Financial Markets and Institutions - 2023 (Prof. Dreassi A.) - Slides+Book+Lessons, Dispense di Mercato Finanziario

Scarica Financial Markets and Institutions - 2023 (Prof. Dreassi A.) - Slides+Book+Lessons e più Dispense in PDF di Mercato Finanziario solo su Docsity! Financial Markets and Institutions - 2023 ALLEGRI DANIELE Class notes & book integration 1 FMAI - 2023 0. Table of Contents 1. THE FINANCIAL SYSTEM ........................................................................................................... 2 2. INTEREST RATES ..................................................................................................................... 10 3. MARKET EFFICIENCY AND BEHAVIOURAL FINANCE ................................................................ 22 4. MONEY MARKETS .................................................................................................................. 28 5. BOND MARKETS .................................................................................................................... 33 6. STOCK MARKETS .................................................................................................................... 41 7. MORTGAGE MARKET ............................................................................................................. 47 8. FOREX ................................................................................................................................... 51 9. FINANCIAL CRISES .................................................................................................................. 55 10. CENTRAL BANKS .................................................................................................................. 64 11. BANKS ................................................................................................................................. 74 12. MUTUAL FUNDS .................................................................................................................. 80 13. INSURANCE AND PENSIONS ................................................................................................. 86 14. THE SECURITIES’ INDUSTRY .................................................................................................. 92 15. DERIVATIVES AND RISK MANAGEMENT ............................................................................... 95 PS: addi<onal examples are to be seen on the slides. Strong recommenda<on: watch “The Big Short”. 4 FMAI - 2023 Countries that have a huge flow in the financial market system experience larger financial crises. Countries that have an organic growth of financial markets achieve higher levels of economic growth. Advantages of the Indirect Channel • Lower transac<on costs (experience, <me, money) due to scale economics; • Addi<onal services (scope economies); • Risk sharing and redu<on of uncertainty; • Diversifica<on; • Redu<on of asymetric informa<on. Asymmetric Informa;on Asymmetric informa<on is one of the reasons for having financial ins<tu<ons. In every transac<on, one party knows be[er (which does not mean they take advantage, not always at least). • Adverse selecXon (ex-ante): worst borrowers (riskier, less faithful) are more ac<ve in seeking counterpar<es. The worse they are, the more noise they have to make; • Moral hazard (ex-post): borrowers may behave against the interests of lenders. When the party that knows be[er takes advantage of the party that does not know. In this case you can decide not to sign the contract. The borrower might engage in undesirable ac<vi<es that make the loan less likely to be paid back. What are the solu<ons? How do financial ins<tu<ons try to avoid these situa<ons? • Finding ways to dis<nguish “good” from “bad” risks: experience, monitoring, guarantees, covenants (but: more complexity and more costs). The result is less cheap than asymmetric informa<on; • Specializing in gathering and managing informa<on (but: free-riding and conflicts of interest). This generates trust issues. You do not know to whom banks give loans; • Increase regula<on and supervision (but: imperfect and costly). The more you ask to regulate something, the more expensive it becomes. You have to find a balance between cost and regula<on. Example Adverse selecXon: • A borrower can be good or bad • Good can pay 5% tops. Bad, instead, 10% • A bank can’t take less than 4% from good, 8% from bad • If we can find our who is good or bad, it’s just fine But if we can’t banks would offer an average rate (6%), but only bad will apply (and happily, lower rate). But banks would lose, and not offer loans. Moral hazard: • Your house value: 100,000. • You insure it at 100% against fire • 0.01% probability of a total loss from fire • Insurers ask 0.01% • 100,000 = 10. • Every 10,000 houses, 1 will burn, cos<ng 10,000 • 10 But what if there is no control, and somebody in need for cash burns his/her own house down? 5 FMAI - 2023 Transac;on Costs The smaller your porlolio the more challenging is to obtain access to markets. • GeSng to markets bears costs, especially if your funds are limited; • Some products have huge denomina<ons; • With li[le money, it is hard to diversify. Larger ins<tu<ons have larger contractual power. Solu<ons? • Scale economies: financial intermediaries are big • Scope economies: financial intermediaries offer a wide range of products • Liquidity service and informaXon Conflicts of interest Mul<ple incen<ves induce opportunis<c behaviour, such as hiding informa<on, damaging other’s interests, … Examples • Underwri<ng and placing of financial instruments in banks: three diverging interests at play (issuer, buyer, bank); • Audi<ng and advising: the advisor profits more by having more clients, clients want easy checks investors want strict scru<ny; • Ra<ng agencies: issuers want good scores, markets trust informa<on, agencies look for more clients (and clients pay for solicited ra<ngs). Typically is the company that pays these agencies. Of course, the judgement is influenced by the payment. Solu5ons • RegulaXon and supervision: they cost, separa<on reduces economies of scope, sanc<ons are enforced aperwards, compliance reduces efficiency; • Teaching ethics Categorizing markets and intermediaries Rights The difference is what kind of rights you have. Then the difference is the term. Debt: • Borrowers pay a predetermined amount at given points in <me un<l maturity • Short (<1y), medium (1-5/10y) and long term (>5/10y) Bond or Mortgage is a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal payments) un<l a specified date (the maturity date), when a final payment is made. The debt instrument could be both short-term or long term. Equity: • Right to distributed earnings and residual interest in net worth • Vo<ng rights 6 FMAI - 2023 Stocks are claims to share in the net income and the assets of a business. Equi<es open make periodic payments (dividends) to their holders and are considered long-term securi<es because they have no maturity date. They also involve the right to vote. An equity holder is a residual claimant; that is, the corpora<on must pay all its debt holders before it pays its equity holders. Equity holders benefit directly from any increases in the corpora<on’s profitability or asset value. Transferability In this case we have Customiza<on vs Standardiza<on Credit (bank loans) and also Insurance (CustomizaXon): • Difficult or impossible to transfer • Customized (on the client). The need is complex • Complex (clauses, …) • Banks and insurance companies SecuriXes (StandardizaXon): • Quickly and easily transferable • Standardized (the need is general) • Uniform contractual features • Securi<es trading ins<tu<ons Source Here we have a clear dis<nc<on. Primary: instruments issued for the 1!" <me. In this case the money goes to the original issuer. • New issues (loans, bonds, stocks, …) • Natural liquidity (cash flow for the borrower) • Mainly for ins<tu<onal investors The main purpose is to fit with the right price the need to borrow of that par<cular firm or government. Secondary: insturments issued before. Your money goes to the previous owner of that instrument. • Old issues • Many intermediaries but also retail players • Ar,ficial liquidity (it creates more liquidity than the primary market) • Prices influence primary markets The main purpose here is to create more liquidity and to create prices. Issuers keep an eye also on the secondary market, for example to set the price of their issuances. Two important func<ons: 1. Make it easier and quicker to sell these financial instruments to raise cash: 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. 2. Determine the price of the security that the issuing firm sells in the primary market. Organiza5on Here the dis<nc<on is more blurred, foggy. Exchange: deeply regulated, internal and external regula<ons. 9 FMAI - 2023 1. Restric<on on entry and exit 2. Disclosure 3. Restric<ons on assets and ac<vi<es 4. Deposit insurance 5. Limits on compe<<on 6. Restric<ons on interest rates 7. Pruden<al supervision 10 FMAI - 2023 2. Interest Rates • Why do we need IR and how do we measure them? • What are Real IR and why are they important? Interest rates are not just the return you get. • How do we use IR to measure returns and risks? • Can we predict interest rates? If you can predict what is happening in the future you can decide when to invest. We have thousands of IRs. Present Value The concept of present value is based on the common sense no<on 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 process of calcula<ng today’s value of dollars received in the future is called discoun,ng the future. We can generalise this process by wri<ng today’s (present) value as PV, the future cash flow as CF, replacing interest rate by i, and years from now by n. This leads to the following formula: 𝑃𝑉 = 𝐶𝐹 (1 + 𝑖)# The concept of Present Value enables us to figure out today’s value of a credit market instrument at a given simple interest rate i by just adding up the present value of all the future cash flows received. IR and Financial Contracts • Baloon/simple loan: you give 𝑥 and aper one year you get 𝑥 + 𝐼. A simple loan, in which the lender provides the borrower with an amount of funds, which must be repaid to the lender at the maturity date along with an addi<onal payment for the interest; • Discount bond (ZC): PV: 99 (less risky) or 95 (more risky). NV is 100 for both. A Discount Bond (ZC) is bought at a price below its face value (at a discount), and the face value is repaid at the maturity date. Unlike a coupon bond, a discount bond does not make any interest payments. o Maturity: not necessarily 1 year, can be more or less; 11 FMAI - 2023 o The final value is always 100; o It does not have flows. We fix the final value. o Many government bonds are like this. o But it is not convenient with long-term maturi<es (because you have no periodical inflows) • Coupon bonds: you get periodical interest payments. A coupon bond pays the owner of the bond a fixed interest payment (coupon payment) every year un<l the maturity date, when a specified final amount (face value or par value) is repaid; • Fully amorXzed loan: there is no final payment. You get repaid the full amount of debt with each instalment. 