Financial Markets and Institutions (30006) full notes, Dispense di Finanza

Scarica Financial Markets and Institutions (30006) full notes e più Dispense in PDF di Finanza solo su Docsity! FINANCIAL MARKETS AND INSTITUTIONS A stock represents the share of ownership in a corporation. it is a claim on the earnings and on the assets of the corporation (it entitles the owner to a share of the company'’s assets and profits). By issuing stock and selling it to the public, corporations raise funds to finance their activities. Why do we need the financial sector? We are facing the worst health crisis in 100 years and the worst economic crisis since 1930s. Increase in the debt: countries are borrowing more than what they are producing; governments worldwide have given trillions of dollars in financial aid to firms and workers. US debt is set to exceed size of the economy next year, a first since World War II. Countries issue their debt through bonds and people lend money to the government. However, they doin’t do so directly, but indirectly through financial intermediaries. The purpose of financial markets is to allocate money efficiently, transferring them from those who lack productive investment opportunities to those who have them —> funds are channelled into most productive investment opportunities. (Essential to promote economic efficiency; efficient allocation of capital which contributes to higher production and efficiency levels for the overall economy). Financial markets are based on the assumption that funds in the economy are not equally distributed: lender - savers have surpluses, while borrowers - spenders have shortages. Well functioning financial markets also directly improve the well-being of consumers by allowing them to time their purchases better. —> improve overall economic welfare. Because of transaction costs, individuals cannot find a lender/investor on their own: they need financial institutions (i.e. banks). Basically, financial markets perform the economic function of channeling funds from households, firms and governments that have saves surplus funds by spending less than their income to those that have a shortage of funds because they wish to spend more than their income. The key idea is to move money from those who lack productive opportunities to those who have them; —> channel funds into most productive investment opportunities. Direct finance (financial markets): borrowers borrow funds directly from lenders in financial markets by selling/issuing financial instruments (i.e. securities) which are claims on the borrower’s future income or assets. Securities are assets for the person who buys them, but they are liabilities for the individual or firm that sells (issues) them. Indirect finance: borrowers borrows funds indirectly from lender-savers via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial assets. (Borrow and then uses these funds to make loans to borrower-spenders). Direct finance: lenders and borrowers coordinate together. Indirect finance: lenders and borrowers are coordinated by a financial institution. The same player can be both a lender and a borrower. Economic actors that perform both functions typically are: households, business firms, government or foreigners (foreign governments as well); Major lender are households and business firms; major borrower are government and business firms. Assets: * Real asset: entity producing flow of goods and services. Examples are lands, plants, machinery, people, new invention, goodwill (intangible) * Financial asset: contract giving its owner a claim to payments. Examples: currency, bonds, stocks, bank deposits, loans, insurances, derivatives (future options). Borrowers sell or issue financial assets to lenders and use the proceeds (earnings) to buy real assets (an investment). 1of93 Structure of financial markets: Financial markets differ along three dimensions: type of securities, type of issuance and maturity. 1. 2. 3. Type of securities: Debt (bond) markets; Equity (stock) markets; Derivatives (options, swap, futures) which are financial instruments that depend on other assets. (Worldwide $15 trillion in December 2016). German bonds have negative interest rates. Type of issuance market/transacting party: primary v. Secondary market By maturity: short term, long term, intermediate term Financial markets securities: Two ways of obtaining funds: 1. By issuing a debt instrument (bond or mortgage), which is a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals until a specified date (maturity date), when a final payment is made. The maturity of a debt instrument is the number of years until that instrument’s expiration date. — > debt market. Debt (bond) markets are issued by companies and governments, provide key-macro variable: interest rates. ($89 trillion in the US on December 2016, world $80 trillion) Short term maturity bonds are bonds with maturity inferior to one year. Long term bonds have maturity of 10 years or longer. In-between we have intermediate-term bonds. Equities common stock are claims to share on the net income (income after expenses and taxes) and the assets of a business. stocks are long term instruments: they have no maturity date. owning stocks means you own a portion of a firm, thus having the right to vote on issues concerning the firm, and to elect its holders. Equity is risky: equity holders are residual claimants: the firm first pays all its debt holders, then it pays its equity holders. —> equity market Equity (Stock) markets represents an ownership claim in the firm; they pay dividends. ($285 trillion in the US in January 2016, $69 trillion worldwide on December 2015) The size of the debt market is usually substantially larger than the size of the equity market. Type of issuance markets/transacting party: Primary market: is a financial market in which a new security, such as a bond or a stock, is sold to initial buyers (Initial Public Offer) by the corporation or government agency borrowing funds. Primary markets are not well known to the public, as it is an investment bank which arranges sale of securities by underwriting them: it guarantees a stock price for a corporation’ securities and then sells to public. We almost never hear about Primary Markets, except during famous IPOs (Facebook, Twitter, Robin hood...) Secondary market: is a financial market in which securities that have been previously issued can be resold. Examples of secondary markets are NASDAQ and the New York Stock Exchange; they are foreign exchange markets, futures markets, options markets. In the secondary market, when an individual buys a security, the issuing firm gets no new funds; it gets funds, only when securities are sold in the primary market. Brokers and dealers are crucial to a well-functioning secondary market. Brokers match buyers with sellers of securities. Dealers link buyers and sellers by buying and selling securities as stated prices. Secondary markets carry out two key functions: - they make the financial instruments more liquid, as they make it easier to buy and sell financial instruments. - they determine the price of the security that the issuing firm sells in the primary market —> pricing: the higher the price of a security in the secondary market, the higher the price of that 2 0f93 Depository institutions accept deposits from individuals and institutions and make loans. They include: - commercial banks: they represent the largest financial intermediaries with the most diversified portfolios of assets. - Thrift institutions (aka thrifts): - savings and loan associations: now very similar to commercial banks - credit unions: small cooperative lending institution organized around a particular group; they acquire funds from deposits called shares and primarily make consumer loans around particular group such as union members. Contractual savings institutions acquire funds at periodic intervals on a contractual basis. They can predict with reasonable accuracy how much they will have to pay out in benefits in the coming years. Liquidity is not relevant for them, these institutions tend to invest their funds primarily in long-term securities. They are divided into: = Insurance companies: (life instances, fire and casualty,. like death, illness, injury, fire, theft = Pension funds and government retirement funds: provide retirement income in the form of annuities to employees covered by a pension plan. Investment intermediaries: = Finance companies: make loans but are funded with short-term and long-term debt (+ commercial banks). Often they are organized by parent corporations. = Mutual funds pool funds and invest in diversified portfolios = Hedge funds (a type of mutual funds) pool funds of small number of wealthy investors and invest on their behalf. They are subject to weaker regulations with respect to mutual funds. = Investment banks: they help corporations issue securities. IB advise corporations on which type of securities to issue (bonds or stocks), they help them sell the securities by purchasing them from the corporation at a predetermined price and reselling them in the market. They also help corporations acquire other companies through mergers and acquisitions. ): offer protection against adverse events Regulation of the financial system: Financial sector is among the most heavily regulated of the economy. Main Reasons for Regulation: 1. Increase Information available to Investors (transparency - reduce asymmetric info): government regulation can reduce adverse selection and moral hazard problems in financial markets and enhance the efficiency of the markets by increasing the amount of information available to investors. The SEC requires corporations issuing securities to disclose certain information about their sale, assets and earnings to the public and restrict trading by the largest stockholders in the corporation (insiders) 2. Ensure the Soundness of Financial Intermediaries (avoid failures, bank runs and panic). Due to asymmetric information, financial intermediaries might even collapse in the so-called financial panic in which providers of funds to FI may not be able to assess whether the institutions holding their funds are sound, if they have doubts about the overall health of financial intermediaries, they may want to pull out of both sound and unsound institutions causing large damages to the economy. Regulation is exercised through: restrictions to entry (i.e. chartering = who can set up a financial intermediary), requirements for disclosure, restrictions on assets and activities (restricted in what they are allowed to do: prevented from engaging in certain risky activities), ensure people’s deposits though deposit insurance, put limits on competition, restrictions on interest rates. CHAPTER 4; An asset is a piece of property that is a store of value. When considering whether to buy or not an asset, an individual must consider the following factors: Determinants of (Financial) Asset Demand: 5 of 93 1. Wealth = the total resources owned by the individual (house, securities, car...) assets included. wealth # income, it’s a stock variable, not a flow; income is part of one's wealth, but wealth also includes the value of the house,... 2. Expected return (over the next period) on one asset and on that asset relative to alternative assets. If demand for a stock increases, expected return increases. 8. Risk (uncertainty on asset return) on one asset relative to alternative assets. Risk lovers/seekers prefer assets with higher uncertainty. 4. Liquidity =the ease and speed with which an asset can be turned into cash: relative to alternative assets; an house is not very liquid. Liquidity is increasing in the demand for the asset: the higher the number of sellers and buyers in the market, the more liquid the asset. The more liquid is an asset relative to an alternative asset, holding everything else unchanged, the more desirable it is, and the greater the quantity demanded. US treasury bills are incredibly liquid assets. 5. Goodwill and credibility of the firm. Wealth: The demand for assets is increasing in wealth, indeed financial assets are normal goods (not inferior); As wealth increases we demand less of inferior goods. (ex. Public transports, potatoes, rice). Holding everything else constant, an increase in wealth increases the demand of an asset. Expected returns: The expected return is the average return across all states of nature: it measure how N much we gain from holding an asset. E(R)= ) piXRi The expected return of an asset is the weighted average of all possible returns, 1 where the weights are the probabilities of occurrence of that return. i Expected returns are additive: The expected return of a portfolio p of two stocks A and B is E(Ryort) = E(Ra + Re) = E(Ra) + E(R8) the sum of the expected returns of the two stocks. Holding everything else constant, an increase in the expected return increases the demand for the asset. Treasury bill = buy bonds online and lend to the government money. Now almost zero nominal interest rate. —>By subtracting inflation we get a negative real interest rate. Risk: The higher the standard deviation, the greater the risk of the asset. A risk averse person prefers a sure thing than a risky asset, even though the stock have the same expected return. Holding everything else constant, an increase in risk decreases the demand of an asset Change in Change in Quantity Variable Variable Demanded Wealth Î î i , —> theory of portfolio Expected retum relative to other assets î f choice Risk relative to other assets î } What is a bond? Liquidity relative to other assets î f A bond is a security that assures the holder the payment of a specified 6 of 93 amount (the face value) in the future upon maturity, as well as the payment of periodic coupon interest. We use the term discounting the future to describe the process of calculating today’s value of dollars received in the future. The concept of present value allows us to figure out today’s value of a credit market instrument at a given simple interest rate, by just adding up the present value of all the future cashflow received. The concept of present value allows us to compare the value of two instruments with very different timing of cash flows. If a coupon bond is purchased at its par value, its yield to maturity must equal the interest rate, which is also equal to the coupon rate. The price of a coupon bond and the yield to maturity are negatively related: an increase in the YTM increases the denominators of the formula to compute the price, thus decreasing the price. Since when the bond is purchased at par, we know that the coupon rate equates the yield to maturity, if the YTM rises above the coupon rate, it means that the price necessarily falls below the face value of the bond. —> bond price is below par value. What does this mean? If the required yield on the bond is more than what the bond actually pays (the coupon rate), then it needs to sell at discount to attract investors. In other words, because investors can make a larger return in the market, they need an extra incentive to invest in the bond. How well a person does by holding a bond or any other security over a particular time period is accurately measured by the rate of return. The rate of return is defined as the payments to the owner plus the change in its value, expressed as a fraction of its purchase price. The prices of longer maturity bonds respond more dramatically to changes in interest rate. —> prices and return for long term bonds are more volatile than those for shorter-term bonds. For short term bonds whose maturity = holding period, there is no interest rate risk (risk associated with possible changes in the interest rate), this is true as the rate of return on the bond is equal to its yield to maturity which is established at the time of purchase; moreover, the face value (i.e. the value at which the bond will be sold) is fixed. Possible changes in the interest rate have no effect on price. Reinvestment risk is a type if interest rate risk, it occurs because the proceeds of a short term bond need to be reinvested at a future interest rate which is uncertain. If the future one year interest rate is higher than the current one, the investor benefits from the reinvestment; on the contrary, the investor will be hurt by a fall in the interest rate. Since the coupon bond makes payments earlier than the zero-coupon bond, we might guess that the coupon bond effective maturity (duration) that accurately measures interest rate risk is shorter than it is for zero coupon bond. Therefore, the interest rate risk for the 10 year coupon bond is less than the 10 year zero coupon bond. All else being equal, the higher the coupon rate, the shorter the bond's duration. The duration of a portfolio of securities is the weighted average of the durations of the individual securities, with the weights reflecting the proportion of the portfolio invested in each. Interest rates are positively correlated with business cycle expansions. (Bond prices negatively correlated) —> supply curves shift more than demand curves Chapter 11. The money market Notes on the notebook. T-bills, Federal funds, repos, commercial papers, negotiable certificates, banker's acceptances. AII low risk and low interest rate. They are close substitutes, if the interest rate of one of them departed from the other, demand and supply mechanisms would soon bring it back to equilibrium. Secondary market for T-bill is well developed—> possible to sell them before maturity, different from commercial banks where brokers charge high fees if sold before maturity. 70f93 Credit ratings How to detect firm’s default probability? _S8P ‘5 ] P(default) _] Classification You can rely on credit-rating agencies. These companies study peso ccm the issuer’s financial characteristics and make a judgement RA_| Aa | High grado _ about the issuer’s possibility of default (probability of default of Ei n the different bonds on the market, included government bonds). Speculative grade (Junk bond) _ These companies have been criticized as they have market 65 |Ba 1.21% _] Non:investment grade speculative power: rating assigned substantially affects the yield the A EDO] Government has to pay on bonds (critic during 2008 crisis: la 24.79% | Estremely epeculetive interest rates rose substantially, people had a lot of power on D_jD ] Delauti rates). These agencies do advising: get paid to give advice to | {°° Yield Comparison companies on how to get better ratings. —> not corrupted as this would make them unreliable. Scales of the grades: Ranking grades vary from investment grade (from AAA = low risk to BBB = high risk), to speculative, junk or high yield grade that go from BB to C, D). Below BBB, bonds are considered to be junk bonds, and the required yield will be much higher than on investment-grade bonds. CC with 25% is pretty speculative investment. D is almost sure default. After the large recovery of the market, in 2008 the demand for risky securities fell: the default rate on speculative-grade bonds so 10 100 was three times that of investment-grade bonds. Bonds have a bond indenture which is a contract stating the lender's rights and the borrower*s obligations. These contracts include restrictive covenants, call provisions, conversion options, not all corporate bonds have all these three characteristics, some have them all, some have none. As managers tend to safeguard the interest of stockholders, bondholders can impose rules and restrictions (covenants) on managers designed to protect their interests. These are known as restrictive covenants (they can limit the amount of dividends that the firm can distribute to conserve cash to pay interest on bondholders” loans, or they can limit the firm’s ability to issue additional debt). The interest rate is lower, the higher the number of restrictions placed on the bond —> safer bond. Covenants allow bondholders to act like sort of shareholders. Most corporate indenture also include call provision which states that the issuer has the rights to force the holder to sell the bond back (bond is callable). In this case the price paid by the corporation is usually set at par price or slightly above. If interest rate falls, the price of the bond will rise. If rate falls enough (market interest rates are lower than the ones paid by the firm), the price will rise above call price, and the firm will call the bond. —> call provisions put a limit on the amount that bondholders can earn from the appreciation of a bond. Call provisions increase flexibility, thus reduce riskiness of the bond —> market interest rate falls: interest rate for callable bond is higher than for non-callable bonds. Call provisions are useful if the company wants to alter its capital structure (reduce debt load and cashflow), if the covenants are too restrictive and impede the growth of the com pany, if interest rate fall too much. In particular firms can choose to issue only callable bonds because in this way if the covenants restricted the firm from some activity, the firm could retire its existing bonds. Bond issuer pays higher interests as this bond is more flexible, it is bad for bond holders as bonds can be called back at any point in time. Bonds are said to have a conversion option when they can be converted into shares of common stock: bondholders can become shareholders of the company. Interest rate is lower for convertible bonds: company loses flexibility in favor of bondholder. If the managers think that the firm will perform well in the near future, they are likely to issue convertible bonds; bondholders can decide not to convert such bonds. Tesla paid interest of 5.25% but low credit ranking: people believed Tesla could really change the 10 of 93 world, thus they did not believe to those ratings. Seniority: buying stocks vs lend money through bonds: seniority tells if you get something back when company defaults: if a company defaults, bondholders are senior to stockholders: bondholders always get paid before. There exist differences in seniority: senior bondholders are paid first, then junior bondholders, then stockholders if anything is left. Secured bonds are ones with collateral attached (eg. Mortgage bonds which are used to finance a specify project: a building might be the collateral for bonds issued for its construction). Mortgage holders have the right to liquidate the property/collateral in order to be paid. Secured bonds are less risky than unsecured bonds, thus they have lower interest rates. Secured bond holders get paid for sure: they are senior to all. Unsecured long term bonds are called debentures, they are backed only be the creditworthiness of the issuer. Collateral pledged to other debtors is not available to the holders of debentures. Debenture are riskier, and have lower priority than secured bonds, therefore they have higher rates. Subordinate debentures have even higher yield as, in case of default, the holders of these bonds are the last ones to be paid. Variable rate bonds have been introduced lately, their interest rate is tied to another market interest rate (eg. Treasury bonds) and is adjusted periodically. Financially weaker security issuers frequently purchase financial guarantees to lower the risk of their bonds. A financial guarantee is much like an insurance policy which ensures that the lender (bond purchaser) will be paid both principal and interest. With such a financial guarantee, bond buyers no longer have to be concerned with the financial health of the bond issuer. Instead, they are interested only in the strength of the insurer. Essentially, the credit rating of the insurer is substituted for the credit rating of the issuer. The resulting reduction in risk lowers the interest rate demanded by bond buyers. Of course, issuers must pay a fee to the insurance company for the guarantee. Financial guarantees make sense only when the cost of the insurance is less than the interest savings that result. Another way to insure bonds is called the credit default swap (CDS). In its simplest form a CDS provides insurance against default in the principal and interest payments of a credit instrument. Say you decided to buy a GE bond and wanted to insure yourself against any losses that might occur should GE have problems. You could buy a CDS from a variety of sources that would provide this protection. Government bonds are rated too: The current yield is an approximation of the yield to maturity. It is computed in the same way of a perpetuity, C/P. In particular, the current yield best approximates the yield to maturity when the maturity on the bond is longer (similar to a perpetuity), or when the bond’s par value is close to the bond's price. 