Financial Systems (Sistemi Finanziari), Sbobinature di Economia Del Sistema Finanziario

Scarica Financial Systems (Sistemi Finanziari) e più Sbobinature in PDF di Economia Del Sistema Finanziario solo su Docsity! 13/09 – Lecture 1 FINANCIAL SYSTEMS In Financial Markets, you can buy/sell financial instruments. Why study Financial Markets and Institutions? Financial Markets are useful because: - Provide finance to companies giving them the opportunity to grow & reduce the unemployment rate. - Provide money for the governments, which will subsequently be used to provide services (such as public care and public transportation). - Help lower the costs we face for buying goods and services, taking out a mortgage, and saving for retirement, by lending our money to a family. - Are big drivers of prosperity (they increase the well-being of the population). - Are tightly regulated and supervised to ensure that they are fair and work properly. - Not only do they affect our everyday life , but also business profits and economic development (the economic well-being of the country, the production of goods and services). - They are the place to transfer funds from those who have an excess of available funds to those who are in shortage of them, in other worlds from people that don’t have a productive use to those who have it, thanks to this we can say that financial markets promote economic growth.  Financial institutions make the transfer of funds easier,  Well-functioning financial markets promote economic growth. - Poorly performed financial markets are those of poor countries (they are one reason that many countries remain poor). - Financial Markets and Institutions are the main channels/primary channels through which capital is allocated in our society: by which we can transfer funds from people that earn more than they spend to people who spend more than they earn.  Investment and financing decisions require managers and individual investors to understand the flow of funds throughout the economy.  Managers and individuals must also understand the operation and structure of domestic and international financial markets. - Financial markets are structures through which funds flow. - Financial markets can be distinguished along 2 major dimensions: 1. Primary vs. Secondary markets, 2. Money vs. Capital markets. 1 st Dimension : Primary vs. Secondary Markets Primary Markets: financial instruments sold directly by the issuer, we can issue and sell financial instruments to raise sufficient capital directly (ex. of financial instrument a bond, which is a claim). - They are markets in which users of funds (for example, corporations) raise funds through new issues of financial instruments, such as stocks and bonds. - Primary Markets include issues of equity by firms initially going public, referred to as Initial Public Offerings (IPOs). We have the user of the funds and the initial suppliers of the funds  financial intermediary not necessary (companies can go to buyers and sell their financial instruments) but with an intermediate, it is actually easier  so an investment bank is necessary. Secondary Markets: the company (issuer of the security) is no longer involved; we can only buy or sell financial instruments which are already been issued by the primary markets (ex. You sell your shares of a company on the secondary market).  They are markets that trade financial instruments once they are issued. We have 2 economic agents (one has already invested in securities and the other want wants them)  financial intermediary is necessary. Why are Secondary Markets important? - for liquidity – or the ability to turn an asset into cash quickly at its fair market value -, to permit funders to have the money back when they want to (to easily turn financial instruments into cash, without suffering any loss), - information about the prices or the value of investments , - trading with low transaction costs .  Market prices: synthesis of how people judge the company, prices of a bond are used to understand on the price of the debt capital. Financial Market Regulation Financial Instruments are subject to regulation imposed by regulatory agencies, such as the Securities and Exchange Commission (SEC).  The main emphasis of SEC regulations is on full and fair disclosure of information on securities issues to actual and potential investors.  SEC monitors trading on the major exchanges to ensure stockholders and managers do not trade on inside information about their own firms. Failures of FIs can cause widespread panic and withdrawal runs on institutions.  The 2008 increase in the deposit cap (to $250,000 per person per bank) was intended to instil confidence in the banking system.  FIs are regulated to prevent market failures, as well as associated costs on the economy and society at large . Financial Markets are regulated for 2 main reasons: - Reduce information asymmetries : you have to declare some information about the financial operation in order to protect the investor, the one who receives the money has a larger range of information than the buyers.  Investors may be subject to moral hazard and adverse selection (to keep investors informed). - Ensure the soundness of the system : • Restrictions on entry - Tight regulation, • Disclosure - Reporting requirements for FIs are stringent,  Restriction on assets and activities - To ensure the safety of the financial system, FIs can’t engage in certain risky activities,  Deposit insurance - The government can insure people’s deposits so that they don’t suffer great financial loss in case of bank failure,  Restriction on interest rates - Preventing banks from applying usury interest rates,  Tight capital requirements . Overview of Financial Institutions (FIs) Financial Institutions perform the essential function of channelling funds from those with surplus funds to those with shortages of funds. Without a financial institution, the level of funds flowing between suppliers and users would likely be quite low due to the following reasons: - Monitoring Costs - Liquidity Risk - Price Risk Monitoring Costs: we waste time collecting information about the investment. A supplier of funds who directly invests in a fund user’s financial claims faces a high cost of monitoring the fund user’s actions in a timely and complete fashion.  A solution is for many small investors to group their funds together by holding the claims issued by a FI (that is, aggregation of funds). Liquidity Risk and Price Risk  FIs act as asset transformers, financial claims issued by a FI that are more attractive to investors than the claims directly issued by corporations.  Often, claims issued by FIs have liquidity attributes that are superior to those of primary securities.  FIs diversify away some, but not all, of their investment risk. Additional Benefits and Functions of FIs Additional services FIs provide to suppliers of funds: • Reduced transaction cost (enjoy economies of scale) • Maturity intermediation (maturity transforming institutions) • Denomination intermediation Economic functions and services FIs provide to the financial system as a whole: • Transmission of monetary policy  Deposits are a significant component of the money supply • Credit allocation • Intergenerational wealth transfers or time intermediation • Payment services Flow of Funds Flow of Funds in a World without FIs Flow of Funds in a World with FIs Segments of Financial Markets Direct Finance: buy securities directly from the suppliers of funds  Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrower’s future income or assets. Indirect finance: Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower’s future income or assets. Types of Financial Institutions Commercial banks = depository institutions whose major assets are loans and whose major liabilities are deposits. Commercial banks’ loans are broader in range (including consumer, commercial and real estate loans), than are those of other depository institutions. Commercial banks’ liabilities include more non-deposit sources of funds, s.a. subordinate notes and debentures, than do those of other depository institutions. Thrifts = depository institutions in the form of saving associations, saving banks and credit unions. Thrifts generally perform services similar to commercial banks, but they tend to concentrate their loans in one segment, such as real estate loans or consumer loans. Insurance companies = financial institutions that protect individuals and corporations (policyholders) from adverse events. Life insurance companies provide protection in the event of untimely death, illness and retirement. Property-casualty insurance protects against personal injury and liability due to accidents, theft, fire, … Securities firms and investment banks = financial institutions that help firms issue securities and engage in other related activities s.a. securities brokerage and trading. Finance companies = financial intermediaries that make loans to both businesses and individuals. Unlike depository institutions, finance companies do not accept deposits but instead, rely on short- and long-term debt for funding. Investment funds = financial institutions that pool financial resources of individuals and companies to invest those in diversified portfolios of assets. Pension funds = financial institutions that offer savings plans through which fund participants accumulate savings during their working years before withdrawing them during their retirement years. Funds originally invested in and accumulated in pension funds are exempt from current taxation. FinTechs: Financial technology, or fintech, refers to the use of technology to deliver financial solutions in a manner that competes with traditional financial methods.  Includes services such as cryptocurrencies (for example bitcoin) and blockchain.  Fintech risk involves the risk that fintech firms could disrupt the business of financial services firms in the form of lost customers and lost revenue.  Supports models of peer-to-peer mass collaboration . Risks incurred by Financial Institutions FIs face various types of risks: • Default risk (that is, credit risk). • Foreign exchange risk • Country (that is, sovereign) risk • Interest rate risk • Market risk, or asset price risk • Off-balance sheet risk • Liquidity risk • Technology and operational risk • Insolvency risk Globalization of Financial Markets and Institutions U.S. markets are the world’s largest, but international markets have seen rapid growth in recent years as a result of various factors: 1. Proof of savings in foreign countries has increased. 2. International investors have turned to U.S. and other markets to expand their investment opportunities. 3. Information on foreign investments and markets is now more accessible and thorough. 4. Some U.S. FIs offer their customers opportunities to invest in foreign securities and emerging markets at relatively low transaction costs. 5. The euro is having a notable impact on the global financial system. 6. Economic growth in Pacific Basin countries, China, and other emerging countries has resulted in significant growth in their stock markets. 7. Deregulation in many foreign countries has allowed the deregulating countries to expand their investor base. - As risk of financial security increases (decreases) the supply of LF decreases (increases)  we are lending our money, so we take into consideration the riskiness (increase = more risk in making the investment). - As near-term spending needs increase (decrease), the supply of LF increases (decreases)  if you need to spend your money to buy goods or services you have less money to invest. - When monetary policy objectives allow the economy to expand (restrict expansion), the supply of LF increases (decreases). - As economic conditions improve in a domestic (foreign) country, the supply of funds increases (if we have bad economic conditions the supply of LF decreases). Factors that affect the Supply of and Demand for Loanable Funds for a Financial Security Factors that affect the Demand for LF - Utility derived from an asset purchased with borrowed funds: if the utility increases (decreases), I’m more (less) willing to buy the asset so there is an increase (decrease) in the demand for LF.  Ex. Easy-jet wants to buy an airplane during pandemic vs. today. - As the restrictiveness of nonprice conditions on borrowed funds decreases (increases), the demand for LF increases (decreases) = if there are provisions that limit it the borrower doesn’t want to borrow money.  Nonprice conditions may include fees, collateral, requirements or restrictions on the use of funds (restrictive covenants). - When domestic economic conditions result in a period of growth (stagnation), the demand for funds increases (during periods of growth the demand for LF increases) (decreases). Factors that affect the Supply of and Demand for Loanable Funds for a Financial Security Determinants of Interest Rates for Individual Securities Aspect to consider to lend your money Real Risk-Free Rate A Real Risk-Free Rate is the interest rate that would exist on a risk-free security if no inflation were expected over the holding period of a security. The Real risk-free rate affects the individual's decisions = you want to be compensated to postpone your consumption need (in order to lend your money you want to receive a price  a positive interest rate = the real risk- free rate). If there is no inflation on an investment risk-free, we will charge only the risk-free rate to pay for the fact that we are postponing our consumption needs. The higher our cost, the higher will be the required risk-free rate. The higher the cost that we face not using our money today, the higher will be the real risk-free rate.  The higher society’s preference to consume today (i.e. the higher its time value of money or rate of time preference), the higher the real risk-free rate (RFR). Fisher effect = refers to the relationships present among the real risk-free rate (RFR), the expected rate of inflation [E(IP)], and the nominal interest rate (i). Nominal interest rate = real RF rate + the expected inflation (assuming that we are dealing with a risk-free counter- party). i=RFR+E( IP) What we really receive from an investment (RFR) = nominal (i) - expected inflation [E(IP)] If we lend our money today, we are postponing our consumption needs; if we are expected that the money we lend will gain value in the future, we have to add it to obtain the nominal value.  The higher the RFR, the higher the nominal rate.  The higher the Expected inflation, the higher i.  The higher the E(IP), the higher the RFR  if we expect man inflation, the willingness to consume today instead of tomorrow will be higher (RFR). Inflation = the continual increase in the price level of a basket of goods and services.  The higher the level of actual or expected inflation, the higher will be the interest rates.  In the U.S., inflation is measured using indexes:  Consumer Price Index (CPI),  Producer Price Index (PPI)  how it changes considering these indexes measure inflation.  It measures how prices vary over time. Annual inflation rate using the CPI index between years t and t + 1 would be equal to: Creditor Risk or Default Risk = risk that the borrower will not be able to give the money back, is the risk that the security issuer will fail to make its promised interest and principal payments to the buyer of a security. Default Risk Premium to compensate for the fact that we are facing the default risk. I = RFR + E(IP) + DRP  The higher the default risk, the higher the interest rate that will be demanded by the buyer of the security to compensate him for the default risk exposure. The difference between a quoted interest rate on a security (security j) and a Treasury security with similar maturity, liquidity, tax, and other features (s.a. callability or convertibility) is called a Default or Credit Risk Premium (DRPj). DRP = ijt - iTj  difference between securities Where: - ijt = interest rate on a security issued by a non-Treasury issuer (issuer j) of maturity m at time t, - iTt = interest rate on a security issued by the U.S. treasury of maturity m at time t. Liquidity Risk = the risk that a security can be sold at a predictable price with low transaction costs on short notice. Liquidity Risk Premium (LRP) = risk that we cannot convert assets into cash quickly.  It can be hard to find a counterparty, so we might lower the price of our security (facing a transaction cost).  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 at short notice.  