Financial Markets & Institutions, Nothes for exam, Appunti di Mercato Finanziario

Scarica Financial Markets & Institutions, Nothes for exam e più Appunti in PDF di Mercato Finanziario solo su Docsity! FINANCIAL MARKETS AND INSTITUTIONS 1. THE FINANCIAL SYSTEM Financial markets → markets in which funds are transferred from people who have an excess of available funds to people who have a shortage. Financial system → organized combination of: • Markets: where demand and supply meet • Intermediaries: produce/trade instruments and related services • Instruments/services: contracts that regulate the transfer of financial assets or liabilities and rights/obligations A security (financial instrument) is a claim on the issuer’s future income or assets. A bond is a debt security that promises to make payments periodically for a specified period of time. Securities are assets for the person who buys them, but they are liabilities for the individual or firm that sells them. An interest rate is the cost of borrowing, or the price paid for the rental of funds. A common stock represents a share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corporation. Aim: • Settling transactions (payments system) • Accumulate savings and fund investments (transferring surpluses and deficits) • Manage risks (insurance, derivatives) • Pricing of instruments • Liquidity Firms issue more bonds than stocks. Bonds and stocks, together, aren’t the main source of funding; Indirect finance (especially banks) prevails on direct finance; Markets, intermediaries and products are heavily regulated; Debt instruments are fixed-income asset that legally obligates the debtor to provide the lender interest and principal payments. Underdeveloped financial systems are associated with low economic growth. DIRECT CHANNEL In the direct channel, borrowers borrow funds directly from lenders in financial markets by selling them securities. We find stock exchanges, if you want to buy stock from a company you might find it listed. BUT the biggest market is NOT the direct channel (which is much smaller than the indirect channel): in the indirect channel you find most financial institutions, financial intermediaries. In the direct channel, you put in contact lenders and borrowers, but you still have to face the difficulties in understanding what savers and borrowers want. INDIRECT CHANNEL Indirect channel: financial intermediaries put in contact savers and borrowers. (ex. Bank) In this case savers get financial instruments shaped as savers want and borrowers get financial instruments shaped as borrowers want. Financial intermediary gain money by taking the risk of creating this balance. EXAMPLE - Bank deposits: you can take your money whenever you want (one thing that savers want) -> savers (people who lend money) get the fund in exchange for their product; then they provide these funds to the borrower (who will lend your money) later and get financial instruments in exchange that are shaped as borrowers want. → In the first part, a bank offers a deposit to savers and as a second step they offer the borrower (who has a loan) a loan. Deposit is liquid (savers can take out their money anytime), while loan is illiquid. Deposit is safe, you don’t risk any loss, while loan is risky: bank could lose money, company can go bankrupt. The indirect channel is larger: ADVANTAGES: - Lower transaction costs due to economies of scale - Additional service = economies of scope - Risk sharing and reduce uncertainty - Diversification - Reduce asymmetric information (when one party in a transaction is in possession of more information than the other) Adverse selection (ex-ante): is the problem created by asymmetric information before the transaction. Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad credit risks—are the ones who most actively seek out a loan and are thus most likely to be selected. Moral hazard (ex-post) is the problem created by asymmetric information after the transaction occurs. Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other. Solutions? ▪ Finding ways to distinguish «good» from «bad» risks: experience, monitoring, guarantees, covenants ▪ Specialising in gathering and managing information (but: free-riding and conflicts of interest) ▪ Increase regulation and supervision (but: imperfect and costly) Good debt has the potential to increase your wealth, while bad debt costs you money with high interest on purchases for depreciating assets. Determining whether a debt is good debt or bad debt sometimes depends on an individual's financial situation, including how much they can afford to lose. TRANSACTION COSTS Getting to markets bears costs, especially if your funds are limited. Some products have huge denominations. With little money, hard to diversify. Solutions? • Scale economies (cost reductions that occur when companies increase production): financial intermediaries are BIG • Scope economies (cost to produce a product will decline as the variety of its products increases): financial intermediaries offer a wide range of products • Liquidity services and Information Yield to maturity, the interest rate that equates the present value of cash flows received from a debt instrument with its value today. For simple loans only it equals the nominal rate. Zero coupon bond: Coupon bonds (and others): How well a person does by holding a bond or any other security over a particular time period is accurately measured by the return. The payments to the owner are the yearly coupon payments of $100, and the change in its value is $1,200 - $1,000 = $200. Adding these together and expressing them as a fraction of the purchase price of $1,000 gives us the one-year holding-period return for this bond, 30% ISSUES WITH THE YTM • Assumes holding period equals maturity → Risks and opportunity costs? • Assumes reinvesting at the same rate → Yields vary over time! • Nominal! → Real values matter more Ex-ante: real IR consider the expected change in price levels (effective IR) : ir + πe[+ir × πe] Ex-post: real IR consider effective inflation (but when the transaction is over!) INTEREST-RATE RISK: riskiness of an asset’s return, that results from interest-rate changes. The finding that the prices of longer-maturity bonds respond more dramatically to changes in interest rates helps explain an important fact about the behaviour of bond markets: Prices and returns for long-term bonds are more volatile than those for shorter-term bonds. As risk of a bond increase → the YTM increases IR AND PERFORMANCE • Rate of return: payments to the owner of a security + relative change in value • IR and RoR differ because of capital gains: • If holding period equals time to maturity, return equals YTM only for ZCs: reinvestment risk (if holding period is longer, even more reinvestment risk) • The bigger the time to maturity → the bigger the effect on capital gains due to changes in IR: interest rate risk • Inverse relationship between IR and capital gains • Even if unrealised, capital gains represent an opportunity cost DURATION Because a zero-coupon bond