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), consis<ng of part of the principal and interest for a set number of years. In the case of the Italian Amor<za<on Plan, the principle is fixed up ‘<ll the maturity date, whereas interest diminishes over <me. This is chosen for the deprecia<on of equipment by firms, because machinery is highly produc<ve at the beginning of its life, but becomes obsolete with the passing of <me. Measures of IR Yield To Maturity (YTM) Yield To Maturity (YTM): the interest rate that equates the present value of cash flows received from a debt instrument with its value today. It can also be called “effec<ve interest rate”. Strikes a balance across cashflows. For simple loans only it equals the nominal rate. • Zero Coupon (ZC): 𝑌𝑇𝑀 = 0 𝐹𝑉 𝐶𝑉 ! − 1 𝐹𝑉: Face Value, 𝐶𝑉: Current Value, 𝑛: n° of years • Coupon bonds (and others): 𝐶𝑉 =3 𝐶𝐹" (1 + 𝑌𝑇𝑀)" # "$% 𝑉𝐴 =3 𝐶" (1 + 𝑌𝑇𝑀)" # "$% + 𝐹𝑉 (1 + 𝑌𝑇𝑀)# +𝑌𝑇𝑀,−𝐶𝑉: an increase in IR lowers the current value (and v.v.). The greater the YTM, the smaller the CV (bond price). Nega<ve rela<on between yields and prices of bonds. The less you pay the bond, the greater the YTM. 14 FMAI - 2023 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 = F 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 H • 100 IR and RoR differ because of capital gains: 𝑅𝑜𝑅 = 𝐶 + 𝑃"(% − 𝑃" 𝑃" = 𝐶 𝑃" + 𝑃"(% − 𝑃" 𝑃" = 𝑖) + 𝑔 o * +" : the Coupon Payment If holding period equals <me to maturity, return equals YTM (assump<on of reinves<ng at ini<al return) only for ZCs: Reinvestment Risk (if holding period is longer, even more reinvestment risk) The bigger the <me to maturity, the bigger the effect on capital gains due to changes in IR: Interest Rate Risk Risk for the in<re face value. There is an inverse rela<onship between IR and Capital Gains (the value of the instrument) Even if unrealised, capital gains represent an opportunity cost. When IR change, the only thing that makes things different is the price. Silicon Valley Bank, that defaulted in the last few days, didn’t wait for maturity because clients requested money before and the bank couldn’t raise enough to give back to clients. IR and risks: Dura;on DuraXon tells the number of years that it will take the bond’s cash flows to repay the price paid for the bond. Dura<on tells us how much a bond’s price might change when interest rates change. Higher dura<on means the bond’s price is more sensi<ve to interest rates changes, and viceversa. The price of a bond with a dura<on of 5 will increase or decrease by 5% due to a 1%-change in the interest rates. • The farther the cash flows, the more the risk. • The shorter the cash flows, the less the risk. Shorter maturi<es and greater coupons imply lower losses due to IR changes. But instruments with the same maturity have different risks (ex.: spread IT/DE), or with different maturi<es they can have similar levels of risk (ex.: they pay coupons or not). SOLUTION: weigh the maturi<es of the single cash flows (dura<on, effec<ve maturity). For Discount Bonds ZC it equals the residual maturity. Other instruments can be represented as porlolios of ZC (zero coupon). How do you compare IR risks in debt instruments with different features? 𝐷𝑈𝑅 = ∑ 𝐹𝐶" (1 + 𝑖)" # "$% • 𝑡 ∑ 𝐹𝐶" (1 + 𝑖)" # "$% • + dura<on, - coupon, + IR = + dura<on o ∑ ,*" (%(.)" # "$% is equal to the Current Price P. o PURPOSE: <ming for each cash flow. § For Zero Coupoun ZC: maturity date! o It is the sum of cash flows weighted by their <me to maturity o Each flow of a bond is a zero coupon. We can look at a bond as a porlolio of zero coupons. o What do you get if you discount cash flows? The price today. 15 FMAI - 2023 • The dura<on approximates the Interest Rate Risk: %∆𝑃 = (𝑃"(% − 𝑃") 𝑃" = −𝐷𝑈𝑅  •   ∆𝑖 (1 + 𝑖) o If IR goes down, Price goes up. The higher the ∆𝐼𝑅, the higher the ∆𝑃. o This is the first deriva<ve of: ∑ ,*" (%(.)" # "$% Issues with Dura;on It is a linear proxy of a convex nega<ve rela<onship between P and i: Dura<on as the first deriva<ve… convexity (how fat or skinny the curve is) as the second! 𝐶𝑂𝑁 = 1 𝑃  •  (1 + 𝑖)0   •  3F 𝐶𝐹" (1 + 𝑖)"   •  (𝑡0 + 𝑡)H 1 "$% Forecas;ng IR Why do interest rates change? • Bonds’ Demand: why do people increase bonds’ demand? Why does the demand ship? (+: right; -: lep) o (+) Wealth owned by an individual o (+) Expected return on the bond rela<ve to other assets o (-) Expected future interest rates o (-) Expected future infla<on (real returns) o (-) Risk (uncertain return) rela<ve to other assets o (+) Liquidity rela<ve to other assets • Bonds’ Supply: Why does the supply ship? (+: right; -: lep) o (+) Profitability of investments (more earnings) o (+) Expected infla<on (cheaper borrowing) o (+) Government deficits (more public debt) Goverment spending increases with the same level of taxes. Profitable companies will supply more bonds 16 FMAI - 2023 • Changes due to inflaXon: When expected infla<on rises, interest rates will rise. This result has been named the Fisher effect. The demand of bonds falls, and the demand curve ships to the lep due to the fall of the expected return on bonds rela<ve to real assets. At any given bond price and interest rate also the supply curve ships as the real cost of borrowing has declined, causing the quan<ty of bond supplied to increase. The equilibrium bond price has fallen because the bond price is nega<vely related to the interest rate, from which follows that the interest rate has risen. The equilibrium quan<ty of bonds remains the same. An increase in expected infla<on affects simultaneously demand (decrease of expected return) and supply (cheaper borrowing). Interest rates will increase (prices fall) and the effect on quan<ty is not readily predictable. o An increase in expected infla<on affects simultaneously demand (decrease of expected return) and supply (cheaper borrowing) o IR will increase (price fall) o Effect on quan<ty is not readily predictable People act based on their expecta<ons. • Changes in IR due to business cycle: economic boom or recession o An economic expansion affects simultaneously demand (increase of wealth) and supply (greater expected returns on investments) o Quan<ty will increase o IR can increase or decrease (usually, increase - and decrease during recessions) Economic boom: people and firms are wealthier; firms take more advantage. 19 FMAI - 2023 slope downward and be inverted. 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. • If bonds at different maturi<es are perfect subs<tutes, their expected return must be equal We have to compute the average of short-term yields: S1 + 𝑖#,3T # = S1 + 𝑖%,3TS1 + 𝑖%,%' T  •   …   •  (1 + 𝑖#4%' ) → 𝑖#,3 ≈ 𝑖%,3 + 𝑖%,%' +⋯+ 𝑖%,#4%' 𝑛 It is basically the average of 1-year bonds star<ng today, 1-year bonds star<ng one year from now, and so on. o Strenght: connec<ons among maturity dates o It explains why short-term and long-term yields tend to move together • Predicts flat curves, whereas yield curves are usually upward-slopin Slope of the yield curve: • Upward-sloping yield curve: short-term yields are expected to go up in the future. • Downward-sloping yield curve: short-term yields are expected to go down in the future 2. Market Segmenta5on theory This theory basically says that yields are simply determined by supply and demand, by the preferences of investors. It accounts for the fact that yield curves almost always slope upward. It sees markets for different-maturity bonds as completely separate and segmented. The key assump<on, here, is that bonds of different maturi<es are not subs<tutes at all, so the expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity, because investors have strong preferences for bonds of one maturity but not for another. In a typical situa<on the demand for long-term bonds is rela<vely lower than that for short-term bonds, long-term bonds will have lower prices and higher interest rates, and hence the yield curve will typically slope upward. People has preferences on return <me. People prefer short-term because it has less risk. • Bonds at different maturi<es are not subs<tutes and each has a specific market, as well as each investor has a preferred maturity • Together with interest-rate risk aversion, explains why longer investments require a risk premium. • Does not explain why IR move together along <me • Does not explain why with high short-term IR inversion is more likely • You do not get why 𝑰𝑹𝑺𝒉𝒐𝒓𝒕4𝑻𝒆𝒓𝒎 > 𝑰𝑹𝑳𝒐𝒏𝒈4𝑻𝒆𝒓𝒎 3. Liquidity Premium theory This theory combines features of both theories. It 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 condi<ons for that bond. Its key assump<on is that bonds of different maturi<es are subs<tutes, 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: bonds are just subs<tutes, not perfect subs<tutes. Investors tend to prefer shorter-term bonds because these bonds bear less interest-rate risk. For these reasons, investors must be offered a posi<ve liquidity premium to induce them to hold longer-term bonds. • Combines the other two in a comprehensive way. 20 FMAI - 2023 • Adds to expecta<ons theory a liquidity premium for longer term bonds that is subject to market (demand, supply) condi<ons for that segment • Bonds are subs<tutes as long as investors’ preferences are compensated with a term (liquidity) premium that is always posi<ve and grows as maturity gets longer 𝑖#,3 ≈ 𝑖%,3 + 𝑖%,%' +⋯+ 𝑖%,#4%' 𝑛 + 𝑙#,3 • Explains inverted term structures (nega<ve curves): when future expecta<ons on short-term IR are of a wide fall, so that their average is not balanced even by a posi<ve liquidity premium (more likely when short-term rates are high) • Support empirical evidence that: o Term structure is a predictor of business cycles and infla<on o Term structure is less reliable for intermediate movements We can’t s<ll determine what happens in the medium-term. It is unlikely that in the long-term the yield curve be perfectly downwards sloping. Forward and spot rates Spot rate: it is interest rate that you can get on a loan that starts immediately. Forward rate: it is the implied interest rate on a loan that begins at some point in the future. Term structures allow to measure expected IR: Expected future IR are forward rates, in contrast to spot rates. Knowing spot IR we can derive market expecta<ons. For instance: 𝑖%,%' = @%(.#,%A # %(.&,% − 1, or, generalizing: 𝑖%,B' = @%(.'(&,%A '(& @%(.',%A ' − 1 Including liquidity premiums: 𝑖%,B' = @%(.'(&,%4C'(&,%A '(& @%(.',%4C'(&,%A ' − 1 Can we gain from knowing the yield curve? Imagine that, as CFO of your firm, you know that you are going to receive 1mln€ in 1 year. Yov also know that: i(1,0)=1% and i(2,0)=3% 0 1 i1,1)}=198%? — +1.000.000 Inflow + 1,000,000 1. Loan +990,099-1,000,000 2. Investment | -990,099 +1,050,396 NET RESULT o 0 +1,050,396 X = 1- DAR FOMANO VATE pr ei 1+2% (4+x ) = (1+35)” 101 (14%) - (4.02)* LeT(4+X) - 1.0609 1o% 1.02 1+X - 4,0460095 Xx = 1.06 009-4 Xe ©.049004 - G.9097,  24 FMAI - 2023 • Future changes in stock prices are unpredictable and seem to follow a random walk Evidence against Efficient Market Hypothesis Evidence against market efficiency is: • Small-firm effect — small firms have higher returns in the long run than bigger firms, even controlling for their greater risk. This may be due to rebalancing of porlolios by ins<tu<onal investors, tax issues, low liquidity of small-firm stocks, large informa<on costs in evalua<ng small firms, or an inappropriate measurement of risk for small-firm stocks; • January effect — recurrently, prices consistently rise between December and January, probably due to taxes issues. Investors have an incen<ve 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 repurchase the stocks, driving up their prices and producing abnormally high returns; • Stock prices may overreact to news announcements and pricing errors are corrected only slowly. Overreac<on is due to new, especially bad, unexpected informa<on; • The stock market appears to display excessive vola,lity: fluctua<ons in stock prices may be much greater than is warranted by fluctua<ons in their fundamental value, f.i. dividends, produc<on, sales, …; • Stock returns display mean reversion: stocks with low returns today tend to have high returns in the future, and vice versa. Mean reversion indicates that there will be a predictable posi<ve change in the future price, sugges<ng that stock prices are not a random walk. The market produces an average. If you can predict a path the market is not efficient. Bubbles, Fraudsters, … Bubbles are not a proof of efficiency, as itself. Bankrupts → badly managed banks must default Prices good for yesterday are not good for today, because the world changes. Assets’ booms or crashes and investor’s good tracks are an<-Efficient Market Hypothesis? • Unexpected new informaXon with impact on fundamentals not incremental (does not mean that it is unefficient. The market can not forecast frauds, catastrophes, pandemics) o accoun<ng frauds or “scandals” (Enron - losses moved to subsidiaries -, Parmalat, …) o catastrophes (9/11, earthquackes, …) • “RaXonal” bubbles (because if everyone believes something, all the firms with that something will get more and more money): o expecta<ons of others being ready to pay higher prices → self-fulfilling o expecta<ons change (fear), adjustments are quick and sharp 25 FMAI - 2023 What about A.I.? Can you determine if it is a bubble or if it will be something revolu<onary? • Some investors seem to overperform (ex.: Warren Buffet, maybe he was just lucky…) o with private informa<on Silicon Valley Bank’s CEO sold stocks one week before the bankruptcy. o with market influence/power If Warren Buffet says he likes more Coca-Cola than Pepsi, people will buy Coca-Cola’s stocks because they assume that he is gonna buy those stocks, therefore increasing the price. o with criminal charges We are only humans… Many assump<ons of economic theory require: • ra<onal, perfectly informed and op<mally ac<ng operators • whose behavior