal National Mortgage Association was set up to buy mortgages from thrifts so that these institutions could make more mortgage loans. At the same time, the Federal Housing Administration was established to insure certain mortgage contracts. This made it easier to sell the mortgages because the buyer did not have to be concerned with the borrower’s credit history or the value of the collateral. One advantage of the insured loans was that they were required to be written on a standard loan contract. As the secondary market for mortgage contracts took shape, a new intermediary, the mortgage bank, emerged. The mortgage bank originated the loans, funding them initially with its own capital. After a group of similar loans were made, they would be bundled and sold. Because of their size, they were able to capture economies of scale in loan origination and servicing. They were also able to bundle loans from different regions, which helped reduce their risk. The increased competition for loans among these intermediaries led to lower rates for borrowers. Securitization of mortgages Intermediaries still faced problems when trying to sell mortgages. The first was that mortgages are usually too small to be wholesale instruments. Many institutional investors do not want to deal in such small denominators. The second problem was that they were not standardized. That makes it difficult to bundle many mortgages together. Third, mortgage loans are costly to service. The lender must collect monthly payments, often pay property taxed and insurance premiums, and service reserve accounts. None of this is required if a bond is purchased. Finally, mortgages have unknown default risk. These problems inspired the creation of the mortgage-backed security, also known as a securitized mortgage. WHAT IS A MORTGAGE-BACKED SECURITY? An alternative to selling mortgages directly to investors is to create a new security secured by a large number of mortgages assembled into what is called a mortgage pool. A trustee, such as a bank, holds the mortgage pool, which serves as collateral for the new security. This process is called securitization. The most common type of mortgage-backed security is the mortgage pass-through, a security that has the borrower’s mortgage payments pass through the trustee before being disbursed to the investors in the mortgage pass-through. If borrowers prepay their loans, investors receive more principal than expected. The possibility that mortgages will prepay and force investors to seek alternative investments, usually with lower returns, is called prepayment risk. TYPES OF PASS-THROUGH SECURITIES Government national mortgage association (GNMA) pass-throughs: a variety of financial intermediaries, including commercial banks and mortgage companies, originate Ginnie Mae mortgages. Ginnie Mae aggregates these mortgages into a pool and issues pass-through securities that are collateralized by the interest and principal payments from the mortgages. Ginnie Mae also guarantees the pass-through securities against default. The usual minimum denomination for pass-through is $25,000. The minimum pool size is $1 million. Federal home loan mortgage corporation (FHLMC) pass-throughs: Freddie Mac purchases mortgages for its own account and issues pass-through securities similar to those issued by Ginnie Mae. Pass-through securities issued by Freddie Mac are called participation certificates (PCs). Freddie Mac pools are distinct from Ginnie Mae pools in that they contain conventional (nonguaranteed) mortgages, are not federally insured, contain mortgages with different rates, are larger and have a minimum denomination of $100,000. One innovation in the FHLMC pass-through market has been the collateralized mortgage obligation (CMO). CMOs are securities classified by when prepayment is likely to occur. These securities help reduce prepayment risk, which is a problem with other types of pass-through securities. CMOs backed by a particular mortgage pool are divided into tranches. When principal is repaid, the investors in the first tranche are paid first, then those in the second tranche, and so on. Investors choose a tranche that matches their maturity requirements. There is a distinct risk differential between tranches as well. Those paid off first are less likely to see a default than those paid off last. When an investor purchases a CMO, there are no guarantees about how long the investment will last. If interest rates fall significantly, many borrowers will pay off their mortgages early by refinancing at lower rates. Real estate mortgage investment conduits (REMICs) were authorized to allow originators to pass through all interest payment tax free. Private pass-throughs (PIPs): one mortgage market opportunity available to private institutions is for mortgages larger than the maximum size set by the government. These so-called jumbo mortgages are often bundled into pools to back private pass-throughs. SUBPRIME MORTGAGES AND CDOs Subprime loans are those made to borrowers who do not qualify for loans at the usual market rate of interest because of a poor credit rating or because the loan is larger than justified by their income. Before the securitized market made it easy to bundle and sell mortgages, if you did not meet the qualifications for one of the major mortgage agencies, you were unlikely to be able to buy a house. Once it became possible to sell bundles of loans to other investors, different rules emerged. These new rules gave rise to a new class of mortgage loans known as subprime mortgages. The growth of the subprime mortgage was