makes no cash payments before the bond matures, it makes sense to define its effective maturity as equal to its actual term to maturity. In other words, the duration of this set of zero-coupon bonds is the weighted average of the effective maturities of the individual zero-coupon bonds, with the weights equalling the proportion of the total value represented by each zero-coupon bond. The longer the term to maturity of a bond → the longer its duration. When interest rates rise → the duration of a coupon bond falls. The higher the coupon rate on the bond → the shorter the bond’s duration. Linear proxy of a convex relationship between P and i. Duration as the 1st derivative… convexity as the 2nd! FORECASTING IR Changes in IR due to inflation: • An increase in expected inflation affects simultaneously demand (decrease of expected return) and supply (cheaper borrowing). In bond markets an increase in expected inflation leads to smaller prices. • IR will increase (prices fall) • Effect on quantity is not readily predictable Changes in IR due to business cycles: • An economic expansion affects simultaneously demand (increase of wealth) and supply (greater expected returns on investments) • Quantity will increase • IR can increase or decrease (usually, increase – and decrease during recessions) FORECASTING IR: DOES MONEY STEP IN? When CBS increase the money supply, IR should decline, but: • Immediate liquidity effect reducing IR • Economic stimulus: more income (income effect) and IR, but it takes time to have effect (wages, investments…) • More inflation (price-level effect) and IR, but it takes time to adjust prices of goods and services • More expected inflation (expected-inflation effect) and IR, with speed of effects depending on people’s speed of adjusting expectations RESULT: • If the liquidity effect is dominant, sharp reduction in IR, then recovery up to a smaller final value • If the liquidity effect is insufficient, sharp reduction in IR, then recovery up to a higher final value • If the liquidity effect is marginal, people adapt their expectations on inflation and the reduction in IR does not take place, and final IR are higher immediately DEFAULT RISK One attribute of a bond that influences its interest rate is its risk of default, which occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or to pay off the face value when the bond matures. Bonds with no default risk are called default-free bonds. RISK PREMIUM: spread between the interest rates on bonds with default risk and default-free bonds, both of the same maturity, indicates how much additional interest people must earn to be willing to hold that risky bond. LIQUIDITY RISK Another attribute of a bond that influences its interest rate is its liquidity. Treasury bonds are the most liquid of all long-term bonds; because they are so widely traded, they are the easiest to sell quickly and the cost of selling them is low. TERM TO MATURITY Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different. The longer the term to maturity of a bond, the longer its duration. THE YIELD CURVE It’s a plot of the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations. It describes the term structure of interest rates for particular types of bonds. The yield to maturity, which is the measure most accurately reflecting the interest rate, is the interest rate that equates the present value of future cash flows of a debt instrument with its value today. A bond's current yield is an investment's annual income, including both interest payments and dividends payments, which are then divided by the current price of the security. Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until its maturation date. 3 theories for explaining the term structure of IR: 1. EXPECTATIONS THEORY The interest rate on a long-term bond will equal to an average of the short- term interest rates that people expect to occur over the life of the long-term bond. For example, if people expect that short-term interest rates will be 10% on average over the coming 5 years, the expectations theory predicts that the interest rate on bonds with 5 years to maturity will be 10%, too. 2. MARKET SEGMENTATION THEORY Bonds at different maturities are not substitutes and each has a specific market, as well as each investor has a preferred maturity. bonds of different maturities are not substitutes at all, so the expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity. This theory of the term structure is at the opposite extreme to the expectations theory. 3. LIQUIDITY PREMIUM THEORY Combines the other two in a comprehensive way. • Adds to expectations theory a liquidity premium for longer term bonds that is subject to market (demand, supply) conditions for that segment • Bonds are substitutes as long as investors’ preferences are compensated with a term (liquidity) premium that is always positive and grows as maturity gets longer • Explains inverted term structures: when future expectations on short-term IR are of a wide fall, so that their average is not balanced even by a positive liquidity premium (more likely when short-term rates are high) bonds of different maturities are substitutes, which means that the expected return on one bond does influence the expected return on a bond of a different maturity. Is the most widely accepted theory of the term structure of interest rates because it explains the major empirical facts about the term structure so well. It combines the features of both the expectations theory and the market segmentation theory by asserting that a long-term interest rate will be the sum of a liquidity (term) premium and the average of the short-term interest rates that are expected to occur over the life of the bond. A rational bubble is present whenever an asset price deviates progressively more quickly from the path dictated by its economic fundamentals. BEHAVIOUR HYPOTHESIS - People are rational, perfectly know all the information and are optimally acting operators - People’s behaviour is based on optimizing functions (utility, profit, …) BEHAVIOURAL FINANCE → removes this assumption of perfectly rational and informed people and just treat humans as they are… humans. MENTAL ACCOUNTING is the tendency to treat the same thing – money, in particular – differently depending on where it came from or what we intend to do with it. This behaviour can also cause people to hyperfocus on one account without considering the full scope of their finances. Why we overreact to bed information compared to how we react to good information? • Short selling → (the way you can profit if you expect stock to fall in value: you normally buy stock that is expected to go up in value, but you can also make money through borrowing and selling when price is high and buy back later when price is lower, when you expect price to go down in the future) the way you can profit if you expect a stock/commodity/asset falling in value. • Overconfidence → people believe they are better than others, in particular believe they are more able to beat the market • Hard behaviour → if a lot