If a security is illiquid, investors add a Liquidity Risk Premium (LRP) to the interest rate on the security that reflects its relative liquidity.  LRP might also be thought of as an “illiquidity” premium.  LRP may also exist if investors dislike long-term securities because their prices (present values) are more sensitive to interest rate changes than short-term securities. The more liquid is an asset, the more it gains value: I = RFR + E(IP) + DRP + LRP Special Provisions or Covenants = we have to consider its value while looking at the nominal interest rate. Special provisions or covenants that may be written into the contract underlying a security also affect the interest rates on different securities:  Some of these provisions include the security’s taxability, convertibility, and callability (by which an issuer has the option to retire – call - a security prior to maturity at a preset price).  For investors, interest payments on municipal securities are free of federal, state, and local taxes.  A convertible (special) feature of a security offers the holder the opportunity to exchange one security for another type of the issuer’s securities at a preset price.  In general, special provisions that provide benefits to the security holder (for example, tax-free status and convertibility) are associated with lower interest rates. - Simple interest : interest computed with respect to the principal or original amount of a loan (FV = PV + I)  the higher the interest rate, the higher will be the future value; the higher the maturity, the higher will be the future value; the higher the interest rate, the lower the present value; the higher the term of maturity, the lower will be the present value. - Compound interest rate : computed with respect to the value in the previous period (principal + interest of previous period). FV = PV(1+r)t Annuity Valuation The present value is the maximum that I’m willing to spend for a sum of annuities payments: PV = PMT * ((1-(1+r)-t))/r 19/09/2022 – Lecture 3 Various Measures of Interest Rates The term interest rates can have many different meanings depending on the time frame used for analysis and the type of security being analyzed. Coupon rate = interest rate on a bond instrument used to calculate the annual cash flow the bond issuer promises to pay the bondholder. (The interest rate that can be used to calculate the periodic cash flow of a coupon bond) Interest rates that have to be computed before an investment decision is made (decide to do the investment or not by comparing the 2). - Required rate of return = is the interest rate that we want to receive in order to compensate the risk of buying a particular security  used to compute the fair present value on a security. - Expected rate of return = interest rate an investor expects to receive on a security if he or she buys the security at its current market price, receives all expected payments, and sells the security at the end of his or her investment horizon. Once we have bought the financial instrument, we want to know how well it is performing: Realized rate of return = measures the actual Interest rate earned in an investment of a financial security, used only after an investment decision is made  it is a historical (ex post) measure of the interest rate. Required rate of return (r) It represents the riskiness of an investment, and it is used to find the fair present value of a financial security  we obtain an estimate of the Future value of the bond to establish whether to buy a financial instrument or not (starting from the current market price of the securities). - Function of the various risks associated with a security and is thus the interest rate the investor should receive on the security given its risk => The higher the risk (default risk liquidity risk, etc.), the higher the charged Interest rate  we can compute the measure of the risk before making an investment, which is called the required rate of return (which is the Interest rate that we are willing to receive in order to bear all the risks related to buying a financial security?) - We can use the required rate of return to measure the fair price (fair present value) of the financial security = how much we are willing to spend considering the riskiness of the investment? - Ex ante measure of the interest rate on a security: EX. We have 5 periods RFR = 1% E(IP) = 2.5% DRF = 6%  no considering a risk-free security, we price the possibility that the counterparty won’t pay us back LPR = 1.5% MP = 1% 1 2 3 4 5 100 110 125 145 170 FV = price that we are willing to spend for the financial instrument. I calculate the required rate of return (r)  sum of all the risks = 12% I compute the PV = 100/(1+12%)^1 (of all the values and then I sum them all) PV tot = 454,562  we are willing to pay no more than that to buy this bond. Default Risk > 0 => It is not a free-risk security  count in calculation of interest. Expected rate of return E(r) Computed before an investment is made, E(r) on a financial security is the interest rate a market participant expects to earn by buying the security at its current market price (𝑃), receiving all projected cash flow payments (CFs) on the security, and selling the security at the end of the participant’s investment horizon. - The IR that investors expect by buying the security supposing that they hold the security until maturity; - The IR that equates the current market price of the bond with the PV of all the cash flows. Ex. Period = 5 years 0 5 80 = PV 100 = FV We can calculate the expected rate of return supposing that we buy the bond and we hold it until it measures: E(r) = (100/80)^1/5 -1 = 4.56% = (FV/PV)^1/t -1 RFR = 0.25% E(IP) = 1% DRF = 1.25% LPR = 0.5% MP = 1% Required rate of return = 4% considering all the risks entering is this business < 4.56% Expected > Required, I will buy the bond (no if it is the contrary) PV = 100/(1+4%)^5 = 82.19 > 80 ( fair price is greater than the current market price. The bond is undervalued so we are willing to buy) Required vs. Expected rate of return • 𝐸 (𝑟) ≥ 𝑟 → 𝑃V ≥ 𝑃  The projected cash flows received on the security are greater than (at least equal to) those required to compensate for the risk incurred from investing in the security  The estimated fair value is higher than the current market price  Buy (do not sell) the security • 𝐸(𝑟) </= 𝑟 → 𝑃V </= P  The projected cash flows received on the security are less than (at least equal) those required to compensate for the risk incurred from investing in the security  The estimated fair value is lower than the current market price  Do not buy (sell) the security The Role of Efficient Markets The speed with which financial security prices adjust to unexpected news, to maintain equality with the fair present value of the security, is referred to as market efficiency. A market is efficient when prices fully reflect all the available information.  If financial markets are efficient, which tends to be the case most of the time, the current market price of a security tends to equal its fair price present value  we expect that E(r) is almost equal to r.  When an event occurs that unexpectedly changes interest rates or a characteristic of a financial security, the current market price of a security can temporarily diverge from its fair present value. If the markets are efficient: E(r) > r (security is undervalued by the market), there will be an increase in the demand of this instrument, but also observe an increase in the current market price of the bond (so, the expected return decreases). So, the expected rate of return will tend to be equal to the required rate of return. Realized rate of return (r ) On a financial security, it is the interest rate actually earned on an investment in a financial security. It’s an Ex post measure of Interest rate, done by comparing the realized rate of return with the expected one we can have. - When it is higher than required  higher cash flow than the one expected to be compensated for the expected risk of the investment. 7 20 50 80 8 20 50 80 10 1020 1050 1080 Face value = 1000 r = 5% 20/(1 + 5%)^1 - 1 5%  coupon rate exactly equal to the interest rate  always have a par bond 2%  coupon rate less to the interest rate  discount bond 8%  coupon rate more to the interest rate  premium bond Bond Valuation Formula used to calculate Yield to Maturity Yield to Maturity = expected interest rate on a bond supposing that the bondholder buys it at the current market price  the return that we receive on a bond. We assume that all the payments are invested periodically all at the same rate. It is the return, or yield, the bondholder will earn on the bond if he or she buys it at its current market price 𝑃𝑏, receives all coupon and principal payments as promised, and holds the bond until maturity is the Yield to Maturity (ytm). The yield-to-maturity calculation implicitly assumes that all coupon payments periodically received by the bondholder can be reinvested at the same rate — that is, reinvested at the calculated yield to maturity. Ex. Coupon rate 5% Price = 100 Face value (M) = 100 t P = 100 1 = 5%*100 = 5 2 5 3 5 4 5 5 100 + 5 = 105 Find an IR such that we will obtain a market price equal to 100. Because the price is equal to the face value, we are dealing with a par bond (the sum of all the discounted cash flows will give me 100)  the interest rate is exactly 5% We suppose that all the cash flows are reinvested at the same IR  once we have received 5$ we are going to invest them at the same IR 5%, and I repeat it for all the periods: = 5*(1 + 5%)^4 t P = 100 c = 5% 1 = 5%*100 = 5  = 5*(1+5%)^4 = 6.08 = 5*(1+5%)^4 = 6.08 2 5 = 5*(1+5%)^3 = 5.69 3 5 5.51 4 5 5.25 5 100 + 5 = 105 105 Total = 127.63 We have Invested 100 to receive 127.63 in 5 years The IR is ((127.63/100)^1/5) -1= 5% In order to receive a return equal to the yield (YTM) we have to reinvest all the cash flows (monetary units) paid by the bond, otherwise we will get a return lower than the yield to maturity. The higher the interest rate, the higher the expected return.  YTM = Expected rate of return (E(r)). Equity Valuation Valuation process for an equity instrument (such as preferred or common stock) involves finding the present value of an infinite series of cash flows on the equity discounted at an appropriate interest rate.  Cash flows from holding equity come from dividends paid out by the firm over the life of the stock. Shares have no maturity, we are supposed to receive the dividends over the life of the financial instrument (an infinite number of dividends)  we can use different variables: (The higher the DP, the higher IR) - Divt = Dividend paid to stockholders at the end of the year t - Pt = Price of a firm’s common stock at the end of the year t - P0 = Current price of a firm’s common stock - rs = Interest rate used to discount cash flows on an investment in a stock Present value methodology applies time value of money to evaluate a stock’s cash flows over its life as follows: The price of a stock is equal to the present value of its future dividends (Divt), whose values are uncertain. We use 3 models to estimate the flow of dividends over the life of the stock: 1. Zero growth in dividends over (infinite) life of stock  No growth in the dividends  we will always receive the same; 2. Constant growth rate in dividends over (infinite) life of stock  There is a monetary growth  tomorrow I will receive higher and higher dividends; 3. Nonconstant growth in dividends over (infinite) life of stock  Abnormal growth in dividends. Zero growth in dividends  all the dividends are equal: It means that dividends are expected to remain at a constant level forever. We have to discount all the dividends (is the easiest model): Constant growth in dividends It means that dividends equal the second one plus a constant g (dividends are expected to grow at a constant rate, g , each year into the future ): The rate of return on the stocks, if they were purchased at price P0, may be determined as follows: Ex. g = 2.5% (growth in dividends) r = 9% D2 = 10€ P = D0 * (1 + g) / (rs - g) = 10/6.5% = 153.85€ < 150€ (the stock is undervalued by the market) Dividend growth assumed by the market participants? 150 = 10/(9% - g) If dividends increase their price P increases, if the riskiness decreases we will observe an increase in the market price Supernormal (or Nonconstant) growth in dividends Firms often experience periods of Supernormal or Nonconstant dividend growth, after which dividend growth settles at some constant rate. To find the present value of a stock experiencing supernormal or nonconstant dividend growth, a 3-step process is used: 1. Find the present value of the dividends during the period of supernormal (nonconstant) growth. 2. Find the price of the stock at the end of the supernormal (nonconstant) growth period using the constant growth in dividends model. Then, discount this price to a present value. 3. Add the 2 components of the stock price together. Same Ex. You are evaluating Financial system Inc (FS) Stock. The stock is expected to experience a supernormal growth in dividends of 20% over the next 3 years. Following this period dividends are expected to grow at a constant rate of 3%. The stock paid a dividend of 0.50 last year. The required rate of return on the stock is 15%. Calculate fair price of stock. Hint: you have to use a three-step process Step 1: Find the present value of dividends during supernormal growth period Step 2: Find the present value of dividends after supernormal growth period Step 3: Add the two components of the stock price together  For 3 years dividends will grow at 20% then they will grow at a constant rate of 3%, r = 15% t 0.5 = 0.5/(1+15%)^1 = 0.52 1 0.6 2 3 4 (0.5*(1+20%)^2) = 0.72 0.864 = 0.864*(1+3%)^4 = 0.88 Total = 1.63426 Find present value (sum first 3 values). Second step: Basically, firstly you calculate the pink value (present value of stock at beginning of first period, after year 3), then compute present value at end of supernormal growth period. Third step: Sum values found in first and second step = 1.63 + 4.87 = 6.5 Impact of the Interest Rate Changes on Security Values The higher the Interest rate, the lower the duration; the higher the coupon rate, the lower the duration  we don’t know which of the 2 coupon bonds has the lowest duration. Economic Meaning of Duration In addition to being a measure of the average life of a bond, duration is also a direct measure of its price sensitivity to changes in interest rates, or elasticity. For small changes in interest rates, bond prices move in an inversely proportional manner based on the size of D. Annual compounding of Interest  the higher the duration, the higher the changes in security prices. The relationship is not linear  we can use duration only while considering close interest rates (the closer the distance between IR, the smaller will be the estimation error). Semiannual compounding of Interest Modified Duration Large Interest rate Changes and Duration Duration accurately measures the price sensitivity of financial securities only for small changes in interest rates of the order of 1 or a few basis points  A basis point is equal to one-hundredth of 1%. Duration misestimates the change in the value of a security following a large change (either positive or negative) in interest rates.  As a result of convexity, the capital loss effect of large rate increases tends to be smaller than the capital gain effect of large rate decreases.  Convexity is the degree of curvature of the price-interest rate curve around some interest rate level. Characteristics of Convexity 1. Convexity is desirable: The greater the convexity of a security or portfolio of securities, the more insurance or interest rate protection an investor or FI manager has against rate increases and the greater the potential gains after interest rate falls. 2. Convexity increases the error in duration as an investment criterion: The larger the interest rate changes and the more convex a fixed-income security or portfolio, the greater the error in using just duration (and duration matching) to immunize exposure to interest rate shocks. 