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

Scarica Financial Markets and Institutions - DREASSI e più Appunti in PDF di Economia E Tecnica Dei Mercati Finanziari solo su Docsity! 1 Financial Markets and Institutions Summary PART ONE INTRODUCTION ........................................................................................................................................... 2 CHAPTER I – WHY STUDY FINANCIAL MARKETS AND INSTITUTIONS? ........................................................................ 2 CHAPTER II – OVERVIEW OF THE FINANCIAL SYSTEM ............................................................................................... 3 PART TWO FUNDAMENTALS OF FINANCIAL MARKETS ....................................................................................... 11 CHAPTER III / IV / V – INTEREST RATES .......................................................................................................... 11 CHAPTER VI – ARE FINANCIAL MARKETS EFFICIENT? ............................................................................................ 22 PART THREE FUNDAMENTALS OF FINANCIAL INSTITUTIONS ...................................................................... 28 CHAPTER VII – WHY DO FINANCIAL INSTITUTIONS EXIST? .................................................................................. 28 CHAPTER VIII – WHY DO FINANCIAL CRISIS OCCUR AND WHY ARE THEY SO DAMAGING TO THE ECONOMY? ..... 39 PART FOUR CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY ............................................ 49 CHAPTER XIX – CENTRAL BANKS AND THE FEDERAL RESERVE SYSTEM ................................................................... 49 CHAPTER X – CONDUCT OF MONETARY POLICY: TOOLS, GOALS, STRATEGY AND TATICS .................................... 58 PART FIVE FINANCIAL MARKETS ........................................................................................................................... 70 CHAPTER XI – THE MONEY MARKET ............................................................................................................................ 70 CHAPTER XII – THE BOND MARKET ........................................................................................................................... 76 CHAPTER XIII – THE STOCK MARKET ....................................................................................................................... 84 CHAPTER XIV – THE MORTGAGE MARKET .................................................................................................................... 89 CHAPTER XV – THE FOREIGN EXCHANGE MARKET ...................................................................................................... 96 PART SIX THE FINANCIAL INSTITUTIONS INDUSTRY ................................................................................ 107 CHAPTER XVII – BANKING AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS ............................................... 107 CHAPTER XX – MUTUAL FUNDS .................................................................................................................................. 120 CHAPTER XXI – INSURANCE COMPANIES AND PENSION FUNDS ............................................................................... 125 CHAPTER XXII – INVESTMENT BANKS, SECURITY BROKERS AND DEALERS AND VENTURE CAPITAL FIRMS ....... 134 PART SEVEN THE MANAGEMENT OF FINANCIAL INSTITUTIONS ............................................................... 139 CHAPTER XXIII – RISK MANAGEMENT IN FINANCIAL INSTITUTIONS .................................................................. 139 CHAPTER XXIV – HEDGING WITH FINANCIAL DERIVATIVES .................................................................................. 140 2 PART ONE Introduction Chapter I – Why study Financial Markets and Institutions? Financial markets, markets in which funds are transferred from people who have an excess of available funds to people who have a shortage. Financial markets, such as bond and stock markets, are crucial to promoting greater economic efficiency by channeling funds from people who do not have a productive use for them to those who do. A security (also called a financial instrument) is a claim on the issuer’s future income or assets (any financial claim or piece of property that is subject to owner- ship). A bond is a debt security that promises to make payments periodically for a specified period of time. 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). Many types of interest rates are found in the economy—mortgage interest rates, car loan rates, and interest rates on many types of bonds. A common stock (typically just called a 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, in which claims on the earnings of corporations (shares of stock) are traded, is the most widely followed financial market in almost every country that has one; that’s why it is often called simply “the 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. The financial system is complex, comprising many types of private-sector financial institutions, including banks, insurance companies, mutual funds, finance companies, and investment banks— all of which are heavily regulated by the government. You would lend to such companies 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. 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. Financial crises have been a feature of capitalist economies for hundreds of years and are typically followed by the worst business cycle downturns. From 2007 to 2009, the U.S. economy was hit by the worst financial crisis since the Great Depression. 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 Lehman Brothers, two 5 The primary markets for securities are not well known to the public because the selling of securities to initial buyers often takes place behind closed doors. An important financial institution that assists in the initial sale of securities in the pri- mary market is the investment bank. It does this by underwriting securities: It guarantees a price for a corporation’s securities and then sells them to the public. The New York Stock Exchange and NASDAQ (National Association of Securities Dealers Automated Quotation System), in which previously issued stocks are traded, are the best-known examples of secondary markets, Brokers are agents of investors who match buyers with sellers of securities; dealers link buyers and sellers by buying and selling securities at stated prices. When an individual buys a security in the secondary market, the person who has sold the security receives money in exchange for the security, but the corporation that issued the security acquires no new funds. A corporation acquires new funds only when its securities are first sold in the primary market. Nonetheless, secondary markets serve two important functions. First, they make it easier and quicker to sell these financial instruments to raise cash; that is, they make the financial instruments more liquid. The increased liquidity of these instruments then makes them more desirable and thus easier for the issuing firm to sell in the primary market. Second, they determine the price of the security that the issuing firm sells in the primary market. The investors who buy securities in the primary market will pay the issuing corporation no more than the price they think the secondary market will set for this security. The higher the security’s price in the secondary market, the higher the price that the issuing firm will receive for a new security in the primary market, and hence the greater the amount of financial capital it can raise. Secondary markets can be organized in two ways. One method is to organize exchanges, where buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades. The New York and American Stock Exchanges for stocks and the Chicago Board of Trade for commodities (wheat, corn, silver, and other raw materials) are examples of organized exchanges. The other method of organizing a secondary market is to have an over-the- counter (OTC) market, in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to them and is willing to accept their prices. Another way of distinguishing between markets is on the basis of the maturity of the securities traded in each market. The money market is a financial market in which only short-term debt instruments (generally those with original maturity of less than one year) are traded; the capital market is the market in which longer-term debt (generally with original maturity of one year or greater) and equity instruments are traded. 6 Internalization of Financial Markets The growing internationalization of financial markets has become an important trend. Before the 1980s, U.S. financial markets were much larger than those outside the United States, but in recent years the dominance of U.S. markets has been dis- appearing. The extraordinary growth of foreign financial markets has been the result of both large increases in the pool of savings in foreign countries such as Japan and the deregulation of foreign financial markets, which has enabled foreign markets to expand their activities. 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—for example, a bond denominated in U.S. dollars sold in London. Currently, over 80% of the new issues in the international bond market are Eurobonds, and the market for these securities has grown very rapidly. As a result, the Eurobond market is now larger than the U.S. corporate bond market. 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 or in foreign branches of U.S. banks. Because these short- term deposits earn interest, they are similar to short-term Eurobonds. World Stock Markets The U.S. stock market was by far the largest in the world, but foreign stock markets have been growing in importance, with the United States not always number one. The increased interest in foreign stocks has prompted the develop- ment in the United States of mutual funds that specialize in trading in foreign stock markets. American investors now pay attention not only to the Dow Jones Industrial Average but also to stock price indexes for foreign stock markets such as the Nikkei 300 Average (Tokyo) and the Financial Times Stock Exchange (FTSE) 100-Share Index (London). The internationalization of financial markets is also leading the way to a more integrated world economy in which flows of goods and technology between countries are more commonplace. Function of Financial Intermediaries: Indirect Finance As shown, funds also can 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-spenders 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 bor- rowers. Why are financial intermediaries and indirect finance so important in financial markets? To answer this question, we need to understand the role of transaction costs, risk sharing, and information costs in financial markets. 7 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 transaction increases. 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. This process of risk sharing is also sometimes referred to as asset transformation because, in a sense, risky assets are turned into safer assets for investors. 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. (Diversification is just another name for the old adage, “You shouldn’t put all your eggs in one basket.”) 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. 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 risks—are the ones who most actively seek out a loan and are thus most likely to be selected. Because adverse selection makes it more likely that loans might be made to bad credit risks, 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 lend- er’s point of view because they make it less likely that the loan will be paid back. The problems created by adverse selection and moral hazard are significant impediments to well- functioning financial markets. Again, financial intermediaries can alleviate these problems. 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 10 Regulation of the Financial System The government regulates financial markets for two main reasons: to increase the information available to investors and to ensure the soundness of the financial system. Increasing Information Available to Investors Asymmetric information in financial markets means that investors may be subject to adverse selection and moral hazard problems that may hinder the efficient operation of financial markets. Risky firms or outright crooks may be the most eager to sell securities to unwary investors, and the resulting adverse selection problem may keep investors out of financial markets. Government regulation can reduce adverse selection and moral hazard problems in financial markets and enhance the efficiency of the markets by increasing the amount of information available to investors. . The SEC requires corporations issuing securities to disclose certain informa- tion about their sales, assets, and earnings to the public and restricts trading by the largest stockholders (known as insiders) in the corporation. Ensuring the Soundness of Financial Intermediaries Asymmetric information can lead to the widespread collapse of financial intermedi- aries, referred to as a financial panic. - Restrictions on Entry: the banking and insurance commissions, as well as the Office of the Comptroller of the Currency (an agency of the federal government), have created tight regulations governing who is allowed to set up a financial intermediary. Only if they are upstanding citizens with impeccable credentials and a large amount of initial funds will they be given a charter. - Disclosure: Their bookkeeping must follow certain strict principles, their books are subject to periodic inspection - Restrictions on Assets and Activities: Financial intermediaries are restricted in what they are allowed to do and what assets they can hold. - Deposit insurance: The government can insure people’s deposits so that they do not suffer great financial loss if the financial intermediary that holds these depos- its should fail. - Limits on Competition: Politicians have often declared that unbridled competition among financial intermediaries promotes failures that will harm the public. State and federal governments at times have imposed restrictions on the opening of additional locations (branches). In the past, banks were not allowed to open up branches in other states, and in some states, banks were restricted from opening branches in additional locations. - Restrictions on Interest Rates: These regulations were instituted because of the widespread belief that unrestricted interest-rate competition had contributed to bank failures during the Great Depression. Later evidence does not seem to support this view, and Regulation Q has been abolished Financial Regulation Abroad Not surprisingly, given the similarity of the economic system here and in Japan, Canada, and the nations of western Europe, financial regulation in these countries is similar to that in the United States. The major differences between financial regulation in the United States and abroad relate to 11 bank regulation. In the past, the United States was the only industrialized country to subject banks to restrictions on branching, which limited their size and confined them to certain geographic regions. (These restrictions were abolished by legislation in 1994.) U.S. banks are also the most restricted in the range of assets they may hold. Banks abroad frequently hold shares in commercial firms; in Japan and Germany, those stakes can be sizable. PART TWO Fundamentals of Financial Markets Chapter III / IV / V – Interest Rates Interest rates are among the most closely watched variables in the economy. Their movements are reported almost daily by the news media because they directly affect our everyday lives and have important consequences for the health of the economy. Types of credit market instruments In terms of the timing of their cash flows, there are four basic types of credit market instruments 1. Simple/Balloon loan: the lender provides the borrower with an amount of funds, which must be repaid to the lender at the maturity date along with an additional payment for the interest. In other words, the principal is repaid entirely at maturity with interests 2. Fixed-payment (fully amortized) loan: 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), consisting of part of the principal and interest for a set number of years. In other words, the repayment occurs periodically and represents interests and a portion of principal. 3. 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. In other words, repayments of interests occur periodically, whereas principal (face/par/nominal value) is repaid entirely at maturity. 4. Discount (zero-coupon) bond: no coupons are paid, therefore the present (purchase) value is under its face value, that is repaid entirely at maturity date. These four types of instruments require payments at different times: Simple loans and discount bonds make payment only at their maturity dates, whereas fixed- payment loans and coupon bonds have payments periodically until maturity. Simple loans and Discount bonds: short period of times (1y or less) Coupon bonds and Fixed payment loans: used for greater maturities Fixed payment loan: typical way a bank gives a loan Variations: exist to adapt to different financial needs Measuring Interest Rates Different debt instruments have very different streams of cash payments to the holder (known as cash flows), with very different timing. Used to compare different bond instruments. 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. The concept of present value (or 12 present discounted value) is based on the commonsense notion that a dollar of cash flow paid to you one year from now is less valuable to you than a dollar paid to you today. The yield to maturity has some limitations (not working properly in all circumstances) but is quick and easy to use à Find the interest rate that balances the present value of all future cash flow of the instrument with its current value, and compare it to the IR of the bank. For simple loans, the YTM equals the simple IR = For Fixed-payment loans = For coupon bonds = The bigger the YTM the smaller the present value (Price): a high interest rate means a high risk (= if you want to attract somebody to buy you have to reduce the Price). When interest rates go up the value of the bond goes down. The table shows the yields to maturity calculated for several bond prices. Three interesting facts emerge: 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; that is, 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. Summary The concept of present value tells you that a dollar in the future is not as valuable to you as a dollar today because you can earn interest on this dollar. Specifically, a dollar received n years from now is worth only $1>(1 + i) today. The present value of a set of future cash flows on a debt instrument equals the sum of the present values of each of the future cash flows. The yield to maturity for an instrument is the interest rate that equates the present value of the future cash flows on that instrument to its value today. Because the procedure for calculating the yield to maturity is based on sound economic principles, this is the measure that financial economists think most accurately describes the interest rate. 