of people are talking about it and investing in it, it must be right • Irrational optimisms → optimistic in new stuff that looks good (for example cryptocurrencies, bitcoin) • Confirmation/attribution bias → when you make an investment and you gain, you believe you know better I am losing on this investment, lets buy more since I can’t be that wrong. EXAMPLE on irrationality, human behaviour on markets: - Facebook IPO (Initial Public Offering). We didn’t have a way to measure the real value of the company. Before going public, it received a number of very different estimations. Higher and higher expectations: from original offer of 5bln$ stocks, number of shares sold was raised and the final amount achieved 16 bln $; It reached beyond 80$ per share. Day 1 of trading with technical problems; price started decreasing (lowest price was 18,8 $). Losses impacted FB’s growth expectations, its employees (many fired), investments firms, retail investors, other IT companies; lawsuits started (investors suited FB for providing wrongful information to the market..). → affected IPOs of all IT companies for some time. 4. MONEY MARKETS Most important market. It can be misleading in the name because it’s not about money itself. AIMS: • Provide low-cost and quick funds for short-term liquidity shortages • Allowing returns and safety for short-term funds’ availability (those who have excess liquidity want to have decent returns but they also want to have their money safe). Money markets host mainly financial instruments that are over the counter. WHY SO IMPORTANT? If the market was perfectly efficient, we would have no needs for the money market. • Because markets are not perfectly efficient and are limited by regulations (bank is not allowed to lend all your deposit but has to keep a portion of you deposit in the central bank, just for safety, to fill a hole that could happen in the central bank) • Banks need to cover short-term funds’ excesses or deficits • Treasuries of governments, firms (investment corporations, securities’ industry, non-financial entities) • CBs/banks are the main operators (institutions that are regulate, can guarantee low risk), most use government bonds that have a relatively low credit risk PARTICIPANTS OF THE MONEY MARKET • Government treasuries borrows only. The U.S. Treasury is the largest of all money market borrowers. • Commercial banks: banks are also the major issuers of negotiable certificates of deposit (CDs), banker’s acceptances, federal funds, and repurchase agreements. • Investment Companies: large, diversified brokerage firms are active in the money markets • Finance Companies: raise funds in the money markets primarily by selling commercial paper. They lend the funds to consumers for the purchase of durable goods such as cars, boats, and home improvements. • Insurance Companies: Property and casualty insurance companies must maintain liquidity because of their unpredictable need for funds. • Pension Funds: Pension funds invest a portion of their cash in the money markets so that they can take advantage of investment opportunities that they may identify in the stock or bond markets. The yield curve shows the interest rates that buyers of government debt demand in order to lend their money over various periods of time. FINANCIAL INSTRUMENTS 1. SHORT TERM GOV. BONDS • Are short term funding from the government and collaterals for other operations in the short term. The government has a short-term liquidity shortage. They have extremely low IR. Greek/Italian/Spanish/Venezuelan bonds have too high IR -> no one would use them as a collateral. Placement trough biddings. 2. COMPETITIVE BIDDINGS: • Maturity, amounts, and features of the bonds are announced in advance • When the order placement window opens, operators that are allowed to enter this bidding send their bids (price and quantity that they want). After all orders are collected, the system ranks them by decreasing price. 3. NON-COMPETITIVE BIDDINGS: • Bidders communicate only amounts, not prices • All offers are accepted, all the quantities are given, but you get the price of the competitive bidding linked with to this non-competitive bidding. If you don’t want to risk being excluded, you participate in non- competitive biddings. The significant difference between the two methods is that competitive bidders may or may not end up buying securities, whereas the non-competitive bidders are guaranteed to do so. 4. INTER-BANKING DEPOSITS • Funds mostly extremely short-term transferred between banks, typically 1 day • This allows banks to cover temporary liquidity gaps • Banks have to respect the reserves requirements, they have to meet some requirements by the end of the day IR developed here are extremely important → link between short-term and long-term rates • Typical maturities are overnight (t, t+1), tomorrow next (t+1, t+2), spot next (t+2, t+3), but also on-sight (t, n) and broken date (k, n) are available 5. REPOS, repurchase agreement • Very short term but longer than the inter-banking funds (1 day) • It is still a short-term loan, but we use government bonds as collateral • The most efficient segment of money markets We pretend that other 2 things happen: Today you buy from me this bond, and you agree to give it back to me within some months. A person has the money and is willing to lend the money for a return, and the other person has the bond and wants the money. They decide to do one operation now and one at a future date, let’s say one month, and they agree immediately to do so. 6. CERTIFICATE OF DEPOSIT = CDS A piece of paper issued by a bank that proves that our deposit was made with that bank, but for large denominations (face value of at least 1 million). • They have a maturity date, an interest rate (fixed or variable). Because a maturity date is specified, a CD is a term security as opposed to a demand deposit: Term securities have a specified maturity date; demand deposits can be withdrawn at any time. 7. COMMERCIAL PAPERS Unsecured promissory notes, issued by corporations, that mature in no more than 270 days. Because these securities are unsecured, only the largest and most creditworthy corporations’ issue commercial paper. The interest rate, the corporation charges, reflects the firm’s level of risk. Typically, an unsecured short-term zero coupons (20-45 days). 