Financial Markets, Credit and Banking (chapters 1 e 2), Appunti di Economia E Tecnica Dei Mercati Finanziari

Scarica Financial Markets, Credit and Banking (chapters 1 e 2) e più Appunti in PDF di Economia E Tecnica Dei Mercati Finanziari solo su Docsity! Markets and institutions (intermediaries) are primary channels to allocate capital in our society , in fact they have been created to facilitate the transfer of funds from economic agents to have surplus funds to ones that are in need of funds. Proper capital allocation is important since it leads to economic growth and individual and social wealth . To maximise the potential growth, markets and institutions must create methods to attract savers excess funds and then give those funds to the best users possible. FUNCTION OF FINANCIAL SYSTEM Financial markets funds are transferred to (the subjects/agents of financial markets): a) Lender-savers (they have funds to invest): Households (considered main savers), Business firms, Government, Foreigners (in open economies they can save and invest their savings in other country) b) Borrower-spenders (they look for funds to invest because their ability to generate savings is not sufficient to finance their investment projects): Business firms (considered main spends), Government, Households, Foreigners Therefore, in financial system we have different counterparts and between them there are Financial Intermediaries and Financial Markets. The transfer from Lenders to Borrowers happened via these two channels: o DIRECT CHANNELLING OF FUNDS when the channel is the Financial Markets. o INDIRECT CHANNELLING OF FUNDS when the channel is the Financial Intermediaries. SIX PARTS OF THE FINANCIAL SYSTEM (Cecchetti & Schoenholtz) 1. Money - to pay for purchases and store wealth. Money is a mean of payment, unit of account and store of value. Money has changed from gold/silver coins to paper currency to electronic funds, now cash can be obtained from an ATM anywhere in the world and transactions made, are everyday more, online. Growing use of technology and sophistication of the payment system. 2. Financial Instruments - to transfer resources from savers to investors and to transfer risk to those best equipped to bear it. Financial Instruments: The written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under specified conditions. Contracts specify the nature and the conditions that characterize financial contracts.  Financial instruments obligate one party (person, company, or government) to transfer “purchasing power” to another party.  Financial instruments specify payments that will be made at some future date.  Financial instruments specify conditions under which a payment will be made.  Means of payment – stores of value – transfer of risk (e.g., insurance).  The enforceability of the obligation is important. Buying and selling individual stocks used to be, in the past, only for the wealthy individuals but today we have mutual funds and other stocks available through banks or online, so putting together a portfolio is now open to everyone. The finance is much more democratic today. 1 CHAPTER 1 3. Financial Markets - to buy and sell financial instruments. Financial markets are places where financial instruments are bought and sold. - Markets are the economy’s central nervous system. - Markets enable both firms and individuals to find financing for their activities. - Markets may promote economic efficiency. Organized markets were created starting from the XVII century. Nowadays transactions are mostly handled by electronic markets (ex. NASDAQ), this has reduced the transactions cost and increases the availability of different financial instruments. Financial markets refer broadly to any marketplace where the trading of securities occurs. The market is a complex organization, and it is always characterized by operating rules. The roles of financial markets:  Market liquidity: Ensure owners can buy and sell financial instruments cheaply. Keeps transactions costs low.  Information: Pool and communication information about issuers of financial instruments  Risk sharing: Provide individuals a place to buy and sell risk. They range from regulated markets (covered by special general rules and supervision, see Law on Finance (TUF), Legislative Decree 58/1998) to so-called over the counter markets (OTC: literally "over the counter") Markets can be restricted to particular categories of traders or open to the public and in particular to end-investors. Another distinction is between wholesale and retail markets. PRIMARY VERSUS SECONDARY MARKETS Primary markets  Markets in which borrowers (corporations and governments) raise funds by selling newly issued financial instruments (stocks and bonds). So, the primary markets are the immediate link between the financial system and the real economy. Primary markets are important for the collection of funds. When we are in primary markets, we use SUBSCRIBE/UNDERRATE instead of BUY/PURCHASE.  Examples of primary markets: government bonds auctions, placements of private issuers (Public offerings of seasoned stocks/ IPOs) Secondary markets  Markets where people trade (buy/purchase and sell) existing financial instruments (e.g., NYSE and Nasdaq, Italian Stock Exchange). Secondary markets are important because we can trade or negotiate.  The secondary market does not provide new resources to deficit units, but it is critical to: - Ensure liquidity (money) to the investors. - Provide price discovery that permit assessment of the securities issued in the continuous (and therefore to make possible the investment/divestment of institutional and private investors). The higher is the development of secondary markets in terms of liquidity provisions and price discovery the more they are desirable, and they are necessary because they are the only way to transform into cash a security which otherwise you will have to wait until the maturity of that financial contract. When we access a financial instrument not only, we have to access it according to the conditions which we know as far as concerned that contract, but we need also an efficiency secondary market because otherwise you will have a good security but if you cannot make it liquid it is going to be a 2 Derivates appeared in 1970s because in that period there was the breakup of the Bretton Woods agreement, we had the oil shock which created a lot of inflation and so we had a lot of volatility in the