SUMMARY: Financial Markets and Institutions, Dispense di Mercato Finanziario

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Financial Markets and Institutions Overview You can classify the types of markets by transacting parties: • Primary markets → companies sell new securities for the first time (i.e. IPO) • Secondary markets → investors trade already issued securities among each other; they make securities more liquid and determine the price of securities sold in the primary market (i.e. NYSE, NASDAQ) Direct vs indirect finance: • Direct finance → where borrowers borrow funds directly from lenders • Indirect finance → where borrowers borrow funds from the financial market through a financial intermediary Term security vs demand deposit: • Term security → it has a specific maturity date • Demand deposit → it doesn’t have a specific maturity date, it can be withdrawn at any time OTC vs organized exchanges: OTC (over-the-counter) exchanges • Participants trade directly between two parties, without the use of a central exchange or other third party; • No physical locations • Market makers set the bid price (price they pay) and the ask price (price at which they sell) and they gain by the spread between the bid price and ask price, together with commissions on trades • Example: NASDAQ Organized exchanges • Physical location, even if nowadays exchanges are conducted mainly electronically • Floor traders (brokerage firms with buy and sell orders) are specialists that matches buyers with sellers in a group of stocks; they meet at the trading post on the exchange and learn about current bid and ask prices. • Example: NYSE Long vs short position • Long position → you benefit when asset price ↑ (i.e. you have a house) • Short position → you benefit when asset price ↓ (i.e. you will need to buy something in the future) Are Financial Markets Efficient? ARBITRAGE • It is the opportunity to make riskless profit by exploiting mispricing in the market • Soon after you start your arbitrage activity it will disappear because prices will adjust • Short selling → an investor borrows a security and sells it on the open market, planning to buy it back later for less money EFFICIENT MARKET HYPOTHESIS The semi-strong form of this hypothesis implies that: • Prices of securities reflect all available public information • Current prices will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return • In an efficient market, all unexploited profit opportunities will be eliminated (= no arbitrage). • Future prices are not predictable: o Prices follow a random walk o Technical analysis, that is studying past stock price data and search for patterns such as trends and regular cycles is useless o It is impossible to beat the market and having performed well in the past does not indicate that an investment adviser or a mutual fund will perform well in the future However, there is also a strong form of this hypothesis which states that: • Prices of securities are always correct; they reflect market fundamentals (= items that have a direct impact on future income streams of the securities) and all available information, both public and private • It rules out the existence of speculative bubbles (it would mean that an asset is priced above fundamentals) • One investment is as good as any other because the securities’ prices are correct • Security prices can be used by managers to assess their cost of capital (= cost of financing their investments) Evidence against the efficient market hypothesis: • Small firm effect → studies show that small firms have earned abnormally high returns in the long run. • January effect → a price rise from December to January is predictable and hence inconsistent with the random- walk behavior; this is probably due to tax issues. • Market overreaction → stock prices may overreact to news announcements and that the pricing errors are corrected only slowly. • Excessive volatility → stock market shows excessive volatility; fluctuations in stock prices may be much greater than fluctuations in their fundamental value. • Mean reversion → stocks with low returns today tend to have high returns in the future, and vice versa. • New information is not always immediately incorporated into stock prices, which continue to rise for some time after the announcement of unexpectedly high profits, and they continue to fall after surprisingly low profit announcements. BEHAVIORAL FINANCE • People are sadder when they suffer losses than they are happy from making gains • People tend to be overconfident in their own judgments → overconfidence and social