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. 15 RoR = return from holding the bond from time t to time t + 1 Pt = price of the bond at time t Pt+1 = price of the bond at time t + 1 C = coupon interest (ic= Interest gain) ( Pt+1 - Pt ) capital gain The price of a bond is strictly connected to the market IR. Interest rate risk affects the value of bonds directly, and it is a major risk to all bondholders. As interest rates rise, bond prices fall, and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases, since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. For example, a 5% bond is worth more if interest rates decrease, since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates. Increasing IR produces capital losses, decreasing IR produces gains. Despite capital gains and losses are unrealized, they represent missed opportunities to earn greater rates of return (opportunity cost) or signals that you might lose your money (greek bonds). Furthermore: 1. if an investor buys a a five-year bond that costs $500 with a 3 percent coupon, interest rates may rise to 4%. In that case, the investor may have difficulty selling the bond when others enter the market with more attractive rates. Older bonds look less attractive as newly issued bonds carry higher coupon rates as well. Further, lower demand may cause lower prices on the secondary market, and the investor is likely to get less for the bond on the market than he paid for it. 2. Suppose there are two fixed-income securities, one maturing in one year and the other in 10 years. When market interest rates rise, holders of the one-year security could quickly reinvest in a higher-rate security after having a lower return for only one year. Holders of the 10-year security would be stuck with a lower rate for 9 more years, justifying a comparably lower security value than shorter-term securities to attract willing buyers. The longer a security's maturity, the more its price declines to a given increase in interest rates à leverage effect If holding period equals time to maturity, return equals yield to maturity only for ZCs (no coupon, only get capital gain). In any other instrument, when you get a coupon, you bear Reinvestment Risk; that occurs because the proceeds from the bond need to be reinvested at a future interest rate that is uncertain. (Nevertheless having coupon around the way reduces other risks more important than reinvestment risk.) Duration YTM gives an idea of your return but you have to consider it IR Risk à Duration measure of risk (idea: find a balance way to weight the cashflows during time), that helps to measure the weight average lifetime of debt instruments’ cashflows. t = years until cash payment is made CFt = cash payment (interest plus principal) at time t 16 i = interest rate n = years to maturity of the security The duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received. When the price of an asset is considered as a function of yield, duration also measures the price sensitivity to yield, the rate of change of price with respect to yield or the percentage change in price for a parallel shift in yields. Macaulay duration is the name given to the weighted average time until cash flows are received, and is measured in years. Transform each instrument into a ZC (each CF is a ZC) and calculate the PV The later you have the cashflow or the bigger the CF, the bigger duration, grater the risk derived by. Increases in interest rates decrease duration. For small changes in IR, duration is a good proxy of interest rate risk: There is a correct proportion between the change in price of the bond and the duration of the bond. If IR goes up, the price of the bond goes down more or less due to the convexity of the price/ yield curve. The duration represents the slope coefficient of the segment that touches such curve in the point of intersection of price and interest.For high IR, the duration underestimates the increase/fall in price connected to an increase/fall of IR Demand and Supply of Assets Demand of assets: 1. Holding everything else constant, an increase in wealth raises the quantity demanded of an asset. 2. When we make a decision to buy an asset, we are influenced by what we expect the return on that asset to be. 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+...pnRn). 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. 3. Lower expected interest rates in the future increase the demand for long-term bonds and shift the demand curve to the right. 4. 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. 17 5. Holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall. 6. The more liquid (it could be sold fast, it’s easy to find a buyer for it) an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is, and the greater will be the quantity demanded. Supply of assets: 1. The more profitable plant and equipment investments that a firm expects it can make, the more willing it will be to borrow to finance these investments. When the economy is growing rapidly, as in a business cycle expansion, investment opportunities that are expected to be profitable abound, and the quantity of bonds supplied at any given bond price will increase. 2. 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. For a given interest rate (and bond price), when expected inflation increases, the real cost of borrowing falls; hence the quantity of bonds supplied increases at any given bond price. 3. Higher government deficits increase the supply of bonds and shift the supply curve to the right. 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. Reasons for changes in interest rates: Bonds’ demand: 
 (+) Wealth owned by an individual
 (+) Expected return relative to other assets
 (–) Expected future interest rates
 (–) Expected future inflation
 (–) Risk (uncertainty in return) relative to other assets
 (+) Liquidity relative to other assets Bonds’ supply:
 (+) Profitability of investments made with loan proceedings
 (+) Expected inflation, leading to cheaper borrowing
 (+) Government deficits, leading to greater issues of public debt Inflation case An increase in expected inflation affects simultaneously demand (decrease of expected return) and supply (cheaper borrowing). Furthermore, it will produce and increase of interest rates, and, for such reason, a decrease in the price of a bond. Nevertheless, the effect on quantity (demanded and produced) is not readily predictable. 20 Furthermore, 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. IR Term Structure Another factor that influences the interest rate 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. Typically: short term IR are low and long term IR are high but distance is not constant and changes along time. Sometimes they are all close to each other [2007/2008: connection between expansion and depression and the level of IR - volatility of long term IR is smaller than short term IR - different range of variationà the interest rate move first and this tend to a financial crisis (if they are high)] Why if one IR changes the other follows? The expectations theory of the term structure states the following commonsense proposition: The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond. The key assumption behind this theory is that buyers of bonds do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. Bonds that have this characteristic are said to be perfect substitutes. What this means in practice is that if bonds with different maturities are perfect substitutes, the expected return on these bonds must be equal. When the yield curve slopes downward, the average of future short-term interest rates is expected to be lower than the current short-term rate, implying that short-term interest rates are expected to fall, on average, in the future. Only when the yield curve is flat does the expectations theory suggest that short-term interest rates are not expected to change, on average, in the future. The market segmentation theory of the term structure sees markets for different-maturity bonds as completely separate and segmented. The interest rate for each bond with a different maturity is 21 then determined by the supply of and demand for that bond, with no effects from expected returns on other bonds with other maturities. The argument for why bonds of different maturities are not substitutes is that investors have strong preferences for bonds of one maturity but not for another, so they will be concerned with the expected returns only for bonds of the maturity they prefer. This might occur because they have a particular holding period in mind, and if they match the maturity of the bond to the desired holding period, they can obtain a certain return with no risk at all. Together with interest-rate risk aversion, explains why longer investments require a risk premium 
 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 (also referred to as a 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, which means that the expected return on one bond does influence the expected return on a bond of a different maturity, but it allows investors to prefer one bond maturity over another. In other words, bonds of different maturities are assumed to be substitutes but not perfect substitutes. Investors tend to prefer shorter-term bonds because these bonds bear less interest-rate risk. For these reasons, investors must be offered a positive liquidity premium to induce them to hold longer- term bonds. LP equation: Any interest rate is the average of all future IR and consider a liquidity premium that is not fixed but is the result of technology, quantity of supply and demand etc. short term interest rates increasing due to some reasons (quickly increasing because more reactive to news). At certain point, when they’re quite high (they touch the long term ones), this means that you expect them to fall quickly and you immediately adapt your liquidity preferences for the future (prefer liquidity and reduce short term IR). Interest rates on different-maturity bonds move together over time: A rise in short-term interest rates indicates that short-term interest rates will, on average, be higher in the future, and the first term in LP equation then implies that long-term interest rates will rise along with them. They also explain 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. Because investors generally expect short-term interest rates to rise to some normal level when they are low, the average of future expected short-term rates will be high relative to the current short-term rate. With the additional boost of a positive liquidity premium, long-term interest rates will be substantially higher than current short-term rates, and the yield curve will then have a steep upward slope. Conversely, if short-term rates are high, people usually expect them to come back 22 down. Long-term rates will then drop below short-term rates because the average of expected future short-term rates will be so far below current short-term rates that despite positive liquidity premiums, the yield curve will slope downward. The liquidity premium 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. Chapter VI – Are Financial Markets Efficient? Throughout our discussion of how financial markets work, you may have noticed that the subject of expectations keeps cropping up. Expectations of returns, risk, and liquidity are central elements in the demand for assets; expectations of inflation have a major impact on bond prices and interest rates; expectations about the likelihood of default are the most important factor that determines the risk structure of interest rates; and expectations of future short-term interest rates play a central role in determining the term structure of interest rates. To determine whether a company is efficient or not, we have to answer two main questions: 1) Are companies able to achieve their predefined objectives?
 2) Are they good at what they do? 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 (also referred to as the theory of efficient capital markets), which states that prices of securities in financial markets fully reflect all available information. this would mean that it would be impossible to "beat the market" consistently on a risk-adjusted basis, since market prices should only react to new information. Unfortunately, no proof is given if this theory is either true or false, but there is just evidence supporting both cases. The branch of Economics dealing with the EMH is called Behavioural Finance. The rationale behind the EMH includes assumptions such as: Þ If the market is efficient, then the change in price is the only thing that matters, because prices reflect all available information Þ The sum of all expectations is the best forecast, providing efficiency through consistent buying/selling decisions Þ Arbitrage occurs when market participants find price discrepancies and eliminate them: this is an example of a critical mass moving prices and money There exist different forms of efficiency: • Allocative: money is given to operators with high expected utility, who make sure that funds are transferred achieving the best total utility • Informative: the market cannot be beaten, because it is formed by joint efforts of operators • Technical: transferring funds implies some difficulties that reduce overall efficiency 25 sense because it does not require everyone in a market to be cognizant of what is happening to every security. Evidence in Favor of EMH • Somebody tested the EMH: investment analysts, technical analysts, mutual fund managers do not perform better than randomly selected assets • Past good performances do not support good performances in the future. When you relate past performance with future one you find there’s no relation. Having performed well in the past does not indicate that an investment adviser ot a mutual fund will perform well in the future. • Positive announcements on publicly available info do not influence assets’ performance. If markets are efficient they were able to predict the price before it is announced publicly • Extremely good performances across time are always linked with illegal actions, such as insider trading, private info or market influence (warren buffet à influence by having a lot of money) • Stock prices can be described following a random walk model (the movements of variable cannot be predicted, because given today’s value, the variable is just as likely to fall as to rise) – future changes in stock prices should, for all practical purposes, be unpredictable. The efficient market hypothesis suggests that the predictable change in stock prices will be near zero, leading to the conclusion that stock prices will generally follow a random walk. • A popular technique used to predict stock prices, called technical analysis, is to study past stock price data and search for patterns such as trends and regular cycles. the empirical analysis described earlier to evaluate the performance of any financial analyst, technical or otherwise. Technical analysts fare no better than other financial analysts; on average, they do not outperform the market, and successful past fore- casting does not imply that their forecasts will outperform the market in the future. The performance of these rules is then evaluated by the profits that would have been made using them. These tests also discredit technical analysis: It does not outperform the overall market. Evidence Against Market Efficiency All the early evidence supporting the efficient market hypothesis appeared to be over- whelming. However, in recent years, the theory has begun to show a few cracks, referred to as anomalies, and empirical evidence indicates that the efficient market hypothesis may not always be generally applicable. • Small firms have higher returns in long run than buffer firms (but are riskier). Why? Small firms imply more transaction costs, fewer stocks available and less liquid assets, so there are higher liquidity risk; tax effects à multinational firms use different tax systems; portfolio rebalancing of investors • An abnormal price rise from December to January that is predictable and hence inconsistent with random-walk behavior. This so-called January effect. January effect is due to tax issues. Investors have an incentive to sell stocks before the end of the year in December because they can then take capital losses on their tax return and reduce their tax liability. Then when the new year starts in January, they can repur- chase the stocks, driving up their prices and producing abnormally high returns. Although this explanation seems sensible, it does not explain why institutional inves- tors such as private pension 26 funds, which are not subject to income taxes, do not take advantage of the abnormal returns in January and buy stocks in December, thus bidding up their price and eliminating the abnormal returns. • Market overreaction to new bad unexpected information, slow adjustments to correct prices later or with new data. This violates the efficient market hypothesis because an investor could earn abnormally high returns, on average, by buying a stock immediately after a poor earnings announcement and then selling it after a couple of weeks when it has risen back to normal levels • Market volatility (variance of returns) is much bigger than the changes of fundamentals (dividends) • Those that had lower performance in the past will have high performance in the future; nevertheless there is a mean in the market (mean reversion) à trend that everybody in the longer term follows Do Stock Prices Always Rise When There is Good News? Stock prices will respond to announce- ments only when the information being announced is new and unexpected. If the news is expected, there will be no stock price response. This is exactly what the evidence that we described earlier suggests will occur—that stock prices reflect publicly available information. Efficient Markets Prescription for the Investor The efficient market hypothesis leads to the conclusion that such an investor (and almost all of us fit into this category) should not try to outguess the market by constantly buying and selling securities. This process does nothing but boost the income of brokers, who earn commissions on each trade. Instead, the investor should pursue a “buy and hold” strategy—purchase stocks and hold them for long periods of time. This will lead to the same returns, on average, but the investor’s net profits will be higher because fewer brokerage commissions will have to be paid. Why the Efficient Market Hypothesis Does Not Imply that Financial Markets are Efficient? The presence of markets boom, market crashes and market bubbles and specific investor’s good tracks are not necessarily inconsistent with EMH. Many financial economists also add the condition that prices in financial markets reflect the true fundamental (intrinsic) value of the securities. In other words, all prices are always correct and reflect market fundamentals (items that have a direct impact on future income streams of the securities) and so financial markets are efficient. First, it implies that in an efficient capital market, one investment is as good as any other because the securities’ prices are correct. Second, it implies that a security’s price reflects all available information about the intrinsic value of the security. Third, it implies that security prices can be used by managers of both financial and nonfinancial firms to assess their cost of capital (cost of financing their investments) accurately and hence that security prices can be used to help them make the correct decisions about whether a specific investment is worth making. Indeed, as the following application suggests, the existence of market crashes and bubbles, in which the prices of assets rise well above their fundamental values, cast serious doubt on the stronger view that financial markets are efficient but provide less of an argument against the basic lessons of the efficient markets hypothesis. 