is based on op<mizing func<ons (u<lity, profit, ...) Behavioral finance inves<gates human behavior in economic and financial decisions, applying concepts of psychology, sociology, …, in the case of imperfect markets and irra<onal operators that act on rules of thumb. “Pain of Paying”: it is how much you feel the ac<on of paying. You lose this “pain” for example with credit cards. Behavioural Finance 1. Prospect theory: • People «filters» informa<on to cope with complexity You have too much informa<on to deal with. When you do something good it’s your success, but when you do something wrong then it is someone else’s fault. You end up in rules of thumb. • People apply «heuris<cs» that lead to errors and distor<ons 26 FMAI - 2023 • Decisions are the result of both a «fast» (emo<onal, ins<nc<ve) and a «slow» (ra<onal, analy<cal) cogni<ve system • The same problem, presented differently, leads to different answers (framing) • Valua<ons are based on value and not on expected u<lity, mostly gains/losses compared to a status quo For example: gips. • Gains and losses are perceived asymmetrically (typically 2:1) We do not think about how market condi<ons will affect savings, pensions, … We base on past, not on future. For losses we react twice than if it was a gain. 2. Mental accoun1ng: o Investors weigh differently their money depending on its origin and purpose, not altogether o Income and wealth are divided in «mental accounts», each with a different propension to being consumed, saved, and a different risk aversion Depending on the source and aim we have a different risk aversion. o These propensions change depending on past results obtained from experience Depending on how we earn money we give different value and importance to it. Combined together you could see that what is on top could harm the bo[om. 3. (main) HeurisXcs (the tricks the brain plays on us): • Availability: o Likelihood of an event is influenced by how easy it is to recall it from memory, but typically it is not the normality o In building scenarios, more weight to more familiar experience • RepresentaXveness: 29 FMAI - 2023 • Banks have short-term excesses/deficits: o Reserve requirements (bank runs) o Limited compe<<on (financial stability) • Treasuries of governments, firms o Inverstment corpora<ons, securi<es’ industry, non-financial en<<es • Central Banks and monetary policy o Monetary policy: highly engaged with the management of interest rate and liquidity (supply of money) Different maturi<es have different prices. EURIBOR: Euro Inter Bank Offered Rate Money Market Instruments Short-Term Government Bonds A Treasury bill (t-bill), or S-T Government Bond, is widely held and is the most liquid security, issued by the Government to finance na<onal debt. The government does not actually pay interest on Treasury bills. Instead, they are issued at a discount from par (their value at maturity. Zero Coupons). • Short-term need for liquidity (ex.: gap between tax inflows and salaries of public employees, buying drugs for hospitals, energy for schools, …) • They are frequently Zero Coupons • They are very safe: IR are very low: low default-risk, low infla<on risk, low liquidity risk (varying across <me/countries, but the risk is s<ll smaller than company bonds in those countries) • Placement usually through bidding • Dematerializa<on (they are not printed any longer) Biddings / Auc?ons They are an efficient way of placing huge amounts of money to the best offer with not too much nor small interest rate. • CompeXXve Bidding: Each week the Treasury announces how many and what kind of Treasury bills it will offer for sale. The Treasury accepts the bids offering the highest price. Each accepted bid is then awarded at the highest yield paid to any accepted bid. You have to pay more than others to win the bid, but you do not know others’ offers in advance. o Maturity, amount and features are announced in advance, so that offers can be prepared → quan<ty + price o Operators make 𝑃/𝑄 bids that are classified by the offered price (high to low) or, equivalently, required yield (low to high) § Too high/too low prices are excluded, because in the past somebody was able to corner the markets. Bonds are collateral. If somebody offers a very high price, and they get all of the bonds, then they have the possibility to set the price of a good that everybody else will need (as a collateral, as said) o Bids are accepted un<l the total amount is achieved 30 FMAI - 2023 o Each bid is priced as bidded (yet other rules apply) • NoncompeXXve Bidding: Noncompe<<ve bids include only the amount of securi<es the investor wants. The Treasury accepts all noncompe<<ve bids. Compe<<ve bidders pay the same price as noncompe<<ve ones. The only difference is that compe<<ve bidders may or may not end up buying securi<es whereas the noncompe<<ve bidders are guaranteed to do so. You are 100% sure that you will get the bond. o Bidders communicate only amounts (not prices) o All offers are accepted and prices through a linked compe<<ve bidding Regula<on is needed to avoid market cornering: admi[ed bidders, size/number of orders, maximum and minimum prices/returns, ... Interbanking Deposits The vast majority of opera<ons have a 1-day maturity. Interbanking Deposits refer to an arrengement between two banks, in which one holds funds in an account for another ins<tu<on. The interbank deposit arrangement requires that the holding bank opens a due to account (liability account) for the other one. The correspondent bank is the one that waits for the deposit. Inter-banking funds (e-MID) are short-term funds transferred (loaned or borrowed) between financial ins<tu<ons, usually for a period of one day. The Central Bank has set minimum reserve requirements that all banks must maintain. To meet these reserve requirements, banks must keep a certain percentage of their total deposits with the Central Bank. The main purpose for inter-banking funds is to provide banks with an immediate infusion of reserves should they be short. Allows banks to cover temporary liquidity gaps rela<vely cheaply or to earn returns on short-term cash availability. Inter-banking funds are usually overnight investments. • Funds mostly extremely short-term (1 day) between banks • Vast volumes: Eurozone Overnight (EZ ON) averaging around 20 billions € daily only. • Both unsecured and secured Before 2008 crisis most of the market was made by unsecured. Then the secured part take over the unsecured. • For reserve requirements and temporary liquidity gaps • Typical maturi<es are overnight (t, t+1), tomorrow next (t+1, t+2), spot next (t+2, t+3), but also on-sight (t, n) and broken date (k, n) are available It is be[er to make those opera<ons with fixed rates. Banks se[le payments through their accounts in the central bank. • IR developed here (Euribor, €STR, Libor) influence other IR(and financial products) A lot of deriva<ve contracts are related to Euribor, €STR, Libor. • CBs influence these rates by ac<ng on reserves or by producing/absorbing liquidity The CB established a maintenance period, and banks have to hold an average over that period. Overnight opera<ons can allow banks to fix the average. Repos (Repurchase Agreements) Repurchase agreements (repos) work much the same as inter-banking funds except that non-banks can par<cipate. A firm can sell Treasury securi<es in a repurchase agreement whereby the firm agrees to buy back the securi<es at a specified future date. 31 FMAI - 2023 A dealer sells government securi<es to investors, usually on a overnight basis, and buys them back the following day at a slightly higher price. That small difference in price is the implicit overnight interest rate. For the dealer → Repo For the buyer → Reverse Purchase Agreement • Very short term but longer than typical interbanking funds • Loan is collateralised by securiXes traded in an ac<ve market (mostly, gov. bonds) Formally selling & purchase using government bonds as what is exchanged. It is a loan: selling & repurchase at different points in <me. • Specified maturity, current market price, specific future price • CBs are also ac<ve in the repo market, injec<ng or absorbing liquidity Other instruments include: CDs (Cer5ficate of Deposit) A negoXable cerXficate of deposit is a bank-issued security that documents a deposit and specifies the interest rate and the maturity date. • Securi<es issued by banks documen<ng a deposit and bearing a maturity date and interest rate (fixed or variable), usually closely tracking infla<on or short-term gov. bonds with a premium • Could be bearer instruments (can be traded, but can incen<vize money laundry), allowing an easier nego<ability (yet An<-Money-Laudry AML applies) Bearer Instrument: a bearer instrument, or bearer bond, is a type of fixed- income security in which no ownership informa<on is recorded and the security is issued in physical form to the purchaser. The holder of a bearer instrument is presumed to be the owner, and whoever is in possession of the physical bond is en<tled to the coupon payments. • Maturi<es are generally between 1 and 4 months, concentrated in shorter maturi<es • High face values: mostly greater than 1 million $ 34 FMAI - 2023 Issuers and lenders: • Issuers of bonds: governments and corpora<ons (financial and non-financial) • Issuers of stocks: corpora<ons (financial and non-financial) • Lenders: o Households Given that they have some savings they may want to invest in this market. o Financial Intermediaries Banks that buy bonds of other banks. o Corpora<ons (f.i. groups) You have a parent company that wants to build a long-term rela<onship with another company. Car manufacturers can buy a chain of sales networks or they can buy a small version of a bank. This bank instead of asking 30k for the car it can offer a lease. The manufacturer of the car may be interest in this addi<onal service, lending to allow more people to buy cars. Stock ownership are a way to have a certain influence of another company. o governments (f.i.“strategic”interests) They can’t issue stocks. With bonds borrowers lock in the interest rate they pay, up to maturity. The problem for China and emerging markets is that money is hard to find internally in the country. People is consuming most of their salary and they can’t save, therefore they can’t buy Bonds/Stocks. In the mean<me, if the companies want to grow they need to raise capital abroad: how do you manage this risk, the Currency Risk? Emerging Markets usually put themselves in trouble because they are raising money abroad. Among those that issued debt: government, non-financial corpora<ons, households. Advanced Economies achieve their level of economic growth by having a large share of Government Debt of GDP, Non-financial corpora<on debt on GDP and low extent of households debt. In total non-financial sector is indebted for way more than 2.5 <mes the GDP of Advanced Countries. On the other hand, emerging markets are experiencing a much lower Government Debt, a comparable Non-financial Corpora<on debt and a comparable slightly less Household debt to GDP. The final figure for them is below the Advanced Markets, but is not that far. Mainly due to non- financial corpora<ons that are more in advanced countries and to governments that are less indebted than non-financial corpora<ons. Non-financial corpora<on debt issues can become a Goverment issue. Emerging Market debt is considered more fragile, more prone to infla<on and bankruptcy than Advanced Markets. If we consider the total of the non-financial sector, with the exep<on of the spike due to the pandemic, the Emerging Countries are catching up very fast, by placing a lot of debt in Non-financial corpora<ons. 35 FMAI - 2023 Fixed Income You have a moment in which you purchase and it has a certain price, then you have a maturity date in which you get the face value and in the mean<me you may have one or more coupons. Coupons can be one, two, twenty <mes per year. The lender wants to see the most amount of money along the year, the borrower wants to pay as li[le as possible. IR: • Typically, fixed or variable (f.i. Euribor 1m + spread) Fixed: predictable flow of coupons. Floa<ng interest rate: variable interest rate, for those who fear interest rates will fall down. In this case you have a problem on both side: lender and borrower. Too much variability will harm you. Interest rates are lep to float above the floor and below the cap. The floor protects the lender, and the cap protects the borrower. Why is it good to have both together? They have contras<ng interest, and imagine two companies: one with 100% floa<ng