8. EUROCURRENCIES • EUROCURRENCY: Eurocurrency is currency held on deposit by governments or corporations operating outside of their home market. (Eurodollars are USD outside the US) → EURODOLLAR: The primary reason is that depositors often receive a higher rate of return on a dollar deposit in the Eurodollar market than in their domestic market. It’s the largest short-term security market in the world. • LIBOR: basic rate of interest (used in lending between banks on the London interbank market) used as a reference for setting the interest rate on other loans and is a range of reference rates for the main currencies and maturities. • The euro short-term rate (€STR) reflects the wholesale euro unsecured overnight borrowing costs of banks located in the euro area. It represents the secured treasury rate for Eurocurrencies. • EUROBOND is a more recent innovation in the international bond market. It is sold outside the countries that have adopted the euro. It is a bond denominated in a currency other than that of the country in which it is sold. Currently over 80% of the new issues in the international bond market are Eurobond. Money market securities are short-term instruments with an original maturity of less than one year. These securities include Treasury bills, commercial paper, federal funds, repurchase agreements, negotiable certificates of deposit, banker’s acceptances, and Eurodollars. Money market securities are used to “warehouse” funds until needed. The returns earned on these investments are low due to their low risk and high liquidity. 5. THE BOND/CAPITAL MARKET After money markets, bond markets are the largest sector in financial markets. Firms and individuals use the money markets primarily to warehouse funds for short periods of time until a more important need or a more productive use for the funds arises. By contrast, firms and individuals use the capital markets for long-term investments. Money market → The primary reason that individuals and firms choose to borrow long-term is to reduce the risk that interest rates will rise before they pay off their debt (reinvestment risk). This reduction in risk comes at a cost. Longer term means a higher cost of borrowing compared to the money market, because now you have to consider the increasing credit risk and also the liquidity premiums. What is difference between money market and bond market? The bond markets provide a long-term source of funds. Even the case of shortest-dated bonds have an initial maturity of more than one year. On the other hand in money market funds are borrowed and lent for a maximum of one year. Present value is the sum of money that must be invested in order to achieve a specific future goal. (Il valore attuale è la somma di denaro che deve essere investita per raggiungere uno specifico obiettivo future.) PV= FV (1+i)n SUMMARY: Yield is the income returned on an investment, such as the interest received from holding a security. The three main capital market instruments are bonds, stocks, and mortgages. Only corporations can issue stock. Corporations and governments can issue bonds. If a bond has an interest payment based on a 5% coupon rate, no investor will buy it at face value if new bonds are available for the same price with interest payments based on 8% coupon interest. To sell the bond, the holder will have to discount the price until the yield to the holder equals 8%. The greater is the amount of the discount, the longer the term to maturity. 6. THE STOCK MARKET Stock market is part of the capital market → the idea is funding long-term funding needs: investments. Main difference from the bond market is that here we don’t have a maturity date. Investors can earn a return from stock in one of two ways. Either the price of the stock rises over time or the firm pays the stockholder dividends. Stock is riskier than bonds because stock-holders have a lower priority than bondholders when the firm is in trouble, dividends are less assured, and stock price increases are not guaranteed. If a stock company goes bankrupt, its stocks are repaid, partially or in full, based on their level of subordination after creditors. PURPOSE AND FEATURES Stocks represent ownership in a company: voting rights are included. Proportionally to number of stocks you buy, you are the owner of the company. If you buy 10%, it’s equal to owning 10% of everything that is inside the company. Since you are the owner of the company, you have the right to have a say about the future of the company-> stocks give voting rights, you can influence the behaviour of the company. Leading shareholders say what the company should do, appoint managers of the company, decides about what the company should do. Returns are based on dividends and capital gains/losses. MAIN CATEGORIES OF STOCK: Common stock: • Typical form, with several variations • Dividends, voting rights and subordination to creditors Preferred stock: • Fixed predetermined dividend (reduce risk, you give some certainty about an inflow of money) • Limited voting rights (the price for less risk) • Priority over common stock (reduce risk) • Frequently hold by founders (more voting and economic rights) Tracking stock: Performing as a division/project rather than a whole firm. Dividends coming from a specific activity of the company. CLASSIFICATION OF STOCKS BASED ON HOW THEY BEHAVE: Income stocks (in mature and profitable sectors): - More frequent and steady dividends payment - Focus on flows (dividends), rather than on capital gains Growth stocks (in innovative sectors → the company is quite new, innovative): - Rapidly increasing profits reinvested rather than distributed - Focus on (future potential) capital gains Value stocks (due to company-specific events and moments): - Healthy but “under-priced” stocks compared to peers, they are risky so they seem under-priced. - Focus on future opportunities, rather than financials → high promise of returns if they work out HOW STOCKS ARE SOLD: Exchanges A specified location where buyers and sellers meet on a regular basis to trade securities using an open- outcry auction model. - Auctions + continuous trading (opening price, a closing price, and in the middle, that can be traded at an higher/lower) - Intermediated by brokers With an action, for a couple of minutes the continuous training is stopped and all orders of that stock are collected, a reference price is fixed as to make more possible transactions. This is used when the volatility is too much. Avoid the impact of irrational behaviour in the market. Over the counter Mostly electronic through dealers with inventories and bid/ask prices (NASDAQ): instead of brokers we have dealers, willing to provide prices to buy or sell a certain stock. Dealers “make a market” in these stocks by buying for inventory when investors want to sell and selling from inventory when investors want to buy. AUCTIONS VS CONTINUOUS TRADING 1. Auctions • Auctions guarantee control over participants and transparency • Price set by “best” buyers, those willing to pay more are those that determine the value • Information increase values: less volatility, better expectations • Costly, less efficient, limited time availability 2. Continuous trading • Better price discovery/signaling, lower evaluation errors • More short-term volatility: firms/environment change quickly (growth, discounting, estimates, …) • Less costly, pricing all over the trading day, dynamic books and more sophisticated orders (f.i. limit) 3. Currently, a hybrid • Open/close auctions / Trading halts and volatility auctions • Some important global markets are auctioned (f.i. LME) HOW TO COMPUTE THE PRICE OF COMMON STOCK: One basic principle of finance is that the value of any investment is found by computing the value today of all cash flows the investment will