27 The presence of markets boom, market crashes and market bubbles and specific investor’s good tracks are not necessarily inconsistent with EMH: • Unexpected new information with impact on fundamentals could be more than just increments (accounting frauds, unprecedented catastrophes) • Rational bubbles (asset that falls and then is declared as overvalued) —> even if an asset is overvalued, as long as the expectation of others being ready to pay higher prices in the future holds, investors will not sell it to adjust the market. The problem is that when expectation change, the fall down is harder. • Some institutional investors have good performance, however frequently they have private info (market research, predict inflation, predict IR etc), usually are very big and when they move they influence the market (this can move itself the price), or they are criminals. Behavioral Finance Doubts about the efficiency of financial markets, particularly after the stock market crash of 1987, led to a new field of study, behavioral finance, which applies concepts from other social sciences, such as anthropology, sociology, and particularly psychology, to understand the behavior of securities prices. As we have seen, the efficient market hypothesis assumes that unexploited profit opportunities are eliminated by “smart money.” Specifically, the efficient market hypothesis suggests that smart money sells when a stock price goes up irrationally. However, for this to occur, smart money must be able to engage in short sales, in which they borrow stock from brokers and then sell it in the market, with the hope that they earn a profit by buying the stock back again (“covering the short”) after it has fallen in price. Short sales can result in losses way in excess of an investor’s initial investment if the stock price climbs sharply above the price at which the short sale is made (and these losses have the possibility of being unlimited if the stock price climbs to astronomical heights). Loss aversion can thus explain an important phenomenon: Very little short selling actually takes place. The fact that there is so little short selling can explain why stock prices sometimes get overvalued. Not enough short selling can take place by smart money to drive stock prices back down to their fundamental value. Overconfidence and social contagion provide an explanation for stock market bubbles. When stock prices go up, investors attribute their profits to their intelligence and talk up the stock market. This word-of-mouth enthusiasm and the media then can produce an environment in which even more investors think stock prices will rise in the future. The result is then a so-called positive feedback loop in which prices continue to rise, producing a speculative bubble. So, some findings of behavioral finance are: - Short selling that happens in the area of losses and people are loss adverse, since the pain of a loss is greater than the happiness of a gain - Overconfidence of people, who think that they are able to beat the market - Herd behavior of people, who are prone to do what others do - Irrational optimism - Confirmation/attribution bias of people, who are convinced to be in the right even if they are not Examples 30 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. That is, you have to put all your eggs in one basket, and your inability to diversify will subject you to a lot of risk. 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. The presence of economies of scale in financial markets helps explain why financial intermediaries developed and have become such an important part of our financial structure. The clearest example of a financial intermediary that arose because of economies of scale is a mutual fund. A mutual fund is a financial inter- mediary that sells shares to individuals and then invests the proceeds in bonds or stocks. 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, making them better off. Expertise Financialintermediariesarealsobetterabletodevelopexpertisetolower transaction costs. Their expertise in computer technology enables them to offer customers convenient services like being able to call a toll-free number for informa- tion on how well their investments are doing and to write checks on their accounts. 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 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 (fact 3). To understand financial structure more fully, however, we turn to the role of information in financial markets. Asymmetric information—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—is an important aspect of financial markets. 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 31 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 It is called the “lemons problem” because it resembles the problem created by lemons in the used- car market.2 Potential buyers of used cars are frequently unable to assess the quality of the car; that is, they can’t tell whether a particular used car is one that will run well or a lemon that will continually give them grief. Lemons in the Stock and Bond Markets A similar lemons problem arises in securities markets—that is, the debt (bond) and equity (stock) markets. In this situation, Irving will be willing to pay only a price that reflects the average quality of firms issuing securities—a price that lies between the value of securities from bad firms and the value of those from good firms. If the owners or managers 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 (because his price is higher than the securities are worth). Our friend Irving is not stupid; he does not want to hold securities in bad firms, and hence he will decide not to purchase securities in the market. The analysis is similar if Irving considers purchasing a corporate debt instru- ment in the bond market rather than an equity share. Only the bad firms will be willing to bor- row, and because investors like Irving are not eager to buy bonds issued by bad firms, they will probably not buy any bonds at all. The analysis we have just conducted explains fact 2—why marketable securities are not the primary source of financing for businesses in any country in the world. It also partly explains fact 1—why stocks are not the most important source of financing for American businesses. The presence of the lemons problem keeps secu- rities markets such as the stock and bond markets from being effective in channel- ing funds from savers to borrowers. 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, so that all involved can tell a good car from a bad one, buyers will be willing to pay full value for good used cars. Because the owners of good used cars 32 can now get a fair price, they will be willing to sell them in the market. The market will have many transactions and will do its intended job of channeling good cars to people who want them. 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 that have the most productive investment opportunities. Private Production and Sale of Information The solution to the adverse selection problem in financial markets is to eliminate asymmetric information by furnishing the people supplying funds with full details about the individuals or firms seeking to finance their investment activities. One way to get this material to saver-lenders is to have private companies collect and produce information that distinguishes good from bad firms and then sell it The system of private production and sale of information does not completely solve the adverse selection problem in securities markets, however, 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. Government Regulation to Increase Information The free-rider problem pre- vents the private market from producing enough information to eliminate all the asymmetric information that leads to adverse selection. A second possibility (and one followed by the United States and most governments throughout the world) is for the government to regulate securities markets in a way that encourages firms to reveal honest information about them- selves so that investors can determine how good or bad the firms are. In the United States, the Securities and Exchange Commission (SEC) is the government agency that requires firms selling their securities to have independent audits, in which accounting firms certify that the firm is adhering to standard accounting principles and disclosing accurate information about sales, assets, and earnings. The asymmetric information problem of adverse selection in financial markets helps explain why financial markets are among the most heavily regulated sectors in the economy (fact 5). Government regulation to increase information for investors is needed to reduce the adverse selection problem, which interferes with the efficient functioning of securities (stock and bond) markets. Although government regulation lessens the adverse selection problem, it does not eliminate it. Even when firms provide information to the public about their sales, assets, or earnings, they still have more information than investors: A lot more is involved in knowing the quality of a firm than statistics can provide. Financial Intermediation Because these roadblocks make it hard for individuals to acquire enough information about used cars, most used cars are not sold directly by one individual to another. Instead, they are sold by an intermediary, a used-car dealer who purchases used cars from individuals and resells them to other individuals. People are more likely to purchase a used car because of a dealer’s guarantee, and the dealer is able to make a profit on the production of information about automobile quality by being able to sell the used car at a higher price than the dealer paid for it. Just as used-car dealers help solve adverse selection problems in the automobile market, financial intermediaries play a similar role in financial markets. A financial intermediary, such as a bank, becomes an expert in producing information about firms, so that it can sort out good credit risks from bad ones. Then it can acquire funds from depositors and lend them to the good firms. Because the bank is able to lend mostly to good firms, it is able to earn a higher return 35 having several of their own people participate as members of the managing body of the firm, the board of directors, so that they can keep a close watch on the firm’s activities. When a venture capital firm supplies start-up funds, the equity in the firm is not marketable to anyone except the venture capital firm. Thus, other investors are unable to take a free ride on the venture capital firm’s verification activities. As a result of this arrangement, the venture capital firm is able to garner the full benefits of its verification activities and is given the appropriate incentives to reduce the moral hazard problem. Debt Contracts Moral hazard arises with an equity contract, which is a claim on profits in all situations, whether the firm is making or losing money. If a contract could be structured so that moral hazard would exist only in certain situations, the need to monitor managers would be reduced, and the contract would be more attractive than the equity contract. The debt contract has exactly these attributes because it is a contractual agreement by the borrower to pay the lender fixed dollar amounts at periodic intervals. If the managers are hiding profits or are pursuing activities that are personally beneficial but don’t increase profitability, the lender doesn’t care as long as these activities do not interfere with the ability of the firm to make its debt payments on time. Only when the firm cannot meet its debt payments, thereby being in a state of default, is there a need for the lender to verify the state of the firm’s profits. Only in this situation do lenders involved in debt contracts need to act more like equity holders to get their fair share. The less frequent need to monitor the firm, and thus the lower cost of state verification, helps explain why debt contracts are used more frequently than equity contracts to raise capital. 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. Obviously, this is a very risky investment, but if Steve is successful, he will become a multimillionaire. He has a strong incentive to undertake the riskier invest- ment with your money because the gains to him would be so large if he succeeded. Tools to Help Solve Moral Hazard in Debt Contracts Net Worth and Collateral When borrowers have more at stake because their net worth (the difference between their assets and their liabilities) is high or the collateral they have pledged to the lender is valuable, the risk of moral hazard— the temptation to act in a manner that lenders find objectionable—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”. 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 eas- ier it is for the firm or household to borrow. 36 Monitoring and Enforcement of Restrictive Covenants As the example of Steve and his ice cream store shows, if you could make sure that Steve doesn’t invest in anything riskier than the ice cream store, it would be worth your while to make him the loan. You can ensure that Steve uses your money for the purpose you want it to be used for by writing provisions (restrictive covenants) into the debt contract that restrict his firm’s activities. By monitoring Steve’s activities to see whether he is complying with the restrictive covenants and enforcing the covenants if he is not, you can make sure that he will not take on risks at your expense. There are four types of restrictive covenants that achieve this objective: 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. Some cov- enants mandate that a loan can be used only to finance specific activities 2. Covenants to encourage desirable behavior. Restrictive covenants can encourage the borrower to engage in desirable activities that make it more likely that the loan will be paid off. 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. These restrictive covenants typically specify that the firm must maintain minimum holdings of certain assets rela- tive 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 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. This type of covenant may also stipulate that the lender has the right to audit and inspect the firm’s books at any time. We now see why debt contracts are often complicated legal documents with numerous restrictions on the borrower’s behavior (fact 8): Debt contracts require complicated restrictive covenants to lower moral hazard. Financial Intermediation Although restrictive covenants help reduce the moral hazard problem, they do not eliminate it. It is almost impossible to write covenants that rule out every risky activity. Furthermore, borrowers may be clever enough to find loopholes in restrictive covenants that make them ineffective. Another problem with restrictive covenants is that they must be monitored and enforced. A restrictive covenant is meaningless if the borrower can violate it knowing that the lender won’t check up or is unwilling to pay for legal recourse. 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. If you know that other bondholders are monitoring and enforc- ing the restrictive covenants, you can free-ride. The concept of moral hazard has provided us with additional reasons why financial intermediaries play a more important role in channeling funds from savers to borrowers than mar- ketable securities do, as described in facts 3 and 4. 37 Conflicts of Interest What Are Conflicts of Interest and Why Do We Care? Although the presence of economies of scope may substantially 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 a substantial reduction in the quality of information in financial markets increases asymmetric information problems and prevents financial markets from channeling funds into the most productive investment opportunities. 