bond, the other one 100% floa<ng bond + cap. Which one would you like to pay more? Other things being equal, if a borrower puts a cap, it need to pay more YTM, because they have to compensate now the expected PV of the circustamces in which the cap is ac<ve. The more <me it is likely to happen, the greater the yield you have to give to the investor → smaller price. On the other hand, if you have a bond without a cap, it is more valuable for the lender, and therefore the price is higher and the YTM is smaller. If you combine the cap and floor, and you price them reasonable (meaning there is the same probability of going above the cap or below the floor) then the two premiums are gonna compensate each other. Because you give something to both lenders and borrowers. Euribor, LIDAR, … : money market measures. • Frequently with caps and floors If they are variable, of course. • Varia<ons: step-up/down (coupons grow/shrink over <me) Coupons in the step-up grow, but we decide it now. First year 1%, second year 1.5%, third year 2%, and so on. Same but opposite with the step down. 36 FMAI - 2023 The idea behind step up and step down is to make it easier to follow a certain growing or shrinking expecta<on about IR. If the market expecta<ons are the follwing: we avoid to bear the fluctua<ons of the IR (red line). The opposite with a step-up bond structure. You can also have both together, depending on the IR expecta<ons. • Other: linked (f.i. on currencies) or structured (f.i. reverse floater, ...) Linked coupon structure, to currency, pays out in dollars but the value of the coupon depends on the change Swiss Mark to Dollar. Imagine a Swiss company dealing with dollars. This can somehow give a sort of protec<on if you believe swiss mark to be stronger than dollar. Structured coupon structure, reverse floater: coupon goes down when IR goes up, and goes up when IR goes down. This is interes<ng if you are highly exposed to the money market. Reverse Floater: An alterna<ve can be leveraging on money market: • Specified maturity dates for principal (except perpetu<ty) and interests (except ZC) Perpetuity: no maturity, but fixed coupon forever. Perpetui<es were the issues for Credit Suisse. As long as you have the coupon and the current price you can determine the yield to maturity of the perpetuity. Divide the coupon by the current price = YTM. 𝑌𝑇𝑀 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒 𝐶𝑜𝑢𝑝𝑜𝑛 %(D.'CE D.'CE . A small change in the YTM through this formula can lead to a greater change in dura<on. Perpeturi<es are something in between Bonds (you get a coupon) and Stocks (in case of default you get nothing) • If payments are missed, bondholders have a claim over debtor’s assets (claim level may vary widely) Even only one payment. 39 FMAI - 2023 • secured (mortgage or other tangibles – asset backed securi,es or ABS) – with higher priority in case of default Vs. unsecured (called debentures) – with lower priority and higher IR Debentures: a type of bond or other debt instrument that is unsecured by collateral. In the case of ABS, pledged assets are other assets that provide a stream of cash periodically. These bonds are more secure, but only if the assets are valuable. • some issues can be tranched in senior/mezzanine/junior tranches, with decreasing subordina<on of claims at default Junior: later in priority in case of bankruptcy. Senior: first in priority in case of bankruptcy. • Investment grade (at or above Moody’s Baa or S&P’s BBB) Vs. high-yields bonds (junk/specula<ve bonds) In the high-yields is not 100% that they fail. Ra;ng Ra<ng companies have a lot of conflicts of interest. Companies that are rated are paid by the ra<ng firms • Investment Grade: likelyhood of defaul<ng is very low • High yield: medium-high risk • Default: almost 100% risk of default, but never 100% RH graph → RaXng splits: when different ra<ng companies do not agree on the same level. The riskier, the greater the differences. Financial Guarantees A form of protec<on: Internal: • purchased by weaker issuers to increase market’s appe<te for their bonds • issued by intermediaries (especially banks and insurers, but also others) • creditworthiness is transferred from guarantor to issuer In someway you can buy the creditworthiness of other companies. You can ask a AAA bank to guarantee your BB bond. 40 FMAI - 2023 External: Outside of the bond contract. • bondholders can purchase a guarantee over a specified issuer • some insurance policies and guarantees specifically address this issue You can ask banks to take the risk of bankruptcy, aper a payment. • some of these can be traded independently from the underlying bond (f.i. credit default swaps – CDS) Credit Default Swaps (CDS): it is highly standardized. It is as simple as it can be. You write the issuer you are protec<ng, the event that will trigger your payment, the dura<on, … but the most important thing is that you can sell this CDS to other people. Financial instruments that help a lot, but they are very open to specula<on, since they do not expose to the risk directly. 41 FMAI - 2023 6. Stock Markets Together with bonds they represent the leading source of funding for financial and non-financial corpora<ons. Stocks are much more vola<le with respect to bonds. Purpose and Features • Stocks represent ownership: voXng rights (with excep<ons) • No maturity date Interes<ng for the company. • Residual claim in case of default (compared to other creditors and within stockholders) In case of bankruptcy you are the last geSng something from liquida<on. • Returns are based on: o Dividends: periodical uncertain payments over profit/reserves Different from coupons: you do not know how much you are gonna get. But no earnings no dividends. Companies can also decide to distribute more than earnings, by decreasing equity returns. o Capital gains/losses: changes in prices (secondary markets) • OpXon rights on new issues that may have a separate market Deriva<ve. Imagine you hold 50% of a company which decides to raise capital. What happens is that aper new capital is issued, op<on rights are given: you have 50%? you can buy new shares in order to maintain your holding. If you do not want to buy the new stocks, you can sell the right you have to others, that will have the right to buy the stocks before they are offered to everyone. Huge vola<lity in expected returns. • Main categories: o Common Stock § Typical form, with several varia<ons § Dividends, vo<ng rights and subordina<on to creditors o Preferred Stock § fixed predetermined dividend They can determine you get 5% of the stock value every posi<ve year. § limited vo<ng rights § priority over common stock § frequently held by founders o Tracking Stocks: performing as a division/project rather than a whole firm When you buy a stock, you buy a percentage of the whole company. But maybe you are not interested on the whole company. Companies can issue stocks linked with specific branches of the company itself. Features/contents strongly depend on country-specific regulaXon. 44 FMAI - 2023 AcXve Funds: those that try to beat the market. Normally passive funds are more a[rac<ve in terms of performance, but ac<ve funds are more able to spot a crisis and react to it x(downside protec<on). Difficult <mes increase the need for ac<vism (of passive funds)? Range of possibili<es of ac<ve and passive. Mutual Funds have prices printed once a day, everyday you know how much the share is valued. Auc;ons vs Con;nuous Trading Auc1ons: • Control over par<cipants and transparency • Price set by “best” buyers (best advantage=highest price) • InformaXon increase values: less vola<lity, be[er expecta<ons • Costly, less efficient, limited <me availability Con1nuous trading: • be[er price discovery/signaling, lower evalua<on errors • more short-term vola<lity: firms/environment change quickly (growth, discoun<ng, es<mates, ...) • Less costly, pricing all over the trading day, dynamic books and more sophis<cated orders (f.i. limit) • Trading advantage of some par<es (informa<ve, tech) Those that have more informa<on can take advantage. For highly liquid markets the threshold is smaller, because it is more difficult for it to have swings. The opposite for illiquid markets. Currently, a hybrid: • open/close auc<ons / Trading halts and vola<lity auc<ons • Some important, global markets are auc<oned (f.i. LME) Stock markets tend to balance the two kind of markets. Informa;on and trading • Prices, volumes, trends, contract data • Most data provided in real-<me • Company financials, analysts’ forecasts • Market indexes, submarkets, industry, ... • Books of orders • News on markets, firms, regula<on, poli<cs, ... • Sta<s<cs and market reviews Humans are limited in terms of speed, there will always be an algorithm doing it be[er and faster. Stock evalua;on How can we tell if a price of a stock is right? 45 FMAI - 2023 First strategy PV of future CF (dividend discount model) • Robust, solid, consistent... but the challenge requires to semplify • Generally: 𝑃3 = F& %(B) +⋯+ F! (%(B))! + +! (%(B))! The generalised dividend model says that the price of stock is determined only by the present value of the dividends and that nothing else ma[ers. Most of the <me a firm ins<tutes dividends as soon as it has completed the rapid growth phase of its life cycle. The stock price increases as the <me approaches for the dividend stream to begin. • If 𝑛 is really long-term, effects on 𝑃3 are nil; hence: 𝑃3 = ∑ F" (%(B))" G "$% • Since ∞ is quite a long <me, assume constant dividend growth (Gordon growth model – but many varia<ons exist, with terminal values, different paths, ...): 𝑃3 = 𝐷% 𝑘' − 𝑔 𝐷: dividends 𝑘: cost of equity capital 𝑔: growth rates Issues: growth companies, growth greater than cost of capital, short-term trading strategies, … Buy a stock that will give a performance in one week/month. Dividend won’t be issued within this <melapse. What if 𝑔 > 𝑘? You have paid to purchase a stock (since it is a nega<ve number)? No Second strategy Easier, since prices come from the market and E comes from the accoun<ng. But it is unlikely that you will have great performances forever. Eventually, compe<tors will catch-up with you. Similar firms should have similar long-run market/book ra<os (mul<ples, P/E, ...) Denominator: measure coming form the annual report (revenues, …) Market vs accoun<ng • P/E [Price / Earnings (Net profit)] compares price with earnings: greater values mean that market expects a rise in earnings or a lower level of uncertainty If the number is above average, this can mean that we expect earnings to go up, then it will level with the average; or, the earnings are less compared to other but they are less vola<le, less risky → reason for high price. Or the earnings are falling but for some reason the price is not responding. • P/BV (Price Book Value) compares price with equity [total or tangible (net of intangibles, hard to value)], measuring the link between historic / forward-looking measures Here we have a clear idea. When + HI ≤ 1, then the company has some troubles. For example, now the banking sector as a whole shows this result. Issues with both Earnings and Book Value: if you compare a US and a EU company, they have different accoun<ng regula<ons. Therfore, this puts some accoun<ng differences in the denominator that do not put any addi<onal (lower) value. This can also happen wrt. laws, and even if you use pre- tax indexes, there are s<ll some problems. A way to avoid this issues we can turn to: 46 FMAI - 2023 • P/CF (Price / Cash Flow) compares price with opera<ng cash flow: earnings may be managed and affected by non-cash items Issues: defining “peers”, different accoun<ng frameworks, contras<ng results, … Main limita<on: finding the list of companies to compare to another company. Third strategy Extrapola<ng informa<on from prices in highly efficient markets to predict market sen<ment and investors’ behavior (technical analysis) Not perfectly efficient. This strategy tries to exploit this. • Sounds reasonable in a behavioural sense, but encompasses a lot of “witchery” (and also sorcerers...) • Limited data requirements («everything» is in prices) Issues: • Short-termed: “fundamentals” emerge in the long run • Outperformance seems just randomness • Requires to align price informa<on from several highly correlated markets (and deal with spurious correla<ons, feedback loop effects, tail events, ...) Difficult to find cause-effect links. Time The grey area is infla<on. Government bonds in a small amount of <me couldn’t beat infla<on. Blue line: Small Stocks; Purple line: Large Stocks Small Stocks earn more than Large Stocks In the short-run stocks are risky, but in the long-run they provide higher returns. Of course, this implies diversifica<on. 49 FMAI - 2023 Growing-Equity mortgages (GEM) help the borrower pay off the loan in a shorter period of <me. With a GEM, the payments will ini<ally be the same as on a conven<onal mortgage. However, over <me the payment will increase. This increase will reduce the principal more quickly than the conven<onal payment stream would. • decreasing opXonal installments (very risky for lenders) • mulXple mortgages on same collateral are possible • reverse annuity (RAM) The reverse annuity mortgage is an innova<ve method for re<red people to live on the equity they have in their homes. 