currencies. So, derivatives in the early 1970s started to acquire huge importance and they were used both to speculate but also to hedge the exposure to different types of risks which can be related to changes in interest rates, changes in foreign exchange, changes in stock prices, so we can use them basically for speculation or hedging, for example, I fixed today the price at which I will buy US dollar in 3 months. Derivatives started to become popular in the 70s also because of the Black and Scholes formula that was a very simple way to price swaps, which are a kind of derivative. But at that time the possibility to run the Black and Scholes formula was also due to another important innovation: COMPUTERS. Computers start to become an important tool for computational reasons and so the higher is the demand of computation to be made to price complex financial tools and the more sophisticated has to be the tool that you use for computational reasons. So, the emergence of computers was important to make possible also the creation of complex financial products like derivatives which demand in some cases high computational abilities. However, derivatives are not something new. Historians of financial instruments found that Romans used to sign contracts with the Egyptians to buy grains. They used to sign this contract to fix the price at which they will have both grains in the future. In this way, they tried to be less exposed to the risk of price changes until the time the grain was ready to be delivered to Italy. Romans started to use forward contracts which is a kind of derivative and the Dutch businessmen started to introduce options contracts in the 16th century to trade options on tulip bulbs. In the 1990s, we had some new derivatives like the so-called credit derivatives, which are different kind of derivative, like for example CDS Credit Default Swaps and nowadays we have also sophisticated derivatives like for example, weather derivatives which are used for speculation and for hedging and they are also another kind of derivatives. Derivative security markets are markets in which derivative securities are traded. Derivative security is a financial security whose payoff is linked to another, previously issued securities or commodities (such as a security traded in the capital or foreign exchange markets). They generally involve an agreement between two parties to exchange a standard quantity of an asset at a set price on a specific date in the future. As the value for the underlying security to be exchanged changes, the value of the security changes. The main purpose of the derivatives markets is to transfer risk between market participants. Why are they called “derivatives”? Because of two reasons: 1. First, because they exist thanks to the existence of an underlying asset. So, you cannot create a derivative without an underlying asset, so their existence derives from the existence of an underlying asset. This underlying asset can have a financial nature, so we talk about financial derivatives (for example, stocks, bonds, currencies, loans or stock indexes) or can have a non-financial nature typically identified as commodity derivatives (for example, oil, silver, gold, rice, cotton). 2. Second, because of their price which depends on the price of the underlying asset. Sometimes there is a direct relationship therefore if the price of the underlying asset increases also the price of the derivative increases. In some cases, instead, is indirect so when the price of the underlying asset increases, the price of the derivative decreases. It depends on the kind of financial contracts we are speaking about. Derivatives can be traded in two main types of derivative security markets:  Exchange listed derivative markets (so regulated markets) are generally liquid and involve no counterpart risk. o Many options and futures contracts  Over the counter derivative markets (OTC): are custom contract negotiated between two counterparties and have default risk. The derivatives traded in OTC markets will be much more complex and sophisticated but, of course, they will lack of transparency and regulations even though both the US regulators and the European regulators after the breakup of the international financial crisis of 2007-2008 introduced specific roles as far as concerned OTC derivatives: so we cannot say that they are completely unregulated nowadays, 5 because, both in the US, with the Dodd-Frank Act, and in the EU, with the EMIR (European market infrastructure regulation), there are rules on OTC derivatives. o FX forward contracts o Forward rate agreements (FRAs) o Swaps (often used by banks to hedge the interest rate risks). In the OTC market, we can find a typical financial instrument which is represented by swaps. Swaps are OTC derivatives, they can be very tailored, and they can have, as an underlying asset, interest rates, foreign exchange rates, credits like loans or also stock indexes. MARKET EFFICIENCY Market in order to be desirable should have some characteristics: - Completeness efficiency: a complete market satisfies two conditions, on one side has negligible transaction costs and perfect information, on the other assures a price for every asset. Therefore, it ensures complete contracts for all operators across the different maturities for all possible states of nature (Arrow-Debreu, 1954). But unfortunately, markets are not complete. We know that, even though financial systems and financial markets are growing with the creation of new financial instruments day by day, financial markets are still far from being complete. - Information efficiency: states that prices that are formed instantaneously reflect all available information. There is no way to "beat" the market because there are no undervalued or overvalued securities available (Fama, 1970). Fama introduced three degrees of information efficiency that take into account the quality of information that are available to investors: a) Weak  In the weak form investors have only historical information, but future stock prices cannot be predicted on the basis of past stock prices. b) Semi-strong  In the semi-strong form investors have both historical information but also some information which are relative to compulsory information like for example changes in the management of a listed company. They have information more often like quarterly. c) Strong  In the strong form investors have stock prices incorporate all info (also private), and prices will react as soon as new info is generated. - Fundamental efficiency: the prices that are formed are the economic foundations of the value of financial assets. The prices are derived from a discounting of future cash flows (dividends, cash flow, …). Fundamental Value does not mean objective value but simply the value that expresses the expected future cash flows and rates of return required. In the short term the fundamental value (FV) may differ from market prices. Here speculators play an important role in order to fill the gap. Requirements for market efficiency:  Width: large order volumes  Thickness: thick price distribution  Elasticity: reactivity of orders for limited price variations The modification of organizational and operational characteristics of financial markets are aimed to improve the efficiency conditions and pricing (price discovery). Price discovery is the process of determining the price of an asset in the market though the interactions of buyers and sellers. Price discovery is influenced by many factors that can change the price at which both sides are willing to trade: structure and development of the market, security type and info available. Again, information is very important since individuals with better info usually have an advantage in the market. 6 4. Financial Institutions (particularly financial intermediaries) - to provide access to financial markets, collect information & provide services. Financial intermediaries can offer services which are related to the functioning of financial markets, money markets, capital markets, primary and secondary markets but they can also involve in other activities, for example credit intermediation, like banks. Banks collect funds from depositors and use these funds to grant loans to borrowers. Intermediaries, in this case, can be involved in the so-called indirect channel of financial intermediation because the funds are not given straightly from savers to borrowers, but they are intermediated by financial intermediaries like banks collecting funds from depositors and granting them to borrowers. Intermediaries can also be involved in the management of collective portfolio like for example investment or pension funds or in offering insurance contracts. Financial intermediaries, whatever they are called, exists because they are able to exploit some advantages in terms of costs:  To reduce transaction costs by specializing in the issuance of standardized securities  To reduce the information costs of screening and monitoring borrowers  To give savers ready access to their funds Banks began as vaults, developed into institutions, to today’s financial supermarket. They offer a huge assortment of financial products and services and can be defined as corporations that provide services as intermediaries of financial markets. Three main types of financial institutions:  Deposit institutions manage deposits and make loans (ex. banks, credit unions, mortgage loan companies)  Contractual institutions (insurance companies, pension funds)  Investment institutions (invest banks) Financial institutions, and specifically those financial institutions like banks, stay in between those which are savers and those which are borrowers, and they have different role depending on the channel, if it is direct or indirect. Although both channels transfer funds from saver-lenders to borrower-spenders, they are distinguished in one important aspect:  Direct financing: borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrower’s future income or assets. In this case securities are assets for the person who buys them, and they are liabilities for the individual or firm that issues them. In this case the primary 7 e) Reception and transmission of orders f) Advice on investments g) Management of MTFs (Multilateral Trading Facilities): Financial intermediaries can be involved with the management of trading platform which are a self-regulated financial trading venue. They can create trading platform which are alternatives to the traditional stock exchanges where a market is made in securities, typically using electronic systems. TYPES OF BROKERAGE SERVICES ® Brokers: individual/firm who works exclusively for third parties by facilitating the cross between supply and demand since it will buy and sell securities for its clients, at client’s wish. They can also offer information services, but they mostly act as intermediaries/agents. They are compensated either trough commission, fees or income but they don’t own any assets. ® Dealers: individual/firm who operate on its own account; in fact, they neither operate on behalf of a client nor facilitate transactions btw parties. They are important since they hold their own portfolio of financial assets that they use to respond promptly to the trading needs of other operators, expressing the bid and ask; in fact, they are the market makers who provide the bid and ask quotes you see when you look up the price of a security in the OTC market. They also help to create liquidity in the markets ensuring the continuity of trades and boosting long-term growth. They are not paid a commission; they will earn by the selling of their assets at a later stage. ® Market makers: are operators acting on their own account and who are committed to make public pricing conditions at which they are willing to negotiate (the bid and ask), so they are committed to "make a market". Their primary goal is to profit on the bid-ask spread. They are compensated for the risk of holding assets because they may see a decline in the value of a security after it has been purchased from a seller and before it is sold to a buyer. The main difference between dealers and market makers is that market makers stands in an exchange (place where everyone trades against everyone, buyers post bid price and sellers post ask price, then when a trade occurs everyone sees the transaction price) while a dealer operates in OTC market (this market lack of transparency since you can only see the price the dealer quotes you, and you can usually compare quotes at different dealer but there is no centralized place that displace all quotes – thus dealers can give you different quotes depending on who you are, think about used car dealers). 