3. All fixed-income securities are convex : as interest rates change, bond prices change at a nonconstant rate. 20/09/2022 – Lecture 4 Pop quiz 2 - When the total wealth of funds supply increases  the supply curve tends to shift to the right; an increase in the risk of financial security will shift it back to the left (they both affect the supply curve, but we don’t know for how much)  the net effect is actually uncertain. - Fisher effect  real risk-free rate = nominal interest rate - the expected inflation premium - In nominal interest rate i = RFR + E(IP) + DRP + LP + MP + SPP, when the inflation is set to 0, the nominal rate will correspond to RFR only if all the risks are equal to 0. - The economic condition affects both the supply and the demand for Loanable funds , when we observe an improvement in the economic condition, the supply curve will shift to the right (there is a decrease in interest rate), it also positively affects the demand curve  shift to the right (IR increase)  the net effect is uncertain. - FV = PV*(1+r)t  positively related , PV = negatively related - Covenant = provision that is related to a financial instrument that limits the discretionary power of the borrower  tends to decrease the interest rate, the risk-free rate will not be affected. - The r is not related to the current market price (the Expected market price is related). - E(r) > r  PV > P - Under the liquidity premium theory, the investors require a liquidity premium  the yield curve will be positively sloped  the unbiased expects it to be flat. - Each time there is a difference between the PV and the current market price in an efficient market it will tend to disappear. Central Banks, Monetary Policy & Interest Rates Central Banks Main task = make decisions (determine, implement, and control) related to monetary policies in their own home countries. There are 3 independent central banks: 1. The Federal Reserve (the Fed) is the central bank of the United States. 2. The European Central Bank (ECB) is the central bank of the Euro Area. 3. The Bank of Japan (BoJ) is the Japanese central bank.  Independent Central Bank. Duties incorporate 4 major functions: 1. Conducting monetary policy  to steer the Interest Rate in financial markets. 2. Supervising and regulating depository institutions  to maintain some financial systems and institutions it is necessary to supervise them (Italian banks are supervised by the European central bank). 3. Maintaining the stability of the financial system  supervising the financial institutions. 4. Providing payment and other financial services to the U.S. government, the public, financial institutions, and foreign official institutions .  Central banks are the deposit institutions of governments. Structure of the Federal Reserve System (FRS) 12 Federal Reserve Banks in cities throughout the U.S.:  Each acts as a depository institution for the banks in its district.  Operate under the general supervision of the Board of Governors.  Each has its own 9-member board of directors  6 elected in the bank and 3 by the Board of Governors. 7-member Board of Governors in Washington, D.C.  Each member appointed by the president of the U.S. and must be confirmed by the Senate.  Members serve a non-renewable, 14-year term.  Primary responsibilities are the formulation and conduct of monetary policy and the supervision and regulation of banks. Federal Open Market Committee (FOMC) FOMC is the major monetary policy-making body of the Federal Reserve System.  Required to meet at least 4 times each year in Washington, D.C., but typically meet more often.  The main responsibilities are to formulate policies to promote full employment, economic growth, price stability, and a sustainable pattern of international trade.  Set guidelines regarding open market operations, the purchase and sale of U.S. government and federal agency securities, as the main policy tool to achieve monetary targets.  Beige Book summarizes information on current economic conditions by Federal Reserve district. Functions performed by Federal Reserve Banks (FRBs) 1. Assistance in the conduct of monetary policy : Set and change the discount rate. Loans transacted through each FRBs discount window  they set the rate of discount rates they can decide and steel the Interest rate available in financial markets. 2. Supervision and Regulation : Each FRB has supervisory and regulatory authority over the activities of state- chartered member banks and bank holding companies located in their districts. 3. Consumer protection and community affairs : Possess authority to implement federal laws intended to protect consumers in credit and other financial transactions. 4. Government services : Serves as the commercial bank for the U.S. Treasury. 5. New currency issue : Responsible for the collection and replacement of currency (paper and coin) from circulation. 6. Check clearing : Operates a central check clearing system for U.S. banks, routing interbank checks to depository institutions on which they are written and transferring the appropriate funds from one bank to another. 7. Wire transfer services : FRBs and member banks are linked electronically through the Federal Reserve Communications System. 8. Research services : Each FRB uses professional economics to conduct research. The European System of Central Banks and the Eurosystem  The European System of Central Banks (ESCB) includes the ECB and the National Central Banks (NCBs) of the Member States of the European Union.  The Eurosystem is a subset of the ESCB as it includes the ECB and the NCBs of the Euro Area.  The governing bodies of the Eurosystem are:  The Executive Board: - President, Vice-President and 4 board members, - Appointed for a non-renewable 8-year term.  The Governing Council: - Executive Board and the governors of the NCBs, - The term of office for NCB governors ranges between 5 and 8 years, - Responsible for formulating the monetary policy (like the FOMC in the US). They provide a ceiling (marginal lending rate) and a floor (deposit facility rate) for the interevent rates. The Interbank Rate is applied between 2 commercial banks with opposite needs when they decide to exchange a specific amount of monetary units. Marginal lending rates provide a ceiling, and the deposit facility rate provides a floor to the interbank rate. Instead of borrowing or lending money from the central bank with higher costs, the 2 commercial banks will have a more convenient rate between them. This channel is called the interest rate corridor. Required Reserves  The ECB requires credit institutions established in the Euro Area to hold a certain amount of funds on their accounts with their respective NCBs.  It is meant to stabilize the money market interest rates and create a structural liquidity shortage.  Not required on a daily basis.  Banks should hold these required reserves on average over a maintenance period of about 6 weeks.  Required reserves are determined by certain elements of balance sheets (e.g., customer deposits with a maturity of up to 2 years).  Required reserves are remunerated at the average main refinance rate.  Excess reserves are remunerated at the deposit facility rate. ECB Non-Standard Monetary Policy to boost the economy  Pandemic Emergency Purchase Programme - PEPP  Designed as a response to the coronavirus (COVID-19) emergency,  Net asset purchases under the PEPP ended as of April 2022.  Pandemic Emergency Longer-Term Refinancing Operations – PELTROs  Provide liquidity support and ensure smooth money market conditions during the pandemic,  7 PELTROs from April 2020 +4 additional PELTROs from December 2020.  Targeted Longer-Term Refinancing Operations - TLTROs  Provide financing to credit institutions for periods of up to 4 years,  Stimulate bank lending to the real economy.  Asset Purchase Programme - APP  Launched in October 2014 with the aim of fulfilling the ECB’s price stability mandate,  Net asset purchases under the APP ended as of July 2022. Effects of Monetary Tools on Various Economic Variables Expansionary Activities - Open market purchases of securities : All else constant, reserve accounts of banks increase. - Discount rate decreases : All else constant, interest rates in the economy decrease. - Reserve requirement ratio decreases : All else constant, bank reserves increase. Contractionary Activities - Open market sales of securities : All else constant, reserve accounts of banks decrease. - Discount rate increases : All else constant, interest rates in the open market increase. - Reserve requirement ratio increases : All else constant, bank reserves decrease. Open Market Purchase: An Example  Open Market purchase of securities (- $100m) => Reserve accounts increases (+ $100m). From the ECB to the Real Economy: the Transmission Mechanism of Monetary Policy By setting the short-term rates, the ECB affects:  Money market rates (directly),  Lending and deposit rates, which are set by banks to their customers (indirectly),  Expectations of future official short-term interest rates and, in turn, medium and long- term interest rates. The impact on financing conditions and market expectations may lead to:  Changes in loan /credit market,  Adjustments in asset prices (stock market prices; bond prices...),  Bank rates ,  The Exchange rate.  Changes in consumption and investment affect domestic demand, relative to domestic supply.  If there’s an excess of supply, a downward price pressure is likely to occur.  These changes in aggregate demand in turn also affect the wage-setting. Impact of Monetary Policy on Various Economic Variables Monetary Policy Tools: ECB vs FED - Open Market Operations - Standing Facilities - Minimum Reserves 27/09/2022 – Lecture 5 Pop Quiz 3 - P = Div/r - g r = required return on stocks g = expected growth individuated The higher is g, the higher the price, the higher is r, the lower the price  we don’t know which one prevails. - r = (Div/p) + g  the higher g, the higher r - Higher Dividends  P is expected to increase. - If new information doesn’t change anything in the formula to calculate the price  information was already known, and the price remains the same. - P = Div/r - g  if r increases the price will decrease, g decreases P decreases  stock overvalued. - Main goal of the ECB  keep inflation close and below 2%. - Marginal lending rate (upper bound) and deposit facility rate (lower bound), these 2 define the corridor. - It depends on the interest rate, maturity and coupon rate if duration is equal, higher, or lower. - Eurosystem is a subset of the ESCB. - IR higher  less money circulating, and European bond will increase their attractiveness so the euro will increase its value. Capital markets = maturity greater than 1 year. Money Markets Money markets: trade debt securities or instruments with maturities of maximum (less than) 1 year (short-term financial instrument), are issued by Government or financial institutions  are risk-free (US T bill  short-term government bond, is risk-free); default risk is close to 0. - Once issued, money market instruments trade in active secondary markets  high level of liquidity (easily turn it into cash without many transaction costs). Not because we are trading money, but because they are extremely liquid and are close to becoming money. - The need for money markets arises because the immediate cash needs of individuals, corporations, and governments do not necessarily coincide with their receipts of cash. Money market instruments have 3 shared characteristics: 1. Generally sold in large denominations ($1m to $10m units)  Wholesale markets, 2. Low default risk, the risk of late or non-payment of principal and/or interest, 3. Must have an original maturity of 1 year or less. Money Market Participants A lot of Money Market Participants  primary purpose = not investing one (extremely low-interest rate), but they are that many because to manage liquidity needs, Government refers to money markets to finance their expenses  Treasury departments (if you need money now, to finance debt).  BOT  Italian bonds - Traded in active secondary market, 2 secondary markets MOT (only retailing inv, 1000€) MTS (institutional inv, million 2.5€), they are competitive, each participant will pay a different price). - Depending on the discount yield I will require a different price. - Issued through an option. T-Bills are short-term debt obligations issued by the Italian government. - Original maturities are 3, 6 and 12 months. - Issued in denominations of multiples of €1000. - Active secondary markets : • MOT: retail investors, minimum denomination €1000. • MTS: institutional investors, minimum denomination €2.5 ml. - A BOT auction is the formal process by which the government sells news issues of T-bills. - Bids are competitive: institutional investors specify the amount of par value of BOT desired and the discount yield, rather than the price. The new issue of BOT  Each authorized participant specifies the amount of par value of BOT desired and the discount yield.  Each has to be less than €1.5 ml.  Max 5 requests.  Bids must differ (at least) by 0.1 bps (1 bps = 0.01%).  To avoid extremely speculative bids, the government excludes those that are not between:  The minimum acceptable rate : the average return on bids that cover the second half of the issue -0,5%,  The maximum acceptable rate: the average return on bids that cover the first half of the issue + 1%.  Bids below the minimum acceptable rate or above the maximum acceptable rate are excluded. Competitive bid: Example - 4 participants - Issue of 7000 BOT - First, once received, sort bids by yield A asks for 900 BOT with a yield of 1%: - We have to compute min and max acceptable yield. - Calculate the average bids D will receive 800 bot with an interest rate of 1.65%. - Starting from bids with the lowest yield , compute the average return on bids that cover the second half (3500) of the issue. - Avg return = 1,8134% - Minimum acceptable yield = 1,8134% - 0,5% = 1,3134% - Exclude bids below this threshold (A1 and A2)  There is no one interest rate while buying BOT.  Starting from bids with the lowest yield, compute the average return on bids that cover the first half (3500) of the issue:  Avg return = 1,7383%  Maximum acceptable yield =1,7383% +1% = 2,7383%  Exclude bids above this threshold (D3).  Each accepted bid is settled at the required yield.  Each bidder receives its own yield.  Bidders below the minimum acceptable yield are settled at the following return: min [minimum accepted yield - 0,10%; minimum acceptable yield] Federal Funds (fed funds)  doesn’t mean that one of the 2 institutions is the federal institution,  They are short-term funds transferred between financial institutions, usually for a period of one day.  Commercial banks trade fed funds in the form of excess reserves held at their local Federal Reserve Bank.  Fed funds rate is the interest rate for borrowing fed funds.  The function of the supply and demand for federal funds among financial institutions and the effects of the Federal Reserve’s trading through the FOMC.  The primary risk of the interbank lending system is that the borrowing bank does not have to pledge collateral for the funds it receives, which are usually in the millions. Interbank Deposits In the European market (like the US fed funds), interbank deposits are short-term loans between 2 financial institutions (UniCredit can ask for necessary funds from the interbank market at Intesa, if it has an excess of funds it will give it to UniCredit). They can be: • Overnight: immediate loan with a maturity of 1 day. • Tomorrow next: one-day loan starting the day after the trade date. • Spot-next: one-day loan starting 2 days after the trade date  2 days after the trade dates. • Call-money: demand deposits redeemable on request. • Conditioned: immediate loan with a maturity of up to 14 days. Repurchase Agreements A Repurchase Agreement (Repo or RP) is an agreement involving the sale of securities by one party to another with a promise to repurchase the securities at a specified price and on a specified date.  Most repos are collateralized, with the seller holding securities to back the transaction.  Collateral has a “haircut” applied, meaning the loan is slightly smaller than the market value of securities pledged.  One-day maturity repos are called overnight repos, while repos with longer maturities are called term repos.  A reverse repurchase agreement (reverse repo) involves the purchase of securities by one party from another with the promise to sell them back. Ex. Unicredit and Intesa: today Uni sells the securities and receives the price, still today Uni decides to repurchase the security at a specified time and date paying a specify price. Overnight repo: n = 1 Repurchase agreements are arranged directly between 2 parties or with the help of brokers and dealers. The yield on repos is calculated as the annualized percentage difference between the initial selling price of the securities and the contracted (re)purchase price, using a 360-day year. Commercial Paper  traded on money market, sold directly to investors. Not affected by reputation of 3rd parties, issuer that decided to sell fin instruments into the market, the buyer knows that if the issuer will default, he will not be able to pay money back. Commercial Paper is an unsecured short-term promissory note issued by a company to raise short-term cash, often to finance working capital requirements.  