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 re<re the debt. Reverse mortgages and annui<es are two quite different financial products, but both are generally used for the same purpose: to generate a steady, reliable stream of income for re<rement. However, if you are considering either of these op<ons, you should be aware that there are important differences between them. The most fundamental of these is the fact that a reverse mortgage is a loan, and an annuity is insurance. Another is how both products are funded: With a reverse mortgage, you are using the value of your house to secure a loan, while an annuity requires a substan<al amount of cash up front for purchase of the contract. There are also differences when it comes to the security offered by each product, as well as their tax implica<ons. Secondary Market • Mortgages are illiquid for lenders • Par<ally also for borrowers (but: laws and regula<on) • Illiquidity threatens lenders: o IR risk (A/L mismatch, reinvestment of future flows) o default risk / market risk of collateral o loan servicing is expensive (administra<ve costs) Secondary markets can be useful, but are difficult: • Ini<ally, ceding loans to other investors (but costly and <me consuming) Loans that pass from an owner to another. You expose different people to very different risks (<me, collaterals, …), therefore it is very costly. • Then, funded by (and transferred to) public repurchase programs (in bulk, with asymmetric informa<on issues) In bulk: you transfer a porlolio of loans. • More recently, trough securiXzaXon Difference in how it is founded. Securi<za<on: the conversion of an asset, especially a loan, into marketable securi<es, typically for the purpose of raising cash by selling them to other investors. Since a mortgage has a 20 years maturity and no secondary market, a bank will see that loan in its books for 20 years. 50 FMAI - 2023 Securi;za;on Process: 1. crea<on of a pool of mortgages, serving as collateral, 2. acquisi<on is funded through new securi<es whose return and reimbursement depends on cashflows from the original pool, 3. risks are transferred to investors, 4. securi<es could be tranches to imply greater or lower risks of default (CDOs, collateralised debt obliga<ons) or different maturi<es (CMOs, collateralised mortgage obliga<ons — CMOs are securi<es classified by when prepayment is likely to occur. These differ from tradi<onal mortgage-backed securi<es in that they are offered in different maturity groups. These securi<es help reduce prepayment risk, which is a problem with other types of pass-through securi<es): hence, higher/ lower interest rates, 5. allows liquidity to originator but also diversifica<on to investors. • Securi<es backed by assets (mortgages, MBS) to fund new acquisi<ons • Useful for a number of small-size loans, unstandardised, with different maturi<es and other economic features, towards borrowers with different credit scores, costly to service, uncertain in default rates • Allows liquidity to originator, diversifica<on to investors • Dangers: distance between risk-bearer and risk-assessment and complexity/pricing Real Estate mortgages are very low risk, they have interes<ng Coupons (wrt. Gov. Bonds), they have a specific collateral covering them, but there are some risks: • Distance between who created risk and those that actually bear risks. • Whenever you have a pool of mortgages somebody buys them. But what if they are not demanded any longer: you have to convince them by increasing the coupon rates. o You can tranche these bonds o Have loans that deliver high returns, genera<ng loans to less creditworthy people, because you then give the risk away to somebody who is not able to monitor the risk. 51 FMAI - 2023 8. Forex • Why do we need the Forex? • How do ER work? • Can we predict ER? • Is there a link between ER and IR? ER: Exchange Rates OTC Market The trading of currencies and bank deposits denominated in par<cular currencies takes place in the foreign exchange market. Transac<ons 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. There are two kinds of exchange rate transac<ons. The predominant ones, called spot transacXons, involve the immediate (two-day) exchange of bank deposits. Forward transacXons involve the exchange of bank deposits at some specified future date. When a currency increases in value, it experiences apprecia<on; when it falls in value, it undergoes deprecia<on. Purpose and Features Exchange rates can be expressed in two ways: • Units of domesXc per foreign currency: o apprecia<on represents a fall in this exchange rate o (f.i. in EU, from 0.93 €/$ to 0.90 €/$) • Units of foreign per domesXc currency: o apprecia<on represents an increase in this exchange rate o (f.i. in EU, from 1.08 $/€ to 1.11 $/€) If a currency becomes stronger it is not necessarily a good thing. If you need to buy Apple computers and sell it in Italy, you want a strong Euro. If you sell italian wine in NY, you want the dollar to be stronger. Extremely bad currencies are always something bad. A very liquid currency means a small bid/ask spread, because the bidders are compe<ng to do trades. Purpose • Trading currencies and, especially, deposits in foreign currencies • Demand/supply determine Q and prices are set as ER: cost of purchasing foreign goods, services and financial assets • Trading on three markets: spot, forward/future, swap Through the exchange of currencies in the future, we fix today the exchange rate that will occur in the future. • ERs affect economy: 54 FMAI - 2023 Interest Parity Condi;on DomesXc assets earn 𝒊𝑫 and foreign assets 𝒊𝑭 (no capital gains): comparison requires conversion. D: Domes,c; F: Foreign Imagine: • 1.1 $/€ is the spot ER, 1.15 is the future ER • John (US) has 1.1$, Maria (IT) has 1€ • Italian returns are 2%, US returns are 5% You can earn more by inves<ng abroad, even though the rate of return is lower, because the exchange rate may be advantageous. • Returns in F currency consider ER expecta<ons, while comparison includes them rela<vely to F return • Returns in D currency and rela<ve returns in terms of D currency get to the same result • If assets are subs<tutes, demand increases where returns are expected higher, so for a given amount of assets, expected returns should be equal (interest parity condiXon): domes<c currency appreciates (∆ + 𝐸") if we expect apprecia<on or ∆ + 𝑖F or ∆– 𝑖,. The Euro is geSng stronger today if it is expected to get stronger tomorrow. Expecta<ons affect immediately the exchange rates. If foreign IR goes up, the current exchange rate goes down. If the domes<c IR goes up, the current exchange rate goes down. And viceversa. The introduc<on of the Euro removed this problem. 55 FMAI - 2023 9. Financial Crises • Why financial crises? Are they similar? Are they avoidable? If we know what happens in a financial crisis, we can forecast other crises and avoid them. • Key stories: o The Great Depression o The 2007-09 Global Financial Crisis • What happens in emerging markets? Why financial crises? • A shock triggers the quick correc<on of an imbalance accumulated over <me • Increase of asymmetric informaXon issues Financial ins<tu<ons are weaker. • Inefficient alloca<on of capital: financial crisis • Credit crunch and recession: bubbles, market crashes, bank runs, country defaults… "Throughout history, rich and poor countries alike have been lending, borrowing, crashing -- and recovering - their way through an extraordinary range of financial crises. Each ,me, the experts have chimed, 'this 1me is different', claiming that the old rules of valua1on no longer apply and that the new situa,on bears liFle similarity to past disasters." All financial crisis follow the same path. But there are reasons why we are unable to stop financial crisis. • Imagine a new luxury asset is invented, that requires <me to be produced, it can not be produced overnight. • Aper taking off, becoming popular, trading goes 20 <mes the average annual salary • Demand is strong: purchased before produc<on or during planning • What happens when someone notes the imbalance between supply and demand? Supply is a frac<on of the demand. Asset Bubbles 56 FMAI - 2023 Ability to produce cashflows or to be rented to somebody. There is a percep<on that the usual matrix of measure are no longer applicable. Then you have some phases: • Enthusiasm phase • Greed phase In the Greed phase some people see the opportunity to cheat. • Denial phase This phase takes less <me, since the fear of losing is stronger than the hype of gaining. • At the end, the price goes back to where it started. This is seen as the first modern financial crisis, but Netherlands did not fall into a recession, the impact on the economy was not that bad. The fear of losing everything makes people run away, therefore the price falls. The common path The Asset Bubble is the “safest” financial crisis. There are 4 triggering causes for a financial crisis: • DeterioraXon in MFI balance sheet Can be banks, par<es in the money market, … • Asset price decline It can be a result of the weakening of the banking system. This happened in the real estate financial crisis. • Increase in IR When IR increase, it is because the CB is trying to cool off the economy, because overhea<ng economy comes with infla<on. Increase in IR, if you can not avoid borrowing, it implies that you borrow and invest at a higher risk. • Increase in uncertainty What state of the world we would have in the next years The worse financial crisis had more open than not a combina<on of these causes. Aper a crisis is triggered, asymmetric informa<on problems come up. This implies some consequences: • Economic acXvity declines It meas there are less deposits, less firms lending or asking for loans, and some firms default. • Banking crises • Asymmetric informaXon problems Most of the crises stop here. But if they are really bad, we enter in Debt DeflaXon phase. • UnanXcipated decline in price level • Asymmetric informaXon • Economic acXvity declines This decline, at this point, lasts for longer. The economy as a whole, need to reduce their liabili<es, compared to their assets/equity. But if debts go down, there is a consequence also on the asset side. What can stop the crisis? • Governments 59 FMAI - 2023 Who did it? Subprime Mortgages • Many lenders (flow of foreign capital), few good borrowers: lax standards and risky loans In order to find a place for all this inflow of money they had to turn to less creditworthy people. Mortgages went to not prime clients. Not every mortgage was a Subprime. • A rela<vely small percentage (23,5% max) of a rela<vely small market • Government-sponsored ins<tu<ons facilita<ng market growth: conflicts of interest • House values “always grow” and “who does not pay its mortgage?”: mul<ple refinancing on apprecia<on Ra<ng agencies were paid to give higher rates than they should have been. • Demand for higher and “safe” returns: credit ra<ngs conflicts, predatory lending, aggressive tranching, ... • Originated To Distribute (OTD): agency issues and asymmetric informa<on problems Mortgages were issued only to be sold on the market. You owe the bank a 100 but the house value is 90. So, you stop paying, but if you default then the bank sell the house on the real estate market, supply increases, not being met. A small round of the first vicious cycle generates many cycles of the second one. Easy credit and predatory lending • Low IR, aper “dot-com” and 9/11 shocks • US current account deficit → inflow of foreign funds (emerging, oil) • Fast growing IR un<l the peak of the crisis: more risk-taking (denial?) • Higher costs/risks than adver<sed (f.i. ARM with very low ini<al interest-only payments and nega<ve amor<za<on), forgery of documents Nega<ve amor<za<on, every month the outstanding debt growing in the first phase, since who supplies it is just willing to resell