in part fueled by the creation of the structured credit products such as the collateralized debt obligation (CDO), introduced as providing a source of funds for high-risk investments. A CDO is similar to the CMO, except that rather than slice the pool of securities by maturity as with the CMO, the CDO usually creates tranches based on risk class. When real estate values were rapidly increasing, borrowers could easily sell their property if they found themselves unable to make the payments. Once the real estate market cooled in 2006-07, it became difficult to sell property and many borrowers were forced into default and bankruptcy. Subprime lending was a leading cause of the financial crisis of 2007-08 and led to a global recession. THE REAL ESTATE BUBBLE People started noticing that quick and apparently easy money was to be made by buying real estate for the purpose of resale. The ability to obtain zero down loans allowed them to buy property easily and with little committed capital. They could then resell the property at a higher price. Zero-down loans along with underqualified borrowers led to speculative growth in home prices and a subsequent collapse when default rates and lack of real demand became public. CHAPTER 15 – THE FOREIGN EXCHANGE MARKET Foreign exchange market Most countries of the world have their own currencies. Trade between countries involves the mutual exchange of different currencies (or bank deposits denominated in different currencies). The trading of currencies and bank deposits denominated in particular currencies takes place in the foreign exchange market. These transactions determine the rates at which currencies are exchanged, which in turn determine the cost of purchasing foreign goods and financial assets. WHAT ARE FOREIGN EXCHANGE RATES? There are two kinds of exchange rate transactions. Spot transactions involve the immediate (two-days) exchange of bank deposits. Forward transactions involve the exchange of bank deposits at some specified future date. The spot exchange rate is the exchange rate for the spot transaction, and the forward exchange rate is the exchange rate for the forward transaction. When a currency increases in value, it experiences appreciation; when it falls in value and is worth fewer U.S. dollars, it undergoes depreciation. WHY ARE EXCHANGE RATES IMPORTANT? Exchange rates are important because they affect the relative price of domestic and foreign goods. When a country’s currency appreciates, the country’s goods abroad become more expensive and foreign goods in that country become cheaper (holding domestic prices constant in the two countries). Conversely, when a country’s currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive. Depreciation of a currency makes it easier for domestic manufacturers to sell their goods abroad and makes foreign goods less competitive in domestic markets. EQUILIBRIUM IN THE FOREIGN EXCHANGE MARKET Equilibrium occurs at point B, the intersection of the demand and supply curves. Suppose that the exchange rate is at 1.05 euros per dollar, which is higher than the equilibrium exchange rate of 1 euro per dollar. The quantity of dollar assets supplied is then greater than the quantity demanded, a condition of excess supply. Given that more people want to sell dollar assets than want to buy them, the value of the dollar will fall in value until it reaches the equilibrium exchange rate of 1 euro per dollar. Similarly, if the exchange rate is less than the equilibrium exchange rate at 0.95 euros per dollar, the quantity of dollar assets demanded will exceed the quantity supplied, a condition of excess demand. Given that more people want to buy dollar assets than want to sell them, the value of the dollar will rise until the dollar is again at the equilibrium exchange rate of 1 euro per dollar. Explaining changes in exchange rates We have simplified this analysis by assuming the amount of dollar assets is fixed: the supply curve is vertical at a given quantity and does not shift. We need to look at only those factors that shift the demand curve for dollar assets to explain how exchange rates change over time. SHIFTS IN THE DEMAND FOR DOMESTIC ASSETS Suppose you are an investor who is considering putting funds into domestic (dollar) assets. When a factor changes, holding all other variables constant, you would earn a higher or lower expected return on dollar assets versus foreign assets. This decision tells you whether you want to hold more or fewer dollar assets and thus whether the quantity demanded increases or decreases at each level of the exchange rate. If the relative expected return of dollar assets rises holding the current exchange rate constant, the demand curve shifts to the right. If the relative expected return falls, the demand curve shifts to the left. Domestic interest rate, iD: Suppose that dollar assets pay an interest rate of iD. An increase in the domestic interest rate iD shifts the demand curve for domestic assets, D, to the right and causes the domestic currency to appreciate (E↑). A decrease in the domestic interest rate iD shifts the demand curve for domestic assets, D, to the left and causes the domestic currency to depreciate (E↓). Foreign interest rate, iF: Suppose that the foreign asset pays an interest rate of iF. An increase in the foreign interest rate iF shifts the demand curve D to the left and causes the domestic currency to depreciate; a fall in the foreign interest rate iF shifts the demand curve D to the right and causes the domestic currency to appreciate. Changes in the expected future exchange rate, Ee t+1: A rise in the expected future exchange rate, Ee t+1, shift the demand curve to the right and causes an appreciation of the domestic currency. A fall in the expected future exchange rate, Ee t+1, shifts the demand curve to the left and causes a depreciation of the currency. Earlier we discussed the determinants of the exchange rate in the long run: these four factors influence the expected future exchange rate. 1. When the expected price level is higher, the value of the dollar will fall in the future. The expected return on dollar assets thus falls, the quantity demanded declines, the demand curve shifts to the left, and the exchange rate falls. 