One of the largest (in terms of dollar value outstanding) of the money market instruments, with nearly $1.1 trillion outstanding as of December 2019.  Companies with strong credit ratings can generally borrow money at a lower interest rate by issuing commercial paper than by directly borrowing (via loans) from banks.  Generally sold in denominations of $100,000, $250,000, $500,000, and $1 million.  Maturities generally range from 1 to 270 days — the most common maturities are between 20 and 45 days.  Generally held by investors from the time of issue until maturity.  No secondary market .  Commercial paper is sold to investors either directly using the issuer’s own sales force or indirectly through brokers and dealers.  Commercial paper underwritten and issued through brokers and dealers is more expensive to the issuer.  Like Treasury bills, yields on commercial paper are quoted on a discount basis. To convert to a bond equivalent yield, the following applies: Negotiable Certificates of Deposit  can be traded at different prices.  A Negotiable Certificate of Deposit (CD) is a bank-issued, fixed maturity, interest-bearing time deposit that specifies an interest rate and maturity date and is negotiable.  Bearer instruments, meaning whoever holds the CD, when it matures, receives the principal and interest.  May be traded any number of times in the secondary market .  Denominations range from $100,000 to $10 million; $1 million being the most common.  Often purchased by money market mutual funds with pools of funds from individual investors. Trading Process  Banks issuing negotiable C Ds post a daily set of rates for the most popular maturities of their negotiable C Ds, normally 1, 2, 3, 6, and 12 months.  Subject to its funding needs, the bank then tries to sell as many C Ds to investors who are likely to hold them as investments rather than sell them to the secondary market.  Negotiable C D rates are negotiated between the bank and the C D buyer.  Large, well-known banks can offer C Ds at slightly lower rates than smaller, less well-known banks.  Negotiable C Ds are single-payment securities.  Interest rates are generally quoted using a 360-day year. Banker’s Acceptances  safer because banked by the reputation of 3 parties (bank), widely used for corporations to raise money, traded in a well-acted secondary market. - A Banker’s Acceptance (BA) is a time draft payable to a seller of goods, with payment guaranteed by a bank. - Make up an increasingly small part of the money markets. T-Notes & T-Bonds : Backed by the full faith and credit of the US Government, the probability of default is considered as 0  sure that we will receive principal + interest at maturity (default risk-free). - T-bonds and Notes pay low rates of interest (yields to maturity) to investors  The lower the risk, the lower the yield to maturity  receive low-interest rate (they go together, negatively related).  The interest rate on T-bonds and T-notes is small but not close to zero because we have to take into account the maturity (long-term government bonds  require a higher maturity premium). - They pay semi-annual coupon interest = receive interest at set 30, we are going to receive interest on March 30. - T-Bills: they have an original maturity of 1 year or less, - T-Notes: original maturities from 1 to 10 years, - T-Bonds: maturity greater than 10 years. - Like T-Bills, once issued, T-Bonds and T-Notes are traded in a very active secondary market  we can sell and receive price without suffering any specific transaction cost (easy to find someone interested in buying these bonds issued by Treasury)  Liquidity risk is close to 0. Treasury issued 2 types of notes and bonds: Fixed Principal and Inflation-indexed: - Both pay interest twice a year. - The Principal value is used to determine the percentage interest payment (coupon) on Inflation-indexed bonds and is adjusted to reflect inflation (measured by the CPI).  In other words, the semi-annual coupon payments and the final principal payment are based on the inflation- adjusted principal value of the security. - Prices are quoted as percentages of the face value on the Treasury security, while coupon rates are set at intervals of 0.125 (or 1/8 of 1) per cent. Depending on the Principal : - Fixed/Constant Principal over the life of the bonds  (2%*100)/2  Principal and Interest are fixed despite the inflation. - Inflation-indexed Principal  the lower the inflation, the lower is the principal/coupon bond  we are going to receive also the coupon related to the inflation (the final value will be the face value + the new inflation)  We would have a face value increased by the percentage of inflation, and on this, we would receive interest by applying coupon rate  makes us exposed to the risk that price changes over time. Receive several Cash Flows T-Note with 3 y to maturity  6 coupons: INT1 INT2 INT3 INT4 INT5 INT6+FV 5 5 5 5 5 5 STRIPS (Separate Trading of Registered Interest and Principal Securities) STRIPS is a Treasury security in which the periodic interest payment is separated from the final principal payment. (Sell every single coupon separately into different zero-coupon bonds + sell the zero-coupon bond with the face value). - Each of the components of the STRIPS is often referred to as “Treasury zero bonds” or “Treasury zero-coupon bonds” because investors in the individual components receive only the single stripped payments in which they invest. - Created by the U.S. Treasury in response to the separate trading of Treasury security principal and interest that had been developed by securities firms. - May be used to: satisfy investment needs of some economic agents (utility of selling a single cash flow  derived from coupon bonds) or to immunize against interest rate risk (given by duration).  Selling different zero-coupon bonds (maturity = duration), better than single coupon bonds (0 < duration < maturity). Why? Suppose a Pension fund that knows that some workers will retire in 20 years, they can invest money directly from 20 years  If we go into the financial market looking for an investment with at least 20 years of maturity, we will see that only coupon bonds or equities will satisfy this. if I want to be sure that in 20 years I will receive my money I have to buy a zero coupon bond, but since on the market there aren’t any, I can satisfy my needs thanks to the STRIPS, we can buy only the principal of the T-Note (the right to receive a 100 monetary units in 10 years). If I buy a coupon bond, instead, I will receive the money periodically during the period (I do not need this money, I need it after 20 years).  If you are selling several zero-coupon bonds, you are meeting the needs of several economic agents,  The utility is higher selling more zero-coupon bonds than a single coupon bond  I can sell them at a higher price and can be used to immunize against the IR risk  you are willing to spend more for ZCB than for the coupon bond.  BY selling a zero-coupon bond  duration = maturity, less risks in changes of IR. Bond Value calculated from the following formula is the price quoted in the financial press: Why STRIP is important? - To match the investment needs of the economic agents, with ZCB => Expected rate of return = yield to maturity. - Easier to compute the duration, and easier to manage duration risks. Accrued Interest = the portion of the coupon payment accrued between the last coupon payment and the settlement day. - Paid by the buyer to the seller if the T-Note or T-Bond is purchased between interest payment dates. - The purchase price of the T-bond or T-note plus accrued interest is called the Full price or the Dirty price of the security, while the price without accounting for accrued interest is the Clean price. Clean Price + Accrued Interest = Dirty Price  Bonds have 2 prices: Dull price and Clean price. You are willing to sell your coupon only at a price which equals the Dirty price . (Coupon referred to a 6-month period, if you sell it before it expires  you are going to consider also the Accrued Interest). You buy the bond at the issue date: Jen 1 2022, Annual coupon  expires Jen 1 2023, One day before Jen 2023 you sell your coupon bond, which price are you willing to receive to sell your coupon bond?  you consider that in 1 day the buyer will receive the money (you price this fact)  you add the accrual interest (we are entitled to it just because we have to hold it to all the period).  When we discount the cash flows, we are computing directly the Dirty Price. In some cases (newspaper, for example), we only find the Clean price. Clean Price (price of the bond) + Accrued Interest (a payment for the fact that I do not receive the last coupon payment) = Dirty Price Explanation: Problem if a bond is traded between 2 coupon payments. It’s because I’m the seller, I will not receive the next coupon payment, but I have only received the interests which have already accrued. So, the buyer has to pay me that interest, if he wants to receive the next payment. Accrued Interest on a T-note or T-bond is based on the actual n° of days the bond was held by the seller since the last coupon payment: Municipal Bonds = securities issued by State and local Governments (regions); primary reasons for issuance are the following: - Fund imbalances between expenditures and receipts. - Finance long-term capital outlays. - Attractive to household investors because interest is exempt from federal and most state/local income taxes. 2 types: 1. General Obligation (GO) Bonds are backed by the full faith and credit of the issuer  region issues a new bond, you buy it if you believe that it will give you back the interest + the principal, 2. Revenue Bonds  issued to finance a specific revenue-generating project and are backed by the cash flows from that project (to build the new line of the underground the region can issue revenues bonds  if region can’t repay (no enough ticket sold) the bond is in default)  riskier. Primary Market Trading  Primary markets in case of municipal and long-term bonds 1- Firm commitment underwriting = the issue of securities by an investment bank in which the investment bank guarantees the issuer a price for newly issued securities by buying the whole issue at a fixed price from the  issuer is sure that it will receive the amount. The investment bank then seeks to resell these securities to suppliers of funds (investors) at a higher price  The risk for the investment bank stands from the price risk (maybe no one is willing to buy the security, so I will have to lower the price). 2- Best efforts offering = the issue of securities in which the investment bank does not guarantee a price to the issuer and acts more as a placing or distribution agent on a fee basis related to its success in placing the issue.  Investment bank tries to sell the securities without buying them, only helps the issuer to sell the security. Risk that the investment bank won’t be able to find buyers. 3- Private placement = a security issue placed with one or a few large institutional buyers  one or 2 investors (less than 10). Differences  requirements for the issuer : - First 2: at the end, securities are expected to be traded on financial markets and sold to thousands of investors, and requirements are stricter (to protect the retailing investors); - In 3rd case: requirements are less strict; the buyer is an institutional buyer, so he has the skills and the money necessary to estimate the riskiness of the operation (no need to be protected by the law, since they have more experience)  securities are expected to be bought by 2 institutional investors. Once issued, securities can be traded on the Secondary Market : Secondary Market Trading - Secondary market trading for municipal bonds is relatively infrequent. - Thin trading is mainly a result of a lack of information on bond issuers, as well as special features (such as covenants) that are built into those bonds’ contracts. - Information on municipal bond issuers (particularly of smaller government units) is generally more costly to obtain and evaluate, although this is in part offset by bond rating agencies. Corporate Bonds = long-term obligations issued by corporations. - Minimum denomination on publicly traded corporate bonds is $1,000. - Coupon-paying corporate bonds generally pay interest semiannually. - A Bond Indenture is the legal contract that specifies the rights and obligations of the bond issuer and the bondholders. Contains several covenants associated with a bond issue.  Bond Covenants describe rules and restrictions placed on the bond issuer and bondholders. o Floating Rate Notes = receive coupon rate that varies over time. It varies according to the LIBOR Rate (market interest rate). Corporate bonds can have a so-called Coupon Cap (ex. 4% means that the coupon rate cannot exceed 4%, it is like a ceiling), as well as a floor.  0.65% + quarterly LIBOR rate: If LIBOR increases  the price of the coupon will increase. Coupon cap = 4% In some cases, coupon rates can have both a cap and a floor. Technical Features of Bonds 04/10/2022 Financial system (recap) 7 Financial markets: why we study it People that are in excess of funds and ppl who are in a shortage of funds. Financial markets: provide finance for companies (so they can invest, grow, …), provide money for government (obtain money to build infrastructures, highways…). When fin systems work well  well-developed economy. Fin markets can be classified in: • Primary: corporations or eco agents which are in shortage of funds can raise money by issuing sec (new security issuing), participants: issuer and first buyer. • Secondary: once issued, sec can be traded in secondary market, part: one who has already bought a sec and one that wants to buy it. • Money: fin instruments with M < 1 year. • Capital: fin instruments with M > 1 year  2 most imp: Bond Capital Market and Stock Market.  Wider price fluctuation in capital than money  instruments traded in 2 have a longer duration. Foreign Exchange Markets: trade foreign exchange rates (prices of currencies expressed in terms of other currencies)  ex. Eurodollar market. We are exposed to foreign exchange risk: we can have a lower profit due to an increase/decrease in the foreign exchange rate. Derivatives Sec. Market: fin. sec. linked to another sec., f.e. futures and options (the higher the price of gas, the higher the value of derivative sec). Fin. int.  ease the flow of funds, reduce monitoring cost, liquidity risk and price risk (when a corporation borrows money from investors, these investors aren’t willing to face the monitoring costs). - Indirect financing: funds flow from lenders to borrowers by means of a financial intermediary, - Direct financing: money flows directly from savers to spenders through fin. market. Risks faced by fin. institutions: - Default risk (credit risk): risk that our counterparty will not be able to pay principal and interest on a loan/sec, - Foreign exchange risk, - Country risk: due to bad situation of a country, - IR risk: due to changes in IR, - Market risk: prices of fin sec may vary over time, and we might suffer a loss, - Off balance risk - Liquidity risk: ability to be converted into cash (if low, might suffer a loss), - Technology risk: related to tech failures, - Insolvency risk: the probability that the counterparty is unable to repay over a period of time. Why there are Changes in IR - Loanable funds theory: divides the market into categories: supplies of LF and the demanders of LF, consider the eq IR where supply and demand coincide. Both demand and supply are affected by factors. Relation direct: factor increases and IR INCREASES TOO. INDIRECT: factor increases and IR decreases. Total health (when it increases  more monetary units, quantity supplied for LF increases  equilibrium interest rate decreases). … Demand affected by : - Utility - Restrictiveness of non-price condition - Economics conditions  direct relationship IR is affected by the inflation premium (I will charge the expected higher prices that I will bear in the future)  risk- free rate. Unbiased expectation theory: considers diff securities and maturities as perfect substitutes, investors consider IR (higher IR higher willingness to invest)  No different btw investing today on a 10 y bond or investing today in 10 annual bonds in a row. Liquidity premium: same as unbiased, diff takes into consideration the maturity premium 8higher maturity, higher IR). Market seg theory: consider that investors have preferences with respect to maturities. To evaluate money: a dollar today is worth more than a dollar tomorrow Lump sum valuation: Yield to maturity of coupon payments = every time we receive a periodic payment, we reinvest it at the same rate (to have final performance = yield to maturity). Pull to parity = movement of security prices over the face value we the sec approach the maturity date (price of the bonds tends to be equal to its face value). Why? Apply formula for lump sum valuation r = ((M/PV)^1/t)-1, if M=PV r=0 Duration: - B1 c = 0 (ZCB) - B2 c = 5% - B3 c = 10%  exposure to IR risk is lower (duration is lower) Direct relationship btw M and duration 14/10/2022 – Lecture 7/8 Stock (Equity) Market Equity (usually in quarters), traded on stock exchanges. Earning report season: the period of time during which a large number of publicly traded companies release their quarterly earnings reports. In general, each earnings season begins 1 or 2 weeks after the last month of each quarter (the last quarter started at end of September). It has a big impact - Wall Street banks slash 34 billion dollars from earnings forecasts for big companies. Ex: We have a 100€ bond; Duration 10 years  Delta price = -10 x 3% = - 30. Delta price = - D (duration) x ∆i Interest rate went up which caused very big losses. Types of Stocks Bond Equity Bond is a piece of paper (promise), with a n° of things you can detach (coupons). There is issuer (type of bond), value, and date of maturity  right to be paid (deterministic). When we move to equity: there is value, no date of maturity. On the right, there are no coupons, but a dividend. It doesn’t give you something for sure. Corporate Stock serves as a source of financing for firms, in addition to debt financing or retained earnings financing. Secondary stock markets are the most closely watched and reported of all financial security markets. • Stockholders are the legal owners of a corporation. 