11 0f93 The last point is explained by the fact that when FV = P —> YTM = coupon rate. As the coupon rate is computed as C/FV, when FV = P, coupon rate = C/FV = C/P = current yield. Chapter 13: The stock market A share of stock in a firm represents ownership: a stockholder owns a percentage of the firm. Stockholders can earn a return from stocks in two ways: they can either earn from an increase in the price of the stocks or they can be paid dividends by the firm. Some firms never pay dividends, and stockholders are paid only through increases in stock prices. Stock is riskier than bonds: stockholders have the right of a residual claimant (they have a claim on all assets and income left over after all other claimants have been satisfied), however, if nothing is left, they get nothing. Among stockholders there is seniority that attributes a specific position in payment in case of default (junior vs senior). If the firm does well, it is much possible to get richer as a stockholder rather than as a bondholder. Moreover, differently from debt holders, stockholders may have the right to vote. Stocks don't have a maturity date and are much more volatile than bonds. There are two types of stock: common and preferred. A share of common stock in the company represents an ownership interest in that firm. Common stockholders vote, receive dividend (if net income is not kept to re-invest in the company), hope the price of their stock rises. Preferred stock is a form of equity which is much similar to a debt rather than to common stocks. Preferred stockholders receive a fixed dividend that never changes, since the dividend is fixed, the price of preferred stocks is relatively stable. Preferred stockholders usually do not vote unless the firm has failed to pay promised dividends (no voting rights), they hold a claim on assets that has priority over common stock holders. Since preferred dividends are not tax-deductible (bonds are tax deductible), preferred stocks are more expensive to the firm, reason why usually only 5% of all capital raised is raised using preferred stocks. Stocks: high control rights (vote), uncertain cash flow (volatile price and uncertain dividends) on the contrary, bonds have low control rights (other than in bankruptcy) but certain cash flows. The stock market reaches much more attention that the debt market, even though debt market is much bigger in terms of volume. However it is more attractive as it is easier to become rich. It is easy to see the market: floor traders shouting and big screen with lots of number to represent panic. There is quite a lot of evidence that in the long run you can outperform the market = make the same returns as the market makes on average. Equity funding is more costly than debt funding: interest rates on bonds are tax deductible, dividends are not. Example: a firm makes $20 million of gross income. Either pays $5 million in dividends or in interest: Debt financed: Financed with preferred stock: gross income $20,000,000 gross income $20,000,000 interest paid _$5,000,000 interest paid so = taxable income _ $15,000,000 = taxable income $20,000,000 tax 30% —$4,500,000 tax 30% 6.000,00 = net income _ $10,500,000 = net income $14,000,000 dividends __$5,000,000 $9,000,000 Primary market: investment bank underwrites shares. Investment banks help firms enter the market and then sell their stocks on the market. (T-bill auction is an example). After shares have been sold, they are part of the secondary market where everyone can buy them. When stocks are traded in the secondary market, the company does not earn anything. Secondary markets might have an indirect effect on the company: price of stocks might increase, thus the company might choose to sell stocks at a higher price in the future, was it to issue new shares. Increase in the demand for stock in the secondary market —> price increases but firms does not directly benefit from this as firm rates shares in the primary market only. 12 of 93 Indexes are just averaging of the stocks composing the index. The basket of underlying stocks changes periodically. Examples of these indices are FTSE (London), FTSE MIB (Milan), NASDAQ... Shares terminology: * Authorized shares: maximum number of shares the company can issue during its lifetime. This number is established when firm files registration statement. It can be changed but requires a vote by shareholders. Outstanding shares: number of outstanding shares. There are two types of outstanding shares: Restricted shares issued to COO or public employees as part of their salaries or bonus. These cannot be bought or sold by the public. These are the only shares available in private companies. Float are the shares available on the market that can be freely = - bought and sold without restrictions by the public. : a Market capitalization = price per share x outstanding shares. Apple for instance: the price of a share is $145 —> $2.4 trillion in Al market capitalization (largest in the market). Drastic increase in 4 Y market capitalization after 2007 with the release of the iPhone. Î Apple Stock History Since ts IPO Any future dividend discounted is so heavily discounted that today has almost no value. Large price changes will not affect the price of the stock today. Holding the stock till infinity (dividends discounted). Dividends grow at some constant rate Dt+1 = dividends of previous period x growth rate , discounted back at today. Not very realistic the fact that dividends grow at a constant rate infinitely. But it is a good approximation as dividends in a distant _ Div, _ Divyx(1+g)_ Div, future have a very little effect on today's price. Atto kg ke7g The required return on equity > return on equity of dividends. If g is constant forever, then the company”s value would grow infinitely large (not restrictive assumption). [meteo 1001 rowwnsor YCHARTS > Stock increased by 21,190% since 19805. Comparison: S&P500 increased by 1,590% How the market sets prices Suppose there are three investors: You: do not know much about company, dividends = 2, g = 3%, uncertainty requires k = 15% Jennifer: requires low return on equity because she knows a lot about the company and is much more confident in it than you. K = 12% (has knowledge of the industry) Bud: is the CEO of the company. He knows what the company's plans are. Only requires 7% —> sure about the success of the company and about estimates. Heterogeneity on the required return on equity explained by the heterogeneity in the information investors have —> different evaluations for company and different stock price. Gordon model: prices reflect the willingness to pay (Maximum acceptable price of each investor). Ina market auction, Bud would get the stock. He would bid just above Jennifer. You —> required discount rate = 15% —> stock price = 16.67 Jennifer —> 12% —> stock price 22.22 Bud —> 7% —> stock price 50 When the stock price is 24, only bud is still in: he will buy the stock. The price will correspond to the willingness to pay of the second largest bidder + a small amount. If Jennifer sees that Bud makes a lot of bids, it will be an opportunity for her to have more info, and she could require a lower K. Maybe Jennifer is more risk averse so she will not risk any further. 15 of 93 Maybe Bud is just less risk averse, so Jennifer would not do well by copying him. Competitive auction markets: the price is set by: * the person that can take the best advantage of the asset and/or has information advantage (the person with the most information). * Or by the buyer with the highest willingness to pay, not necessarily p= WTP * The price may be set due to overoptimism driven by market euphoria: if the expectations are wrong we have a bubble (bid does not reflect real price of the stock —> bubble: prices go far by market fundamentals), when bubbles burst they create damages. (—> behavioral finance). AIl the models require to compute expected earnings, dividends and growth rates. Such evaluations might contain errors which lead to bad mistakes. Example: different possible growth rates: different growth rates = different prices. Price difference gets larger as g grows. Small mistake in growth rate expectation lead to big mistakes in the bid price. Errors in the estimation of the growth rate can translate to large errors in the valuation of the stock. Crisis 2007-2009 Started in august 2007. Was the start of one of the worst bear markets in history. What contributed to low prices in a recession according to 5 Gordon model? 10 1. g is revised downward (growth rate is revised downward due to crisis) as expectation of future growth for US companies are revised downward. 2. Kis also higher due to high uncertainty (crisis) Both contribute to a fall in price. Growth (%) Price ($) Chapter 24. Hedging with Financial Derivatives Derivatives: future and forwards Financial derivatives are financial instruments designed to help financial institutions hedge against risk. Financial derivatives have payoffs that are linked to previously issued securities and are extremely useful risk-reduction tools. They enable financial institutions to engage in a financial transaction that reduces or eliminates risk. Here is Warren Buffett’s definition: “Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values” They are financial contracts whose priced cash flows are determined by underlying items (typically bonds): how much money will change hands between two people if underlying assets such as bonds, price changes, index changes —> good to hedge risk. They can be problematic. 2002: “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal” —> potential harm of derivatives predicted in 2002, 5 years before crisis. Do derivatives contain or amplify risk? They contain risk for the market as a whole. (Desirable role), but they can concentrate risk in the hands of a few = counterpart risk. If these few are interconnected to everyone, a small problem such as a subprime mortgage default, can lead to a collapse of the system —>in both financial crisis AIG (financial company) was selling credit default swap Two notions for the sides of risk: 16 of 93 1. Longposition: benefit from price appreciating. (When a financial institution buys or owns an asset). Long positions expose the financial institution to risk if the returns on the asset are uncertain. 2. Short position: benefit from the price falling. (short selling: borrow an asset for someone, selling it on the market hoping the price will fall, then buy it back at lower price and give back to the one you borrowed it from). A short position is acquired when a financial institution sells an asset that it has agreed to deliver to another party at a future date (borrowed asset that must be returned in the future to the original owner). (Now overvalued —> price will fall). A lot of money so that they can buy a lot of stocks and sell them. People with market power as they have large scale sales that they can make, just by doing so they contribute to the depreciation of the asset. (You are short on some assets) You profit if the price goes down. If you are long you run the risk that the price goes down. If you are short you risk that the price increases. Hedging risk involves engaging in a financial transaction that reduces or eliminates risk. The idea is to enter a financial contract with a risk that is opposite (negatively correlated) with the original one (that cost you to enter the contract). This means: financial transaction that offsets a long position by taking aan additional short position, or offsets a short position by taking an additional long position. In practice: if a financial institution has bought a security, thus taking a long position, it conducts a hedge by contracting to sell that security (take a short position) at some future date. Alternatively, if it has taken a short position by selling a security that it needs to deliver at a future date, then it conducts a hedge by contracting to buy that security (take a long position) at a future date. Example of hedging + forward contract (see below) It is Oct2019. Suppose you own an oil company. You have just been given the rights to extract oil from an oil field in Texas from October 2020. Your cost of production is $25/bbl (barrel). The spot price (current price) is around $60. You're a smart entrepreneur and want to hedge the risk that the price will fall below $25 (production price > sell price = loss). There is a utility company that purchases oil to produce electricity. They are happy with the spot price of $60, but worry that geopolitical tensions may increase it They are short in oil and would be happy to enter a long position to hedge. We could write a contract that promises the delivery of 10,000 barrels for $60/bbl (delivery price) in 10/2020 1. The oil company would still make a profit of $35/bbl (producing at 25) 2. The utility company locks in today”s price (happy with current price, ensuring themselves against the risk of an increase in price). Forward contract Forward contracts are agreements by two parties to engage in a financial transaction at some future date. They are not standardized in any way (every time you enter into a contract you have to specify details below), least details needed for a forward: 1. Whatitem should be delivered (specification of the debt instrument to be delivered) 2. Amount of the debt instrument to be delivered (how much) 8. At what price (delivery price) will it be sold when delivered (negatively depends on interest rate) 4. Date of the delivery Forward contract eliminate uncertainty abut the future price, but there is always one winner and one loser (ex post = after the future state of the world have realized, before future has realized it appears to be a good opportunity for both parties). 17 of 93 t= T Item exchanged or contract closed at Fr Standardization overcomes the problem of market liquidity (find a counterparty) that forwards have. Futures are more specific. The delivery of items in futures market almost never actually happens, due to the possibility of closing one's position by offsetting it with the opposite position, operation done directly through the exchange: if you’re long (bought a future), you can enter a short position (sell the same future) with the exchange. The exchange cancels both contracts. This allows to avoids the cost of delivery (transaction costs) —> you close your position with an offsetting position in the same exchange. No contact between seller and buyer. The exchange clears the market. If you sell or if you buy, you go to the clearing house. Like with forward contracts, people who have agreed to buy a future contract are said to be taking a long position, while parties who have sold a future contract (those who have agreed to sell the bonds) have taken a short position. Non arbitrage: Another important feature of futures is that the future price will converge to the spot price at the delivery date ( Fr = S7). This is to avoid arbitrage opportunity. If the future price for today is lower than spot price, we can buy a future today, get the good and sell it immediately for profit at the spot price. (Many people want to buy, the price of the contract will gradually rise till it will match the price go the underlying asset). If the future is above spot price, everyone will try to sell the contract: sellers get x from selling the futures contract but have to pay only x-1 for the treasury bonds that they must deliver to the buyer of the contract, the 1 of difference is their profit. —> seller buys at spot and sells futures. (As many people want to sell, t eh price will decrease and gradually converge to the price of the underlying asset). —> profit with certainty by arbitrage Since there are smart traders that will realize this immediately, arbitrage opportunities are immediately eliminated. The number of contracts required to hedge interest-rate risk is found by dividing the amount of the assets to be hedged by the dollar value of each contract: NC =VA/VC, where NC = number of contracts for the hedge, VA = value of the asset, VC = value of the contract. Payoffs: * Payoffto the long side of a future contract closed at datet: fr - Fo Where Fò is the price initially paid on the future and XK is the price of the future when closing (selling). * Payoffto the short side of a future contract closed at date t: Fo- A Where ro is the price initially received on the future and Fis the price of the future when closing (buying) If the contract is kept until delivery, then t = T and Ft = Fr = Spot price Example: profits going long: Assume that you took a long position on a futures contract when the price was $50. Today the futures price is $40. What is your profit/loss if you closed your portion today? What if you wait until the delivery/settlement date, when the price of the underlying asset is $30? * If you close now you lose 10 because you need to go short sell at the lower price 40 —> book loss of 40-50=10. 20 of 93 * If you wait until T, you bought at 50 something that you will sell for 80 —> loss of 20. If you could look in the future you would close your position sooner. Everything the opposite if we were short (+10, +20), and we had had better waiting until the end. Exchanges and default risk Just like forward contracts, also with futures contract we deal with the risk of default of the counterparty (the side might not meet obligations). How does the exchange guarantees that all obligations will be executed even if the other party defaults? The exchange acts as a clearinghouse (CCP, Central CounterParty) for both traders (seller and buyer). The clearing house guarantees all futures will be executed even if one counterparty defaults. The exchange gets the money to pay the other party in case of default from buyers’ and sellers’ margin accounts (accounts whose value is tied to the value of the future contract). The buyer of futures contract does not need to worry about the financial wealth or trustworthiness of the seller (the same holds for the seller), as they did in the forward market. Indeed, the seller and the buyer of a futures contract make their contract not with each other but with the clearinghouse associated with the futures exchange. As long as the clearinghouse is financially solid, buyers and sellers of futures contracts do not have to worry about default risk. To make sure that the clearinghouse is financially sound and does not run into financial difficulties that might jeopardize its contracts, buyers and sellers of futures contracts must put an initial deposit called a margin requirement in their margin accounts. Future contracts are marked to market daily, meaning that at the end of every trading day, the change in the value of the futures contract is added or subtracted from the margin accounts. If the seller gains 1000, this amount is added to its margin account. The margin account is called so because the exchange will make a margin call (i.e. will ask the buyer/seller to put more money into their account) in case the value of the future contract changes such that the margin account does not meet maintenance margin requirement anymore. If the margin account has insufficient funds and the party does not top up funds after receiving a margin call, the position will be automatically closed. The key point is that the margin accounts are adjusted daily (daily settlement). The future price changes continuously, so does the margin account. At the end of every day, the exchange looks at how futures prices have moved. It credits the margin account of the party whose contract has become more valuable and debits the counterparty’s account by exactly the same amount. This is called mark to market and it eliminates default risk. The amount debited/credited corresponds exactly to the change in futures prices between today and yesterday: Fi — Fi. Exercise mark to market Suppose a trader has taken a long position on oil futures at $75 per barrel (the trader is long on oil futures: benefits from an increase in the oil price). The contract expires in 3 days and it consists of 5,000 barrels The trader needs to deposit 4% as initial margin. (4% refers to the total value of the contract). Q: The futures price in the following three days are $80, $74, $77. Calculate the trader’s profits and losses in her margin account. Initial margin: 5000 x 75 x 0.4 = 15 000 If oil price goes up to 80: the price difference multiplied for the number of barrels will go to the account: 5 x 5000 = 25 000 —> money put in the margin account of the person going long. These money are taken out from the margin account of the person going short. When price goes to 74: difference is -6 —> 6 x 5000 = 30 000 will be subtracted from the margin account of the person with the long position, and added to the margin account of the person going short. 21 of 93 Eventually, the spot price is 77 —> 3 x 5000 = 15 000 on top of the margin account of the person going long. T7 -T75=2—>2x5000= 10000 is the total change in the margin accounts, the final amount in the person going long is 25 000. Since the position was not closed before maturity, delivery takes place at the spot price of 77$ (not at $75). This is also the price of a future bought at the delivery date (convergence of future with spot price). But wait! She bought oil futures for $75/bbl, as agreed 3 days before, and not $77. Those 2$/bbl are in the margin account! As if she had closed the contract for 75. In fact, on the futures position the long trader gained. In particular: zong = + St — Fo xcontractsize= 77 —- 75 x 5000 = +$10,000. This is the same as the total cash flow in the margin accounts. (+25,000-30,000+15,000). So the trader pays $77 for barrel, but also gets +$10,000 in the margin account which is like paying $75 for each barrel. -$77 + ($10, 000 / 5, 000 bbl) = -75$ When the price went down, cash was taken out from seller account and put into that of the buyer. This ensures that although the price is 74, and the position is closed because the buyer defaults, the seller will receive money from the buyer's margin account allthe same. Stock index futures To reduce stock market risk, financial institution managers use stock index futures (most widely traded of all future contracts). A stock index future has a stock market index as underlying asset. The cash amount delivered is equal to the stock market index at the delivery date x multiplier; the index is the difference between the spot price and the future price ong = multiplier x (Sr — Fo) short = multiplier x (Fo — Sy) The standard & Poor's 500 Index futures contract is the most widely traded stock index futures contract in the US. It measures the value of 500 of the most widely traded stocks. Stock index futures contracts differ from most other financial futures contracts in that they are settled with a cash delivery, rather than with the delivery of a security. Cash settlement give these contracts the advantage of a high degree if liquidity and rules out the possibility of people cornering the market. For the S&P500 futures the multiplier is 250. This means that the cash delivery due is $250 times the index, so if the index is at 1,000 on the final settlement date, $250,000 would be the amount due. The price quotes for this contract are also quoted in terms of index points, so a change of 1 point represents a change of $250 in the contract’s value. If you sell one contract at a price of $1,500, you agree to deliver in the future 250xS&P500 value at the delivery date (S&P500T ). If S&P500T=1,000, the index is 1000/250 = 4 —> short = 250 x $1500 — $1000 = $125,000 —> You sold at $375,000=$1,500x250 but only need to deliver $250,000. Technically, only $125k will be exchanged at delivery Example: Why would you use a stock index future? * Suppose that in March 2017, Mort has a portfolio of stocks valued at $100 million that moves one- to-one with the S&P Index. Suppose also that the March 2018 S&P500 Index contracts are currently selling at a price of 1,000 (The S&P500 today is 1,000). How many of these contracts should Mort sell so that he hedges the stock market risk of this portfolio over the next year? (How to hedge a 22 of 93 You can buy/sell either type (both call and put): * Buy a call option = you have the right to buy the underlying assets * Sell a call option = you are giving someone else the right to buy the underlying asset, meaning that you are obliged to sell the underlying asset at some point in time if the option is exercised. * Put option = gives the holder the right to sell. * Selling a put option | give someone else the right to sell the option, meaning I am obliged to buy the underlying asset if the buyer exercises the option. The option (gross) payoff is the amount the option pays at expiration. The option payoff is also called option value. The option profit is the (gross) payoff minus the premium paid (long side) or plus the premium received (short side). Example options: Suppose you have a call option with a strike price of $100, maturing tomorrow and a premium of $5. 