contagion explain stock market bubbles • Most people are risk averse, so very little short selling actually takes place → this can explain why stock prices sometimes get overvalued Interest rates PRESENT VALUE Simple loan (interbank loans) 𝑃𝑉 = 𝐹+𝐼 (1+𝑖)𝑛 Fixed-payment loan (fixed rate mortgages, car loans) 𝑃𝑉 = ∑ 𝐹𝑃 (1+𝑖)𝑘 𝑛 𝑘=1 Zero coupon bond (treasury bills, commercial paper) 𝑃𝑉 = 𝐹 (1+𝑖)𝑛 Coupon bond (long-term corporate and government debt) If there is no default risk, then coupon bonds are risk-free instruments because their cash flows are known in advance 𝑃𝑉 = [∑ 𝐶 (1+𝑖)𝑘 𝑛−1 𝑘=1 ] + 𝐶+𝐹 (1+𝑖)𝑛 Perpetuity 𝑃𝑉 = ∑ 𝐶 (1+𝑖)𝑘 ∞ 𝑘=1 = 𝐶 𝑖 𝐹 = face value (price the issuer pays at maturity) 𝐼 = interest payment 𝐹𝑃 = fixed payment 𝑖 = interest rate 𝐶 = coupon payment 𝐶𝐹 = cash flow 𝑛 = year 4. REPURCHASE AGREEMENTS (REPO) • Agreement for the sale of securities by one party to another with a promise to repurchase the securities at a specified date and price • Useful to manage liquidity and take advantages of anticipated changes in interest rates • Short term (3-14 days) • Low risk, due to treasury security as collateral 5. COMMERCIAL PAPER • Short-term promissory notes (maturity <270 days to avoid to register the security issue with the SEC) • Issued by a company, which sells the commercial paper directly to the buyer (it bypasses the dealer to save commission costs) • They are usually unsecured • Issued at discount • The interest rate reflects the firm’s level of risk • Useful to raise short-term cash • They are better than bank loans because they cost less; however, if a company want to pay the previous commercial paper with a new one, it must be sure that there will be someone who buys it. Usually this is not a problem: there is always someone who is going to buy a new commercial paper, even if something goes wrong. Indeed, the company and the bank agree that the company pays a fee to the bank to ensure that in case of emergency the bank will buy the commercial paper. This remains convenient for the company because the fee it pays to the bank is still less than what it manages to save using this mechanism. 6. BANKER’S ACCEPTANCE • It is an order to pay a specified amount of money to the buyer of a good on a given date • The payment is guaranteed by a bank • Useful to finance goods that have not yet been transferred from seller to buyer • Issued at discount The Bond Market Characteristics • Capital market • Maturity → medium and long term (>1 year) • Risk → default and interest rate risk • Bond → security that represents a debt owed by the issuer to the investor The issuer pays: (1) the face (or par) value at maturity, (2) periodic interest payments (= coupon payments) at the coupon rate (usually fixed, ≠ market 𝑖) Advantages • Issuing long term bonds allows firms to ↓risk that 𝑖 ↑ before they pay off their debt (= ↓volatility). However, this comes at a cost: long-term 𝑖 > short-term 𝑖, due to risk premiums. • Generally, the longer the time until maturity, the higher the changes in the price of the bond: this does not cause losses to investors who are not going to sell the bond, but most investors don’t hold the bond until maturity and if 𝑖↓ they would receive less than what they paid. Determinants of bond demand ↑ Wealth of investors ↑ Liquidity ↓ Expected interest rate: 𝑖ⅇ↑ means 𝑃ⅇ↓ and expected returns↓ ↓ Risk ↓ Expected inflation: because the bond would pay less in real terms Determinants of bond supply ↑ Expected profitability of investment opportunities ↑ Expected inflation: it ↓cost of borrowings in real terms ↑ Government deficit: in case of deficit the government sells more bonds Fisher effect When expected inflation 𝜋ⅇ↑, 𝑖 ↑ and vice versa, why? If 𝜋ⅇ↓ demand↑, but supply↓ (going from point 1 to point 2) This makes P↑ and therefore 𝑖↓ Instruments 1. TREASURY NOTES AND BONDS • Issued by the government to fund the national debt • Practically no default risk because the government could print more $ if necessary • Maturity → notes 1-10 years, bonds 10-30 years • TIPS (Treasury Inflation-Protected Securities) → the 𝑖 is fixed, but the principal changes according to the consumer price index to remove inflation risk. • STRIPS (Separate Trading of Registered Interest and Principal Securities) → each coupon and principal payment of the treasury bond becomes a separate zero-coupon bond of its own, so that the same bond can belong to different people. 