10 NB: Bids (offerte): prices at which buyers are willing to buy. Asks (domande): prices at which sellers are willing to sell. Bid-ask spread (differenza tra domanda e offerta): amount by which the ask price exceeds the bid price (the more an asset is liquid, the less spread) WHY DO FINANCIAL INTERMEDIARIES EXIST? Because financial intermediaries are an important component of financial systems. They are involved in the indirect channelling of funds, that is specifically the case of banks, which raise funds through the issuance of primary liabilities and then use these funds to lend money to different kinds of borrowers. In the indirect channel, we can also find some other intermediaries which are involved in credit intermediation activities, like for example the finance companies, which are specialised in the provision of different kinds of lending like leasing, factoring for fitting, consumer loans or even mortgages. Instead, in the direct channel, those who have funds to be invested into projects, subscribe or buy liabilities which are issued stately by agents who are looking for funds, like for example companies or the government, but financial intermediaries are also active within the direct channel of funds because they provide different investment services. Economies of scale on transaction costs One possible explanation relies on the exploitation of economies of scale: intermediaries exist because they can exploit economies of scale in terms of transaction costs. Gurls and Shaw  Search costs: The first type of transaction costs is search costs because if you have money and you want to invest them in the liabilities of a borrower investing in some specific projects and you want to participate as creditor or as shareholder you need to search markets facilitating searching costs because the issue of new securities is concentrated into markets.  Screening costs: Then we need to understand the solvency of this counterparty (screening costs). So, whether I want to become a shareholder or a creditor of this counterparty, I need to go through and analytical process which allowed to understand whether the counterparty will be solved in the future: producing dividends in in the future as a shareholder or for example allowing the value of the stocks to grow overtime. Screening costs are also time-consuming since they need some abilities to collect information and this information may be also not ready accessible to everybody.  Costs to produce financial contracts: There are some other costs like the costs to produce financial contracts. Once you identify a potential counterparty then it is necessary to define the contract which regulate the exchange of funds between you and the counterparty. So, of course, we need time and skills in terms of legal knowledge to write the contract and make it enforceable, but they required costs.  Monitoring costs: In addition, it is also important to consider the monitoring costs because once you sign a financial contract and you become a shareholder of a company buying in the secondary market shares of Generali but once you buy the stocks the story is not ended because you need to monitor the behaviour of your investments, so you need to check what is called monitoring. So, intermediaries since they run their activities in favour of large number of counterparts, they may exploit economies of scale. For example, they have departments which are involved in the analysis of new potential borrowers and also technologies and competences: they can exploit these technologies and skills for a huge number of potential borrowers so in this way they exploit economies of scale. 11 When intermediaries act as brokers within the financial markets (direct channel of funds) they can also exploit economies of scale because they are able to set up an organisation, use some different types of technologies and the higher the number of customers with which they are in touch, the higher is the exploitation of economies of scale. Gurley and Show, almost 50 years ago, wrote the theory about the existence of transaction costs and the possibility for intermediaries to exist because of the exploitation of economies of scales on transaction costs. Provision of liquidity services The second reason is the provision of liquidity services. This is specifically the reason of the existence of banks: banks, via the acceptance of deposits, which are redeemable at any moment, is providing a very high level of liquidity services. Some other financial intermediaries may also provide some kind of liquidity services like investment fund (or also pension fund or insurance contract): in an open hand investment fund you can ask to the asset management company to sell your units and this units will be transformed into liquidity, not immediately, but in few days. So, there are some other intermediaries offering liquidity services but their abilities in terms of liquidity services are lower than what is offered by banks. Another advantage of banks is the fact that when you are to the bank to withdraw money, the bank is going to give you exactly the money you asked to withdraw. Instead, if you ask to the asset management company to sell your units and to transform them into liquidity then, the money which will be paid to you depends on the value of the portfolio which is runed by the asset management company. So, you will not be sure that you will receive the money exactly you invested. This risk is not faced when you deposit your money to banks because they are obliged to redeem the money at their nominal value. So, there is no risk of loss. Risk sharing provision Intermediaries may exploit risk sharing provision. That is the case for example of one of the activities which is defined under the expression of asset transformation.  Asset transformation This is typically the case of banks. Banks collect deposits which are usually small size deposit, they are short term or more in general they are at site, they provide liquidity services for those deposits which are a large part of the liabilities of banks. Then they use these funds to grant different type of loans which usually carry maturities much larger than the maturity of the liabilities collected by banks. In this case, banks are able to run what is called a maturity transformation because they raise funds in the short term, and they use these funds to grant loans with a medium or long-term maturity. The bank is running an important activity allowing to reconcile the different preferences of two counterparts which in the market will never meet because they have different preferences and so they cannot meet: they have different preferences in terms of risk, maturity and size of the amounts. This reconciliation between these two counterparties is made by intermediaries, in this case by banks, which carry the risks which are associated with this transformation because they transform the liabilities collected from the depositors of savers and they make them available to borrowers having different preferences. This transformation is run by intermediaries because in some cases markets cannot allow this matching because the two counterparties have different set of preferences.  