1. Have a right to share in the firm’s profits (through dividends) after the payment of interest to bondholders and taxes. 2. Have a residual claim on the firm’s assets (shareholders are the most subordinated creators of a company - if a company is liquidated, you are the last to be paid). Ranking: employees (first to be paid), commercial relationships (people you buy things from), banks, bondholders and then lastly the rest. 3. Have limited liability. 4. Have voting rights (for example, to elect the Board of Directors). 2 types of corporate stock exist: Common stock vs Preferred stock (all public corporations issue common stock, but few issue preferred stock). Common Stock It is the fundamental ownership claim in a public or private corporation, and many characteristics differentiate it from other types of securities: discretionary dividend payments, residual claim status, limited liability, voting rights. They earn a dividend as long as the company is earning money, and this dividend directly corresponds to the profit made by the company. High profits mean high dividends . Dividends are discretionary, and are thus not guaranteed. Their payment and size are determined by the board of directors of the issuing firm. Dividends are taxed twice (once at the firm level and once at the personal level)  may partially avoid this double taxation effect by holding stocks in growth firms that reinvest most of their earnings to finance growth rather than paying larger dividends. The return to a stockholder over a period t-1: We can consider it as a perpetuity (all dividends are equal). A = sum of all dividends divided by (1 + r)^t  A = Div/re  P = Div/re Constant growth rate formula  called Gordon Model. Residual claim Common stockholders have the lowest priority claim in the event of bankruptcy (they have residual claim). Controversial Trading Practices • Flash trading is a practice in which, for a fee, traders are allowed to see incoming buy or sell orders milliseconds earlier than general market traders. • Naked access allows some traders to rapidly buy and sell stocks directly on exchanges using a broker’s computer code without exchanges or regulators always knowing who is making the trades  banned by SEC in late 2010. • Dark pools of liquidity are trading networks that provide liquidity but that do not display trades on order books  in 2013, the SEC approved a plan for new rules requiring dark pools to disclose and detail trading activity on their platforms. The NASDAQ and OTC Market Securities not sold on one of the organized exchanges are traded Over The Counter (OTC). OTC Markets do not have a physical trading floor; rather, transactions are completed via an electronic market (there is a dealer instead of a broker, which is directly involved in trading). NASDAQ was the world’s first electronic stock market: • Primarily a dealer market, where dealers are the market makers who stand ready to buy or sell particular securities; • In contrast to the NYSE, NASDAQ is a negotiated market - that is quotes from several dealers are usually obtained before a transaction is made . • Small Order Execution System (SOES) provides automatic order execution for individual traders with orders of less than or equal 1,000 shares. Choice of Market Listing Firms listed with the NYSE Euronext must meet the listing requirements (extensive) of the exchange. Reasons a NYSE is attractive to firms : 1. Improved marketability of the firm’s stock, 2. Publicity for the firm, 3. Improved access to the financial markets. Firms that do not meet the requirements of the NYSE Euronext exchange listing trade on the NASDAQ (most NASDAQ firms are smaller, of regional interest, or unable to meet the listing requirements of the organized markets; over time many NASDAQ firms supply for NYSE listing). Electronic Communications Networks and Online Trading Major stock markets currently open at 9:30 am eastern time and close at 4:00 pm eastern time. Extended-hours trading involves any securities transaction that occurs outside these regular trading hours (most extended-hours trading is processed through computerized alternative trading systems ATSs , also known as electronic communication networks ECNs such as NYSE Arca or Instinet). ECNs are computerized systems that automatically match orders between buyers and sellers and serve as an alternative to traditional market-making and floor trading. Stock Market Indexes A stock market index is the composite value of a group of secondary market-traded stocks. • Dow Jones Industrial Average (DJIA) is the most widely reported stock market index and includes the values of 30 large corporations selected by the editors of The Wall Street Journal (Dow indexes are price-weighted averages). • NYSE Composite Index includes all NYSE-listed common stocks (value-weighted index). • S&P 500 Index consists of the stocks of the top 500 of the largest U.S. corporations listed on the NYSE and the NASDAQ. • NASDAQ Composite Index consist of stocks traded through NASDAQ that are industrials, banks, and insurance companies. • Wilshire 5000 Index is the broadest stock market index and possibly the most accurate reflection of the overall stock markets  Contains virtually every stock that meets 3 criteria: 1. Firm is headquartered in the U.S., 2. Stock is actively traded in a U.S.-based stock market, 3. Stock has widely available price information (which rules out the smaller OTC stocks from inclusion). Though the index started with 5,000 firms, because of firm delistings, privatizations, and acquisitions it currently includes just 3,618 stocks.  Value-weighted index. Market Participants Holders of corporate stock from 1994 through 2019: - Households are the single largest holders (38% in 2019), - Mutual funds and foreign investors (23.5% and 15.9%), - Households indirectly invest in corporate stock through investments in mutual funds and pension funds (together, these holdings totalled approximately 74% in 2019). US stock ownership rates are highly related to income, but also vary by age: on average, 62% of U.S. adults aged 30 to 64 own stocks, compared with 31% of those aged 18 to 29 and 54% of those aged 65 and older. Other Issues Pertaining to Stock Markets Economic Indicators Stock market indexes might be used to forecast future economic activity. An increase (decrease) in stock market indexes today potentially signals the market’s expectation of higher (lower) corporate dividends and profits and, in turn, higher (lower) economic growth. Stock prices are 1 of the 10 variables included in the index of leading economic indicators used by the Federal Reserve as it formulates economic policy. Market Efficiency Market efficiency refers to the speed with which financial security prices reflect unexpected news. a) Weak form market efficiency concludes that investors cannot make more than the fair (required) return using information based on historic price movements.  Empirical research suggests markets are weak form efficient. b) According to semi-strong form market efficiency, investors cannot make more than the fair (required) return by trading on public news releases  Financial markets have generally been found to immediately reflect information from news announcements. c) Strong form market efficiency states that stock prices fully reflect all information about the firm, both public and private (implies that there is no set of information that allows investors to make more than the fair – required - rate of return on a stock). Stock Market Regulations Main emphasis of SEC regulation is on full and fair disclosure of info on securities issues: • Securities Act of 1933 required listed companies to file a registration statement and to issue a prospectus. • Securities exchange Act of 1934 established the SEC as the main administrative agency responsible for the oversight of secondary stock markets. • Sarbanes-Oxely Act, passed in July 2002, created an independent auditing oversight board under the SEC, increased penalties for corporate wrongdoers, forced faster and more extensive financial disclosure, and created avenues of recourse for aggrieved shareholders. SEC has delegated certain regulatory responsibilities to the markets (ex: NYSE and NASDAQ; they are self- regulatory organizations). - Financial Industry Regulatory Authority (FINRA) is the largest independent regulatory for all securities firms doing business in the US (formed in 2007, oversees all aspects of the securities business). - Wall Street Reform and Consumer Protection Act of 2010 gave the SEC and other regulators new powers to oversee the operations of stock markets. International Aspects of Stock Markets US stock markets are the world’s largest  European markets grew in importance during the 2000s, as a result of implementing the euro, a common currency in 2002. International stock markets are attractive to investors because some risk can be eliminated by holding stocks issued by corporations in foreign countries. But at the same time, international diversification can also introduce risks: 1. information about foreign stocks is less complete and timely than that for US stocks; 2. Foreign exchange risk, 3. Political (sovereign risk). American Depository Receipts (ADRs) It is a certificate that represents ownership of a foreign stock - Typically created by a US bank, which buys stock in foreign corporations in their domestic currencies and places them with a custodian. The bank then issues dollar ADRs backed by the shares of the foreign stock. There are 3 main types of ADR issuances : 1. Level 1 ADRs are the most common and most basic of them (have the least amount of regulatory requirements ). 2. Level 2 ADRs can be listed on the major stock exchanges, but they have more regulatory requirements than Level 1 ADRs. 3. Level 3 ADRs represent the most respected ADR level a foreign company can achieve in the US markets.  Clearing-house: part of the stock exchange (monitors behaviour of companies listed) - a bankers' establishment where cheques and bills from member banks are exchanged, so that only the balances need to be paid in cash. Lesson 9 (Rebe) Markets at Auction and Markets with Market Making Auction Market Market Making Follows a pricing order-driven process. The flows of purchase and sales orders are crossed on the basis of price and time priorities. A process of pricing odds drivers takes place. Financial intermediaries operate as dealers and with a specific function of market making, that is to quote securities (the intermediary shows the proposals of price and the relative quantities which it is willing to Sell or Buy). The other participants, when they agree with the proposals, close the exchange directly with the market maker. Order Driven Market In the auction market, all individuals and institutions that want to trade securities announce the prices at which they are willing to buy and sell  These are referred to as bid and ask prices. An efficient market should prevail by bringing together all parties and having them publicly declare their prices. The best price of a good need not be sought out because the convergence of buyers and sellers will cause mutually agreeable prices to emerge. The biggest advantage is its transparency: it clearly shows all of the market orders and what price people are willing to buy at or sell for NYSE is an auction market. Order-driven market is for treasury bonds (by government), large stocks. Market Order Book An Order Book is the list of orders (manual or electronic) that a trading venue (in particular stock exchanges) uses to record the interest of buyers and sellers in a particular financial instrument . A matching engine uses the book to determine which orders can be fulfilled i.e. what trades can be made. Types of orders : - Orders with daily validity • In relation to the price, we can distinguish: orders with limited price, odder best execution; • In relation to the market phases: at the opening, daytime phase, after hours, vwap. - Multi-day Orders: 30 days or other period. - Conditional orders or stop orders. Quote-Driven Market Participants are joined through electronic networks. The dealers: 1) hold an inventory of the security in which they “make a market ”, then 2) stand ready to buy or sell with market participants. These dealers earn profits through the spread between the prices at which they buy and sell securities. Corporate Bonds markets, currencies and commodities are a dealer market: here the dealers (market makers) provide firm bids and ask prices at which they are willing to buy and sell a security. The theory is that competition between dealers will provide the best possible price for investors. Stocks Market in Italy • MTA (Mercato Telematico Azionario): market within which shares, convertible bonds, option and warrants are negotiated. • AIM Italia (Alternative Investment Market): market dedicated to small and medium-sized Italian companies  fewer requirements than MTA (liquidity limited than MTA). Insurance Companies (ICs) The primary function of insurance companies is to compensate policyholders if a pre-specified event occurs, in exchange for premiums paid. • Insurance underwriters assess and price risks. • Insurance brokers sell insurance contracts. Insurance is broadly classified into 2 groups. 1. Life insurance policies provide protection against untimely death or illness, and/or transfer of wealth through time to retirement. 