2. MUNICIPAL BONDS • Issued by local, county, and state governments to finance public interest projects • Higher default risk than treasury bonds because they can’t print more $ • They may be tax exempt → 𝑖𝑡𝑎𝑥-𝑓𝑟ⅇⅇ = 𝑖 × (1 − tax rate) • Municipalities borrow at ↓ cost because investors accept ↓𝑖 if bonds are tax exempt • They can be: o General obligation bonds → unsecured, no asset pledged as security o Revenue bonds → the revenues of the project will repay investors 3. AGENCY BONDS • Issued by government-sponsored enterprises (GSEs) to raise funds for purposes of national interests • GSEs are protected by the government → this ↓ borrowing cost of GSEs but ↑ moral hazard • GSEs sell bonds and buy mortgages from banks which now can make new loans • Examples: o the Student Loan Marketing Association (Sallie Mae) o the Federal National Mortgage Association (Fannie Mae) o the Federal Home Loan Mortgage Corporation (Freddie Mac) 4. CORPORATE BONDS • Issued by firms to borrow funds for long periods of time • Heterogeneous default risk because it depends on the company’s health • Bond indenture → contract that states the lender’s rights and privileges and the borrower’s obligations • Restrictive covenants → rules that make manager willing to protect bondholders’ interests (instead of only shareholders’ interest). For example, limiting dividends, limiting the issuing of additional debt, make restrictions. • Sinking fund → requirement to pay off a portion of the bond issue each year; it makes the bond more attractive, so 𝑖↓. • Conversion to stock → bondholders may be able to choose to convert their bond into a share of the firm when stock prices increase. This is useful also for the firm because, while selling stocks gives the idea that the firm is insecure of its financial situation, issuing convertible bonds does not give this impression to investors. • Call provision → bonds may be callable (= the issuer buys the bond back before maturity). Why should the firm call the bond? a) If 𝑖↓ P↑ and P > call price b) Sinking funds make 𝑖↓ c) Too many restrictive covenants d) It wants to change its capital structure • Bearer and registered bonds → bearer bonds (= payments are made to whoever had physical possession of the bonds) were substituted by registered bonds (= the bondholder must register with the firm to receive interest payments). Protection in case of default (↑protection = ↓𝑖) • Secured bonds o Mortgage bonds (collateral = building) o Equipment trust certificates (collateral = tangible non-real-estate property) • Unsecured bonds o Debentures → lower priority than secured bonds o Subordinated debentures → lower priority than debenture Financial guarantees • Insurance → the firm uses it only if cost of insurance < interest savings • Credit Default Swaps (CDS) → it’s an insurance that you can buy it even if you don’t own the bond The Stock Market A firm issuing stock can decide: 1. Pay dividends to stockholders and get financed with bank loans  stockholders receive $ from dividends 2. Don’t pay dividends and get financed with stockholders’ money  stockholders receive $ from the increased stock price Stock vs Bond • Dividends are not tax deductible, while coupon payments are tax deductible → equity more expensive • Stocks are riskier than bonds → stockholders require higher rate of return • Stocks do not mature Type of stocks 1. Common stocks • It represents an ownership interest in the firm • It gives you to a discretionary dividend payment • It gives you the right of a residual claimant (after bondholders and preferred stockholders) → stockholders have a claim on all assets and income left over after all other claimants have been satisfied • Stockholders have limited liabilities • Stockholders have the right to vote in the board of directors 2. Preferred stocks • Form of equity from a legal and tax standpoint • It gives you fixed periodic payments (similar to a bond), but firms can miss a payment without going into bankruptcy • Stockholders have no voting right (unless dividend payments are missed) a) Participating → actual dividends may be higher in case of high profit Non-participating → dividends are equal to the promised amount b) Cumulative → missed dividends must be paid Non-cumulative → missed dividends are not paid How stocks are sold Organizations that gain profit from trading fees and concessions. 