1. The stock tomorrow is worth $120. Do you exercise the option? What is your profit? Yes because | have the right to buy at 100 something that is worth 120 (I can immediately sell for 120), since | pay 5 for the premium I have a profit of 15. 2. The stock tomorrow is worth 90. Do you exercise the option? Profit? No because you would lose 15. -15 is the profit if you exercise the option. As you don't exercise you lose only 5 because of the premium. Profits for the holder of an option (long): When you hold an option, you always have to subtract p. * You exercise a call option only if buying at the exercise/strike price X is more favorable than the spot price S (price of the underlying asset). Payoff is the difference between the spot price and the strike price at which you bought the option, never below zero (because call — max(S— X,0) — if S< X you simply don't exercise the option). tong ’ p To get the profit subtract the premium from the payoff: Profit (call for person going long): take the largest value of S - X Call Payoff (always > 0). And subtract p. If S < X, then we have a negative value for the first part of the equation, which takes as maximum value between the negative number and 0 0, so:0-p=-p—> loss of the size of the premium. If S > X, then the maximum value that can be obtained is S - X —> profit = S - X - p. You exercise a put option only if selling at the strike price X is more favorable than the spot price S (price of the underlying asset): nt, = max(X— 5,0) —p Put Payoff Profit from holding (long) a call: X axis = spot price. To the right of the intersection S > X —> in this case we n Max — A,U)—p Will exercise the option to buy the underline asset: buy at X and sell at S, with Ù S > X. The larger the spot price, the greater the profit. Payoff = profit + p (price already paid for the right to exercise the option. Profit from holding (long) a put (right to sell the asset): Pay p=right to sell. We sell only if S < X —> spot price is less than the exercise price. Best case scenario: S = 0 —> buy for free and sell it for X. (P = premium you have to pay to get the profit —> always to be subtracted). max(X — 5,0) —p Payolt Breakeven case = > S = X but we are making a loss anyway because we have to pay the premium. Profit for the writer of a short option (selling the option = giving it away): When you write an option you always add the premium. * Call option = you are obliged to sell if the buyer of the call exercises the option. He will exercise only if S > X, but he always pays the premium. (But at X, sell at S) profit: xS4,=p-max(s-x,0) —> We are getting p anyway. Giving aways the call option. | am obliged to sell when S > X. I can make a loss: larger S = larger loss. At best | am making p when S < X (the other party does not exercise the option and get p). * Put option: you are obliged to buy if the buyer of the put exercises the option. He will exercise only if X > S (strike price > spot price), but he always pays the premium. Your profit is: 78}, =p-—max(X-S,0) Best case scenario we get p - O (that is: when X < S and we get p): option not exercised. The payoff is always negative or O. The profit is either negative or equal to p. When S > X, the holder of the put option won't exercise it and the writer gets p (best case scenario). Worst case scenario: party sells at X, you buy at X (spot price is higher). Payoff is p - X. Examples of options: Callable bonds: bonds that can be called back by the issuing corporation at a pre-determined price (A call option!! Right to buy the bond). The firm has to pay a premium for the right to call which comes in the form of higher interest rate. Stock options are options on individual stocks. They are a popular compensation for managers and CEOs, who hence benefit if price of underlying asset (company’s stock) increases: manager has incentive of company going well. In theory it align the incentives of manager and company: pay linked to performance. (Financial) futures options are option contracts on financial futures. These are now the most widely traded option contract. Financial futures contracts have been so well designed that their markets are often more liquid than the markets of the underlying debt instruments. Options types: European options do not allow early exercise, while American options do allow early exercise. We can trade American options in Europe: American can be exercised before maturity. Exotic option: payoff structure is determined in a nonstandard way: examples: average price of an underlying asset in a certain period of time (Asian option) Options terminology: * In the money: when exercise today is profitable A call is in the money if S > X (spot price > strike price): you can buy at X and sell immediately after at S (higher than X). 26 of 93 A put is in the money if X > S (strike price > spot price) —> the price of the underlying instrument is below the strike price At the money: X = S the strike equals the current price of the asset (the option’s intrinsic value is 0). —> the holder of the option is indifferent to whether he exercises the option or not, in any case he will have to pay for the premium. Out of money: exercise today would be unprofitable. A call is out of money when X > S: strike price > spot price. —>The price of the underlying financial instrument is below the strike / exercise price. A put is out of money if X < S: spot price > exercise/strike price. Buying at S and selling at X you make a negative payoff. Pricing options (premium) Determinants the affect the premium of options: If the spot price increases (price of the underlying financial instrument): * The price of a call option goes up because we sell at higher price. * The price of the put option goes down because the spot price has soared but we have committed to sell at the same lower spot price of before. If the strike price increases * The price of the call option goes down, thus lower premium: we buy at higher strike price. The higher the strike price, the lower the profits on call option contracts, and the lower the premium that investors are willing to pay. * The price of the put option goes up because now we can sell at higher price. If volatility increases: * the price of the call option goes up because we buy at a lower price —> potentially higher profit in the call option, but very limited loss because you can decide not to exercise the option. * The price of the put option increases; same reasoning as with call option: you have the right to sell at some X, underlying asset is very volatile meaning that you can buy at very low price. You don't lose from volatility but can benefit from it because you can just not exercise the option if it is not profitable, or you exercise it with a very low spot price. If time of expiration increases (there is greater chance that the price of the underlying financial instrument will be very high or very low by the expiration date). * the price of the call option will increase: higher uncertainty is better: if the price becomes very high and goes well above the exercise price, the call (buy) option will yield a high profit; if the price becomes very low and goes well below the exercise price, the losses will be small because the owner of the call option will simply decide not to exercise the option. The price of the put option increases—> higher value because the possibility of greater price variability of the underlying financial instrument increases as the term to expiration increases. The greater chance of a low price increases the chance that profits on the put option will be very high. But the greater chance of a high price does not produce substantial losses for the put option, because the owner will again just decide not to exercise the option. An increase in time of expiration or volatility, leads to potentially larger gains (Increases chances of positive gains), but only limited losses. (-p at worst). —> higher p will be required. Volatility only has a positive effect (you can decide not to exercise the option). Same logic for term to expiration: it only increases the chance of a positive gain, with no impact on losses, capped at -p. Even by the non-linearity (has a kink: piecewise linear: kink at which option is not exercised) of the profit function (not so for futures). Hedging with options: example: 27 of 93 Suppose that a share of Microsoft had a closing price yesterday of $90, but new infor- Whenever information is not incorporated in stock prices mation was announced after the market closed that caused a revision in the forecast of i i i i i i the price fc i ti to $120. If th l equilibrium reti Mi ft there is arbitrage opportunity which is exploited by market 153%" ht does he tficieni mart hypothsisInciate the price wil o 0 tocoy men participants, and prices are driven to the value that reflects the market opens? (Assume that Microsoft pays no dividends.) all the available information. > Solution — — na o. _ The price would rise to $104.35 after the opening. With arbitrage, market participants eliminate unexploited profit opportunities, meaning returns on a security that are pa = PZ A+C _ pe larger than what is justified by the characteristics of that n di . vere security. RY = optimal forecast of the return= 15% = 0.15 Arbitrage leads to the efficient market hypothesis. Another R° = equilibrium retum = 15% ptimal forecast of price next year = $120 rice today after opening way to state the efficient market condition: In an efficient Pi market, all unexploited profit opportunities will be pi _ eliminated. An extremely important factor in this reasoning e Ae Pesio si is that not everyone in a financial market has to be well informed about a security for its price to be driven to the point at which the efficient market condition holds. Financial markets are structured so that many participants can play. As long as a few (Who are often referred to as “smart money”) keep their eyes open for unexploited profit opportunities, they will eliminate the profit opportunities that appear; so doing, they earn a profit. The efficient market hypothesis makes sense because it does not require everyone in a market to be cognizant of what is happening to every security. We have seen arbitrage with futures converging to spot prices at delivery. Other examples: - same asset trades with different prices on two different exchanges. Buy where cheaper and sell where more expensive. The price of the cheaper asset will go up and the price of the more expensive assets will go down (law of demand). - Two assets with identical cash flows and risk but different prices. When arbitrage opportunities are exploited, they disappear —> shift in demand and supply increase or decrease price of the asset till the prices converge. For this reason, arbitrage opportunity cannot survive for long in a competitive market. Efficient market hypothesis: The fact that there are few arbitrage opportunities (rise free profit) tells us that there are few securities whose price does not reflect all publicly available information (otherwise there would be an easy arbitrage opportunity). Assets prices are publicly available information = EMH. EMH definition: semi-strong form: “The security’s price reflect all available public information at all times” —> you can still make profits by having inside information (you know price of BMW is low now and you will sell as price will go up). You can make normal return if you have normal public information accessible to everyone. You cannot predict future stock prices form any info that is public knowledge (otherwise arbitrage would be easy). There is no scientific proof that correctly predicts the price of a stock in the future. EMH does not say that we cannot profit from private information: but that is not incorporated in the stock price. Indeed, the existence of market crashes and bubbles, in which the prices of assets rise well above their fundamental values, casts serious doubt on the stronger view that financial markets are efficient but provides less of an argument against the basic lessons of the efficient market hypothesis. The efficient market hypothesis views expectations as equal to optimal forecasts = best guess of the future using all available information. This does not mean that the forecast is perfectly accurate, but only that it is the best possible given the available information. which in turn implies that the expected return on the security will be equal to the optimal forecast of the return. = current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return. Div, (+k)î P = fundamental = Y” 30 of 93 Weak form: all past stock prices are reflected in today’ stock price. Strong form: all information, whether public or private, is priced-in. Prices in the financial market reflect the true, fundamental (intrinsic) value of securities (contain all available information) Evidence of the efficient market hypothesis: Favorable evidence: 1. Random walk behavior of stock prices is unpredictable, and follows a random walk: knowing stock price today does not give any insight about future stock price. Random walk of stock prices = future changes in stock prices should be unpredictable. 2. Anticipated announcements don't affect stock price —> news that are expected do not have any effect on stock price. if information is already publicly available, a positive announcement about a company will not, on average, raise the price of its stock because this information is already reflected in the stock price. 3. You can't beat the market (not even analysts and funds —> According to this point, buying shares through investment advisers and mutual funds should not be better than just buying a basket of the market (randomly) as a whole. There are some funds that do this; this typically do better some analysts or mutual funds (they don't beat the market but follow it)). when purchasing a security, you cannot expect to earn an abnormally high return, a return greater than the equilibrium return. Having performed well in the past does not indicate that an investment adviser or a mutual fund will perform well in the future. EMH says that some advisers will be lucky and some will be unlucky. Being lucky does not mean that a forecaster actually has the ability to beat the market If EMH is right, prices should be a random walk, and anticipated announcements should have no effect on stock prices: the information is already reflected in the stock price (anticipated). Unanticipated announcements will affect the stock price, but under EMH there must be a full immediate adjustment to the new price. Unanticipated announcement example is the number of users using Snapchat fell because Facebook incorporated some of Snapchat’s functions. EMH implications: * Does not imply prices do not change: as new information comes in, securities are re-evaluated * Does not imply that a rational investor always gets the price right, only that his expectations are correct (on average he is right). * Does not imply that a zero average market returns: earn a fair return in equilibrium (which reflects market return), based on the riskiness of the security. * Risk presences change overtime which reflect why stock prices change (investors more risk seeking = invest in more risky stocks). fluctuations might just reflect changes in expectations or preferences. Example EMH: A firm unexpectedly announces today that it will increase its dividends by 20% starting next year. The price of the stock today does not change. Exactly one year from today, just before the announced dividend increase, the stock price goes up by 20%. Is the pattern of price movements consistent with EMH? As soon as the firm announces the change, the price should change; it shouldn't do so when the firm actually increases dividends. It is not consistent with EMH. 31 of 93 Evidences against EMH: “The evidence in support of the efficient markets model is extensive, and (somewhat uniquely in economics) contradictory evidence is sparse”. However, in recent years, the theory has begun to show a few cracks, referred to as anomalies, and empirical evidence indicates that the efficient market hypothesis may not always be generally applicable. (Animal spirits) 1. January effect: a common phenomenon is that price falls in December and rise in January —> abnormal positive and predictable return —> inconsistent with random walk behavior. This effect is no more so prominent in the data as it used to be (still there for some small firms), and is now more difficult to predict. Effect is reversed because of higher demand for stocks in December due to January effect expectations. Some financial economists argue that the January effect is due to tax issues. Investors have an incentive to sell stocks before the end of the year in December because they can then take capital losses on their tax return and reduce their tax liability. As new year starts, they can repurchase the stocks, driving up their prices and producing abnormally high returns. Small-firm effect: many empirical studies have shown that small firms have earned abnormally high returns over long periods of time, even when the greater risk for these firms has been considered. this is a challenge for EMH because no stock should consistently exhibit excess returns. Market overreaction and momentum: sometimes stock prices overreact to news announcements, nets (overshooting), and the pricing errors are corrected only slowly. When corporations announce a major change in earnings, say, a large decline, the stock price may overshoot, and after an initial large decline, it may rise back to more normal levels over a period of several weeks. This violates the efficient market hypothesis because an investor could earn abnormally high returns, on average, by buying a stock immediately after a poor earnings announcement and then selling it after a couple of weeks when it has risen back to normal levels. Sometimes prices continue to rise for quite some time after a positive news (Momentum). momentum strategies: sell stocks that have had bad returns and buy those with high returns in the last 3-12 months. Excessive volatility (volatility sometimes changes crazily, and not due to changes in so short period of time): EMH implies that prices basically reflect all and only market fundamentals (PV of future dividends). However stocks appear to have excessive volatility compared to volatility of fundamentals. for example: Shiller found that fluctuations in the S&P500 could not be justified by the subsequent fluctuations in the dividends of the stocks making up this index. Shiller concluded that there must be factors other than the fundamental affecting stock prices. Mean reversion: Stocks with low returns today tend to have high returns in the future, and vice versa. Hence stocks that have done poorly in the past are more likely to do well in the future —< mean reversion goes against random walk of stock prices. Nowadays mean reversion is a controversial evidence. It might as well be a confirmation of EMH, of how stock prices move randomiy. New Information Is Not Always Immediately Incorporated into Stock Prices: stock prices do not instantaneously adjust to profit announcements. Instead, on average stock prices continue to rise for some time after the announcement of unexpectedly high profits, and they continue to fall after surprisingly low profit ammouncements. Sometimes a stock price declines when good news is announced. Although this seems somewhat peculiar, it is completely consistent with the workings of an efficient market. Suppose that although the announced news is good, it is not as good as expected. HFC's earnings may have risen 15%, but if the market expected earnings to rise by 20%, the new information is actually unfavorable, and the stock price declines. The EMH tells us that hot tips, investment advisers’ published recommendations, and technical analysis—all of which make use of publicly available information— cannot help an investor outperform 32 of 93 Other restrictions = market accessible only with large denominations. FI reduce transaction costs by: - Economies of sale = average cost decreases as the size increases (fixed cost in investing, will be pretty low if you deal with large quantities, while in small investments such fees represent big shares of investment). Financial institution bundle investors’ funds together, thus reducing transaction costs for the individual investors by exploiting economies of scale. Economies of scale exist because the total cost of carrying out a transaction in financial markets increases only a little as the size of the transaction grows. For example, the cost of arranging a purchase of 10,000 shares of stock is not much greater than the cost of arranging a purchase of 50 shares of stock. The clearest example of a financial intermediary that arose because of economies of scale is a mutual fund: a financial intermediary that sells shares to individuals and then invests the proceeds in bonds or stocks. Because it buys large blocks of stocks or bonds, a mutual fund can take advantage of lower transaction costs. These cost savings are then passed on to individual investors after the mutual fund has taken its cut in the form of management fees. An additional benefit for individual investors is that a mutual fund is large enough to purchase a widely diversified portfolio of securities. The increased diversification reduces their risk, making investors better off. - Economies of scope: average cost decreases as the number of products offered increases example: banks offer various services to customers and the same piece of information can be used for different services: figure out who the customer is (default risk), information used for many services (credit card and mortgage). Asymmetric information Throughout the world, non-financial businesses mostly use indirect finance as a source of external funds (i.e. allthose funds that do not come from the business itself through retained earnings) 1. Small firms do not issue bonds and stocks 2. There is more debt (bonds + loans) than equity around the world 8. Bankloans often require collaterals (are secured) WHY? Main reason: Asymmetric Information There is asymmetric information when one counterparty lacks crucial information about another party, impacting decision-making. In the worst case scenario we have a ,market failure in the presence of asymmetric information. There are two types of asymmetric info: adverse selection and moral hazard. Adverse selection (or hidden characteristics) It occurs before the transaction takes place (ex-ante). Before agreeing to a transaction one party has more information than the other. The party that knows more about the transaction is most likely to produce the undesirable (adverse) outcome. A famous example is the Akerlof's market for secondhand cars. Another example is health insurance: very healthy or not (depending on genes). It is an exogenous characteristic on which you have no control. Better genes = longer life expectancy. If insurance companies notices that a lot of people with bad genes are hedging, they will increase insurance premium because a lot of expenses. People with good life expectancy will refuse to pay more as they are in good health. Therefore the share of people demanding the insurance and in good health will diminish even more. The premium will increase as the insurance will have to pay more as a percentage of what it earns. This will go on till no one will demand insurance anymore —> market failure. Key point: the parties who are the most likely to produce an undesirable outcome are the most likely to engage in the transaction 35 of 93 Another example is the bank which does not know the creditworthiness of a potential borrower Exercise: You want to buy a corporate bond. There are three bonds offered: 1 high-quality, 1 medium-quality, 1 poor quality. The respective values are 120, 90, 60. You can't tell which is which. Assume first that also the bond dealer does not know the quality of his bonds. Q: if he offers a bond for sale how much are you willing to pay for it? You are willing to pay 90: the average quality bond. Equal chance of getting good, medium or bad Q: and if the dealer knows the quality, but you don't? Willing to pay 60 at most. If you paid 90 or 120, he’d sell you the junk and earn 30 or 60. The seller will sell you the junk no matter what. You know it, so you pay 60. Large well established firms have less asymmetric info of financial markets (direct finance). Hence they can more easily issue stocks and bonds: investors know they probably won't get a lemon This explain fact 1 above: small firms have hard time issuing stocks and bonds directly because of adverse selection, and they typically have to go through intermediaries. How to solve adverse selection? 