Portfolio diversification On the other side, financial intermediaries are able to exploit the benefits of portfolio diversification. For example, the bank is able to get in touch with different kind of borrowers, belonging to two different sectors of activity. They can also explore the different kind of loans, secured and not secured, short-term, medium and long-term, with different type of borrowers, household, firms or some other counterparties. So, they are 12 The return of financial instruments is made of different components. It can be due to: a) Interest rates (this is the case of debt securities) are the costs paid by the borrower for having borrowed some money from the counterparty. So, it is the cost of money. The interest rate could be of different types: o nominal (coupon) o real o fixed o floating b) Dividends are some shares of earnings that companies distribute to shareholders. So, dividends are the components of return provided by some specific financial systems like stocks. Dividends allow shareholders to participate to the profits made by the company. c) Price changes can be determined by different factors. d) FX changes can decrease or increase your return if the investment you are choosing is denominated in another currency. e) Inflation can increase or decrease your return since the higher the inflation rate, the lower the purchasing power. to evaluate the profitability of a future investment I have to discount it with the yield maturity ex-post represents actual values (what they earn, not what they estimate). RISKS FACED BY FINANCIAL INSTITUTIONS All face a variety of risks that can be generally divided into two types: 1. Financial risks: Credit risk (or default risk on loans, stocks, bonds) is the risk that the promised cash flows from loans and securities held by financial intermediaries may not be paid in full. Financial intermediaries make loans or buy bonds backed by a small percentage of capital. Thus, banks, thrifts, and insurance companies can be significantly hurt by even minor amounts of loan losses. Many financial claims issued by individuals or corporations have: Limited upside return (with a high probability) Large downside risk (with a low probability) It means that intermediaries granting different type of credits like loans or subscribing bonds, they are with a high probability exposed to the fact that the credit will be repaid, and they will gain the interests which are associated with those credits. So, this means limited upside return which is the possibility to gain the interests which were contractually agreed with the high probability: we associate to these risks the given probability to profit and the probability to lose. In the case of credit, we are exposed to limited upside return which is profiting receiving the interests with the high probability. So, in the majority of cases the credit will be repaid by the counterparty but there is also a low probability that the loan or the credit granted will not be repaid in full or totally. A key role of FIs involves screening and monitoring loan applicants to ensure only the creditworthy receive loans. FIs also charge interest rates commensurate with the riskiness of the borrower. Liquidity risk is the risk that a sudden and unexpected increase in liability withdrawals may require an FI to liquidate assets in a very short period of time and at low prices. 15 Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched and interest rates are volatile. Market risk is the risk incurred in trading assets and liabilities due to changes in interest rates, exchange rates, and other asset prices. Foreign exchange (FX) risk is the risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in foreign currencies. Country, or sovereign, risk is the risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments. Sovereign entity is the risk that a sovereign entity will not be able to meet its own obligations. Off-balance-sheet (OBS) risk is the risk incurred by an FI as the result of activities related to contingent assets and liabilities. 2. Operational risks: technology, human errors and fraud, legal and compliance, reputation, natural disasters, Operational risk is the risk that existing technology or support systems may malfunction or break down. Insolvency risk is the risk that an FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities. Changes in regulatory policy constitute another type of discrete or event-type risk. Macroeconomic risks include increased inflation, inflation volatility, and unemployment. Cyber risk is the loss that arise when information technology systems fail or are compromised. GLOBALIZATION OF FINANCIAL MARKETS AND INSTITUTIONS The pool of savings from foreign investors is increasing and investors look to diversify globally now more than ever before thanks to technological improvements that allowed more immediate and cheaper access to real-time data worldwide. Information on foreign markets and investments is becoming readily accessible and deregulation across the globe is allowing even greater access, furthermore international mutual funds allow diversified foreign investment with low transactions costs. Global capital flows are larger than ever. ((financial crisis helped to understand how countries are interconnected – no country was excluded)). The significant growth of foreign fin markets is due to the increase in the pool of savings in foreign countries, the investors ‘will expand investments opportunities and improve the portfolio risk. REGULATION OF FINANCIAL INSTITUTIONS FIs are heavily regulated to protect society from market failures and from the possibility of fraud, in fact regulations impose a burden on FIs. Regulators attempt to maximize social welfare while minimizing the burden imposed by regulation. When one FI defaults, the wealth of many people can be destroyed unless the gov intervenes (the gov can handle a limited number of simultaneous failures). An economic crash is cause by the contagious of failures btw FIs, that is when the failure of one or few FI causes the failure of others. Before the fin crisis policies were deregulatory in nature, but nowadays the trend is changed in order to limit risks and to promote fin stability. 