1. Organized Securities Exchanges (NYSE Euronext) • There is a physical trading floor • Every trading post has specialists (market makers), who stabilize order flow and prices; they belong to specialist firms and pay concession fees to NYSE • Commission brokers and floor brokers trade at the trade posts with other brokers or with the specialists: o Market orders (executed at market price) o Limit orders (stored in the order book and executed once price satisfies limit condition) • Program trading → online trading, whose automatization can be risky sometimes; this is why circuit breakers limit extreme losses, since they are forced trading pauses triggered by well-defined conditions. • NYSE advantages → liquid market and prestige • The NYSE merged with Archipelago, an Electronic Communication Network (ECN) firm FUTURES • They are centralized exchanges for future transactions, where many people are collected in the central exchange. • Since there are so many people there is the need of standardized contacts. • They solve the problem of illiquid forward contracts, but sometimes they are too precise and standardized • Since there are standardized times for the delivery, what do you do if the delivery is scheduled in December, but you need it in January? If the good is durable you keep it until January, if it is not durable you still accept the future contract to hedge against risk, but you close it right before the delivery and give it to someone who will use the good in December. • If the seller (1) cannot deliver the good to (2) anymore, (1) could buy it from (3) and finally give it to (2). However, this is inefficient and (2) could have simply bought it from (3). Counterparty risk → it’s the risk that the counterparty will not give you the good (you may be still able to find another seller, but maybe at a higher price). However, the buyer will not lose anything: the difference between the higher price and the initial lower price that the buyer has to pay will be compensated using $ from the margin account of the defaulting seller. Margin account → when you have a future contract you are asked to open a margin account to avoid the counterparty risk. It is like a bank account where you have an initial amount of $. If $↓ you might be unable to repay, and your margin account has fallen below the maintenance margin. If this happens, you are asked to refill the account. Profit of the seller (short position) → 𝜋 = 𝐹1 − 𝑆𝑇 Profit of the buyer (long position) → 𝜋 = 𝑆𝑇 − 𝐹1 Note! In general, 𝐹𝑇 = 𝑆𝑇, but even if you close the contract before delivery (at time C) you consider 𝐹𝐶 = 𝑆𝑇 to avoid arbitrage Future on a stock market index → the contract is cash-settled: it has a multiplier and the end of the contract the seller delivers in cash • 𝜋𝑡𝑜𝑡 = 𝜋 × 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 • 𝑖𝑛𝑑𝑒𝑥 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑎𝑙𝑢𝑒 = 𝑖𝑛𝑑𝑒𝑥 𝑣𝑎𝑙𝑢𝑒 × 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑤𝑜𝑟𝑡ℎ OPTIONS • They give you o the right to buy an asset (call option, long position) o the right to sell an asset (put option, short position) in the future at a predetermined price (= strike price) • With options you are always the buyer (= holder), either of a call or put option • The buyer may choose whether to exercise this right of buy/sell, but the seller cannot refuse to buy/sell the asset under unfavorable conditions. • There is asymmetry between the rights of a buyer and the rights of a seller: to compensate for his weaker rights, the seller demands an option premium (𝑝) Determinants of the option premium: An ↑ in… Premium of a call option Premium of a put option Strike price X Spot price S Volatility Term to expiration ↓ ↑ ↑ ↑ ↑ ↓ ↑ ↑ • When an option is exercised depends on its style: o American-style options → can be exercised at any moment until the expiration date o European-style options → can be exercised only on the expiration date 𝐹1 = future price when the contract is made 𝑆𝑇 = spot market price at delivery Profit of the buyer of a call option 𝑃 = { 𝑆𝑇 − 𝑋1 𝑖𝑓 𝑋1 < 𝑆𝑇 0 𝑖𝑓 𝑋1 ≥ 𝑆𝑇 𝜋 = 𝑚𝑎𝑥(𝑆𝑇 − 𝑋1, 0) − 𝑝 Profit of the buyer of a put option 𝑃 = { 𝑋1 − 𝑆𝑇 𝑖𝑓 𝑋1 > 𝑆𝑇 0 𝑖𝑓 𝑋1 ≤ 𝑆𝑇 𝜋 = 𝑚𝑎𝑥(𝑋1 − 𝑆𝑇 , 0) − 𝑝 Note! In general, 𝑋𝑇 = 𝑆𝑇, but even if you close the contract before delivery (at time C) you consider 𝑋𝐶 = 𝑆𝑇 to avoid arbitrage Note! To see if an option is in/at/out of the money, it only matters which payoffs (P) it has, and we don’t have to consider the premium Why Do Financial Institutions Exist? 