40 Dynamics of Financial Crises in Advanced Economies Financial crises in advanced economies have progressed in two and sometimes three stages. To understand how these crises have unfolded, refer to Figure 8.1, which traces the stages and sequence of financial crises in advanced economies. Stage One: Initiation of Financial Crisis Financial crises can begin in several ways: credit and asset-price boom and busts or a general increase in uncertainty caused by failures of major financial institutions. Credit Boom and Bust The seeds of a financial crisis are often sown when an economy introduces new types of loans or other financial products, known as financial innovation, or when countries engage in financial liberalization, the elimination of restrictions on financial markets and institutions. Financial liberalization has a dark side: In the short run, it can prompt financial institutions to go on a lending spree, called a credit boom. Unfortunately, lenders may not have the expertise, or the incentives, to manage risk appropriately in these new lines of business. Eventually, losses on loans begin to mount, and the value of the loans (on the asset side of the balance sheet) falls relative to liabilities, thereby driving down the net worth (capital) of banks and other financial institutions. With less capital, these financial institutions cut back on their lending to borrower-spenders, a process called deleveraging. Furthermore, with less capital, banks and other financial institutions become riskier, causing lender-savers and other potential lenders to these institutions to pull out their funds. Fewer funds means fewer loans to fund productive investments and a credit freeze: The lending boom turns into a lending crash. When financial institutions stop collecting information and making loans, financial frictions rise, limiting the financial system’s ability to address the asymmetric information problems of adverse selection and moral hazard. As loans become scarce, borrower-spenders are no longer able to fund their productive investment opportunities and they decrease their spending, causing economic activity to contract. Asset-Price Boom and Bust Prices of assets such as equity shares and real estate can be driven by investor psychology well above their fundamental economic values, that is, their values based on realistic expectations of the assets’ future income streams. The rise of asset prices above their fundamental economic 41 values is an asset-price bubble. When the bubble bursts and asset prices realign with fundamental economic values, stock and real estate prices tumble, companies see their net worth (the difference between their assets and their liabilities) decline, and the value of collateral they can pledge drops. Increase in Uncertainty U.S. financial crises have usually begun in periods of high uncertainty, such as just after the start of a recession, a crash in the stock market, or the failure of a major financial institution. Stage Two: Banking Crisis Reasons for initiating a crisis (you could have all of them): 1) For some reasons a group of financial institutions are no longer profitable, less willing to expand their activity because they took to much risk, and stop their function of connecting lenders and savers. Deteriorating balance sheets and tougher business conditions lead some financial institutions into insolvency, when net worth becomes negative. Unable to pay off depositors or other creditors, some banks go out of business. If severe enough, these factors can lead to a bank panic, in which multiple banks fail simultaneously. The source of the contagion is asymmetric information. Uncertainty about the health of the banking system in general can lead to runs on banks, both good and bad, which will force banks to sell off assets quickly to raise the necessary funds. These fire sales of assets may cause their prices to decline so much that the bank becomes insolvent, even if the resulting contagion can then lead to multiple bank failures and a full-fledged bank panic. 2) Decline in asset price: asset is overvalued, price went up too quickly and too fast, giving the illusion it could last forever (2007 house price index) 3) Increase in IR: credit access is normal and you have a lot of people taking advantage of borrowing money but if IR increase, some borrowers stop getting this loans, because they are not able to pay them back, or they try to increase the risk they take 4) Change in uncertainty (connected to asymmetric information): investors thought that mortgage securities was safe investments to do and, when they realized they were wrong they started selling all of them à decline asset price à etc. If asymmetric info increases: less lenders are able to get in touch with borrowers —> economic activity declines When institutions are in crisis the asymmetric information problem increases —> deflation Stage Three: Debt Deflation Debt deflation occurs when a substantial unanticipated decline in the price level sets in, leading to a further deterioration in firms’ net worth because of the increased burden of indebtedness. In economies with moderate inflation, which characterizes most advanced countries, many debt contracts with fixed interest rates are typically of fairly long maturity, ten years or more. Because debt payments are contractually fixed in nominal terms, an unanticipated decline in the price level raises the value of borrowing firms’ liabilities in real terms (increases the burden of the debt) but does not raise the real value of borrowing firms’ assets. The borrowing firm’s net worth in real terms (the difference between assets and liabilities in real terms) thus declines. 42 To better understand how this decline in net worth occurs, consider what happens if a firm in 2015 has assets of $100 million (in 2015 dollars) and $90 million of long-term liabilities, so that it has $10 million in net worth (the difference between the value of assets and liabilities). If the price level falls by 10% in 2016, the real value of the liabilities would rise to $99 million in 2015 dollars, while the real value of the assets would remain unchanged at $100 million. The result would be that real net worth in 2015 dollars would fall from $10 million to $1 million ($100 million minus $99 million). The substantial decline in real net worth of borrowers from a sharp drop in the price level causes an increase in adverse selection and moral hazard problems facing lenders. Lending and economic activity decline for a long time. The most significant financial crisis that displayed debt deflation was the Great Depression, the worst economic contraction in U.S. history. The Mother of All Financial Crises: The Great Depression In 1928 and 1929, prices doubled in the U.S. stock market. Federal Reserve officials viewed the stock market boom as excessive speculation. To curb it, they pursued a tightening of monetary policy to raise interest rates to limit the rise in stock prices. The Fed got more than it bargained for when the stock market crashed in October 1929, falling by 40% by the end of 1929, as shown in Figure 8.2. By the middle of 1930, stocks recovered almost half of their losses and credit market conditions stabilized. What might have been a normal recession turned into some- thing far worse, however, when severe droughts in the Midwest led to a sharp decline in agricultural production, with the result that farmers could not pay back their bank loans. The resulting defaults on farm mortgages led to large loan losses on bank balance sheets in agricultural regions. The weakness of the economy and the banks in agricultural regions in particular prompted substantial withdrawals from banks, building to a full-fledged panic in November and December 1930, with the stock market falling sharply. For more than two years, the Fed sat idly by through one bank panic after another, the most severe spate of panics in U.S. history. “The only thing we have to fear is fear itself,” Roosevelt told the nation. The damage was done, however, and more than one-third of U.S. commercial banks had failed. Stock prices kept falling. By mid-1932, stocks had declined to 10% of their value at the 1929 peak (as shown in Figure 8.2), and the increase in uncertainty from the unsettled business conditions created by the economic contraction worsened adverse selection and moral hazard problems in financial markets. With a greatly reduced number of financial intermediaries still in business, adverse selection and moral hazard problems intensified even 45 Residential Housing Prices: Boom and Bust Aided by liquidity and low interest rates on residential mortgages, the subprime mortgage market took off after the recession ended in 2001. By 2007, it had become over a trillion-dollar market. The development of the subprime mortgage market was encouraged by politicians because it led to a “democratization of credit” and helped raise U.S. homeowner- ship rates to the highest levels in history.1 The asset-price boom in housing (see Figure 8.4), which took off after the 2000–2001 recession was over, also helped stimulate the growth of the subprime mortgage market. With housing prices rising, subprime borrowers were also unlikely to default because they could always sell their house to pay off the loan, making investors happy because the securities backed by cash flows from subprime mortgages had high returns. The growth of the subprime mortgage market, in turn, increased the demand for houses and so fueled the boom in housing prices, resulting in a housing price bubble. As housing prices rose and profitability for mortgage originators and lenders was high, the underwriting standards for subprime mortgages fell to lower and lower standards. High-risk borrowers were able to obtain mortgages, . When asset prices rise too far out of line with fundamentals—in the case of housing, how much housing costs if purchased relative to the cost of renting it, or the cost of houses relative to households’ median income—they must come down. Eventually, the housing price bubble burst. With housing prices falling after their peak in 2006. The decline in housing prices led to many subprime borrowers finding that their mortgages were “underwater”—that is, the value of the house fell below the amount of the mortgage. When this happened, struggling homeowners had tremendous incentives to walk away from their homes and just send the keys back to the lender. Defaults on mortgages shot up sharply, eventually leading to millions of mortgages in foreclosure. Deterioration of Financial Institutions’ Balance Sheets The decline in U.S. housing prices led to rising defaults on mortgages. As a result, the value of mortgage-backed securities and CDOs collapsed, leaving banks and other finan- cial institutions with a lower value of assets and thus a decline in net worth. With weakened balance sheets, these banks and other financial institutions began to deleverage, selling off assets and restricting the availability of credit to both house-holds and businesses. Run on the Shadow Banking System The sharp decline in the value of mortgages and other financial assets triggered a run on the shadow banking system, composed of hedge funds, investment banks, and other non depository financial firms, which are not as tightly regulated as banks. Funds from shadow banks flowed through the financial system and for many years supported the issuance of low interest-rate mortgages and auto loans. These securities were funded primarily by repurchase agreements (repos), short-term borrowing that, in effect, uses assets like mortgage-backed securities as collateral. 46 Rising concern about the quality of a financial institution’s balance sheet led lenders to require larger amounts of collateral, known as haircuts. For exam- ple, if a borrower took out a $100 million loan in a repo agreement, it might have to post $105 million of mortgage-backed securities as collateral, and the haircut is then 5%. With rising defaults on mortgages, the value of mortgage-backed securities fell, which then led to a rise in haircuts. At the start of the crisis, haircuts were close to zero, but they eventually rose to nearly 50%.The result was that the same amount of collateral would allow financial institutions to borrow only half as much. Thus, to raise funds, financial institutions had to engage in fire sales and sell off their assets very rapidly. Because selling assets quickly requires lowering their price, the fire sales led to a further decline in financial institutions’ asset values. This decline lowered the value of collateral further, raising haircuts and thereby forcing financial institutions to scramble even more for liquidity. The result was similar to the run on the banking system that occurred during the Great Depression, causing massive deleveraging that resulted in a restriction of lending and a decline in economic activity. The decline in asset prices in the stock market (which fell by over 50% from October 2007 to March 2009 and the more than 30% drop in residential house prices (shown in Figure 8.4), along with the fire sales resulting from the run on the shadow banking system, weakened both firms’ and households’ balance sheets. The worsening manifested in widening credit spreads, causing higher costs of credit for households and businesses and tighter lending standards. The resulting decline in lending meant that both consumption expenditure and investment fell, causing the economy to contract. Global Financial Markets Despite huge injections of liquidity into the financial system by the European Central Bank and the Federal Reserve, banks began to horde cash and were unwilling to lend to each other. The drying up of credit led to the first major bank failure in the United Kingdom in over 100 years, when Northern Rock, which had relied on short-term borrowing in the repo market rather than deposits for its funding, collapsed in September 2007. A string of other European financial institutions then failed as well. Particularly hard hit were countries like Greece, Ireland, Portugal, Spain, and Italy, which led to a sovereign debt crisis. On Monday, September 15, 2008, after suffering losses in the subprime market, Lehman Brothers, the fourth-largest investment bank by asset size with over $600 billion in assets and 25,000 employees, filed for bankruptcy, making it the largest bankruptcy filing in U.S. history. The day before, Merrill Lynch, the third- largest investment bank, who had also suffered large losses on its holding of subprime securities, announced its sale to Bank of America for a price 60% below its value a year earlier. On Tuesday, September 16, AIG, an insurance giant with assets of over $1 trillion, suffered an extreme liquidity crisis when its credit rat- ing was downgraded. It had written over $400 billion of insurance contracts (credit default swaps) that had to make payouts on possible losses from sub- prime mortgage securities. The Federal Reserve then stepped in with an $85 billion loan to keep AIG afloat Height of the 2007–2009 Financial Crisis The financial crisis reached its peak in September 2008 after the House of Representatives, fearing the wrath of constituents who were angry about bailing out Wall Street, voted down a $700 billion dollar bailout package proposed by the Bush administration. The Emergency Economic 47 Stabilization Act finally passed nearly a week later. The stock market crash accelerated, with the week beginning October 6, 2008, showing the worst weekly decline in U.S. history. Credit spreads went through the roof over the next three weeks, with the spread between Baa corporate bonds (just above investment grade) and U.S. Treasury bonds going to over 5.5 percentage points (550 basis points), as illustrated by Figure 8.6. The impaired financial markets and surging interest rates faced by borrower- spenders led to sharp declines in consumer spending and investment. Real GDP declined sharply, falling at a –1.3% annual rate in the third quarter of 2008 and then at a – 5.4% and –6.4% annual rate in the next two quarters. The unemployment rate shot up, going over the 10% level in late 2009. The recession that started in December 2007 became the worst economic contraction in the United States since World War II and as a result is now referred to as the “Great Recession.” Starting in March 2009, a bull market in stocks got under wayand credit spreads began to fall (Figure 8.6).3 With the recovery in financial markets, the economy started to recover but, unfortunately, the pace of the recovery has been slow. Chronology of the crises 2007 - AUG: panic after pricing difficulties experienced by MBS/CDO - SEP: Northern Rock (UK) faces liquidity crisis from securitizations 2008 - JAN: largest fall in US house selling in 25y announced - FEB: Northern Rock nationalized - MAR: Bear Stearns bought by JP Morgan to avoid bankruptcy - MAY: US Treasury says “the worst is over” - SEP: bailout of Freddie Mac / Fannie Mae, bankruptcy of Lehman Brothers, rescue of HBOS by Lloyds TSB, Goldman Sachs and JP Morgan Chase move from investment banks to holding companies, bankruptcy of Washington Mutual and Wachovia (US), Ireland - into recession - promised bailout of whole banking system (not happened) - OCT: US government project for “toxic” assets, collapse of Iceland’s 3 biggest banks (and freeze of UK assets), joint cut of IR by BoE/ECB/FED/other 5, bailout of several UK banks (RBoS, Lloyds TBS, HBOS) 50 Despite there is a separation between government and FR, there is a connection because the members of the BOG are appointed by the president. Furthermore, there is a system of control between the bodies à balance of powers 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 three largest Federal Reserve banks in terms of assets are those of New York, Chicago, and San Francisco—combined they hold more than 50% of the assets (discount loans, securities, and other holdings) of the Federal Reserve System. The New York bank, with around one-quarter of the assets, is the most important of the Federal Reserve banks. 