generate over its life. → First strategy: PV of future CF - DIVIDEND DISCOUNT MODEL Same as we used for bonds. But unlike bonds, it is not the only strategy, because cash flows in stocks are much less predictable, we don’t know if dividend is going to be paid → huge amount of uncertainty makes us simplify the model. With this model we assume that we will be able to predict future dividends. But Future flows have to be discounted by a rate that includes also risk premium, since when buying a stock there is uncertainty. The best method of stock valuation, theoretically, is the dividend valuation approach. If a firm is not paying dividends or has a very erratic growth rate, the result may not be satisfactory. Issues: growth companies, growth greater than cost of capital, short-term trading strategies, … → Second strategy: similar firms should have similar long-run market/book ratios (multiples, P/E, …) • P/E: Price to earnings: Greater values → Market expects rise in earnings or a lower level of uncertainty The P/E shows what the market is willing to pay today for a stock based on its past or future earnings. How many years of profitability an investor is willing to pay. A high P/E ratio could mean that a stock's price is high relative to earnings and possibly overvalued. • P/BV: Price to equity (book value) → Measures the link between historic / forward-looking measures The price-to-book ratio is important because it can help investors understand whether a company's market price seems reasonable compared to its balance sheet. For example, if a company shows a high price-to-book ratio, investors might check to see whether that valuation is justified given other measures, such as its historical return on assets or growth in earnings per share (EPS). • P/CF compares price with operating cash flow: earnings may be managed and affected by non-cash items This strategy tries to reduce the amount of assumptions you need to make a calculation → less forecast, less subjective measure. Issues: it stays inside the assumption, it requires to cluster comparable firms, you have to clearly identify competitors → Third strategy - TECHNICAL ANALYSIS Extrapolating information from prices in highly efficient markets to predict market sentiment and investors’ behaviour by looking only at past prices → strategy based on graphs. Advantage: limited data requirements (sticks to efficient market hypothesis: “everything” is found in prices) Issues: • Short-termed → these operations are able to predict prices only in the short-term • Outperformance seems just randomness • The main limitation of technical analysis applied on stocks is to overlook correlations and spillovers across many interwined markets. (trascurare le correlazioni e le ricadute tra molti mercati interconnessi) EXAMPLE Which of the following Italian stocks is riskier (11.2013)? Required return: Third, mortgage loans are relatively costly to service. → Compare the servicing a mortgage loan requires to that of a corporate bond. The lender must collect monthly payments, often pay property taxes and insurance premiums, and service reserve accounts. None of this is required if a bond is purchased. Finally, mortgages have unknown default risk. Investors in mortgages don’t want to expend energy evaluating the credit of borrowers. These problems inspired the creation of the mortgage-backed security, also known as a securitized mortgage. An alternative to selling mortgages directly to investors is to create a new mortgage-backed security: (secured by) a large number of mortgages assembled into what is a mortgage pool. Securitization: a trustee (bank, government agency) holds the mortgage pool which serves as collateral for the new security. The most common type of mortgage-backed security is the mortgage pass-through. 8. THE FOREX MARKET: FOREIGN EXCHANGE MARKET Trading of currencies and bank deposits, denominated in particular currencies, takes place in the foreign exchange market. Transactions conducted in the foreign exchange market determine the rates at which currencies are exchanged, which in turn determine the cost of purchasing foreign goods and financial assets. Spot transactions involve the immediate (two-day) exchange of bank deposits Forward transactions involve the exchange of bank deposits at some specified future date The spot exchange rate is the exchange rate for the spot transaction The forward exchange rate is the exchange rate for the forward transaction - Usually, quotes are in units of domestic per foreign currency: how many € in your pocket you need to buy 1 $ (foreign currency)? Easier: units of foreign per domestic currency. - Demand/supply determine Q and P set as ER: cost of purchasing foreign goods, services and financial assets. Appreciation: when a currency increases in value. (Ex. in EU, from 1,33$/€ to 1,43$/€). Depreciation: when it falls in value and is worth fewer U.S. dollars. When a country’s currency appreciates (rises in value relative to other currencies), the country’s goods abroad become more expensive and foreign goods in that country become cheaper (holding domestic prices constant in the two countries). Conversely, when a country’s currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive. The foreign exchange market is organized as an over-the-counter market in which several hundred dealers (mostly banks) stand ready to buy and sell deposits denominated in foreign currencies. EXCHANGE RATES AFFECT ECONOMY: Appreciation → own goods more expensive (export) and foreign good cheaper (import) if prices are constant (depreciation the opposite) • Economic and financial integration makes this relevant for the overall economy, not just for imports/exports (example, if importing gets cheaper, you may hire new workers) • Exchange rates are (at least partially) linked with IR trough return on assets. There isn’t a real market for currencies. The spot market is the most popular type, as it allows forex traders to buy/sell currency pairs immediately. LONG-RUN: Theory of purchasing power parity (PPP) Basic idea: imagine there are two countries that produce the same good; there is no difference in costs for transportation, no barriers. Sooner or later, the price of the goods will be the same. The theory of PPP is simply an application of the law of one price to national price levels. • The exchange rate (ER) between 2 currencies must reflect changes in price level (inflation). → If in one country inflation is higher (in local currency the price for a good gets higher), then the currency must depreciate to balance the price with another country that has a lower inflation. If price levels rise here, currency depreciates, and others appreciates → always think in relative terms. • Real ER (rate at which domestic goods can be exchanged for foreign goods) represent how one country’s production relates to our country production. Real exchange rate (net of inflation), In the long run, should get close to 1 across all currencies LONG-RUN - Goods are perfect substitutes (the goods produced in a country are the same as those