1. LOWER TRANSACTION COSTS • Economies of scale → financial institutions make a huge number of transactions, reducing transaction costs and becoming experts • Economies of scope → financial institutions provide multiple services, reducing transaction costs 2. RISK SHARING Having low transaction cost allows financial institutions to diversify their investments 3. ASSET TRANSFORMATION Financial institutions can transform asset into more attractive ones • Maturity transformation → assets with long maturities (illiquid) can be transformed into more liquid assets • Denomination transformation → assets with a large minimum investment can be transformed into smaller investments 4. ASYMMETRIC INFORMATION • Financial institutions are experts in handling asymmetric information problems • Since debt contracts are private, outsiders can’t acquire the information that these institutions have • Be aware of possible conflicts of interest that can arise due to financial institutions’ unique knowledge a) Adverse selection → one party has more information before the transaction • It can be reduced through: o Government regulation o Private collection of information o Intermediation o Collateral • Consequences: o Small firm may not be able to access security markets directly o Financial markets are heavily regulated 𝑋1 = strike price when the contract is made 𝑆𝑇 = spot price at delivery b) Moral hazard → after the transaction, one party can do something for its own benefit that cannot be observed by the other party • It can be reduced through: o Monitoring (costly) o Incentives o Intermediation o Collateral • Consequences: o Debt contracts have restrictive covenants o Debt contracts become more convenient o Lenders rely heavily on collateral and borrower net worth to keep the incentives of borrowers aligned with their own (incentive compatibility) Types of Financial institution Commercial Banking • They are depository institutions that accept deposit and make loans • Much larger than other depository institutions like saving institutions and credit unions • They are regulated differently than other depository institutions BALANCE SHEET ASSETS 1. Cash items a) Reserves • $ stored at the bank and reserves held at the FED • banks are required to hold a certain amount of reserves • it is the most liquid asset b) Cash items in process of collection → checks drawn on account of other banks that haven’t cleared yet c) Deposits at other banks → non-interest bearing deposits for corresponding bank arrangement 2. Securities • They only hold debt securities (not equity), usually treasury, government bonds… • When securities are very liquid they are called “secondary reserves” 3. Loans • Higher interest income • Less liquid because adverse selection makes it hard to sell loans to other banks • Examples: commercial loan, real estate loans, interbank loans, consumer loans… ASSET MANAGEMENT To have high return and low risk on securities and loans the bank has to: • Screen borrowers • Diversify • Manage liquidity carefully LIABILITIES 1. Checkable deposits • Deposits that allow the owner of the account to write checks to third parties • Low cost funding for the bank because of low or no interest paid • Payable on demand, whenever the customer wants • Account types: a) Demand deposit → checking functionality, no interest paid b) NOW → negotiable order of withdrawal, interest bearing c) MMDA → money market deposit account, interest bearing Demand Side (Commercial Banks) • 𝑖 > 𝑖𝑑 → banks borrow more cheaply from the FED discount window than from other banks, so 𝑖𝑑 is an upper bound • 𝑖𝑜𝑟 < 𝑖 < 𝑖𝑑 → there is a normal downward sloping demand curve • 𝑖 < 𝑖𝑜𝑟 → banks borrow as much fed funds as they can and earn money on the difference, so at 𝑖𝑜𝑟 the demand curve is flat Supply Side (FED) Monopolistic (FED is the only supplier of reserves) → supply curve is vertical Supplies fixed amount of reserves in open market operations + unlimited reserves at 𝑖𝑑 (discount window borrowing) In normal times, open market operations are effective. As long as we’re on the downward-sloping part of the demand curve, changes in quantity of reserves directly change the fed funds rate. UNCONVENTIONAL MONETARY POLICY INSTRUMENTS Following the 2008 crisis, monetary policy hit the zero lower bound: monetary models estimated that the target rate should be negative, but FED can’t target negative rates. Therefore, the FED made a large increase of reserves via asset purchases (= Quantitative Easing), printing money. Slow normalization Recently, the FED is ↑𝑖 and ↓ its securities holdings (the FED is letting securities mature without rolling-over funds into new securities, they are not actively selling the securities) The Fed can ↑𝑖 even with large reserves, by: 1. Increasing interest on excess reserves 2. Increasing reserve requirements 3. Reverse REPOS EUROPE The ECB uses similar monetary instruments like the FED to implement its policy: 1. Open market operations → main refinancing operations (like REPOS) via a bid system from its credit institutions 2. Lending to banks and other liquidity provision → LTROs (long-term refinancing operations) or asset purchases (long-term government bonds) 3. Reserve requirements Mutual Funds • They combine investors’ resources and invest them in diversified portfolios of assets • They allow redemption of outstanding shares at a fair market price • They became popular in the 1970s/1980s due to the interest rate ceiling on bank accounts, and even more popular in the 1990s due to the equity boom • Advantages: o Better diversification o Lower transaction costs o Liquidity intermediation o Denomination intermediation o Managerial expertise TYPES OF REDEMPTION 1. Open-end • Investors can acquire/redeem shares directly • Easier growth of fund • More liquid investment for shareholders, even if the funds keep some liquidity to always meet redemption requests • Valuation → net asset value (NAV) is calculated daily: 𝑁𝐴𝑉 = 𝑛ⅇ𝑡 𝑤𝑜𝑟𝑡ℎ 𝑛° 𝑜𝑓 𝑠ℎ𝑎𝑟ⅇ𝑠 2. Closed-end • Investment company whose shares are listed on a stock exchange or OTC market • After funds are placed in an IPO, they can’t raise further funds and investors can’t redeem their shares (only sell them to other investors) • Less liquid • Valuation → investors know the NAV (= net asset value), but the market price ≠ NAV, why? o New funds appear on the market at a premium and move rapidly to a discount o Closed-end funds usually trade at substantial discounts relative to their NAV o Discounts (and premia) are subject to wide variation o Only when closed-end funds are terminated prices converge to reported NAV TYPES OF INVESTMENT 1. Equity funds • Invest in stocks • Capital appreciation funds → seek rapid increase in share prices (relatively risky) • Total return funds → seek a combination of current income (from dividends) and capital appreciation, invest in a mix of mature companies and growth companies • World equity funds → seek international diversification, so they invest in stocks of foreign companies 2. Bond funds • Invest in bonds • The most popular are strategic income bond funds → invest in U.S. corporate bonds with high yields to generate high current income • Diversification is not crucial, which explains why bond funds had less success than equity funds 3. Hybrid funds • Invest both in stocks and bonds 4. Money market funds • Invest in money market securities • Initial minimum investment is usually in the range $500-$2000 • Many MMMFs offer check-writing privileges • MMMFs are not insured (unlike savings accounts) 5. Index funds • They replicate the composition of an index • They are not actively managed • Low management fees, good diversification FEES • Mutual funds charge high fees • Models for charging fees: 1. Load funds (“class A shares”) → charge you a one-time commission at the time of the purchase of the share 2. Deferred load funds (“class B shares”) → charge you a one-time commission when you redeem your share 3. No load funds (“class C shares”) → charge you no commission for purchasing/selling your share (but still charge other fees) • They charge an annual management fee (“12b-1” fees, SEC-imposed cap of 1% per year) to meet operating costs • They charge an annual an extra fee to finance their marketing expenses 𝐹𝑟𝑜𝑛𝑡 𝑙𝑜𝑎𝑑 𝑓𝑒𝑒 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑎 𝑠ℎ𝑎𝑟ⅇ−𝑁𝐴𝑉 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑎 𝑠ℎ𝑎𝑟ⅇ REGULATION • The SEC regulates fees, information disclosure, independence of fund directors, acceptable operating standards… • The SEC regulates also conflicts of interest, such as: o Late trading → allowing trades after 4pm to trade at the 4pm price of that day; if news became public after 4pm a trader could make gains o Market timing → due to time zone differences, NAV may be already many hours old • The SEC tried to solve these issues by: o Hardening of the 4pm valuation rule o Better enforcement of redemption fees → fee waivers must now go through the board of directors ETF ETFs are formed when a basket of securities is purchased, and a stock is created based on this basket that is traded on an exchange • They are listed and traded as individual stocks • They are indexed rather than actively managed • Their value is based on the underlying NAV of the stocks held in the index basket. • The exact content of the basket is public so that intraday arbitrage keeps the ETF price close to the implied value Creation and redemption mechanism ETFs designate several authorized participants (stock dealers), who: • Trade and keep inventory of the assets in the relevant index on their own account • They often hold at their own risk some inventory of the shares of the ETF, creating more liquidity