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 (a requirement of membership), 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 three A directors (elected by the member banks) are professional bankers, and the three B directors (also elected by the member banks) are prominent leaders from industry, labor, agriculture, or the consumer sector. The three C directors, who are appointed by the Board of Governors to represent the public interest, are not allowed to be officers, employees, or stockholders of banks. The directors oversee the activities of the district bank, but their most important job is to appoint the president of the bank (subject to the approval of the Board of Governors). The twelve Federal Reserve banks are involved in monetary policy in several ways: • Their directors “establish” the discount rate (although the discount rate in each district is reviewed and determined by the Board of Governors). • They decide which banks, member and nonmember alike, can obtain dis- count 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) 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 51 • 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. Currently about a third of the commercial banks in the United States are members of the Federal Reserve System, having declined from a peak figure of 49% in 1947. Board of Governors of the Federal Reserve System At the head of the Federal Reserve System is the seven-member Board of Governors, headquartered in Washington, D.C. Each governor is appointed by the president of the United States and confirmed by the Senate. To limit the president’s control over the Fed and insulate the Fed from other political pressures, the governors can serve one nonrenewable, 14-year term plus part of another term, with one governor’s term expiring every other January.1 The governors (many are professional economists) 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. It is expected that once a new chair is chosen, the old chair resigns from the Board of Governors, even if there are many years left to his or her 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 (seven governors and five presidents of the district banks), the Board has the majority of the votes. • It sets reserve requirements (within limits imposed by legislation) 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. • 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 (larger than those of individual Federal Reserve banks), which provides economic analysis that the Board of Governors uses in making its decisions 52 Federal Open Market Committee (FOMC) The Federal Open Market Committee (FOMC) usually meets eight times a year (about every six weeks) 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. For example, when the media say that the Fed is meeting, they actually mean that the FOMC is meeting. 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. Hence they have some input into the committee’s decisions. 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 eas- ing of monetary policy (a lowering of the federal funds rate) are made. The FOMC does not actually carry out securities purchases or sales. Instead, it issues directives to the trading desk at the Federal Reserve Bank of New York, where the manager for domestic open mar- ket operations supervises a roomful of people who execute the purchases and sales of the government or agency securities. The manager communicates daily with the FOMC members and their staffs concerning the activities of the trading desk. Why the Chair of the Board of Governors Really Runs the Show So why does the media pay so much attention to every word the chair speaks? Does the chair really call the shots at the Fed? If so, why does the chair have so much power? The chair does indeed run the show. He or she is the spokesperson for the Fed and negotiates with Congress and the president of the United States. He or she also exercises control by setting the agenda of Board and FOMC meetings. The chair also influences the Board through the force of stature and personality. How Independent Is the Fed? How free is the Fed from presidential and congressional pressures? Do economic, bureaucratic, or political considerations guide it? Is the Fed truly independent of outside pressures? Instrument independence, the ability of the central bank to set monetary policy instruments, and goal independence, the ability of the central bank to set the goals of monetary policy. The Federal Reserve has both types of independence and is remarkably free of the political pressures that influence other government agencies. Indeed, the General Accounting Office, the auditing agency of the federal government, cannot currently audit the monetary policy or foreign exchange market functions of the Federal Reserve. Because the power to control the purse strings is usually synonymous with the power of overall control, this feature of the Federal Reserve System contributes to its independence more than any other factor. 55 Differences Between the European System of Central Banks and the Federal Reserve System First, the budgets of the Federal Reserve Banks are controlled by the Board of Governors, whereas the National Central Banks 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 National Central Banks in each country, so monetary operations are not centralized as they are in the Federal Reserve System. Third, in contrast to the Federal Reserve, 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 Governing Council, which 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 National Central Banks has one vote in the Governing Council; each of the six Executive Board members also has one vote. Only the 23 members of the Governing Council attend the meetings, with no staff present. Just as the Federal Reserve releases the FOMC’s decision on the setting of the policy interest rate (the federal funds rate) immediately after the meeting is over, the ECB does the same after the Governing Council meeting concludes (announcing the target for a similar short-term interest rate for interbank loans). To deal with this potential problem, the Governing Council has decided on a complex sys- tem of rotation, somewhat like that for the FOMC, in which National Central Banks from the larger countries will vote more often than National Central Banks from the smaller countries. How Independent Is the ECB? 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 of the Maastricht Treaty make the ECB highly independent. The Maastricht Treaty specifies that the overriding, 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. The Eurosystem has defined the quantitative goal for monetary policy to be an inflation rate slightly less than 2%. The Eurosystem’s charter cannot be changed by legislation; it 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. To sum up the two different system: FED and ECB behave differently; one of the things that changes the most is the monetary policy. The US/Fed System: The Fed is the result of a federal system; the US has local budget, federal budget, local system, federal system etc. it is a complex country which reflects to the Fed System. The federal reserve system has the board of governors that is composed by 7 members who are appointed by the President/Senate. After they are appointed they cannot be removed from their 56 role until they die/resign/deadline. The board of governors appoint the cha irman. The Board of Governors decide reserve requirements, they have power of appointment (they appoint 6 directors for the Federal Reserve Banks). The other 3 directors per Federal Reserve Banks are appointed by the Member Banks. Then, these 12 FRB appoint the Federal Advisory Council where there are 12 bankers, one for each district, and their role is to give advice to the BoG. Then, the FRB and BoG together appoint the Federal Open Market Committee, which takes important decisions. In this organ there is the full BoG, the presidents of FRB of Ny and 4 members of FRBs. What does this organ do? It gives advice regarding reserve requirements, discount rate but it also propose law for the open-market transactions. The fact that the Fed is fully independent it is not true; let’s think about Trump. The EU/ECB System: The situation is very different because there is not a federal system. We’re moving toward to this system but it’s going on very slow. At the core of European System CB, we find NCB (national centra bank), that gave up their monopoly to an external body the ECB, but they also hold a seat together with the other participating partners. The EU banks members are much more than the the US once (2.800, while for the EU 6.000). The ECB is composed by the Executive board (6 members appointed by governments) and Governing council is made by the executive board + governors of Euro NCB. So the amount of political influence is very weak since there are 6 members appointed by governments in relation to the 28 members. NCBs has great power: they decide the ECB’s budget, enforce monetary policy, enforce regulation and supervision, greater independence, treaties require price stability and changes are extremely difficult: more goal independence. Once this system is formed, the NCB, ECB and EU treaties all focus on monetary policy and from that they move to policy tools like reserve requirements, open -market transactions and discount rate. Compared to the Fed the ECB is much more independent, because the only thing that limits the ECB are treaties. 57 Pros of independence: - Political shortsighted influence produces inflation by acting on short—term goals (unemployment and IR): election dates rather than economy - Treasuries’ influence accumulates risk by promoting abnormal absorption of public debt and concentration in CB/Banks - Monetary policy requires specific expertise Cons of independence: - Lack of accountability and democratic control, influence: they see as a problem that Mario Draghi was not appointed by people. - If a government has full right over fiscal policies these decisions may be made weaker by monetary policy. MP is more important then national fiscal policy - Independence did not avoid crisis —> they do not do what we need The more independent a CB is, the lower the level of inflation is. Germany is the most independent one and has the lower inflation rate. 60 banking systems that sees an increase in monetary base and money supply (the opposite on repayment) We thus see that a discount loan leads to an expansion of reserves, which can be lent out as deposits, thereby leading to an expansion of the monetary base and the money supply. Similar reasoning indicates that when a bank repays its discount loan and so reduces the total amount of discount lending, the amount of reserves decreases along with the monetary base and the money supply. Reserve requirements Less important monetary policy tools. Give a lot of funds to CB but can’t use them for monetary policy decisions. - It is difficult to control reserves - Although infrequent, mandatorily increase demand for reserves 
 The Market for Reserves and the Federal Funds Rate We have just seen how open market operations and Federal Reserve lending affect the balance sheet of the Fed and the amount of reserves. Now we will analyze the market for reserves to see how the resulting changes in reserves affect the federal funds rate, the interest rate on overnight loans of reserves from one bank to another. The federal funds rate is particularly important in the conduct of monetary policy because it is the interest rate that the Fed tries to influence directly. Open market operations and Federal Reserve lending are the principal tools that the Fed uses to influence the federal funds rate. In addition, there is a third tool, reserve requirements. Demand and Supply in the Market for Reserves Demand Curve [ RD = Required reserves + Excess Reserves] Recall from the previous section that the amount of reserves can be split into two components: (1) required reserves, which equal the required reserve ratio times the amount of deposits on which reserves are required, and (2) excess reserves, the additional reserves banks choose to hold. Therefore, the quantity of reserves demanded equals required reserves plus the quantity of excess reserves demanded. Excess reserves are insurance against deposit outflows, and the cost of holding these excess reserves is their opportunity cost, the interest rate that could have been earned on lending these reserves out, minus the interest rate that is earned on these reserves, 61 ior. When the inter-banking rate is above the rate paid on excess reserves, ier, as the inter-banking decreases, the opportunity cost of holding excess reserves falls. Holding everything else constant, including the quantity of required reserves, the quantity of reserves demanded rises. Consequently, the demand curve for reserves, R , slopes downward when the inter-banking rate is above ier,. If however, the inter-banking rate begins to fall below the interest rate paid on reserves ier, banks would not lend in the overnight market at a lower interest rate. Instead, they would just keep on adding to their holdings of excess reserves indefinitely. The result is that the demand curve for reserves, Rd, becomes flat (infinitely elastic) at ier. Supply Curve [ RS = Reserves nonborrowed + Reserves borrowed] The supply of reserves, Rs, can be broken into 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 CB is the interest rate the CB charges on these loans, the discount rate (id). Because borrowing funds from other banks is a substitute for borrowing (taking out discount loans) from the CB, if the inter-banking rate iIBR is below the discount rate id, then banks will not borrow from the CB and borrowed reserves will be zero because borrowing in the banking funds market is cheaper. Thus, as long as iIBR remains below id, the supply of reserves will just equal the amount of non borrowed reserves supplied by the Fed, NBR, and so the supply curve will be vertical. However, if the inter-banking rate were to rise even infinitesimally above the discount rate, banks would want to keep borrowing more and more at id and then lending out the proceeds in the banking funds market at the higher rate, iIBR. The result is that the inter-bank rate can never rise above the discount rate and the supply curve becomes flat (infinitely elastic) at id. Market Equilibrium Market equilibrium occurs when the quantity of reserves demanded equals the quantity supplied, Rs = Rd. Equilibrium therefore occurs at the intersection of the demand curve Rd and the supply curve Rs at point 1, with an equilibrium federal funds rate of i* How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate Now that we understand how the federal funds rate is determined, we can examine how changes in the four tools of monetary policy—open market operations, dis- count lending, reserve requirements, and the interest rate paid on reserves—affect the market for reserves and the equilibrium federal funds rate. The first two tools, open market operations and discount lending, affect the federal funds rate by chang- ing the supply of reserves, while the third tool, reserve requirements, affects the federal funds rate by changing the demand for reserves, and the fourth tool affects the federal funds rate by changing the interest rate paid on reserves. An open market purchase causes the inter-banking rate to fall, whereas an open market sale causes the inter-banking rate to rise. However, if the supply curve initially intersects the demand curve on its flat section, open market operations have no effect on the inter banking rate. To see this, let’s again look at an open market purchase that raises the quantity of reserves supplied, 62 which shifts the demand curve from Rs to R1s, but now where initially iIBR = ier à The shift in the supply curve moves the equilibrium from NBR to NBR1, but the inter banking rate remains unchanged at ier because the interest rate paid on reserves, ier, sets a floor for the inter baking rate, iIBR. The effect of a discount rate change depends on whether the demand curve intersects the supply curve in its vertical section versus its flat section. If the intersection occurs in the vertical section of the supply curve so there is no discount lending supply and demand curves remains at point NBR. Thus, in this case, no change occurs in the equilibrium federal funds rate, which remains at iIBR . Because this is the typical situation—since and borrowed reserves, BR, are zero. In this case, when the discount rate is lowered by the CB from id to i1b, the horizontal section of the supply curve falls, as in Rs2, but the intersection of the supply and demand curves remains at point NBR. Thus, in this case, no change occurs in the equilibrium federal funds rate, which remains at iIBR . Because this is the typical situation—since the CB now usually keeps the discount rate above its target for the federal funds rate—the conclusion is that most changes in the discount rate have no effect on the federal funds rate. However, if the demand curve intersects the supply curve on its flat section, so there is some discount lending (i.e., BR > 0), changes in the discount rate do affect the inter banking rate. In this case, initially discount leading is positive and the equilibrium federal funds rate equals the discount rate, iIBR=id. When the discount rate is lowered by the CB from id to i1d, the horizontal section of the supply curve falls from Rs to R1s, moving the equilibrium from NBR+BR to NBR+BR1. When the required reserve ratio increases, required reserves increase and hence the quantity of reserves demanded increases for any given interest rate. Thus, a rise in the required reserve ratio shifts the demand curve to the right from Rd to R1d moves moves the equilibrium from point iIBR to point i1IBR, and in turn raises the inter banking rate. The result is that when the CB raises reserve requirements, the inter banking rate rises. Conversely, a decline in the required reserve ratio lowers the quantity of 65 federal funds target. However, in the aftermath of the global financial crisis, banks have accumulated huge quantities of excess reserves, and in this situation, to increase the federal funds rate would require massive amounts of open market operations to remove these reserves from the banking system. The interest-on-reserves tool can come to the rescue because raising this interest rate can instead be used to raise the federal funds rate Nonconventional Monetary Policy Tools and Quantitative Easing When the economy experiences a full-scale financial crisis like the one we have recently experienced, conventional monetary policy tools cannot do the job for two reasons. First, the financial system seizes up to such an extent that it becomes unable to allocate capital to productive uses, and so investment spending and the economy collapse along the lines. Second, the negative shock to the economy can lead to the zero-lower-bound problem, in which the central bank is unable to lower the policy interest rate further because it has hit a floor of zero, as occurred at the end of 2008. For both these reasons, central banks need non-interest-rate tools, known as nonconventional monetary policy tools to stimulate the economy. These nonconventional monetary policy tools take three forms: (1) liquidity provision, (2) asset purchases, and (3) commitment to future monetary policy actions. Liquidity Provision 1. Discount window expansion 2. Term auction facility: Term Auction Facility (TAF), in which it made loans at a rate determined through competitive auctions. It was more widely used than the discount window facility because it enabled banks to borrow at a rate lower than the discount rate, and it was determined com- petitively, rather than being set at a penalty rate. 3. New lending programs The Fed broadened its provision of liquidity to the financial system well outside its traditional lending to banking institutions. These actions included lending to investment banks, as well as lending to promote purchases of commercial paper, mortgage-backed securities, and other asset-backed securities. Asset Purchases Because, as we have seen earlier in the chapter, Federal Reserve asset purchases lead to an expansion of its balance sheet and the monetary base, these asset purchase programs have been given the name quantitative easing (QE). Commitment to Future Policy Actions Although short-term interest rates could not be driven below zero in the aftermath of the global financial crisis, the Federal Reserve could take another route to lower long-term interest rates, which, as we have mentioned above, would stimulate the economy. This route involved a commitment by the Fed to keep the federal funds rate at zero for a long period of time in order to lower the market’s expectations of future short-term interest rates, thereby causing the long-term interest rate to fall. This strategy is referred to as management of expectations. 