produced in another country, BUT goods that are perfect substitutes don’t really exist) - All goods can be traded (BUT it’s not true; some can move across countries but others don’t) - There are no transportation and barriers costs (transportation costs exist and are getting cheaper BUT they are not always negligible) The theory of PPP suggests that if one country’s price level rises relative to another’s, its currency should depreciate (the other country’s currency should appreciate). Which factors determine D and S? • Relative price levels → rising domestic inflation (compared to other countries) depreciates national currency • Trade barriers → increasing trade barriers appreciate national currency (more demand for local goods) • Demand’s preferences → increasing appetite for domestic goods appreciates national currency • Productivity → greater productivity (more output with less input) in internationally traded goods reduce their relative price and appreciates national currency (more to sell at the same price). SHORT-RUN Considering again demand and supply, but on assets in national and foreign currencies: • Supply (domestic assets) can be considered given in the short run • Demand decreases as currency appreciates (keeping future expected ER constant), since lower current ER with constant expected future ER means higher returns on national assets. • IR: if national assets provide greater returns compared to foreign ones, demand increases, ER appreciates • Expected IR: if the future expected IR increase (because of expected lower national price levels, higher trade barriers, lower foreign import, higher national exports, higher national productivity), returns on national assets increase, demand increases, and ER appreciates. Nominal interest rate = real interest rate + inflation IR can change because of real IR or expected inflation changes: different impact on ER • If nominal IR goes up it’s because either more real IR or more inflation. If it is more inflation → currency depreciates; If it is more real IR → currency appreciates • If real IR increase, returns increase: more demand of national assets, appreciation • If expected inflation is higher: returns decrease, national demand declines, depreciation INTEREST PARITY CONDITION Differences in IR on similar bonds in different countries reflect expectations of future changes in ER SUMMARY: The theory of purchasing power parity suggests that long-run changes in the exchange rate between the currencies of two countries are determined by changes in the relative price levels in the two countries. Other factors that affect exchange rates in the long run are tariffs and quotas, import demand, export demand, and productivity. 3. In the short run, exchange rates are determined by changes in the relative expected return on domestic assets, which cause the demand curve to shift. Any factor that changes the relative expected return on domestic assets will lead to changes in the exchange rate. EXAMPLE Imagine: • 1.1 $/€ is the spot ER, 1.15 is the future ER • John (US) has 1.1$, Maria (IT) has 1€ • Italian returns are 2%, US returns are 5% J and M have the same amount of money that they have available and they want to invest. For J, USA is domestic, for M Italy is domestic. They need to convert: for J, 1,1$ (his money). Is converted in 1€ and for Maria 1€ is 1,1$ (they have the same amount to invest). They invest and get returns. If they invest abroad they need to convert. J would get 1,173 $ from 1,02€ (after conversion) if he invested in Italy: by investing in Italy, the performance is bigger (return is 6,6%). M in Italy gets exactly 2% (no conversion); if she invested in USA she would get 1,155$ and then she needs to convert = 1,004€: not favourable, return is just 0,4%. So it is more convenient to invest in Italy for both J and M because of the exchange rate. Today the exchange rate is 146 JPY/EUR. Six months ago it was 0,007 EUR/JPY. The Euro, compared to the Yen: 146JPY = 1€ X = 0.007€ → 1000JPY = 7€ → 1000:7 = 143 → 143JPY = 1€, Euro depreciated (Final – Initial) / Initial → if appreciated/depreciated EXAMPLES - CARRY TRADE On your trading desk you note the following: • Your capital allowance for the day is 1.000.000 USD • Three different banks are quoting 1,12 CHF/EUR 0,89 EUR/USD 1,02 USD/CHF What can you do? What if many do? PART 2: INSTITUTIONS 9. THE FINANCIAL CRISIS Asymmetric information problems act as a barrier to financial markets channeling funds efficiently from savers to households and firms with productive investment opportunities and are often described by economists as financial frictions. When financial frictions increase, it is harder for lenders to ascertain the credit- worthiness of borrowers. They need to charge a higher interest rate to protect themselves against the possibility that the borrower may not pay back the loan, which leads to a higher credit spread, the difference between the interest rate on loans to businesses and the interest rate on completely safe assets that are sure to be paid back. A financial crisis occurs when information flows in financial markets experience a particularly large disruption, with the result that financial frictions and credit spreads increase sharply, and financial markets stop functioning. Then economic activity will collapse. Why financial crises? • Mounting imbalances (something going out of scale) • Shock makes it clear that these imbalances are unnatural and have to be sold. • Asset bubbles. Imbalances created an inflation in values in some assets; the bubble then burst, the value of assets fall down. • Asymmetric information when the bubble falls down: some institutions are in trouble, retreat from the market (there are fewer players) increasing asymmetric information • Inefficient capital allocation because of asymmetric information • Market crash, credit crunch, bank runs: banking institutions can determine which firms are good or bad so they give less credit. Shadowbanking. • Default of firms: fewer creditors available -> fewer firms -> fewer work, jobs, products produced -> • Weak transparency of derivatives. OTC derivatives (such as CDS) able to hide losses. • Poor accountability of under-the-line leveraging (he use of debt (borrowed funds) to amplify returns from an investment or project). Derivatives were able to create leverage that is under the line. • Excess leverage of financial institutions, but also households and firms. Increased leverage that was concentrated in under-the-line commitments towards the mortgage-backed securities market. SHADOW BANKING Unregulated (legal) entities compete with banks in providing lending opportunities. Shadow banks are not beyond the law (they are still legal); they do similar activities to banks (provide credit) without actually being banks; they are not as regulated as banks. Also, a mutual fund could be a shadow bank. Main consequences of Great Depression 2.0 - Real estate bubble burst - Run on shadow banking system - Bubble extends to stock and bonds outside the financial sector - Liquidity injections are