Financial Markets
Markets that channel funds from savers (lenders) to users of funds (borrowers), affecting personal wealth, businesses, and economic growth.
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| Term | Definition |
|---|---|
| Financial Markets | Markets that channel funds from savers (lenders) to users of funds (borrowers), affecting personal wealth, businesses, and economic growth. |
| Why Financial Markets Matter | They support economic growth, influence wealth, and help create a well-functioning economy. |
| Main Types of Financial Markets | Debt markets, equity markets, and foreign exchange markets. |
| Debt Markets | Markets that allow governments, corporations, and individuals to borrow money by issuing debt securities (bonds). |
| Bond | A security issued by a borrower that requires repayment of principal plus interest over time. |
| Interest Rate | The cost of borrowing money. |
| Examples of Debt Market Interest Rates | Mortgage rates, car loan rates, and credit card rates. |
| Equity Markets | Markets where common stock is traded. |
| Common Stock | A financial security representing ownership in a firm. |
| Primary Market | The market where companies initially sell stock to raise money. |
| Secondary Market | The market where investors trade stocks with one another after initial issuance. (New York Stock Exchange [NYSE]) |
| Foreign Exchange (FX) Markets | Markets where international currencies are traded and exchange rates are determined. |
| Why Exchange Rate Fluctuations Matter | They affect travel costs, international trade, and demand for domestic goods. |
| Effect of a Strong U.S. Dollar | Foreign purchases of U.S. goods tend to decrease. |
| Importance of Financial Markets | 1) Efficient Allocation of capital within the economy 2) Improvement in the well-being of consumers |
| Direct Finance | - Borrowers borrow directly from lenders in financial markets - Sell financial instruments which are claims on borrower's future income, asset |
| Indirect Finance | - Borrowers borrow indirectly from lenders via financial intermediaries (type of financial institutions) - Issue financial instruments which are claims on borrower's future income, assets |
| Money Markets | Any transaction involving short term debt (maturity < 1 year) |
| How firms benefit from secondary markets | 1) Provides liquidity (easy to buy and sell company's securities) 2) Provide security prices (useful for company valuation) |
| Exchange Market | Trades conducted in central locations (New York Stock Exchange) |
| Over-the-Counter Markets (OTC) | Dealers at different locations buy and sell (Treasury Securities) |
| Capital Markets | Long term debt (maturity > 1 year); Equities (no maturity) |
| Internationalization of Financial Markets: Foreign Bonds | - Denominated in a foreign currency - Targeted at a foreign market |
| Internationalization of Financial Markets: Eurobonds | Denominated in one currency, but sold in a different market |
| Internationalization of Financial Markets: Eurocurrency Market | - Foreign currency deposited outside of home country - Gives borrowers an alternative source for dollars |
| Eurodollars | US dollars deposited outside US - Euro euros => euros deposited outside the EU |
| Financial Intermediary | An institution, such as a bank, that obtains funds from savers and then makes loans/invests with borrowers |
| Benefits of Financial Intermediation | 1. Reduce Transaction Costs by taking advantage of economies of scale 2. Provide Liquidity by easily connecting savers and users 3. Enable risk-sharing by bunding various assets and securities 4. Reduce information asymmetry by developing expertise |
| Adverse Selection | - Occurs before transaction - Borrower knows more about himself/herself - Lender cannot know if borrower intends to repay loan - Insurance: high-risk individuals do not disclose known conditions |
| Moral Hazard | - Occurs after transaction - Borrower can engage in immoral activities that make it more likely loan won't get paid back - Another view is a conflict of interest -- lender often bears more risk than the borrower - Insurance: people engage in risky activities only after being insured |
| Depository Institutions | Accept deposits and make loans - Examples: Commercial Banks and Savings & Loans and Credit Unions |
| Commercial Banks | - Raise funds primarily by issuing checkable, savings, and time deposits - Deposits then used to make commercial, consumer, and mortgage loans - Largest financial intermediary, have most diversified asset portfolios |
| Savings & Loans and Credit Unions | - Raise funds primarily by issuing checkable, savings, and time deposits - Deposits then used to make commercial, consumer, and mortgage loans - Issue deposits as shares that are owned collectively by depositors (typically one group such as employees) |
| Contractual Savings Institutions | Acquire funds from clients at periodic intervals on a contractual basis. Fairly predictable future payout requirements. - Examples: Life Insurance Companies, Fire and Causality Insurance Companies, and Pension and Government Retirement Funds |
| Life Insurance Companies | Receive funds from policy premiums, can invest in less liquid securities (actual benefit payouts are close to those predicted by actuarial analysis) |
| Fire and Casualty Insurance Companies | Receive funds from policy premiums, invest most in liquid government and corporate securities (loss events are harder to predict) |
| Pension and Government Retirement Funds | Receive funds through employee and employer contributions, invest in corporate securities (provide retirement via annuities) |