2. Property-casualty insurance protects against property damage, personal injury and liability associated with specific events. Insurance companies also sell a variety of investment products (similar to other FIs). Life Insurance Companies 872 life insurance companies existed in the U.S. in 2015. • Compares to over 2,300 in 1988. • The industry has seen consolidation to take advantage of scale and scope economies. Aggregate industry assets were $6.47 trillion at the beginning of 2016  Compares to $1.12 trillion in 1988. The 4 largest life insurers wrote 30.5% of the industry’s over $681 billion premiums in 2015. • Many of these policies are sold through commercial banks. • For example, in 2015 commercial banks sold over 17% of all annuity contracts. Life insurers pool the risks of individuals to diversify away some of the customer-specific risks. Thus, they are able to offer insurance services at a cost lower than any individual could achieve on his/her own . This allows the transfer of income-related uncertainties from the individual to the group. Other activities of life insurance companies: • Sell annuities, which are savings contracts that involve the liquidation of those funds saved over a period of time. • Manage pension plans (example: tax-deferred savings plans). • Provide accident and health insurance. Insurance companies accept or underwrite risk that a pre-specified event will occur in return for insurance premiums  Underwriting decisions determine: 1) which risks are accepted, and which are not, and 2) how much to charge (in the form of premiums) for accepted risks. The adverse selection problem is the problem that customers who apply for insurance policies are more likely to be those in need of coverage. The Role of Actuaries Actuaries reduce the risks of underwriting and selling insurance. • With traditional life insurance, actuaries analyze mortality, produce life tables, and apply time-value-of-money tools to price life insurance, annuities, and endowment policies. • With health insurance, actuaries analyze the rates of disability, morbidity, mortality, fertility, etc. Life Insurance Policies Life Insurance Policies come in many forms. Some of the typical policies include: 1. Term Life: the insured is covered while the policy is in effect, usually 10 - 20 years lump sum.  No saving component. 2. Other: similar to term life, when the term of the policy expires, the insured can get the cash value of the policy or an annuity. It costs more than the term life. 3. Survival Insurance: it pays a lump sum or an annuity if, at some date, the insured is still alive.  Insurance against life…Covers retirement years. The 4 Types of Life Insurance #1 - Ordinary life insurance is marketed to individuals (policyholders make periodic premium payments in exchange for coverage). • Term life is the closest to pure life insurance; has no savings element attached  No saving components. • Whole life protects the individual over an entire lifetime rather than for a specified coverage period.  Ex. Pay 7,000 for 10 years and get 100,000 in case of death at any time. • Endowment life combines a pure (term) insurance element with a savings element.  Face value at expiration or in case of death. • Variable life invests fixed premium payments in mutual funds of stocks, bonds, and money market instruments. • Universal life and variable universal life. #2 - Group life insurance covers a large number of persons under a single policy. • Contributory: both the employer and the employee cover a share of the premiums. • Noncontributory—the costs are borne entirely by the employer. #3 - Credit life insurance protects lenders against borrower death prior to the repayment of a debt contract, such as a mortgage or car loan. #4 – Other activities include the sale of annuities, private pension plans, and accident and health insurance. • Annuities represent the reverse of life insurance principals. • Popular among individuals as a mechanism used to save for retirement. • Annuity sales in 2015 topped $236.7 billion. • In 2016, life insurance companies were managing over $3.6 trillion in pension fund assets, equal to 41% of all private pension plans. • More than $171 billion in premiums were written annually by life and health companies in accident-health in 2015.  Insurance policies during covid were in a positive period: car accidents were 0. Annuities: Example You have a policy with a cash value of $250,000 which you wish to annuitize. You are currently 62 years old, and your spouse is 58. Interest rates are 5% per year, and you are considering receiving monthly payments under 3 options: • In option 1, you will receive 10 years of monthly payments. • With option 2, you will receive a monthly payment until you die, which is expected to be in 14 years. • With option 3, you will receive a monthly payment until both you and your spouse die. Your spouse is expected to outlive you by 8 years. How much will you receive per month with each option (ignoring administrative costs and fees)? Company Assets and Liabilities Assets Life insurance companies derive funds (assets) from 2 sources: 1. they receive premiums that must be used to pay-out future claims when the insured dies; 2. they receive premiums paid into pension funds managed by the life insurance company. Insurers earn profit by taking in more premium income than they pay out in policy payments. Firms can increase their spread between premium income and policy pay-outs in 2 ways: a) Decrease future required payouts for any given level of premium payments (accomplished by reducing the risk of the insured pool). b) Increase the profitability of interest income on net policy reserves  if the interest rate increases, people will pay more to the insurance companies, and the companies will have greater returns also from investments. Life insurers concentrate their assets investments at the longer end of the maturity premium/spectrum. • Example : corporate bonds, equities, and government securities. • In 2016, 10.8% of assets were invested in government securities, 67.6% in corporate bonds and stocks, and 6.8% in mortgages. Liabilities Life insurance companies have 2 primary liabilities : 1. life insurance payouts, 2. pension funds payouts. Technical reserves are set aside to cover these liabilities Actuarial calculations . - Net policy reserves made up to $2.9 trillion, or 44.1% of total liabilities and equity. - To meet unexpected future losses , life insurers hold a capital and surplus reserve fund with which to meet such losses (reserves for life insurers in 2016 totalled $280.8 billion, or 5.9% of total liabilities and capital). Property-Casualty (P&C) Insurance Companies Currently, 2544 companies sell property-casualty insurance, and approximately half of those firms write P&C business in all or more of the US: top firms have a 50% market share, top 200 firms have more than 95% market share; in 2016, State Farm was the top firm, writing 11.3% of all PC insurance premiums. - Property Insurance: it involves coverage related to the loss of real and personal property. - Casualty Insurance: it offers protection against legal liability exposure. P&C Lines • Fire insurance and allied lines: protects against the perils of fire, lighting, and removal of property damaged in a fire. • Homeowners multiple perils (MP) insurance: protects against multiple perils of damage to a personal dwelling and personal property, as well as liability coverage against the financial consequences of legal liability resulting from the injury to others. • Commercial multiple peril (MP) insurance: protects commercial firms against perils similar to homeowners. • Automobile liability and physical damage (PD) insurance: provides protection against losses resulting from legal liability due to the ownership/use of the vehicle and theft or damage to vehicles. • Liability insurance (other than auto). Balance Sheet of PC Companies - Assets: P&C companies invest the majority of their assets in long-term securities, but hold a much lower proportion in common stock than do life insurance companies  Shorter maturity. - Liabilities: Loss reserves and loss adjustment expenses are a major component (34.4% of total liabilities and capital). • Loss reserves are funds set aside to meet expected losses from underwriting the P&C lines. • Loss adjustment expenses are the expected administrative and related costs of settling claims.  Unearned premiums, reserves set aside that contain the portion of a premium that has been paid before insurance coverage has been provided, are also a major liability and make up 13.2% of total liabilities and capital. PC Recent Trends Many catastrophes of historically high severity have occurred recently. An underwriting cycle is a pattern that the profits in the P&C industry tend to follow. The federal government has consistently increased their role of providing compensation and reconstruction assistance following natural disasters. Risks related to Insurance Companies Underwriting Risk It is the risk that premiums are insufficient to cover losses and administrative expenses after taking into account investment income. It may result from: unexpected increases in loss rates, unexpected increases in expenses, and unexpected decreases in investment yields. PRACTICING MANAGER (INSURANCE MANAGEMENT) Screening - Risk based premium - Restrictive provisions - Prevention of fraud - Cancellations of Insurance - Deductibles - Coinsurance - Limits on the amount of insurance. Loss Risk (function of actuarial predictability): • Property vs. liability insurance (property more predictable). • Severity vs. frequency  Eg Earthquake terrorism. They are mutual funds which invest in financial instruments which have short-term (maturity less than a year, money market)/ mid-term or long-term maturity. E. Objective : income (mutual fund aimed to produce a constant flow of dividends to mutual funds participants) vs. capital gain (mutual fund does not distribute earnings; there is an increase in the value of investment over time) vs. total return (comprises both; we do expect to receive some cash flows over the period, and we expect an increase in the value of the investment. It is an income fund with capital gain). F. Costs : load (a mutual fund which charges a sales fee or commission, as long as you keep your money invested for a specific period) vs no-load funds. Hedge Funds, another type of Mutual Funds Hedge Funds (HFs) are related to an investment company which is considered the riskiest investment company. HFs are a type of investment pool that solicits funds from (wealthy) individuals and other investors (for example, commercial banks) and invests these funds on their behalf.  Similar to MFs in that they are pooled investment vehicles that accept investors’ money and generally invest it on a collective basis.  Not subject to the numerous regulations that apply to MFs for the protection of individuals  While MFs are very highly regulated, HFs have generally been unregulated.  Do not have to disclose their activities to 3rd parties, and thus offer a high degree of privacy for their investors.  Use aggressive strategies unavailable to MFs, including short selling, leveraging, program trading, arbitrage, and derivatives trading.  Historically, HFs have avoided regulation by limiting the n° of investors to less than 100 individuals and by requiring investors to be “accredited”.  HFs are only sold via private placements, may not be offered or advertised to the general investing public, and they are prohibited from abusive trading practices. Types of Hedge Funds:  More Risky  Market directional – These funds seek high returns using leverage, typically investing based on anticipated events.  Moderate Risk  Market neutral or Value orientation – These funds have moderate exposure to market risk, typically favouring a longer-term investment strategy.  Risk Avoidance  Market neutral – These funds strive for moderate, consistent returns with low risk. Why do Mutual Funds exist? It is not necessary to invest in mutual funds to build up wealth over time, since each investor can manage his wealth on his own and can obtain a desirable return. Investing in mutual funds does not necessarily imply obtaining a strictly positive return. Moreover, the fund’s asset manager invests the capital but does not bear any investment risk. On the opposite, all the risks connected to the investment activity are borne by investors. However, Mutual Funds have some characteristics which make them attractive. Benefits of Mutual Funds  Diversification: Collecting small wealth from thousands of investors, the fund manager can build and invest a consistent sum. Therefore, the manager can divide the portfolio across hundreds of assets, giving investors a desirable degree of diversification.  Operating costs: mutual funds incur proportionately lower trading commissions with respect to the ones incurred by individual investors. Lower transaction costs may reflect in better performances.  Shareholder services: if one wants to compound his wealth quickly the fund can re-invest in the fund itself all profits generated (ie, dividends and capital gains); possibility to switch between funds.  Liquidity: very low transaction costs; to limit liquidity risk, mutual funds always keep a percentage (of the fund’s wealth) in cash.  Denomination intermediation: Example: we could participate in a common portfolio with just 100 monetary units. Suppose the portfolio invests in 100 financial instruments (traded at 1000 monetary units each) - we have rights, thanks to denomination intermediation. Mutual Fund Industry The first mutual fund was established in Boston in 1924. The industry grew slowly at first; since then, the number of funds and asset size of the industry has increased dramatically due to:  The advent of money market mutual funds, funds that invest in securities with an original maturity under 1 year, in 1972.  Tax-exempt money market mutual funds first established in 1979.  The explosion of special-purpose equity, bond, emerging market, and derivative funds.  Rise in retirement funds under management by mutual funds .  Many of these retirement funds are institutional funds, mutual funds that manage retirement plans for an institution’s employees.  Target date funds, which follow a predetermined reallocation of risk over time, and lifestyle funds, which maintain a predetermined risk level, are also popular among retirement funds. The Mutual Fund (money market and long-term mutual funds) Industry is larger than the insurance industry but only slightly larger than the depository institutions industry  Through the end of 2019, the DI industry was the largest FI group, but the mutual fund industry surpassed the DI industry in size in 2019. Low barriers to entry in the U.S. mutual fund industry have allowed new entrants to offer funds to compete for investor attention.  Share of industry assets held by largest mutual fund sponsors has changed little since 1990.  Largest 25 companies that sponsor mutual funds managed 80% of the industry’s assets in 2019, slightly larger than 76% in 1990. Different Types of Mutual Funds The Mutual Fund (MF) Industry is usually considered to have 2 sectors: short-term funds and long-term funds. Short-term funds comprise taxable money market mutual funds (MMMFs) and tax-exempt money market funds.  The principal type of risk is interest rate risk due to the predominance of fixed-income securities, but this risk is mitigated to a large extent because of the shortness of maturity of the assets (often less than 60 days).  Have virtually no liquidity or default risk.  Money market mutual funds (MMMFs) consist of various mixtures of money market securities. They provide an alternative investment opportunity to interest-bearing deposits at commercial banks.  Tax-exempt money market mutual funds contain various mixes of those money market securities with an original maturity of less than 1 year. Long-term funds comprise equity funds, bond funds, and hybrid funds:  Equity funds consist of common and preferred stock securities  Typically well diversified, and the risk is more systematic, or market-based.  Bond funds consist of fixed-income capital market debt securities  Extensive interest rate risk because of their long-term, fixed-rate nature.  Hybrid funds consist of both stock and bond securities. Households own the majority of both long- and short-term funds. Other Types of Investment Company Funds  An Open-end MF is a fund for which the supply of shares is not fixed, but can increase or decrease daily with purchases and redemptions of shares.  A Closed-end investment company is a specialized investment company that has a fixed supply of outstanding shares and generally do not continuously offer shares for sale.  Real estate investment trust (REIT) are closed-end investment companies that specialize in investing in real estate company shares and/or in buying mortgages.  Unit investment trusts (UITs) sell a fixed n° of redeemable shares that are redeemed on a set termination date. Mutual Fund Prospectus and Objectives MF managers must specify their fund’s investment objectives in a prospectus (a formal summary of a proposed investment), which is made available to potential investors. Managers in the prospectus must include a brief recap of previous performances, the riskiness of investments, general information about the types of securities related to a mutual fund held, and information also about costs and fees. Through this document, we can understand if the portfolio meets my requirements/needs. The management company does a lot of research to identify the financial instruments which are expected to increase/decrease in their value.  