2. With higher expected trade barriers, the value of the dollar is higher in the long run and the expected return on dollar assets is higher. The quantity demanded of dollar assets thus rises, the demand curve shifts to the right, and the exchange rate rises. 3. Then expected import demand rises, we expect the exchange rate to depreciate in the long run, so the expected return on dollar assets falls. The quantity demanded of dollar assets falls, the demand curve shifts to the left, and the exchange rate declines. 4. When expected export demand rises, the exchange rate is expected to appreciate in the long run. The expected return on dollar assets rises, the demand curve shifts to the right, and the exchange rate rises. 5. With higher expected domestic productivity, the exchange rate is expected to appreciate in the long run, so the expected return on domestic assets rises. The quantity demanded rises, the demand curve shifts to the right, and the exchange rate rises. EFFECT OF CHANGES IN INTEREST RATES ON THE EQUILIBRIUM EXCHANGE RATE When domestic real interest rates rise, the domestic currency appreciates. When domestic interest rates rise due to an expected increase in inflation, the domestic currency depreciates. Because a rise in domestic expected inflation leads to a decline in expected dollar appreciation that is larger than the increase in the domestic interest rate, the relative expected return on domestic (dollar) assets falls. The demand curve shifts to the left, and the equilibrium exchange rate falls from E1 to E2. APPENDIX TO CHAPTER 5 – THE INTEREST PARITY CONDITION Comparing expected returns on domestic and foreign assets Suppose that dollar assets pay an interest rate of iD and do not have any possible capital gains, so that they have an expected return payable in dollars of iD. Similarly, foreign assets have an interest rate of iF and an expected return payable in the foreign currency, euros, of iF. To compare the expected returns on dollar assets and foreign assets, investors must convert the returns into the currency unit they use. First let us examine: when François considers the expected return on dollar assets in terms of euros, he recognizes that it does not equal iD; instead, the expected return must be adjusted for any expected appreciation or depreciation of the dollar. Writing the current exchange rate as Et and the expected exchange rate for the nex period as Ee t+1, the expected rate of appreciation of the dollar is (Ee t+1 – Et)/Et. The expected return on dollar assets RD in terms of foreign currency can be written as: RD in terms of euros = iD + Et+1 e − Et Et However, François’ expected return on foreign assets RF in terms of euros is just iF. Thus, in terms of euros, the relative expected return on dollar assets is calculated as: Relative RD = iD − iF + Et+1 e − Et Et As the relative expected return on dollar assets increases, foreigners will want to hold more dollar assets and fewer foreign assets. Next let us look at the decision to hold dollar assets versus euro assets from Al, the American’s point of view. We know that the expected return on foreign assets RF in terms of dollars is: RF in terms of dollars = iF − Et+1 e − Et Et Al’s expected return on the dollar assets RD in terms of dollars is just iD. Hence, in terms of dollars, the relative expected return on dollar assets is calculated as: 𝑅𝑒𝑙𝑎𝑡𝑖𝑣𝑒 𝑅𝐷 = 𝑖𝐷 − (𝑖𝐹 − Et+1 e − Et Et ) = 𝑖𝐷 − 𝑖𝐹 + Et+1 e − Et Et The key point here is that the relative expected return on dollar assets is the same – whether it is calculated by François in terms of euros of by Al in terms of dollars. Thus, as the relative expected return on dollar assets increases, both foreigners and domestic residents respond in the same way – both will want to hold more dollar assets and fewer foreign assets. Interest parity condition We currently live in a world in which there is capital mobility: foreigners can easily purchase American assets, and Americans can easily purchase foreign assets. If there are few impediments to capital mobility and we are looking at assets that have similar risk and liquidity, then the assets are perfect substitutes. When capital is mobile and when assets are perfect substitutes, if the expected return on dollar assets is above that on foreign assets, both foreigners and Americans will want to hold only dollar assets and will be unwilling to hold foreign assets. Conversely, if the expected return on foreign assets is higher than on dollar assets, both foreigners and Americans will not want to hold any dollar assets and will want to hold only foreign assets. For existing supplies of both dollar assets and foreign assets to be held, it must be true that there is no difference in their expected returns; that is, the relative expected return must equal zero. This condition can be rewritten as: iD = iF − Et+1 e − Et Et Exchange rate regimes in the international financial system