| Investment Intermediaries | - Examples: Finance Companies, Mutual Funds, Money Market Mutual Funds, Hedge Funds, Investment Banks |
| Finance Companies | Sell commercial paper (short term debt instruments) and issue stocks and bonds to raise fund for consumers and businesses |
| Mutual Funds | Selling shares of individual investors and use the proceeds to purchase large, diversified portfolios of stocks and bonds |
| Money Market Mutual Funds | Sell checkable deposit like shares to individual investors and use the proceeds to purchase highly liquid and safe short-term money market instruments |
| Hedge Funds | Require large investments ($100,000 or more), long holding periods, and are subject to few regulations -- funds invest across almost all asset classes |
| Investment Banks | Advise companies on securities to issue, underwriting security offerings, offer M%A assistance, and act as dealers in security markets |
| Why regulate Financial Markets?? | Increase information to Investors - Asymmetric info means investors are subject to adverse selection and moral hazard - SEC requires corporations issuing securities to publicly disclose info about their sales, assets, and earnings and restricts trading by corporate insiders - Increase efficiency of financial markets Ensure Soundness of Financial Intermediaries - Difficult for savers to assess financial soundness of institutions holding funds - Doubts about overall health of financial intermediaries can lead to withdrawal of funds, financial panic - Such panics produce large losses for the public and cause serious economic damage |
| Types of Regulation | 1) Restrictions on Entry 2) Disclosure 3) Restrictions on Assets 4) Deposit Insurance |
| Restrictions on Entry | - Tight regulations as to who is allowed to set up a financial intermediary - Must obtain a charter from state or federal government - Only upstanding citizens with impeccable credentials, and large amount of initial funds will receive a charter |
| Disclosure | - Booking must follow certain strict principles - Books are subject certain info available to the public - Must make certain info available to the public |
| Restrictions on Assets | - Investors/depositors want to know their funds are safe, financial obligations will be met - One way: restrict financial intermediaries from engaging in certain risky activities Another way: restrict financial intermediaries from holding certain risky assets, or limit how much of certain assets they can hold |
| Deposit Insurance | - Government can insure deposits in case financial fails - Federal Deposit Insurance Corporation (FDIC) insures depository institutions up to a loss of $250,000 per account - National Credit Union Share Insurance Fund (NCUSIF) insures credit unions |
| Time Value of Money | a dollar today is worth more than a dollar tomorrow |
| Why is Time Value of Money true? | 1) Risk: dollar tomorrow is not guaranteed 2) Inflation: dollar tomorrow has less purchasing power 3) Opportunity Costs: dollar today can be used for other things |
| Yield to Maturity (YTM) | Interest Rate that equates today's value with present value of all future payments - Directly related to risk - Required return demanded by investors |
| YTM -- Fixed Payment Loans | Require identical payment each period - Part of each payment goes towards interest, remaining amount reduces principal |
| YTM -- Bonds | Most corporate bonds have regular fixed payments plus future lump sum payment |
| How are Bond Prices and YTM related? | Negatively Related |
| If YTM < Coupon rate what does the bond trade at? | Bond trades at a premium |
| If YTM = Coupon rate what does the bond trade at? | Bond trades at par |
| If YTM > Coupon rate what does the bond trade at? | Bond trades at a discount |
| Current Yield = ? | Coupon / Current Bond Price |
| What is Current Yield? | Return earned only from interest |
| Nominal Interest Rate | Stated interest rate, no adjustment for changes in price levels |
| Real Rate | Interest rate that is adjusted for changes in price levels |
| Real rate = ? | Nominal Rate - Inflation rate |
| Interest Rates | Refer to the cost of borrowing money |
| Return rates | Refer to the value earned on an investment |
| Relation between Interest rates and price of bonds | Inversely related |
| Rate of Return = ? | [ (p1 - p0) / p0] + CF1 / p0 p0 = Current Bond price p1 = Future bond price CF1 = cash flow 1 |
| Reinvestment Risk | Occurs when investor holds short-term bonds over long term period |
| Securitized | Turned into something that can be traded of a financial security |
| Macaulay Duration | Measure of a loan's maturity; Weighted average that account for timing of future payments |
| Modified Duration = ? | Macaulay Duration / [ 1 + (Annual Interest Rate / # Compounding Periods)] |
| What is Modified Duration? | Reflects the change in Bond price if interest rates change by 100 basis points (1 percentage point) |
| Relationship between Modified Duration and Bond Price | - If rates increase by 100 bp, Bond price will decrease by ~ 4.8% - If rates decrease by 100 bp, Bond price will increase by ~ 4.8% |
| Asset | Resource used to generate future value |
| Factors that influence the decision to purchase an asset: | 1) Wealth: total resources owned by the individual, including all assets 2) Expected Return on one asset relative to alternative assets 3) Risk on one asset relative to other assets 4) Liquidity: ease and speed with which an asset can be turned into cash |