it soon. • Conflicts of interests: in ra<ng agencies, in originators, in servicing securi<za<ons 60 FMAI - 2023 Financial innova5on • Complexity VS accountability: ARM (adjustable rate mortgages), MBS (mortgage backed securi<es, CDO (collateralized debt obliga<ons), CMO (collateralized mortgage obliga<ons), CDS (credit default swaps), ... They were not born in 2007-2009, they just kept growing in market importance: the amount of people willing to buy them. • Securi<za<on may spread and accumulate risks, increasing the chances of contagion The risk was just moved around. • Mul<ple layers add to concentra<on again • Innova<on some<mes seeked/used to circumvent regula<on • Unknown/underes<mated risks are not priced • Financial innova<on → GDP per capita growth • Financial innova<on→Innova<ve firms and externally funded grow faster but with more vola<lity • Financial innova<on → more fragile banks (if smaller market share, growing fast, less tradi<onal) due to profit vola<lity • Financial innova<on → greater reduc<ons in profit aper crisis RMBS: Residen<al Mortgage Based Security. CDO: From many BB your can get a AAA CDO. 61 FMAI - 2023 𝐶𝐷𝑂0: pool of pools of pools. Not able to see the risk of the performance of 100s of 1000s of mortgages. Deregula5on and leveraging • Waived separa<on between investment-commercial banks • Increased deposit insurance: less monitoring • Weak transparency of deriva<ves • Poor accountability of under-the-line leveraging • Excess leverage of financial ins<tu<ons, but also households and firms Shadow Banking • Unregulated (legal) en<<es compete with banks in providing lending opportuni<es not protected by deposit insurance, not required to have deposits in the central bank, if they have liquidity issues they can not ask the central bank for help. • Fragile during run to withdraw funds and to cope with securi<za<ons’ breakdown What followed? Main consequences: • Real estate bubble, extending to bonds/stocks and outside financial ins<tu<ons • Deteriora<on of financial ins<tu<ons • Run on shadow-banks • Liquidity crisis: injec<ons are insufficient • Contagion to public sector Through the public purchase program. • Recession, unemployment • Innova<ons: o TBTF paradigm under scru<ny Too Big To Fail, financial ins<tu<ons that where thought they could not fail. The opposite: Global Systemic Instu<ons o Re-regula<on o end of pure investment bank paradigm Investment Banks that survived became more tradi<onal banks. The pandemic caused the GDP to go down at the global level for the first <me. Wrt. 2008, some countries were not hit that much. Emerging Markets Emerging countries are weaker in case of a crisis. Similar steps, although with some differen<a<ons: • RegulaXon/supervision weaker, riskier lending Because infrastructure are weaker, educa<on is not that good, entrepreneurship is low • Fiscal imbalances, central banks not independent Governements spend more than they collect. 64 FMAI - 2023 10. Central Banks • Fed vs ECB • Why different CB models? • Monetary policy: tools, mandates, goals • CB & Financial Crises • CB & Currencies Fed - USA Complex system of weights and balances, controls and responsibili<es (indipendence within the government). POTUS: President Of The United States • BoG: chairman has public and internal influence, oversight • FOMC (“the Fed”): o Independent choice of instruments and goals o Influence from Congress and President Main Powers of the CB: • Reserve Requirements Managing on a daily basis payments and transac<ons, and on top of that you have to maintain a stable deposit in the central bank. But if the central bank decides to increase the minimum reserve requirements, this can lead to problems for banks • Open Market TransacXons The main power is here. The main body is the FOMC. 65 FMAI - 2023 Lately, increase of unconven<onal open market transac<ons. • Discount Rate This does not affect monetary policy that much. ECB - EU NCBs at the core of the ESCB NCBs: • define ECB’s budget • enforce monetary policy, regula<on and supervision • greater independence, more need to compromise • trea<es require price stability and changes are extremely difficult: more goal independence Goverments have to appoint 6 people at European level. The Governing council has less checks and balances to go through wrt. the FED, since what they can or can not do is wri[en in the Trea<es. The ECB is much more independent wrt. the FED. Why are CBs different? How close of far they are from poli<cal power. • Pros of independence: o Poli<cal shortsighted influence produces infla<on by ac<ng on short-term goals (unemployment and IR): elec<on deadlines rather than economy needs 66 FMAI - 2023 o Treasuries’ influence accumulates risk by promo<ng abnormal absorp<on of public debt in CB/banks If the CB is not independent the treasury can absorb public debt. o Monetary policy requires specific exper<se • Cons of independence: o Accountability and democra<c control (?) o Governments’ fiscal policies weakened by monetary policy (?) Governements, despite the infla<on, would s<ll like to spend blame the monetary policy to be too strict. o Independence did not avoid crisis... Less independence, more infla<on. Monetary Policy ASSETS side • SecuriXes: the largest are governemt bonds. An increase in government securi<es held by the CB leads to an increase in the money supply. • Discount loans: banks ask them when they have liquidity issues CBs have profits. These profits are distributed to the owners, typically in a reduc<on in taxes. LIABILITIES side • Currency: CBs can issue currency, but the Reserves is much larger than Currency in circula<on. Currency in circula<on is the amount of currency in the hands of the public (outside of banks)—an important component of the money supply. • Reserves are debt of the central bank wrt. banks. Reserves is both borrowed and not borrowed. It is very cheap to raise funds for the central banks. Very low interst expense. Monetary Policy Tools Open market operaXons Open market opera<ons, the central bank’s purchase or sale of bonds in the open market, are the most important monetary policy tool because they are the primary determinant of changes in reserves in the banking system and interest rates. An open market purchase leads to an expansion of 69 FMAI - 2023 • For the ECB: MRO (main refinancing opera<ons, 1 week), LTRO (long term RO), SMP (securi<es markets program), TLTRO (targeted long term RO), QE, PEPP: growing non conven<onal tools Now CBs are selling bonds destroying the reserves in order to increase interest rates. Effects of discount lending (lower IR on discounts) Just a smaller distance between the minimum and the maximum. • Short term liquidity for solvent but illiquid ins<<<ons • «Lender of last resort», also for bank runs issues (but: moral hazard) • For the ECB: marginal lending facility (ON borrowing) In normal <mes discount lending is not effec<ve in changing interest rates. But in the case the 𝑖LHM is pushing up, it can be working. Effects of reserve requirements (increase) Effects are different if demand and supply meet where flat, but mostly irrelevant. All banks have to increase the amount of reserves, which increases the interest rates. If all of a sudden banks have to change reserve requirements, cash flow management becomes very difficult for them. This tools is effec<ve but it can kill banks. “Unconven5onal policies” • Nega,ve interest rate policies to avoid defla<onary currency o Effec<ve in dealing with lower bound events o Side effects: less bank interest margins Banks struggle earning profits. o Longer-term effects: unknown (probably happening now) 70 FMAI - 2023 • “Unusual” lending to deal with disrup<on of monetary policy transmission o Contained funding issues on interbank/money markets o Longer maturi<es (LTRO), more eligible collateral/counterpar<es, different lending terms/goals o Effec<ve for flows to the private sector and stabilizing expecta<ons o Side effects: inefficient alloca<on of credit, weaker leverage reduc<on Weaker banks survive just because money is cheap. But when IR go back, then you see who survives. • Asset purchase programmes for lower bound and monetary policy issues o Protected assets during fire sales and incen<vized loans securi<sa<on. o Side effects: limited weakening CB balance sheets, poorer asset valua<ons, scarcity in repo markets, spillovers on commodity prices You buy a lot of bonds at low IR, but sooner or later the IR will go up. Therefore you paid much for assets with poor value. • Forward guidance to reduce uncertainty (RIP) o Clarifying ahead of <me inten<ons and tools o Quite effec<ve, subject to credibility and flexibility issues Monetary policy goals Primary goal: Price Stability • “Low” and stable increase in price level Price stability does not mean infla<on = 0, a li[le bit of infla<on is good. If it is too much, the system does not work. Must not be low on average, but if you decide 3% infla<on, every year it should be the same. • Reduced uncertainty and sXmulates economic growth Low and stable infla<on lowers uncertainty. • Need for a nominal anchor (recently FED and ECB moved to a “symmetrical” target): o Typically, infla<on or money supply The choice between the two can be controversial. Money supply is farther than infla<on from choices of people and firms. If you are told money supply increased by 5%, it is more difficult to understand and to link with actual purchasing power, rather than if you were told infla<on grew by 5%. o Reduces <me-inconsistency: long-run effec<veness o Constrains discre<onary policies 71 FMAI - 2023 Nominal anchor: number representa<ve of the price objec<ve. Ex: I want to be healthier, I choose weight as value to determine how healthy I am. Symmetrical target, because on average they tend to keep infla<on slightly lower than the nominal anchor value chosen. In this case, even values slightly higher are accepted. Intermediate targets are needed to understand if your instrument are working in reaching the nominal anchor. Other goals • High employment (lower than 100%): o fric<onal unemployment is beneficial (looking for be[er jobs, educa<on, ...), o structural unemployment (mismatch between demand and supply) is outside CBs’ powers – “natural rate of unemployment” 100% employment is not good, because this affects infla<on. If a firm wants to hire people and there are no unemployed people, the only thing other firms can do is offering higher wages, which in turn causes infla<on to grow. • Economic growth: investments and savings • Financial markets stability • IR stability • ER stability: o to assist compe<<on and reduce uncertainty o to avoid “imported” infla<on o to assist dependency on foreign trade In the long run goals converge, but there are short-term trade-offs, so CBs get mandates: • hierarchical mandates: price stability first, and growth and employment then (f.i. ECB): less <me inconsistency First they have to achieve the price stability, then they can focus on other goals. It is considered to be a strenght because they are more consistent. But it is more prone to discre<onary choices. • dual mandates: achieving together price stability and minimum unemployment (f.i. FED) FED have to follow at the same <me high stability and high employment. They have to balance them together. If you want to reduce infla<on you have to increase IR. But at the same <me, if it is too expensive to invest, you hire less people. They have to find the right balance. Why inflaXon targeXng for price stability? • Infla<on targe<ng is easily understood and communicated • Provides easy accountability and less <me-inconsistency • Reduces poliXcal pressures requiring a long run focus But... • Outcomes are slow to emerge and infla<on policies lag • Can be rigid • Ac<ng on infla<on is difficult, so intermediate targets (monetary aggregates and IR): o trade-offs: once a monetary aggregate target is set, IR fluctuate (and viceversa) 74 FMAI - 2023 11. Banks • Main banking management areas • Banks’ financial structure • Banking performance • Evolu<on and issues in banking Banks are the most important ins<tu<ons aper the Central Banks. Bank Management Banking opera<ons move around asset/maturity transformaXon: By exposing to both borrowers and lenders, they transform the money of depositors in the money of borrowers. • Selling liabiliXes with features desirable to lenders • Buying assets with features desirable to borrowers • Profitable if liabili<es cheaper than assets, considering also risks and costs: o Liquidity risks: unbalance between short term sources/uses of cash (i.e. loans & securi<es VS deposits, bank runs and safety nets) o Credit risks: assets and off-balance sheet exposures (esp. loans) Borrowers can default, depositors will always get 100% of what they saved. o Market risks: from trading book and collateral o OperaXonal risks: human resources, IT, controls, ... o Other: reputa<onal, legal, strategic Banks do this for profit, but they are a fragile ins<tu<on: they have short-term liabili<es, and long- term risky assets. They fund themselves with liquid short-term liabili<es and have long-term illiquid assets (loans). 