Exchange rate regimes in the international financial system are classified into two basic types: fixed and floating. In a fixed exchange rate regime, the value of a currency is pegged relative to the value of one other currency (called the anchor currency) so that the exchange rate is fixed in terms of the anchor currency. In a floating exchange rate regime, the value of a currency can fluctuate against all other currencies. When countries intervene in foreign exchange markets to influence their exchange rates by buying and selling foreign assets, the regime is referred to as a managed float regime (or a dirty float). FIXED EXCHANGE RATE REGIMES After World War II, the victors set up a fixed exchange rate system that became known as the Bretton Woods system, which remained in effect until 1971. The Bretton Woods agreement created the International Monetary Fund (IMF), headquartered in Washington D.C. The IMF was given the task of promoting the growth of world trade by setting rules for the maintenance of fixed exchange rates and by making loans to countries that were experiencing balance-of-payments difficulties. The IMF also took on the job of collecting and standardizing international economic data. The Bretton Woods agreement also set up the International Bank for Reconstruction and Development, referred to as the World Bank. It provides long-term loans to help developing physical capital that would contribute to their economic development. The funds for these loans are obtained by issuing World Bank bonds, which are sold in the capital markets of the developed countries. In addition, the General Agreement on Tariffs and Trade (GATT, Switzerland) was set up to monitor rules for the conduct of trade between countries. The GATT has since evolved into the World Trade Organization (WTO). Because the U.S. emerged from World War II as the world’s largest economic power, the Bretton Woods system of fixed exchange rates was based on the convertibility of U.S. dollars into gold at $35 per ounce. The fixed exchange rates were to be maintained by intervention in the foreign exchange market by central banks in countries besides the U.S. that bought and sold dollar assets, which they held as international reserves. The U.S. dollar, which was used by other countries to denominate the assets that they held as international reserves, was called the reserve currency. Even after the breakup of the Bretton Woods system, the U.S. dollar has kept its position as the reserve currency in which most international financial transactions are conducted. The fixed exchange rate was finally abandoned in 1973. From 1979 to 1990 the European Union instituted its own fixed exchange rate system, the European Monetary System (EMS). HOW A FIXED EXCHANGE RATE REGIME WORKS In panel (a), the exchange rate at Epar is overvalued. To keep the exchange rate at Epar (point 2), the central bank must purchase domestic currency to shift the demand curve to D2. In panel (b), the exchange rate at Epar is undervalued, so the central bank must sell domestic currency to shift the demand curve to D2 and keep the exchange rate at Epar (point 2). When the domestic currency is overvalued, the central bank must purchase domestic currency to keep the exchange rate fixed, but as a result it loses international reserves. When the domestic currency is undervalued, the central bank must sell domestic currency to keep the exchange rate fixed, but as a result, it gains international reserves. Devaluation and revaluation: if a country’s currency is overvalued: if the country’s central bank runs out of international reserves, it cannot keep its currency from depreciating, and a devaluation must occur, in which the par exchange rate is reset at a lower level. If a country’s currency is undervalued: the central bank might not want to acquire these international reserves, and so it might want to reset the par value of its exchange rate at a higher level (a revaluation). Perfect capital mobility: if perfect capital mobility exists then a sterilized exchange rate intervention cannot keep the exchange rate at Epar because the relative expected return of domestic assets is unaffected. THE POLICY TRILEMMA A country (or a currency union like the Eurozone) can’t pursue the following three policies at the same time: (1) free capital mobility, (2) a fixed exchange rate, and (3) an independent monetary policy. Economists call this result the policy trilemma (or the impossible trinity). A country can choose only two of the three options. In option 1, a country chooses to have capital mobility and an independent monetary policy but not a fixed exchange rate. The Eurozone and the U.S. have made this choice. Hong Kong and Belize have chosen option 2, in which there is free capital mobility and the exchange rate is fixed, so the country does not have an independent monetary policy. Other countries, like China, have chosen option 3, in which they have a fixed exchange rate and pursue an independent monetary policy but do not have free capital mobility because they have capital controls, restrictions on the free movement of capital across the borders. MONETARY UNIONS A variant of a fixed exchange rate regime is a monetary union (or currency union) in which a group of countries decide to adopt a common currency, thereby fixing their exchange rates vis à vis each other. The key advantage is that it makes trade across borders easier because goods and services in all the member countries are now priced in the same currency. The disadvantage is that a currency union means that individual countries no