for the ETF. • They do it to have the exclusive right to directly interact with the ETF → they can deliver a bundle of shares of the relevant proportions (as in the index) to the ETF and receive ETF shares in turn (or vice versa) • This allows authorized participants to exploit arbitrage opportunities → the market-clearing price may be different from the fundamental value, so authorized participants exploit this mispricing • Authorized participants are dealers and therefore have the lowest transaction cost of all market participants; they also have the incentive to transaction cost low as much as possible to benefit from arbitrage Advantages 1. High liquidity • ETFs are continuously traded on secondary markets; however, this is also true for closed-end mutual fund shares. The difference with ETFs is that they eliminate any discounts/premia over NAV because: o ETFs closely track a benchmark whose composition and valuation known in real time, preventing information asymmetries or valuation uncertainty o The “creation and redemption” mechanism allows to exchange ETF shares for index assets, and vice versa. 2. Low fees • ETFs can offer lower fees because: o ETFs are passively managed o Transaction costs are externalized: fund doesn’t pay any transaction cost, buyers/sellers pay it when transacting o The “creation and redemption” mechanism keeps transaction cost for ETF rebalancing low 2. Change in net worth ➔ Duration gap analysis • Values of assets and liabilities on the balance sheet will re-adjust, depending on their duration (if 𝑖↑ value of securities with long maturity↓) • Duration is useful to estimate the impact of ∆𝑖 on asset values because it measures the “effective” maturity. • However, we must assume that the ∆𝑖 is the same for all assets and liabilities! • First, we determine the % changes of asset values and liability values: Then, we take absolute changes and subtracting terms from each other gives us the ∆Net Worth: The duration gap quantifies the sensitivity of (market) net worth to interest rate changes Financial Regulation WHY REGULATING? The bankruptcy of a firm may not always be a bad thing, but the bankruptcy of a bank involves much greater damages and this explains why banks are heavily regulated. • Thousands of depositors may lose parts of their savings • Information about borrower creditworthiness is lost • The failed bank cannot be easily replaced by others because operating in an environment of adverse selection requires expertise • A bank failure can affect other banks that are sound (contagion): o Fire sales of securities can inflict losses on other asset holders o Every bank can become illiquid if enough people withdraw • In a banking crisis, financial intermediation in the economy may be disrupted The high social cost of bank failures means that the government tries to do every possible thing to prevent banks from failing, and this sometimes leads to moral hazard: • Banks may take excessive risks and rely on the government safety net • All gains to private owners, all losses to taxpayers GUARANTEES THAT CREATE MORAL HAZARD 1. Deposit insurance Deposit insurance reduces your risk of loss in case the bank fails, and it reduces the risk of a bank-run arising in first place. In the U.S., the FDIC insures commercial banks against failure, but if they still fail the FDIC applies one of the following methods: • Payoff method → the FDIC allows the bank to fail and pays off its depositors up to the insurance limit • Purchase and assumption method → the FDIC reorganizes the bank (merger/take-over with other institution) Many countries after the U.S. have introduced deposit insurance; however, for some of them it has been harmful. If a country does not have strong regulatory institutions to mitigate moral hazard, deposit insurance may invite banks to take excessive risk. Example You must choose between two assets: • Asset A has a R = 5% for sure • Asset B has a return of 20% with 80% probability, and a return of -80% with 20% probability → Re = 0% Therefore, if you’re risk-neutral (or risk-averse), you would you choose asset A (and also a fully equity-financed bank would choose asset A) But what if… • The bank is financed with 96% deposits • There is costless deposit insurance • Bank pays 4% interest to depositors (who don’t care about A vs B due to insurance) • Capital (= equity) must be ≥ 4% by law Asset A Bank Interest income = 5%*100 = 5 Interest expenses to depositors = 4%*96 = 3.84 Net income = 5-3.84 = 1.16 ROE = 1.16/4 = 29% Asset B Bank if asset has high outcome: Interest income = 20%*100 = 20 Interest