The Prospectus provides general information about the types of securities the mutual fund holds as assets.  In 1998, the Securities Exchange Commission (SEC) mandated that fund prospectuses must be written in “plain English” instead of overly legal language.  Individuals’ preferences for a mutual fund’s objective often change over time . Passively managed Funds can be: 1. Index funds: are funds in which managers buy securities in proportions similar to those included in a specified major index. Involve little research or management, which results in lower fees and higher returns than more actively managed funds. 2. Exchanges traded funds (ETFs): long-term mutual funds that are also designed to replicate a particular stock market index. Legally classified as open-end mutual funds, but similar to closed-end funds in that a fixed n° of shares are outstanding at any point. Trade intraday on a stock exchange at prices determined by the market. Management fees are lower than actively managed mutual funds. Unlike index funds, ETFs can be traded during the day, sold short, and purchased on margin  Closed box, the n° of shares remains constant over time. In order to get liquidity, we have to sell shares to a counterparty interested (easy to find, since there is an active secondary market). Mutual Fund Costs A. Shareholders fees: paid by each investor directly from his/ her investment.  Sales loads: fees charged to investors to compensate the broker who sells the mutual fund’s share. Sales loads can be classified into a) front-end sales load (paid at the time of purchase), b) back-end sales load (paid at the time of sale).  Redemption fees: Mutual funds charge shareholders when they decide to redeem their shares. Unlike the back-end sales load, the redemption fee is paid directly to the fund, not to the broker.  Exchange fees: are sometimes imposed on shareholders when they switch to another fund within the same fund group.  Account fees: Are sometimes imposed on investors for the maintenance of their accounts.  Purchase fees: It is similar to a front-end sales load. However, they differ because the former is paid to the fund while the latter is paid to the broker. B. Annual fund operating expenses: paid each year as a percentage of the value of the investment (or, in other words, as a percentage of the NAV ).  Management fees: These fees are paid from the fund’s assets to the fund’s investment adviser, for managing the fund’s investment portfolio.  Distribution (or services or 12b-1) fess: These fees are paid from the fund’s assets to cover marketing, advertising and distribution expenses, as well as to cover the printing and mailing of prospectuses to new investors.  Other expenses: This category contains all the expenses not included in the preceding ones, such as custodial expenses or legal expenses.  Total Annual Fund Operating Expenses : it represents all the fees and expenses categorized as the fund’s operating expenses. It is expressed as a percentage of the fund’s average net assets. Usually, the former are called Direct Fees, the latter Indirect Fees. Often, funds offer different share classes (all of which invest in the same underlying portfolio of assets), but each share class may offer investors different methods of paying for broker services : A. Class A shares carry a front-end load that is charged at the time of purchase as a percentage of the sales price and usually have an annual 12b-1 fee between 25 and 35 basis points of the portfolio’s assets. B. Class B shares are offered for sale at NAV without a front-end load, but charge an annual 12b-1 fee (usually 1%) and a back-end load (usually based on the lesser of the original cost of the shares or the market value at the time of sale). C. Class C shares are offered at NAV with no front-end load, but charge an annual 12b-1 fee of 1% and a back-end load (set at 1% in the first year of purchase; not charged on redemption after the first year). Allow for both employer and employee contributions.  401(k) plans are offered to employees of taxable firms, while 403(b) plans are offered to employees of certain tax-exempt employers.  Contributions are made on a pretax basis and thus reduce the employee’s taxable salary.  Most plans are transferable if the employee changes jobs.  Participants generally make their own choice of the allocation of assets from both employee and employer contributions  Younger participants generally invest more in equities, while older participants invest more in fixed-income securities. In order to calculate return on a 401k Plan, use formula of Annuity = Value of annuity [(1+r)^(t) - 1]/r Calculating the Return on a 401(k) Plan Individual Retirement Accounts (IRAs) Individual retirement accounts are self-directed retirement accounts set up by employees who may also be covered by employer-sponsored pension plans as well as self-employed individuals. - Contributions are made strictly by the employee . - First allowed in 1981 as a method of creating a tax-deferred retirement account to supplement an employer- sponsored plan. - As of 2020 maximum contributions were $6,000 per year. Roth IRAs were introduced in 1998. In 2020, they allowed a maximum of $6,000 after-tax contribution per individual ($12,000 per household). Contributions are taxed in the year of contribution, and withdrawals are tax-free (provided the funds have been invested for at least 5 years and the account holder is at least 59 1⁄2 years old). Only available to individuals or households with an adjusted gross income of less than $139,000 or less than $206,000, respectively. Koegh Accounts A Keogh account is a retirement account, available to self-employed individuals, in which contributions by the individual may be deposited in a tax-deferred account administered by a life insurance company, a bank, or other financial institution. 1. Profit-sharing Plan: contributions can vary by year (from 0 to 25% of the individual’s income, up yo $56,000). 2. Money Purchase Plans: require a mandatory contribution (at a constant % of the employee’s income) each year whether the individual has profits or not.  Contributions can be as high as the lesser of $56,000 or 25% of the individual’s self-employed income. Public Pension Funds Pension Funds sponsored by the federal or state and local governments are referred to as Public Pension Funds. Employees of state or local governments may contribute to pension funds sponsored by these employers. - Most are funded on a “pay as you go” basis. - Due to an increasing number of retirees relative to workers, some pension funds are underfunded. Federal government sponsors 2 types of pension funds: 1. Funds for federal government employees, including civil service employees, military personnel, and railroad employees. 2. Social Security, which provides retirement benefits to almost all employees and self-employed individuals in the U.S. Recent Trends Private Pension Funds Public Pension Funds Financial assets (pension fund reserves) held by private pension funds in 1975 totalled 244.3 billion, compared to 10,833 billion in 2019.  In 2019, 66.28% of pension fund assets were in corporate equities or equity mutual fund shares, compared to 44.61% in 1975. In 2019, defined benefit funds had 34.11% of their funds invested in U.S. government securities and corporate and foreign bonds, compared to 7.27% for defined contribution funds.  Defined benefit funds had 34.17% of their assets invested in corporate equities, compared to 23.27% by defined contribution funds. Like private pension funds, state and local pension funds held most of their assets in corporate equities or equity mutual fund shares.  In 1975, 23.32% of pension fund assets were in equities. Second in importance were US government securities and bonds (11.14% in 2019): • In 1975, 66.03% of pension fund assets were in US government securities and bonds. • At the federal level, Social Security contributions are invested in relatively low-risk, low-return Treasury securities. Proposals & Regulations Social Security 2100 Act 1. Increase the combined payroll tax rate by 2.4 percentage points , from 12.4 to 14.8%, phased in by 0.1% per year over 24 years; 2. Apply the entire payroll tax to earnings above $400,000 and, ultimately, to all income as the current wage- indexed maximum of $132,900 caught up; 3. Offer some benefit credit for new taxes paid by increasing benefits by 2% of all wage income above $400,000; 4. Increase the income threshold for taxation of 85% of Social Security benefits to $50,000 for single filers and $100,000 for joint Bilers, up from $34,000 and $44,000; 5. Increase the lowest Primary Insurance Account (PIA) factor in the benefit formula from 90 to 93%, increasing benefits across the board; 6. Use the faster-growing, experimental Consumer Price Index for the Elderly (C P I-E) for Cost-Of-Living Adjustments (C O L A s); 7. Create a minimum benefit of 125% of the poverty line for people who have worked 30 years or more. Pension Fund Regulation Major piece of regulation governing private pension funds is the Employee Retirement Income Security Act (ERISA) of 1974. While ERISA does not mandate employers establish pension funds for their employees, it requires them to meet certain standards if a fund is to be eligible for tax-deferred status. Principal features of ERISA focus on the following:  Pension Plan Funding: prior to ERISA, there were no statutory requirements forcing demand benefit fund administrators to adequately fund their pension funds. Provisions in ERISA led many companies to switch from defined benefit plans to defined contribution plans. ERISA established guidelines for funding and set penalties for fund deficiencies .  Contributions to pension funds must be sufficient to meet all annual costs and expenses and to fund any unfunded historical liabilities over a 30-year period.  Any new underfunding arising from low investment returns or other losses must be funded over a 15-year period.  Vesting of Benefits: a vested employee is eligible to receive pension benefits because he or she has worked for a stated period of time.  Prior to ERISA, some plans required their employees to work 15 and even 25 years before they were eligible to receive pension benefits.  ERISA requires that a plan must have a minimum vesting requirement and sets a maximum vesting period of 10 years.  Fiduciary responsibility : a pension plan fiduciary is a trustee or investment advisor charged with the management of the pension fund.  ERISA required that PF contributions be invested with the same diligence, skill, and care as a “prudent person” in like circumstances (that is, the prudent-person rule).  Fund assets are required to be managed with the sole objective of providing the promised benefits to participants.  Pension Fund Transferability: ERISA allows employees to transfer pension credits from one employer to another when switching jobs.  Pension Fund Insurance: ERISA established the Pension Benefit Guarantee Corporation (PBGC), an insurance fund for pension fund participants similar to the FDIC. PBGC ensures participants of defined benefit funds if the proceeds from the fund are unable to meet its promised pension obligations.  During 2019, PBGC assumed financial responsibility for 47 underfunded single-employer plans that were terminated.  Despite premium increases over the years, the PBGC has generally operated at a deficit since its inception.  Pension Protection Act of 2006 called for increasing the annual premiums paid by companies to $30 per worker from $19 and the imposition of automatic increases in premiums each year. Global Issues Pension systems vary widely in Europe.  The U.K., the Netherlands, Ireland, Denmark, and Switzerland all have a tradition of state- (or public-) funded pension schemes .  Spain, Portugal, and Italy have less developed systems .  France uses a pay-as-you-go system. One method of distinguishing systems across countries is by the extent to which a person’s contributions are linked to the benefits he/she receives in retirement. The link between contributions and benefits is weak in France and Germany, but strong in Sweden, Italy, the U.K., and Chile . Reform around the globe has included benefit reduction, measures to encourage later retirement, and expansions of private funding for government pensions. Ch.11 Commercial Banks Commercial Banks are the largest group of financial institutions in terms of the dollar value of assets. Also called depository institutions because a significant proportion of their funds come from customer deposits. Major assets are loans (financial assets), and major liabilities are deposits . They perform services essential to U.S. financial markets:  Play a key role in the transmission of monetary policy.  Provide payment services.  Offer maturity intermediation services. Banks are regulated to protect against disruption in the provision of these services and the cost this would impose on the economy and society at large. Differences in Balance Sheets of Commercial Banks and Nonfinancial Firms Commercial Bank Assets The majority of the assets held by commercial banks are Loans.  In 2019, net loans and leases amounted 55.7% of total assets.  Bank premises and fixed assets, other real estate owned, intangible assets, and all other assets amounted to 22.9% of total assets in 2019. Investment securities generate interest income and provide banks with liquidity. It was not until the 1980s and 1990s that regulators allowed banks to merge with other banks across state lines (that is, interstate mergers). In 1994, Congress passed a legislation (the Reigle-Neal Act) easing branching by banks across state lines. It has only been since 1987 that banks have possessed powers to underwrite corporate securities. Full authority to enter the investment banking (and insurance) business was received only with the passage of the Financial Services Modernization Act in 1999. Shadow Banking Activities of nonfinancial service firms that perform banking services have been termed shadow banking. The shadow banking system intermediates the flow of funds between net savers and net borrowers. Credit intermediation is performed through a series of steps involving many nonbank financial service firms.  Face significantly reduced regulation than traditional banks .  Can often perform credit intermediation processes more cost-efficiently than traditional banks.  2010 Wall Street Reform and Consumer Protection Act called for regulators to be given broad authority to monitor and regulate nonbank financial firms that pose risks to the financial system. Bank Size and Concentration  Community Banks have less than $1 billion in asset size and tend to specialize in Retail Banking.  Retail Banking is consumer-oriented banking, s.a. providing residential and consumer loans and accepting smaller deposits.  Decreasing both in number and importance, as asset share has dropped from 36.6% in 1984 to 6.2% in 2019.  The relative asset share of largest banks (over $1 billion in size) increased from 63.4% in 1984 to 93.8% in 2019.  Regional or Superregional Banks engage in a complete array of wholesale banking, or commercial-oriented, activities  Have access to the markets for purchased funds (for example, interbank or federal funds market), to finance lending and investment activities.  Money Center Banks engage heavily in wholesale activity in money markets, with retail banks and large firms as clients. Bank Size and Activities Size has traditionally affected the types of activities and financial performance of commercial banks. Small banks typically focus on the retail side  Generally, hold fewer OBS assets and liabilities than large banks. They rarely hold derivative securities; are more sheltered from competition in highly localized markets; and lend to smaller, less sophisticated customers than do large banks. Large banks usually engage in both retail and wholesale banking, but focus on the wholesale side of the business. They operate with lower amounts of equity capital than small banks; tend to use more purchased funds and have fewer core deposits. They lend to larger corporations, which means their interest rate spreads (that is, the difference between their lending rates and deposit rates) and net interest margins (that is interest income minus interest expense divided by earning assets) have usually been narrower than those of smaller regional banks. They pay higher salaries and invest more in buildings and premises ; diversify their operations and services more than small banks; and generate more noninterest income than small banks. Industry Performance  Strong performance of commercial banks during early 2000s.  