| Standard Deviation | Measure of risk for assets held in isolation |
| How does the Quantity Demanded respond to a change in the demand predictor: wealth? | If wealth increases, Change in Quantity Demanded increases |
| How does the Quantity Demanded respond to a change in the demand predictor: Expected Return (relative to other assets)? | If Expected Return increases, Change in Quantity Demanded increases |
| How does the Quantity Demanded respond to a change in the demand predictor: Risk (relative to other assets)? | If risk increases, Change in Quantity Demanded decreases |
| How does the Quantity Demanded respond to a change in the demand predictor: Liquidity (relative to other assets)? | If liquidity increases, Change in Quantity Demanded increases |
| How are Bond Prices and Interest Rates related to Quantity Demanded? | Bond Prices are Negatively Related Interest Rates are Positively Related |
| How are Bond Prices and Interest Rates related to Quantity supplied? | Bond Prices are Positively Related Interest Rates are Negatively Related |
| Changes in Equilibrium Interest Rate | - Movement along the curve reflects changes in Quantity Demanded or Supplied - Shift in the curve caused by change in Quantity Demanded or Supplied at every price |
| Factors that have a positive relationship with Demand | Wealth and Liquidity |
| Factors that have a negative relationship with Demand | Expected Interest Rate, Expected Inflation, and Risk |
| Factors that have a positive relationship with Supply | Profitability of Investments, Expected Inflation, and Government Deficit |
| What causes rates on the same bond to change year-to-year? | Risk Structure of Interest Rates |
| Three Keys to Risk structure of interest rates | 1) Default Risk 2) Liquidity Risk 3) Income Tax Considerations |
| Default | Bond issuer is unable (or unwilling) to make payments |
| Default Risk Premium | - Difference in interest rates of bonds with and without default risk - As default risk increases, risk premium increases |
| Are more liquid assets more or less risky? | Less risky |
| Liquidity Risk Premium | - As liquidity risk increases, risk premium increases - Another way: as liquidity increases, risk premium decreases |
| Term Structure of Interest Rates | Bonds with different maturities tend to have different required interest rates (with all else equal) |
| What must any theory of term structure of interest rates explain? | 1) Yield curve is typically upward sloping 2) Interest rates of different maturities move together 3) Yield curve is steep when short-term rates are low 4) Yield curve inverts (slopes downward) when short-term rates are high |
| Theories on Term Structure | 1) Expectations Theory 2) Market Segmentation Theory 3) Liquidity Premium Theory |
| Expectations Theory | Key Assumption: Bonds of different maturities are perfect substitutes Key Implications: Yields on bonds of different maturities are equal |
| Rate in long-term bond | Average of expected short-term rates over bond's life |
| Can Expectations Theory Explain the Term Structure of Interest Rates? | 1) No - Only occurs when short term rates are expected to rise, but they-'re just as likely to fail 2) Yes - short-term rate changes are persistent, so a rise on short term rates should increase all rates 3) Yes - if short term rates are low then long-term rates are high and slope will be steep 4) Yes - if short-term rates are high then long-term rates are low and slope with invert |
| Market Segmentation Theory | Key Assumption: Bonds of different maturities are not substitutes at all Key implication: Markets are segmented, interest rates for bonds with different maturities are determined separately |
| Can Market Segmentation Theory Explain the Term Structure of Interest Rates? | 1) Yes- Investors prefer shorter holding periods, so demand is higher for shorter bonds. Higher demand increases prices which decreases yield. 2) No 3) No 4) No |
| Liquidity Premium Theory | Key assumption: Bonds of different maturities are imperfect substitutes Key implication: Combines Expectations and Market Segmentation Theories Key modification: Investors prefer short-term rather than long-term bonds, which implies a positive liquidity premium for long-term bonds |
| Can Liquidity Premium Theory Explain the Term Structure of Interest Rates? | 1) Yes - Liquidity premium increases with maturity 2) Yes- rate changes are persistent, so a rise in short-term rates should increase all rates 3) Yes - if short-term rates are low then long-term rates are high and slope will be steep 4) Yes - if short-term rates are high then long-term rates are low and slope will invert |
| Purpose of Financial Institutions | Move funds from savers to borrowers efficiently to support a vibrant economy |
| Financial System | Structure that channels funds from savers to borrowers using institutions and markets |
| Key Question of the Financial System | How investors ensure funds are used for the most productive investments |
| Indirect Finance | Financing through financial intermediaries rather than directly from lenders |
| Direct Finance | Financing where firms raise funds directly through securities markets |
| Collateral | Assets pledged to protect lenders in debt contracts |
| Debt Contracts | Complex legal agreements restricting borrower behavior |