1. Private Collection/production and Sale of Information - Health examination before selling insurance - Credit Rating Agencies, CRA (S&P, Moody's) + audits that check financial statements. - Credit scores to get credit card Private production of info creates a free riding problem: once info is out in the market, hard to keep secret: also people who did not pay for the information take advantage of the information other people paid for. Therefore the gain that should have been obtained by people paying for the information is obtained by free-riders instead. This discourages people from paying a price for the information, which means that less information will be produced in the marketplace, so adverse selection will still interfere with the efficient functioning of securities markets. 2. Government Regulation to Increase Information: reduce asymmetric information by having true company's information revealed. The government encourages firms to reveal honest information about themselves through the SEC (in the US) which is the government agency that requires firms selling their securities to have independent audits, to certify that the firm is adhering to standard accounting principles and discussing accurate information about sales, assets and earnings. Auditors check financial statements (does not always work: see Arthur Andersen in the Enron scandal.) This helps explain why financial markets are among the most heavily regulated sectors in the economy 3. Screening ex-ante from FI (especially banks): Like private collection of information, but rather than selling it (like rating agencies) FI make private loans that other investors cannot observe. They also repeatedly lend to same businesses 4. Collateral and Net Worth: ask ex-ante borrowers to have some “skin in the game” - Collateral: property promised to the lender if the borrower defaults, reduces the consequences of adverse selection because it reduces the lender’s losses in the event of a default. - Net worth= Assets - Liabilities (similar to collateral): If a firm has a high net worth, then even if it engages in investments that cause it to have negative profits, thus defaulting on its debt payments, the lender can take title to the firm’s net worth, sell it off, and use the proceeds to recoup some of the losses from the loan. In addition, the more net worth a firm has in the first place, the less likely it isto default, because the firm has a cushion of assets that it can use to pay off its loans Adverse selection explains why small firms are shut out of capital markets and use banks, and why bank loans are usually collateralized. The presence of lemons prevent securities markets such as the stock and bond markets from being effective in channeling funds from savers to borrowers. 36 of 93 Value of Assts ($ billons, end of year) One fact still remains unexplained: why so little equity as a —_ eri source of external finance? Why so much debt (bonds+loans)? Center nb ada Moral Hazard can explain that. SS Moral hazard (or hidden action) La insurance comp ; palio It is a situation where one party has the incentive (hazard) to sm 4965 engage in undesirable (immoral) activities after the transaction has occurred (ex-post). These are undesirable from the lender’s point of view because they make it less likely that the loan will be paid back. (ex post = after people got insurance). The transaction gives an incentive for immoral/unhealthy behavior. This lead to an increase in the premium, and increase in the cost. Examples: Once people get insurance, they become careless, Customers leaving full plates at all-you- can-eat sushi, Once the loan is obtained, entrepreneur uses funds for a riskier project than the one approved, Employee can become lazy right after a promotion. The entrepreneur, once the funds are obtained, has the incentive to take on riskier projects Eroding Banks' Market Share L4T4 Money market mutual funds The Principal - Agent problem The analysis of how asymmetric information problems affect economic behavior is called agency theory. It arises mainly due to moral hazard. The Principal-Agent Problem 1. Resultof separation of ownership by stockholders (principals) from control by managers (agents) 2. Problem: agents act in own rather than principals' interest Problem arises because the agents know more about the company than principals, and can act in its own interest # principal’s. Shareholders have to invest in expensive technologies to look after managers. Shareholders don't know whether the business goes bad because of manager’s behavior or because there is no market. Solutions to agent-principal problem: 1. Monitoring: ex-post screening: shareholders can observe the level of effort of the manager. — Problem with monitoring is that it is costly (both time and money). FI are good at this: for example venture capitalists do constant, active monitoring and receive equity share in start-up that is not tradable 2. Government Intervention: enforce the laws on fraudulent behavior (hiding & stealing profits) 3. Debt Contracts: the principal-agent problem arises with equity because equity is a claim on all profits of the firm. Thus the principal needs to make sure no profit is diverted away by the agent. It requires monitoring (costly). A debt contract can reduce monitoring costs: only need to monitor in some states of the world (default). If the firm has high profits, the lender receives the fixed payment, as agreed, and does not monitor. On the other hand, when the firm performs very poorly there is monitoring. Important result in theoretical finance: debt is the optimal security if moral hazard is present. As a shareholder: all the money you put in the business can be gone. Differently, lenders are paid before. How to overcome moral hazard problem with Debt: Moral hazard can explain why debt (bonds+loans) is much more prevalent than equity, but debt itself is not immune from moral hazard. To overcome moral hazard, debt contracts often have: 37 of 93 assess substantial penalties for early withdrawal. Small-denomination time deposits (deposits of less than $100,000) are less liquid for the depositor than passbook savings, earn higher interest rates, and are a more costly source of funds for the banks. Large-denomination time deposits (CDs) are available in denominations of $100,000 or more and are typically bought by corporations or other banks. Large-denomination CDs are negotiable; like bonds they can be resold in a secondary market before they mature. For this reason, negotiable CDs are held by corporations, money market mutual funds, and other financial institutions as alternative assets to Treasury bills and other short-term bonds. (saving accounts and time deposits both have limited withdrawals). Repos: repurchase agreement: issue an asset and say you will buy it back in the future at high price —> collectible is a t-bill. Other short term borrowing (18%): Banks also obtain funds by borrowing from the Federal Reserve System, the Federal Home Loan banks, other banks, and corporations. Borrowings from the Fed are called discount loans (also known as advances). Banks also borrow reserves overnight in the federal (fed) funds market from other U.S. banks and financial institutions, to have enough deposits at the Federal Reserve to meet reserve requirements. (Federal funds = by banks to other banks.) Other sources of borrowed funds are loans made to banks by their parent companies (bank holding companies), loan arrangements with corporations (such as repurchase agreements), and borrowings of Eurodollars (Interbank offshore dollar deposits: deposits denominated in U.S. dollars residing in foreign banks or foreign branches of U.S. banks). Borrowings currently account for 19% of bank liabilities * Bank capital: The final category on the liabilities side of the balance sheet is bank capital, the bank's net worth, which equals the difference between total assets and liabilities. A bank's capital is raised by selling new equity (stock) or from retained earnings. Bank capital is a cushion against a drop in the value of its assets, which could force the bank into insolvency. Assets: A bank uses the funds that it has acquired by issuing liabilities to purchase income-earning assets. Bank assets are referred to as uses of funds, and the interest income earned on them enables banks to make profits. * Reserves: All banks hold some of the funds they acquire as deposits in an account at the Fed. Reserves are these deposits plus currency that is physically held by banks (called vault cash because it is stored in bank vaults). Although reserves earn a low interest rate, banks hold them for two reasons. Required reserves, are held because of reserve requirements: the regulation that for every dollar of checkable deposits at a bank a certain fraction must be kept as reserves, i.e. required reserve ratio. The more banks keep at the FED, the less they can lend = lower supply of funds in the market = higher interest rate. Changing minimum reserve requirements, CB changes interest rate. Banks hold additional reserves, called excess reserves, because they are the most liquid of all bank assets and a bank can use them to meet its obligations when funds are withdrawn. Cash Items in Process of Collection Suppose that a check written on an account at another bank is deposited in your bank and the funds for this check have not yet been received (collected) from the other bank. The check is classified as a cash item in process of collection, and it is an asset for your bank because it is a claim on another bank for funds that will be paid within a few days. Deposits at Other Banks Many small banks hold deposits in larger banks in exchange for a variety of services, including check collection, foreign exchange transactions, and help with securities purchases. This is an aspect of a system called correspondent banking. Collectively, reserves, cash items in process of collection, and deposits at other banks are referred to as cash items. Securities A bank's holdings of securities are an important income-earning asset: Securities (made up entirely of debt instruments for commercial banks, because banks are not allowed to hold stock) account for 20% of bank assets, and they provide commercial banks with about 10% of their revenue. These securities can be classified into three categories: 40 of 93 - U.S. government and agency securities (also called secondary reserves) - state and local government securities, - and other securities. The U.S. government and agency securities are the most liquid because they can be easily traded and converted into cash with low transaction costs. Banks hold state and local government securities because state and local governments are more likely to do business with banks that hold their securities. State and local government and other securities, although tax deductible, are both less marketable (less liquid) and riskier than U.S. government securities, primarily because of default risk: There is some possibility that the issuer of the securities may not be able to make its interest payments or pay back the face value of the securities when they mature (Securities 22%: only debt (commercial banks are not allowed to hold stocks). Mostly US government debt and mortgage-backed securities (mortgage is collateral for these). Loans: Banks make their profits primarily by issuing loans. 56% of bank assets are in the form of loans, and in recent years they have generally produced more than half of bank revenues. A loan is a liability for the individual or corporation receiving it, but an asset for a bank. Loans are typically less liquid than other assets because they cannot be turned into cash until 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. The largest categories of loans for commercial banks are commercial and industrial loans made to businesses and real estate loans. Commercial banks also make consumer loans and lend to each others. The bulk of these interbank loans are overnight loans lent in the federal funds market. The major difference in the balance sheets of the various depository institutions is primarily in the type of loan in which they specialize. * Other assets: The physical capital (bank buildings, computers, and other equipment) owned by the banks is included in this category. Off-balance sheet activities: are activities that never show up in the balance sheet. In the past two decades banks have greatly expanded their income generating form OBS activities. Off-Balance Sheet activities are: - Loan sales: also called a secondary loan participation, involve a contract that sells all or part of the cash stream from a specific loan and thereby removes the loan from the bank's balance sheet. Banks earn profits by selling loans for an amount slightly greater than that of the original loan. Because the high interest rate on these loans makes them attractive, institutions are willing to buy them, even though the higher price means that they earn a slightly lower interest rate than the original interest rate on the loan, usually on the order of 0.15 percentage point. - Generation of fee income: generation of income from fees that banks receive for providing specialized services to their customers, such as making foreign exchange trades on a customer’s behalf, servicing a mortgage-backed security by collecting interest and principal payments and then paying them out, guaranteeing debt securities such as banker's acceptances (by which the bank promises to make interest and principal payments if the party issuing the security defaults), and providing backup lines of credit. There are several types of backup lines of credit. The most important is the loan commitment, under which for a fee the bank agrees to provide a loan at the customer’s request, up to a given dollar amount, over a specified period of time. Other lines of credit for which banks get fees include standby letters of credit to back up issues of commercial paper and other securities and credit lines (called note issuance facilities, NIFs, and revolving underwriting facilities, RUFs) for underwriting Euronotes, which are medium-term Eurobonds. Off-balance-sheet activities involving guarantees of securities and backup credit lines increase the risk a bank faces: If the issuer of the security defaults, the bank is left holding the bag and must pay off the security’s owner. Backup credit lines also expose the bank to risk because the bank may be forced to provide loans when it does not have sufficient liquidity or when the borrower is a very poor credit risk. 41 of 93 - Trading activities and risk management techniques: banks’ attempts to manage interest-rate risk with financial futures, options for debt instruments, and interest-rate swaps. Banks engaged in international banking also conduct transactions in the foreign exchange market. All transactions in these markets are off-balance-sheet activities because they do not have a direct effect on the bank's balance sheet. Bank trading in these markets is often directed toward reducing risk or facilitating other bank business, banks may also try to outguess the markets and engage in speculation. Trading activities, although often highly profitable, are dangerous because they make it easy for financial institutions to make huge bets quickly. A particular problem for management of trading activities is the principal-agent problem. Given the ability to place large bets, a trader (the agent) has an incentive to take on excessive risks: If her trading strategy leads to large profits, she is likely to receive a high salary and bonuses, but if she takes large losses, the financial institution (the principal) will have to cover them. As the Barings Bank failure in 1995 demonstrated, a trader subject to the principal-agent problem can take an institution that is quite healthy and drive it into insolvency very rapidly. To reduce the principal-agent problem, managers of financial institutions must set up internal controls, which include the complete separation of the people in charge of trading activities from those in charge of the bookkeeping for trades. In addition, managers must set limits on the total amount of traders’ transactions and on the institution’s risk exposure. Managers must also scrutinize risk assessment procedures using the latest computer technology. One such method involves the value-at-risk approach. In this approach, the institution develops a statistical model with which it can calculate the maximum loss that its portfolio is likely to sustain. Another approach is called “stress testing”: a manager looks at the losses the institution would sustain if an unusual combination of bad events occurred. These two methods allow a financial institution to assess its risk exposure. U.S. bank regulators have become concerned about the increased risk that banks are facing from their off-balance-sheet activities and are encouraging banks to pay increased attention to risk management. The most important OBS activities: 1. Securitization: sell loans and repackage them into securities to free up space in balance sheet 2. Loan commitment: for a fee the bank agrees to provide a loan up to $X upon customer’s request. risk: bank may be forced to provide loan when it does not have sufficient liquidity 8. Trading/hedging (ForEx, derivatives: options, futures, interest rate swaps). OBS activities do not show up in book equity but are/should be taken into consideration for market equity => market value of assets - market value of liabilities + net OBS position. Also depends on how much the market knows about OBS (public v private information). Given EMH these information should flow the market and be publicly available. Basic banking Banks engage in asset transformation: deposits (Savings of people) are used to make loans: they borrow short maturity and sell long maturity (“Borrow short and lend long”). Lend with high maturity and interest rates. They have uncertainty of not being able to fund these loans in the future (not being able to borrow short). When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves. Exercise: deposit of $100 cash into First national banks. How does the bank balance sheet look life after the transfer? the check come from an account the customer held at another bank (Second National Bank). How does Second National Bank First National Bank Second National Bank Assets Liabilities Assets Liabilities 42 of 93 * Liquid, short-term securities are easy to convert into cash if liquidity problems (deposit outflows) occur. * But they yield less than long-term illiquid assets Seek for the highest returns and the lowest risk: they attempt to do so in four basic ways: 1. Banks try to find borrowers who will pay high interest rates and are unlikely to default on their loans. They seek out loan business by advertising their borrowing rates and by approaching corporations directly to solicit loans. It is up to the bank's loan officer to decide if potential borrowers are good credit risks who will make interest and principal payments on time = they engage in screening to reduce the adverse selection problem. 2. Second, banks try to purchase securities with high returns and low risk. 8. In managing their assets, banks must attempt to lower risk by diversifying. They accomplish this by purchasing many different types of assets (short- and long- term, U.S. Treasury, and municipal bonds) and approving many types of loans to a number of customers. 4. The bank must manage the liquidity of its assets so that it can satisfy its reserve requirements without bearing huge costs. This means that it will hold liquid securities even if they earn a somewhat lower return than other assets. In addition, banks want to hold U.S. government securities as secondary reserves so that even if a deposit outflow forces some costs on the bank, these will not be terribly high. If it avoids all costs associated with deposit outflows by holding only excess reserves, the bank suffers losses because reserves earn no interest, while the bank's liabilities are costly to maintain. Liability management Starting in the 1960s large banks began to expire ways in which the liabilities on their balance sheet could provide them with reserves and liquidity. This led to an expansion of overnight loan markets, such as the federal funds market, and the development of new financial instruments such as negotiable CDs, which enabled these large banks to acquire new funds quickly. In these way, banks no longer depended on checkable deposits as the primary source of bank funds, and no longer treated liabilities as given. Instead they aggressively set target goals for their asset growth and tried to acquire new funds as they were needed. Capital adequacy Management: Banks have to make decisions about the amount of capital they need to hold for three reasons: 1. Bankcapital helps prevent bank failure (when the bank cannot satisfy its obligations to pay its depositors and other creditors and so goes out of business). 2. The amount of capital affects returns for the owners of the bank (equity holders). 3. Aminimum amount of bank capital (bank capital requirements) is required by regulatory authorities. Bank capital/Equity/Net Worth When banks have a negative net worth they are insolvent: they don't have enough assets to pay off all their liabilities. A high bank capital lessens the chance that the bank will become insolvent, bit it also makes it less profitable. Equity = Funds supplied by bank owners (shareholders) either directly via purchases of shares, or through retention of retained earnings: portion of profits that are not distributed through dividends. When losses occur, these first get subtracted from the bank's net worth, before other creditors get affected. —> shareholders are the first to lose their funds, creditors do so afterwards. (Creditors have priority in insolvency). If the value of assets drops below the value of liabilities, the bank's net worth (book value) becomes negative. Banks need to manage the amount of capital held for two main reasons: 1. a strong capital stock protects from bank failure 2. the capital stock affects the bank's profitability (negatively) 45 of 93 1) Bank capital is a cushion that prevents bank failure. 