16 REGULATION OF FINANCIAL SYSTEMS The crucial nature of the functions performed by the financial systems justifies the extensive regulatory activity that distinguishes them. The need to prevent "failures" in the system is connected to the charges related to a market crisis, the impact of it on the confidence of the market participants and on the growth of the economies involved. The globalization of financial intermediation makes more important to strengthen the measures for the coordination of supervision and harmonization of international regulations. AIMS OF FINANCIAL REGULATION 1) Increasing the information available to investors to reduce the adverse effects of asymmetric information. 2) Ensuring the stability of the financial intermediaries by: □ Standards containing restrictions on entry into the financial system by financial intermediaries. □ Mandatory information produced by financial intermediaries. □ Rules on control and containment of the risks taken by financial intermediaries. □ Insurance of deposits / investors □ Restrictions on competition and on interest rates ITALIAN REGULATORY AND SUPERVISORY AUTHORITIES  Bank of Italy contributes to the decisions of monetary policy (within the Euro system) and is responsible for the implementation of monetary policy on the Italian territory. It performs the function of supervision of banks and financial intermediaries for the purposes of sound and prudent management and protection of overall stability and efficiency of the financial system (as part of the Single Supervisory Mechanism of the ECB) it has the right to make inspections to all fin intermediaries.  Consob performs the functions relevant to the protection of investors in the aspects of fairness and transparency with regard to financial instruments and issuers, financial intermediaries and markets  Ivass (Institute for the supervision of insurance) supervises the insurance companies for sound and prudent management, transparency and ethical behaviour and stability and efficiency of the system.  Covip (Supervisory Commission on pension funds) supervision of operations of the pension fund system for the protection of savings in private pension funds. To this end, the correct and transparent administration and management of pension funds.  Agcm (Competition Authority and the market) supervises the agreements restricting competition on abuse of dominant position and merger filing. EUROPEAN SYSTEM OF FINANCIAL SUPERVISION (ESFS) This system consists of the European Systemic Risk Board (ESRB) and the three European Supervisory Authorities (ESA)-ESMA based in Paris, -the European Banking Authority (EBA) based in London (after Brexit, Paris will be the new location) -the European Insurance and Occupational Pensions Authority (EIOPA) based in Frankfurt. The ESRB monitors and evaluates potential threats to financial stability that arise from macroeconomic developments and from developments within the financial system as a whole (“macro-prudential supervision”). THE EUROPEAN BANKING UNION The Banking Union is founded on a single supervisory mechanism and a single banking crisis resolution mechanism for the euro-zone countries. 17 This supply and demand of funds is also made by agents which, in some cases, act as “Surplus” agents (having funds to be supplied) or “Deficit” agents (demanding for funds). The match between this dynamic of demand and supply of funds from surplus agents and deficit agents determine the “Equilibrium” rate. The loanable funds theory of interest rate determination views the level of interest rates in financial markets as resulting from factors that affect the supply (for example, from households) and demand (from corporations) for loanable funds. This is similar to the way that the prices for goods and services in general are viewed as being the result of the forces of supply and demand for those goods and services. The loanable funds theory says that we can find different interest rate equilibria which reflect the demand and supply and that any time the interest rate deviate from the equilibrium level there are forces that bring the level of interest rate to converge to the equilibrium level. If the interest rate goes above the equilibrium level, there will be an increase of supply because as interest rate increase also supply increase, but if the supply increases it will push the level of interest rate to decrease. If the interest rate goes below the equilibrium level, this will attract a lot of borrowers that want to borrow at that level of interest rate, but exactly as consumers demand heavily a given good and that will make the price to increase, that will happen also to interest rate. So, if the demand is growing that will make the interest rate to increase and to converge to the equilibrium level. LOANABLE FUNDS THEORY - INSTITUTIONAL SECTORS CLASSIFICATION Central Banks use this Theory to estimate the supply and demand of funds from specific groups of institutional agents (that are households, business, government and foreign sources) through their flows of funds accounts. Their interaction within a specific Economic Environment will ultimately determine the dynamics of Interest Rates (Some of these groups will offer and others demand funds). In order to identify the key groups of “agents” that loan one another the “funds”, the Market Regulator (Central Bank) defines the criteria of their key characteristics in order to create homogeneous groups of agents being financially independent and having each their own separate book-keeping. a) Non-financial firms (for example, manufactories companies or companies providing services but not being financial intermediaries) are state owned and private non-financial firms with more than 5 employees. b) Financial firms are banks, finance companies, investment firms, asset management companies, insurances, regulatory and supervisory authorities but also financial advisors, credit and insurance brokers. 