insufficient - Contagion goes global involving countries - Recession, unemployment (stage 3 of financial crises) - 2 innovations → TBTF paradigm under scrutiny → End of the pure investment bank paradigm (some investment banks disappeared, some were not 100% investment banks, increasing the amount activities that are not only investment activities, like deposits and loans) WHAT ABOUT EMERGING MARKETS? Similar steps, although with some differentiations: • Regulation/supervision weaker, riskier lending (fewer annual reports from companies to check their numbers, fewer rules to comply to, less transparency, less information) • Fiscal imbalances, central banks not independent (Government prints more money that the economy is able to produce in terms of output -> currency depreciates) • Less collateral available • Foreign monetary policies can increase dependent countries’ IR (The country tries to attract with higher IR -> more dependent on other countries) • Usually a currency crisis is involved, hyperinflation • To attract capitals IR are increased, leading to issues for highly leveraged institutions • Banks and debtor’s default (failure of a government to honour some or all of its debt obligations) • Whole countries default or call for debt restructuring, transforming short-term debt into long-term debt. EXAMPLE The case of Zimbabwe: 1980: independence and strong growth. Disastrous economic reforms in 1990s (with IMF/WB): weak protection of property, weak entrepreneurship. High corruption, Congo wars, misreporting, heavy repression of opposition. Wide printing of ZWD, lack of trust on future • 2000s: economic/banking collapse (unemployment: 80%). Hyperinflation: 7-20% from 1980-1990, 20%-60% from 1991-2000, 100-1,200% from 2001-2006, … up to 80,000,000,000% per month in 2008 (luckily the government declared in 2007 inflation “illegal”…): prices adjusted several times a day. Increasing role of foreign currencies, even if restrictions to use only ZWD were present (and just fueled a black market). In 2009 the ZWD abandoned, in 2015 switch to USD. Drained currency reserves + parallel market: in 2019 new ZWL, pegged, multicurrency again in 2020, lost peg again. 10. CENTRAL BANKS “The FED” - Federal Reserve System There is a board of governors with a chairman. Board is made of 7 members appointed by the President or by the Senate. The board appoints 6 Directors for each of the Federal Reserve Banks. There are 12 FRB. Directors are not limited to 6; for each FRB, 3 are appointed by the banks (member banks, members of the FRB system). Each FRB made by 6 + 3 directors appoint FOMC Federal Open Market Committee (where entire board of governors sit, as well as presidents of FRB of New York together with other 4 presidents of FRB) and Federal Advisory Council. Board of governors alone has the power to establish reserve requirements, but need advice of the FOMC. In deciding the discount rate, power is of Board of governors and the 12 FRB after the advice of the FOMC. FED’s main objectives: price stability and macroeconomic support with growth + employment For open market transactions → FOMC. There is a concentration of power in FOMC, which can make decisions and influence for other decisions. Monetary policy tools are reserve requirements, open-market transactions and discount rate. Reserve requirements are not used very often; discount rates are used but are not very effective policy tools and open-market transactions are the most effective and used. ECB EU Power in ECB: Executive board + Government council + General council. National banks have much more influence on the ECB than in FED system: they decide the budget to spend, enforce decisions in each country, enforce regulation and supervision, leading to a greater independence. → Most influence power remains in the national central banks. When ECB decides monetary policy (reserve requirements, open-market transactions, discount rates), they are subject to a much stronger biding and controlling thing that is the EU treaties, the regulation working in the EU. The main function of the Governing Council of the ECB is to conduct monetary policy and its primary objective is to maintain price stability in the euro area. The Executive Board is responsible for the day-to-day operations and management of ECB + Eurosystem. ECB’s 3 main objectives: maintain price stability; support economic policies; ensure open market economy DIFFERENT MODELS: WHY? During the last four decades, both theory and empirical evidence have suggested that the more independent a central bank the more effective monetary policy is. There are two key dimensions of central bank independence. The first dimension, goal independence, encompasses those institutional characteristics that insulate the central bank from political influence in defining its monetary policy objectives. The second dimension, instrument independence, refers to the ability of the central bank to freely implement policy instruments in its pursuit to meet its monetary goals PROS of independence: - Political short-sighted influence produces inflation by acting on short-term goals (unemployment and IR): lection dates rather than economy needs. Political power is short-sighted. Needs of the economy may need a solution right now, can’t wait for elections and decisions by politicians. - Treasuries’ influence accumulates risk by promoting abnormal absorption of public debt and concentration in CB/banks. - Monetary policy requires specific expertise about how important it is to make decisions for CB CONS of independence: - Accountability and democratic control (we don’t elect those people; if we are unsatisfied with their decision we can’t bring them to court) - Governments‘ fiscal policies weakened by monetary policy (if fiscal policy is different by the monetary policy, government policy is weakened, since monetary policy is stronger) - Independence did not avoid crisis MONETARY POLICY Balance sheet of a CB: has mainly 2 assets and 2 liabilities (most important ones): - Assets: Government securities (mainly government bonds) that the CB purchased from another bank (government sells bonds to a bank, and then that bank sells them to the Central Bank. Influences liquidity of the financial system. This is what open-market transactions mostly do. Open-market transactions are the first monetary tool) and discount loans (offered to banks in need of liquidity, second monetary tool) - Liabilities: currency in circulation, together with Treasury’s currency, and Reserve (held by banks and owed by CB, either required or voluntary = if you want you can leave some money to the CB. Reserve requirements are the third monetary tool). MONETARY POLICY TOOLS: • Open-market transaction: most important. CB buy/sell securities (mostly bonds) from other institutions mainly on the secondary market. The more you buy, the more prices go up. They affect the primary market, where new issuances will be cheaper. • Discount lending: providing loans to banks that have lack of liquidity is more precise in delivering liquidity to institutions in need