2) Capital Reduces Profitability For example, consider these two banks: Assume both banks make $1M of net income Hi Capi Bn Lo capi Bn u x High Capita Bank Low Capital Bank a _ I l Return per unit of capital —Return per unit of capital ” | ono 1/10=10% %=25% The low capital bank is insolvent: even if it sold all its * So banks may not want to naturally hold high level asset, not enough $ to pay all creditors of capital (even if it improves solvency) Measures of bank profitability and bank performance: Return on assets (ROA) NI/A = net profit after taxes / assets —> for every dollar of asset, how many dollar the bank makes after taxes. ROA gives a broad idea of how well the bank is using its assets to generate profits, i.e. how well the banks is being managed. Return on equity (ROE) = net profit after taxes / equity —> for very $ invested in the bank, how much profit is the bank making after taxes = how much am | getting as a shareholder? ROE is what owners (equity holders) ultimately care about: this is the return they get on the capital they provided to the bank. The two ratios are linked (same numerator): the link between them is the equity multiplier (EM): Assets / equity (> 1). ROE = ROA x EM The smaller the ratio of capital to assets, the greater the ROE, for a given net profit. Equity holders prefer to have less capital (i.e. more leverage), all else equal. Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank. Banks’ income statement Operating income is the income that comes from a bank's ongoing operations. Most of a bank's operating income is generated by interest on its assets, particularly loans. Interest income represented 65.4% of commercial banks’ operating income. Interest income fluctuates with the level of interest rates, and so its percentage of operating income is highest when interest rates are at peak levels. Non-interest income, which made up 34.6% of operating income in 2015, is generated partly by service charges on deposit accounts, and (mostly) from off-balance-sheet activities, which generate fees or trading profits for the bank. Operating income = interest income + non-Interest income Operating expenses are the expenses incurred in conducting the bank's ongoing operations. An important component of a bank”s operating expenses is the interest payments that it must make on its liabilities, particularly on its deposits. Just as interest income varies with the level of interest rates, so do interest expenses. Interest expenses as a percentage of total operating expenses reached a peak of 74% in 1981, when interest rates were at their highest. Non-interest expenses include the costs of running a banking business: salaries for tellers and officers, rent, maintenance and utilities for bank buildings, purchases of equipment, and servicing costs of equipment such as computers. The final item listed under operating expenses is provisions for loan losses. When a bank has a bad debt or anticipates that a loan might become a bad debt, it can write up the loss as a current expense 46 of 93 in its income statement under “provision for loan losses”. Provisions for loan losses have been a major element in fluctuating bank profits in recent years. The 1980s brought the third-world debt crisis; a sharp decline in energy prices in 1986, which caused substantial losses on loans to energy producers; and a collapse in the real estate market. As a result, provisions for loan losses were particularly high in the late 19808, reaching a peak of 13% of operating expenses in 1987. They rose sharply during the 2007-2009 financial crisis, when they reached a new peak of 32.7% of operating expenses. In 2015, provisions for loan losses were down to 7.4% of operating expenses. Operating expenses = interest expense (bank paying expense to its debtors) + non-Interest expenses (like wages) Net operating income = operating income - operating expenses. Net operating income is closely watched by bank managers, bank shareholders, and bank regulators because it indicates how well the bank is doing on an ongoing basis. Net income (i.e. profits after taxes) = net operating income - taxes, extraordinary items, loan losses provision Net income does not adjust for the bank's size, thus making it hard to compare the performances of two different banks. For this reason we use ROA and ROE. Net interest margin (NIM) = (interest income - interest expenses) / assets. NIM measures how well the bank generates income from its primary (core) functions: issuing liabilities and investing in interest-earning assets. NIM is the spread between what the bank earns in interest income and what it has to pay. If the interest cost of its liabilities rises relative to the interest earned on its assets, the net interest margin will fall, and bank profitability will suffer. Chapter summary: Off-Balance Sheet Activities: some of the (risky) activities that banks engage in that don't appear on the balance sheet Bank capital benefits the owners of a bank in that it makes their investment safer by reducing the likelihood of bankruptcy. But bank capital is costly because the higher it is, the lower will be the return on equity for a given return on assets. In determining the amount of bank capital, managers must decide how much of the increased safety that comes with higher capital (the benefit) they are willing to trade off against the lower return on equity that comes with higher capital (the cost). Chapter 10. Conduct of monetary policy Central banking: The Fed injects reserve into the banking system in two ways: * open market operations: CB purchases or sells securities in the open market * Discount loans: make loans to banks. Monetary policy’s function is to insure stable currency and stable level of inflation. In US monetary policy is uses to stimulate economy. In EU just for stable economy and inflation rate at 2%. FED in USA: similar targeting but also to stimulate economy. What do central banks like the U.S. FED do? Central banks are government authorities in charge of monetary policy, determining how much currency is in circulation at any given moment in time. You”ve studied some central banking topics already in macro: keywords that should ring a bell are: supply of money, interest rates, inflation targeting. But central banks also have effect on bank credit. 47 of 93 Before 2008 the Federal Reserve did not pay interest on reserves, but since the autumn of 2008 the Fed has paid interest on reserves at a level that is set at a fixed amount below the federal funds rate target and therefore changes when the target changes. To target inflation, the FED steers the interest rate on federal funds towards a target value which varies over time, depending on other parameters of the economy. The FED can’t force market participants in the fed funds market to quote a specific interest rate (free market economy), but it can create the right market conditions that such rate is attained as an equilibrium result (channel interest rate to be in a particular range using discount rate). Market Equilibrium in the Fed Funds Market There are three relevant interest rates: * i or is the interest rate that banks earn on reserves deposited at the FED (until recently it was zero) * i is the interest rate that the FED is targeting for the fed funds market, i.e. the rate that the FED “wants” (typically very high). * i a is the discount rate at which the FED lends out unlimited quantities of reserves. Demand Side (Commercial Banks): When the federal funds rate is above the rate paid on excess reserves, io, as the federal funds rate decreases, the opportunity cost of holding excess reserves falls. Holding everything else constant, the quantity of reserves demanded rises. Consequently, the demand curve for reserves, RS, slopes downward when the federal funds rate is above iop. If, however, the federal funds rate begins to fall below the interest rate paid on reserves io, banks would not lend in the overnight market at a lower interest rate. Instead, they would just keep on adding to their holdings of excess reserves indefinitely. The result is that the demand curve for reserves, RS, becomes flat (infinitely elastic) at i, for i e[io,; ig] there is a normal downward sloping demand curve: the cheaper fed funds are, the more banks want them to insure against deposit shocks for ig < ir, banks would borrow as much fed funds as they can and earn money on the difference, so ati, the demand curve must become flat. Supply Side (FED): Money supply is a monopoly of the Fed. The Fed adjusted the interest rate by changing the reserves, i.e. by buying or selling securities. The supply of reserves, RS, can be broken into two components: the amount of reserves that are supplied by the Fed’s open market operations, non-borrowed reserves (NBR), and the amount of reserves borrowed from the Fed, called borrowed reserves (BR) —> unlimited. The primary cost of borrowing from the Fed is the interest rate the Fed charges on these loans, the discount rate (iy). Because borrowing federal funds from other banks is a substitute for borrowing (taking out discount loans) from the Fed, if the federal funds rate igis below the discount rate ig, then banks will not borrow from the Fed. Thus, as long as ig remains below ig, the supply of reserves will just equal the amount of non-borrowed reserves supplied by the Fed, and so the supply curve will be vertical: the amount of reserves is fixed (mono poly of the Fed) at whatever rate. However, if the federal funds rate were to rise even infinitesimally above the discount rate, banks would borrow at ig from the Fed, and then lend out the proceeds in the federal funds market at the higher rate, ig. The result is that the federal funds rate can never rise above the discount rate and the supply curve becomes flat (infinitely elastic) at ig. 50 of 93 Using open market operations the supply curve shifts: purchase assets = inject - reserves into the economy = shift to the right. When Fed Funds rate is above discount rate, discount lending allows for an unlimited supply of reserve at ig —> supply is horizontal. Normally, the interest rate charged in the market corresponds to the intersection of the two curves. Federal Funds Rate, i Discount rate sets a team would nt "| A FED fund rate would move between these two limits bc fr the j î Bani at Righe rate (horizontal lines). than from Fed) Demand is downward sloping until interest from interbank Fed Funds —ys}____ loans (ig) becomes higher than the discount rate, at that target . ar — — point demand for reserves is inelastic —> horizontal. Interest on excess reserves sets a floor; , (banks would not Re lend to other bank: i ii = i i i prede i Vertical line = Bank charges interest rate which is lower hold reserves at ______-_ than i, you can go to Fed and ask for an interest rate Fed Supply curve is vertical because Co, equal to the i , lor Horizontal of the same curve happens with discount lending. When the federal funds rate is above the equilibrium rate (ig), more reserves are supplied than demanded. When the federal fund rate is below equilibrium, more reserves are demanded than supplied. In both situation market forces drive federal fund rate back to equilibrium level. In normal times, open market operations are effective: as long as we're on the downward-sloping part of the demand curve, changes in quantity of reserves directly change the fed funds rate. By choosing the right amount of securities to buy/sell in an open markets operation, the FED can implement its target rate. Monetary policy affecting Federal Funds Rate ron fi ESS Open market operations when equilibrium occurs in the downward sloping portion of demand. ato met - open market purchase of securities increases reserves supplied —> dia ° supply curve moves to the right. Thus lowering the equilibrium Fed Funds san rate ni - An open market sale decreases the non-borrowed reserves supplied, decreasing supply of reserves, shifting the supply curve to the left. This raises the Federal Funds rate. Open market operation when intersection is along horizontal portion of demand curve: — open market operation have no effect on the federal funds rate. Discount lending when the intersection between supply and demand takes place along the vertical section of supply curve. Along the vertical section there is no discount lending (because discount rate is higher than federal funds rate), and borrowed reserves are zero. In this case a decrease in the discount rate lowers the horizontal section of supply, but does not change equilibrium. Discount lending when intersection is along horizontal section of supply: 51 of 93 A reduction in the discount rate affects the demand for reserves, by lowering the equilibrium federal funds rate. Changes in the reserve requirements: An increase in the required reserve ratio increases the quantity of reserves demanded for any given interest rate —> demand curve shift to the right. Thus raising the federal finds rate. A decline in the reserve requirements lower the federal fund rate. Changes in interest on reserves paid by the Fed Depends on whether the supply curve intersect the demand decree along the flat section or downward sloping one. increase in the interest rate shifts upward the flat section of demand curve —> if intersection is along downward sloping protein there is no change. If it is along the horizontal, the federal fund rate increases. Conversely, a fall in the interest rate paid on reserves lowers the federal funds rate. rms ci Open market operations, discount lending, reserve requirements, interest on excess reserves are conventional monetary tools. Open market operations: - Dynamic: intended to change the level of reserves - Defensive: intended to offset movements in other factors that affect reserves. Open market operations are mostly conducted in Treasury securities as their market is very liquid. Fed mainly uses temporary open market operations, like repurchase agreements (repos): the Fed purchases securities with an agreement that the seller will repurchase them in short period of time (< 15 days). —> defensive open market purchase. Other temporary open market operations are matched sale-purchase transactions (or reverse repo) in which the Fed sells securities, and the buyer agrees to sell them back in the near future. Discount lending: Primary facilities: healthy banks borrow small amounts (discount rate is high), usually overnight. —> standing lending facility. If there is an unexpected steady increase in demand for reserves, federal funds rate increases, but reaches the limit of the discount rate, there cannot rise any further. In this way primary credit facility put a ceiling on fed funds rate. Secondary credit is given to back in financial trouble. (Liquidity problems). The interest rate on secondary credit is just 0.5% higher than Fed Funds rate (primary are 1% higher). Seasonal credit is given to small and few banks in vacation and agricultural areas (seasonal pattern of deposits); here the discount rate = fed funds rate. When the federal finds system was created. It was intended to be a lender of last resort. To prevent banks failures and financial panics. Discounting is effective in helping banks during a crisis because finds are directly channelled to the most needing banks. The Fed’s discount window can help prevent and cope with financial panics that are not triggered by bank failures, as was the case in 2007-2009 crisis. 52 of 93 In Europe: monetary policy at the ECB: Normal operations that in normal times give the interest rate charged by the ECB: The ECB uses similar monetary instruments =" a ne like the FED to implement its policy: + the Euro Over Night Index Average (EONIA) s the average interest rate on all unsecured overnight transactions on the interbank market. 1. open market operations: main refinancing operations (MRO), +. Note that deposit facilities and EONIA are below zero now! like repos, via a bid system from its credit institutions (competitive bids before 2008, uncompetitive now) so that very bank that requires liquidity is provided with liquidity, with competitive bids there was the risk that some banks did not have enough liquidity 2. Lending to banks and other liquidity provision * LTROs (long-term refinancing operations) * asset purchases (long-term government bonds) 8. reserve requirements Further Monetary Policy Instruments: * Marginal Lending Facility (MLF): overnight loans, interest rate as :4 a ceiling for the overnight (interbank) market interest rate + (_ vio “emergency credits” —> swing management: interest rates on overnight loans: if banks can’t get loans anywhere, they go to De the CB and ask for overnight loans that are charged at the rate of marginal lending facilities = discount rate. If discount rate t changes it means CB changed the policy. Deposit Facility (DF): (give the floor) overnight deposits, interest rate as a floor for the overnight (interbank) market interest rate + “emergency deposits” too much liquidity, they can deposit to ECB. Average interest rate charged on the interbank banks: what banks on average charge each others. Lending facility = upper bound Deposit facility= lower bound. In the course of the last two decades interest rate decreased significantly. And around 2015 they were negative: ECB charges negative interest rate for deposits banks, and commercial banks are starting charging negative interest rates on deposit as well. (Happy if you are not charged to hold money in the bank). From a monetary perspective negative rates are good because now we can recover from very bad crisis (no more zero lower bound). However, they are not good as they stimulate consumption instead of saving. Eurozone: ECB balance sheet (asset size): asset purchase has increased dramatically from 2016. Chapter 20. Mutual funds (financial institution). Definition: A mutual fund is a financial institution that pools investor resources and invests them in (diversified) portfolios of assets. * mutual funds use funds from investors to purchase assets on financial markets * the pooling of resources reduces the transaction cost and brings better diversification to small investors 55 of 93 * the majority of mutual funds continuously sells new shares to investors and allows redemption of outstanding shares at fair market price History of mutual funds: compared to banks, mutual funds are a relatively recent invention in financial markets: * the first “modern” mutual fund in the U.S. was started in 1924: the Massachusetts Investors Trust (initiated in Boston). The stock market crisis of 1929 set mutual fund growth back for several decades because small investors distrusted stock investments. j The investment company act in 1940 reinvigorated the industry by ope requiring much more disclosure of fees on mutual funds and of a investment policies. vear Regulation Q on money market side increased their po pularity dramatically (around the 80s), and their competitive advantages (relative to banks) helped money market mutual funds gain much popularity in the 80’s 4 of mutual funds 8 Why did mutual fund industry grow so much? until the 70’s, the number of mutual funds was not very high. money market mutual funds became very popular in the 1970’s and 1980’s due to Regulation Q which put interest rate ceilings on bank accounts (around 5%): with bank deposit account bank was not allowed to give you more. At the time markets were willing to give more than they could. So they invented mutual funds (Similar to saving accounts) but able to give higher interest rates and characterized by the absence of regulations, differently from deposits and savings. * in the 1950s and 1960s, these ceilings were far above market interest rates; so they did not matter. * but in the 1970s, market interest rates at times exceeded interest rate ceilings on bank deposit accounts « money market mutual funds then offered substantially higher returns than bank deposits the equity boom in the 1990’s further boosted demand for long-term mutual fund investments: allowed people and households with lower level of wealth to invest (not need to invest in house but in real estates mutual funds and now you have shares of real estates). « mutual funds are the easiest possibility to invest in a diversified equity portfolio Benefits: 1. Liquidity intermediation: investors can turn shares into cash quickly and at low cost (open end mutual fund), at any time and in any amount. Some mutual funds are designed especially to meet short-term transaction requirements and have no fees associated with early redemption = MMMF (long term investment may have some early redemption fees). This characteristic is important for opportunity cost: if there is an interesting investment you can redeem your shares, get cash and invest in what else you wanted. 2. Denomination intermediation: small investors get access to securities they would be unable to purchase alone (little money needed). (Recall that to access the money market large denominations are needed). 3. Diversification: by holding a portfolio of diversified securities, investors can lower their risk. Moreover, mutual funds provide a low cost way to diversify into foreign stocks. 4. Cost advantages: institutional investors negotiate much lower transaction fees than are available to individual investors. Lower transaction costs but be careful with the fees. 5. Managerial expertise: we know that it is impossible to outperform the market. Nonetheless, many investors prefer to rely on professional money managers to select their stocks. (manager that 56 of 93 keeps changing you portfolio but charges you for that and there is no Stock (at current market value) —$20,000,000 good evidence that managers really outperform the market). Bonds (at current market value) — $10,000,000 Cash $500,000 There are currently about 7,500 separate mutual funds for investors to Total value of assets ——— $30,500,000 choose from. This means there are more separate mutual funds than there ee (ee) SI are stocks trading on the New York and NASDAQ stock exchanges na combined Net asset value is $30,200,000 / 10,000,000 = $3,02. In a little over 40 years the amount invested in mutual funds has increased from $47 billion to over $15 trillion. To put this figure in perspective, this is about the same as the amount deposited in all commercial banks in the United States. Mutual funds accounted for $7.1 trillion, ot 30%, of the U.S. retirement market at the beginning of 2016. This represents 40% of all mutual fund assets. Diversification benefits: The ability of mutual funds to provide better diversification is particularly important for investors: If you want to invest $1,000 and want to diversify into 50 different shares, you will bear enormous transaction costs: * say your stock broker charges $5.99 flat for any trade. You’d pay $299.50 = 29.9% of your investment in fees! (30% of the investment). * but if you join forces with 100 other investors and each of you invests $1,000, the transaction cost of acquiring a diversified basket of 50 shares with a total value of $100,000 will still be just $299.501 * this is exactly the idea behind mutual funds: use the large number of investors to reduce transaction cost and create well diversified asset portfolios (without having to be particularly wealthy to do that). Mutual funds structure: Types of mutual funds, by redemption: * open-end mutual funds * closed-end mutual funds Types of mutual funds, by investment : * Long-term funds: equity funds =only invest in equity; bond funds; hybrid funds (investing in both equity and bonds); index funds; * Short therm funds: money market mutual funds Closed-end (make up 2-5% of mutual funds) * a closed-end fund is an investment company whose shares are listed on a stock exchange or OTC market * A fixed number of unredeemable shares of the fund are placed in an IPO * after the IPO, the fund cannot raise further funds from investors (traded on second market) * similarly, investors can't redeem their shares (but can sellthem to others at current market price, just like with any other stock). * used by mutual funds that invest in less-liquid securities (small firms, municipal bonds) Open-End (98% of mutual funds today: largely replaced closed-end mutual funds) * investors can acquire or redeem shares directly (More easy, closed funds cannot do it at all) at any time (the fund simply increases the number of outstanding shares). This makes growth of the fund much easier, and keeps the investment more liquid for shareholders. * but the fund needs to keep some liquidity to be able to meet redemption requests at all times. * The fund agrees to pay back shares form investors at any time. —> very liquid investment. 