expenses to depositors = 4%*96 = 3.84 Net income = 20-3.84 = 16.16 ROE = 16.16/4 = 404% If asset has low outcome: Interest income = -80%*100 = -80 but the bank can at maximum lose 4 (capital), who loses the other 76? The depositors ROE = 4/4 = -100% → Expected ROE = 0.8*404% + 0.2*(-100%) = 303.2% Deposit insurance leads to: • The banks have higher ROE if it invests in a risky asset • Depositors require a low interest (4%) to the bank, even if they could lose a lot • If the bank has high returns (+20) its shareholders keep all the profit, but if the bank has low returns (-80) the shareholders only lose 4 (privatize gains but share losses) 2. Too-big-to-fail banks For very large banks, failure may be unthinkable because the cost would be tremendous, so markets expect that the government will always rescue a big bank, at any cost to the taxpayer. The risk for creditors of a big bank will be lower, and a big bank can borrow cheaply no matter in how much risk- taking it engages. 3. Too-connected-to-fail banks A similar issue arises if the bank is too tightly connected to others in the financial system, and contagion after a bank failure would have disastrous effects. HOW COULD A REGULATOR DISCOURAGE MORAL HAZARD? 1. Capital Requirements • Forcing banks to have a minimum amount of capital, so that losses are losses to bank owners • In our example bank B shareholders only lost 4 and deposit insurance covered 76 out of the total loss of 80, but a minimum capital requirement of 56.8% is enough to deter risk shifting • Advantages: o Less moral hazard (risk-shifting) o Protection against default • Disadvantages: o ROE ↓ a. Leverage ratio approach Through most of the 1980’s, regulators used a minimum leverage ratio: 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐴𝑠𝑠ⅇ𝑡 There was a scale how good/bad you were, depending on your leverage ratio: • > 5%: well-capitalized • > 4%: adequately capitalized • < 4%: undercapitalized • < 3%: significantly undercapitalized • < 2%: critically under-capitalized (will be shut down by FDIC) If bank capital fell short of any of these thresholds, there would be restrictions to what the bank can do. PROBLEM → this approach ignored the risk of the asset that was being held (a risky loan required same amount of capital as safe treasury bonds) and off-balance-sheet activities would not incur any capital requirement at all. In the end, capital requirements had not much to do with the actual risk taken by the bank To solve this problem, a committee of central bankers made international agreements in Basel at the BIS (bank of international settlements): b. Basel I (1988) • This agreement still applies to all but the largest banks in the U.S. • Capital requirement: 8% of banks’ risk-weighted assets • Risk-weighted assets are determined according to a weight catalog: o Reserves and government debt of some OECD countries: 0% risk weight o Claims on banks and corporates rated AA-or better: 20% risk weight o Municipal bonds, residential mortgages: 50% risk weight o Loans to consumers and corporations: 100% risk weight PROBLEM → risk weights classes are not precise enough: banks look for the riskiest asset within the same risk weight class c. Basel II (1999) • Basel II attempted to “fix” the weaknesses of Basel I: o Capital requirements aim to be more sensitive to “true” riskiness and are determined with either of the following three methods: ▪ Standardized approach: refined buckets to determine risk-weighted capital; capital charge depends on borrower rating and other risk indicators ▪ Internal ratings-based approach: regulators supply the model, assumptions, and calibration for “loss- given-default” models that determine capital charge ▪ Advanced internal ratings-based approach: loss-given-default model supplied by regulators, banks can adjust calibration o Off-balance sheet items can now impact capital requirements o Credit risk, operational risk and market risk estimations are now based on data and formal techniques • Basel II has three pillars: o Regulatory minimum capital requirements o Regulatory supervisory review to complement and enforce minimum capital requirements o Requirements on rules for disclosure of capital structure, risk exposures, and capital adequacy to increase transparency PROBLEMS → Basel II reduced banks’ regulatory arbitrage, but now capital requirements became procyclical: low in boom times, high in crises times. Since Basel II became effective in the U.S. in 2008, a crisis time when banks were already losing capital, the tightening of capital requirements due to Basel II became a severe problem.