longer have their own independent monetary policy to deal with shortfalls of aggregate demand. CURRENCY BOARDS AND DOLLARIZATION Smaller countries are often willing to tie their exchange rate to that of a larger country in order to inherit the more disciplined monetary policy of their bigger neighbor, thus ensuring a low inflation rate. An example of such a strategy is the currency board, in which the domestic currency is backed 100% by a foreign currency and in which the note-issuing authority establishes a fixed exchange rate to this foreign currency and stands ready to exchange domestic currency for the foreign currency at this rate whenever the public requests it. An even more extreme strategy is dollarization, in which a country abandons its currency and adopts that of another country, typically the U.S. dollar. SPECULATIVE ATTACKS A shortcoming of fixed exchange rate systems is that they can lead to foreign exchange crises involving a speculative attack on a currency – massive sales of a weak currency or purchases of a strong currency that cause a sharp change in the exchange rate. MANAGED FLOAT Although most exchange rates are allowed to change daily in response to market forces, many central banks have not been willing to give up their option of intervening in the foreign exchange market. Preventing large changes in exchange rates makes it easier for firms and individuals purchasing or selling goods abroad to plan into the future. Countries with surpluses in their balance of payments do not want to see their currencies appreciate because it makes their goods more expensive abroad and foreign goods cheaper in their country. Surplus countries have often sold their currency in the foreign exchange market and acquired international reserves. Countries with balance-of-payments deficits do not want to see their currency lose value because it makes foreign goods more expensive for domestic consumers and can stimulate inflation. Deficit countries have often bought their own currency in the foreign exchange market and given up international reserves. Capital controls CONTROL ON CAPITAL OUTFLOWS Capital outflows can promote financial instability in emerging market countries because when domestic residents and foreigners pull their capital out of a country, the resulting capital outflow forces a country to devalue its currency. This risk is why some politicians in emerging market countries have found capital controls attractive. These controls suffer from disadvantages. First, controls on capital outflows are seldom effective during a crisis because the private sector finds ingenious ways to evade them and has little difficulty moving funds out of the country. Second, the evidence suggests that capital flight may even increase after controls are put into place because confidence in the government is weakened. Thirds, controls on capital outflows often lead to corruption, as government officials get bribed to look the other way when domestic residents are trying to move funds abroad. Fourth, controls on capital outflows may lull governments into thinking they do not have to take the steps to reform their financial systems to deal with the crisis, with the result that opportunities to improve the functioning of the economy are lost. CONTROLS ON CAPITAL INFLOWS Capital inflows can lead to a lending boom and excessive risk taking on the part of banks, which then helps trigger a financial crisis. However, controls on capital inflows may block those funds from entering a country that would be used for productive investment opportunities. Although such controls may limit the fuel supplied to lending booms through capital flows, over time they produce distortions and misallocation of resources as households and businesses try to get around them. Indeed, controls on capital inflows can lead to corruption. The role of the IMF The International Monetary Fund was originally set up under the Bretton Woods system to help countries deal with balance-of-payments problems and stay with the fixed exchange rates by lending to deficit countries. When the Bretton Woods system of fixed exchange rates collapsed in 1971, the IMF took on new roles. Its role as an international lender first came to the fore in the 1980s during the Third World debt crisis, in which the IMF assisted developing countries in repaying their loans. The financial crises in Mexico and in East Asia led to huge loans by the IMF to these and other affected countries to help them recover from their financial crises and to prevent the spread of these crises to other countries. Then starting in 2010, the IMF made large loans to Greece, Ireland, and Portugal to help them avoid a default on their government debt. SHOULD THE IMF BE AN INTERNATIONAL LENDER OF LAST RESORT? In large industrialized countries when a financial crisis occurs, domestic central banks can address matters with a lender-of-last-resort operation to limit the degree of instability in the banking system. In emerging market countries, where the credibility of the central bank as an inflation fighter may be in doubt and debt contracts are short-term and denominated in foreign currencies, a lender-of-last-resort operation becomes a double-edged sword. However, central bank lending to the financial system in the wake of a financial crisis may well arouse fears of inflation spiraling out of control, causing a greater currency depreciation and still greater deterioration of balance sheets. The resulting increase in moral hazard and adverse selection problems in financial markets would only worsen financial crisis.