Federal Reserve cut interest rates 13 times during this period.  Lower interest rates made home purchasing more affordable .  The development of new financial instruments helped banks shift credit risk from their balance sheets to financial markets and other FIs , such as insurance companies  Improved IT helped banks manage their risk better.  Rising interest rates in the mid-2000s caused performance to decline, but not significantly.  Third quarter 2006 earnings represented the second highest quarterly total ever reported by the industry.  The industry’s core capital ratio increased to 10.36%, the highest level since new, risk-based capital ratios were implemented in 1993.  No FDIC-insured banks failed during 2005 or 2006.  Performance deteriorated in the late 2000s as the U.S. economy experienced its strongest recession since Great Depression => For all of 2007, net income was $99.94 billion, a decline of $45.28 billion (31.1 percent) from 2006.  Average ROA for 2007 was 0.81%, the lowest yearly average since 1991 and the first time in 15 years that the industry’s annual ROA had been below 1% => ROA for 2008 was 0.03%, the lowest since 1987  1 in 4 institutions (25.0%) was unprofitable in 2008.  Bank performance slowly recovered from 2010 to 2016: 2010 industry ROA and ROE increased to 0.65% and 5.85%, respectively; by 2016, industry ROA and ROE increased to 1.04% and 9.27%, respectively => By the end of 2019, 96.4% of banks were profitable. Regulators U.S. banks may be subject to the supervision and regulations of as many as 4 separate regulators: 1. Federal Deposit Insurance Corporation (FDIC) was established in 1933 and insures deposits of commercial banks. It acts as receiver and liquidator when an insured bank is closed; and manages the Depositors Insurance Fund, or DIF. 2. Office of the Comptroller of the Currency (OCC) is the oldest U.S. bank regulatory agency, established in 1863. Its primary function is to charter (and close) national banks. 3. Federal Reserve System (FRS) serves as the country’s central bank, and has regulatory power over some banks, and where relevant, their holding company parents. 4. State Bank Regulators perform functions similar to those the OCC performs, but only for state-chartered commercial banks. Global Issues Advantages of International Expansion Disadvantages of International Expansion 1. Risk diversification, 2. Economies of scale, 3. Innovations, 4. Funds source, 5. Customer relationships, 6. Regulatory avoidance. 1. Information/monitoring costs, 2. Nationalization/expropriation, 3. Fixed costs. Global Banking Performance The financial crisis of 2008 to 2009 spread worldwide and banks saw losses that were magnified by illiquid markets. The largest banks in the Netherlands, Switzerland, and the U.K. had net losses in 2008. Banks in Ireland, Spain, and the U.K. were especially hard hit because they had large investments in mortgages and mortgage-backed securities, both U.S. and domestic. Many European banks averted outright bankruptcy thanks to direct support from their central banks and national governments. Greece suffered a severe debt crisis in the spring of 2010. Problems from the Greek banking system then spread to other European nations, such as Portugal, Spain and Italy. The situation stabilized after 2012, but a major debt payment was due from Greece to creditors on June 30, 2015. A deal was reached that required Greece to surrender to all its creditors’ demands, including tax increases, pension reform, and the creation of a fund (under European supervision) with state-owned assets earmarked to be privatized or liquidated. The European banking system was rocked again in June 2016 with “Brexit”. If a trade deal is not in place by December 31, 2020, then Britain will fall back on basic World Trade Organization terms. Lesson 12 (Rebe) – Ch. 12 Types of Risks Incurred by Financial Institutions Risks involve uncertainty; in Layman’s terms, it is the possibility that a negative event will occur. Financial Risk is: • the degree of uncertainty associated with the return on an asset; • the probability of a loss on financial assets. A major objective of FI management is to increase the FI’s returns for its owners, but increased returns typically come at the cost of increased risk: 1. Credit risk: the risk that promised cash flows from loans and securities held by FIs may not be paid in full. 2. Liquidity risk: 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. 3. Interest rate risk: the risk incurred by an FI when the maturities of its assets and liabilities are mismatched, and interest rates are volatile  Interest rates change over time. 4. Market risk: the risk incurred in trading assets and liabilities due to changes in interest rates, exchange rates, and other asset prices  Example: we buy a stock or bond; the market risks incur when we sell back the financial instrument, since the amount of money I receive could be lower than the amount that I paid to buy it. 5. Off-balance-sheet risk: the risk incurred by an FI as the result of its activities related to contingent assets and liabilities. 6. Foreign exchange risk: the risk that exchange rate changes can affect the value of a FI’s assets and liabilities denominated in foreign currencies. 7. Country or Sovereign risk: the risk that repayments by foreign borrowers may be interrupted because of interference from foreign governments or other political entities. 8. Technology risk: the risk incurred by a FI when its technological investments do not produce anticipated cost savings. 9. Operational risk: the risk that existing technology or support systems may malfunction, that fraud that impacts the FI’s activities may occur, and/or that external shocks such as hurricanes and floods may occur. 10. Insolvency risk: the risk that a FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities. Credit Risk at FIs Credit risk is the risk that the promised cash flows from loans and securities held by HIs may not be paid in full.  It arises every time we lend money to an economic agent that is in shortage of funds.  Virtually all types of FIs face this risk, but FIs that make loans or buy bonds with long maturities are more exposed than are FIs that make loans or buy bonds with short maturities  longer maturities, higher credit risk.  Even as losses due to credit risk increase, FIs continue to willingly give loans because they charge a rate of interest on a loan that compensates for the risk of the loan .  An important element in the credit risk management process is pricing  to compensate for the risk, banks will price the financial instrument to fully reflect the exposure - interests).  Many claims issued by FIs are characterized by a limited (known/fixed) return that is expected to occur with a high probability (eg, each period the borrower receives a fixed interest, x% of the principal). On the other hand, however, FIs bear a large downside risk (loss of principal and promised interest) that is expected to occur with a much smaller probability. The probability that the counterparty is going to default (and so we will get a lower outcome) is known as the Probability of Default (PD) (probability that FIs bear a large downside risk).  PD > 0 counterparty is not default risk-free.  Such a downside risk, namely the Credit Risk, needs to be managed.  If the outcome is lower than the expected one  downside risk, so we will suffer a loss. 2 types of losses :  Expected Loss : represents the loss that may be estimated before entering the loan contract due to nature of obligor, contract, institutional context, … EL influences the spread and hence the interest rate applied to the loan contract: r = rf + spread. We can use some statistics or software to estimate the losses we can have on our exposure  EL = PD*LGD*EAD. To estimate it:  PD Probability of Default: the probability that our counterparty will default. Depends on firm-specific traits (economical and financial structure, type of business). The higher is the probability, the higher is the expected loss. It is related to the projects undertaken by the corporation, the type of business, the financial structure and so on.  LGD Loss Giving Default: measures how much of the loan will be lost because of the default of the counterparty. We are granting a loan to a corporation, if the corporation will default we will be able to recover a part of it (collaterals), instead of losing the total amount, we just lose a part of it. How much I lose depends on the type of loan, warranties, and efficiency of the legal system; the higher the efficiency, the higher is the probability to recover part of the loan. The higher LGD (based on collaterals, warranties), the lower the part we can recover.  EAD Exposure at Default: measures the level of exposure (real exposure) at the time of default. Both LGD and EAD depend on loan-specific traits (type of loan, warranties), recovery costs, and recovery procedures. Pricing Loans: cf cost of funding (cost of money raised through debt instruments or deposit); PD*LGD is the risk premium for default risk. k(ROE-cf) is the profit margin on capital; OC operating cost (expenses related to the loan). If PD increases, the interest rate increases. If LGD increases, interest rate increases. The higher cf, the higher the interest rate. The higher ROE, the higher interest rate (price), The higher OC, the higher the price. • Unexpected Loss: the difference between the realized loss and the expected one. To cover expected losses they use reserves and allowances, the unexpected is covered with capital. Knowing the PD and the nature of the contract, we can measure expected loss and calculate the price we have to apply to the contract (interest rate) to compensate for the exposure. Liquidity Risk Liquidity risk is the risk that a sudden and unexpected increase in liability withdrawals may require a FI to liquidate assets in a very short period and at low prices  We may suffer a loss when we have to sell our securities, we have to reduce the price to find a counterparty to buy financial instruments.  On the assets side of the BS, loan requests and the exercise by borrowers of their loan commitments and other credit lines cause liquidity risk (the most liquid asset of all is cash).  To meet the demand for cash by liability holders, FIs must either liquidate assets or borrow additional funds.  When, all, or many, FIs face abnormally large cash demands, the cost of purchase of borrowed funds rises and the supply of such funds becomes restricted  FIs may have to sell some of their less liquid assets to meet the withdrawal demands, resulting in serious liquidity risk. Financial Institutions: banks are depository institutions that are going to finance long-term assets by issuing very short time deposits, there might be unexpected liquidity withdrawal. Impact on Equity Value: sudden withdrawal of deposit. The quantity of non-liquid assets reduces , cash assets are reduced to compensate the liquidity withdrawal, deposits are reduced since people want their money back, and equity is used to compensate for the loss suffered on non-liquid assets (which are sold at a lower price to compensate the huge amount of non-liquid assets). If our assets are extremely liquid, we will not face any loss. Interest Rate Risk Interest rate risk is the risk incurred by a FI when the maturities of its assets and liabilities are mismatched and interest rates are volatile.  Asset transformation involves a FI buying primary securities/assets and issuing secondary securities/liabilities to fund the assets (primary securities that FIs purchase and secondary securities that FIs sell often have different maturities characteristics).  Refinancing risk is the risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments  Type of interest rate risk that occurs when a FI holds longer-term assets relative to liabilities.  By holding shorter-term assets relative to its liabilities, a FI faces Reinvestment risk, the risk that the returns on funds to be reinvested will fall below the cost of funds. Price risk is the risk that the price of the security will change when interest rates change. Rising (falling) interest rates increase (decrease) the discount rate on future assets or liability cash flows and reduce (increase) the market price or present value of that asset or liability. Mismatching maturities by holding longer-term assets than liabilities means that when interest rates rise, the economic or present value of the FI’s assets falls by a larger amount than its liabilities. FIs can seek to hedge or protect themselves against interest rate risk by matching the maturity of their asset and liabilities, but this strategy is not necessarily consistent with an active asset transformation function for FI s.  Matching maturities hedges interest rate risk only in a very approximate rather than complete fashion. Market Risk Market risk is the risk incurred in trading assets and liabilities due to changes in interest rates, exchange rates, and other asset prices.  Closely related to interest rate and foreign exchange risk.  Adds another dimension of risk : trading activity.  Market risk is the incremental risk incurred by a FI when the interest rate and foreign exchange risks are combined with an active trading strategy , especially on that involves short trading horizons such as a day.  FI’s trading portfolio can be differentiated from its investment portfolio on the basis of time horizon and liquidity. The trading portfolio contains assets, liabilities, and derivative contracts that can be quickly bought or sold on organized financial markets, whereas the investment portfolio contains assets and liabilities that are relatively illiquid and held for longer periods. The Investment (Banking) Book and Trading Book of a Commercial Bank  * Derivatives are off-balance-sheet. Off-Balance-Sheet Risk Off-balance-sheet (OBS) risk is the risk incurred by a FI as the result of activities related to contingent assets and liabilities. OBS activities do not appear on a FI’s current balance sheet since it does not involve holding a currency primary claim (asset) or the issuance of a current secondary claim (liability). OBS activities involve the creation of contingent assets and liabilities that give rise to their potential placement in the future on the balance sheet  Contingent assets and liabilities are assets and liabilities of OBS that potentially can produce positive/ negative future cash flows for a FI. More attention has been drawn to the OBS activities of banks, especially large ones, as opposed to small depository institutions or insurers. Issuing a letter of credit (LC) is an OBS activity: LC is a credit guarantee issued by a FI for a fee on which payment is contingent on some future event occurring, most notably the default of the agent that purchases the LC. Other examples of OBS activities are Collateralized mortgage obligations (CMOs), loan commitments by banks, mortgage servicing contracts by depository institutions, and positions in forwards, futures, swaps, and other derivative securities by almost all large FIs. The ability to earn fee income while not loading up or expanding the balance sheet has become an important motivation for FIs to pursue OBS business. Foreign Exchange Risk Foreign exchange (FX) risk is the risk that exchange rate changes can affect the value of a FI’s assets and liabilities denominated in foreign currencies. Returns on domestic and foreign direct investments and portfolio investments are not perfectly correlated for 2 reasons: 1. Underlying technologies of various economies differ, as do the firms in those economies. 2. Exchange rate changes are not perfectly correlated across countries. FIs expand globally by acquiring foreign firms or opening new branches in foreign countries, as well as investing in foreign financial assets. A net long position in a foreign currency involves an FI holding more foreign assets than liabilities. • FI loses when the foreign currency falls relative to the domestic one . • FI gains when the foreign currency appreciates relative to the domestic one . A net short position in a foreign currency involves an FI holding fewer foreign assets than liabilities. • FI gains when the foreign currency falls relative to the domestic one . • FI loses when the foreign currency appreciates relative to the domestic one .