but not effective in changing IR. • Reserve requirement can be effective, but they aren’t used very often. → When you increase a reserve requirement, all banks simultaneously have to increase reserves and have less liquidity available; → When you reduce them, you have more liquidity available to banks and they can increase the credit they give) OPERATIONS IN THE MARKET FOR RESERVES The federal funds rate is particularly important in the conduct of monetary policy because it is the interest rate that the Fed tries to influence directly. • Influence inter-banking rate (iIBR) and therefore other market IR • Through reserve requirements and IR on reserves (ier) • Influenced by open-market non- borrowed reserves (NBR) and borrowed reserves at the discount rate id. • If credit is booming, it is easier to see it and the impact is usually huge How should CBs respond? • Influencing IR has uncertain outcomes: it does not discourage “bubble-investors” and higher IR make bubble burst sooner and harder • Usually it’s a specific asset being involved: CBs have tools that are general • Acting on IR causes a short-term loss of growth, employment… heavy political pressure • Hence, CBs do not respond to burst bubbles, but to facilitate recovery: it’s questionable to say that they are “late”, or “did not see it” (but they also care about financial stability…) CB AND ER CBs act also on currencies: • By buying/selling international reserves, changing the monetary base and the value of the domestic currency: unsterilised intervention • Sterilised interventions add another offsetting open market transaction to keep the monetary base stable: no effect on ER or IR, but signalling effect on future actions CBs could be involved because of ER regimes: • Floating ER regimes may import inflation or damage internal economy through wide fluctuations • Fixed ER regimes, setting an anchor, require availability of international reserves: if insufficient a devaluation occurs, may trigger currency attacks and crises, is expensive and makes CBs lose grip on inflation. • The global system is a mix of managed floats and temporarily fixed ER Trilemma: ER (exchange rate), MB (monetary base), IR (interest rate)? → they can only use one at time https://www.ecb.europa.eu/pub/annual/ html/ecb.ar2021~14d7439b2d.en.html 11. BANKS The major source of gain for a bank: more interest rates in the assets side than in the liabilities side (IR margin). Banks are the most fragile in terms of liquidity risk, because they have mostly short term on-sight liabilities and illiquid assets (loans). If a certain amount of depositors decide to run away from the bank for whatever reason, even if you have the best level of capital in the market you are dead, because most of your liquidity is frozen in long-term loans, end the run-out of cash from deposit can happen overnight. Banks make profits by selling liabilities with one set of characteristics (a particular combination of liquidity, risk, size, and return) and using the proceeds to buy assets with a different characteristics (=asset transformation) BANK MANAGEMENT 1) To keep enough cash on hand, the bank must engage in liquidity management, the acquisition of sufficiently liquid assets to meet the bank’s obligations to depositors (deposit outflows). 2) The bank manager must pursue an acceptably low level of risk by acquiring assets that have a low rate of default and by diversifying asset holdings (asset management). 3) The third concern is to acquire funds at low cost (liability management). 4) Finally, the manager must decide the amount of capital the bank should maintain and then acquire the needed capital (capital adequacy management). Excess reserves are insurance against the costs associated with deposit outflows. The higher the costs associated with deposit outflows, the more excess reserves banks will want to hold. Assets management: We want to diversify assets, avoid concentrating too much on one asset. After you place a loan there is the problem of monitoring, checking from time to time if there are signals of worsening conditions of borrowers. Banks try to find borrowers who will pay high IR and are unlikely to default on their loans . The bank must manage the assets’ liquidity in order to satisfy the reserve requirements. Liquidity management: We can split the problem of liquidity into two parts: - Long-term: do I have access to sources of funds that can back up my assets? I rase long-term funds → I employ short-term funds. - Short-term is the other side of the coin: the same liability that are funding you are also the same absorbing liquidity. Bonds are sources of liquidity but they are also absorbing liquidity at each coupon payment. Managing liquidity is very costly: they also liquidities require plans. Capital management: You need to have enough capital for 3 reasons: - To absorb losses. (A bank maintains bank capital to lessen the chance that it will become insolvent) - To reward shareholders (they want dividends that are consistent with the risk they are taking). - To reach requirements of minimum reserve. A regulator wants to avoid that a bank goes bankrupt leaving creditors with no money; they want to protect mainly depositors. Sometimes the objectives are similar (optimization), sometimes they are in conflict. FINANCIAL STRUCTURE OF BANKS BANKS AND NPLS Non-performing loans are loans in which the borrower is in default and hasn't made any scheduled payments of principal or interest for a certain period of time. They are increasing in volume, but we can spot them in time and provide response measures to avoid them: - We can scrutiny clients and monitor them (are they still making profits, still growing? Or are there any bad signals?) - We can ask for collaterals or apply conditions (as long as you have this loan, you can’t do certain things) - We can work on pricing: higher interest rates for riskier clients; provisions and write-offs - We can use lawyers to push people to pay; you can sell loans and securitize them. Banks with NPL → decrease dividends because money has to go to LLP (Long Lost Provisions) 12. MUTUAL FUNDS Mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. They achieved a size that makes them comparable to banks in terms of importance. We met then when talking about money markets. IR in money markets at a certain point was higher than the one for deposits, so we had the idea to allow people to participate the money market. WHY MUTUAL FUNDS? Impressive exponential growth in the last decades closely linked with their competitive advantage: • Liquidity of investments → advantage compared to stocks (investments convertible in an easy way into cash) • Access to securities sold at large-denominations (access to large denomination assets) • Diversification also for small-invested capitals (we can increase the level of diversification for each investor) • Affordable fees VS huge transaction costs (fixed cost is spread on a large base) • Provision of expertise on a continual basis (you get expert services) • Cheap and quick transferability of funds STRUCTURE