57 of 93 one-time commission at the time of the purchase of the share, which was immediately subtracted from the reception value of the shares. * Deferred load funds (“class B shares”) charge you a one-time commission when you redeem your share. Deferred loans discourage early withdrawals of deposits. * No load funds (“class C shares”) charge you_no commission for purchasing / selling your share (but still charge other fees). These can be purchased directly by the investor and no intermediary is required. In general, the main purpose of load funds is to provide a com pensation for brokers. All funds charge an annual management fee to meet operating costs. They charge annually an extra fee to finance their marketing expenses. The fees are taken out of the portfolio income before it is passed on to the investor. Since the investor is not directly charged the fees, many don't realize that they have even been subtracted. Most widely used fees are: * A contingent deferred sales charge imposed at the time of redemption is an alternative way to compensate financial professionals for their services. This fee typically applies for the first few years of ownership and then disappears. * A redemption fee is a back-end charge for redeeming shares. It is expressed as a dollar amount or a percentage of the redemption price. * An exchange fee may be charged when transferring money from one fund to another within the same fund family. * An account maintenance fee is charged by some funds to maintain low balance accounts. * 12b-1 fees = annual management and marketing fees. 12b-1 fees, if any, are deducted from the fund’s assets to pay marketing and advertising expenses or, more commonly, to compensate sales professionals. These are the annual management and marketing fees. They and have a SEC-imposed cap: cannot exceed 1% of the fund’s average net assets per year. Fee schedules used to be very opaque —> calls for regulation. No research supports the argument that investors get better returns by investing in funds that charge higher fees. On the contrary, after fee deduction, perform worse than low-fee funds. Lately, mutual funds fees have been substantially lowered. One factor undoubtedly contributing to this reduction is the requirement by the SEC that mutual funds clearly disclose all fees and costs that investors will incur. Regulation of Mutual Funds the SEC regulates mutual funds to protect investors. Regulation of mutual funds includes issues such as: information disclosure (prospectus), independence of fund directors, acceptable operating standards. As part of the government regulation, all funds must provide two types of documents free of charge: a prospectus and a shareholder report. A mutual fund’s prospectus describes the fund’s goals, fees and expenses, and investment strategies and risks; it also gives information on how to buy and sell shares. The SEC requires a fund to provide a full prospectus either before an investment or together with the confirmation statement of an initial investment. Prospectus must show a sample account of $10,000 invested for 1, 3, 5, and 10 years, with all charged fees shown for each of the cases. The SEC also imposed caps to some fees (12b-1 fee). Annual and semiannual shareholder reports discuss the fund’s recent performance and include other important information, such as the fund’s financial statements. By examining these reports, an investor can learn if a fund has been effective in meeting the goals and investment strategies described in the fund’s prospectus. Mutual funds are the only companies in America that are required by law to have independent directors. 60 of 93 The SEC also addressed how funds handle conflicts of interest. There have been cases of substantial conflicts of interest due to the governance structure of mutual funds. Conflicts of interest arise when there is asymmetric information and the principal’s and agent’s interests are not closely aligned. Investors in a mutual fund are the shareholders. They elect directors, Who are supposed to look out for their interest. The directors in turn select investment advisers, who actually run the mutual fund. Shareholders depend on directors to monitor investment advisers. Unfortunately, recent evidence demonstrates that directors’ efforts have not been sufficient to prevent abuses. The incentive structure for compensating investment advisers does not ensure that they will be motivated to maximize shareholder wealth. In the absence of monitoring, investment advisers will attempt to increase their own fees and income, even at the expense of shareholder. Most of the abuses centered on two activities: late trading and market timing, both of which take advantage of the structure of open-end mutual funds that provide daily liquidity to shareholders by marking all trades to the NAV as of the close of business at 4p.m. * Late trading: Late trading refers to practice of allowing trades that are received after 4pm to trade at the 4pm price of that day when they should trade at the next day’s price. Suppose that on Wednesday at 4:00 p.m. the NAV for a technology fund is $20. Now suppose that news is received by traders at 6:00 p.m. that HP, Intel, and Microsoft have reported their income surged 50% over the last quarter. Traders, knowing the industry impact this will have, may want to buy orders for the fund at the $20 price. They are sure the NAV on Thursday will be substantially higher and they can earn a quick profit. A late trader can trade at 4:00 p.m. price and buy/ sell the funds the next day at a profit. —> if relevant news became public after 4pm, a trader could make a gain. (Late trades are illegal but remained undetected because there are some exceptions where mutual funds can make late trades). Under the SEC regulations, late trading is illegal. Why could they trade after 4pm? If a broker received a buy order from a client at 2:00, the order might not get consolidated with other orders and transmitted to the fund by 4:00. Since the investor placed the order before the market closed, the investor could not benefit from the late trade. Late trades were simply an opportunity to catch up with order processing (4pm price because no inside training nor arbitrage: problem was because of time constraints). It was when large investors took advantage of their special arrangements at the expense of other shareholders that the legal line was crossed. Market timing: though technically legal, is considered unethical and is expressly forbidden by virtually all mutual funds’ policy standards. mutual funds calculate NAV using latest released prices; but due to time zone differences, these may be already many hours old (and fail to contain relevant information). Market timing involves taking advantage of time zone differences that allow arbitrage opportunities, especially in foreign stocks. Mutual funds will set their 4:00 closing NAV using the most recent available foreign prices. However, these prices may be very stale The government has responded to these issues: by hardening of the 4pm valuation rule, better enforcement of redemption fees that discourage rapid in-and-out trading (fee waivers must now go through the board of directors) Exchange traded funds (ETF) Avoid fees and hidden costs that come with some mutual funds. It tries to get the best from open and closed mutual finds. Open-end mutual funds are flexible in size: they grow or shrink their portfolio according to investor in- and outflows. This flexibility is costly: portfolio rebalancing incurs trading fees, ultimately passed on to investors. Closed-end fund shares instead trade on secondary markets, so no resources are wasted on liquidation/rebalancing of asset holdings as investors get in / out. But closed-end funds lock the money in: size fixed, shares typically have low liquidity (difficult to buy/sell them). 61 of 93 Investor wishlist: liquidity of investment, low fees, flexible fund size. —> ETFSs were born! Advantages. 0 Liquidity: ETFs are typically more liquid than comparable n a mutual fund shares ; Î I I Like shares of stock, ETF shares are quoted and traded continuously in secondary markets. This is also true for closed-end mutual fund shares, which often suffer from poor liquidity. What's different with ETF's? Several reasons: ETFs closely track a benchmark (e.g. a stock index) whose composition and valuation are known in real time (easy to check) —> Typically little information asymmetries or valuation uncertainty when it comes to buy shares. Creation & redem ption mechanism allows designated third parties to easily exchange ETF shares for index assets, and vice versa. This possibility, combined with arbitrage, eliminates any sizable discounts / premia over net asset value, in sharp contrast to closed-end fund shares. (Closed-end mutual funds: either sold at discount or at a premier relative to NAV) Willing to pay more for this mutual fund because of higher liquidity. * Value of the ETF is typically equal to its price (close to fundamentals). Low Fees Unlike actively managed mutual funds, ETFs are passively managed: tracking a benchmark is a no- brainer = no manager that actively updates the portfolio. Despite very low fees the performance of ETF is quite similar to the performance of mutual funds, and subtracting fees ETF is much betterl Not surprising! Markets are quite efficient, active management has a hard time to beat their benchmark. In addition, the creation & redemption mechanism keeps transaction cost for ETF rebalancing low, which further contributes to low ETF fee structure History The history of ETFs is short but successful: first ETF was SPDR, launched by State Street in January 1993 it tracks the S&P 500 index and remains the largest ETF today. For the past decade money has been pouring into ETFs: S&P500 is not very diversified portfolio (betting oil US economy). This is better because more diversified, pretty cheap but remunerative. cash cash se» tavestor Authorized Copia Creation and redemption mechanisms ARNO) | regnare = | Parente scri Marte Every ETF designates several Authorized Participants. 7 7 Authorized participants are stock dealers who keep inventory of the sono! are assets in the relevant index on their own account. They are authorized Siani de to buy and sell stocks that are already traded at relative index of ETFs. Moreover they can create ETF shares or subtract them depending on cresca demand. They have an exclusive right to directly interact with the ETE. ini They also often hold at their own risk some inventory of the shares of the ETF, creating further market liquidity for the ETF. They can deliver a bundle of shares of the relevant proportions (as in the index) to the ETF Asset Manager, and receive ETF shares in turn (or vice versa). They pay for the creation of securities the capital markets. Then they can create ETF shares by selling basket of these securities representing ETF shares to the ETF manager and in turn getting ETF shares. Then ETF shares are sold to investors who are willing to pay for them. 62 of 93 * Performance fees: performance fees are unique to hedge funds. It is an extra fee on positive returns (as incentive to the fund manager): on average 20 %, but even 50 %. * Hurdle rate: some hedge funds do not assess a performance fee unless a minimum annualized performance benchmark (hurdle rate) is attained. * To limit excessive risk-taking by managers, some hedge funds only charge a performance fee when the new net asset value exceeds the maximum net asset value that the fund has attained ever before. (Extra fee if returns are at least as high as they used to be in the past). Chapter 22. Investment banks Investment banks are intermediaries that help corporations raise funds. Despite the name, an investment bank is not a bank in the ordinary sense: it does not take in deposits and lend them out, nor does it engage in asset transformation. One feature of investment banks that distinguishes them from stockbrokers and dealers is that they usually earn their income from fees charged to clients rather than from commissions on stock trades. The Glass-Steagall Act separated commercial banks from investment banks to avoid conflicts of interest. Investment banks are less about investment, more about trust. Good banks are the ones that removed asymmetric information Users of Funds (Corporations is- Underwriting with Initial suppliers of from the market. suing debt/equity | Funds | Investment Bank | Funds | Funds (Investors) Investment banks primarily serve as brokers between the instruments) suppliers and users of funds (indirect market function): . Investment Banks offer a broad range of services. In their underwriting business, they intermediate funds between the issuers of securities (debt, equity) and investors. They also play an important role as intermediaries in many mergers and acquisitions, in private equity and private equity buyouts (act like brokers). They offer securities brokerage services to their clients. Underwriting securities is the most basically function and core activity of investment bank. John Morgan = key figure in IB. The historical roots of investment banking Many bankers in the 1890’s sold U.S. securities in Europe (so did J.P. Morgan). Until 1933, many large U.S. money center banks were both normal banks and active sellers/underwriters of securities. But in the Great Depression, more than 40% of banks failed, allegediy because many had given loans for the purchase of securities. The Glass-Steagall Act (1933) made it illegal for commercial banks to buy or sell securities on behalf of its customers (clear separation between commercial banks and IB). Basic idea: separate “classic” banking from the more risky business, and protect savers from potential conflicts of interest of the bank. Commercial banks held deposits from households, and used them for asset transformation. However they invested in very risky portfolios —> with the 1929 crisis they lost a lot of money: the financial sector collapsed and many households were left with no money. Commercial banks are depository institutions # investment banks. IB like Lehman brothers were not supposed to hold simple deposits: they were using Repos to finance risky investment of their own. Some mortgage securities (very risky and high default risk). Repurchasing agreements: issue a security on MM and say you will buy it at higher price in the next period. Lehman brothers were doing a lot of Repos: in an indirect way, and were hiding deposits from people by renewing repos and using them for risky investments. 65 of 93 When the market found out there was a run on repos (run on banks: run and withdraw money from banks; banks are not enough liquid). Lehman lost all deposits because no more repos by banks. —> critical feature of financial iris. Short term deposit used for long term deposits, when they could not renew repose they defaulted. Lehman brothers was not rescued, other were rescued because the entire system could have collapsed if they hadn't. The separation between investment banks and commercial banks is blurred nowadays: In 1999 the Glass-Steagall requirement to separate investment banks from commercial banks was repealed by the Gramm-Leach-Bailey Act (separation did not exist in most countries: regulators banks said that they had a competitive disadvantage = economy of scale connecting commercial and investment banks). Since then, the line between commercial banks and investment banks has become very blurry: before the crisis, the investment banking industry realized high profits... but in 2008, the remaining five U.S. investment banks ceased to exist: Lehman Brothers went bankrupt, Bears Sterns was acquired by J.P. Morgan, Merill Lynch was acquired by Bank of America, Goldman Sachs applied for commercial bank charter, just like Morgan Stanley. Underwriting stocks and bonds: When selling securities, there are several reasons for using the services of an underwriter: investment banks have massive expertise in emitting new securities, whereas many firms lack the necessary knowledge because they rarely access primary markets = lower transaction cost + expertise. Investment banks have reputational capital: because investment banks depend on their customers returning for future business, they can't afford any improper conduct of due diligence or striking deals that are unfair for investors. And since the market is more inclined to buy securities that were emitted with the help of underwriters than securities that were emitted by a firm directly, IB have incentive to do it fairly. If a firm goes to the market and does an IPO, people don't know the firm so it is difficult to evaluate the fairness of the price. The firm does not have an incentive to tell the truth. IB have an incentive because they are doing this all the time: they have reputation capital: price they are charging: IB goes to the firm, analyzes it, tries to figure out fair price and offers it to primer market to selected investors. Then they will sell to firms on the market and make money on the difference. If a firm has not very high value, but IB thinks so, it will list it by setting a very high price. When on the secondary market investors realize the price # value, supply > demand and the price will decrease. The IB loses reputational capital. There exists a dynamic incentive for IB to do the right job because they will get in touch with he same investors in the market over and over again —> they need to make sure the evaluation is solid. 1. Giving advice: Investment banks give advice to firms that are planning a new emission: should the company raise capital by selling stocks or by selling bonds? When is a good timing for the offering? At which price should the security be offered? Pricing securities might be more or less difficult: * Seasoned issues if the company has already issued shares earlier and those are already trading in the secondary market, their price can be used to determine the offering price. In this case pricing securities is not too hard. * Initial Public Offering if the company is issuing stock for the first time, the investment bank must determine the most appropriate price through its expertise in valuation (a hard task) This is the hardest part: If the evaluation is wrong, the firm could make a huge loss; the same is true if investors in primary market don't share their opinion. 66 of 93 As for the price at which the security should be sold, investment bankers and the issuing firms have somewhat differing incentives: the IB would prefer a lower pice so that it can make a higher profit. On the other hand, the issuing company prefers selling its shares at the highest possible price so to raise the largest capital. When the issuing firm and the investment bank firm come to an agreement on a price, the investment banker can assist with the next stage, filling the required documents. 2. Filing documents: Investment banks assist in filing documents: as we already know, issuers of securities to the general public are required to file a registration statement with the SEC (unless the amount is less than $1.5 million, or the maturity below 270 days); investment bankers will provide their assistance to fill in the documents. The prospectus is a portion of the registration statement that is made available to investors for review. The SEC then reviews the registration statement to check whether the statement contains all required disclosures. Note, the SEC review does not validate any information in the statement itself and is no endorsement! Further tasks of the investment bank: * for bonds, secure a rating from a rating agency * for stocks, arrange for the stock to be listed at an exchange 8. Underwriting Investment banks underwrite new issues of securities: this is often done jointly (in syndicate) with other investment banks to share risk (hard to figure out value of the firm and avoid buying at high price and selling at low price). A syndicate is a group of investment banking firms, each of which buys a portion of the security issued. Each firm in the syndicate is then responsible for reselling its share of the securities. The investment bank buys the entire issue from the issuing firm at a pre-specified price. Then, the investment bank will attempt to sell the shares to the general public at a slightly higher pre-specified price. By underwriting, the investment bank certifies to the quality of the issue to the public (by showing that it is willing to bear the risk of holding all unsold securities on its own balance sheet). Occasionally, this traditional underwriting is also referred to as firm commitment offering —> committing to a certified quality of the stock being issued. The problem for the investment bank: - If the chosen price is too low, there will be more interested buyers than securities —> the issue is oversubscribed - If the chosen price is too high, the bank will not find enough interested buyers —> the issue is undersubscribed —> sales agents have been unable to generate sufficient interest in the security among their customers to sell all of the securities by the issue date. - in an oversubscribed issue, the issuing firm may feel uneasy about having received less than its fair value —> loses reputational capital. - in an undersubscribed issue, the investment bank can lose huge amounts of money (because the stock sells for less than what the investment bank paid). Huge because of the volume of securities involved. The goal for the investment bank is a fully subscribed issue (neither over-, nor undersubscribed): The longer the investment banker holds the securities before reselling them to the public, the greater the risk that a negative price change will cause losses. One way that the investment banking firm speeds the sale is to solicit offers to buy the securities from investors prior to the date the investment 67 of 93 20-year average return on venture capital 1990-2010 is 23.4%, the 10-year period 1990-2000 was even better, with avg. return > 30%. the 1999 average return exceeded 165%. They fell with the stall of technological progress in 2000, and recorded losses from 2008 crisis. Venture Capitalists Reduce Asymmetric Information For investors, high-tech start-up firms are full of uncertainty and asymmetric information. venture capital firms purchase equity of such start-up firms. Before investing, they collect lots of information about the start-up (note, many people in venture capital firms are industry experts) —> this reduces adverse selection. Once they have bought into a firm, they monitor progress and provide their expertise to the young firm. They also often take positions in the board of directors of the firm > this reduces moral hazard and problems of costly state verification. Venture capitalists invest for a long timespan (up to 10 years) Ventura capital firms have industry experts in some areas —> good when they invest on a firm because bring new expertise. Fundraising limited partners make funding commitments, firm will “call” these commitments as investing begins Investing venture capital firm invests the funds