75 FMAI - 2023 Liquidity MGMT Excess reserves reduce liquidity risks for the bank stemming for deposits, but reduce their profitability. When a deposit oullow occurs, holding excess reserves allows the bank to escape the costs of (1) borrowing from other banks or corpora<ons, (2) selling securi<es, (3) borrowing from the Fed, or (4) calling in or selling off loans. Excess reserves are insurance against the costs associated with deposit oullows. The higher the costs associated with deposit oullows, the more excess reserves banks will want to hold. Asset MGMT To maximise its profits, a bank must simultaneously seek the highest returns possible on loans and securi<es, reduce risk, and make adequate provisions for liquidity by holding liquid assets. Banks try to accomplish these three goals in four basic ways: 1. Find borrowers who pay high interest rates and are unlikely to default on their loans 2. Purchase securi<es with high returns and low risk 3. Banks must diversify. Different types of assets and approve many types of loans to a number of customers 4. Sa<sfy its reserve requirements without bearing huge costs. Hold liquid securi<es even if they earn a somewhat lower return than other assets. Capital MGMT Banks have to make decisions about the amount of capital they need to hold for three reasons. First, bank capital helps prevent bank failure, a situa<on in which the bank cannot sa<sfy its obliga<ons to pay its depositors. Second, the amount of capital affects returns for the owners of the bank. Third, a minimum amount of bank capital is required by regulatory authori<es. A bank maintains bank capital to lessen the chance that it will become insolvent. But bank capital is costly because the higher it is, the lower will be the return on equity for a given return on assets. Liability MGMT A bank can acquire funds by selling a nego<able CD (Cer<ficate of Deposit). If it has a reserve shorlall, it can borrow funds from another bank without incurring high transac<on costs. 76 FMAI - 2023 Financial Structure of Banks Assets A bank uses the funds that it has acquired by issuing liabili<es to purchase income-earning assets. The interest payments earned on them are what enable banks to make profits. All banks hold some of the funds they acquire as deposits in an account at the Central Bank. Reserves are these deposits plus currency that is physically held by banks (called vault cash because it is stored in bank vaults overnight). Banks hold reserves for two reasons: first, some are reserve requirements, and second, some are addi<onal reserves, because they are the most liquid of all bank assets and a bank can use them to meet its obliga<ons when funds are withdrawn by depositors. A bank’s holdings of securiXes are an important income-earning asset. Securi<es are made up en<rely of debt instruments for commercial banks, because banks are not allowed to hold stock. Banks make their profits primarily by issuing loans. Loans are typically less liquid than other assets because they cannot be turned into cash un<l the loan matures. Loans also have a higher probability of default than other assets. Because of the lack of liquidity and higher default risk, the bank earns its highest return on loans. Other assets incluse Property, Plant and Equipment (PPE) and Goodwill. Liabili5es A bank acquires funds by issuing (selling) liabili<es, such as deposits, which are the sources of funds the bank uses. Checkable deposits are bank accounts that allow the owner of the account to write checks to third par<es. Checkable deposits and money market deposit accounts are payable on demand; that is, if a depositor shows up at the bank and requests payment by making a withdrawal, the bank must pay the depositor immediately. They are usually the lowest-cost source of bank funds because depositors are willing to forgo some interest to have access to a liquid asset that can be used to make purchases. Non-transacXon deposits are the primary source of bank funds. Owners cannot write checks on non- transac<on deposits, but the interest rates paid on these deposits are usually higher than those on 79 FMAI - 2023 However: • regula<on s<mulates innova<on and arbitrage (f.i. shadow banking) Shadow banks didn’t disappear, they provide loans without being banks, they are s<ll less regulated. • separa<on can be circumvented (f.i. borders, securi<sa<on, ...) By cross-border opera<ons you can cirvumvent regula<ons that try to separate one thing from the other. • innovaXon is faster than rule-based regula<on (f.i. FinTech) It takes more <me to regulate innova<ons than it takes for them to be developed. • regula<on has costs lowering efficiency and compe<<on (f.i. interest rate restric<ons) Example: Italian Banks Assets 60% is lent to italian borrowers. 10% Gov. bonds. Row: Rest of the World MFI: Money and Financial Ins<tu<ons Liabili?es and Equity 65% is in deposits from Italians, 7% from European, …, just 9% of equity. 80 FMAI - 2023 12. Mutual Funds • Why mutual funds? How? • Performance measures • Types of mutual funds • Costs Mutual funds pool the resources of many small investors and using the proceeds to buy securi<es. Through the asset transforma<on process of issuing shares in small denomina<ons and buying large blocks of securi<es, mutual funds can take advantage of volume discounts on brokerage commissions and can purchase diversified porlolios of securi<es. Mutual funds allow small investors to obtain the benefits of lower transac<on costs in purchasing securi<es and to take advantage of a reduc<on in risk by diversifying their porlolios. Why do Mutual Funds exist? Mutual Funds lately were able to a[ract a lot of funds. They allow you to invest and get a return but they are s<ll a liquid asset. Not as liquid as a bank deposit, but s<ll good. Impressive exponenXal growth in few decades linked with their compe<<ve advantage [2021: 130.000+ funds, 70+ trn USD in Assets under Management (AUM)]: • liquidity of investments: holdings represented by shares, mostly aiming at capital gains (several “distribu<ng” funds exist). What you own with shares, is shares related to money, not PPE. Instead of buying a specific asset, like bonds, stocks, oil, gold, …, mutual funds give you the possibility to become a shareholder, together with other people, to buy a lot of those assets together, depending on how big the pocket. 81 FMAI - 2023 How is this liquid? It has a secondary market. Mutual funds can sell the por<on of assets and give you the amount of money it owes you. Not at every moment like bank deposits, but from one day to another. • access to securi<es sold at large-denomina<ons Altogether with other people they give you the possibility to get large assets. • diversificaXon also for small amounts Altogether with other people you have the possibility not to get just a few assets, but to diversify your porlolio. • affordable fees: economies of scale on transac<on costs The asset manager do not have to manage the assets for each single person. Instead, the pool of assets is managed for the whole base of par<cipants, therefore the cost for the single person is lower. • provision of experXse You can benefit from the decision of someone that knows more than you. • cheap and quick transferability of funds There can be different funds: one has bonds as assets, the other has stocks has assets. The mutual fund gives you the possibility to access to both funds and the customer has the possibility to decide where they want more money allocated to. The cost is substan<ally lower wrt. purchasing and selling the single assets. • mul<dimensional specializaXon • simple organizaXonal structures Other reason for them to be pre[y cheap. The most of them is just a bunch of directors that decide to set the bundaries of the investment bundaries of a fund. Then there are checks that everything goes on smoothly. Depository Bank are needed to avoid that Investment Advisors take advantage of having a large amount of money and run away. Investment Advisors never see a penny of people’s money. How Mutual Funds Balanced/Mix: puts together Equity, Money Market and Bond instruments. The number of funds is increasing, but also the single funds are geSng larger and larger. Cross-border funds: localiza<on of funds and the people who buys them is different. 84 FMAI - 2023 In a closed-end fund, a fixed number of nonredeemable shares are sold at an ini<al offering and are then traded in the over-the-counter market like common stock. The problem with closed- end funds is that once shares have been sold, the fund cannot take in any more investment dollars. Thus, to grow the fund managers must start a whole new fund. The advantage of closed-end funds to managers is that investors cannot make withdrawals. The only way investors have of geSng money out of their investment in the fund is to sell shares. o mutual funds’ shares are fixed in number at the ini<al offering o withdrawals and new investments are (typically) not possible: only finding somebody willing to exit/enter, in the secondary market. o concentra<on in few specific asset classes (f.i. real estate, art, startups, ...) Structure needed of the assets are not liquid if they do not want to be as fragile as a bank. • open-end: Investors can contribute to an open-end fund at any <me. The fund simply increases the number of shares outstanding. Open-end funds agree to buy back shares from investors at any <me. Advantages: 1. because the fund agrees to redeem shares at any <me, the investment is very liquid 2. the open-end structure allows mutual funds to grow. As long as investors want to put money into the fund, it can expand. o largest group o new investors can get new shares, buy-back/liquida<on op<on o the fund has a variable number of shares People normally favours the liquidity of the open-end funds. F.I.: in 2016 Germany had 3,500 close-end and 6,000 open-end funds, with 83 and 1,800 bln € of AUM respec<vely. Main investment target (each category can be broken down in many others): • equity funds: aiming at current income (dividends), capital gains or a combina<on (i.e. total return funds) • bond funds: government, corporate, currency, maturity, ... • money market funds: short-term, versa<le and cheap • hybrid funds: stocks and bonds combined together • index funds: passive management (f.i. Exchange Traded Funds (ETFs), Exchange Traded Commodi<es (ETCs), ... - passive investments) • hedge funds: seeking pricing anomalies (market inefficiencies) from predicted paths, open unregulated and/or offshore, longer term to cope with higher risk, frequent use of leverage Blamed to be evel because they have a lot of leverage, not only equity. Also because they are in places in where there aren’t the same rules and taxes as in other places. There is a barrer to entry: you must have millions of bucks. 