20 c) Public administration is government and municipalities. d) Households and not-for-profit organizations are households and family firms with less than 5 employees and not-for-profit organizations. e) Foreigners: the balance of the foreign sector is provided by the balance of the Foreign Trade Balance between Italy and foreign countries. Based on such Classification, Central Banks can determine an accounting scheme (of the likes Corporations use to determine their own Account Statement and their Balance-sheet) to see how each category of Institutional Agents manages their own Stock and Flow of money. This enables the Central Authority to “trace” and “detect” the dynamics of Supply and Demand of money based on the “Surplus” and “Deficit” each Institutional Agent shows from time to time. LOANABLE FUNDS THEORY – FINANCIAL BALANCE FOR INSTITUTIONAL AGENTS Bank of Italy calculates the financial balance: Households FB = S – I Non-financial firms FB = S – I Financial firms FB = S - I Public Sector FB = (T- G) – I Foreign Trade Balance FB = M – X (National current account balance) T = Taxes; G = Current Expenditures; M = Exports; X = Imports; I = Real Investments; S = Savings Traditionally, households and family firms have a positive financial balance, so they are typically surplus agents (providers of funds), because they have savings in excess of their real investments, therefore, they are able to supply funds to those demanding funds within the financial system. Why households or family firms are surplus agents? Because real investments are few and so, they are able to save over time. Instead, non-financial firms are typically deficit agents because they usually exhibit negative financial balance: they look more for funds because their saving abilities are very low. Financial firms have sometimes a slightly positive sometimes a slightly negative financial balance. The public sector is a deficit agent because it is a typical investor, and its saving activities are not enough to finance its investments. If foreign trade balance is positive, exports are above imports, and it means that it is Italy financing the foreigners, so the foreign sector is a debtor vis a vis Italy. A SCHEME FOR THE FINANCIAL BALANCE Each Institutional Agent is thought as running its own Financial Balance based on the scheme below: T A1=T A0+ I+∆ FA T L1=T L0+S+∆ FL 21 TA = Total Assets TL = Total Liabilities I = Investments S = Savings FB = Financial Balance (Imbalance if < 0) SURPLUS Agents DEFICIT Agents F B1=S−I=∆ FA−∆ FL How can we measure the financial imbalance? We can measure the financial imbalance in two ways:  As the difference between S and I  As the difference between the FA and FL because any imbalance between S and I trigger changes in the financial position of that institutional sector. LOANABLE FUNDS THEORY – SUPPLY SIDE: DETERMINANTS OF HOUSEHOLD SAVINGS One important institutional sector as provider of funds to the rest of the financial system is household.  Income (Y) is primarily used for consumption (C). Generally, Y > C and so it follows that Y - C = S (savings): the greater the wealth or income, the greater the amount saved.  S may be not a residual variable: i.e., some agents define S and adapt C as a function of Y.  S is used to fund the investment process (I) in real terms. 1. Income and wealth: the greater the wealth or income, the greater the amount saved. 2. Cultural attitudes about saving versus borrowing. 3. Credit availability: the greater the amount of easily obtainable consumer credit, the lower the need to save. 4. Job security and belief in soundness of entitlements. 5. Interest rates: savings increase with higher interest rates. 6. Tax policy: taxation on savings and/or passive interests on loans/mortgages deductibility alter household’s attitude towards savings. LOANABLE FUNDS THEORY – DEMAND SIDE: DETERMINANTS GOVERNMENT DEMAND FOR FUNDS Governments borrow heavily in the markets for loanable funds. National debt (and interest payments on the national debt) have to be financed in large part by additional borrowing. • Governments borrow to fund temporary imbalances between operating revenues (i.e. taxes) and budgeted expenditures (i.e. school constructions, public infrastructures, public health systems, etc.). At present, the eruption of the Covid-19 pandemic is triggering precisely such a rush to raise fresh capital through issuance of new debt instruments. • Governments (especially highly indebted ones like Italy) normally try to reduce their outstanding debt and this should reduce the potential for crowding out and/or dependence on foreign investment flows. LOANABLE FUNDS THEORY – DEMAND SIDE: BUSINESS DEMAND FOR FUNDS Business invests also according to the level of interest rates: when the cost of loanable funds is high (i.e., interest rates are high), businesses finance internally. Another factor is the expected future profitability vs. risk: the greater the number of profitable projects available to businesses, the greater the demand for loanable funds. And also the expected economic growth. 22 TA = Total Assets TL = Total Liabilities I = Investments S = Savings FB = Financial Balance (Imbalance if < 0) Financial Balance The blue line is less risky, the black line is riskier. The less risky diminishes the interest rate compared to the riskier (since the holders of the riskiest must be compensated more since they face risks). The difference between the two is called premium (or spread). This (spread) is a simple way to gauge the Default Risk Premium (DRP) for an aggregate group of similar Debt Securities through time versus a conventional benchmark. 25 4. Liquidity Risk (LRP): risk that a security cannot be sold at a predictable price with low transaction costs on short notice. A highly liquid asset is one that can be sold at a predictable price with low transaction costs and thus can be converted into its full market value in a short term. If a security is illiquid, investors add a Liquidity Risk Premium (LRP) to the interest rate on the security, so the effect is direct. Liquidity premium can be easily measured comparing two securities issued by the same issues. In this case, we compare a 10-year Treasury (in blue) and a 3-month U.S. Treasury Bill. We notice the interest is higher for investors investing in the 10-year when compared to the one for 3 months (since the 3months are short term and more liquid). The difference between the two is the spread/premium. This (the spread) is a simple - albeit approximative - way to gauge the Liquidity Risk Premium (LRP) for debt instruments issued by the same issuer whose key difference is their time to Maturity. 