66 Monetary Policy Tools of the European Central Bank Like the Federal Reserve, the European System of Central Banks (which is usually referred to as the European Central Bank) signals the stance of its monetary policy by setting a target financing rate, which in turn sets a target for the overnight cash rate. The monetary policy tools used by the European Central Bank are similar to those used by the Federal Reserve and involve open market operations, lending to banks, and reserve requirements. - Open Market operations: Like the Federal Reserve, the European Central Bank 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 and are similar to the Fed’s repo transactions. They involve weekly reverse transactions (purchase or sale of eligible assets under repurchase or credit operations against eligible assets as collateral). 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. - Lending to Banks: This lending takes place through a standing lending facility called the marginal lending facility. There, banks can borrow (against eligible collateral) 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 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: Like the Federal Reserve, the European Central Bank 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 central banks. The Price Stability Goal and the Nominal Anchor Over the past few decades, policy makers throughout the world have become increasingly aware of the social and economic costs of inflation and more concerned with maintaining a stable price level as a goal of economic policy. Indeed, price stability, which central bankers define as low and stable inflation, is increasingly viewed as the most important goal of monetary policy. Primary goal: price stability • “Low” and stable increase in price level • Reduced uncertainty and enhancement of economic growth • Nominal anchor: choosing of a target variable: - Typically, inflation or money supply - Reduces time-inconsistency problems: short-run policies hamper long-run efficacy à unable to consistently follow a plan over time; the good plan will soon be abandoned. - Constrains discretionary monetary policies: more expansionary than firms or people expect because such a policy would boost economic output (or lower unemployment) in the short run à higher inflation, higher prices, but not higher production. 67 Other goals: • High employment (lower than 100%): - frictional unemployment is beneficial (looking for better jobs, education, ...), structural unemployment (mismatch between demand and supply of labour) is outside CBs’ powers - match demand and supply: natural rate of unemployment • Economic growth: promoting investments and savings, also in combination with fiscal policy • Financial markets stability: by responding to excessive or insufficient funds within intermediaries. Reduction of financial crisis. • IR stability: reducing fluctuations that create uncertainty and make it harder to plan for the future. Fluctuations in interest rates that affect consumers’ willingness to buy houses, for example, make it more difficult for consumers to decide when to purchase a house and for construction firms to plan how many houses to build. • Foreign Exchange Marekts stability: - to assist internal competitiveness and avoid “imported” inflation - to reduce uncertainty and assist economies highly dependent on foreign trade 
 Relationship between goals In the long run all goals converge whereas in the short term can conflict. Although price stability is consistent with the other goals in the long run, in the short run price stability often conflicts with the goals of high employment and interest-rate stability. For example, when the economy is expanding and unemployment is falling, the economy may become overheated, leading to a rise in inflation. To pursue the price stability goal, a central bank would prevent this overheating by raising interest rates, an action that would initially lower employment and increase interest-rate instability. Therefore CBs are usually ruled as follows: Þ By hierarchical mandates: setting price stability as the primary goal, and growth and employment as secondary objectives (f.i. ECB), preferred since time inconsistency is reduced and as long as other goals are pursued Þ By dual mandates: achieving together price stability and minimum unemployment (f.i. FED) Short-term fluctuations of price stability are tolerated to achieve other goals if not contrasting with long run price stability. Because output fluctuations should also be a concern of monetary policy, the goal of price stability should be seen as primary only in the long run. Attempts to keep inflation at the same level in the short run no matter what would likely lead to excessive output fluctuations. As long as price stability is a long-run but not short-run goal, central banks can focus on reducing output fluctuations by allowing inflation to deviate from the long- run goal for short periods and, therefore, can operate under a dual mandate. However, if a dual mandate leads a central bank to pursue short-run expansionary policies that increase output and employment without worrying about the long-run consequences for inflation, the time-inconsistency problem may recur. Price stability is usually achieved by inflation targeting: Why? • Inflation targeting is easily understood and communicated 70 PART FIVE Financial Markets Chapter XI – The Money Market The term money market is actually a misnomer. Money—currency—is not traded in the money markets; the term refers to an exchange of wealth. Because the securities that do trade there are short-term and highly liquid, however, they are close to being money. Money market securities, which are discussed in detail here, have three basic characteristics in common: • They are usually sold in large denominations. • They have low default risk. • They mature in one year or less from their original issue date. Most money market instruments mature in less than 120 days. Money market transactions do not take place in any one particular location or building. Instead, traders usually arrange purchases and sales between participants over the phone and complete them electronically. Because of this characteristic, money market securities usually have an active secondary market. Another characteristic of the money markets is that they are wholesale markets. This means that most transactions are very large, usually in excess of $1 million. Why Do We Need the Money Markets? The banking industry exists primarily to mediate the asymmetric information problem between saver-lenders and borrower-spenders, and banks can earn profits by capturing economies of scale while providing this service. In situations where the asymmetric information problem is not severe, the money markets have a distinct cost advantage over banks in providing short-term funds. Money Market Cost Advantages Banks must put aside a portion of their deposits in the form of reserves that are held without interest at the Federal Reserve. Thus, a bank may not be able to invest 100% of every dollar it holds in deposits.1 This means that it must pay a lower inter- est rate to the depositor than if the full deposit could be invested. Interest-rate regulations were a second competitive obstacle for banks. One of the principal purposes of the banking regulations of the 1930s was to reduce com- petition among banks. With less competition, regulators felt, banks were less likely to fail. The cost to consumers of the greater profits banks earned because of the lack of free market competition was justified by the greater economic stability that a healthy banking system would provide. One way that banking profits were assured was by regulations that set a ceiling on the rate of interest that banks could pay for funds. The Glass-Steagall Act of 1933 prohibited payment of interest on checking accounts and limited the interest that could be paid on time deposits. The limits on interest rates were not particularly relevant until the late 1950s. Figure 11.1 shows that 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. These new investors caused the money markets to grow rapidly. Commercial 71 bank interest-rate ceilings were removed in March of 1986, but by then the retail money markets were well established. Banks continue to provide valuable intermediation, as we will see in several later chapters. 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 - Combine demand and supply - Provide low-cost and quick operations in order to cover short-term lack of liquidity - Allows returns and high level of safety The goal of most investors is to 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. It is important to keep in mind that 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. Recall from Chapter 4 that 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. The sellers of money market securities find that the money market provides a low-cost source of temporary funds. Operators The same intermediaries act as both lenders and borrowers, from time to time • Government’s treasuries: always demanding for money • Central banks: serve their monetary policy • Banks: most of their operations are deposit (most of them are repurchase agreements, certificate etc.) and short- term government bonds. • Investment corporations and securities: money brokerage firms, finance companies, insurers and pension funds and money market mutual funds 72 Money Market Instruments 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. Treasury bills are sold with 28-, 91-, and 182-day maturities. • Zero coupons (easier to measure risk, yield, DUR..)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. • Assumed to be risk free • Low inflation risk • Low liquidity risk: easier to find a buyer and a seller • As expected for a risk-free security, the interest rate earned on Treasury bill securities is among the lowest in the economy. • Offered through biddings (options) that are mostly competitive (decide a price not too high not too low), but there are also some of them noncompetitive (get always some bond but don’t know how much it will cost you) • Dematerialized Biddings Competitive bidding: • Maturity, amount of price and features are announced • Operators make P/Q bids that are classified by the offered price (H to L) or, equivalently, required yield (L to H) • Bids are accepted until the total amount is achieved • Each bid is priced as of the last highest accepted bid Noncompetitive bidding: • Bidders only communicate only amounts (NOT prices offered) • All offers are accepted and priced through a linked competitive bidding Regulation is needed to avoid market cornering that consists of obtaining sufficient control of a particular stock, commodity, or other asset in an attempt to manipulate the market price. . In order to avoid market cornering, two solutions can be applied: • By looking at the offers of everybody, they measure a bottom line exclusion price, so those that offer a high level of interest rate are excluded. This is done to protect government. • By looking at the offers of everybody. Inter-banking funds (banks and deposits) Federal funds are short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day. Fed funds are usually overnight investments. Banks analyze their reserve position on a daily basis and either borrow or invest in fed funds, depending on whether they have deficit or excess reserves. Suppose that a bank finds that it has $50 million in excess reserves. It will call its correspondent banks (banks that have reciprocal accounts) to see if they need reserves that day. 75 Banker’s Acceptances A banker’s acceptance is an order to pay a specified amount of money to the bearer on a given date. Banker’s acceptances have been in use since the 12th century. They are used to finance goods that have not yet been trans- ferred from the seller to the buyer. They are sold on a discounted basis like commercial paper and T-bills. Dealers in this market match up firms that want to discount a banker’s acceptance (sell it for immediate payment) with companies wishing to invest in banker’s acceptances. Interest rates on banker’s acceptances are low because the risk of default is very low. 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. London banks responded to this opportunity by offering to hold dollar-denominated deposits in British banks. These deposits were dubbed Eurodollars (see the following Global box). The Eurodollar market has continued to grow rapidly. The primary reason is that depositors receive a higher rate of return on a dollar deposit in the Eurodollar market than in the domestic market. At the same time, the borrower is able to receive a more favorable rate in the Eurodollar market than in the domestic market. This is because multinational banks are not subject to the same regulations restricting U.S. banks. The most notable feature is that 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. In addition, because these instruments have so many of the same risk and term characteristics, they are close substitutes. Consequently, if one rate should temporarily depart from the others, market supply-and-demand forces would soon cause a correction. Examples The us go up and down much more than eu area (more volatility of IR to similar signals) the changes in the Us take place before the eu area (act sooner also the reason for having wider reaction à act sooner=more uncertainty) 2013 series of biddings of Italian gov bonds average return changes dramatically month by month similar amounts between (7 and 8,5 billions) above one (return): market demand was higher than the offer) little difference between min max and average price. QUIZ: - With a repo, the lender obtains effect similar to: collateralized loans - The most volumes, in money markets, are represented by: government bonds 76 Chapter XII – The Bond Market This chapter talks about the first of several securities that trade in a market we call the capital market. Capital markets are for securities with an original maturity that is greater than one year. These securities include bonds, stocks, and mortgages. Capital Markets Main features: • The target is long-term; from 1y to forever • Interest-rate risk reduction for borrowers • Higher cost of borrowing: credit risk (cooperatives find it difficult to join money markets due to credit risk) and liquidity premiums • Very active markets, but less than money markets • Very diverse and competitive (competition is global), but not for all securities/firms • Bonds > Stocks Main Participants Issurers (issuers of bonds – governments and corporations, since they cannot be issued by individuals or issuers of stocks – corporations, they cannot be issued by individuals since some requirements must be fulfilled) • The primary issuers of capital market securities are federal and local governments and corporations. The federal government issues long-term notes and bonds to fund the national debt. State and municipal governments also issue long-term notes and bonds to finance capital projects, such as school and prison construction. 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. Lenders • Households: frequently, individuals and households deposit funds in financial institutions that use the funds to purchase capital market instruments such as bonds or stock. • Financial intermediaries • Corporations (f.i. within groups) • Governments (f.i. strategic interests) 77 Capital Marketing 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. Investment funds, corporations, and individual investors can all purchase securities offered in the primary market. You can think of a primary market transaction as one where the issuer of the security actually receives the proceeds of the sale. When firms sell securities for the very first time, the issue is an initial public offering (IPO). Subsequent sales of a firm’s new stocks or bonds to the public are simply primary market transactions (as opposed to an initial one). The capital markets have well-developed secondary markets. A secondary mar- ket 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. Bonds Features As a borrower, you’re scared that the interest rate goes too high you can establish a cap that helps the borrower so that after a certain point the interest rate stops. To have the protection, he has to pay always slightly more: this can be seen as an insurance. If you establish a cap close to the current value of the interest rate, in that case the cost is higher. The floor is the opposite: it is the interest of lender. In that case, you establish a minimum value for the interest rate; this is done in order to protect the lender. Interesting variations: step-up/down (coupons grow/shrink over time). You can have bonds that are linked to inflation, other currencies etc. and then you can have structured bonds which are even more complex • Represent a debt owed by an issuer to the investor Specified IR: • Typically, nominally fixed, or variable (f.i. Euribor1m+spread) • Quite frequently with caps and floors • Interesting variations: step-up/down (coupons grow/shrink over time) • Other structures:
 - inked (f.i. on currencies) - structured (f.i. path-dependent, reverse floater, ...) 