85 FMAI - 2023 Costs Fee structure: • Load Funds: commissions are paid to intermediaries up-front reducing the investment Fee paid to enter the fund. • Deferred load funds: fees are charged when leaving the fund, usually with declining % (redemp<on fee) • No-load funds: sold directly with no entry/exit charges (but with ongoing/performance fees) Several other fees: • costs of switching • administraXve fees • income sharing • … Fees reduce the net return. If returns are very low, subscribers may decide to go out. Funds have to compete with ETF, which has very small costs. In the long-run, the one with entry fees is the most desirable. You should avoid entry fees if you invest in the short-run. The thing that ma[ers is cost structure. Exept to the entry fees in the short-run, you should choose the less costly. Level of risk is comparable between Mutual Funds and ETF, but ETF returns are lower. The story including fees may be different. On average, inves<ng in Italy is costly. It seems that normally the ETF is be[er than the ac<ve management funds, because of lower costs. But when there is a crisis, ac<ve management should be aware of it and avoid you huge losses. They give you lower returns than passive index, but they protect you more. 86 FMAI - 2023 13. Insurance and Pensions • Why insurance? How does it work? • Types of insurers and policies • Why pensions? How does it work? • Types of pensions and funds • A glance at the italian pension system They were not born for the financial sector. They ended up in it. Insurance companies are in the business of assuming risk on behalf of their customers in exchange for a fee, called a premium. Insurance companies make a profit by charging premiums that are sufficient to pay the expected claims to the company plus a profit. Why Insurance? Future, «unpredictable» events with adverse financial consequences on communi<es and/or individuals. First solu<on: mutuality → the uncertain individual exposure is pooled and transformed into a share of an uncertain collec,ve exposure Example of sharing one merchant’s goods to more than one ship, so that if one ship sinks the merchant loses only a frac<on of its goods stock. Second solu<on: insurance → upfront cost (premium) in exchange of indemnity when/if a future uncertain event occurs (claim) Insurance means that each one of us is weak against something unpredictable, whereas together we can face it being stronger. Ability of insurers depends on how many people buy the insurance, based on mutuality. Example: you own land worth 100. A flood can destroy it. You do not know that p = 10%. In the second case, the tails of the distribu<on get smaller. The more people par<cipate to the pool, the smaller is the devia<on from each scenario. 89 FMAI - 2023 Investments in Insurance Most of the stocks held by the insurance companies are intra-group stocks, used to control subsidiaries for example. If we take out these intra-group equity, investment in stocks is just 3%/4%. Pensions A pension plan is an asset pool that accumulates over an individual’s working years and is paid out during the nonworking years. Pension systems aim at providing re<rement income as well as protec<on from several of these uncertain<es (health, infla<on, ...). Due to long cumula<on phases, pension funds are the largest ins<tu<onal investors. Income and consump<on are not stable: demographic and financial risks. • Need for income aper re<rement + protec<on from uncertain<es (health, infla<on, unemployment, ...) • Long cumula<on phases, pension funds are very large ins<tu<onal investors • Pension funds similar to mutual funds, but with constraints on liquidity and frequently with tax incen<ves How pensions? Two main regimes: • Defined-benefit (DB): 90 FMAI - 2023 Under a defined-benefit plan, the plan sponsor promises the employees a specific benefit when they re<re. The payout is usually determined with a formula that uses the number of years worked and the employee’s final salary. The defined- benefit plan puts the burden on the employer to provide adequate funds to ensure that the agreed payments can be made. o par<cipants decide the future benefit o contribu<ons are changed accordingly o risky for sponsors and par<cipants • Defined-contribuXon (DC): Instead of defining what the pension plan will pay, defined-contribu<on plans specify only what will be contributed to the fund. The re<rement benefits depend en<rely on the earnings of the fund. Corporate sponsors of defined-contribu<on plans usually put a fixed percentage of each employee’s wages into the pension fund each pay period. o par<cipants decide the level of contribu<ons o benefit will depend on cumulated contribu<ons o financial and demographic risks passed on par<cipants Public funds are open PAYG (Pay As You Go), many provide defined benefits and usually mandatory. The issue is that people that stop working is larger because life expectancy is increasing. Private funds are funded, mostly DC and open voluntary. Risks of PAYG systems: Risks of funded systems: • Demographic risk (annuity conversion) • Financial risk Because money is invested. • Responsibility of individuals: financial literacy + long term planning When you have a lot of <me they invest in stocks, then bonds, then… Why Italy? Long series of reforms, aper emergence of «difficul<es» since late 1980s: • PAYG, now en<rely contribuXon-based (with transi<on) • Progressively aligning requirements between genders, public/private sector, employees and self-employed (not between/within genera<ons) • Progressively removing «full» early reXrement: advance of old-age benefits with penal<es on conversion rates • ReXrement age linked to life expectancy (67+, but effec<ve age is much lower) Increasing the age of re<rement allows governments to decrease the number of people they have to give pensions to. • Contribu<ons compounded as nominal average GDP growth • Replacement rates vary between 40-80%: huge impact of salary/careers/age Retribu<on vs Contribu<on 91 FMAI - 2023 The more we live the later we re<re. If for a newborn life expectancy is 85 more or less, for a person that is already 65 the life expectancy is even greater, because you already survived all those things that when you were born were supposed to possibly kill you. The longer the life expectancy the greater the expenditure for the government, since they have to keep paying pensions, but also medical expenses. Examples Insurance distribu5on channels In Italy and in other countries insurance ins<tu<ons deal mostly with banks. Also because the banking system is well developed. Wrt. non-life insurance, mostly is done by agents. In UK they are more based on brokers rather than agents. They have their own employee selling their products. Direct wri<ng: the company sells directly to the client. There are no intermidiaries. Pension fund assets In the long-term equity markets give higher returns. But when you approach re<rement, it would be risky to keep money in the equity market. So they should move your funds from the equity market to the bond market. Italy’s share of equity is small, because people have poor financial knowledge. CIS (Collec<ve Investment Securi<es) = Mutual Funds Silver tsunami Silver tsunami: huge wave of older people. It refers to the fact that people is geSng older and older, and they are always more and more. Higher life expectancy means more people in the re<rement budget and more stress on the health system. 94 FMAI - 2023 • Supply funds to start-ups with growth poten<al but limited access to tradi<onal markets • Usually specialized: (seed capital, early/later-stage) and segment (f.i. biotech, IT, ...) Seed capital: you just have the idea, you do not have a company yet. Early/Later Stage: everything that happens before a company can be successful enough to be in the stock market. Here diversifica<on is easily achieved, because each opera<on costs not much. Private equity / buyout: focus on old business ideas that are not profitable any longer. • buy troubled public companies to delist them (“private”) Since the company is unprofitable, the stocks are worth much less, and they buy them in order to delist them. • regulatory burden relieved, new management, return to profitability • more capital absorbed, but more collateral available Then, if they are profitable again, they put them back into the stock market. Here diversifica<on is very difficult, since in order to buy a company you need a lot of money (millions or billions). Examples IPO: 1 day returns and MLOTT There is a distance between Venture Capitalists and investors in IPOs. MLOTT (Money Leu On The Table): difference between day 1 close and offered price, <mes n. stocks offered. Difference between the closing price at the end of the first day - the opening price <mes the number of stocks. Having a price that is too small, they lost a lot of money. Prices and Returns IPOs about startups are very difficult to price, and the hit and run strategy is more profitable than the buy and hold strategy. IPOs are not good for long-term investors. PE/VC (Investeurope) Some countries are more likely to have Venture Capitalists, because they have a very liquid and well- working stock market. Otherwise you would have to rely on the banking sector. Pension Funds invest a lot in it, because the more likely to be profitable is a firm that is born now, rather than a firm that was born 100 years ago. Sovereign wealth funds: typically government sponsored. Norway extracts oil and invests these funds in this market. 95 FMAI - 2023 15. DerivaKves and Risk Management Risk can be sold to other ins<tu<ons. • Hedging and the why of Deriva<ves Hedging: covering the risk that you already have in your porlolio. • Types of Deriva<ves and payoff • Investments strategies with Deriva<ves When you buy OTC you may reduce your risk you want to manage, but you accept counterparty risk. When they have to pay you to manage your risk, they may default. Reason for seSng things in cash: speeding up the process. It is easier to transfer cash rather than commodi<es, also because you do not need a facility to accept cash. Hedging and Deriva;ves Hedging: protec<on through a transac<on offseSng another • micro-hedging: Micro because it is 1 exposure with 1 deriva<ve. 1:1 rela<oship o One exposure protected by taking another symmetrical one o F.i. an ITA firm has to pay $ in 30dd and buys a deposit in $ now • macro-hedging: One deriva<ve for different exposures. 1:many o One group of similar exposures protected by taking one that is symmetrical o F.i. an Italian bank holds a porlolio of fixed-interest loans and borrows through a fixed-interest bond • parXal hedging: One deriva<ve only for a por<on of a risk exposure. 1:1/2 rela<onship for example. o One exposure protected through another for a component/por<on of the whole risk o F.i. an Italian firm that will buy oil gets a deposit in $ to hedge the currency risk only • cross-hedging: When there isn’t something exactly your risk. Just correlated with your risk. o One exposure protected through another that is highly correlated but not symmetrical o F.i. exposure to fuel costs of a delivery company is protected through an exposure to Brent oil PROBLEM: offseSng exposures are costly, exact coverage hard to find, addi<onal risks arise. How to make hedging more effec<ve and simpler? By designing an instrument that: • Requires ligle or no iniXal investment (compared to the exposure effect obtained) • Segled at a future date • Referenced to one or more external variables 96 FMAI - 2023 As of themselves they do not have value. Their value is a deriva<on of the asset, the risk, the thing that is making the deriva<ve possible. Main instruments (mostly OTC, but also exchange-traded): Credit deriva<ves: newest, en<rely OTC, pre[y illiquid. Here things are complex, you only find professionals. Difference between the 4: • Forward is the original contract, Future is the stock exchange traded version (standardized). If you sign it today you have only one future transac<on and both par<es have to fulfil their obliga<ons. If it’s a commodity, an index, a risk category, a financial instrument you can find pre[y much always a deriva<ve a[ached to it. One date, one transac<on but decided today. • OpXon: can we find a way in which we can decide to do it or not? In this case the two par<es are different: the stronger one can decide, at maturity, to pay or not. Therefore, the weak party at the beginning charge a higher price (premium) for this unknown future even. • Swap: what if I have to make many transac<ons over <me? Without Swaps a firm, for example, would have to build some protec<on every <me they have to bear some risk. In this way they can, link a deriva<ve to more than one transac<on. Swapping two streams of flows: for example a jewelry buys gold every month, as they flow, and the other one is geSng money (deriva<ve). For example contracts that Swap interest rates, a fixed and a variable rate. Another interes<ng Swap is flows in different currencies: Foreign Exchange Swaps (FX Swaps). • Credit derivaXves: much less standardized. Designed to manage credit risk, but credit risk is different from ir risk, currency risk, …, and so each of them requires a specific structure. It seems that each contract is different. Useful Terminology • Strike Price: the reference amount required to se[le a contract. • Underlying: asset, index, rate, commodity, ... from which the contract derives its value and targets its se[lement. • Seglement Date: date at which obliga<ons are met. • NoXonal: amount of underlying on which the contract is built. Size of the contract in terms of the underlying. F.I.: 10 kgs of gold that costs €20,000. It is the kg, not the price. It is not the price they have to pay to se[le the contract (Market Price). It can be waaay smaller than the No<onal. • Market Price: current transfer/se[lement price.