in young firms: ® seed investing: firm has no real product yet ® early-stage investing: firm has started production > late-stage investing: firm is already more advanced but needs to grow further for successful IPO Exiting via IPO (note, venture capital firm is subject to insider trading restrictions), or via mergers/acquisitions Chapter 23. Risk management: Managing credit risk and managing interest rate risk are faced by firms. - Credit risk: promised cash flows may not be paid in full - liquidity risk = large liquidity demand can inflict losses - interest rate risk = drop in values of investments market risk arises from market price fluctuations - off-balance-sheet risk arises from contingent assets and liabilities (e.g. expected M&A, warranties, some derivatives) (pro about to merge with someone, but there might be associated risks). - foreign exchange risk can affect value of assets and liabilities —> appreciation and lower currency value risk = appreciation with respect to other currencies. - country risk / sovereign risk = embargoes, defaults, nationalizations - technology risk = risk that technological investments don't produce anticipated cost savings - Operational risk = risk of fraud, technological failures, catastrophes, skimming, phishing, hacking - insolvency risk materializes if sudden losses erode capital Not all risks can (or should) be hedged: there is no way of getting rid of every possible risk, nor is this necessarily desirable. But financial institutions must be careful not to expose themselves to too much risk (else they will be bankrupt soon), hence they to analyze very well: a) Which risks they are exposed to, b) how the different types of risks may interact with each other c) how severe risks that may threaten the existence of the FI can be hedged —> this is the central idea behind risk management Look at standard deviation of prices of a portfolio. Firs moment = expected value » average Second moment = variance = by how much individual realizations deviate from expected value. Larger variances are more risky 70 of 93 Charge: Of Rate On Single Family Residential Mortgages, Booked In Domestic . . . iti tri ft, Al Commercial Banks (CORSERMACS) Third moment = skewness = in which direction distribution is Delnquency Rate O Single Famty Resientia Mortgape, Book In Domestic ces, All Commercial Banks (DRSFRMACBS) skewed —> chance of really high gains = right skewed distribution. If two equal expected value and different variance, we go with the one with the smaller variance. Percent) Some risks cannot be hedged. Completely hedged = hedged also against positive risk = so nothing earned. or 1986 2001 2006 moi 2016 Shadeg areas indicate US recessione. [FRED 2013 researchistiouisted.ora Managing credit risk Charge-off rate is the share of deb that is not paid back by borrower. Credit risk is the risk that promised cash flows from loans and destare becillione securities may not be paid in full. Most easy example is bankruptcy. In 2007-2009, commercial banks and investment banks lost billions of dollars due to credit risk on sub-prime mortgages and mortgage-backed securities. In the recent crisis we have seen that credit risk can have huge impact on macroeconomic conditions, and vice versa Solid line is the charge off. For pretty long time, up to the crisis the rate for mortgage was pretty low, then it increased at 3-4%. Delinquency rate is the share not paid yet (though expected to be paid in the future). How Fl’s protect themselves against credit risk: Asymmetric information is present in loan markets because lenders have less informa- tion about the investment opportunities and activities of borrowers than borrowers do. This situation leads financial institutions to perform two information-producing activities —screening and monitoring. Screening is essential for identifying high quality borrowers and denying credit to unreliable ones. Monitoring of outstanding loans and enforcement of covenants prevents borrowers from engaging in more risky actions (moral hazard!) Screening & monitoring The screening activities of Fl’s are: credit screening (using hard & soft information) credit scoring (using hard information): credit agencies assign ratings depending on past information and financial statement. Credit scores are based on statistical measures derived from answers that predict whether the borrower is likely to have trouble making loan payments. When FI don’t pay back loans, these will assign a low credit. Restrictive covenants which prohibit the borrower from engaging in risky activities. —> monitor borrowers” activities to see whether they are complying with the restrictive covenants and by enforcing covenants if they are not. A loan commitment is a powerful tool used by FI to reduce bank’s costs for screening and information collection. —> bank’s commitment to provide a firm with loans up to a given amount at an interest rate tied to some market interest rate. —> beneficial for both the firm (always funds available) and bank (does not have to start new screening procedure every time + the firm periodically provides the FI with financial reports. Principles of credit risk management: Fl’s work in a way that is designed to maximize their screening efficiency: 71 of 93 * Long-term customer relationships = extrapolate information from financial behavior in the past. Long term customer relationship reduces the costs of information collection. The cost of monitoring long term customers is lower than that of monitoring new ones —> already established procedures to monitor. —> lower interest rate for these lower costs. The last advantage of long term customer relationships is that customers that want to preserve a good relationship with he FI will not undertake risky behavior not envisaged / restricted by restrictive covenants as they want to get credit in the future. Long term customer relationship allows the financial institution to deal with unanticipated moral gazers contingencies. * Specialization in lending —> provide credit to firms in the same industry so to have more specialized knowledge + loans to local firms easier to monitor. * Collateral (secured loans) = it is a property promised to the lender as com pensation if the borrower defaults, lessens the consequences of adverse selection as it reduces the lender’s losses in case of a loan default. It reduces moral hazard because borrowers has more to lose * credit rationing: it can take two forms: no supply of credit to borrower, or restricted supply of credit to borrower = credit lines, i.e. pre-set borrowing limits. first type of credit rationing when the lure for high interest rate linked to high risk does not make up for the potential loss incurred by the FI in the likely possibility of default. Second type of credit rationing: moral hazard: the larger the loan, the greater the incentive to engage in activity which are likely to lead to a default. Credit screening Traditional credit screening combines hard and soft information: During the credit screening process, loan officers collect all available information about a prospective borrower: hard information: * employment history * income * existing obligations of the borrower * value of collateral Loan officers may also use soft information (which has subjective aspects and can't be processed automatically) such as: * appearance of the prospective borrower * information embedded in the local community * non-verifiable information from the business relationship with the prospective borrower Credit scoring Credit scoring models use available hard information to compute a credit score: * credit scoring is very cost-efficient and has become the dominant method for assessing the creditworthiness of small business loans and residential mortgages * first, statisticians find from existing data which parameters appear to influence credit risk * this informs which scores are given for which properties. Example: no credit history: score +0, missed payment in last 5 years: -15, all payments met in last 5 years: +50. * scoring models look at numerous parameters, all of which are hard information, such as: district in which the applicant lives, length of residence, number of major credit cards Example: Factors that influence FICO scores (Fair Isaac Corporation), in order of importance 1. Major derogatory items on the credit report (bankruptcy, foreclosures, slow pay) 2. Time at present job 3. Occupation 72 of 93 Change in interest rate can change behavior of the bank. If a financial institution has more rate-sensitive liabilities than assets, a rise in interest rates will reduce the net interest margin and income, and a decline in interest rates will raise the net interest margin and income. NIM = (interest income - interest expense) / bank's assets What happens to an FI if interest rates change? Changes in income: interest income on variable-interest loans, new loans and some other securities will adjust. —> Income gap analysis. (How much company is exposed to risk when income changes) Changes in net worth: values of assets and liabilities on the balance sheet will re-adjust, depending on their duration —> duration gap analysis Income gap analysis: Income gap analysis is used to measure the sensitivity of bank income to changes in interest rate. Go over the balance sheet, collect all items whose income flow will adjust with the interest rate = rate- sensitive assets. The items left are the rate-insensitive assets. Collect rate-sensitive liabilities; the difference RSA and RSL will be an indicator by how much your income will change: RSA - RSL = GAP —> AI = GAP x Ai For each dollar by which rate-sensitive assets exceed liabilities, the bank earns Al in additional income if interest rates increase by Ai —> AI = GAP x Ai Banks typically have more rate sensitive assets than rate sensitive Assume ter area inpocon ne have eni o iotoving liabilities. positions: Rate-sensitive assets will increase net income when interest increases Rae ci 321 Fate bio 5 but rate-sensitive liabilities will increase expenses as interest increases mate neonato esse co | rate ngensino iablios __S0S Total 100 | Tora! 100 and they are the greater position here, the change in income will be negative —> look at net worth: change in assets side - change in liabilities” GAP = $32 million — $49.5 million = -$17.5 million Thus, the change in net income due to a 1% increase in interest rates is AI = GAP x Ai = -$17.5 million x 0.01 = -$175, 000 —> bank is losing. Limitations of income gap analysis: Basic income gap analysis is still relatively coarse: assets with maturity < 1 year were classified as rate-sensitive, assets with maturity of 1.5 years as rate-insensitive > not clear picture! Refinement: use maturity bucket approach: calculate the GAP for several maturity subintervals, e.g.: this year, for the coming year etc assuming a certain scenario (such as a one-time 1% increase in interest rates). This gives a better picture of the medium-term situation. So far, we have totally ignored another problem: if interest rates rise, the asset values of bonds, loans and securities with long maturities will fall! Bank shareholders do not only care about interest rate income but also about the market value of the bank’s assets. This can affect financial institutions even if they plan to hold those securities until maturity. If securities fall in value the corresponding amount will have to be written off, reducing the bank's net worth. Interest rate risk changes market value as interest changes. Duration gap analysis: I! Duration gap analysis should be done with market values, not with historical-cost book values 75 of 93 Example: Bank G has assets of $140 million and liabilities of $125 million The duration of its assets is 4.3 years, and the duration of its liabilities is 1.2 years. What is the bank's duration gap? By how much does its net worth change approximately if interest rates increase from 5% to 5.5%? Answer: 25 » Duration gap: DU Ryap = 4.8 years — 133 x 1.2 years = 3.23 years » Change in net worth: Ai ANW = A-(-DURg ( gez 0.055 — 0.050 1+0.05 = $140 million x (-3.23) = —$2.153 million “effective” maturity; Duration is just an average. It uses weights: numerator is the sum of discounted cashflows, with time maturities as different weights. Takes into consideration the effect of changes in the interest rate on the market value of the net worth of the financial institution. Duration gap analysis comes up with a number that describes the sensitivity of a bank's net worth to interest rate risk. N PV «Ca DUR=Y 4-3 => Su i tot Dia desse Duration is a measure of 4 n di P, PUR dl rate of capital gain Duration was very useful because we could estimate the impact of interest rate changes on asset values: P= PO. AP =P1-PO. Change in the value of assets = - duration x increase in interest rate over 1 + i. Duration is additive: the duration of a portfolio of securities is the weighted average of the durations of the individual securities. Weights reflect the proportion of the portfolio invested in each. Weighted duration = duration of the asset x amount of the asset / total assets. Use average duration of assets and liabilities to estimate the effects of interest rate changes. For instance, if 40% of the balance sheet assets have a duration of 2 years and 60% have a duration AA , di = x (DURA) x 7 AL di = duration. of five years, their combined duration is 0.6 x 5+ 0.4 x 2 = 3.8 (DURI) -L: (DURI x A years. If interest rate changes twice, we compute twice the change in To estimate the change in net worth DU Riap = DURA -i DUR, Under an interest increase of Ai: This gives us the change in net worth of asset, how much NW changes. relative to asset value: for every dollar The duration gap is defined as: ANW di = -DURyag*X 773 A URsan* Hi Duration tells us something about sensitivity of net worth to interest rate changes. Keeping the duration gap “under control” will keep the bank out of trouble in case interest rate change —> knowing the duration gap DURaaP, we now can directly calculate change in net worth as: Shortcut that allows to estimate how much the Fl’s net worth will increase/fall under a change of interest rates: YAPassets - YAPLiabilities = A NW The usefulness of the duration gap rests on an important simplification: we assumed the Ai is the same for all assets and liabilities (abstracting from term structure). However different assets have different interest rates, this calculation is hard in practice with many interests rates. —> Need for a more sophisticated income gap analysis. L DUR, = + X DUR; aTA l 76 of 93 A positive duration gap, and a rise in the interest rate lead to a higher market value of net worth. To immunize the market value of the bank's net worth from interest rate risk, the bank manager must set Chapter 18. Regulation of financial institutions: Many regulations are motivated of excessive risk taking of FI. Banks are central to the functioning of financial sector. All around Bocconi, there are many small restaurants where you can get some food. In 2012, some of them were not the same as today: some have gone bankrupt, some have moved their business to somewhere else, others have started fresh. Is it a bad for society if some of those restaurants went bankrupt? Should the government take measures to reduce the frequency of bankruptcy of restaurants? Probably not. If a restaurant has excellent service/food/prices, it is likely to thrive near Bocconi and make great business; so the restaurants that closed were not successful, either because they were too expensive or their food or service were not “good enough”. When inefficient restaurants close, it doesn't negatively affect the business of other restaurants (which will have more customers), nor does it have much impact on the rest of society (only on owner and creditors). It would be way worse if the government would do anything to keep those inefficient restaurants running, which would discourage new efficient restaurants from entering the market, and meanvwhile it would not foster improvements of old inefficient restaurants —>the outcome for society would be worse! If restaurant fail it is because they either don't meet demand, or don't create it by failing to create valuable goods for consumers. Or again, because they are not cost effective. Those that survive provide extra value to consumers —> market self regulates # market failure. With market failures intervention is needed: Monopoly, oligopoly, company with large shares of an infrastructure industry (railways), or companies that employ many people, their failure would cause much harm to the society / economy as many people would get unemployed. Or again if the banks failing are many, it might as well be a problem. Now, around Bocconi there are several banks where you can deposit cash or get a loan. In 2012, there were more of them than this year: none has gone bankrupt, but some have closed down their branch offices, and none have started fresh Is it a bad thing for society if some of those banks went bankrupt every year? Should the government take measures to reduce the frequency of bankruptcy of banks? Of course! Banks are different from restaurants: the failure of a bank is socially extremely expensive: thousands of depositors may lose part of their savings, information about borrower credit-worthiness is irrevocably lost. The failed bank can not be easily replaced by others because operating in an environment of adverse selection requires expertise, and such failure can affect other banks that are sound (contagion effect): fire sales of securities can inflict losses on other asset holders, a rumor can be enough to trigger bank runs —> every bank can become illiquid. T7 of 93 Asset A has a return of 5% for sure Asset B has a return of +20% with 80% probability, and a return of -80% with 20% probability If you’re risk-neutral (or risk-averse), which asset would you choose? Comparing expected returns, we note that asset B has an expected return of 0.8 x 20% + 0.2 x (-80%) = O. If you are risk-neutral or risk-averse and had to buy the asset with your own money, you would prefer asset A over asset B. The same would be true for a fully equity-financed bank. Asset A Bank Asset B Bank Assets Liabilities Asset A 100 | Capital 100 y y return on equity expected ROE is 0% (ROE)= 5% Assets Liabilities Asset B 100 | Capital 100 Example of moral hazard created by the insurance: Let's see what happens if the bank is financed with 96% deposits. Assume there is costless deposit insurance, bank pays 4% interest to depositors (who don't care about A vs. B due to insurance) also assume capital must be > 4% by law 4% x 96 = 3.84. 5 - 3.84 = 1.16 —> 5 is what you are making on interest Capital 4 will be in the numerator when computing ROE. Asset B: Investor get only 4% return even if things go bad, thanks to the insurance. Asset A bank never goes bankrupt. Its depositors will never claim deposit insurance. Asset B bank goes bankrupt with 20% probability. The only reason why it can still borrow at 4% is deposit insurance. The safety net is something like a hidden subsidy. If asset B pays the low payoff (creating a loss of 80), bank B shareholders bear 4 and deposit insurance bears 76 in losses, but if asset B pays the high payoff, bank B shareholders get all the gains! So by choosing the more risky asset shareholders have found an ingenious way of sharing losses, and privatizing gains. But since they invest in the inferior asset, this is socially suboptimal! moral hazard is behind those higher returns. Asset A Bank Asset B Bank Assois Liabilitios Assois Liabilitios Asset A 100 | Deposits 96 Asset B 100 | Doposits 96 Capital 4 Capital 4 net income = 1.16, expected ROE = 292? ROE= 29% Let's see what happens if the bank is financed with 96% deposits: » what's the expected ROE of the Asset B bank? » if asset has high outcome, » interest income 20% x 100 = 20 » expenses 4% x 96 = 3.84 > net income: 20 — 3.84 = 16.16 ® ROE conditional on high asset outcome: 19,18 404% » if asset has low outcome, interest income is —80 and bank is insolvent (ROE=-100%). Depositors claim insurance. » expected ROE of bank B = 0.8 x 404% + 0.2 x (-100%) = 303.2% Asset B Banks has higher ROE - what the heck is going on here? > does investing in an inferior asset via a bank magically give higher returns?! » Absolutely not. In this example, shareholders of the bank are reaping benefits from deposit insurance. The deposit insurance implicitly makes losses publicly shared, and gains shared privately. Discouraging risk shifting: How could a regulator discourage such risk shifting? There are several approaches, and each corresponds to one dimension of existing regulation. Capital Requirements: 80 of 93 “Let the losses be losses of the bank” (put more equity so that the bank has more to lose if it fails). First type of capital requirement: Leverage ratio = capital /total assets. Well capitalized if leverage ratio >5%, if it is below 3% it triggers increased regulatory restrictions on the bank. Second type of capital requirement: risk-based. In our example bank B shareholders only lost 4 and deposit insurance covered 76 out of the total loss of 80. If shareholders would have to shoulder more of the losses (and not just the gains) of their firm, their incentive to risk-shift (i.e. choose asset B) would diminish quickly. To increase the losses that the bank B shareholders are exposed to we should force banks to have a minimum amount of capital! In our simple example, we can verify that a minimum capital requirement of 56.8% suffices to deter risk shifting. Why? ExpReturn(A) > ExpReturn(B) =>5- 0.04 x (100 — E) > (20 — 0.04 x (100 — E)) x 0.8 - E x 0.2 100 - amount of equity to find amount of debt. —> if the risk taking possibilities are less severe, even a much smaller amount will suffice. Bank runs: September 2007 amount withdrawn was 1 billion in 8 hours —> banks might lack liquidity to pay everyone. Benefits, Issues, Limitations the benefits of higher capital are clear: less moral hazard (risk-shifting), more buffer against default; but of course for bank shareholders this is not good news: remember ROE = net income / capital = net income /assets x assets /capital ==> ROA x EM. For a given ROA, the more capital the lower the ROE. So how much capital requirement (in % of assets) is “enough”? Threshold so that banks engage in stable activity without using too much ROE of shareholders: Leverage ratio = how much of assets must be financed by equity. > 5%: well-capitalized; > 4%: adequately capitalized; < 4%: undercapitalized; < 3%: significantly undercapitalized; < 2%: critically under-capitalized (will be shut down by FDIC). If bank capital fell short of any of these thresholds, there would be restrictions to what the bank could do. The leverage ratio based approach had its shortcomings: * It was ignorant as to which asset of which risk type was being held (did not take into consideration riskiness of assets). * a risky commercial loan would require same amount of capital as safe treasury bonds * any off-balance-sheet activities would not incur any capital requirement at all In other words, capital requirements had not much to do with the actual risk taken by the bank. A committee of central bankers of many nations spent a long time in Basel at the BIS (Bank of International Settlements) searching for solutions to these issues and the resulting international agreements were called: Basel | (1988), 26 pages, Basel Il (1999), > 500 pages, Basel III (2017) no flyweight either Basel I: Basel | tried to deal with the non-differentiation of assets of the leverage ratio: risk weighted average. * capital requirement of 8% of risk-weighted assets. This agreement still applies to all but the largest banks in the U.S. Risk-weighted assets are determined according to a simple weight catalog: * reserves and government debt of some OECD countries: 0% risk weight «claims on banks and corporates rated AA- or better in OECD countries: 20% risk weight e municipal bonds, residential mortgages: 50% risk weight * loans to consumers and corporations: 100% risk weight * Off balance sheet activities were treated similarly: they were assigned a credit-equivalent percentage that converted them to on balance sheet items. 