| Facts of Financial Structure | Issuing stocks and bonds is not the primary way in which businesses finance their operations. • Indirect finance (involving financial intermediaries) is many times more important than direct finance (where businesses raise funds directly from lenders). • Financial intermediaries (particularly banks) are the most important source of external funds used to finance businesses. • The financial system is among the most heavily regulated sectors of the economy. • Only large, well-established corporations have easy access to securities markets to finance their activities. • Collateral is a prevalent feature of debt contracts for both households and businesses. • Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers |
| Value of Financial Intermediaries | 1. Reduce Transaction Costs • Often difficult to bring borrowers and lenders together • Economies of scale, develop expertise 2. Provide Liquidity • Easier to borrow and lend at centralized location • Buying a house without financial system 3. Reduce Information Asymmetry • Borrowers and lenders typically do not have access to the same information • For example, can be hard to differentiate between honest and nefarious borrowers • Two key types we will focus on: Adverse Selection and Moral Hazard |
| Adverse Selection | 1. One party has better information than the other party 2. Before transaction occurs 3. Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected |
| Moral Hazard | 1. One party has incentive to behave differently once agreement is made 2. After transaction occurs 3. Borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back |
| Tools to Mitigate Adverse Selection | Private production and sale of information • Free-rider problem can interfere with this solution Government regulation • Annual audits of public corporations • Disclosure of "material" events Financial intermediation • Similar to a "used car dealer" • Avoids free-rider problem by making private loans |
| Moral Hazard and Equity | Principal Agent Problem • Separation of ownership of stockholders (principals) from control of managers (agents) • Managers act in own interest rather than stockholders' interests |
| Tools to mitigate Moral Hazard in debt contracts | 1. Monitoring (production of information) 2. Government Regulation (disclosures, penalties) 3. Restrictive Covenants (limits behavior during contract) 4. Financial Intermediation (specialized monitoring) |
| Conflicts of Interest | Type of moral hazard that occurs when: • Person or institution has multiple interests • Serving one interest is detrimental to the other |
| Three classic conflicts have developed in financial institutions | 1. Underwriting and Research in Investment Banking 2. Auditing and Consulting in Accounting Firms 3. Credit Assessment and Consulting in Rating Agencies |
| Underwriting and Research in Investment Banking | • Investment banks research public companies and underwrite their securities issuances • Research is expected to be unbiased and accurate – used by public to guide investment choices • Underwriters have easier time if research is positive (i.e., firm's outlook is optimistic) • Securities issued by a firm with optimistic outlook sold at higher prices • Should investment serve the interest of the issuing firm or the public? • Consider the "tech boom" of the late 1990s and early 2000s: • Research reports were clearly distorted to please issuers • Firms with no hope of ever earning a profit received favorable research • Lead to spinning – underpriced equity was allocated to executives who promised future business to the investment bank |
| Auditing and Consulting in Accounting Firms | • Auditors check firm's financial statements for quality and accuracy • Objective in an unbiased view of the firm’s financial health • Consultants (for a fee) help firms with variety of managerial, strategic, and operational projects • Institution acting as both auditor and consultant for same firm is not objective • Problem exacerbated if consulting fees exceed auditing fees • Consider the case of Arthur Andersen • Myriad of conflicts with its client Enron • When Enron collapsed, resulted in demise of Arthur Andersen • Resulted in the eventual demise of Arthur Andersen when Enron collapsed • "Big Four Accounting Firms" but used to be "Big Five" |
| Credit Assessment and Consulting in Rating Agencies | • Rating agencies assign credit rating based on projected cash flow, assets pledged, etc. • Rating helps determine security's riskiness • Consultants (for a fee) help firms with variety of managerial, strategic, and operational projects • Agency acting as both auditor and consultant for same firm is not objective • Problem exacerbated if consulting fees exceed auditing fees • Consider rating agencies like Moody's and S&P during the Financial Crisis • Firms asked agencies to help structure debt offerings to attain the highest rating possible • When debt subsequently defaulted, difficult for agencies to justify original high ratings • Perhaps it was just error… • …but most believe rating agencies were blinded by high consulting fees |
| Remedies for Conflicts of Interest | Sarbanes-Oxley Act of 2002 • Established oversight board to supervise accounting firms • Increased SEC’s budget for supervisory activities • Limited consulting relationships between auditors and firms • Enhanced criminal charges for obstruction • Improved quality of financial statements and board of directors Global Legal Settlement of 2002 • Requires investment banks to sever links between research and underwriting • Explicitly banned spinning • Imposed $1.4 billion fine on accused investment banks • Added additional requirements to ensure independence and objectivity of research reports Dodd-Frank Act of 2010 • Volcker Rule limits proprietary trading of banks |