 Specified maturity dates for principal and interests: • Par/face/maturity/nominal value, usually at maturity 80 investors seeking safety caused the spread to hit a record 3.38% in December 2008. A bond’s interest rate also depends on its features and characteristics. Characteristics of Corporate Bonds Restrictive covenants A corporation’s financial managers are hired, fired, and compensated at the direction of the board of directors, which represents the corporation’s stockholders. This arrangement implies that the managers will be more interested in protecting stockholders than they are in protecting bondholders. Since bondholders cannot look to managers for protection when the firm gets into trouble, they must include rules and restrictions on managers designed to protect the bondholders’ interests. These are known as restrictive covenants. They usually limit the amount of dividends the firm can pay (so to conserve cash for interest payments to bondholders) Call Provisions Most corporate indentures include a call provision, which states that the issuer has the right to force the holder to sell the bond back. The call provision usually requires a waiting period between the time the bond is initially issued and the time when it can be called. The price bondholders are paid for the bond is usually set at the bond’s par price or slightly higher (usually by one year’s interest cost). If interest rates fall, the price of the bond will rise. If rates fall enough, the price will rise above the call price, and the firm will call the bond. Because call provisions put a limit on the amount that bondholders can earn from the appreciation of a bond’s price, investors do not like call provisions. A second reason that issuers of bonds include call provisions is to make it possible for them to buy back their bonds according to the terms of the sinking fund. A sinking fund is a requirement in the bond contract that the firm pay off a portion of the bond issue each year. This provision is attractive to bondholders because it reduces the probability of default when the issue matures. Because a sinking fund provision makes the issue more attractive, the firm can reduce the bond’s interest rate. A third reason firms usually issue only callable bonds is that firms may have to retire a bond issue if the covenants of the issue restrict the firm from some activity that it feels is in the best interest of stockholders. Finally, a firm may choose to call bonds if it wishes to alter its capital structure. A maturing firm with excess cash flow may wish to reduce its debt load if few attractive investment opportunities are available. Conversion Some bonds can be converted into shares of common stock. This feature permits bondholders to share in the firm’s good fortunes if the stock price rises. Most convertible bonds will state that the bond can be converted into a certain number of common shares at the discretion of the bondholder. The conversion ratio will be such that the price of the stock must rise substantially before conversion is likely to occur. Issuing convertible bonds is one way firms avoid sending a negative signal to the market. Types of Corporate Bonds Secured Bonds Secured bonds are ones with collateral attached. Mortgage bonds are used to finance a specific project. For example, a building may be the collateral for bonds issued for its construction. In the event that the firm fails to make pay- ments as promised, mortgage bondholders have the right to liquidate the property in order to be paid. Because these bonds have 81 specific property pledged as collateral, they are less risky than comparable unsecured bonds. As a result, they will have a lower interest rate. Unsecured Bonds Debentures are long-term unsecured bonds that are backed only by the general creditworthiness of the issuer. No specific collateral is pledged to repay the debt. In the event of default, the bondholders must go to court to seize assets. Collateral that has been pledged to other debtors is not available to the holders of debentures. Debentures usually have an attached contract that spells out the terms of the bond and the responsibilities of management. The contract attached to the debenture is called an indenture. Debentures have lower priority than secured bonds if the firm defaults. As a result, they will have a higher interest rate than otherwise comparable secured bonds. Subordinated debentures are similar to debentures except that they have a lower priority claim. This means that in the event of a default, subordinated debenture holders are paid only after non- subordinated bondholders have been paid in full. As a result, subordinated debenture holders are at greater risk of loss. Variable-rate bonds (which may be secured or unsecured) are a financial innovation spurred by increased interest-rate variability in the 1980s and 1990s. The interest rate on these securities is tied to another market interest rate, such as the rate on Treasury bonds, and is adjusted periodically. The interest rate on the bonds will change over time as market rates change. Junk Bonds Recall from Chapter 5 that all bonds are rated by various companies according to their default risk. These companies study the issuer’s financial characteristics and make a judgment about the issuer’s possibility of default. A bond with a rating of AAA has the highest grade possible. Bonds at or above Moody’s Baa or Standard and Poor’s BBB rating are considered to be of investment grade. Those rated below this level are usually considered speculative. Speculative- grade bonds are often called junk bonds. Protection/Guarantees Internal: are bought by the issuer to increase market’s appetite for their bonds In case of bankruptcy you don’t have just the assets of the bondholders but also of the institution; the institution offers its financial strength as a service - It can be purchased by weaker issuers to increase market’s appetite for their bonds
 - They are issued by financial intermediaries (especially banks and insurers, but also others) - Creditworthiness is transferred from guarantor to issuer (plus benefit of correlation) External: - Bondholders can purchase a guarantee over a specified issuer to increase their safety - Some insurance policies and guarantees specifically address this issue - Some of these can be traded independently from the underlying bond (f.i. credit default swaps – CDS) - CDS ≠ insurance 
 82 CDS (can’t insure things that i’m not exposed to) you can by a cds even if you’re not exposed toà betting on the failure of that company there is an issuer of cds but what about the credit worthiness? Financial Guarantees on Bonds Financially weaker security issuers frequently purchase financial guarantees to lower the risk of their bonds. A financial guarantee ensures that the lender (bond purchaser) will be paid both principal and interest in the event the issuer defaults. With such a financial guarantee, bond buyers no longer have to be concerned with the financial health of the bond issuer. Instead, they are interested only in the strength of the insurer. Essentially, 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. Of course, 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 J.P. Morgan introduced a new way to insure bonds called the credit default swap (CDS). In its simplest form a CDS provides insurance against default in the principle and interest payments of a credit instrument. Say you decided to buy a GE bond and wanted to insure yourself against any losses that might occur should GE have problems. You could buy a CDS from a variety of sources that would provide this protection. In 2000 Congress passed the Commodity Futures Modernization Act, which removed derivative securities, such as CDSs, from regulatory oversight. Additionally, it preempted states from enforcing gaming laws on these types of securities. The effect of this regulation was to make it possible for investors to speculate on the possibility of default on securities they did not own. Catastrophic Bonds I cat bond sono l'espressione stenografica di catastrophe bond, ‘obbligazioni-catastrofe'. Facciamo un esempio. Il Giappone, come si sa, è prono ai terremoti, e gli assicuratori giapponesi sono preoccupati. Come evitare di andare, finanziariamente, a pancia all'aria se una grossa scossa fa scattare trilioni di yen di danni? Una via d'uscita per ridurre il rischio è la ri-assicurazione presso un altro assicuratore. Un'altra via d'uscita è quella di emettere dei cat bond. Queste obbligazioni danno un interesse generoso, ma se la catastrofe si verifica, non pagano in tutto o in parte il capitale. I soldi incassati dall'emittente andranno allora a pagare i danni. Si tratta insomma di una operazione di trasferimento del rischio dall'assicuratore agli investitori. Questi ultimi accettano il rischio in cambio di un ‘di più' di rendimento; e acquisiscono anche uno strumento finanziario il cui rendimento non è correlato agli altri (perché dipende principalmente dal verificarsi della catastrofe, evento che è indipendente dall'andamento dei mercati) ed è quindi utile in un'ottica di diversificazione del portafoglio. Among all potential variations, ‘cat bonds’ rise up as an interesting category. Most part pays a coupon until a catastrophe or similar trigger event occurs, after which the coupon or even the principal are reduced or waived. Currently they total an outstanding of nearly 20 bln $. 85 Stock styles Income stocks: mature sectors but they are still profitable. They are called income because they provide mostly income - More frequent, regular and steady dividend payment - Focus on flows, rather than on capital gains Value stocks: they are healthy but underpriced stocks compared to peers. If you just look at their financial condition, they are weak, but you have to think that in the future they will get better/higher. Focus on future opportunities, management etc rather than financials. - “Underpriced” stocks compared to peers - Focus on future opportunities and management rather than financials Growth stocks: innovative sectors, not mature but new concepts. Start-ups. They focus on future potential capital gains. - Rapidly increasing profits reinvested rather than distributed Focus on (future potential) capital gains - Also, stocks could be listed according to their volumes (large, mid, small cap stocks) Stock Market Organized securities exchanges. 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. Organized exchanges are characterized as auction markets that use floor traders who specialize in particular stocks. These specialists oversee and facilitate trading in a group of stocks. Floor traders, representing various brokerage firms with buy and sell orders, meet at the trading post on the exchange and learn about current bid and ask prices. These quotes are called out loud. In about 90% of trades, the specialist matches buyers with sellers. About one of four orders on the New York Stock Exchange is filled by floor traders personally approaching the specialist on the exchange. The other three-quarters of trades are executed by the SuperDOT system (Super Designated Order Turnaround system). The SuperDOT is an electronic order routing system that transmits orders directly to the specialist who trades in a stock. This allows for much faster communication of trades than is possible using floor traders. About 75% of orders to buy or sell on the NYSE are executed using this system. Over The Counter markets (OTC) Securities not listed on one of the exchanges trade in the over-the-counter (OTC) market. This market is not organized in the sense of having a building where trading takes place. Instead, trading occurs over sophisticated telecommunications networks. One such network is called the National Association of Securities Dealers Automated Quotation System (NASDAQ). This system, introduced in 1971, provides current bid and ask prices on about 3,000 actively traded securities. Dealers “make a market” in these stocks by buying for inventory when investors want 86 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. Total volume on the NASDAQ is usually slightly lower than on the NYSE; however, NASDAQ volume has been growing and occasionally exceeds NYSE volume. Electronic Communications Networks (ECNs) ECNs have been challenging both NASDAQ and the organized exchanges for business in recent years. An ECN is an electronic network that brings together major brokerages and traders so that they can trade among themselves and bypass the middleman. ECNs have a number of advantages that have led to their rapid growth. - Transparency - Cost Reduction - Faster execution - After-hour trading Exchange-Traded Funds (ETFs) In their simplest form, ETFs are formed when a basket of securities is purchased and a stock is created based on this basket that is traded on an exchange. The makeup and structure are continuing to evolve, but ETFs share the following features: 1. They are listed and traded as individual stocks on a stock exchange.