81 of 93 Basel | had severe limitations: risk weights for each asset class were too coarse and ad-hoc. Banks engaged heavily in regulatory arbitrage: looked for the riskiest asset within the same risk weight class. In the end, Basel | allowed banks to engage in more risky activities > Basel Il tried to fix this. Basel Il: Capital requirements aimed to be more sensitive to “true” riskiness. More differentiated risk weighted, but too small weights making assets almost non existing. Off-balance sheet items could now impact capital requirements: credit risk, operational risk and market risk estimations were based on data and formal techniques. Capital requirements for credit, for example, were determined with either of the following three methods: 1. standardized approach: refined buckets to determine risk-weighted capital: capital charge depends on borrower rating and other risk indicators 2. internal ratings based approach: regulators supply the model, assumptions and calibration for “loss-given-default” models that determine capital charge 8. advanced internal ratings based approach: loss-given-default model supplied by regulators, banks can adjust calibration Basel Il has three pillars to decrease problems of asymmetric information: 1. regulatory minimum capital requirements: standardized or internal ratings based approach to credit risk, market risk (including interest rate risk), operational risk 2. regulatory supervisory review so to complement and enforce minimum capital requirements calculated under Pillar 1 8. requirements on rules for disclosure of capital structure, risk exposures, and capital adequacy so as to increase transparency and enhance market/investor discipline Basel Il reduced regulatory arbitrage but was no clear success. It became effective in the U.S. on April 1st, 2008 (Europe adopted it already in 2006). It appears to have reduced the extent to which banks use regulatory arbitrage. But then capital requirements became strongly pro-cyclical: low in quiet boom times, high in turbulent crises because they get risky and their weights are re-adjusted, banks have to increase capital requirements which is not good for a bank already in trouble. —> need for more capital on the side, but probably already facing liquidity problems. High ratings in quiet boom times, so low capital requirements. And low rates in bad times: banks, firms go bankrupt: more capital by banks, and recession that demands for higher equity. When firms struggle, their ratings go down, forcing lending banks to hold more equity. Since banks were already losing capital in the crisis due to write-offs, the tightening of capital requirements due to Basel Il became a severe problem. Basel III (2010) adds new regulation on Capital: - Emphasis on quality of capital (on numerator rather than denominator of the leverage ratio) - Less pro-cyclical capital standards: counter-cyclical buffers activated on discretion by central bank: higher capital requirements in good times, lower in bad times. - additional non-risk-based leverage ratio constraint, including off-balance sheet exposures Liquidity: - Liquidity Coverage Ratio: ensured banks had sufficient liquidity to survive 30 days of funding stress - Net Stable Funding Ratio: incentive to use stable sources of funding And others: - risk coverage: revisions to standardized approach, limits to internal approach 82 of 93 function). It usually depends on labor and capital. The economy moves around full employment. Economic policies are implemented to reach/ get closer to full employment. Not full employment is a problem of financial sector and translates into a problem of the economy. Most financial crises in advanced economies follow a relatively similar pattern of three stages: 1. the seed of most crises are sown in good times: a credit boom, often due to financial liberalization or technological innovation, lets credit in the economy grow rapidly; asset price bubbles, or uncertainty caused by failures of major financial institutions. Initiation: Asset prices decline / asset price bubbles burst. Stock prices goes from being at the roof (prices above fundamental = bubble), to the floor. since these assets are on banks’ BS, balance sheets of Fl’s deteriorate —> this affect their financial health, Fl’s start to deleverage (lend less: some businesses don’ get liquidity: stock prices goes down. Prices down and interest rate up). 2. Stage 2: Banking Crisis: Economic activity declines, Fl's suffer losses, liquidity evaporates, “fire- sale” prices (banks just try to get liquidity somehow selling loans at very low prices), banks fail 3. Stage 3: (not always there) Debt Deflation: (Japan) substantial and unanticipated decline in price levels. As prices fall and consumption stalls, firms don't generate enough revenues to service their debt. Falling wages further depress consumption and accelerate the deflationary spiral. Firms go bankrupt, reduce wages, which lead to a further fall in consumption, prices falls,... The seeds of financial crisis: Credit booms: Crisis are often rooted in financial innovation (new instruments introduced) or financial liberalization (elimination of restrictions on financial markets and institutions = more competition or liberalized cash inflows and outflows from the country). In the long run financial liberalization yields positive results, but in the short run it may lead to credit booms. With the liberalization of the banking sector, banks can now lend more. Maybe financial liberalization is due to new monetary union: same currency and same interest rate among more countries: some countries receive a lower interest rate, others a higher one (the equilibrium interest rate is an average of the many interest rates existing before the new monetary union): now countries share the risk. The booms preceding severe crises are often booms in credit: a credit boom is a period in which the aggregate amount of credit in the economy shows a substantial and positive deviation from its long- run trend. The newly available additional credit often spurs demand for certain assets in the economy, which appreciate substantially in price (See below) —> Lenders increase their lines of business, also to areas in which they do not have expertise, they engage in risky transactions which not always yield positive results. But in any case they support this approach as they know that government safety nets and deposit insurance will cover the losses. —> decrease in market discipline and increase in moral hazard. As losses and loans begin to mount, banks slow down lending because their net worth has steadily decreased (also capital decreased, now these FI are riskier). As loans become scarce, borrower- spenders are no longer able to fund their productive investment opportunities and they decrease their spending, causing economic activity to contract. The Good: often credit booms are simple expansions of credit with no follow-up problems, and are good for economic development. (79/135 countries in a sample) The Bad: Credit growth and probability of subsequent crisis are related. Not all credit booms come to a good end: there appears to be a link between the speed of credit growth and the probability of subsequent crisis. (31 out of the 135 credit boom events are followed by banking distress) 85 of 93 The Ugly: 23/135 by a systemic banking crisis! —> entire financial system is in danger and people might lose everything. Some (largely unconfirmed) hypotheses about credit booms: * deregulation of the banking sector seems to play a major role: in strictly regulated banking industries lending is more cautious (but often too little and too expensive) * credit booms grow especially large when they can run on “cheap fuel”: * banks can fund their lending cheaply because they can borrow abroad (and couldn't do so before) (joined monetary union). * or, banks fund their lending cheaply because the country has joined a monetary union! * or, the central bank keeps interest rates low for a prolonged time * last but not least, an asset price bubble on the collateral asset tends to boost lending a lot! Loans given out secured by a collateral that are usually potentially viable assets. Asset price boom and bust Prices of assets can be driven by investor psychology well above their fundamental economic values = their values based on realistic expectations of the assets’ future income streams; when this happens we talk of asset-price bubble. Asset-price bubbles are often also driven by credit booms, in which the large increase in credit is used to fund purchases of assets, thereby driving up their price. Bubbles increase economic activity, and net worth but are unsustainable. The problems start when credit or banking stability depend on the value of a bubbly asset. Increasing asset prices can always further increase credit boom, debts given out are collateralized, and the value of the collateral increases with asset prices gobs —> more valuable collateral = greater lending opportunities At some point in the lending boom, some loans start going bad. As a result, loan values fall and bank capital erodes. This prompts banks to reduce their liabilities by cutting back on lending: they deleverage (don’t renew them because of liquidity problem). As bank capital melts away, banks become more risky and some of their creditors pull out their funds; this again prompts banks to cut back on lending... As a result, the economy experiences a credit freeze When the bubble bursts and asset prices realign with fundamental economic values, stock and real estate prices tumble, companies see their net worth decline, and the value of collateral they can pledge drops. Now companies have less “skin in the game” and are more likely to make risky investments because they have less to lose = moral hazard. As a result, financial institutions tighten lending standards for borrower-spenders and lending contracts. The decline in net worth and of collateral —> deterioration in their balance sheets, which causes banks to deleverage, steepening the decline in economic activity. As more and more loans go bad, banks need to worry about adverse selection problems much more: money market investors will pull their funds out of banks or demand higher interest as a compensation for risk. Since bank funding costs rise, banks also need to charge higher interest rates on loans, but increasing interest rates will deter the best borrowers and leave the bank with the borrowers that present worse risks. The bank may end up deciding not to lend to anyone. Higher interest rates also reduce the cash flows of firms, which in turn reduces firms’ investments. But if interest rates increase, cash flows drop in value and the firm must seek external funding from a bank—> “unknown” new customers will show up at the bank; many loans will get denied, and economic activity fall sharply Exercise: 86 of 93 Scenario 2: Only €40 euros are repaid. Moreover, the bank expects further losses for €5 on remaining loans. Consider a bank with the following balance sheet Assets iabi Ss * Q: can the bank lend €40 again? Is capital sufficient? Reserves €5 Deposits €80 * A: No. If it lent €40 again the balance sheet would be Loans €95 | Bank capital €20 Rssets | abiliti Total €100 | Total €100 Reserves €5 | Deposit €50 __—_—___—_________ Loans €80 | Bankcapital €5 * €50 of loans will mature next quarter. Total 85 | Total es * The bank can either lend the maturing loans again (roll- + Because it had losses for €15. Now the capital ratio is over) or keep the money as reserves. 5/80=6.25%<10%. The bank instead can convert the €40 of maturing loans into reserves and will not renew The minimum level of bank capital is 10% of loans. the loans * Now capital is * Scenario 1: All borrowers repay. enough: 5/40= * Q: can the bank lend €50 again? Is capital sufficient? 12.5%>10% A: yes it can, the balance sheet would be identical and capital is 20/95=21%>10% required minimum . Banks often deleverage (stop lending out money) as loans are not paid back. In the economy credit freeze: banks don’t give out as many loans as they did before. Deleverage —> credit freeze and asset minimum lending goes down. This is bad for firms and starts affecting real economy: firms lose access to credit —> they devalue and prices fall even more (as when bubble burst). Firms are in trouble, prices go down, consumption goes down because with deflation consumers realize prices will be lower tomorrow = delay consumption. Now firms lose revenues —> fore blown recession that started distortion in financial sector with credit boom. Banks are in trouble (loans go bad) —> interest rates go up because banks are not willing to give out loans anymore. So interest rate goes up. If interest rate goes up, quality of borrowers goes down (adverse selection). If you are not willing to pay back loan anyway, you don’ care that puts cost (interest rate) goes up. —> default probability goes up. Even good investors now will engage in more risky investments to compensate for higher interest rate moral hazard. High interest rates are bad for the firms because cashflows are now discounted heavily because of higher interest rates. From distortion in financial market, to full blown recession in the economy, prices keep falling —> deflation —> lower consumption —> lower revenues —> no more credits / funds for firms —> banks in trouble. Now even worse: investors realize realize something is going on: deposit insurance are not made for situation of risk. Hard to know whether your bank is in trouble or not —> asymmetric information. Everyone run to banks to get their funds back (= bank run). Bank run put struggling banks into even worse situation (liquidity problem because it seriously goes down), also banks in good financial health have problems. Either banks fail or they try to get as much liquidity as possible through fire sale: sell their assets and sell them at very low prices just to get credits. This is all the same very bad for firms. As firms are in trouble, wages fall —> less consumption and revenues. Stage | can also be a period of high uncertainty. With information hard to come by in a period of high uncertainty, financial frictions increase, reducing lending and economic activity Stage II: Banking Crisis 87 of 93 Scenario B: Severe Fiscal Imbalances The crisis starts in relatively quiet “normal” times and can involve government fiscal imbalances instead of a boom-bust cycle. Argentina’s 2001-2002 crisis is a good example: banks were in good shape, and had strong regulation in place, but the government deficit got out of hand. No one wanted to buy government bonds (I.e. government debt), so the government forced the banks of the country to purchase its newly emitted debt. As market confidence in those bonds plummets, their price falls and bank net worth is eroded —> banks cut their lending, asymmetric information problems get worse. In the worst case there is a banking panic Stage Il: currency crisis As speculators realize that something is wrong, the EM currency comes under attack: if you short-sell the currency now and the EM central bank is forced to abandon its peg, a big (and almost certain) gain is yours. At some point, the currency collapses and a currency crisis ensues. Contributing factors that make the attack more likely to be successful are deterioration of bank balance sheets, severe fiscal imbalances. In such circumstances a government central bank would commit economic suicide if it were to increase interest rates, which would be required to defend the currency peg. So it would decide in favor of devaluation (gain for speculators and large losses for the government). Argentina trades with the US. Demand for pesos goes down, capital goes out of Argentina, and the pesos is devaluated. For one pesos you get less dollars. If Argentina wants to avoid this, they need to artificial increase the demand for the pesos: they buy pesos and sell foreign exchange. This can be done only as far as CB has dollars, when it does not have anymore $, the peg is broken. Stage III: Full-Fledged Financial Crisis The currency devaluation hits borrowers in the economy. When EM countries borrow abroad, they often can exclusively do so in foreign currency rather than in their own currency (original sin). The logic is clear: if they would try to borrow in domestic currency, their cost of defaulting on foreign lenders by generating inflation is rather low, but borrowing in another currency poses major problems if exchange rates can not be stabilized. In case of a devaluation of the domestic currency, debt may greatly increase overnight. Example: in Argentina in January 2002, people went to sleep with 10 000 Pesos of Dollar-denominated debt ($10,000), and they woke up with 14 000 Pesos of debt ($10,000 after devaluation)! The consequences of devaluation increasing debt load erodes firm net worth moral hazard and adverse selection pose increasing problems investment and economic activity decline sharply inflation may also rise (as import prices shoot up and the central bank may have limited credibility in inflation targeting) stress on banks comes from both sides: assets lose value as default frequency increases, whereas liabilities skyrocket because of currency crisis in such situation, the whole banking system of a country may fail the “twin crisis” combination of currency crisis with banking crisis has particularly long-lasting and severe impact on the economy Summary of the entire course 90 of 93 The financial system performs the basic function of moving $ from lenders/savers to borrowers/ spenders. It uses financial assets, which are claims on real assets. It can do this with direct finance (borrowers access financial markets directly) or with indirect finance (borrowers deal with an intermediary who is managing the ultimate lender’s savings). The financial system reduces transaction costs and solves problems of asymmetric information. Direct Finance: direct issuance of either debt or equity = no intermediary These claims are traded in secondary markets. Debt entails no ownership right, but it promises the debt holder a pre-defined (often fixed) payment and has a predefined maturity (although there are also perpetuities) —> different from equity Equity entails ownership rights and has no pre-defined maturity. Benefit from ownership/ equity: they are residual claimant = holders are entitled to whatever is left after creditors have been paid off. Debt instruments with original maturity of less than 1 year are traded in money markets. Debt instruments with original maturity of more than 1 year are traded in the bond market (part of capital markets together with the stock market). The price of any financial asset is inversely related to its return. The price of debt, therefore, is inversely related to interest rates (and the longer the maturity, the more the price will fall if interest rates rise = concept of duration). Duration measures the sensitivity of a financial instrument to variation in interest rate. Interest rates are determined by the forces of supply and demand which are affected by many things (Wealth, risk, Eli), 7 e, government deficits...) Equity is traded in the stock market (grouped in an index). There are multiple ways stocks can be traded, which are generally classified as organized exchanges and over-the counter markets. As for any financial instrument, future expectations matter for stock valuation, not the past of the stock In order to value a share of stock, one needs to discount future expected cash flows by the appropriate discount rate. Equity holders expect a cash flow distribution at some point, even if the firm doesn't pay dividends. Derivatives are financial securities whose payoffs are linked to another previously issued security (or asset). * forwards (OTC, not standardized, $ exchanged in the future at delivery) * futures (traded on exchanges, standardized, daily settlement) are much more liquid * options (premium paid upfront, option value or payoff # option profit) An important function of derivatives is hedging (insurance against particular risks) = cannot hedge all risks in that case we would also hedge negatively ourselves. Market efficiency is the degree to which the prices of financial securities reflect those securities’ fundamental values. There are three forms of market efficiency: weak, semi-strong, and strong. Markets are probably semi-strong efficient most of the time, at least in the short-term some evidence not in favor of strong market efficiency hypothesis Sometimes, however, market efficiency may break down, especially over long horizons. Financial markets are plagued by transaction costs and information asymmetries. These problems create a need for financial institutions. 91 of 93 Financial institutions specialize in collecting and processing information about borrowers and financial products, and minimize transaction costs by benefitting from economies of scale and scope. That's why most external finance is provided by FI (indirect finance) rather than financial markets (direct finance). And moral hazard can explain why debt is more common than equity (less need for monitoring) Commercial Banks are depository institutions that take deposits and make private loans (and other investments). They need to keep excess reserves (with FED) to manage the outflow of deposits and manage to have enough capital to remain solvent while giving returns to shareholders. Their overall profitability can be assessed with ROA, ROE (ROE = ROA x A/E). Their ability to generate cash from interest activities with the Net Interest Margin (“NIM”) NIM= (Interest Income-Interest Exp)/Assets Central banks are in charge of Monetary policy. Assets = securities. Liabilities = reserves + money in circulation. Greatly expanded their balance sheet after 2008 (Quantitative easing) They implement monetary policy (i.e. the supply of money in the economy) in the market for bank reserves. Interest rate paid on excess reserves provides a floor (flattening out of curve) for Fed Funds rate. The supply of reserves by the central bank is vertical (monopolist can decide how much liquidity in the system) but discount window rate provides a ceiling. Mutual funds and hedge funds pool money of individual investors and invest this pool into diversified portfolios. These institutions help investors minimize transaction costs and provide them with financial expertise. Main revenue: fees ETFSs are passive open-end index funds but trade like a single stock (closed-end). ETF price = Net Asset Value (“NAV”). Deviations of price from the announced NAV are arbitraged away. —> successful system Mutual Funds are regulated, hedge funds are not much regulated as they deal with wealthy investors. Investment banks help firms issue debt and equity in primary markets (underwriting). Primary market transactions occur when the issuer of the security receives the funds (like IPOs) Company may opt for firm commitment underwriting, guaranteed to raise an amount, or for best effort underwriting. Investment banks, but also mutual funds, and other intermediaries are prone to conflicts of interest (multiple objectives and those objectives conflict with each other) —>This is a type of moral hazard. Banks are asset transformers: They sell liabilities (deposits) with one set of characteristic and buy assets with a different set of characteristics. Generally, banks” liabilities are more liquid and have shorter maturities than their assets (duration gap > 0, income gap?0) —> This exposes banks to IRR. Bank net worth is what is owned by bank owners. Net worth (capital) is the cushion against insolvency, i.e. a situation where net worth becomes negative. Banks also need to manage credit risk and interest rate risk. Regulation: Bank failures are costly. So the government uses a safety net, such as deposit insurance to prevent bank failures. It will also rescue the too-big-to-fail banks 92 of 93