5. Special Provisions or Covenants (SCP): are provisions (such as bond convertibility, callability, taxability...) that impact the security holder beneficially or adversely and, by this, are reflected in the interest rates. Generally, when the benefits are provided to the security holder (ex. convertibility of shares) the rates are lower; instead, when the benefits are given to the security issues (callability – callable bonds) the rates are higher. 6. Term to Maturity (MP): is the length of time a security has until maturity (the relation between rates and maturities is often called term structure interest rates or yield curve - this is a comparison of rates assuming that all characteristics are the same except for maturities). The change in interest rates due to maturity is called MP - maturity premium. The effect is direct, the longer the maturity and the higher the rate. 26 TERM STRUCTURE OF INTEREST RATES: THE YIELD CURVE The datapoint-plot called “Yield Curve” is a combination of maturities on the x-axis and the yields to maturity in the y-axis. This provides us the so-called Term Structure of Interest Rate or Yield Curve. It can have different shapes: a) Upward Sloping since the higher the time to maturity, the higher the yield to maturity. b) Inverted or Downward Sloping since greater the time, the smaller the yield. c) Flat so for each expected maturity we have the same yield to maturity. We have three key Explanatory Theories that examine the shape of the Term Structure of Interest Rates (so the relation between a security’s interest rate and its remaining term to maturity): 1. Unbiased Expectations Theory (UET) This theory demonstrates that at any given point in time, the yield curve reflects the market’s current expectations of future short-term rates. As such, the return for holding a four-year bond to maturity should equal the expected return for investing in four successive one-year bonds. In other words, and in a more formalized mathematical way, we say that the long-term interest rate is the geometric average of the current and expected future short-term rates governing each holding period between now (t=1) and the end of our investment horizon (t=T). Current long-term interest rates (1RN) are geometric averages of current and expected future, E(Nr1), short term interest rates. 1RN=¿¿ 1RN = actual N-period rate today (1) N = term to maturity, N = 1, 2, …, 4, … 1R1 = actual current one-year rate today E (i r1) = expected one-year rates for years i = 1 to N The non-arbitrage condition postulated by the UET mandates that the compounded return obtained through a 4-years straight investment must be equal to the product of the shorter-period returns. 27 The market segmentation theory claims that there are two or three distinct maturity segments (the segments are ill-defined) and market participants will not venture out of their preferred segment, even if favorable rates may be found in a different maturity. At the same time, a sufficient interest rate premium may induce investors to switch maturity segments. The idea behind segmentation is that institutions naturally have liabilities of a distinct maturity, ex. life insurers have long term liabilities, so they will tend to invest only in long term financial instrument (so they will not invest short term). Hence, there is no or only a very weak relationship between interest rates of different maturities and the fact that supply and demand of a given maturity sets the individual interest rates. IMPLIED FORWARD RATES A forward rate (f) is an expected rate on a short-term security that is to be originated at some point in the future. The one-year forward rate for any year, N years into the future is: N f 1=¿ A forward rate is a rate that can be computed from the existing term structure, so it is a mathematical tautology since given a set of long-term zero-coupon spot rates one can find the set of individual one year forward rates. For instance: ¿ ¿ means that 1R6 and 1R5 are the long-term zero-coupon spot rates from today to year 6 and 5 respectively and F stands for a forward rate. The first subscript refers to the loan origination date, where 1 means “today”. The second subscript refers to the term to maturity. Since all the spot rates are known (they are plotted on the Yield Curve, see page 6) one can construct the full set of forward rates, iF1, from them. The assumption we are making here is that the U.S. Treasury (or any issuer alike) issues zero coupon bonds for any given maturity of the Yield Curve, but this is not true. If you check again table on page 5 you will see that only “certain” tenors have an actual “rate” attached to it. In CH 6 we will see that there is a way to “create” the “missing” maturities, the process is called stripping program. (most debt instruments issued by Governments and Corporations alike beyond one year pay coupons) for Government Bonds, in particular, there exist a stripping program through which “synthetic” zero-coupon bonds (and subsequent spot rates) are created from the coupons paid out by existing debt instruments (in the U.S. we call such synthetic zero-coupon bonds “S.TR.I.P.S.”). One can calculate the series of zero-coupon spot rates implied by the Treasury yields via a process called bootstrapping. The zero-coupon rates are called spot rates. 30 TIME VALUE OF MONEY AND INTEREST RATES The time value of money is based on the notion that a dollar received today is worth more than a dollar received at some future date. • Simple interest: interest earned on an investment that is not reinvested. (+) • Compound interest: interest earned on an investment that is reinvested, most commonly used. (*) PRESENT VALUE OF A LUMP SUM (=cash flow) Discount future payments using current interest rates to find the present value (PV). PV=FV t I (1+r )t PV = present value of cash flow FVt = future value of cash flow (lump sum) received in t periods r = interest rate earned per period on investment t = number of compounding periods in investment horizon FUTURE VALUE OF A LUMP SUM The future value (FV) of a lump sum received at the beginning of the investment horizon. FV t=PV (1+r )t RELATION BETWEEN INTEREST RATES AND PRESENT AND FUTURE VALUES As interest rate increases, the present value of a given investment decreases (inverse relationship). As interest rate increases, the future value of a given investment increases (direct relationship). 31