 2. They are indexed rather than actively managed.
 3. Their value is based on the underlying net asset value of the stocks held in the index basket. The exact content of the basket is public so that intraday arbitrage keeps the ETF price close to the implied value. The primary disadvantage of ETFs is that since they trade like stocks, investors have to pay a broker commission each time they buy or sale shares. This provides a cost disadvantage compared to mutual funds for those who want to frequently invest small amounts. Features Trading through auctions: • Control over participating operators and transparency • Price set by buyers below its maximum potential: the winning buyer should be the one taking the best advantage of the asset, otherwise would not offer the highest price (or strongly believing it) • Information has the role to increase assets’ values or reducing their risk (uncertainty) 
 Continuous trading reduces valuation errors (that explain part of short-term volatility): • Firm and environment change, affecting growth rates (small changes, through perpetuity, lead to wide price variations) • Competition renders difficult to keep growing at high rates • Consensus on discount (risk) factors is unlikely • Estimating dividends is hard, as well as expressing unanimous future expectations 87 Information provided by markets: • Not only prices, but volumes and trends with real-time contract data • Company financials, analysts’ forecasts • Market averages (open/close) • Books • Indexes of submarkets (f.i. MTA), of specific industries (f.i. financials), of geographical areas (f.i. Latin America), • News and rumors on markets, companies, regulation, politics, ... • Statistics and market reviews Evaluation The value of stock is the present value of all future cash flows. The only cash flows that an investor will receive are dividends and a final sales price when the stock is ultimately sold. The generalized formula for stock can be written as: If you were to attempt to use this equation to find the value of a share of stock, you would soon realize that you must first estimate the value the stock will have at some point in the future before you can estimate its value today. In other words, you must find Pn in order to find P0. However, if Pn is far in the future, it will not affect years from now using a 12% discount rate is just one cent [$50>(1.12 ) = $0.01]. This means that the current value of a share of stock can be found as simply the present value of the future dividend stream. The generalized dividend model is rewritten in Equation 3 without the final sales price. The generalized dividend model says that the price of stock is determined only by the present value of the dividends and that nothing else matters. Many stocks do not pay dividends, so how is it that these stocks have value? Buyers of the stock expect that the firm will pay dividends someday. Most of the time a firm institutes dividends as soon as it has completed the rapid growth phase of its life cycle. The stock price increases as the time approaches for the dividend stream to begin. The generalized dividend valuation model requires that we compute the present value of an infinite stream of dividends, a process that could be difficult, to say the least. Therefore, simplified models have been developed to make the calculations easier. One such model is the Gordon growth model, which assumes constant dividend growth. This model is useful for finding the value of stock, given a few assumptions: 1. Dividends are assumed to continue growing at a constant rate forever. Actually, as long as they are expected to grow at a constant rate for an extended period of time (even if not forever), the model should yield reasonable results. This is because errors about distant cash flows become small when discounted to the present. 2. The growth rate is assumed to be less than the required return on equity, ke. Myron Gordon, in his 90 Despite having long term maturity and high interest rates, the risk premium is cut down thanks to the security involved (house), that is going to last for a long time as collateral to the loan. 1. Strength: you can get now a mortgage loan for 20y at below 2% IR, just because the collateral keeps the uncertainty and the risk quite low; 2. Weakness: trusting the value of the collateral is what made banks do a lot of mistakes. Given the particular features of the borrower, it is possible to have variable or fixed interest rate, decreasing/increasing installments over the years etc — each installment, however, it’s always partially principal (P) and partially interest (I) The interest rate borrowers pay on their mortgages is probably the most important factor in their decision of how much and from whom to borrow. The interest rate on the loan is determined by three factors: 1. Current long-term market rates: 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. Life (term) of the mortgage: longer-term mortgages have higher interest rates than shorter- term mortgages. Because interest-rate risk falls as the term to maturity decreases, the interest rate on the 15-year loan will be substantially less than on the 30-year loan. 3. The number of discount points paid: 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 and receives the proceeds of the loan. In exchange for the points, the lender reduces the interest rate on the loan. Borrower’s characteristics: creditworthiness, available net worth and income, outstanding debt, past behavior and related scores. Lender’s characteristics: strategy, funding and portfolio, expectations and competition Somebody taking a mortgage today has to pay an IR for 10y: how to calculate the correct IR? Fixed IR and variable IR • Premium on fixed IR if expectations of increases in IR are bigger, because on bank-side they suffer IR risk . People pays the risk because of fixed salary, predictable expenditures and therefore you can rely upon a fixed amount of money every month. • If you are rich you prefer variable IR to not pay to bank the premium 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 institution 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 underlying loan defaults. 91 Down Payments To obtain a mortgage loan, the lender also requires the borrower to make a down payment on the property, that is, to pay a portion of the purchase price. The balance of the purchase price is paid by the loan proceeds. Down payments (like liens) are intended to make the borrower less likely to default on the loan. [reduction of moral hazard]. Private Mortgage Insurance Another way that lenders protect themselves against default is by requiring the borrower to purchase private mortgage insurance. PMI is an insurance policy that guarantees to make up any discrepancy between the value of the property and the loan amount, should a default occur. PMI is usually required on loans with less than a 20% down payment. Borrower Qualification Historically, before granting a mortgage loan, the lender would determine whether the borrower qualified for it. FICO score is a credit score based on a model that weights a number of variables found to be valid predictors of creditworthiness. Types of Mortgages - Can be guaranteed by public agencies (f.i. veterans, young couples, ...) - IR: adjustable rate, ARM, with caps/floors, also in combination (f.i. fixed installment,variable rate) - Increasing installments, such as graduated payment (GPM, designed to allow credit qualification) and growing equity (GEM, designed to allow early repayment) – risky if offered aggressively - Decreasing optional installments (extremely risky for lenders) - Multiple mortgages on same collateral are possible - Reverse annuity (RAM) 
 Insured mortgages are originated by banks or other mortgage lenders but are guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA). Conventional mortgages are originated by the same sources as insured loans but are not guaranteed. Private mortgage companies now insure many conventional loans against default. As we noted, most lenders require the borrower to obtain private mortgage insurance on all loans with a loan-to-value ratio exceeding 80%. 92 In fixed-rate mortgages, the interest rate and the monthly payment do not vary over the life of the mortgage. The interest rate on adjustable-rate mortgages (ARMs) is tied to some market interest rate and therefore changes over time. ARMs usually have limits, called caps, on how high (or low) the interest rate can move in one year and during the term of the loan. A typical ARM might tie the interest rate to the average Treasury bill rate plus 2%, with caps of 2% per year and 6% over the lifetime of the mortgage. if rates fall unless they are willing to refinance their mortgage (pay it off by obtaining a new mortgage at a lower interest rate). Lenders, by contrast, prefer ARMs because ARMs lessen interest-rate risk. Recall from Chapter 3 that interest-rate risk is the risk that rising interest rates will cause the value of debt instruments to fall. The effect on the value of the debt is greatest when the debt has a long term to maturity. Since mortgages are usually long-term, their value is very sensitive to interest-rate movements. Lending institu- tions can reduce the sensitivity of their portfolios by making ARMs instead of standard fixed-rate loans. Graduated-Payment Mortgages (GPMs) Graduated-payment mortgages are useful for home buyers who expect their incomes to rise. The GPM has lower pay- ments in the first few years; then the payments rise. The early payments may not even be sufficient to cover the interest due, in which case the principal balance increases. As time passes, the borrower expects income to increase so that the higher payment will not be a burden. The advantage of the GPM is that borrowers will qualify for a larger loan than if they requested a conventional mortgage. This may help buyers purchase adequate housing now and avoid the need to move to more expensive homes as their family size increases. Growing-Equity Mortgages (GEMs) Lenders designed the growing-equity mortgage loan to help the borrower pay off the loan in a shorter period of time. With a GEM, the payments will initially be the same as on a conventional mortgage. However, over time the payment will increase. This increase will reduce the principal more quickly than the conventional payment stream would. GEMs are popular among borrowers who expect their incomes to rise in the future. It gives them the benefit of a small payment at the beginning while still retiring the debt early. The loan still pays off in 30 years. The goal of the GEM is to let the borrower pay off early. Second Mortgages (Piggyback) Second mortgages are loans that are secured by the same real estate that is used to secure the first mortgage. The second mortgage is junior to the original loan. This means that should a default occur, the second mortgage holder will be paid only after the original loan has been paid off and only if sufficient funds are available from selling the property. riginally second mortgages had two purposes. The first is to give borrowers a way to use the equity they have in their homes as security for another loan. Another purpose of the second mortgage is to take advantage of one of the few remaining tax deductions available to the middle class. Consumers prefer that the line of credit be secured so that they can deduct the interest on the loan from their taxes. Reverse Annuity Mortgages (RAMs) The reverse annuity mortgage is an inno- vative method for retired people to live on the equity they have in their homes. The contract for a RAM has the bank advancing funds on a monthly schedule. This increasing-balance loan is secured by the real estate. The borrower does not make any payments against the loan. When the borrower dies, the borrower’s estate sells the property to retire the debt. 95 market led mortgage sales people to target less financially sophisticated borrowers who were less able to properly evaluate their ability to repay the loans. 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). A CDO is similar to the CMO discussed above, except that rather than slice the pool of securities by maturity as with the CMO, the CDO usually creates tranches based on risk class. The Real Estate Bubble At times, speculators were selling to other speculators as the demand drove up prices. As with most speculative bubbles, at some point the process ends. Default rates on the subprime mortgages increased and the extent of speculation started to make the news. Those left owning properties bought at the height of the market suffered losses, including lending institutions and investors in mortgage-backed securities. One indication of this is the decline in global CDO issuance. It peaked at $520 billion in 2006. By 2009 it had fallen to $4.2 billion. By 2012 the market had recovered to $58 billion. By separating the lender from the risk, riskier loans were issued than would have been had the securitized mortgage channel not existed. Mortgages are illiquid for lenders. Partially also for borrowes (but:laws and regulation). Illiquidity threatens lenders: - IR risk (A/L mismatch but also reinvestment of future flows) - Default risk/market risk of collateral - Loan servicing is expensive (administrative costs) Secondary markets can be useful but are difficult: - Initially, ceding loans to to other investors (but costly and time consuming) - Then, funded by (and transferred to) public repurchase programs (in bulk, with asymmetric information issues) - More recently, through securization Process of securization: - Creation of a pool of mortgages, serving as collateral - Acquisition is funded through the creation of new securities, whose return and reimbursement depends on cashflows from the original pool - Risks are transferred to investors, who buy the mortgages - Securities could be tranced to imply greater or lower risks of default (CDOs, collateralized debt obligations) or different maturities (CMOs, collateralized mortgage obligations): hence, +/– IR 
 • asymmetric information problem between banks and investors: investors don’t know ‘what there’s inside’ the pool of mortgages (made of mortgages with different grades of default risk) • banks get free liquidity through the selling of the securities, and are able to increase the number of mortgage issue 96 • investors have greater capability to diversify their investment The mortgage market should increase reflecting the house price index, since the issuance and the dimension of mortgages is strictly connected with the general price of the houses . In 2007 the mortgage market was the result of increase in US price indexes or the contrary? At the beginning house index increased and, as consequence, mortgage market increased; but then mortgage market influenced the US house price index: it was easy to finance higher house prices, since the banks issued more mortgages = increase of the house prices. Chapter XV – The Foreign Exchange Market Foreign Exchange Market Trade between countries involves the mutual exchange of different currencies (or, more usu- ally, bank deposits denominated in different currencies). When an American firm buys foreign goods, services, or financial assets, for example, U.S. dollars (typically, bank deposits denominated in U.S. dollars) must be exchanged for foreign currency (bank deposits denominated in the foreign currency). The trading of currencies and bank deposits denominated in particular cur- rencies takes place in the foreign exchange market. Transactions conducted in the foreign exchange market 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. The predominant ones, called spot transactions, involve the immediate (two-day) 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. 97 Why Are Exchange Rates Important? Exchange rates are important because they affect the relative price of domestic and foreign goods. The dollar price of French goods to an American is determined by the interaction of two factors: the price of French goods in euros and the euro/dollar exchange rate. When a country’s currency appreciates (rises in value relative to other currencies), the country’s goods abroad become more expensive and foreign goods 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. How Is Foreign Exchange Traded? You cannot go to a centralized location to watch exchange rates being determined; currencies are not traded on exchanges such as the New York Stock Exchange. Instead, the foreign exchange market is organized as an over-the-counter market in which several hundred dealers (mostly banks) stand ready to buy and sell deposits denominated in foreign currencies. Because these dealers are in constant telephone and computer contact, the market is very competitive; in effect, it functions no differently from a centralized market. Exchange Rates in the Long Run Like the price of any good or asset in a free market, exchange rates are determined by the interaction of supply and demand. To simplify our analysis of exchange rates in a free market, we divide it into two parts. First, we examine how exchange rates are determined in the long run; then we use our knowledge of the long-run determinants of the exchange rate to help us understand how they are determined in the short run. Law of One Price The starting point for understanding how exchange rates are determined is a simple idea called the law of one price: If two countries produce an identical good, and transportation costs and trade barriers are very low, the price of the good should be the same throughout the world no matter which country produces it. Suppose that American steel costs $100 per ton and identical Japanese steel costs 10,000 yen per ton. For the law of one price to hold, the exchange rate between the yen and the dollar must be 100 yen per dollar ($0.01 per yen), so that one ton of American steel sells for 10,000 yen in Japan (the price of Japanese steel) and one ton of Japanese steel sells for $100 in the United States (the price of U.S. steel). Theory of Purchasing Power Parity One of the most prominent theories of how exchange rates are determind is the theory of purchasing power parity (PPP). It states that exchange rates between any two currencies will adjust to reflect changes in the price levels of the two coun- tries. The theory of PPP is simply an application of the law of one price to national price levels. The theory of PPP suggests that if one